For ten years, Japan has tried to ignore the problems created in its banking system by the massive collapse in asset values which followed the puncturing of the bubble economy in 1990.
Now, however, nemesis has appeared in the shape of a potential further crisis – or rather, a fresh manifestation of the chronic problems that have been bubbling beneath the surface for years and which erupted into the open in 1998 when several banks collapsed.
The difference this time is that there appears finally to be a frank acknowledgement of the deep-rooted and very serious nature of the problem, and a determination to do something about it.
The Bank of Japan’s landmark decision on March 19 to bolster banking system reserves and to create and maintain a zero interest rate policy, until deflation is scourged from Japan, was the most important development in this regard. It became clear, too, when Japanese prime minister Yoshiro Mori met US President George W. Bush for a summit meeting in Washington that same day that the problems of Japanese banks have been elevated to the level of a global concern.
Both sides cited these as a factor which threatens to exacerbate an economic slowdown on both sides of the Pacific and which could herald global recession in the absence of appropriate policy actions. Portents of a resurgence of a banking crisis have appeared.
Daiwa Bank was rumoured in financial markets to be in trouble (although the bank strenuously denied it) and rating agency Fitch IBCA announced that it is considering downgrading the ratings of 19 Japanese banks.
Sanwa and Tokai banks meanwhile warned that they would declare heavy losses for the financial year to March 31 after more than doubling their planned bad debt write-offs.
Japan’s leading city banks and trust banks as a whole were said to be facing huge losses on their equity portfolios with the Nikkei at the level of around 12,000, to which it plunged in mid-March – marking a 16-year low. Analysts put these losses at anything from ¥1000bn ($8bn) to as a high as ¥3000bn–¥4000bn on equity holdings said to total around ¥34,000bn.
Bank losses could in themselves trigger a crisis of confidence and possible runs. Against this background, the Bank of Japan’s (BoJ) policy board agreed on March 19 to adopt a new approach to monetary policy that focuses, in effect, upon increasing the quantity of money in the system rather than simply influencing the price of money.
The BoJ will increase the amount of reserves held with it by commercial banks by 25%, from ¥4000bn to ¥5000bn. This, the bank said, should have the effect of driving short-term money market interest rates down to virtually zero.
More importantly, the BoJ undertook to take actions to hold rates at around zero until such time as the consumer price index – which has declined for the past two years – stabilises above zero.
By so doing, the BoJ not only adopted what amounts to an inflation target but also deprived itself of freedom of manoeuvre in adjusting short-term rates. This is deemed essential in the light of what has become an accelerating process of deflation – both in current prices and in and the price of assets – within Japan.
Japanese officials insist that the latest BoJ actions represent more than simply a reversion to the zero interest rate policy which the BoJ abandoned last August amid great controversy. (The BoJ has since gone part of the way toward restoring this policy by reducing from 0.25% to 0.15% the rate at which it targets interest on ‘call’ money for up to five days).
Given the assurance that short-term rates will remain at around zero until consumer prices cease to fall, the BoJ strategy means that banks have access, in effect, to free money for an indefinite period. The hope is that this will provoke new credit creation and reverse the 38-month-long drop in bank lending in Japan, while also stimulating economic activity and asset prices.
By increasing banking system reserves, a central bank sets in motion a multiplier effect whereby the total increase in lending made possible by such a move is considerably in excess of the amount of additional reserves that are created.
There is no guarantee that banks will, in fact, increase their lending in an environment where some economists claim that there is very little demand for funds at present. The benchmark June 10-year Japanese Government Bond futures jumped to a new record high of 140.25 after the BoJ’s move, on market expectations that banks will largely re-circulate their increased reserves back into the bond market.
Any increase in bank lending will take some months to show up in statistics, but the BoJ moves are designed to send a signal to financial markets that the central bank has, in effect, adopted an inflation target and that that policy will be bent toward this end from now on.
The effective restoration of zero short-term interest rates is expected to have a positive impact upon Tokyo stock prices. The Nikkei 225 average soared by more than 50% in value during the 18 months that the zero interest rate policy was in operation before – and plunged after that policy was ended.
If stockmarket values do respond now as expected, this will have the effect of reducing the cost of capital raised through the stockmarket and thus serve to help revive corporate activity even if the channel of increased bank lending should remain closed, or at least partially blocked for some time.
The stockmarket may also benefit from a new quasi-government fund to buy up stocks, which is under consideration. Moves to shore up the market are seen as essential to prevent a possible crisis of confidence that could be triggered by leading Japanese banks having to declare losses at the financial year end, and financial services minister Hakuo Yanagisawa promised a set of banking-system support measures by around the end of March.
Meantime, the BoJ’s latest moves also provide assurance that ample liquidity will be available to all banks regardless of their market credit standing. BoJ governor Masaru Hayami insists that financial system problems must be settled in order to raise the effectiveness of monetary policy in Japan.
“Bad loans must be detached from banks’ balance sheets to strengthen the financial system and, at the same time, banks must set aside appropriate provisions for those claims that need to be watched carefully,” he told the official Council of Economic and Fiscal Policy.
The BoJ’s pledge to hold short-term interest rates at or around zero levels should assist this provisioning process.
