As the Golden Age of Japan Inc. comes to a dangerous end, a nervous world is suggesting remedies for the country’s economic recovery in the hope that a sustained crash of the Japanese market can be averted. At stake is not only the prosperity of Japan, but the stability of the euphoric European and American markets, all uncomfortably linked across a borderless globe.

Japan’s major partners in the Group of Seven industrialized nations have demanded a quick fix in the form of economic stimulus or fiscal policy. Historically, such measures have meant that fundamental problems are momentarily forced into hiding—where they tend to grow. Without a proper understanding of underlying conditions, these kinds of remedies are at best a palliative, and at worst could hasten the decline they are supposed to prevent.

The United States, in particular, has asked that the Japanese stimulate their economy with aggressive spending on public works and a simultaneous "permanent’ tax cut. One ought not to forget that in the past five years, Japan has spent $600 billion on public works, in addition to its annual budget appropriations. Nor should we overlook the recent $215 billion packages to bail out failing financial institutions and write off bad debts. Regardless of the fact that these steps are clearly not sufficient in themselves, senior American officials, from the president on down, are pushing the stimulus program as "the best prescription for Japan," a notion shared by Wall Street and the newly prosperous American army of 401(k) holders who fear that careless Asians could puncture their high-flying financial balloon.

This gloomy picture would look somewhat better if Japan had a political leader with the intelligence to grasp the problems at hand, the courage to explain them to the Japanese and their edgy partners, and the energy to work for a consensual solution. Unfortunately, I see no such person.

There are five problem areas that could lead—singly or in concert—to the crash of the Japanese market.

Today’s reality is that the Nlkkei stock index is at 37 percent of its peak of the 1980s. Tokyo real estate, which drove the Japanese boom, is at less than 20 percent of its former highs. Yet corporate accounts books have not been corrected to fully reflect the collapse in the value of assets.

It is routine Japanese practice for accounting firms, at the request of a corporate client, to issue a "dean statement" to the Ministry of Finance. This has sometimes meant that when financial institutions went bankrupt, creditors discovered that a firm’s liabilities were as much as 10 times greater than the "audited" books showed.

The first grave indication of accounting mismanagement came as a surprise in early 1997, during an event known as the Kyotaru shokku, the Kyotaru shock. Kyotaru, the country’s largest sushi chain operator, filed for the Japanese equivalent of Chapter 11 bankruptcy after the company’s accountant refused to fudge the books any longer. Concealed bad debts had risen to nearly $1 billion in diversified enterprises unrelated to the core business.

So, if all over Japan the books are truly opened and the balance sheets are made to reflect market reality, the shokku, or crash, will spill over the sushi counter and most certainly be felt throughout the world.

Japan was shaken last February when a prestigious and profitable company, Daido Concrete, filed for bankruptcy and withdrew from the ‘Tokyo Stock Exchange. Hisatada Ishikawa, Daido’s CEO, revealed that the company had net debts of $153 million. Its problems stemmed from its having given several banks shido nenshos, or "letters of awareness." The nenshos were no more than unofficial letters written by Daido’s managers, stating that the company was "aware" that its Asian subsidiaries were borrowing money from the banks. The nensho is not an official letter of guarantee by the parent company for the subsidiaries’ loans. In fact, the paper has no legal significance whatsoever.

When clients with nensho loans decline to pay, banks act collectively in the absence of legal protection, forming "wolf packs." For example, Daido refused to accept responsibility for the loans of its overseas subsidiaries, preferring to let them go bankrupt. As a result, when Daido’s own short-term borrowings came due for renewal, the banks acted in unison, refusing to roll over the loans. This meant that when Daido had to generate cash in a hurry, no bank responded.

The Daido shokku becomes significant because it draws attention to a widespread practice peculiar to Japan. Japanese banks have tended to lend money almost casually to longtime clients, with many large loans going unsecured. For many years this was not a problem because the corporations honored their oral promises. In such a climate, nenshos written on scratch paper were deemed sufficient assurance. Not now. Following the Daido shokku, banks began asking their clients to provide formal letters of guarantee or surrender adequate collateral. For most borrowers this is difficult, and they are resisting. Although the overall sum of nensho liabilities is not known, some well-informed insiders say the total amount of this type of unsecured off-the-books lending could exceed $1 trillion. It should be noted that nensho loans are in addition to the $1 trillion in bad and nonperforming conventional loans already disclosed.

Japan’s popular postal savings program now offers 0.35 percent interest for a one-year deposit. This is considered attractive compared with the banks’ time deposit rate of 0.30 percent. By comparison the average rate for a six-month certificate of deposit in the United States is 4.65 percent, more than 15 times the comparable rate in Japan. At present, the Bank of Japan cannot raise rates for fear of an avalanche of failures of heavily leveraged companies, mostly in property-related markets. Yet, if it doesn’t raise rates, Japan’s national savings supply, which has prolonged the life of many over-extended corporations, would eventually be drained by a massive flight of capital to higher-yielding shores, notably the United States.

