Global Intelligence Update
Red Alert
October 19, 1998
U.S. and Japan Near Showdown Over Financial Restructuring
Asia and the international financial system that was established
after World War II at Bretton Woods are both approaching a
defining moment. When we speak of the fate of Bretton Woods, we
need to be a bit more precise, because Asia in general and Japan
in particular have never been completely part of that system. In
effect, the system created after World War II was only partially
a free trade system. It was a general free trade regime within
which individual countries were able to create islands of
activity protected from free competition. Japan in particular
took full advantage of these non-market protections. They
benefitted from them and are now suffering from them. The United
States also took advantage of these protections, but to a much
lesser degree. The United States suffered from exposure to
market forces and now benefits from them.
Most important, the United States exposed its capital markets to
global market forces, while Japan protected its capital markets.
The Japanese financial meltdown is a direct result of its
protected capital markets. Japan is now struggling with the
question of how to respond to the failure of its financial
strategy. The United States is pressing it in the direction of
massive trade and capital liberalization. The Japanese are
resisting and are searching for alternatives. This debate
between Washington and Tokyo is coming to a head. The outcome
will define international relations for a generation.
* The Japanese Banking Crisis
The Asian banking system has, in effect and on the whole, gone
bankrupt. This particularly applies to the banking system of the
world's second largest national economy: Japan. Thus, the
question facing the world is how to refloat the Japanese banking
system, on the reasonable theory that unless Japan's banking
problems are solved, Asia's cannot be solved, and once Japan's
banking problems are solved, Asia's will be solved. Thus, the
Asian question has boiled down to the question of Japanese banks.
Japanese banks are bankrupt because they have issued far too many
bad loans. No one knows for certain what percentage of
outstanding loans are non-performing, but it doesn't really
matter that much anymore. It is clear that, whatever the number,
most major Japanese banks would be bankrupt if they were forced
to write these loans off at one time. So how can Japan manage
the accounting of the bad loans without shutting down its major
financial institutions?
First, how did Japan get into this situation? Essentially,
decisions on loans were not made on market considerations in
Japan. Neither the cost of money nor lending decisions were
based on free market processes. Historically, the cost of money
to Japanese corporations was kept artificially low by government
policy and informal banking arrangements. This gave Japanese
companies a tremendous competitive advantage over non-Japanese
companies in the short run. In the long run, it allowed Japanese
companies to develop massive inefficiencies. Where U.S.
companies had to go through a period of wrenching downsizing
driven by high interest rates, Japanese companies could cover up
inefficiencies by borrowing cheap money. The decision to lend
money was not made on the basis of calculations of rates of
return on investment. Rather, the primary calculation was the
ability to repay a loan at extremely low interest rates.
The assumption was that the differential in interest rates
between Japan and the rest of the world would allow Japanese
goods to be exported at lower prices than domestic production in,
for example, the United States. In addition, since Japanese
manufacturing facilities were newer than American facilities,
Japanese products were both lower priced and of better quality
than American goods. There was no question to the banks that an
export driven company would be able to repay the loans, because
of their artificial advantage.
As a result, Japanese banks wound up with portfolios of
economically irrational loans. Most important, companies that
were financing their development on loans rather than on raising
equity became indifferent to profitability. We will all recall
speeches made by Japanese businessmen on how Americans were too
concerned with short-term profits and how they should be more
far-seeing like the Japanese. Well, underneath the rhetoric,
what was really going on was that the Americans were disciplining
themselves by measuring performance against profits while the
Japanese, and the rest of Asia, were maintaining market share and
cash flow, but not profitability. This indifference to profits
meant not only that the Japanese were making irrational
investments, unjustified by the rate of return, but that they
were not building up capital reserves against downturns. Rather,
they depended on inflated savings rates that were borrowed at
absurdly low interest rates and used to maintain operations and
make imprudent investments. The net result: the Japanese are
broke.
This is the critical point. Asia has never really been part of
the free trade system because their capital markets have never
been fully integrated with the global capital market. The
dramatic split between domestic Japanese interest rates and
lending criteria and rates and criteria in the United States and
Europe is what drove Japan and Asia to their triumph in the 1980s
and 1990s. It also drove Japan and Asia to their current crisis.
* The Great Debate
The American solution to Japan's crisis is simple: Japan should
let market forces restructure Japan's economy. The United States
experienced double-digit interest rates, inflation rates, and
unemployment rates during the 1970s. In response, Americans
ripped apart the American economy during the 1980s in what was
called, at the time, slash and burn capitalism. The brutal
experience of the 1970s, coupled with high interest rates, drove
U.S. business to reinvent itself in a miserable, generational
experience that has scarred American society deeply, even as it
created an era of unprecedented prosperity. This is what the
United States is recommending to Japan.
Japan desperately wants to avoid this path. Were Japan to open
up its capital markets, Japanese interest rates would go through
the roof. True, Japanese interest rates are low today, but that
is meaningless as, on the whole, Japanese banks can't meet demand
at those rates. Loans are being made politically rather then
economically. If foreign banks came in with sufficient cash to
meet real demand, interest rates would soar. By world standards,
many Japanese businesses are simply not credit worthy. Others
can borrow, but only at junk-bond rates. Most businesses would
have to restructure operations to qualify for loans.
