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Will "Convoy Capitalism" Sink Japan?

Zero interest rates may be causing more harm than good.

When the Bank of Japan (BOJ) decided in September to end its zero interest-rate policy, it came under enormous public pressure from the Ministry of Finance (MOF) and the ruling Liberal-Democratic Party (LDP). This dispute was not about the difference between zero percent and the recently raised 0.25 percent overnight loans. What is really at stake is whether Japan will finally rid itself of its notorious "convoy capitalism" or whether the BOJ will be forced to keep pumping out nearly cost-free loans to keep "zombie" banks and borrowers alive.

What is convoy capitalism? Just as no ship in a convoy can go faster than the slowest boat, Japan's economy bleeds the most efficient companies to support the dying ones. In the past, this was done mostly in covert fashion. The high prices that Toyota pays for glass, steel, and electricity are disguised subsidies for Japan's inefficient sectors. But in recent years the cost of keeping the convoy intact -- by preserving the survival of the least fit -- has become so high that the transfer of resources from the fittest companies to the weakest has come into public view. The government has transferred hundreds of billions of dollars to Japan's banks to prop up their weakest borrowers. The funds have come from individual and business taxpayers and savers, who have received virtually no interest, even on long-term deposits.

The recent saga of the Sogo department store chain epitomizes the syndrome. The banks and the government agreed to forgive an astonishing US$6 billion worth of Sogo debt to keep the company solvent. For the sake of one firm, the banks were prepared to eat up one-twelfth of the US$72 billion capital injection that Tokyo pumped into the major banks last spring. Only a loud public uproar over a direct transfer of funds from the Deposit Insurance Corp. to Sogo forced a retreat. Sogo ended up failing with US$ 18 billion in liabilities, one of the largest non-bank failures in Japanese history.

Since Sogo's failure, two giant life insurance firms have failed, one with US$40 billion in liabilities. A number of large construction firms have avoided bankruptcy only because of debt forgiveness by the banks, totaling about US$ 18 billion.

No wonder so many banking experts now believe that the banks will have to return to the public trough for more capital within a year or two.

Near-zero interest rates have become an essential component of convoy capitalism. As former Citicorp Chairman John Reed explained in a recent speech to the New York Japan Society, the interest rate is the cost of time. If banks have to pay their depositors, say, 3 or 4 percent, they know they cannot generate the cash from non-performing loans. They have to get rid of the dead wood on their books, foreclose on deadbeats, and generate whatever cash they can from the sale of assets -- even it's only twenty cents on the dollar. However, if banks can get away with paying their depositors 0.2 percent for ten-year large-denomination deposits, then where is their incentive to get bad loans off their books?

Is it any wonder that since the spring of 1999, when zero interest rates debuted and taxpayer funds began pouring into the banks, progress in reducing bad debt has stopped dead in its tracks? In fiscal 1999, which ended March 2000, the mountain of non-performing loans increased 3 percent to US$280 billion (30.4 trillion yen), while healthy loans fell by US$200 billion (22.1 trillion yen). In addition to their non-performing loans, the banks have another US$560 billion (60.5 trillion yen) in "Category 2" loans, which are performing but dubious. That is the same amount of Category 2 loans they were carrying a year earlier. Japanese regulators estimate that 20 percent of these loans are likely to go under. Reportedly, many of Sogo's bankers considered its loans to the company as Category 2.

The banks took less action in fiscal 1999 -- after being bailed out -- than the year before, when they were in more dire straits. In fiscal 1998, the banks disposed of US$126 billion (13.6 trillion yen) in bad debt, either through write-offs or through loan loss reserves. But in fiscal 1999, debt disposals shrank in half to US$62 billion (6.9 trillion yen). The outstanding bad debt failed to decline because new bad debts cropped up as fast as old ones were paid off.

The case of near-bankrupt Kumagai Gumi construction firm is another illustration of how bad debts mount under a zero interest-rate policy. Kumagai Gumi cannot even generate enough cash to pay the interest on its loans. Yet it is kept on artificial life support by its main bank, Sumitomo, which is lending it money to pay the interest. Far from using the breathing space to reform, Kumagai actually increased its debt load by US$1.3 billion over the past year, bringing it to US$10 billion. Yet Sumitomo is organizing a debt forgiveness program by Kumagai's banks. After all, if Sumitomo can get all the money it wants at zero cost, why not help out an old friend?

One reason for the banks' largesse to their bad borrowers is pressure from the LDP, which insisted that the banks end the so-called "credit crunch" in exchange for the 7.5 trillion yen (US$70 billion) injection of government money into the banks.

Not only has the government channeled money to zombie borrowers via the banks, it has done so directly via assorted credit guarantee programs. The government now provides US$460 billion (50 trillion yen) in credit guarantees to small and medium firms that can't get loans on their own. That's more than 10 percent of GDP. Last May, 353 firms with credit guarantees went bust, leaving debts of US$ 1.4 billion (152 billion yen). Since a special credit guarantee program was initiated in the fall of 1998, more than 3,300 guaranteed firms have failed. Last April and May, local and regional credit guarantee associations had to help more than 13,000 borrowers unable to pay interest costs, a 40 percent increase from the year before. As a result, Tokyo has had to cough up US$14 billion (1.5 trillion yen) from state coffers to replenish association funds and help finance insurance payouts from Japan Small and Medium Enterprise Corp.

