|JPRI Working Paper No. 68: June 2000
Why Japan Cannot Deregulate Its Financial System
by Akio Mikuni
Japan poses for the world a key question: can it join the so-called global economy and, if so, at what cost to itself and others, chiefly the United States? Of course Japan has played a role in the global economy, and a very critical one, as a net exporter of both goods and capital. But this role was assumed for historical reasons and bureaucratic imperatives, not because of the pressure of global market forces. Japan has been able to sustain this role despite the growing countervailing pressure of market forces for two reasons.
First, Japan's governing bureaucracy has, since the early days of postwar reconstruction, successfully implemented an economic policy of maximizing production far in excess of domestic demand. All other policy considerations have been subordinated to this goal. As any beginning student of economics knows, production that outstrips demand shows up on national accounts as a current account surplus. Japan's producers and their financiers base investment and commercial decisions not on the criterion of profit maximization but on the roles they play in the pursuit of this national policy. In turn, their viability is guaranteed by the government. In this sense, all business transactions are ultimately carried out on behalf of the government.
Second, Japanese manufacturers can sell the dollar proceeds of their exports to their financiers for yen. Japan's financial authorities have seen to it, however, that the country's financial institutions in turn do not have to sell their dollar holdings for yen. As long as the dollar proceeds of Japan's exports can be held within Japanese entities, the exchange rate can be prevented from rising to levels that would destroy export competitiveness. Meanwhile, exporters can pay workers and domestic suppliers in yen while continuing to enjoy unlimited expansion of production.
But what do Japanese financial entities do with all these dollars? The yen/dollar exchange rate at the current level of some 100 yen per dollar may be too strong in light of a purchasing power parity estimated generally at around 160 to 180. But by the standards of Japan's chronic current account surplus and burgeoning net creditor position-- some ´133 trillion at the end of 1998-- this rate is far too low and requires explanation. Meanwhile, total indebtedness incurred by Japan's central and local governments has doubled from 60 to 120 percent of GDP in the past seven years, without any material growth in the GDP. Yet Japan continues to enjoy an extremely low interest rate on the government bonds (JGB's) that finance this indebtedness.
Defending the Japanese Economy from Market Forces
To understand how Japan has suppressed interest rates in the face of galloping fiscal deficits, and how Japan's currency has strengthened by only some 20 percent over the past decade despite huge trade surpluses, it is necessary to explain how Japan's political economy actually functions. Since Japan's economic system does not rest on considerations of corporate profitability or efficiency as defined by Western economists, it cannot allow profit-seeking players to invade its national economy. Japanese producers and their financiers act with the understanding that market forces are tightly controlled by the bureaucracy in their favor. The government socializes credit risk as well as market risks in order to provide friendly managerial environments for producers and their financiers. Sustaining such environments requires the isolation of the domestic economic system from outside forces, something that has long been an unstated goal of Japan's policy makers. However, this has confronted Japan's political leaders with a monumental public relations problem.
Today, foreigners are being permitted into carefully delineated and much-hyped areas of the economy. Foreign chains selling consumer luxuries such as coffee, hamburgers, and handbags can readily be seen on Japanese city streets. A few foreign investors have been invited to see what they can do with a handful of deeply troubled firms such as Nissan and failed banks such as the Long-Term Credit Bank. But real foreign participation in the economy is not compatible with continued bureaucratic control, and it has been and will continue to be covertly resisted. And should foreigners by some unlikely set of circumstances succeed in circumventing the barriers to full participation, the disruptive effects would almost certainly be far higher than the champions of an "open" Japan can possibly imagine.
Japan's Banking System
In Western countries limits to a bank's lending capacity are set by the availability of funds through deposits and the interbank and capital markets. In Japan, banks create deposits by allocating loans for the purpose of accommodating the funding requirements of borrowers. They do not wait for deposits to accumulate before lending. The Bank of Japan (BOJ) stands ready to provide them with any liquidity necessary to bridge the asset/liability gap. This is why in Japan banks rather than capital markets provide the vast majority of external corporate financing requirements. The Provisional Law on the Control of Interest, enacted in 1948 and still, despite its name, in effect, exempts banks from application of the anti-trust law. Meanwhile, the vast majority of Japan's household savings take the form of bank deposits. This system functions to separate the profitability of borrowers from the returns available to savers. For the system to work, savers and borrowers cannot be allowed to compete, respectively, for higher returns or lower borrowing costs. They must accept whatever is offered to them. Profitable borrowers cannot be allowed to grow faster than unprofitable ones.
