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As Japan's decade-long economic stagnation continues, there has been much analysis of the immediate macroeconomic problems that confront the Japanese economy. This book looks past the short-run challenges to the future of Japan and highlights the intermediate and longer-term issues that country faces.

In this, the first book-length academic treatment of this important issue, a team of notable contributors present nine papers, offering a comprehensive assessment of those economic difficulties and addressing a range of specific issues, from financial restructuring and the impact of the aging Japanese population to corporate behavior, public lending, employment practices, and innovative capacity. In each paper, contributors clearly identify and outline problems and concerns, carefully pose provocative questions, and in many instances present concrete suggestions for improvement.

The resulting volume is a timely and important examination of critical issues for Japan's stalling economy, packed with both telling data and expert analysis and offering valuable perspectives on Japan's current obstacles.

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Structural Impediments to Growth in Japan

By Magnus Blomstrom

University of Chicago Press

Copyright © 2003 Magnus Blomstrom
All right reserved.
ISBN: 0226060217
Financial Sector Profitability and Double-Gearing

Mitsuhiro Fukao

The Japanese economys average annual real growth rate was only 0.8 percent from 1991 to 2001. Reflecting the weak economy, Japan has not been able to restore stability in its financial sector even though more than a decade has passed since the 1980s bubble. The Bank of Japan (BOJ) has had a zero nominal interest rate policy most of the time since February 1999, but it has been ineffective because of deflation. By the end of 2001, the gross domestic product (GDP) deflator was about 7 percent below its 1994 peak when adjusted for the 1997 consumption tax hike. The index was falling at annual rate of 1.5 percent at the end of 2001. Given the estimated 6 percent deflationary GDP gap and the near-zero real growth in 2002, deflation is likely to accelerate to more than 2.0 percent by early 2003 (see Japan Center for Economic Research [JCER] 2002, chapter 1).

In this chapter, I show that Japan will not be able to have a viable banking sector without stopping deflation. The banking industry has not shown a profit since fiscal 1993 (ended March 1994) if one excludes capital gains from stock and real estate portfolios. Interest margins have been too low to cover the increase in loan losses brought about by the weak economy.

Banks cannot raise margins for several reasons: competition with subsidized government-sponsored financial institutions (GFIs); intense political pressure, backed by the Financial Services Agency (FSA), to make new loans to small and medium companies; and deflation-weakened borrowers. I expect that the Japanese government will have to nationalize most of the banking sector by 2005. Capital injections will not solve the problems.

Established Japanese life insurance companies also face a serious situation. In the 1980s and early 1990s they promised high minimum yields on long-term contracts. For whatever reason, the companies did not match these long-term liabilities with long-term fixed-income investments. Under the BOJ zero-interest rate policy, insurers thus are suffering large negative carry. (Carry is the industry term for the difference between a products income and its associated costs).

A complicating factor in this dire picture is banks and life insurance companies providing each other capitala practice called double-gearing. Weakened banks ask insurance companies to provide equity capital and subordinated loans. In return, the mutual life insurers ask banks to subscribe their surplus notes (similar to nonvoting redeemable preferred shares) and subordinated debt. When Chiyoda Life failed in October 2000, Tokai Bank lost 74 billion. The FSA actively encourages this dangerous practice. Thus, Shokichi Takagi, director of FSAs Supervision Department, has publicly stated that double-gearing among financial institutions is highly beneficial to enhance public confidence (Under-Capitalized Banks Are Not Likely Even after Special Examinations: Interview with Mr. Takagi, Head of Supervision Dept. of FSA, Nihon Keizai Shinbun, 27 November 2001, p. 7).

The life insurers problem is easier to solve than the banks problem. Using a reorganization procedure, life insurance companies can fail and cut promised interest rates on their policies. On the other hand, bank runs would ensue if the government did not fully pay the depositors of a failed large bank because a large part of the banking sector is either insolvent or very nearly so. In such a situation, the government would have to bear the full brunt of defaulting loans at a time when its own debt to GDP ratio is rising by 10 percentage points a year. If things continue as they are, the Japanese government is unlikely to maintain investment-grade credit ratings on its bonds.

The chapter continues with an analysis of banks bad loans and their underreserving for them. The deteriorating condition of banks is then considered, and the causes of bank unprofitability examined. As part of this, the effects of deregulation and the role of government-sponsored financial institutions is considered. Turning to life insurance companies, their problems and weak supervision are discussed. The risks of the banks and insurers engaging in double-gearing is then analyzed.

1.1 Banks Bad Loans

Table 1.1 and table 1.2 show data on problem loans of Japanese banks. Japanese banks have acknowledged 82 trillion in losses from bad loans for the ten years through March 2002. In spite of this enormous loss, they still have more than 42 trillion of disclosed bad loans, about 8 percent of their loan portfolios.

I am one of the many who feel the disclosed figures understate the real situation. The FSA collects data on classified loans, a broader concept of problem loans, but does not disclose it for individual banks. Under the FSAs Bank Examination Manual, banks are required to rate their loans, taking account of default risk and quality of collateral. There are four grades: normal, substandard, doubtful, and estimated-loss loans. The last three are considered classified loans. Banks then estimate their loan-loss reserves and the amount of write-offs. Because of the broader definition, the amount of classified loans is more than twice that of disclosed bad loans. Total classified loans for all banks was 71.1 trillion in March 2002.

1.1.1 Underreserving

Total loan loss reserves of Japanese banks have been low relative to those of U.S. banks. While U.S. bad loans declined from 3 percent of total loans in 1992 to 1 percent in 1999, the Japanese ratio rose from 2 percent to 6 percent (fig. 1.1). Loan-loss reserves in the United States have been above 160 percent of bad loans since 1994, while in Japan they have been in the 40 percent to 60 percent range (fig. 1.2). We can clearly see that although the U.S. banking sector recovered quickly from its bad-loan problems in early 1990s, the Japanese situation has been deteriorating even with the 1999 capital injection by the government.

Many analysts of Japanese banks suspect that the banks are not recording enough loan-loss reserves. This problem is exacerbated by the lenient reserving policy stipulated by the FSA Bank Examination Manual. Japanese banks usually calculate loan-loss reserves by dividing their loans into the FSA-mandated categories, then estimated losses for each group using the following time horizons.

1. Normal loans and substandard loans without arrears or reduced interest rates: expected one-year loss rate.

2. Substandard loans with arrears or reduced interest rates and doubtful loans: expected three-year loan loss rate.

Most loans are routinely rolled over, so the one-year figures understate the net present value of future losses over the true life of the loans in category 1. Thus, instead of a one-year rate, banks should reserve using, as a minimum, the three-year cumulative rate for all substandard loans.

To estimate more appropriate reserve figures, I have estimated required loan loss reserves based on FSA data of classified loans. A Bank of Japan (1997) sample study looked at the actual subsequent loan losses of eighteen banks for each category of classified loans on their fiscal 1993 reports (table 1.3). At the end of three years (in March 1997) about 17 percent of substandard loans and over 75 percent of doubtful loans had been lost and almost 100 percent of estimated loss loans....