Originally published in THE WALL STREET JOURNAL

Tuesday, November 25, 1997

Japans Folly Drags Asia Down


Board of Contributors

"A tax cut in Japan that allowed the yen to get back to 100 yen per dollar would do a great deal to end Asias competitive devaluations and strengthen the regions economy."

Japans Ministry of Finance is undermining the countrys economy, and bringing down much of Asia in the process. If Japan had followed a more sensible policy to stimulate its own recovery, the exchange rate crisis in Southeast Asia and Korea could have been avoided or made much less painful. Its not too late, however: If Japan provides a fiscal stimulus and permits the yen to appreciate, the damage in the rest of Asia can be reversed.

In Japans weak political system, it is the bureaucrats at the Ministry of Finance who control all economic policy, including tax and spending decisions, monetary policy and the supervision of banks. So the blame for Japans poor economic performance in the 1990s rests squarely at the ministry.

Japans economic growth has averaged less than 1% a year since 1992, and its unemployment rate has been rising since the beginning of the decade. The ministry nevertheless refuses to provide the fiscal stimulus of a tax cut. This spring it perversely raised the value added tax to 5% from 3%, causing consumer spending to collapse and gross domestic product to decline at an astonishing 11% rate in the second quarter.

The Ministry of Finances excuse for not cutting taxes is a misguided claim that Japan cannot afford to do so because of its large budget deficit. In fact, the deficit, at 3% of GDP, is similar to that in many other industrial countries. If Japan were operating at full capacity, the resulting rise in tax revenue would all but eliminate the budget deficit. Moreover, government borrowing is small relative to Japanese private saving, leaving an excess of national saving over investment of 2.3% of GDP, which goes abroad as foreign investment.

Instead of providing a fiscal stimulus to correct the weak economy, the Ministry of Finance instructed the Bank of Japan to cut the official discount rate from 6% in 1991 to 2% in 1993 and to only 0.5% today. Even the interest rate on 10-year government bonds is now less than 2%.

This decline of Japanese interest rates and the persistent weakness of the Japanese economy have caused the yen to fall from 90 per dollar in the first half of 1995 to 127 now. Although the low yen gives Japan an enormous trade surplus ($91 billion over the past 12 months), this has not been enough to rescue the Japanese economy and make up for the lack of a fiscal stimulus. But the decline of the yen caused the currencies of Thailand, Malaysia, Indonesia, the Philippines and South Korea to fall by an average of more than 25% vs. the dollar during the past six months. The suddenness with which those currencies collapsed and the domestic difficulties of adjusting to that decline resulted from the previous misguided attempts to peg those currencies to the dollar. But the basic cause of their decline was the fall of the yen.

This market driven process of exchange rate declines may continue to spiral downward if nothing is done to reverse the yens weakness. As each countrys currency falls, its trade competitiveness increases, putting pressure on the currencies of its competitors. A tax cut in Japan that allowed the yen to get back to 100 per dollar would do a great deal to end these competitive devaluations and strengthen the entire regional economy.

The external positions of the Southeast Asian countries have been precarious for several years. Thailand and Malaysia, and to a lesser extent Indonesia and the Philippines, became dependent on large capital inflows to finance their current account deficits, causing them to accumulate disturbingly large foreign debts. The primary source of this lending has been the Japanese banks.

It was therefore Japanese monetary and banking policies that encouraged and facilitated the large current account deficits of Southeast Asia and of South Korea. The low interest rates offered by the Japanese banks and their relatively lax credit standards made it possible for Asian borrowers to incur large amounts of Foreign debt, much of it denominated in dollars. The Japanese banks were eager to lend abroad because of the low interest rates and weak demand for credit at home. And they liked lending in dollars because of the higher interest receipts. When the yen fell relative to the dollar, however, many Asian borrowers found that they could no longer service their debts.

If the Ministry of Finance had pursued a sensible fiscal policy, interest rates in Japan would have been higher and Japanese banks would have had less incentive to make foreign loans on weak collateral. But it was not so. Now, as economic conditions in Japan have deteriorated and bank capital has been eroded, the Japanese banks have begun reducing their foreign lending, exacerbating the situation in the borrowing countries.

Japanese banks were weak long before the recent currency crisis began, primarily because of the 65% collapse in the price of the Japanese urban land. The weakness was compounded by the 60% fall in stock market prices that had also occurred by 1995, since Ministry of Finance rules allow banks to include 45% of unrealized stock market gains in the banks regulatory capital. Unfortunately, the ministry ignored the banks deteriorating collateral and declining capital, allowing the situation to get progressively worse.

It is now clear even to the Ministry of Finance that that strategy has failed. The ministry recently took the unprecedented step of allowing Japans 10th-largest bank, Hokkaido Tokushoku, to fail, with a total loss of shareholders equity and the retirement of all top management. Although Japan doesn't have formal deposit insurance laws--since no bank had been allowed to fail in the past half century--the depositors have been completely protected by a loan from the Bank of Japan, which is to be repaid by an industry fund financed by a tax on all deposits. This was good policy that fulfilled an implicit promise to depositors without bailing out shareholders and bank executives.

Looking ahead, there must be more honest write-downs of bank assets and further bank shutdowns. In protecting shareholders, the Ministry of Finance should go beyond what it did with Hokkaido Tokushoku and recognize the governments implicit obligation to depositors without imposing more taxes on depositors of healthy banks. The government should use general funds to meet its obligations to the depositors of future failed banks. Although these payments may be classified as deficit spending, unlike other budget deficits such outlays do not encourage increased consumer spending (since the depositors know that they have that value in their accounts) and financing those outlays by issuing new bonds does not crowd out other lending (since the banks or their successor organizations would have a demand for assets to replace the loans taken over by the government).

In contrast, if the Japanese government were to increase the capital of weak and insolvent banks by purchasing preferred shares, this would be an undesirable bank bailout. By keeping insolvent institutions alive in a way that protects shareholders and managements, Japan loses the discipline on the future behavior of banks. The claim that such capital injections are needed to maintain adequate capital in the banking system is unfounded. Adequate capital can be maintained by securitizing and selling existing bank loans to nonbank buyers and by allowing Japanese banks to be bought by nonbank corporations and by foreign investors.

Although the Ministry of Finance has been unwilling to incur increased budget deficits to stimulate the economy, it was eager to contribute $100 billion to a newly established Asian monetary fund to countries in the region whose currencies come under attack. Although this can be seen as an indirect way of protecting foreign assets of Japanese banks, it also a major foreign policy initiative for Japan that would have displaced the International Monetary Fund and the U.S. in Asia and increased Japans regional economic hegemony. It would have been ironic if Japans pursuit of the bad domestic policies that created todays currency crises in Asia had been rewarded with an increase of Japans economic and political power. Fortunately, the U.S. was able to persuade the other countries of the region to reject this proposal.

What remains now is to convince the Ministry of Finance that using that $100 billion to finance tax cuts at home would be best for both the Japanese economy and for the other nations of Asia.

Mr. Feldstein, former chairman of Presidents Council of Economic Advisers is a professor of economics at Harvard University.