The Squeeze on Japan

March 21, 2003
Gary North

The war has focused our attention on Iraq. This is reasonable; our troops are at risk. But this war will have international repercussions.

Japan is already tottering on the edge of bankruptcy. Its banks are in desperate shape. Japan imports most of its oil from the Middle East. With the price of oil going through the roof, the Japanese are forced to pay whatever the traffic will bear. The higher price would not have been a problem in, say, 1987. It is today.

In a March 13 column, Dr. Paul Erdman discussed the present condition of Japan's banks. Erdman is the author of a series of banking-related thrillers, published over two decades ago. He himself was an American banker in Switzerland three decades ago. He knows about banking. He has sounded a warning:

Given the facts that Japan's economy is the world's second largest, that Japan is the largest exporter of capital on earth, that the Bank of Japan owns hundreds of billions of U.S. Treasury bonds and notes, a financial crisis there could send new shock waves around the world.

One of the threats of worldwide recession is that people need liquidity in their own currency units. Second, people tend to bring money home unless they live in a banana republic that is facing an inflationary blow-off or confiscation. Most people want their money where they can put their hands on it. This is why a nation that is the greatest international creditor constitutes a threat to the currency units of those nations in which its citizens are investors. They may start selling their foreign-currency- denominated assets. In the case of Japan, that means dollar-denominated assets.

The entire banking system there is tottering on the edge of catastrophe. The situation is so acute that it requires management on a day-to-day basis.

On Wednesday, the Nihon Keizai Shimbun, that country's equivalent of our Wall Street Journal and hardly a publication that has alarmist tendencies, reported: "The Bank of Japan supplied a large amount of funds to the money market today, as it did yesterday, to avoid a systemic financial crisis."

Erdman then quoted an unconfirmed source:

That same day it also reported that an executive of a major bank received a phone call from a close aide to Prime Minister Junichiro Koizume on Sunday who asked: "What emergency steps can the government take to avert a meltdown of the financial system should the stock market crash after the war on Iraq starts?"

The fractional reserve banking system appears to be stable most of the time. Then, when a shock hits the economy, depositors get nervous. They decide to withdraw money. If they withdraw currency and do not re-redeposit it, the inverted debt pyramid starts to topple. It is always deflationary for depositors to withdraw currency and not deposit it in another bank.

At the core of the problem are the Japanese commercial banks. All are grossly undercapitalized. All have huge investments in Japanese stocks, which they still carry on their books at cost.

As the Nikkei sinks ever further, the unrealized losses on their stock holdings keep mounting. They already exceed $50 billion. If the banks were required to mark them to market, the capital that they do have would be for the most part wiped out.

What is true of Japanese banks is equally true of American banks. This is why the regulators of both nations do not require banks to mark to market, i.e., carry their assets at market present market value. American banks would have gotten killed in the early 1980's had bonds been carried on the books at market value. The same is true of Japanese banks today.

The world banking system knows this. That is why the international banking system's standards for bank capitalization are not actually enforced on Japan. When the regulations were drawn up by the G-10 nations in 1988, Japan was given a temporary exemption. Even during the wildest upward phase of the Japanese boom, the bankers knew that Japan's banks were at risk. The Accord became law in 1992, yet Japan still has yet to comply with the Accord's capitalization requirements.

It's not just stocks. The banks also own an unprecedented amount of government bonds, now exceeding 50 trillion yen [$420 billion], bonds that the government has been stuffing down their throats for years in order to finance massive deficit spending programs. Even a slight reversal in interest rates, now at record low levels, would significantly drag down the prices of those bonds, causing the banks to incur enormous losses.

Because no one will invest in Japanese banks, thereby supplying new capital, the banks ought to get rid of loans, so as to reduce their exposure to bad loans. They are doing the opposite. They have a sweetheart deal with the borrowers.

They are lending new money to their large corporate clients, many of whom are suffering huge ongoing losses in their operations and belong in bankruptcy, who then use the funds to buy newly issued shares of their lender. What this amounts to is using the same capital twice. In any other country that would land you in jail for twenty years.

Dr. Erdman knows of which he speaks. A long time ago, he landed in jail in Switzerland for banking violations. His violation was a mere technicality compared to Japanese central bank policy.

The other source of new capital for the commercial banks is the government itself, including the Bank of Japan. The problem is that the BoJ already has huge holdings of both stocks and government bonds. Which means that the nation's central bank is itself dangerously exposed if stocks prices decline further and interest rates begin to rise.


HOW LOW?

Years ago, back when things were merely terrible for the Japanese stock market, the standard estimate of the fail-safe price of the Nikkei index was 12,000. If it fell below this number, non-Japanese analysts said, the banks would have to reduce their exposure by selling their shares and reducing their loan portfolio. That would further depress the price of the shares, forcing banks to sell more shares, etc. That would be meltdown. Well, the joke is on the analysts! The Nikkei is now in the 8,000 range, but the banking system limps along.

But limping is the best the system can do. The newly appointed head of the central bank, Toshihiko Fukui, told the media last week: "The Japanese economy is in an extremely severe situation, where one false step could send it over the brink into a deflationary spiral." (JAPAN TIMES, March 19) I cannot imagine language this strong coming from Alan Greenspan or any other high official. Yet Fukui is no radical. Erdman describes him as follows:

He is a typical member of the Japanese establishment, a graduate of the law school of the University of Tokyo that for decades has been producing the bureaucrats who run the country, mandarins who are loathe to ever really rock the boat.

The erosion of capital in Japan has been steady. Japanese stock brokers no longer bother to issue statements about the recovery of the stock market, which once stood at 39,000 (1989). Nobody would believe a broker who promised such success. Year after year, investors in Japanese stocks lose money.

The government promises reform, but reform never comes. The system seems to be beyond repair.

Overall, the BoJ's assets are proportionally five times the size of those held by the Federal Reserve or the Bank of England. As the BoJ seeks to stave off further declines in the stock market and as it simultaneously seeks to keep the commercial banks above water, the private-sector assets on its balance sheet are bound to grow dramatically to even more alarming proportions. This means that the entire Japanese financial system, not just its banks, will become increasingly suspect.


TERRORISM AND THE FLOW OF OIL

Now the war threatens the stability of the Middle East, which supplies Japan with oil. This is no minor threat. Japan has verbally supported the U.S. This puts Japan in a bad light all over the oil-exporting world.

The terrorists know where the soft underbelly of the West is: oil. They can do suicide bombings until the pigs come home, but the effect is psychological, not economic. If the Allies' constant bombing of German cities only increased the resolve of German civilians to resist, what good is a suicide bombing? Answer: it depends on the bomber's target. The oil fields have to be the terrorists' ultimate target. I think this is what the troops in Saudi Arabia are there for, and why they will be stationed in Iraq permanently. Arab governments have a vested interest in keeping the spigots open. The terrorists don't. They have contempt for governments that are not in opposition to the United States.

The typical Arab still wants the benefits of oil revenues. But as hostility against the United States grows, the envy-driven fringe will become more convinced of the need to bring down the United States. There is no more obvious lever than the oil fields. When the desire to inflict pain on an enemy is greater than the desire to avoid pain, the defender has a problem in defending what he has. The best possible example of this mentality is 9-11.

This mentality is a dagger aimed at Japan's belly. No wealthy Western nation is more at risk from an oil crisis than Japan. Its banks are too fragile.

CONCLUSION

This means that however successful our troops may be in Iraq, instability can spread, and almost surely will spread. The fact that the United States seems immune to terrorism should not blind American investors to the fact that in an worldwide division of labor, everyone is at risk if Japan is at risk.