Crisis Prevention: Time for Japan to Act -- A Commentary by Yusuke Horiguchi, Director, Asia and Pacific Department, IMF

September 20, 2001

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Crisis Prevention: Time for Japan to Act
A Commentary
By Yusuke Horiguchi
Director, Asia and Pacific Department
International Monetary Fund

Reprinted from the Asian Wall Street Journal © 2001
Dow Jones & Company, Inc. All rights reserved

Asian Wall Street Journal
September 20, 2001

The government of Prime Minister Junichiro Koizumi should be commended for its commitment to implementing wide-ranging structural reforms. Given its victory in the recent Upper House elections, Mr. Koizumi and his party have an opportunity to implement this agenda and bring about real change for the better in the Japanese economy.

Not everyone agrees, however, that this is the right time to press ahead with reforms, or even that such reforms will help solve Japan's economic problems. Some commentators have suggested that reforms be delayed because of the weakening domestic economy and the uncertain outlook for global growth.

Others have argued that the cause of Japan's poor performance since the early 1990s has not been structural weaknesses in the banking and corporate sectors, but a lack of demand in the economy. According to this view the solution is not structural reform —which may actually intensify deflationary pressures in the near term —but more aggressive macroeconomic policies aimed at boosting demand. It is argued that all that is needed to address the current problems is for the Bank of Japan to aggressively pump additional liquidity into the economy, and for the government to continue its expansionary budget policies.

There is no denying that lack of demand is a problem and that macroeconomic policies have an important role to play. But would more expansionary macroeconomic policies by themselves restore strong, sustainable growth? The answer is no. Such policies have been pursued for much of the last decade without successfully reinvigorating the economy.

Structural problems lie at the heart of Japan's economic difficulties and a sustained rebound in private demand will remain elusive until these factors are decisively addressed. For more than a decade Japan has adjusted too slowly to the forces of globalization, lagging behind in innovation and productivity growth. The country must now remove the obstacles to efficiency in the domestic sectors of the economy, unwind the excess capacity and debt that was built up during the bubble years, and curb the rapid expansion of public-sector debt.

The government, therefore, needs to move ahead with reforms. Delaying or watering down the program will only prolong economic weakness and increase the risk of crisis. As an absolute top priority, the problems in the banking sector must be dealt with in a decisive manner. The government's April policy package to accelerate the disposal of bad loans is a welcome initiative. The measures need to be vigorously implemented and extended to all deposit-taking institutions—not just the major banks.

However, despite this initiative and the progress made by the Financial Services Agency in strengthening its surveillance of the banking system, there still remains considerable uncertainty about the size of the bad loan problem and the adequacy of banks' provisions against these loans. Until the scale of the problem is fully recognized, a final resolution will remain difficult to attain.

An important first step, therefore, will be to undertake a complete assessment of the scale of the bad-loan problem. To accomplish this, banks will need to further strengthen their credit assessments and adopt a more forward-looking approach to loan classification and provisioning. This is particularly important in the current environment of weak growth and continuing deflation where the likelihood of a loan becoming nonperforming is higher than under more favorable economic conditions.

Japan's recent decision to participate in the International Monetary Fund's Financial Sector Assessment Program, an existing monitoring program in conjunction with the World Bank, will contribute to this effort by helping to achieve a better understanding of the key issues faced by its banking industry. Under this program, the IMF has already assessed several dozen countries, including Canada.

Were the scale of the nonperforming loans to be significantly larger than currently recognized by the banks, additional provisions would be needed. This, of course, would adversely impact bank capital. In such a situation, public capital injections targeted at weak but viable institutions may be necessary to restore bank capital to adequate levels, maintain systemic confidence in the banking system and avoid a credit crunch that would further worsen the current economic situation. Ways would have to be found to minimize moral hazard associated with public money injections.

Debt workout agreements in the context of resolving banks' bad loan problems need to be sufficiently strong to achieve a durable turnaround in corporate performance. The reform program will be a success only if it achieves deep restructuring of distressed companies and the prompt closure of nonviable firms.

In other areas, addressing concerns about the sustainability of government and social-security finances should be high on the reform agenda. Fiscal reforms are necessary to underpin a credible, medium-term fiscal consolidation strategy —including a reduction in public works spending, reforms of pension and medical care programs, and an end to the practice of earmarking revenues in advance for specific purposes.

At the same time, decisions on when to start the process of fiscal reform, and how quickly to pursue it, need to be made with care; the weak economy and disposal of bad loans and corporate restructuring are likely to have a negative impact on growth and employment in the short term. Thus, while establishing a credible framework for medium-term fiscal consolidation is important, the government should avoid an abrupt withdrawal of stimulus so long as economic activity is weak. Indications that the government will introduce a supplementary budget later this year to expand the social safety net are welcome.

With regard to monetary policy, the BoJ has made a good decision to raise its quantitative target and increase its purchases of Japanese government bonds. Further measures are still likely to be necessary, however, and the effectiveness of policy would be enhanced if the BoJ clearly specified a reasonable timeframe for eliminating deflation. Monetary policy along these lines should contribute to stronger economic activity by counteracting deflationary expectations and boosting domestic asset prices. Such a policy could also result in a weakening of the yen. But regional concerns about a weaker Japanese currency are likely to be markedly less than during the 1997-98 Asian financial crisis, given the adoption of flexible exchange rates by many countries and healthier external-debt profiles throughout the region.

The Japanese government also needs to introduce measures to strengthen the regulatory structure, reduce the role of public enterprises in the economy, improve corporate governance, increase labor market flexibility, and revitalize the real-estate market. Such policies will be important to generate new investment and employment opportunities, and raise productivity growth over the medium term.

Implementing these reforms will not be easy, but bold measures are needed to return the economy to strong, sustained growth. The past decade has shown the perils of delay. Now is the time to act.


Mr. Horiguchi is director of the Asia and Pacific Department of the International Monetary Fund. This article was submitted for publication before Sept. 11.


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