Markets do exist in Japan, but their primary purpose is to create the illusion that Japan is a market economy. In actual fact, most markets-- including the Japanese Government Bond market-- are tightly controlled by the monetary authorities and the financial institutions that are licensed and commanded by these authorities. As a result, Japanese financial markets are characterized by small floats easily subject to manipulation. And there exist many methods, such as withholding taxes or inefficient and risky delivery and settlement systems, to discourage outside participation.
The aggregate level of capital spending in the economy is decided by the government-- more specifically, by the economic ministries such as the Ministry of International Trade and Industry (MITI). Each important industry started life as a consortium led by MITI, thereby freeing lenders from credit risk. When capacity expansion programs in a given industry were completed, domestic demand was usually inadequate to ensure full capacity utilization-- understandably so, since the expansion was undertaken without regard for demand. Thus external markets played a pivotal role in assuring full capacity utilization.
In Japan, capital outlays and the trade surplus account for relatively large and at the same time stable proportions of GDP. Exports and capital spending drove the Japanese economy; export earnings led to capital spending which led to more exports. Domestic demand played no essential role in this cycle; exports always took precedence. The Japanese government has frequently been confused when western counterparts demanded an easing of domestic credit in order to reduce the current account surplus. That may make sense in an economy where easier credit results in higher consumer spending and thus higher imports. But in Japan, additional credit simply makes its way into the coffers of export manufacturers and their financiers, bringing on yet more Japanese exports. Japanese government officials do not, however, wish to explain to foreigners how the Japanese system actually works. Instead, they largely caved into foreign pressures to make credit easier, with the result that Japan has amassed an enormous net creditor position.
The Need for a Strong Dollar
The Japanese elite understands that a strong dollar regime is essential in forestalling challenges to its power to determine economic outcomes. This regime is now threatened by Japan's endless current account surpluses. As Japan learned by historical experience during World War I and the Korean War, mushrooming current account surpluses can pose problems. If they are not to be spent on imports, thereby threatening domestic producers, or converted into yen, thereby threatening export competitiveness by producing a stronger currency, they must continue to be held as foreign currency. However, allocating domestic money to fund the holding of foreign assets subjects the economy to deflationary pressures.
In the prewar period and during the two decades following World War II, imports of advanced capital goods helped to reduce the trade surplus. But since 1970, Japan has been able to produce most capital goods for itself. Meanwhile, the largest deficit nation, the United States, produces nothing that Japan requires in sufficient quantities to reverse the trade imbalance between the two nations. Accordingly, Japan has now run chronic trade surpluses with the U.S. for some 30 years. Most of these surpluses have been invested in dollar instruments that produce interest and dividend cash flows resulting in the expansion of current account surpluses even faster than the trade surpluses. The U.S. and other Asian countries are now dependent on Japanese components; any rise in global economic activity inevitably gives rise to a demand for Japanese goods. Under such circumstances, no scenario for the reduction of Japan's current account surplus exists except a sharp and probably catastrophic soaring of the yen's value.
When the floating exchange regime began in 1973, many hoped that the appreciation of the yen against the dollar would reduce trade imbalances. But with the United States unwilling or unable to take action on its side to shrink its deficits, trade imbalances can only be reduced if surplus countries take the initiative. Japan, as the largest surplus country, would have to close factories and lay off workers or, to put it in other words, end its long-established economic policy of maximizing production to bring about a reduction in its current account surpluses. Such steps are politically impossible. Indeed, in the early 1990s separate committees sponsored respectively by the Ministry of Finance and MITI recommended that exchange rates not be used to reduce payment imbalances, and that instead Japan should continue to accumulate net claims on the rest of the world. These were justified as pools of capital for a capital-hungry world.
