Inside The Bank Of Japan

Defying critics, Governor Hayami says raising interest rates is the way to fix Japan's economy

On any given Sunday, you'll find a sprightly 74-year-old parishioner joyfully belting out hymns at Asagaya Baptist-Methodist Church in central Tokyo. It's Masaru Hayami, a devout Christian who rarely misses services. The divine inspiration he receives there, he says, has direct application to his secular life, where he's governor of the Bank of Japan, central banker to the second-biggest economy on earth--and a controversial one, as he wrestles with the cheap money habit that he says is holding back the radical corporate reform Japan needs.

Since February, 1999, the bank has practically been giving money away in a forlorn hope of pulling Japan out of its severest postwar recession. It has pumped liquidity into the markets in a relentless effort to cut key overnight rates nearly to zero. Other short-term rates are at historic lows. And despite Japan's monster budget deficit, clocking 10% of gross domestic product, long-term bond rates are just 1.7%.

Now, Hayami is signaling that the party is over. In defiance of the Japanese government, the International Monetary Fund, and U.S. Treasury Secretary Lawrence H. Summers, he is getting ready to raise rates. The minutes of an Apr. 12 meeting of the bank's nine-member policy board, released on May 22, suggest it's a question of when, not if. "The time is approaching" for the bank to reexamine its policy, Hayami said. Two unidentified policy board members, as well as resident hawk Eiko Shinotsuka, were leaning that way, too.

Raising rates? It seems to defy common sense in an anemic economy. But Hayami should be taken seriously. He's shaping up as the only policymaker in Japan willing to push reform. Quick fixes such as heavy government spending and free money, though fine in a crisis, are no substitute for the kind of cathartic restructuring Japan needs. And in a rare round of interviews with Business Week, Hayami and four other board members fretted that keeping zero-rates in place too long is letting corporate debt-heads and banks off the hook.

DUD LOANS. Instead of dramatic overhauls, companies such as general contractor Hazama Corp. and retail giant Sogo Co. on May 26 hit up their banks for debt forgiveness totaling $7 billion. And thanks to a government bailout and the BOJ's money pump, big banks keep billions worth of dud loans on their books instead of forcing borrowers to restructure. Since the crisis year of 1998, there has been "a big deceleration in the speed of restructuring," says ING Barings analyst James Fiorillo.

The result is that some companies have it too easy, and domestic competition is being stifled. Delaying restructuring "will not contribute to the overall economic recovery," says Hayami. What's more, while cheap money has kept some of the weakest companies alive, bank lending fell 6% in March for the 27th straight month. Meantime, low rates are robbing mostly elderly Japanese, who get a measly 1% to 2% on their $12 trillion of savings. Adds Hayami: "We have to correct this unusual situation."

The prospect that the bank might raise rates at its June 12 board meeting has added to the uproar in stock markets. Since Apr. 12, the Nikkei stock index has sunk more than 20%, and critics such as former Finance Ministry bigwig Eisuke Sakakibara blame Hayami in part. "What's happening now is deflation, so why tighten?" he says, adding: "All that very conservative central bank type of thinking is obsolete."

That may be overly harsh. The blunt-talking Hayami is unlikely to throw caution to the winds. Although corporate earnings are rebounding, household spending jumped 3.6% year-on-year in April, and the unemployment rate went to 4.8% from a record 4.9% the month before, he may well wait for confirmation of these trends before moving. Even then, expect baby steps--a series of 25 basis-point hikes--starting later this summer and bringing short-term rates to 1% or so over the next year.

ON THE ROPES. All the same, the policy debate is getting acrimonious as campaigning for the June 25 elections for the lower house of the Diet heats up. Given that growth will be weak this year, and unemployment remains high, the ruling Liberal Democratic Party is on the ropes. Prime Minister Yoshiro Mori is already struggling in the polls. With just 19% support, the last thing he wants to see is a rate hike.

A too-abrupt rise in Japanese rates could whack the U.S. economy in an election year, too. The huge 4.6 percentage-point differential between U.S. and Japanese rates has helped keep the dollar strong, imported inflation at bay, and capital flowing into Wall Street. "The Americans have been demanding zero rates," says former McKinsey Japan chief Kenichi Ohmae, because the exodus of money out of the U.S. "is the nightmare" of Summers.

Other analysts fear an ill-timed rate hike could cause a crash in Japan's bond market, sending long-term rates and the yen soaring. Brendan Brown, head of research at Tokyo-Mitsubishi International PLC in London, figures there is a 25% chance of that happening in the next 12 months. He thinks Hayami shouldn't touch rates until 2002, because Japan needs to offset the spending cuts the next government will have to make to reduce the budget deficit.

Hayami is not short of unsolicited advice. One tide of opinion inside Japan wants him to ramp up the money supply and court inflation. Such a strategy, first suggested by economist Paul Krugman in 1998 and supported by many in the LDP, would melt away the debt pressures on companies, free up cash for new investment, and get consumers spending now to beat price increases later, say advocates. It could also generate extra tax revenues.

Inflation would be sparked by sluicing yet more money into the system, say proponents. Takatoshi Ito, deputy vice-minister for international affairs at the Finance Ministry, says Hayami needs to target inflation of 1% to 3%, vs. nearly zero now. Ito argues the central bank must also put the money supply into overdrive and if need be, underwrite and buy long-term Japanese government bonds and even stocks. Without fiscal support or additional monetary oomph, "I'm very worried about the second half," says Ito.

Yet, with the exception of policy board member Nobuyuki Nakahara, a former chairman of oil refiner Tonen Corp., nobody at the BOJ wants to risk inflation. To Hayami it would just prop up sick companies, while whittling away the value of savings. "We would destabilize the economy and the financial markets and further weaken the financial system," adds Deputy Governor Yutaka Yamaguchi. BOJ officials suspect the LDP merely wants the bank to fund yet more pork-barrel spending. Such an abandonment of fiscal discipline would simply send long-term rates soaring and raise the cost of government borrowing, says Hayami.

