Japan's Reformer

Junichiro Koizumi has a radical plan to restructure the dysfunctional economy, but the new Prime Minister has only weeks to act. Does he have a fighting chance?

After anointing self-proclaimed reformer Junichiro Koizumi as Japan's new Prime Minister, the faithful of the ruling Liberal Democratic Party called a rally at party headquarters. "Gamboro!" they shouted after tributes to their new leader. Rough translation: "Let's close ranks and kick some butt." Koizumi vowed to create a new LDP that "will stick out its chest and move strongly toward the future." Rich stuff, given that the LDP is a hornet's nest of factional intrigue and Koizumi himself could fall in a matter of months.

As the LDP's blue-suited brigade departed its nondescript headquarters in Tokyo, everyone knew Japan's ruling party had just embarked on a bold gambit. This, the stodgiest of Establishment parties, has selected as its leader a quirky maverick who favors austerity and pain--a hard sell for any politician anywhere. Even Koizumi rival Shizuka Kamei, chairman of the LDP's Policy Research Council--who dropped out of the race before the Apr. 24 vote--marvels at how Koizumi pulled it off. "He looked like a white knight on a ride for justice," says Kamei. "That mesmerized our members."

By choosing Koizumi as Prime Minister, the LDP--or a big chunk of it, anyway--is trying to save its skin by selling the Japanese public on a policy shift toward true economic reform. Gone, its resident optimists will tell you, are the cushy contracts for political supporters and the bailouts that have been standard LDP operating procedure for decades. This policy about-face is risky: Many of the party's backers in industry dread the sting of reform and will do just about anything to avoid it. Koizumi faces many battles before he puts his program in play.

But much has changed in Japan, making the moment ripe for a reformer like Koizumi. In the mid-1990s, the LDP was in a state of denial about the depths of the financial and economic crisis. Monetary and fiscal policy was being held hostage by bureaucrats or LDP elders concerned solely with protecting their own interests. Now, thanks in part to increasing pressure from a revitalized opposition, Koizumi and his reform-minded allies are willing to talk candidly about what needs to be done. The central bank is increasingly independent and no longer willing to allow politicians to hijack monetary policy. And even as policy is more openly debated, voters are becoming receptive to new ideas. "The fact that the rank-and-file Liberal Democrats cast ballots overwhelmingly in favor of Koizumi is a clear signal to the Liberal Democratic Party that they have to change," says Minoru Makihara, chairman of Mitsubishi Corp. "It's a strong signal, and I hope they'll react."

It would be political and economic suicide for the LDP to continue its course of the last decade. As Koizumi says, without "resolutely implementing structural reform," Japan will face a far uglier reckoning later on. Tough love won't be fun in the short term, but other industrialized nations have endured similar pain and emerged stronger. "If we prolong the current situation," says Koizumi, "we won't get a recovery."

BACKROOM DEALS? As Japan's $4.1 trillion economy lurches toward another recession, policymakers, investors, and business executives in the U.S. and Europe can only hope Koizumi is the real thing. For years, the West has been waiting impatiently for Japan to halt its slide. The most recent fear is that a new recession in Japan will have a knock-on effect that will destabilize the rest of Asia, just as U.S. demand for Asian goods starts to slump. So Bush Administration officials are cautiously endorsing Koizumi--and ardently hoping he hasn't made any backroom deals that undercut his bold plans.

The results of past inaction by Japanese governments are painfully plain: a bourse that has lost 65% of its value in the last decade, a cratered property market, the biggest budget deficits in the world, and the most dysfunctional banking system among developed nations. The latest scary revelation to emerge from Japan: the number of nonperforming loans is far higher than previously estimated--perhaps not as high as the $1.2 trillion claimed by the political opposition, but at least 25% higher than the most recent official figure of $400 billion, according to ING Barings analyst James Fiorillo.

The driving need to defuse this financial bomb explains why Koizumi's fate is so important and why the world will scrutinize his every move in the coming days. Many are worried he'll fail the test and turn out to be a transitional figure--the politician who kicked off an important political realignment in Japan but failed to lead it. "Is this the first chapter of the New Japan?" wonders Clyde V. Prestowitz Jr., president of the Economic Strategy Institute in Washington. "Or another chapter of the Old Japan?"

