The Return of Japan's Zombie Finance

Includes: EWJ, FXY
by: Darrel Whitten

Economists and policy makers agree that a major contributing factor to Japan’s 10-year “Heisei Malaise” was the prevalence of “zombie finance”, where Japanese banks continued to provide support for highly inefficient, debt-ridden companies, commonly referred as zombie companies, and the government effectively allowed the banks to simply ignore their festering bad loans with lax accounting practices, including the absence of mark-to-market. Zombie financing in turn prevented the creative destruction necessary to clear the dead wood from various industries and prevented more productive companies from gaining market share, thereby cutting off a potentially important source of productivity gains for the overall economy.

For a brief time under the Koizumi Administrations, it appeared that the Japanese government at last got the joke, i.e., that full-scale reforms were required to restore Japan’s economy to a sustainable growth path.

The DPJ: Dismantling the Koizumi Reforms Piece by Piece

In subsequent administrations and particularly since the DPJ took power, the Koizumi reforms are increasingly seen in Japan as an example of what not to do.

In 2003, the Koizumi Administration proposed splitting Japan’s postal services system into four separate companies: a bank, an insurance company, a postal service company, and a company to handle the post offices as retail storefronts of the other three. Privatization of Japan Post was a cornerstone of the Koizumi Administration’s structural reform initiatives, with the three profit-making entities planned for eventual listing on the stock market.

Each of these companies were to be eventually privatized. However, while a bill to complete this reform barely passed the lower house of the Diet In 2005, it was defeated in the upper house because of opposition from the DPJ as well as scores of defections from the LDP, including the current Financial and Postal Affairs Minister Shizuka Kamei.

When voted into power in September 2009, one of the first moves by the new Hatoyama Administration was to freeze the Japan Post privatization plan, and they are now moving to dismantle the Koizumi-era reforms piece-by-piece, beginning with the dismantling of the Japan Post privatization plan.

Japan Post runs the world’s largest postal savings system, with JPY220 trillion of household savings in Yu Cho deposits before the privatization plan began. In addition, another JPY128 trillion of household savings was in Kampo insurance policies. This JPY340 trillion of household savings was worth some 65% of Japan’s GDP. Japan Post also maintained a network of some 24,700 post offices nationwide.

While deposit balances began to decline after the postal savings were brought under Yucho Bank, the Bank still had some JPY180 trillion of savings deposits as of December 2008, while Kampo had some JPY113 trillion of assets under management.

Japan Post as a DPJ Piggy Bank

Our read is that the DPJ wants to keep what is essentially a giant piggy bank under government control as insurance against a substantial increase in JGB issuance. Facing the need to issue over JPY50 trillion of new JGBs in 2010, the fact that some 80% of Yucho Bank and Kampo assets are invested in JGBs has not been lost on the new Administration.

Postal and finance minister Shizuka Kamei has also said the re-combined Yucho and Kampo pool of funds could be used as a funding source for loans to regional SMEs (small and medium-sized enterprises).

To complete the reversal of the Japan Post privatization, Japan Post’s previous reformist president Yoshifumi Nishikawa was forced to resign, and an ex-MOF minister (Jiro Saito) was installed, virtually guaranteeing Japan Post’s return to a government organization.

Back to “Zombie” Finance

As seen by the 180-degree reversal on Japan Post, investors are becoming increasingly concerned about the DPJ’s vision of a “welfare economy”.

The DPJ, again led by Shizuka Kamei, is also championing a “debt moratorium” program for SMEs as well as individual mortgages. Japan’s Financial Services Agency (FSA), instead of conducting inspections to ensure that the balance sheets of the nation’s banks remain healthy, has been tasked with developing quantitative means to measure how much the banks will ease lending conditions, such as debt moratoriums, restructured interest rate schedules and lengthened repayment periods, i.e., basically systematically discouraging the banks from declaring loans in arrears as “bad” loans, ostensibly based on credit guarantees by the government through credit guarantee associations. Even here, however, the deputy minister of the FSA has indicated that financial institutions would be required to bear the majority of the burden of bad loans incurred.

The Ministry of Economy, Trade and Industry (METI) has also been roped into the program, and will introduce a new system to provide credit guarantees covering the debts of any SME borrowers that go bankrupt under the moratorium program. Credit guarantee associations will guarantee 40% of the loans, and financial institutions would be compelled to reduce interest rates charged on the guaranteed portion of the loans. On the other hand, they would be fully exposed to the remaining 60% of the loan.