Despite the assault by critics, Hayami doesn't seem to harbor the least doubt about what to do. His steadfastness stems from a bedrock conviction that a central bank should be the "guardian of the integrity of money," primarily focused on price stability with an eye toward long-term growth--and immune to the wishes of markets, the LDP, or Washington.

SHARP BREAK. But, to maintain credibility, he needs the support of at least six of the bank's nine board members before he can hike rates. At the board's twice-monthly meetings, which run five or more hours, Hayami isn't afraid to challenge the monetary experts. "Discussions are quite frank," says market-savvy member Teizio Taya. "Sometimes he listens, and sometimes he doesn't," adds one senior bank staffer. Now, though, Hayami has to convince the skeptics: Yamaguchi, a poker-faced and highly regarded monetary expert; former University of Tokyo economist Kazuo Ueda; and Taya, a former IMF economist. They favor ending the zero-rate policy, but only when there's evidence of a stronger recovery.

Hayami's biggest ally, Shinotsuka, is a former labor economist who concedes she is not a monetary whiz. Deputy Governor Sakuya Fujiwara, a former journalist whose book on a Japanese actress became a hit musical, lacks formal economic training but helped rewrite the bank's charter in 1998. Along with former Nippon Steel Corp. executive Toshio Miki and Industrial Bank of Japan economist Susumu Taketomi, he is likely to follow when Hayami is ready to pull the trigger.

The diversity of opinion and background on the board is a sharp break with the past, as is its members' willingness to defy the government. Today, board members are chosen by the Cabinet and approved by the Diet. Not so long ago, they were picked in secret by the Ministry of Finance and the bank, and a Finance official had a vote on the board. No more. Indeed, board meetings "were a joke," says Fujiwara, who used to cover the BOJ for Jiji Press.

The bank's reputation sank ever lower as cuts in its overnight lending rate, from 6% in 1991 to 0.5% in the fall of 1995, failed to overcome the massive excess debt, capacity, and payrolls that riddled the economy. Then, ill-timed tax hikes, the Asian financial crisis, and a round of bank and brokerage failures triggered a severe recession in late 1997. Finally, in 1998, Tokyo prosecutors uncovered a bribery scandal implicating 98 staff members. A top official leading an in-house probe hanged himself. Then-Governor Yasuo Matsushita resigned in disgrace. "It was the first major crisis the BOJ had encountered in its history," recalls Shinotsuka.

In the depths of the crisis, then-Prime Minister Ryutaro Hashimoto tapped Hayami to run the bank, which had just been made independent of the government. Hayami was viewed as unlikely to rock the boat, but immediately pushed for greater transparency and accountability. Fujiwara, who joined in 1998, remembers Hayami telling him early on: "In front of God, we are supposed to be fully accountable for what we have done on the earth." Hayami went to the Diet 115 times to defend BOJ policies last year.

DESPERATE. The bank confronted a barrage of external challenges, too: a crippled banking system and a spiral of declining prices, earnings, and wages, as well as a depression psychology among consumers and corporate bosses. That's why Hayami and the board initially pushed rates to zero, flooded the money market with liquidity, and even started buying corporate debt to prop up the private sector in early 1999. Things were so desperate that the BOJ was "taking corporate paper on its own balance sheet to keep companies afloat," says Eiji Fukasawa, economist at the Fuji Research Institute.

Although hardly a monetary ace in the mold of Federal Reserve Chairman Alan Greenspan, Hayami is no slouch. He joined the BOJ in 1947 and rose to the rank of executive director. Two private secretaries guard his schedule and the bank has a strict hierarchy. Junior employees use an honorific style of Japanese and bow deeply when they greet or leave him. "We are still very much like a traditional Japanese company," says one staffer. Hayami can, however, be informal: He often lunches on a sandwich or bento box at his desk.

In late 1981, he left to run Nissho Iwai Corp., a trading company that ran into debt problems during the bubble years. "I was then on the borrowing side of the economy," says Hayama. "We expanded, and I made some good investments and bad investments." The experience taught him a valuable lesson about central banking: Cheap money fueled massive lending that set the stage for a decade of lost growth. That's why Hayami is now a monetary hawk, unwilling to turn the BOJ into a piggy bank for the LDP. And he obviously relishes his role as a holdout. "I think the BOJ should be very proud of the criticism," he says.

Hayami is blunt and stubborn, qualities that are both admired and seen as a handicap in the bank. He wins high marks as the first BOJ official to lash out at Japan's debt-besotted commercial banks. In early 1999, he accused them of having concealed their bad loans for years. "Frankly, I think it is an embarrassment," he said. His outburst helped gain support for a $60 billion bailout that has since stabilized the financial sector.

But his stubbornness sometimes gets him into hot water, as in the three-cornered feud that raged between Hayami, the Ministry of Finance, and Summers during last fall's Group of Seven meeting in Washington. Summers thought that Hayami had agreed to an expansionary monetary policy to ensure the Japanese recovery and rein in the yen. Hayami now says that in his vague statement, which he refused to clarify at the time, he was in fact turning the U.S. down.

Hayami and the bank still need to tread carefully. Legally, the LDP could write a new bank charter and seize control of monetary policy. "Unless we can leave a good track record under our newly acquired status, then we will always be vulnerable to that threat," says Yamaguchi. There is also a worry that Hayami won't wait until the case for raising rates is airtight.

In any event, Hayami has every intention of seeing his term through to 2003. The government can't fire him. And barring a health problem, Hayami can be counted on to keep up his crusade to turn a tainted institution into a power player.

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