There would be two consequences. First, the current management
of much of Japan, Inc. would be fired as a requirement for
foreign lending. Many Japanese companies would be maneuvered
into mergers and buyouts with U.S. and European firms. The
Japanese elite would undergo a greater transformation than had
occurred after World War II. At the other end of society,
unemployment in Japan would soar. Japanese businesses are still
bloated with superfluous employees and are still engaged in
businesses that they have no business being in. Japanese
business is still tilted heavily toward manufacturing rather than
toward service. The Japanese are great at building low profit
margin printers, but are weak at producing high profit margin
software consultancies.
Thus, if Japan's capital markets were simply opened to market
forces, Japan would undergo an unprecedented social upheaval.
The Japanese are not going to permit this to happen. We must
remember that Japan is the only advanced industrialized country
in the world to have never been touched by a social revolution.
Even defeat and occupation in World War II was managed without
social collapse. The American demand is for social collapse and
reconstruction. This will not happen.
This means that Japan will not be able to recapitalize its
economy with foreign money. Its other strategy is to export its
way out of trouble, by generating cash flow from profitless
sales. But Asia isn't buying and the United States is making it
clear that it won't allow it. One of the consequences of recent
rate cuts in the United States is that it drove the yen up
against the dollar. This increased the price of Japanese exports
in the United States, decreasing Japan's ability to generate a
surplus without selling goods at an outright loss.
The United States has made three things clear. First, the U.S.
is going to use its interest rate policy to solve American
problems, not Japanese problems. Second, funds given the IMF,
which are wholly insufficient anyway, will not be forthcoming
until the Japanese move to solve their banking problems. Third,
the United States, through the IMF, will battle against non-
market solutions to Asia's problems. The U.S. has placed Japan
in an impossible position. If Japan acquiesces to American
demands, the result will be social chaos. If it resists American
demands it will have to solve the problem on its own.
This is why the Japanese have simply not been able to devise an
effective strategy. What they want is a return to the status quo
ante, in which they could selectively participate in the global
market while protecting strategic areas of their own market from
those forces. A continuation of that policy now means that
meaningful international help for their banks is not going to
materialize. Therefore, the Japanese must devise a plan that
will maintain the status quo ante without recourse to U.S. and
European support.
* The Emerging Japanese Solution
Japan is not going to be able to refloat its banks with dollars.
It must find a solution in which the Japanese government
recapitalizes its banks with yen. Doing this would have two
advantages. It would stabilize the banks on paper while
weakening the yen substantially. That would increase the
competitiveness of Japanese exports to the United States and
generate an inflow of dollars. It would also allow the Bank of
Japan to maintain low interest rates, keeping marginal Japanese
enterprises in business. From the Japanese point of view, this
is a great solution and the one they seem to be pursuing. There
are two weaknesses in the strategy. First, it would infuriate
the United States by creating a massive imbalance of trade.
Second, and more important, capital would flee Japan, as the
combination of a weak yen and low interest rates caused a
financial hemorrhage.
Therefore, there is a final element to this plan: currency
controls. This would place legal controls on the ability to take
yen, dollars and other currency out of the country. Japan had
such controls in the past and knows how to administer them. If
this were done, then the yen-based refloating of Japan's banks
could take place without capital flight. The Japanese economic
organization Keidanren, which speaks authoritatively on economic
policy, last week endorsed Malaysian currency controls.
Malaysia's Prime Minister is currently in Tokyo, the honored
guest of the Japanese government in spite of the fact that street
demonstrations are raging in Kuala Lumpur. Japan has clearly and
publicly endorsed Malaysia's currency controls.
We believe that Japan will also impose currency controls as part
of its bank recapitalization scheme. It will solve the capital
flight problem but not Japan's American problem. Washington will
still be exposed to an export surge. The Japanese solution will
be designed to stave off social tension and protect Japanese
society from the ravages of the international capital markets,
and of the consequences of their own economic decisions. It will
take care of Japan's problems, leaving the United States as the
only victim, soaking up Japanese exports while currency controls
limit imports from the United States.
The U.S. will counter with protectionist measures. Asia will be
trapped between its hunger for U.S. markets and its fear of U.S.
solutions. A struggle for the hearts and minds of Asia will
ensue and a new geography of Asia will unfold. Singapore is in
the American camp along with the Philippines. Both oppose
currency controls. Malaysia will be in Japan's camp. Indonesia
is officially opposed to currency controls, but that is a weak
commitment. China has always had currency controls. Korea's
position is unclear. Each Asian nation will have to define its
foreign policy in these terms.
At this moment, a low-grade Cold War is already underway in Asian
capitals over the issue of capital controls. There is less and
less commonality between the American solution to Asia's problems
and the Japanese solution. America has an economic solution at a
social cost Japan will not pay. Japan has an administrative
solution in mind at a price that America will not pay. Whatever
happens, we think that Bretton Woods is in its death throes. The
world will look very different in a year from the way it looks
now. The U.S.-Japanese confrontation will continue for a very
long time.
We do not see a way out of this. Unless the United States is
prepared to underwrite the recapitalization of Japanese banks
without demanding a major restructuring of the Japanese economy,
the Japanese must solve the problem themselves. The U.S. will
not solve Japan's problems. In turn, Japan will not permit an
economic solution that creates social chaos. If these two
premises are accepted, and they seem obvious to us, then we do
not see how a political upheaval in Asia can be avoided.
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