For years now, the Bank of Japan has averted a crisis in the world's second-biggest economy with cheap money. So cheap, in fact, that many banks and companies couldn't have survived without it.
How can Japan wean its economy off ultra-low interest rates once and for all? Raise them dramatically, of course.
It's what Goldman Sachs (Japan) Ltd Managing Director David Atkinson calls the "5 percent solution" to what ails Japan. Raising rates to 5 percent or 6 percent for a year would force hopeless companies into bankruptcy rather than wait for a bailout.
"With rates so low, companies can be in the red for a very long time without going bust," Atkinson says. Because the average company is paying just over 2 percent interest on loans, businesses that don't have a prayer of paying back the principal are still considered sound.
That's the beauty of this tough-love solution: It forces change.
It's highly doubtful the BoJ would even consider it now. After all, central bank Governor Masaru Hayami was vilified as the global village idiot for daring to raise rates from close to zero to 0.25 percent a little over a year ago. Hayami's bold move was meant to spook Japan's public and private sectors into implementing structural reforms. It didn't work -- he returned rates to zero in March.
Maybe the BoJ should rethink the strategy. The bank's mistake wasn't raising rates, but boosting them too little and giving up too quickly. Hayami admits the BoJ's ``super-easy" stance is allowing companies to delay needed restructuring and undermining the role of markets in setting risk premiums. Japan's debt is a third larger than the economy and bond yields are an impossibly low 1.40 percent.
Ultra-low interest rates help Japan hide the true magnitude of its bad-loan problem. Atkinson estimates non-performing loans to be about 50 percent more than the Yn151 trillion (US$1.26 trillion) the government's Financial Services Agency says. Atkinson's examination of debt and operating profit of 2,823 publicly traded companies puts bad loans at an eye-popping Yn237 trillion.
The main reason asset quality in Japan isn't properly reflected is because nominal interest rates are so low. Companies can pretend to be sound because borrowing costs are negligible enough for them to make interest payments out of cash flows. Companies can be underwater but survive for years, so long as they can report an operating profit, or at least hold operating losses to a minimum.
All this leaves executives with little urgency to restructure.
Since they're propped-up by low rate loans, companies only have to cut costs enough to minimize losses, or preferably report just enough operating profit to cover the interest expense. "The low level of interest rates and the postponing of pain that it has allowed help to create a self-regulating, low-growth environment," Atkinson says.
A large number of Japanese companies are close to the edge. If borrowing costs rise or Japan's credit rating is downgraded, many companies couldn't afford the extra interest expense. Many would go bust.
It's at that point that things really get bad. Headlines about massive job losses at companies like Fujitsu Ltd, which is shedding 5,000 workers in Japan, may undermine consumer spending and send the economy even lower. Standard & Poor's this week had to deny reports it was lowering Japan's "AA+" credit rating amid fears mounting bad debts would destabilize the economy. The mere fact investors took the reports seriously speaks volumes about the economy's situation.
In the long run, however, trying the "5 percent solution" may be what Japan needs. Prime Minister Junichiro Koizumi seems sincere in his pledge to trim spending and enact the painful reforms from which his predecessors ran. Yet Tokyo can't even come clean about the magnitude of its bad-loan problem. That said, how seriously should we take Koizumi's efforts? If it's true that the first step toward fixing any problem is an honest appraisal of it, Japan isn't close to tackling its troubles.
With every week and ratcheting down of economic growth, the bad-loan problem worsens. It's increasingly spreading beyond the real estate, construction and retail industries that have long been the economy's biggest deadbeats. Manufacturers are hurting too.
The government's emphasis on supporting the weakest companies is undermining healthy ones. In most economies, officials' are guided by a kind of financial Darwinism; the weakest companies should be driven out by the strongest. Tokyo's approach has been to offer subsidies and low borrowing costs to ensure the fragile survive.
Yet the very fact that rates are at zero and Japan is still trapped in deflation demonstrates that cheap money isn't helping the economy recover, but merely holding it together. The BoJ knows ``that unless this is accompanied by concerted progress on structural reform, including a resolution of Japan's bad loans, then additional monetary relaxation is unlikely to make much of an impact,'' says Takashi Yamanaka, an economist at Sanwa Bank Ltd.
Raising rates to 5 percent or 6 percent would be harsh medicine, indeed. But it would do something nothing has for 11 years now: Shake Japan's policymakers out of denial.
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