[A-List] Henry Liu on central banking 4b

["Michael Keaney" <michael.keaney@xxxxxx>]

BANKING BUNKUM
Part 4b: The Japanese experience
By Henry C K Liu
Asia Times, May 30 2003

* Part 1: Monetary theology
* Part 2: The European experience
* Part 3a: The US experience
* Part 3b: More on the US experience
* Part 3c: Still more on the US experience
* Part 3d: The lessons of the US experience
* Part 4a: The Asian experience

The domestic problems in Japan are caused by its economy's tilt toward
export, compounded by export trade being denominated mostly in dollars, not
yen. Japanese policymakers are quite aware of this unhappy situation and
have been trying to propose a tri-currency (dollar-euro-yen) global
financial architecture since 1997. This proposal has been turned down
repeatedly by the United States. Japan could not open its domestic market to
foreign imports because its does not have a domestic market to open. In
place of a domestic market, Japan has a vertically integrated distribution
system controlled by a few big commercial combines (keiretsu). Its entire
postwar economy is structured for export.

Prior to World War II, the entire Japanese economy was structured for war
production. After that war, the Japanese economic infrastructure was kept
intact by US occupation policy but diverted from war production toward
export. The relationship of Japanese banks to their clients is structurally
different than what the New Deal set up for US banks, with an arm's-length
relationship between lenders and borrowers. Japanese banks own substantial
shares of their corporate borrowers, thus there is little financial
advantage in corporate debt foreclosure.

This credit relationship is natural for a national banking regime and has
evolved to achieve maximum efficiency for financing export production.
Mitsubishi never has to compete for capital or credit the way General Motors
does. It can always get credit at a rate that will ensure its price
competitiveness in the export market. This is also why Japan is not well
equipped to finance new entrepreneur ventures. Sony and Honda are maverick o
utsiders in the "Japan Inc" system, as is Softbank, the new financial giant
for the information technology sector.

The reason dollar assets yield higher returns than yen assets is that yen
assets are not structured for highest returns but for effective support of
the Japanese export regime. Japanese banks are not profit centers. They are
service institutions in support of a national purpose. In the past decade,
however, major US corporations such as GE, General Motors and Ford have
taken on the role of non-bank financial entities to provide low-cost loans
as a key competitive pricing strategy, bypassing their traditional
dependence on banks. Henry Ford was famously critical of banks as financial
predators.

This trend of subordinating finance to enhance market competitiveness, not
for national purpose but for corporate profit, is the Achilles' heel of the
US economy. While Japan is being put through the wringer by the adoption of
a central banking regime, the US non-bank financial sector is bypassing the
regulatory limits of central banking. This more than any other factor gives
validity to the anticipation that the US economy will follow the Japanese
economy into a decade of deflation and stagnation, even though the US banks
are relatively healthy by Bank for International Settlements (BIS)
standards - unless of course the Federal Reserve adopts a monetary policy of
aggressive inflation targeting beyond the banking system, with the bailout
of LTCM as an obvious precedent. Fed chairman Alan Greenspan said in a
speech before the Council on Foreign Relations in Washington, DC, last
November 19: "Thus central banks are led to provide what essentially amounts
to catastrophic financial insurance coverage."

Japanese culture, fundamentally influenced by Chinese culture, views the
individual as an integral part of community and as such, while there is no
equality in Japanese society in the Western liberal sense, the Japanese
elite assumes an innate responsibility for the welfare of the people it
leads. Thus a Japanese corporate leader feels personal shame in the
corporation's misfortune and he is expected to punish himself before he
allows the employees to suffer. US values celebrate individualism as the
basic unit of society and thus put the responsibility of individual welfare
on each person even though the US system has evolved in a way that the
individual is increasingly powerless to control his/her own destiny. Thus US
management would proudly lay off 10,000 employees to achieve short-term
profitability with which to reward executives with fancy "performance"
bonuses. The Fed would righteously use unemployment to defend the value of
money (to fight inflation). It would declare the ease and immunity with
which US business can shed unneeded workers on short notice as systemic
strength. Greenspan has repeatedly criticized both Japanese and German
companies for being "inefficient" because of the high cost and inflexibility
their management faces in shrinking their workforce on demand.