The strong dollar policy announced by then-U.S. Treasury Secretary Robert Rubin in 1995 amounted to a tacit acceptance of the Japanese position. Joint interventions by the two countries to reduce the yen and strengthen the dollar in August of that year cemented the policy alignment. But the result has brought the global financial system into uncharted territory, with the United States-- the world's largest economy and provider of the closest thing to a universal currency-- running a current account deficit that today amounts to about 4% of GNP. This deficit will not shrink under any conceivable economic scenario except for a sharp and probably catastrophic American recession.
Threats to the Strong Dollar Regime
Thanks primarily to Japan's willingness and ability to hold its ever-growing countervailing surpluses in dollars, the United States can experience a "deficit without tears"-- to quote a charge leveled at that country a generation ago by a prominent French economist, Jacques Rueff. Since Japan's dollar holdings remain automatically and permanently in the U.S. banking system, they continue to provide the United States with additional credit to enable it to grow and expand the deficit yet further. Imports of goods help stabilize prices while higher growth rates in consumer spending provide more sales and revenues, resulting in higher profits. Higher current account deficits by definition suck capital into the United States, thus automatically creating more credit to fuel the stock market.
Thus, in theory, so long as Japan continues to recycle her surpluses in dollars, the so-called imbalances between the United States and Japan will continue forever. But to recycle those surpluses instead of converting them into yen or into imports, Japan must fund them. Unless the Bank of Japan can somehow create adequate credit to fund the burgeoning external assets position, Japan will be faced with the unpalatable choice of a tightening monetary regime as an ever greater percentage of domestic money is drained into funding the external position, or converting some portion of the external assets to yen. Since there is virtually no supply of yen outside Japan, the result would be a soaring of the yen/dollar rate, making it impossible for Japanese companies to export without ruinous dollar price increases.
In the 1980s, the government promoted "excessive" lending by banks to fund Japan's external asset position. As we have seen, deposits in Japan area function of the volume of loans, not the reverse. A huge bubble in bank lending was made possible because of the ability of the authorities to engineer a concomitant real estate bubble. Since most Japanese banks lend on the basis of collateral rather than cashflow, astronomical real estate prices permitted lending far in excess of underlying economic activities. Landowners sold their properties at bubble prices. Since many of these people are wealthy, with a low propensity to spend, they did not disperse their funds immediately on receipt but kept them as purposeless and immobile deposits, which the banks used to help fund the permanent external assets.
With the end of the bubble in the early 1990s and the end of the government's ability to prop up real estate prices, Japan has had to turn to massive public works spending in order to stimulate the stagnant economy and also to create the deposits necessary to fund its external position. Efficient investment in public works would have translated at once into increased wages and would have stimulated the economy. This would, however, not provide the purposeless and immobile deposits needed to fund the external assets. Therefore, intentionally or unintentionally, the Japanese government disbursed its construction funds in an inefficient manner, including large transfers to construction companies that they could not spend at once and kept as bank deposits. These deposits could be used to fund the external position. However, in the same way that it turned out to be impossible to engineer infinite increases in real estate prices, the government now seems to be bumping up against limits in its ability to flood the economy with fiscal spending.
If the day comes when the government can no longer sustain fiscal deficits-- if and when the Japanese Government Bond market collapses, bringing on a sharp and catastrophic rise in interest rates-- the bureaucracy will simply be unable to support all those dependent on it. In the wake of the collapse of bureaucratic control, we will see the end of the socialization of market and credit risk, accompanied by wide price fluctuations and a wave of corporate bankruptcies. This will finally herald the reduction or reversal of Japan's current account surplus and, with it, the American economic expansion it helps finance. It will serve, perhaps, as a sign that the long-called-for integration of Japan with the global economy is about to occur. The price, however, may be far higher than elites in Tokyo and Washington can imagine today.
AKIO MIKUNI is President of Mikuni & Co., Ltd., Tokyo, Japan's leading independent, investor-supported bond-rating agency. He is the author of "Japan's Big Bang: Illusions and Reality," JPRI Working Paper 39 (October 1997) and "Why Japan Can't Reform Its Economy," JPRI Working Paper 44 (April 1998). A version of this paper was presented at a conference at the University of Amsterdam, February 3-5, 2000. © Akio Mikuni, 2000.