Japan’s Changes Will Affect World’s Economies

Fears about Japan roiled world financial markets last week--near-term fears that Japan’s banks would fail and longer-term worries about Japan’s curious economy, which has stagnated for a decade.

There is cause to worry. In the next year or two, Japan is going to dramatically affect the world economy as it works out problems of government debt and industrial restructuring.

The yen probably will decline in value, causing other countries in Asia, South America, Eastern Europe and elsewhere to devalue their currencies.

“We are dealing with something unprecedented in world financial history,” says Kenneth Courtis, the Tokyo-based vice chairman of Goldman Sachs.

Yet many of last week’s concerns about Japan’s banks were off the mark because stock market traders didn’t understand the situation.

Japan’s banks are in the process of writing off bad loans and selling shares of industrial companies that the banks have held for years at inflated prices. This has caused Japanese stock market averages to decline even further.

The banks are cleaning up their balance sheets because new accounting rules come into effect April 1, the start of Japan’s fiscal year. In the next six months, the banks’ capital accounts must meet strict standards. Some banks will be phased out by the government, others will be recapitalized with public funds.

The yen will decline, if not in the next two months, then later in the year, predicts Adam Posen, senior fellow at the Institute of International Economics in Washington and author of a 1998 book, “Restoring Japan’s Economic Growth.”

The yen’s decline may not be temporary. Looming behind the current concern is the huge overhang of Japanese government debt, resulting from a decade of deficit financing, government loan guarantees, savings deposits, pensions and other contingencies. Total debts could be as much as five times Japan’s gross national product, or the equivalent of $20 trillion.

But now Japan is going to start working out those debts. Over the next few years, experts say, the government will monetize the debt--that is, print money to pay the loans and guarantees.

That would be inflationary, but better to have inflation than the deflation Japan has now. Land and property prices are declining 1.5% a year in Japan. Businesses can borrow money at nominally low interest rates--2.5% to 4%--but taking into account the declining value of assets, real interest rates are high.

Inflation and the difficulties of working out Japan’s problems would mean a lower value for the yen compared with the dollar and other currencies.

That would set off devaluations elsewhere. Asian countries, including China, would have to devalue their money rather than try to compete in world markets against Japan’s companies, which would be even more competitive with a weak yen.

Brazil, Argentina and other South American countries would be forced to devalue; the fate of Mexico’s peso, linked so closely to the dollar, is imponderable.

With currencies falling everywhere, the U.S. would become even more the importer of the world’s goods and services.

The United States would be affected in many other ways. How could it not be? Japan, keep in mind, is not a poor country. Though its government debt is enormous, Japan still runs trade surpluses with most countries and has $2 trillion invested around the world in government bonds, corporate stocks and direct investments in factories.

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Of that total, $1.25 trillion is invested in the United States, Courtis estimates. The countries are joined in a unique relationship.

Questions arise. How relevant is Japan’s situation to the current slowdowns and stock market declines in the U.S. and other countries? Also, how could this debt build-up have come about in Japan, a country once regarded as an economic model? And what does the present portend for the future of Japan and the world economy?

First, the U.S. and European slowdowns are not directly related to Japan. They are cyclical industrial declines, coming off years of high investment in technology, plants and equipment. They are also caused by higher energy prices.

As equipment is used and new business arises, economies will pick up--although at what pace remains to be seen.

Japan’s debt build-up came about because banks failed to write off bad loans and companies did not shut plants or lay off employees after the bubble burst on 1980s real estate and stock investments. By contrast, around the same time, the U.S. wrote off its savings and loan debacle and its banks wrote off bad loans.

In addition to rolling over delinquent loans, Japanese banks also kept stock and real estate assets on the books at inflated values.

The Japanese government repeatedly spent huge sums on public works in the 1990s, trying to lift the economy. But the economy never remained stimulated for long before sputtering into recession again.

Inevitably, much public money went for expensive projects with questionable economic benefit. Economists cite a bridge between Honshu and Shikoku islands that cost $26 billion and may never repay the government bonds that financed it.

In the aftermath of a decade of massive public spending but little economic growth, there are serious problems. Some of the household savings of Japan’s people, officially estimated at $11 trillion, have eroded because they were invested in government bonds and public projects.

Other savings have been lost amid troubles for Japan’s companies. Two bankrupt insurance companies declared recently that policies that had promised investors a 5% annual return over 10 years would instead pay only 1% to 1.5% a year. The effect on retirement savings is devastating.

What will happen? Most economists and other experts say that Japan’s problem is more political than economic. Frank Gibney, head of the Pacific Basin Institute at Claremont Pomona College and a longtime Japan scholar, says political change is necessary to break the hold of the ruling Liberal Democratic Party, which has been in power since World War II. “Times changed but the political powers didn’t,” Gibney says.

The LDP kept the economy from responding correctly to crisis a decade ago, Gibney says, using public spending to keep itself in power. Now political change could begin with parliamentary elections this summer, although the process may be slow.

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In Japan’s industrial sector, however, change could be rapid. Just one example may indicate a future pattern: Renault of France two years ago bought a major interest and took over management of Nissan Motors, which hadn’t shown a profit in 11 years. Last year Nissan earned more than $1 billion and its cars have won back customers around the world.

The last decade saw recurring claims that Japan was “coming back” to economic prominence, but such claims always proved groundless. Whether this time will be different, one thing is certain: Coming changes in the world’s second-largest economy will affect lives and livelihoods everywhere.

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Japan’s Lost Decade

Japan’s economy ran out of steam in the 1990s, falling from economic growth that averaged 4% a year in the ‘80s. The world’s second-largest economy has spent the last 10 years straining to grow while stock market prices, as measured by the Nikkei index, have tanked. Figures are for annual percentage changes in gross domestic product and annual Nikkei averages.

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Economic growth

‘89: 5.2%

‘00: 1.0%

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Nikkei averages

Dec. ‘89: 38,915.87

March ‘01: 12,232.00

*Note: Estimated--fiscal year ends March 31.

Sources: OECD economic surveys, Times calculations, Bloomberg News