The Jolt Japan Needs?

Its slump is now so bad that Tokyo may be forced to make real changes

The crisis of Japanese capitalism is lurching into a new and dangerous stage. Every sign points to a deep recession, the worst contraction the country has seen since the oil shock of 1974. Investors are losing faith in the government: Between March 26, when Prime Minister Ryutaro Hashimoto announced a $120 billion stimulus package, and April 1, the Nikkei tumbled 4.3%, and the yen weakened 4%, to 133.6 against the dollar. The markets figure Hashimoto will not deliver a needed tax cut, but opt instead for public works that give little lift to the economy. And businesses are bracing for one of the worst months ever, as companies close the books on their fiscal year and report record losses and writeoffs.

Pressure is building from other quarters. Japan's Big Bang financial market liberalization, which kicked off on April 1, may give ordinary Japanese a chance to dump local stocks and bonds and invest overseas. That would further weaken the yen and the markets. U.S. policymakers may react strongly if the falling yen pulls Asia's other battered currencies into another dizzying fall. Taken together, the factors are there to force Japan's leaders to cut taxes and deregulate the economy further.

A huge shock may be necessary to jolt the Japanese out of their policy paralysis. For now Tokyo is following the same old script. The ruling Liberal Democratic Party promises real action; the markets react with disbelief; the economic data get more and more alarming. The U.S. provides the background chorus, warning Japan to change, to cut taxes, to deregulate, to do something. Commentators then note the LDP is too beholden to special interests in the construction industry and its rural constituents to back anything other than more pork for public works.

The old formula used to work well enough, despite the criticism it provoked. The Ministry of Finance was able to divert enough public money into the markets to boost confidence, and use its enormous influence to keep local investors from running. But now the MOF itself is under siege by prosecutors probing for evidence of corruption. There's little belief in any quarter that the MOF and its LDP allies can defuse the latest economic crisis. The government wanted the Nikkei at 18,000 before the end of the fiscal year on Tuesday, Mar. 31. Instead, it closed at 16,527.

The markets are paying a lot more attention to the worsening business news than the government's posturing. Take the banks. The government has softened accounting rules so it's easier for them to meet capital requirements. But investors still view the banks' balance sheets as suspect, and the banks remain wary of making fresh loans. So Japan's terrible credit crunch will continue. In a March survey of 1000 companies by the Ministry of Finance, 40% said they were facing far tougher lending terms, and 38% said the scarcity of credit was hurting their businesses. The latest casualty is Daiichi Corp., a real estate lender and broker. Burdened with sour property loans of some $3.3 billion, it filed on April 1 for liquidation after its main creditor, Mitsui Trust & Banking Co. Ltd., cut it off.

WEAK DEMAND. The news is going to get worse. Industrial production contracted 3% in February. Consumers are not spending. The jobless rate is at a record 3.6%. The betting is that it will reach 5.2% next year. Corporate profits for the fiscal year that ended Mar. 31 are expected to plunge 15%. Mitsubishi Electric Corp. will probably announce a 1997 loss of $680 million, because of weak demand for its appliances and troubles at it chip unit. Toshiba will likely report its pretax profits fell 64%, to $77 million.

Reading the signs, J.P. Morgan & Co. and HSBC-James Capel are now telling their clients to run for cover. J.P. Morgan economist Jesper Koll sees the Nikkei index crashing 25%, to 12,000 by yearend. Says Andrew Shipley, an economist with Schroders Japan Ltd., "Things are just falling apart."

There is also a real risk that Japan could face a currency crisis of its own. The yen is at its weakest level in more than two years. Analysts are looking at 140 to 150 by June, as the economy weakens more and policy drift continues. More important may be one change from the partial deregulation of the financial-services industry that started on Apr. 1. Under newly liberated foreign-exchange rules, ordinary Japanese will have a far easier time swapping yen for foreign currency and sending capital abroad. That could send a wall of money out of Japan in search of richer yields. Pensioners and boomers, dismayed at the puny returns on their domestic bonds and savings deposits, may decide to invest in U.S. securities.

The prospect of a dramatically weaker yen is even frightening some of Japan's politicians. "Japan's economic situation, as well as Asia's, is now in danger," says Naoto Kan, Japan's most powerful opposition politician. He says the LDP could trigger a new Asian crisis if the weak yen forces other regional governments to devalue to keep exports up. American policymakers cannot afford a weak yen either. Weaker currencies in Asia mean more cheap exports to the U.S., much weaker demand for American-made goods, and the threat of a new regional banking crisis.

TAX-CUT CHORUS. This all means pressure--more pressure than the LDP and the Ministry of Finance have probably felt in decades. Naoto Kan echoes the opinion of most economists by calling for a massive tax cut of at least $45 billion annually for several years and an end to the corrupt connection between the LDP and its backers in the construction industry. So far, LDP elders are balking at any big policy shift. But a contraction that threatens to turn into a collapse could change their minds.

Skeptics point out that the Japanese system can endure repeated blows without changing. The government-managed postal savings system has $3.2 trillion in deposits. That gives Tokyo leverage to ride out the storm by borrowing from postal savings to bail out banks, build more bridges, and generally avoid a wholesale rearrangement of the economy. Tokyo has pumped more than $550 billion into various packages since 1993. That's roughly twice what Germany spent on reunification.

Yet only recently have the Japanese faced record rates of bankruptcy, a cracking banking system, a collapse in consumer spending, and a regional crisis. It's getting ominous. This time, even Japan's mandarins may not be able to keep the world at bay.

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