That is the trillion-dollar question. Koizumi has only a matter of weeks to put coherent policies in place--not because the economy is about to fall off a cliff, but because the embattled LDP faces an upper-house election on July 29, a contest it is widely expected to lose. If Koizumi cannot stop a rout, he himself could be swiftly deposed by the party that just selected him for the top job. And even if Koizumi does win over voters in the July election, his struggles won't ease. He "could change politics in this country," figures Nasdaq Japan Chief Executive Officer Tatsuyuki Saeki. But make no mistake: "People will want to shoot him in the back." In other words, the old regime, and the special interests it represents, won't die without a bitter struggle.

Yet Koizumi does have a plan more ambitious than any LDP leader has proposed. The strategy has the support of the LDP rank and file and probably a large number of voters. Whether he can ram new legislation through before the government faces the voters is unclear. But elements of the plan tackle the core issues plaguing the economy:

-- Bank reform. LDP elders recently proposed a three-year plan to coax the banks into writing off their problem loans and start lending again to healthy companies. Critics say the blueprint refers only to some $270 billion of the worst loans, or only about two-thirds of what analysts say is the real total of bad debt. Koizumi wants something closer to an earlier, tougher plan fashioned by Hakuo Yanagisawa, the top financial regulator. That could mean accelerating the timetable from three years to two, tackling a greater share of the bad debt, and providing more public money to keep the banks afloat as they write off billions of dollars in dud credit.

-- Jobless benefits. Japan has nothing like the government-subsidized unemployment plans common in Europe and the U.S. And tough labor laws make it hard to lay off workers. Yet higher unemployment is inevitable if Koizumi forces the banks to call in loans and shove delinquent borrowers into bankruptcy. So he wants to create jobless benefits paying as much as 100% of a laid-off worker's pay for up to 12 months. Such a cushion could make a company's decision to lay off employees and restructure much easier.

-- Social security makeover. Because of Japan's rapidly aging population, the pension system will likely go bust some time next decade without an infusion of new money. HSBC Securities economist Peter Morgan estimates the system is underfunded by $4.3 trillion, or 100% of gross domestic product. So far, Koizumi's ideas for fixing social security are sketchy, but he hopes to root out waste and put more of a burden on the wealthy, once it is economically feasible.

-- Deficit spending. Budgets at both the central and local level are out of control, with their total deficit adding up to 10% of GDP. No modern developed nation has run such deficits before. "The Japanese government borrows $40 million an hour, 24 hours a day," says Wilbur Ross, a U.S. investor now making deals in Japan. Koizumi wants to cap government borrowing at $245 billion a year by ordering the Finance Ministry to cap new bond issues.

-- Privatizing the postal savings system. This is the savings bank, run by the post office, in which millions of Japanese have stashed $2 trillion in deposits. For decades, the money has been shoveled into wasteful government projects, to Koizumi's chagrin. Of all his reform proposals, none fires him up like postal savings privatization. Japanese bankers, who view the system as a tax-subsidized monster that diverts deposits away from the financial markets, are amazed at Koizumi's intensity on the subject. "He has written a book, holds all kinds of seminars, and bet his entire political life on this issue," says Akira Kanno, vice-chairman of the Japanese Bankers Assn. "He is always giving us a scolding for not being more passionate about this." Koizumi would love to break up the postal savings system into regional savings funds, then eventually privatize them as individual banks.

Koizumi will probably defer his attack on the postal savings system until he's sure his emergency program will pass. That may be wise: His proposals are not without considerable risk. For starters, fixing the banks will mean cutting off corporate borrowers. As a result, Japan's 4.7% jobless rate could surge to 6%, and 1.5 percentage points could be shaved off annual growth for the next two years. Koizumi's team needs to make sure that any spending cuts aren't so heavy that they push the economy deeper into recession.

Much of Koizumi's success will depend on whom he names to his Cabinet. As BusinessWeek went to press, it seemed likely that Yanagisawa, the taskmaster of the watchdog Financial Services Agency, would keep his job. And it looks like Koichi Kato, a fiscal hawk who wants to halt wasteful public works spending, will get the Finance portfolio. Economic reformer Taku Yamasaki is tipped to get the key job of LDP Secretary General. And outspoken Makiko Tanaka, daughter of the former Prime Minister, may also get the Foreign Ministry. Tanaka defied party elders by calling on the LDP faithful to support Koizumi.

While Koizumi is an untested maverick, his arrival on the scene comes at a potentially propitious moment. The Big Bang financial reforms set in motion four years ago by the Hashimoto Administration are forcing Japan to bring itself in line with international accounting practices. Consolidation of the financial sector over the past 18 months makes it easier to deal with the bad loans.

