Commentary: The Bank of Japan's Real Message: Reform Now

By Brian Bremner

For almost a year now, politicians in Tokyo and abroad have been urging Bank of Japan Governor Masaru Hayami to throw caution to the wind. Japan's deepening crisis calls for radical measures, they declared, including zero interest rates and a deliberate effort by the BOJ to foster inflation to help relieve Corporate Japan's debt burden. Hayami curtly dismissed such advice as absurd and reckless. Few expected him ever to bend.

On Mar. 19, however, Hayami appeared to abruptly reverse course by announcing measures that will effectively drive the overnight call rate back down to zero and pump up the money supply to push the consumer price index up. Markets are now abuzz with speculation that Japan will deliberately ramp up inflation past 3%, and that Hayami is a convert to the cause of fast reflation.

MODEST GOALS. Yet that analysis misses a far more subtle mating dance that is going on among the central bank, the Finance Ministry, and the ruling Liberal Democratic Party. First, the BOJ's goal is not really to melt away the debt pressures on Japanese companies. Nor is it to get consumers to pry open their wallets and buy a new Toyota before the price goes up.

Rather, the aim is simply to halt the deflationary trend that is hammering corporate profits and the Nikkei, which has been trading near a 16-month low. In an interview with BusinessWeek, Deputy BOJ Governor Yutaka Yamaguchi insisted that inflation rates even as high as 3% to 4% are "not in our sight or in our intentions." What's more, he says, the BOJ's increased purchases of government bonds--the usual way to increase the money supply--will be modest and directed at addressing liquidity problems in the banking sector.

Nor is the BOJ's zero-rate program a pain-free bailout of the banks. Pushing the short-term overnight call rate to zero from 0.15% "is not a major change in practical terms because it is reducing banks' borrowing costs only marginally," notes J. Brian Waterhouse, bank analyst at HSBC Securities.

So what is going on? First, it's clear that Hayami pulled the trigger too soon when he departed from the zero-interest-rate policy last August and pushed rates up. The BOJ underestimated the impact of a slowdown in the U.S. economy and didn't see the coming global train wreck in the technology sector.

But Hayami has not given up on the other part of his agenda: to press for real restructuring inside the banks and corporations. So Hayami is signaling that he will ease up on his hard-money ways in exchange for some real action by the banks: "While we are doing our part, we hope the government and the financial system will do what's necessary on their side," says Yamaguchi.

Will the other side fulfill its part of the bargain? Hayami and Hakuo Yanagisawa, head of the watchdog Financial Services Agency, will certainly keep pushing banks to write off their loans, sell off underlying collateral, and take a tougher stance on weak borrowers. Meanwhile, Finance Minister Kiichi Miyazawa has sounded the alarm about Japan's fiscal mess. ING Barings bank analyst James Fiorillo thinks the pressure from the three financial bosses, plus what looks like a tacit deal between the Bush Administration and Tokyo to let the yen slide, suggests that "strong medicine for the banks must be forthcoming."

If reforms go forward, the BOJ would ensure that no big money-center banks go under. And Yanagisawa would push through a credible bank bailout deal, perhaps with more public money. The resulting impact on Corporate Japan, as banks cut off deadbeat borrowers, companies go bust, and joblessness shoots up to 5% or 6%, would be partly offset by a weak yen delivering more export growth.

It's hard to say Japan will finally take the plunge, given the lack of solid political leadership. But this much is clear: Monetary easing without serious reform is a waste of time. Sick banks won't use excess liquidity to lend; they'll buy government bonds. Overextended companies won't borrow for fresh investment. And anxious consumers aren't going to buy that Toyota.

Hayami and his crew are offering the ruling LDP and its corporate backers a deal. Get going with the heavy lifting of reform, and we will do what we can to ease the pain. What the bankers won't do is hand over the yen printing presses to an intellectually bankrupt LDP that loves to put off tough decisions for another day. And that is a wise decision.

Bremner is Tokyo bureau chief.

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