Acting as postwar resident emperor, General Douglas MacArthur imposed
"democracy" on Japan. And the Japanese adopted its form without its essence.
>From its founding in 1955 and for the next 38 years, Japan's conservative
Liberal Democratic Party (LDP) won all national elections and selected every
prime minister and nearly every cabinet member. From 1955 until 1993, the
LDP held power without interruption, while the Japan Socialist Party (now
the Social Democratic Party) acted as a token opposition force. This
political landscape was known as "the 1955 setup". It allowed voters to see
an obvious, ongoing struggle between the LDP and the Japan Socialist Party,
notwithstanding under-the-table agreements. Other democracies have had
similarly dominant parties, but few approach the LDP for longevity in power
and complete dominance of the political scene. In fact, many political
scientists have suggested that the LDP is very similar to the ruling
communist parties in socialist countries.

Then, in 1993, a political earthquake transformed Japan from a system of
stable one-party rule into one of mercurial political coalitions. For the
decade since 1993, the LDP struggled to regain its position of dominance and
for the most part succeeded. At the start of the new millennium, the LDP
lacked a majority in the House of Councilors, the upper house of the
Japanese Diet, but it is nevertheless strong and confident once again while
the opposition is in disarray.

Politically, Japan by 1985 found itself needing new national goals, since it
had caught up with the Western industrial powers in production if not in
innovation. Unfortunately, Japanese political leaders failed to formulate a
new national vision. The lack of leadership allowed the bureaucracy to
continue to steer the nation along a traditional but obsolete path of export
dependency, hiding the transfer of national wealth overseas with a
speculative bubble of the 1980s. It was inevitable that this bubble would
burst, as the economic benefits of this export "success" could not be
repatriated back to Japan because of dollar hegemony. The bubble's burst
fueled a distrust of the bureaucracy that had clung to denial, which
continues today.

While it is valid to fault business and industrial leaders for management
myopia, it should be recognized that they had no choice beyond playing
according to the rules of the game set up by dysfunctional national
policies. The political leadership must bear the responsibility for failing
to set visionary goals for the nation. The current sentiment in Japan of
being at a structural impasse and not knowing how to move forward in new
directions is the direct result of the lack of focus on national goals for
the past two decades.

The Plaza Accord of 1985 on exchange rates forced the yen's climb - from 242
yen to the dollar before the agreement to as high as 79 yen in slightly more
than a decade. The structural damage of the rise of the yen had been
undeniable. The United States reversed the notion of the need for stable
exchange rates as envisaged by the Bretton Woods regime, and openly used
exchange-rate policy as a way of addressing its trade imbalance. Instead of
addressing its own fiscal irresponsibility, the US decided to solve its
problem by forcing Japan to change its economic system through an
exchange-rate policy. This approach of achieving a balance of trade through
exchange-rate management triggered unwanted changes not only in the Japanese
economy but also in Japanese society as a whole. Japan is still in the
throes of this unwanted change, and the resulting anxiety has fostered a
national sense of being in a blind fix.

The essence of this change for the Japanese is their inability to develop a
heightened consciousness of themselves as consumers of the fruits of their
efforts, instead of exporters. The Japanese political system and
administrative apparatus has been heavily weighted in favor of export
production since the end of World War II, while suppressing a consumer
culture. It is a civic pride to produce but not to consume. The war of
export was won by a denial of domestic consumption that fitted cerebrally
the Japanese culture of self-restraint. To overcome this export fixation,
the political system and administrative apparatus have to change. But
culture changes only slowly. Further, the stagnation of the export economy
reinforces the conventional wisdom that consumption in hard times would be
foolhardy and only lead to financial ruin for the imprudent individual.

Deregulation requires that consumers take responsibility for their own
decisions. Thus as Japan takes steps to deregulate its economy, the
government dilutes its power of persuasion to stimulate consumer spending.
Neo-liberals argue that since the government can no longer protect the
individual, Japan needs improved transparency, as embodied in the principle
of disclosure, as an essential condition of a consumer-oriented society. Yet
culture does not change as easily as government policies or corporate
strategies. The flip side is for government to preserve its tradition of
elitist opacity by insulating the public from economic pain, which was
essentially what had happened.

The past decade in Japan has been one in which the public has been insulated
from the pains of an economic decay that has been largely confined to the
corporate level. It is the opposite of what happened in the United States,
where the pain is felt directly and immediately by the defenseless public
while companies consolidate through downsizing and merging.

