With Japan's unemployment at the highest level on record, it makes it all the more urgent for the government to change policies that inhibit long-term investment. The first step would involve fixing the financial system whereby ailing banks are recapitalized so they can increase the supply of credit. Only when there is sustainable growth can durable employment opportunities be provided.
There are several painful truths about Japan's economy. It remains plagued by structural inefficiencies and the banking system is near collapse. This means that it is not inadequate demand that holds the economy back from recovery.
It may be a good thing that the Japanese government has finally acquiesced to a request by the International Monetary Fund (IMF) to examine domestic banks. Due to a different way of measuring nonperforming loans (NPLs), the IMF estimates that Japan's NPLs are as much as five times larger than Tokyo's. Overall economic stability and the capacity to attain a sustained recovery depend upon the condition of the financial system.
A consensus has finally formed that recognizes that Japan's economic problems cannot be resolved without bank reform to sort out the mountain of bad debts. Japan's banks must clear their books of bad loans before significant growth can return. Despite having carried out over ?70 trillion in write-offs since 1992, Japanese banks still show new and growing bad loans.
According to the Financial Services Authority, Japan's banks have ?31,800 billion (US$265 billion) of bad loans. This amount increases to ?140,900 billion or nearly a quarter of gross domestic product by adding in risky debts that could turn bad.
It is also important that they be forced to come clean. Uncertainty over the mess in the banking system interferes with making spending forecasts. Consumer demand and business investment will remain on hold if there is no clear idea on how bad the financial problems really are. There should be full disclosure and banks need to hasten to write off bad loans.
Following experience elsewhere, it is possible that about half of this can be collected. That means that aggregate losses for the banking system will be at least US$300 billion. These amounts equal or exceed the entire current-capital and provisions for loan losses and would be over four times the proportion of GDP required to clean up the US savings and loan problems of the 1980s.
At the end of the 1980s, a raft of bad loans the US financial sector were disposed of through the Resolution Trust Corporation (RTC). It took over the assets of failing financial institutions using Treasury funds of about US$60 billion. The approach relied upon a process for securitizing bad loans and real estate holdings.
It is not that nothing has been done to sort out Japan'a banks. It is just too little has been done and more progress must be made before it is too late.
One of the first steps was taken in 1999 when the government gave US$50 billion to the largest banks to replenish their capital-adequacy ratios to meet the minimum 8 percent threshold. At the same time, Tokyo topped up the deposit insurance fund and forced smaller lenders to shut down or merge.
Meanwhile, the Resolution & Collection Corporation (RCC) has spent US$8 billion purchasing bad loans at an average 4 percent of their face value since 1999. And the backs have set aside almost US$50 billion in reserves against bad debts.
In fact, Japanese banks have healthy earnings Operating profits from trading and fees bring in about US$25 billion a year. However, since they are also holding devalued real estate or shares as collateral, they lack the capital and earning power to handle aggressive write-offs. At current levels of the benchmark Nikkei index, Japanese lenders have US$15 billion of unrealized losses from shareholdings.
So, steps must be taken quickly to resolve the nonperforming loans that hang like an albatross around the economy. Bad debt and real estate held as collateral must be removed from the banks to be resolved outside the system. For example, debt-equity swaps can be used to convert nonperforming loans into shares of stock from the debtor. This removes a financial burden to the borrower who no longer has to pay interest.
But the disposal of bad debts will sharply undermine the banks' capital base. Unless insolvent institutions are recapitalized with real capital, bad loans will continue to rise. If the key to economic recovery is effective bank reform, then it all hinges upon recapitalization.
It turns out that there are limited options for recapitalization. Of course, the banks could provide their own new capital. The banks insist that business profits can cover the cost of resolving bad loans. However, there is another ?151 billion yen of potentially risky loans waiting to raise their ugly heads. After years of being unprofitable, the Japanese banking system does not have sufficient capital to sort out its own problems.
Alternatively, the government could commit more public funds, but it has pledged not to. To do so would only lead to an increase in public-sector debt. As it is, the Institute of American Enterprise in Tokyo estimates that Japan's national debt is now nearly 18 percent of global GDP. Direct debt held by the government at the end of March this year was 146 percent of GDP. As it is, 65 percent of central government tax receipts are used to service this debt, while long-term debt exceeds revenue by a factor of more than 15.
Or the Japanese corporate sector could be the source of new capital. But this would simply return to the days of business-as-usual and reopen the Pandora's box of cross-shareholding that lies at the heart of the ongoing difficulties.
It appears that the best solution is to allow greater involvement of foreign financial institutions. Not only would they make fresh capital available to the Japanese economy, they would bring in new lending and risk-management practices. They would also transfer new technology and introduce best corporate governance practices.
Several other steps could be taken to assist banks in disposing of their shareholdings and real estate. They include lowering or abolishing taxes for registration and the sale of real estate ought would reduce the transaction's costs. Commissions charged by brokerage houses could be lowered. Presently, they are between 3.5 and 4.5 percent of total investment in stock investment trusts.
A reduction in capital gains from sales of stocks should also be considered. A rate of 26 percent must be paid when listed separately from other income on tax returns. Buying shares is less attractive since holding deposits and savings are taxed at only 20 percent. And investors are not able to carry over losses from stock transactions in one fiscal year to another as a way of receiving an exemption or reduction in tax liability.
As long as bad investments remain, they will continue crowding investments that could create more jobs and wealth. Let's hope that policymakers in Tokyo can focus their minds on what must and can be done, and do it quickly.
Christopher Lingle is global strategist for eConoLytics.com.
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