Why Japan's Banks Have A Friend In Washington

To global financial experts, the stunning disclosure at an Oct. 16 hearing on Capitol Hill only fed their worst fears about the depth of Japan's banking woes. House Banking Committee Chairman James A. Leach (R-Iowa) revealed that the Federal Reserve had privately promised Japanese officials that the U.S. stood ready to provide emergency liquidity to avert a financial crisis. "This is further confirmation that they have world-class problems with their banking system," says Bert Ely, an Alexandria (Va.) banking-industry consultant.

But the Fed wasn't simply promising altruistically to help a longtime ally in trouble. The U.S. has a great stake in Japan's shaky banking system: Problems there could quickly spread to the U.S., driving up interest rates, depressing real estate, and sending the dollar on another downward spiral. These negative consequences could result from a sell-off of U.S. assets by the Japanese government to rescue its banks.

SCARY SPECTER. The failure of just three small Japanese lenders already has virtually depleted Tokyo's $10 billion deposit-insurance fund. And with public sentiment running against a taxpayer-financed bailout, financial experts worry that Japan's government may have to dip into its vast $180 billion reserve of foreign holdings--nearly all in U.S. Treasuries--to cover future bank losses. Private Japanese investors, who hold at least $40 billion more in U.S. Treasuries, also might start selling.

That's why the Fed swung into action. The central bank isn't talking, but Leach staffers say the Fed is offering repurchase agreements: The Japanese government could borrow cash from the Federal Reserve Bank of New York using its Treasury holdings on deposit at the bank as collateral. This would provide the cash Tokyo might need to cover losses at U.S. affiliates of Japanese banks--which control $66 billion.

Leach says Tokyo isn't likely to need cash any time soon. But bond traders fear that the mere specter of a Japanese sell-off would trigger a surge in interest rates and help stall a less-than robust expansion in the U.S. And many traders already are jittery, fearing that a budget stalemate in Washington could cause the government to default on its bonds. Tension mounted on Oct. 17 when Treasury Secretary Robert E. Rubin vowed to scale back an upcoming Treasury auction unless Congress raised the federal debt ceiling.

If no compromise is reached, a U.S. default could reverse the powerful bond rally fueled by Japan's recent aggressive purchase of Treasuries to brake the surging yen. And a Japanese sell-off of U.S. Treasuries would only make matters worse. During the first half of 1995, Japanese buyers sopped up $43.2 billion worth of U.S. notes and bonds, one-third more than they did in all of 1994 (chart). "Japan has been serving as the 13th Federal Reserve District," says William P. Sterling, an economist and investment strategist for New York-based BEA Associates.

STEAM VALVE. The Fed plan is designed to ease the pressure on Japanese banks. They generally are more dependent than their U.S. counterparts on funding from short-term global money markets, which could shut out Japan at a hint of trouble. Indeed, Japanese banks already are paying higher premiums--0.25 percentage points more than U.S. and European banks pay for dollar borrowings in London. That's pushing the cost of borrowing above the return mn some U.S. commercial loans and could force Japanese banks to trim their portfolios. With Japan accounting for 17% of all U.S. corporate lending and 20% of all syndicated business commitments, a Japanese pullout could drive up commercial rates for U.S. corporate borrowers. It also could leave domestic banks hard-pressed to fill the void. "Do you think Chemical [Bank] is going to absorb the 20%?" asks one banker.

To be sure, Leach notes, Fed Chairman Alan Greenspan has assured him that he "does not expect an unmanageable situation to arise." Yet Japan's financial situation is sensitive enough for Greenspan to beg off a request by Leach to testify about it in public, perhaps for fear of spooking the markets.

Privately, U.S. officials appeared more concerned last July when the Nikkei stock market index drifted close to 14,000--the critical level that could decimate Japanese banks' capital reserves, which consist largely of stock holdings. That prompted the U.S. and Japan to go on a massive dollar-buying spree, driving the yen down 25% since April. The result: The Nikkei rose to 18,000, and the value of equity holdings by Japanese banks soared from $30 billion to $130 billion, giving Tokyo breathing room to implement financial reforms.

These days, U.S. officials are more optimistic about the longer-term prospects for Japanese banks, though they're hardly bullish. "The Japanese banks are somewhere between the U.S. system of the 1930s and U.S. system of the 1990s--but probably closer to the 1990s," says one senior U.S. official. Reassuring words. But his oblique allusion to the bank crisis that ushered in the Depression shows just how seriously the U.S. government is taking the fragility of Japan's banks.