Both the Meiji Restoration of 1868 and the socio-economic restructure
imposed by MacArthur after World War II were carried out under pressure from
foreign powers. This latest opening of Japan has been triggered again by
foreign pressure in the form of US-led globalization.

In April 1999, the Japanese government deregulated foreign-exchange
transactions. After Japan's Big Bang, the country ended up with an open
financial market where foreign banks and brokerages were the dominant
players. If Japanese banks cannot serve the Japanese consumer because of
their structural link to Japan Inc, US banks will.

Globalization in Asia means new players entering from outside the region.
But resistance is still strong in Japan. Many there, along with others in
Asia, interpret this development as another neo-imperialist assault by
Western economic power as well as Western culture and values. And they are
beginning to oppose it with a revival of nationalism. In Japan, it takes the
form of a revival of the nationalism of the final years of the Tokugawa
shogunate in the 19th century. Prime Minister Junichiro Koizumi may be
Japan's first internationalist leader who came to power in the name of
chauvinism.

Neo-liberals believe that Japan, along with the rest of Asia, will have no
choice but to make major changes in response to the globalization process.
The trend toward transparency challenges the belief that keeping certain
things concealed is one key to social harmony. The Western notion of the
rule of law is often touted as an indispensable component of modernization.

Yet Japan is based on a deep-rooted Confucius culture. In The Analects of
Confucius, the sage is described as responding to the selfless rule of law
by saying: "In our part of the country, those who are upright act
differently. The father conceals the misconduct of the son, and the son
conceals the misconduct of the father." This embodies the conflict between
legalism and the hierarchical order of Confucianism in ancient China, a
conflict still very much alive in contemporary China. Although this episode
in The Analects concerns the relationship between parents and children, the
application is much broader to include issues of governance.

Traditionally, Asian, including Japanese, law-enforcement officers often let
offenders off with a stern warning if circumstances warrant it. In the
Kabuki drama Kanjincho (The Subscription List), the official in charge of
the Ataka Barrier Station is charged with capturing the fugitive Yoshimune.
He is so impressed by the efforts of Benkei, Yoshimune's retainer, to shield
his lord that he turns a blind eye and allows the disguised hero and his
retinue to pass. Japan also has heroes who flout the law, such the
chivalrous robber Kunisada Chuji (1810-50), the Japanese Robin Hood.

Countries vary considerably as to how rigidly they apply the law. William
Blake said that one law for the lion and the sheep is oppression. The West
has often observed critically that China lacks the rule of law. In reality,
the West merely is not happy with China's concept of rule of law. Americans
also do not think that Japan meets their standards for genuine rule of law.
Asians often describe the US way as the rule by law rather than of law.
There's nothing in nature that says an advanced modern nation has to be a
rigid constitutional state, and the United States' adherence to that
principle may not be the reason it achieved its measure of power and
influence in the world, among many other factors. Yet, as globalism
proceeds, the rest of the world is compelled to measure its daily actions
against US standards, merely because the US is the sole superpower.

Exchange-rate volatility since 1985 has had a huge impact on Japan. Stock
prices have in fact been driven by exchange rates because of global capital
flow and international banking standards. If a two-party system ever emerges
in Japan, it will be based on two political ideologies: one that believes in
free markets and small government, and another that believes there are flaws
in a free-market economy and that government exists to minimize the
resulting disparities in wealth and help society's weaker members, and that
for this Japan needs high taxes. But Japan is some distance from reaching
that point. For the foreseeable future, a one-party system with two opposing
factions is likely to continue. Nor is the notion that the weak are the
responsibility of the strong, at least within Japanese society, likely to
disappear from Japanese culture.

After World War II, Japan developed into a country with small disparities in
income, perhaps the smallest of any major economy in the non-communist
world. That helped create a stable society, and it also took the steam out
of calls for a redistribution of wealth or progressive income-tax regime.
Japan has a de facto national socialist system in the descriptive,
non-pejorative sense of the term. There has always been a voting minority of
about 20 percent who are dissatisfied with the government, but that group
does not constitute an identifiable economic or social class.

