Commentary: Relax: Japan Won't Bring on Financial Armageddon

By Brian Bremner

In global finance, it has long been the sum of all fears. What if one of Tokyo's $1 trillion money-center banks keels over, triggering a cascade of other failures among Japanese companies and lenders. Banks, life insurers, and companies frantically shore up their balance sheets by cashing out their U.S. Treasuries and stocks, causing the dollar to crater and U.S. interest rates to spike. Big Japanese lenders default on their end of complex derivative transactions, exposing U.S. and European banks to horrendous losses. Chaos ensues.

That prospect is why big guns in Washington such as Treasury Secretary Paul H. O'Neill and Federal Reserve Chairman Alan Greenspan nag Tokyo about fixing its decade-long banking crisis before it's too late. With signs that Prime Minister Junichiro Koizumi's government has lost interest in reform, the calls have become more shrill. "The time for half-measures and postponement has passed," warned O'Neill last month.

But Japan keeps taking its own sweet time. Does that mean the global financial system is headed toward the cliff? Not a chance. Since the late 1980s, when Japanese banks dwarfed Western rivals and had a big international presence, most have quietly retrenched from foreign markets. And foreign banks have strictly limited their exposure to Japan. So a banking collapse "would have no future impact on the global economy," says Pascal Nguyen, research director at WBP Financial Integrator, a Tokyo consulting firm.

Retrenchment, of course, does not mean a return to health: Japanese banks are sick puppies. Koizumi's promise to clear out the lion's share of their nonperforming loans--an estimated $600 billion to $1 trillion--by 2005 looks like a nonstarter. And the big equity holdings of Japanese banks, which count as capital, make them vulnerable to market swings, such as the 11% drop in the Nikkei since mid-May. But if the debt bomb drops, "fallout on the regional and global financial system seems manageable," according to the International Monetary Fund's global financial stability report in June.

Take U.S. Treasuries. The Japanese do own 27% of the $1.2 trillion in Treasury bills, bonds, and notes held by foreigners, but other big players such as Britain, Germany, China, and the deep pool of U.S. pension and mutual funds, could pick up the slack if the Japanese pulled out. Also, only the most cash-strapped Japanese banks would forsake the healthy returns on U.S. Treasuries. And foreign investors hold only a measly 5% of Japan's $4-trillion bond market, which could take a beating if the Japanese sold their domestic bond holdings to raise cash.

As for the stock market, a bank-induced crash in the Nikkei would hurt but wouldn't be catastrophic. Back in 1990, the Japanese markets represented 30% of global market capitalization. Now, it's only 10%. And there are only 36 foreign companies listed on the first section of the Tokyo Stock Exchange, vs. 127 in 1991.

What about the loans foreign banks made to highly indebted Japanese companies that could get cut off at the knees by their cash-strapped domestic bankers? Well, in a two-year period ending last September, international banks' loans outstanding to Japanese borrowers fell by 16%, to about $513 billion, and the loans are mostly to blue chips with strong balance sheets. As for the big, highly leveraged derivatives deals that might leave foreign banks burned if a Japanese counterparty bank defaulted, Japanese banks represent only 10%, or $100 billion, of that market.

It's true that by dithering over its banking mess and keeping its economy in low gear, Japan is robbing the rest of the world of potential trade and investment. O'Neill figures that Japan sacrificed $5 trillion worth of economic output over the past decade by growing an average of 1% instead of 3%. But forget those overwrought predictions of a global market firestorm touched off by a failure in Japan's financial system. It just isn't going to happen.

Bremner covers Japanese finance from Tokyo.

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