Playing Don Quixote at the Bank of Japan

Hayami's gambit is meant to spur reform, but it probably won't

Bank of Japan Governor Masaru Hayami is one frustrated central banker. Eighteen months after Prime Minister Junichiro Koizumi took office promising radical bank reform, little has happened. The banks are still groaning under a ton of bad debt. The corporate landscape remains littered with "zombie" companies that survive only because the banks don't foreclose on their loans. Regulators say the problem is under control. And a thoroughly alarmed Hayami keeps insisting it isn't.

So on Sept. 18, Hayami tossed the equivalent of a hand grenade into the financial system. He announced that the Bank of Japan would buy up some of the banks' $200 billion in stock holdings, which in a falling market have been eroding the institutions' capital base. The idea, according to senior central bankers, is to shore up the banks' balance sheets so they can focus on cleaning up their bad loans. But the bigger point, says one insider, is psychological: Hayami's stock purchase, said to be set at about $24 billion, is meant to send a signal to the markets that the bank crisis is headed to a new, more perilous level. That, in turn, might "ignite full-fledged efforts" by Koizumi to ram through real reform, in the words of one senior BOJ official.

As gambits go, this one is very intriguing, and very Japanese. The BOJ gets points for trying shock therapy: Someone needs to force some movement toward real reform. And Prime Minister Koizumi is already making some new gestures that favor change. A cabinet shuffle is expected in October, and one of the casualties may be Hakuo Yanagisawa, boss of the Financial Services Agency, the banks' regulatory watchdog. Hayami has assailed the FSA for failing to take the bank debt crisis seriously. Despite Yanagisawa's denials, rumors of his resignation even strengthened the yen on Sept. 25.

But don't take this bureaucratic ballet as a sign that official Japan is finally coming to grips with the worst financial crisis in the developed world. Hayami's proposal is a quixotic measure unlikely to have any long-term effect. As the senior BOJ official concedes: "We are taking a big risk that could undermine the credibility of the bank."

The BOJ move's most immediate impact was to give a dangerous jolt to Japan's bond markets. Fears that the bank might shift its financial firepower from buying government bonds to purchasing stocks triggered a minor panic. When the government held a debt auction on Sept. 18, it was undersubscribed by some $1.3 billion, which pushed long-term interest rates up 30%, to 1.3%. The unsold bonds were bought by the underwriters, and rates subsequently dropped back. But the episode sent shivers through a government that carries some $5.6 trillion in debt and must grapple with a budget deficit clocking 8% of gross domestic product.

Some bond jitters would be acceptable if Hayami's move did shore up stock prices and gave the banks some breathing room. It didn't. After a mini-rally inspired by Hayami's announcement, the Nikkei resumed its slide. That's understandable: Investors saw no real sign of follow-through from other government agencies. Even if Yanagisawa were to resign, for example, there's no guarantee a new boss at the FSA would heed Hayami's call and put more pressure on banks to offload their NPLs. Instead, Yanagisawa and his deputies put total bad bank debt at a manageable $350 billion and insist the banks are dealing with the problem. Independent analysts say the debt is closer to $600 billion and growing. Koizumi, who has publicly welcomed Hayami's move, seems to be ignoring the real message: It's time for a painful bank overhaul that would imperil borrowers from politically powerful industries.

So where does that leave Hayami and the BOJ? The markets are still left "without a picture of how the government would follow up," says Barclays Capital economist Mamoru Yamazaki. It may simply turn out that the banks get a no-strings-attached financial injection from the stock purchase, scheduled to take place over a two-year period beginning in October, without being subjected to any emergency workouts. All carrot, no stick.

The BOJ would be better off pumping up the skimpy budget of Japan's Resolution & Collection Corp., whose job is to buy up sour bank loans, restructure the debt, or shut down deadbeat corporate borrowers. If the RCC emerged as something resembling the Resolution Trust Corp., which cleaned up the U.S. savings-and-loan mess back in the 1980s, Japan might turn a corner.

Insiders at the BOJ insist Hayami's baffling move is the opening act of a larger drama, part of a comprehensive package to clear out the bad debt wreckage. Maybe the Japanese will surprise the world by following Hayami's cue. Right now, though, it seems the BOJ, FSA, and Koizumi's Cabinet will keep reading from different scripts.

By Brian Bremner in Tokyo.

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