Commentary: Finally, Japan Lets A Sinking Ship Sink

Japan's newly reelected government has made the smartest financial decision of its brief political life. On July 12, it backed away from a controversial plan to bail out Sogo Co., an ailing department store chain, with $1.8 billion of taxpayers' money. Immediately, Sogo filed for protection from creditors, to whom it owes over $17 billion, and became Japan's second-largest corporate bankruptcy ever.

Prime Minister Yoshiro Mori's about-face was in response to pressure from within Japan. The local press, opposition parties, and even a large segment of Mori's ruling Liberal-Democratic Party all cried foul when Mori initially took the easy way out. By so doing, they have exploded the myth that no Japanese government can afford politically to let ailing companies go to the wall and spark big layoffs.

GET IN LINE. It's a good start to real reform. But plenty remains to be done. Companies are still lined up for debt forgiveness from their banks--which ultimately turn to the government and Japanese taxpayers for money. Already construction giant Hazama Corp. and property developer Seiyo Corp. have their hands out. "The banks' bad debt woes are far from over," says HSBC Securities analyst J. Brian Waterhouse.

That's for sure. The scary truth is that nobody in Japan really knows just how extensive the bad debts are. In Tokyo, the admitted figure is just $200 billion. That's far too low. For one thing, unlike the U.S. bailout of failed savings and loans in the late '80s, which affected just one industry, large swaths of the Japanese economy are in trouble. In particular, sectors such as construction, hotels, golf-course development, and retailing are vulnerable. Few banks aren't facing problems.

At present, the banks are no longer bleeding cash. In fact, big banks reported profits in March for the first time in three years--but that's mostly because of unrealized gains on their stock portfolios last year, when the Nikkei index soared. Even so, with the recession grinding on, Japan's top 15 banks took $42 billion in loan-loss charges last fiscal year as companies sought help. That was three times what analysts expected. Worse, if the Nikkei falls much below 17,000, the banks' hidden stock gains could evaporate, figures credit agency Fitch IBCA. This year loss charges could reach $50 billion, says Lehman Brothers analyst Nozomu Kunishige.

Obviously, the whole system needs a breath of fresh air--and a lot more clarity. Japanese companies, for example, still don't have to consolidate the debts of their subsidiaries onto their own books. The device is an insidious way to hide bad debts. The government did enact a measure to end the practice and then, in the face of corporate pressure, delayed the start date by several months.

Reviving that measure could lead to a more radical overhaul of Japanese corporate culture. Businesspeople had begun to believe that bankruptcy was unthinkable. Sogo, with 10,000 workers and maybe 9,000 suppliers, hardly represents a systemic risk to the economy. Its failure would scarcely be a national calamity. All the same, Sogo executives had good reason before July 12 to believe that the government would come to their rescue--because, thanks to lax management by Japan's weak watchdog, the Financial Revitaliza- tion Committee, debt forgiveness had become all the rage.

TOOTHLESS. The FRC needs teeth--or at least a leader who will use its existing powers forcefully. Banks are still gambling with impunity that by infusing more cash now, they will increase their chances of getting paid back, rather than suffering even bigger losses if their borrowers default altogether. But those kinds of corporate comebacks take inspired management and cut- throat restructuring, scarcely Japanese managerial strengths.

Left unchecked, banks will continue to play this dangerous game until their reserves against bad loans, bolstered by a $70 billion government bailout in 1999, wind down to dangerous levels. That could easily detonate a real crisis as bank capital evaporates or the banks cut off their borrowers.

Tokyo was right to say no now, before every poorly managed, overleveraged Japanese company comes crawling its way--and before every bank turns to the bureaucrats for rescue.

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