Japan Will Muddle Through . . . Again
By Peter J. Morgan
The Wall Street Journal
January 29, 2002Mr. Morgan is chief economist at HSBC Securities Japan in Tokyo.
In what seems to have become a biannual ritual, market players are once again talking about a banking-sector meltdown in Japan. Ultimately, the question is whether market forces can overpower the government's position that the banking sector is solvent. Despite rumors of a final reckoning, however, a crisis will likely be averted. The Japanese government simply has too much control over the rules of the game and Japan's financial market is too insulated from external pressures.
U.S. Treasury Secretary Paul O'Neill has expressed growing frustration over Japan's "mountain" of nonperforming loans, but frankly the U.S. has little leverage. Since Japan runs a current account surplus, it doesn't depend on foreign capital inflows. Last week's unveiling of a plan to securitize 100 billion yen ($745 million) in NPLs is a step in the right direction, though it barely scratches the surface of official NPL estimates of 43 trillion yen.
While financial collapse is by no means imminent, no one should discount the seriousness of the threat to Japan's banking system. The two largest potential risk factors are the implementation of the first phase of ending full deposit insurance and the Financial Service Agency's special inspection of large borrowers, which should be completed by the end of January.
The first risk is that mass withdrawals of time deposits from banks perceived to be weak -- including possibly some city banks -- could lead to a full-scale run on those banks and a systemic crisis. Starting this April, time deposits will be insured for no more than 10 million yen per person. This will be extended to demand and other deposits in April 2003. Individual holdings of time deposits of 10 million yen or more amount to more than 66 trillion yen, or about one-third of total time deposits. This is a huge amount that could start sloshing around the banking system unpredictably.
However, the actual amount of deposit outflows between now and the end of March is likely to be far less. First, only the net amount of each deposit over 10 million yen loses coverage and needs to be shifted. Second, since demand deposits are still fully protected for another year, depositors can simply switch the funds to a demand deposit at the same bank. Third, individuals can spread their time deposits among even weak banks, since each new time deposit would still be protected up to the limit.
Fourth, an unknown but probably large amount of funds likely has already shifted in anticipation of the removal of deposit insurance. Between April and October last year, many categories of smaller banks saw a decline in overall deposits. Deposits of credit cooperatives (small credit unions) suffered the largest fall, down 850 billion yen, or 4.5% of the total. In contrast, city banks' deposits have risen by 3.7 trillion yen. This suggests that depositors have begun to vote with their feet, but the amounts are still quite small.
However, Bank of Japan statistics show that total time deposits of banks have already fallen by a much larger amount, about 13 trillion yen since March of last year. This has been offset by increases in demand deposits, as well as cash, government bonds, foreign currency deposits and gold. Therefore, the amount of adjustment that has already taken place may be substantially greater than suggested by the total deposit data alone.
Although it has received little attention, the Financial Services Agency has been energetically weeding out weaker small banks. Last year 46 credit unions plus one secondary regional bank were shut down, and another six credit unions have failed this month alone. This represents an 8% reduction in the total number of credit unions. These closures are likely to accelerate in the next year or so, but substantial progress has already been made. Nonetheless, individuals are likely to remain concerned about the viability of many of these institutions.
Last, and definitely not least, the government can always make exceptions. Financial Services Minister Hakuo Yanagisawa has already said that the government might still allow blanket deposit protection in individual cases if a bank's failure might have significant negative impacts on a particular region. Therefore, although a large-scale run on banks cannot be completely ruled out, it seems unlikely at this point.
What about the FSA inspection? The results of the inspection will strike a fine balance between the need to appear more strict and the need to maintain the solvency of large banks and avoid "large" impacts on regional areas. The first aspect was illustrated by the bankruptcy of Aoki Corp., a mid-sized construction company. At the same time, the massive bailout package for Daiei Inc., a major retailer, shows that the principle of "too big to fail" is alive and well.
The crucial battleground is the capital adequacy of city banks. The government maintains that Japanese banks have Bank of International Settlement ratios of 10% or more. This would enable them to write off about 6 trillion yen of bad debts this year. Even if they have operating profits of only about 4 trillion yen, they could still reduce reserves by several trillion yen in total while maintaining their BIS ratios at or above 8%, at least for this year.
Although technically true, the quality of the capital of major Japanese banks is quite poor. Indeed, if one strips out public funds and deferred tax assets there is little left. Moreover, banks are required to pay back the public funds beginning in 2008. In view of the continuing large amounts of new bad debts emerging each year, most of them have little prospect of being able to do so. Once again, however, the Japanese government can change the rules and postpone the requirement.
The government appears fundamentally unwilling to nationalize any more large banks, mainly because they probably would have to be sold to foreign institutions. What's more, the collapse of Hokkaido Takushoku Bank in 1997 showed that the regional impact of a large bank failure can be severe. For all these reasons, the government probably regards the large banks as too big to fail.
Therefore, the most likely outcome is more muddling through without a near-term crisis or rapid resolution of the banks' NPLs. A further downgrade of Japanese government bonds to single-A status would require banks to give them a 20% risk weighting (0% currently) under new BIS standards starting in 2004. This certainly would prompt more foreigners to sell the bonds, but they only hold about 6% of the total. The government has the option to exempt Japanese banks from this rule, and it most certainly would exercise it.
Finally, if more funds are needed to stabilize the banking sector than are currently available, additional government debt issuance could be financed by the Bank of Japan if necessary. The U.S. could threaten to talk up the yen, but that would only weaken the economy further and magnify the risks of a financial crisis that could spill over into global markets. In that sense, Japan Inc. itself is considered -- both in Washington and Tokyo -- too big to fail.