Neither the banks' nor the government's bailout of zombie firms would be possible with lots of near-free money created by the BOJ. Now, says the BOJ, it is time to separate the healthy firms from the zombies. Otherwise, Japan cannot recover.

In the eyes of the BOJ, an end to zero interest rates is critical to reintroducing credit risk into Japan's economy by forcing banks to cut off credit to the unworthy. As one BOJ official put it in private, "These firms are already dead. The question is when the banks will recognize it."

Since the Sogo collapse and the BOJ's announcement of its intention to end the zero interest-rate policy soon, the bond market has begun to increase interest rate spreads between BBB firms and AAA firms. Even A-rated banks have had to pay a bit more in credit risk on their bonds. From the BOJ's standpoint, this is all for the good.

When Japan was in a state of emergency in 1998 and early 1999, and facing a potential financial meltdown, zero interest rates were clearly necessary. The BOJ did what was necessary to prevent a deflationary spiral. As BOJ officials define it, a deflationary spiral is more than just falling prices; it is a crisis in which price deflation and shrinking demand keep feeding each other. A shrinking economy causes prices to drop. That makes it harder for firms and consumers to pay their debts, which rise as a percentage of declining nominal income. To raise cash, firms invest less and sell assets such as buildings, while consumers buy less. This causes prices to drop even more, feeding another round of the cycle. The Great Depression in the 1930's was a classic example.

If preventing a financial meltdown meant keeping lots of moribund firms alive, that was a price the BOJ was prepared to pay--and rightly so. But those emergency days have passed. True, by some measures, such as the GDP deflator, prices are still falling at a 1 to 2 percent annual rate. However, prices are a lagging indicator. Today's deflation reflects the big GDP drop of 1998. If today's recovery continues, deflation should end in 2001.

It is possible that Japan might once again be faced with a banking crisis. If so, the cause would not be deflation or the end of zero interest rates, but rather the fact that Japan refuses to clean up its bad debts.

The bottom line: The costs of a zero interest-rate policy have begun to outweigh any remaining benefits. The BOJ has no intention of replacing this policy with tight money. Officials say the bank intends to bring the overnight call rate to 0.25 percent and keep it there for a year or two.

Why, then, is there so much opposition to ending zero interest rates? The motivation of the ruling LDP, the MOF, and the banks is clear. They want to preserve convoy capitalism for the sake of their clients in the business world, particularly the construction firms that employ 10 percent of Japan's workers and provide much of the legal and illegal funds for the LDP. Given the recent arrest of a former construction minister for accepting bribes, one must be skeptical of statements that appear to express more respectable motivations. One must also be skeptical of their attempts to discredit the BOJ by claiming that its only motivation is "turf warfare," an attempt to establish its newly won independence. Whether one agrees with the BOJ or not, conversations with bank officials make clear that their motivations are sincere.

There are better arguments for keeping zero interest rates. One of the strongest arguments--shared by the U.S. Treasury-is the uncertainty of Japan's economic recovery. Despite all the positive indicators, no one can say for sure that the recovery is able to continue without continued massive fiscal and monetary stimulus. Why risk making the same mistake via premature interest rate hikes that the MOF made via premature tax hikes in 19977 The astonishing thing is that, a year-and-a-half after an expansion supposedly had begun, and with budget deficits still at 10 percent of GDP, analysts question whether the recovery can survive if interest rates go to a very minimal 0.25 percent. That begs the question of why such massive macroeconomic stimulus, which has pulled most other countries out of slumps, has failed to work in Japan. In part, "convoy capitalism" is the culprit. Throwing good money after bad drains macroeconomic stimulus of much of its power.

Some critics say the BOJ has no business trying to provide incentives for structural reform. That is not the job of a central bank. Moreover, the attempt will prove futile, they say. Indeed, if it oversteps its bounds, the government may take back the independence it granted the BOJ just a short time ago. Others argue the truism that, in macroeconomics, one cannot kill two birds with one stone. Efforts by the BOJ to target structural reform automatically imply a trade-off, a limit in its ability to promote nominal GDP growth.

Surely the BOJ can decide whether it wishes to act as an enabler for convoy capitalism by providing tons of funny money. The BOJ has no power to stop the LDP and the banks from doing whatever they want. But, without a zero interest-rate policy, bailout costs will be more transparent and the public can make an informed decision as to how their taxes should be spent. The Sogo affair indicates what that decision is likely to be.

Richard Katz is Senior Editor of The Oriental Economist Report. This article was adapted and updated from the lead story in the August 2000 issue.
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Author:Katz, Richard
Publication:The International Economy
Geographic Code:9JAPA
Date:Nov 1, 2000
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