Japan: Hope, Despair, and Signposts [EDIT: and Japan will continue to do its duty and export money]
morganstanley.com
Robert Alan Feldman (Tokyo)
The cabinet changes in Japan present a new set of opportunities for investors in Japan. The degree of progress can be measured in a framework with one axis for the speed of financial sector reform and one axis for the speed of disposal process. The course of the economy through this grid will depend on how politics and bureaucratic discipline evolve. In my view, the new cabinet has started Japan on the road to fast reform in both areas, but most investors remain skeptical. Thus, there is a need for signposts.
Issues on Financial Reform
The first issue concerning financial reform is that of loan classification. Heretofore, Financial Services Agency (FSA) inspections have resulted in inadequate loan classifications, as demonstrated by the need to tighten of criteria every year. These problems have arisen from a number of the criteria used for loan classification, but the most important are (i) the use of interest payment arrears as the central determinant of loan quality, and (ii) the use of historical bankruptcy patterns to predict future events. The first criterion is inadequate because of the inordinately low level of interest rates. The second is inadequate because changes in the environment make history less reliable as a guide to the likelihood of bankruptcy. The criteria for loan classification are now under reconsideration in the special committee organized by Minister Takenaka at the FSA. Should more stringent criteria be adopted and applied uniformly across banks and borrowers, then investors can conclude that Japan is speeding reform.
In addition, the FSA has been criticized widely (e.g., by the IMF) for definitions of capital that are too loose, in areas such as generous treatment (compared to other countries) of tax-loss carry-forwards in core capital, of subordinated debentures and public capital injections. Furthermore, Minister Takenaka has stressed that bank profitability remains inadequate, and has suggested introduction of RoA and RoE targets. The prompt corrective action rules could also be reviewed. Finally, there will be a fierce debate on methodology for capital injection, particularly under whether injections would merely dilute current equity holders, or would actually force them to surrender ownership. The faster the FSA moves on these issues, the more likely a successful reform process.
Issues Related to Disposal
Among the many issues related to disposal, the first is whether the Resolution and Collection Corporation (RCC) will be used as a vehicle for capital injection into weak financial institutions or a vehicle for disposal of bad assets. The former role would result in the RCC becoming a pickling factory for bad assets. Should the RCC become a vehicle for disposal, then a whole new structure for the RCC would be needed. The first need would be for a method to decide -- quickly! -- which of the bad assets have viable economic futures and which do not. The second need would be for quick sale of the assets to private interests; a key bottleneck here is finding managers capable of reviving the good parts of bad companies.
The second set of issues related to the RCC concerns regulations and business practices. For example, the requirement that fully licensed lawyers handle certain parts of transactions has combined with the very small number of lawyers to create a huge bottleneck. The bottleneck will be even tighter should a flood of transactions result from any reorganization of the RCC. In addition, land use rules remain complex and their administration archaic. The tax system constitutes a barrier in a number of ways, such as the existence of a significant land transfer tax. Moreover, the complexity of taxation of land income and of financial products dealing in land (e.g., J-REITS) makes many investors reluctant to participate. Tenant rights can be a problem in land transactions as well; in some cases, there has been trouble with illegal squatters seeking payment for agreement to move. Finally, the RCC remains far too small, relative to the size of the problem.
Issues of Political and Bureaucratic Discipline
There remain powerful elements in the political world and in the bureaucracy that oppose PM Koizumi’s new, more aggressive approach to the bad loan/bad borrower problem. They can be expected to retaliate against him for taking recent moves. This retaliation will likely take several forms, including emphasis of the negative aspects of restructuring through the media, mud-slinging at those pushing the reform process, disruptive debate on issues in foreign relations such as North Korea and Iraq, and sabotage of attempts to drive legislation through the Diet. Of course, PM Koizumi will retaliate against the retaliation. The problem is that a messy battle with anti-reform forces in the Diet and in the bureaucracy will slow down the process of reform at the FSA and the RCC.
The economic debate has already begun to focus on the deflationary and recessionary consequences of rapid bad loan/bad borrower disposal. One major thread of debate is tax cuts. Already, the Koizumi government has been pushing for tax cuts, and the likelihood of a larger (e.g., ¥2.5 trillion) cut is rising. In addition, topping up the unemployment insurance fund (which is nearly out of funds) will likely be necessary.
Scenarios for Investors
The outlook for Japanese markets depends on how rapidly reform moves at the FSA and the RCC. The speed will in turn be affected by the amount of discipline that PM Koizumi can impose on the Diet and on the bureaucracy. There are four potential combinations of fast/slow on the two axes. Until the cabinet change, the combination was "slow at the FSA, slow at the RCC." Things could now change.
At the moment, Minister Takenaka is trying to accelerate reform of the FSA, and thus trying to move from slow/slow at least to fast/slow. However, full success for Takenaka can only come if the changes at the FSA are successful and are also followed by changes at the RCC.
Hope, Despair, and Signposts
My view is that, despite mudslinging and roadblocks erected by both political and anti-reform bureaucratic forces, both FSA and RCC reform will proceed far more quickly under the new Cabinet. Investors, however, remain to be convinced. In this sense, the equity market has not so much said that it dislikes the new policies as that it does not believe that all will be implemented. A half-hearted FSA reform with no RCC reform would only repeat the bitter experiences of the past. The markets are in effect saying, "If you are going to do this, do it thoroughly and completely."
Should the personnel at the FSA and the RCC come into line with the philosophical unity in the Cabinet, the road to reform will be easier. If not, then investors will be disappointed. If anti-reform forces retire from the Diet, the same will be true. If the Democratic Party breaks up in the wake of their recent internal struggles, then PM Koizumi will have new potential allies in the quest for reform. If not, the fight within the LDP will only deepen. If the upcoming anti-deflation package convinces the country that support for the unemployed will be sufficient during the workout period, then implementing structural reforms will be easier. If not, then popular support might turn against the PM. Investors will watch these signposts with great interest. |