Moreover, the government's inability to fix the economy has forced Corporate Japan to rehabilitate itself. Increasingly, companies are spinning off noncore assets and cutting costs in an effort to make themselves globally competitive. Legislation has already been passed to make such spin-offs easier. And Corporate Japan seems prepared to back Koizumi. Says Tetsuya Katada, vice-chairman of the Japan Federation of Economic Organizations: "We expect him to implement reform measures without being bound by vested interests."

At the same time, despite their fears of increasing unemployment, a large number of Japanese voters finally seem to be coming around to the notion that there can be no gain without pain. In the week before the Diet vote, LDP upper house member Yoshimasa Hayashi was startled by how Koizumi's tough-love agenda struck home with his constituents in southern Japanese cities.

Indeed, Koizumi cleverly exploited the deep anxiety among grassroots LDP members that the status quo, championed by former Prime Minister Ryutaro Hashimoto--who pitched go-slow restructuring and more government spending--would lead the party into the political wilderness. On the stump, on Sunday talk shows, and on his Web site, Koizumi warned that the party stood at "a crossroads that will determine whether the people of Japan completely give up on LDP governance or whether we are able to regain the confidence and trust of the nation." That played to the survival instincts of LDP members with vulnerable seats.

The new Prime Minister also tapped into residual anger among the LDP rank and file over the closed-door selection of his predecessor, Yoshiro Mori, last year. Lower-echelon party members were simply not consulted, and the Mori Cabinet's subsequent gaffes, scandals, and witless economic policy turned the party into a laughingstock. Bringing an end to Japan's faction-driven politics is another of Koizumi's passions. He argues that annual Cabinet shuffles reward political loyalty, not talent. He says the system kills perfectly good policy ideas in the cradle.

"NOTHING WILL CHANGE." But the fact remains that Koizumi would not have triumphed without the support of the very factions he affects to despise. One of those is co-managed by LDP policy chief Kamei, who is among the party's most formidable power brokers. Kamei is almost certainly expecting some sort of payback--and he may try to pressure Koizumi to pursue a tax cut. The new Prime Minister's defeated rival, Hashimoto, head of the LDP's largest faction, may try to water down legislation that threatens the interests of his backers in the construction and post office business groups. Also, it's one thing to abandon such big LDP supporters in an intraparty beauty contest but quite another to spurn their support in national campaigns that require lots of cash. "The factions will not be able to betray their vested-interest supporters so easily," reckons Robert A. Feldman, Morgan Stanley Dean Witter & Co.'s Tokyo-based chief economist.

Nor can Koizumi expect to forge a coalition with the opposition. Democratic Party of Japan leader Yukio Hatoyama dismisses any talk of his opposition bloc teaming up with a renewed LDP to create a reform-minded government. When push comes to shove, says Hatoyama, the LDP won't turn on its business backers. "Nothing will change," he insists. The DPJ and its opposition allies think they'll grab control of the upper house and force a general election by the fall, no matter who leads the LDP.

So, is Koizumi the right man for one of the world's most thankless jobs? He is certainly ambitious. This is his third run at the LDP presidency in six years--in 1995 he lost to Hashimoto, and in 1998 he was bested by late Prime Minister Keizo Obuchi. And he has demonstrated the ruthlessness required to succeed in Japanese politics. Last November, when fellow reformer Koichi Kato led a rebellion to oust Mori, Koizumi didn't lift a finger to help, instead sticking by the Premier despite his disastrous record. Then, when Mori resigned in disgrace in early April, Koizumi made his move and elicited the support of Kato and other reformers.

Japan's 11th Prime Minister in 12 years is also pragmatic and not above seeking the counsel of his elders. Merrill Lynch & Co. chief economist Jesper Koll points out that Koizumi has wisely sought out the patronage and advice of ex-Prime Minister Yasuhiro Nakasone, generally viewed as Japan's strongest postwar leader, who successfully managed an anti-mainstream ticket during the mid-1980s. Says Koll: "Japan now has a leader with a vision and a purpose."

The burning question is whether Koizumi be around long enough to turn that vision into policy. Japanese voters have seen self-styled reformers storm into power only to be disgraced by scandal or co-opted by the LDP bosses. If Koizumi joins that list, count on more policy gridlock when the economy can least afford it. But for now, Japan has a glimmer of hope, and Junichiro Koizumi has a chance to make a difference.

By Brian Bremner and Robert Neff, with Ken Belson, in Tokyo, and Julia Lichtblau and Irene M. Kunii in New York

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