Commentary: Japan: How To Turn An Illusory Recovery Into A Real One

To halt deflation, the BOJ's Fukui must ride banks hard to get their books in order

When he took over as the Bank of Japan's governor in April, Toshihiko Fukui had probably the toughest central-bank job on earth. Japan's economy seemed moribund after 12 years of stagnation, the bank system was a mess, deflation was rampant -- and Prime Minister Junichiro Koizumi's government had been lashing out at the BOJ for failing to play its part.

Today, Fukui is the toast of Tokyo financial circles. Newspapers are full of merriment about Japan's outlook. The 8.2% third-quarter spurt in the U.S. and heady growth in China have stoked Japan's export machine. The economy will probably expand more than 2% in the fiscal year ending in March.

Complacency Ahead?

In all of this, Governor Fukui has played his hand skillfully. The BOJ has spent a staggering $180 billion this year to push the yen down against the dollar and keep exports humming. Fukui has kept interest rates at near zero and flooded the money markets with extra liquidity, enabling Japan's sick banks to deal with nonperforming loans. And he purchased $1.8 billion in asset-backed securities and corporate paper to give weak companies a chance to recover. The medicine is working: As Japan's economy has strengthened, dud loans at the big banks have fallen 15%, to $155 billion. Koizumi and Fukui seem a powerful team -- unlike the fractious partnership between the Prime Minister and Fukui's predecessor, the outspoken Masaru Hayami. On Dec. 2, Fukui boasted of rising exports and corporate profits and predicted healthy economic growth.

But a savvy financial thinker like Fukui should know better than to join in the boosterism. His job is far from finished, for this recovery is no more real than the chimera that graces bottles of Kirin beer. Japan's self-congratulation could turn into complacency unless Fukui reminds Japanese how tough things remain. Look at nominal gross domestic product, which is adjusted to include price declines. It shows starkly how deflation is still tearing through the economy: After adjusting for deflation, Japan is expected to grow a meek 0.3% in fiscal 2003. GDP could actually contract in 2004 and 2005. That's no reason to celebrate.

Governor Fukui does deserve credit for understanding the roots of Japan's problem. He dismisses as nonsense the xenophobic canard that cheap imports from China are the prime driver of deflation. What ails Japan, Fukui said on Dec. 2, are "excess debt, excess labor, and financial-system fragility." So banks still aren't lending, and companies are forced to chop prices to get consumers spending. Until those issues are resolved, Japan will remain the world's preeminent deflation nation.

Fukui must spend some of his political capital to rescue Japan from its deflationary mess. For starters, it's time he halted free handouts to zombie companies. Banks brag that they've cut bad loans, but 27% of that decline in 2003 came through outright debt forgiveness. So a lot of corporate deadbeats live to fight another day while their unworkable business strategies and overcapacity punish healthier players. Fukui has been eerily silent on the massive debt forgiveness that in Japan passes for loan workouts.

Next, Fukui must ride the banks hard to get their books in order by writing off more dead loans faster and undertaking massive restructuring. Some 6.5% of bank loans are still bad, and it will be tough to meet the government's target of 4% in 2005 unless Fukui tells them debt forgiveness alone isn't enough. In fact, such policies have only encouraged weak lenders to get into fresh trouble. Local and regional banks, which provide 40% of loans in Japan, may trigger the next emergency. The Nov. 29 failure of Ashikaga Bank is just the beginning of a great unraveling among small lenders.

Advocating harsh measures may end Fukui's honeymoon with the ruling Liberal Democrats. But Koizumi can't fire Fukui, whose term lasts through 2008. So if Fukui really wants to slay the deflation beast and get the banks to reform, he'll be able to do so -- and still make amends with power brokers before his term is up.

By Brian Bremner

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