In the first month after the deregulation of the foreign currency exchange laws on April 1, as much as $20 billion fled Japan. During the same month, the Bank of Japan injected $20 billion, or 10 percent of its entire reserves of foreign currency, to reverse the decline of the yen—to no avail. The slide will not stop until the spread in the interest rates between Japan and other key countries narrows. However, if the Japanese interest rate goes up, even slightly, the inevitable crash will happen as massive corporate bankruptcies occur.

The yen has weakened against the dollar by more than 50 percent in the last two years, and nothing seems able to arrest its decline. Not even the recent intervention by the U.S., German and Japanese central banks is having much effect. The result is a "triple low" for Japan: low interest rates, low-value currency and low stock prices, leading to a massive capital flight as the yen continues to depredate. This threatens other Asian economies, as China, for example, loses its export competitiveness and quickly runs short of capital. In fact, because of the jitters on Wall Street, the declining yen could be the reason for a global crash, originating in New York. The United States benefits from the injection of fresh capital fleeing Asia, and yet Wall Street could be deflated by the fear of a plunge by China and other Asian economies. This was the reason behind the massive currency manipulations this month, and the resulting volatility in markets all over the world.

The so-called "Japan premium," the added cost for Japanese banks to borrow in the inter-bank market, has fluctuated between 0.20 percent and 1.5 percent, or 20 to 150 basis points. Since banks operate with only about a 25-basis-point margin, the Japanese banks have effectively been forced out of the international market. The Bank of Japan is understandably concerned. So is the US. Federal Reserve: If Japanese banks are hit by a liquidity crisis, they may have to sell U.S. ‘treasury bonds, which they have held in large quantities since the 1980s. A strong sell-off could have the effect of pushing down bond yields and rattling Wall Street.

The liquidity situation in Japan became serious last November when Sanyo Securities and Hokkaido Takushoku Bank failed and the world financial community worried about other possible casualties. Due to emergency liquidity (some $200 billion) injected into the system by the Bank of Japan, and with the help of the U.S. Federal Reserve, the level of concern abated. Then this month, the troubles of the once-prestigious Long Term Credit Bank raised the issue anew, and Japan finds itself in the middle of its second liquidity embarrassment in less than a year.

Many Japanese banks are facing a struggle for survival, putting government policy to a test. On the one hand, the Ministry of Finance has promised there will be no more bankruptcies of major financial institutions; on the other, the Japanese government is committed to deregulation of the financial markets, the so-called Big Bang, which implies survival of the fittest and extinction of the weakest.

In reality, the contradiction may not matter. When they fall, the banks will likely all fall together. Since Japanese banks traditionally form syndicates to finance large projects, no bank will be absolutely safe should one of its members fall. In effect, there is no ‘good bank" or ‘bad bank" in Japan. If a "good bank" wants to write off had debts and separate itself from the syndicate, the remaining banks threaten to withdraw funding from the projects the good bank is leading.

The overall situation is worsening. The Japanese economy is now classified as deflationary as unemployment reaches a high of 4.1 percent and consumer spending and confidence levels decline at alarming levels.

The outlook is clearly bad., but there are reasons to believe that panic can be avoided, provided the government is candid enough to explain the real situation to the Japanese people and the rest of the world, since the matter is of global concern.

First of all, the Japanese government has more than $4 trillion worth of assets and properties hidden in its balance sheet. This is more than enough to clear the country’s financial problems, and may even be enough to cover all of Asia’s troubled debts. Furthermore, Japan’s consumers have $12 trillion in personal savings in addition to $28 trillion worth of assets.

Unlike its Asian neighbors, Japan has no foreign debt Japan’s problems are entirely internal. Despite the prevailing negative sentiment, Japan still retains a very strong consumer sector, powerful industries with ample exporting capabilities and, above all, diligent people. Trouble became acute primarily because the government tried to hide the facts and rescue the wrong industries at the taxpayers’ expense.

What Japan needs to do is to create an institution, independent of the Finance Ministry and the Bank of Japan, with lines of credit backed up by the national assets. This way, when the chain reaction of bank failures begins, the relatively strong ones could gain refuge and separate good assets from the bad. As in Sweden in 1994, this approach makes sense in a country where there is a good. deal of accumulated public wealth and the people are relatively docile and cooperative. To do this, Japan requires a political visionary strong enough to allow bad banks and corporations to fail, and smart enough to open the economy to the globally competitive ones. In the process of Japan’s ‘normalization," the American and other markets will fall a little. But the recovery will be fast if the enormous amount of wealth, currently hijacked by the Finance Ministry to rescue the wrong people, is used for everyone’s benefit. The solution is quite obvious: Improve the quality of life, at the lowest possible cost, by allowing goods and services to come from anywhere in the world.

Instead of demanding that Japan spend more on public works and the artificial creation of jobs for special interests, the US. government should work to secure long term benefits for both countries. This means, though, that in the short term it has to warn its own people to prepare for a rough patch ahead.

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Added July 4, 1998