Since the end of the Bretton Woods regime, the relentless Japanese quest for
trade surplus in dollars and not in yen has been a big mistake. Dollars can
no longer be converted to gold and dollars cannot be spent in Japan. Dollars
can only buy dollar assets such as the Rockefeller Center in New York. The
Germans have been making an even bigger mistake with their quest for trade
surplus in dollars. Everyone accepted deutschmarks before the birth of the
euro. Japan and Germany should have incurred as large a trade deficit in
their own currencies as their trading partners would accept. Trade yields
currency. When export yields another country's currency, it is hard to
benefit the domestic economy with it. It is hard for Americans to understand
this because world trade yields dollars that are usable in the United
States. It is also hard for the rest of the world to understand this because
they did not catch on to the meaning of the dollar being no longer backed by
gold.

Suggestions that Japan's bad bank loans may now equal almost half of the
country's gross domestic product (GDP) have been greeted with official
denial in Japan but have shaken the markets for more than a decade. Market
estimates of non-performing loans (NPLs) now amount to 237 trillion yen
(US$2 trillion), dramatically larger than published government data
indicate. The Financial Services Agency (FSA), the main regulator, claims
that bad loans at the banks total only 18 trillion yen, or 3 percent of GDP.

The discrepancy is not from the bank data, but from different rules for
measuring bad loans. In particular, the FSA ignores the effect of deflation
when classifying problem loans. The FSA sorts loans into "good", "risky" and
"bad" categories based on whether a company is able to pay interest. This
classification system, useful in an inflationary environment, where nominal
interest rates are high, is not useful in Japan's low-interest-rate regime
where most companies could make interest payments - even if their business
prospect is so hopeless that they would never be able to repay their loans.
Such companies are corporate versions of the walking dead.

Bank economists have suggested that the risk level of a loan should be
judged on whether a company's operating margins are good enough to repay the
loan within term. On this basis, corporate data on listed companies suggests
that more than a third of all bank loans are bad risks, even though most are
not classified as risky by the government. Japanese banks have already
written off bad loans to the equivalent of 13 percent of Japan's GDP in the
past decade. There may be another 50 percent of GDP equivalent to go.

Other analysts dispute this method of loan classification, saying that
Japanese banks have never extended loans on the basis of cash-flow analysis,
but on assets such as real estate. Yet even on this basis, deflation has
eroded asset value. Government officials also argue that no country in the
world calculated bad loans from the ratio of operating margin to bank
lending. The Bank of Japan (BOJ), the central bank, is uneasy with the fact
that the "real" bad-loan problem is greater than FSA numbers show, given the
weak economy and the impact of deflation. As a central bank, BOJ allegiance
is to the value of its currency, rather than the health of the economy.
Central banks take this view because they believe that the health of the
economy depends on the soundness of money. They reject the notion that the
health of the economy is the basis of a sound currency. Central bankers are
not above arguing that the operation is a success, though the patient died.

Japan's institutional and economic history has been front and center
mercantilist. Japan does not export to live. It lives to export. Yet since
the Bretton Woods fixed-exchange-rate regime based on a gold-backed dollar
ended in 1971, Japan has been exporting not for gold, nor for gold-backed
dollars. It has been exporting for a fiat currency called the dollar that
the United States can print at will and at no cost. Japan has been shipping
its goods overseas in exchange for paper that cannot buy anything in Japan.
The trade surplus in dollars is merely pieces of paper than can buy other
pieces of paper called US Treasuries, or share certificates of US companies
that compete with Japanese companies. Or certificates of ownership of dollar
assets outside of Japan that pay dividends in pieces of paper that cannot be
spent in Japan. The conventional wisdom is that Japan must earn dollars to
buy needed imports such as oil and other commodities that Japan does not
produce. But Japan exports way in excess of its import needs.
Notwithstanding the fact that if Japan exports less, it will also need to
import less oil and iron ore, there is no reason Japan needs to have a trade
surplus, or that a trade surplus is of benefit to Japan.

Economist Hyman P Minsky asserts that an understanding of a country's
institutional and economic history is essential for a clear understanding of
its financial processes. Institutional and historical realities mean that a
country cannot easily escape its relatively rigid past to join a global
system without serious penalty. Japan's trade surplus in dollars is the
serious penalty for its fixation with export in a trade regime based of
another country's fiat currency. The United States, whose influence on
financial globalization is paramount, enjoys the least upheaval to its
national system in the transition to neo-liberal globalization because the
global system is in essence an extension of the US system. And dollars, the
scorekeeping instrument for world trade, can only be spent in the US on US
assets. So no matter who owns dollars, the economic benefits of the dollar
are firmly focused on the US economy.