Separately, the Japanese government is committed to bailing out Japan Airlines, its flagship airline carrier. The government has now indicated they are willing to use taxpayer money as the likely rescue option for Japan Airlines Corp. (JP:9205), whose financial position is rapidly deteriorating. The total JPY300 billion in public and private assistance proposed for JAL is roughly equivalent to the company's current market capitalization. The infusion of public funds could make the government the carrier's top shareholder, and would place the onus on the government to restructure JAL as a new company capable of competing internationally, but there is no guarantee that JAL can survive even with a government bailout. With the airline operator's finances growing more precarious by the day, the task force assigned by the government to come up with a rescue plan doubled its request for funding, but did not recoomend how the government and private sector would split the JPY300 billion yen bill.

Substantially More Fiscal Deficits and JGB Issuance Is in the Cards

Overseas, a debate rages on about how damaging the rapid increase in US debt and fiscal deficits will be to USD as well as to future growth potential in the US economy. However, the fiscal deficit and debt funding issue is actually more serious in Japan, given the already high level of Japanese debt. Essentially, Japan’s ballooning government debt is choking the life out of Japan’s economy, and there is nothing we can see in the new Japanese government’s policies that will directly address, a) Japan’s massive debt, and b) Japan’s structurally depressed growth potential, in the foreseeable future.

When the DPJ took power, they promised a new program of expenditures centering on the welfare of the people, while insisting these expenditures (over JPY7 trillion) could be paid for by re-allocating fiscal resources.

In the original FY09 national budget, the Aso administration put JGB issuance at JPY33 trillion, or modestly higher than the JPY30 trillion issuance cap set by the Koizumi Administration. As the full destructive force of the financial crisis/global recession was realized, however, the Aso Administration moved to introduce a major stimulus package of just under JPY15 trillion, which would primarily be paid for by expanding new JGB issuance to JPY44 trillion.

It is now obvious that the DPJ is struggling to implement the expenditure promises in the manifesto while maintaining some semblance of discipline regarding the fiscal deficit. Firstly, tax revenues in FY2010 will by at least JPY6 trillion lower than a previously assumed JPY46 trillion, itself already representing a 27% YoY decline in tax revenues even before the promised abandonment of the gasoline excise tax.

Consequently, revenue from the issuance of new bonds will exceed tax revenues as a source of budget funding for the first time since the end of WWII. Further, the compiled budget requests of the various ministries tops the scale at JPY95 trillion, which compares to the DPJ’s original story of keeping the budget nearer to JPY92 trillion.

This puts the new administration in the politically uncomfortable position of a) having to issue significantly more JGBs (i.e., at least JPY50 trillion worth instead of the previously indicated JPY44 trillion) and b) trimming back or delaying promised expenditures. As for b), the first to go could be the elimination of the gasoline excise tax and/or the plan to make expressway tolls free.

The End Result; Higher JGB Yields, Weak Bank Stocks and a Blowout in the Yen?

The deep economic recession has already meant over PY6 trillion less of tax revenues for the government. As debt-ridden zombie companies pay no taxes, this program will do nothing to improve the government’s tax revenue base. Indeed, it may well make it worse as more SMEs become zombies. The alarming growth in Japan's debt cannot continue indefinitely, even if over 90% of this debt is owned by Japan's savers either directly or indirectly through Japan's financial institutions. Japan is rapidly aging and its aging population is just as rapidly dissaving (the savings ratio has plunged from over 10% to just 2%).

The dark side of the DPJ’s vision of a welfare state already has JGB yields backing up to 1.345% from recent lows under 1.25%. In the foreseeable future, we would not be surprised to see yields back up to the 2% level they were at as recently as 2007.

Further, while the government will back 40% of loans under the moratorium scheme, the risk of default on the remaining 60% of the total balance is the banks’ problem. This has investors leery of the banks, who could well see a significant increase in non-performing loans on the one hand, and the need to again significantly bolster their regulatory capital with the introduction of stricter BIS capital requirements.

So far, the yen has been one of the strongest currencies in the world. But what happens if domestic investors (the major buyers by far of newly issued JGBs) simply begin to boycott the JGB auctions? Ironically, US treasuries would probably be hit first, as the Japanese government begins trimming back its forex reserves (mostly held in US treasuries) to fund domestic expenditures.

We would not even be surprised to hear from someone in the Hatoyama Administration (Shizuka Kamei is on the short list) that Japan use a big portion its $1.06 trillion of forex reserves to create a sovereign wealth fund to “invest” in the domestic economy, which could dramatically reduce Japan's new purchases of US treasuries. After all, the Japanese government at one point was seriously considering using its forex reserves to purchase bonds of troubled Freddie Mac (FRE) and Fannie Mae (FNM) in 2008. Such half-baked schemes always have unintended consequences. In this case, it would be a blowout of the yen to, for example, the JPY50/US suggested by a Sumitomo Mitsui currency strategist.

Disclosure: No positions in EWJ or FXY