Because of the BIS requirement on capital and loan classification, Japanese
banks continue to suffer from the supportive loans made to Japanese
corporations during the "bubble" era more than a decade earlier. Such loan
policies were not a problem when Japan operated under a national banking
regime. But under a central banking regime, Japanese banks have become by
definition distressed institutions in deep crisis. Despite the fact that a
large proportion of these loans have turned into NPLs by BIS standards, many
Japanese banks have delayed the recognition of such NPLs until recently.
Unlike US banks, which quickly wrote off their NPLs in the early 1980s to
meet domestic regulatory requirements, though not without great pain to the
US economy and the general public, none of the Japanese banks wrote off
their NPLs until Sumitomo Bank took the lead in March 1995. Since then, top
Japanese banks have begun to write off NPLs, voluntarily following Sumitomo,
albeit only with strong pressure from the global investor community acting
on bank share prices. The reason for this is that the US central bank can
print dollars without directly affecting the exchange value of the dollars,
a phenomenon known as "dollar hegemony", and the BOJ cannot.

Under a national banking regime, Japanese banks attracted investors not
because they produce high returns, but because they were part of the
national enterprise that strengthened the Japanese economy. Under a central
banking regime, global investors are interested primarily in the profit
margin of the banks, often to be achieved at the expense of the economy.
When a liquidity trap immobilizes interest-rate policy as an economic
stimulant, there is still an exchange-rate channel by means of which
monetary policy can exert stabilizing effects. This is why Japan has been
trying to push the yen down, not to increase exports, but to stabilize
deflation at home.

The main reasons for the hesitance of Japanese banks to write off NPLs can
be attributed to the policy indecisiveness of the Ministry of Finance (MOF),
which still holds a view on the function of banks along national-banking
lines. The MOF is reluctant to recognize and address the NPL problem as
defined by a central banking regime, for it sees no useful purpose in such
an exercise. Also, the Japanese tax system does not permit tax deductions
for loan writeoffs. Banks also were deluded by anticipation of pending
economic recovery from counter-cyclical government fiscal measures. The dual
role of banks as shareholders and creditors of the borrowing entities also
presents a disincentive. There is also the problem of insufficient capital
for banks to write off the loans to satisfy BIS requirements.

The BOJ addressed the insufficient-capital issue in 1995 by increasing the
nation's money supply to lower interest rates, a move that increased the net
interest income of Japanese banks because of larger spreads on loans over
cost of funds. In this new monetary-policy environment, many banks were
supposed to be able to generate sufficient profits to write off NPLs.
Japan's equity and real-estate bubbles collapsed within a short time of each
other, with equity prices dropping more than 50 percent in early 1990 and
land prices beginning a long slide downward in 1991. After raising official
interest rates to counteract overheating financial markets, the BOJ began
lowering interest rates from more than 6 percent in March 1991 to 0.5
percent by October 1995.

Despite this favorable operating environment for banks, the quality of
Japanese banks' assets continued to deteriorate because of what John Maynard
Keynes identified as a liquidity trap. A liquidity trap is created when
further increases in money supply by the central bank (monetary base) cannot
further affect output, prices, interest rates or other variables. Increases
in the money stock are entirely neutralized by increases in liquidity
preference to hold money.

The idea of a liquidity trap originated with Keynes during the Great
Depression. Keynes postulated that once the interest rate fell below 2
percent, its effect on monetary expansion might be "push on a string". While
rates might be low, banks might still have difficulty lending because the
low interest-rate spread would reduce credit risk tolerance. Soon the banks
would only lend to those who did not need to borrow.

Under current circumstance, the BOJ can stop interest-rate and price decline
by purchasing foreign currencies to push the foreign-exchange values of the
yen down, or by purchasing corporate bonds and stocks, or other assets. But
the BOJ as a central bank is committed to preserve the market, not to
eliminate it. So it sticks with the traditional central-bank instrument of
interest-rate policy. It seeks to control the price of money rather than
prices in general in the economy, making the liquidity trap a reality.

International capital markets started to charge a "Japan premium" on
inter-bank loans. In addition, Japanese banks faced difficulty in complying
with BIS capital-adequacy ratio as the depreciation of the yen increased the
value of their overseas assets and liabilities. This also increased the
banks' reluctance to provide loans to less creditworthy small and
medium-sized companies that had no access to credit markets beyond their
main banks. To address the banking and credit crunch problems, public funds
totaling 60 trillion yen (12 percent of GDP) finally were set aside in
1998-99 to recapitalize banks. Also, the low short-term rates created
problem for non-bank long-term financial institutions, such as insurance
companies.

The increasing number of bankruptcies, as well as the collapse of Hokkaido
Takushoku Bank in November 1997, illustrated the seriousness of the NPL
problem, which is currently estimated to be near $2 trillion. Over the past
18 months, the Japanese government has enacted laws to use public funds to
purchase preferred stock of Japanese banks in order to provide the banks
with the much-needed capital to write off additional NPLs. The Resolution
and Collection Corp (RCC), an agent established to purchase loan assets and
to collect the debt, has been expanded to purchase NPLs from Japanese banks.

On July 7, 2001, commenting on the bad-loan problem, Prime Minister Koizumi
was realistic: "I do understand that it is impossible to get rid of all
existing bad loans within two to three years but we are working on reducing
that," he said. "I think it is a bit premature to say that the government
does not have total grip on bad loans. What we are working on is the bigger
issue of the economy." The bigger issue, of course, is economic growth.

In a government package released three months earlier, in April 2001, Japan
set a deadline for top banks to eliminate loans to borrowers in, or at risk
of, bankruptcy - worth 11.7 trillion yen - in two years, or three years for
new NPLs. Some estimates valued the problem loans at banks at as much as 150
trillion yen. The worries about banks have been a key factor in a prolonged
stock market slump. Koizumi warned that Tokyo stock prices were poised to
remain depressed for the time being. It is worthwhile to note that no
serious analyst expected Japan to resolve its NPLs within two years from
2001.

Japan's government is in an inescapable debt-death spiral by virtue of the
fact that nominal GDP is falling at an annual rate of about 5 percent.
Stabilizing the Japanese government's debt-to-GDP ratio would require that
nominal GDP rises at a rate equal to the interest rate on its outstanding
debt, or about 1 percent. The fact that nominal GDP is falling at a 5
percent rate means that Japan's debt-to-GDP ratio will rise at least 6
percent a year, even without a sudden need to recapitalize insolvent banks.
That debt-GDP ratio is now 130 percent, and at 6 percent a year it will
double in just over a decade. That fact will itself accelerate the collapse
of Japanese government bonds unless deflation is reversed.

Actually, the debt burden of Japan's government is worse than the 130
percent debt-to-GDP ratio widely reported in the press. First, accelerating
deflation will cause that ratio to rise even more rapidly as government
revenue collapses. Further, the contingent liabilities of the government,
including its responsibilities to protect bank depositors, will jump
abruptly once the increasingly likely crisis in the banking system emerges.

The Japanese government possesses assets that could be sold to improve its
ability to deal with large losses in the banking system. The problem with
such sales, for example the sale of government-owned shares in Japan Tobacco
or NTT (Japan's telephone company), is that they further depress the value
of these shares on the stock market. This is just another example of the
dangers of a deflationary environment in which assets that had been viewed
as reserves can no longer function as liquid reserves because attempts to
realize liquidity further depress their value.

Japanese deflation gathered pace in the first quarter of 2003 as
year-on-year prices fell 3.5 percent - their fastest drop on record. The
fall may fuel fears that Japan, which has managed to co-exist with
relatively mild deflation since the mid-1990s, could be sliding into an
accelerating deflationary spiral. Japanese prices - as measured by the gross
domestic product deflator, considered a more accurate measure than the
consumer price index, have been falling continuously since 1995. Annual
price falls have averaged between 1 and 2 percent for most of that time.
Recent figures showed deflation accelerating in fiscal 2002, a year in which
Japan was technically growing out of recession, to minus 2.2 percent, a
record for a full year. The figures were released along with GDP data
showing that growth in the first quarter 2003 fell to almost zero, leading
some economists to conclude that the economy was on the brink of yet another
recession. Nominal growth fell 0.6 percent in the March quarter, or minus
2.5 percent on an annualized basis.

The issue of deflation has split government officials with disputes over its
causes and disagreement over its effects. Heizo Takenaka, the new minister
of state for economic and fiscal policy and head of FSA, has acknowledged
that falling prices pose a threat but takes the position that banking reform
is need to cure it. He said: "Deflation remains severe. While pursuing
structural reform we must also press on with efforts to end deflation." On
the other hand, Eisuke Sakakibara, former vice finance minister, also known
as Mr Yen, said Japan could live with mild deflation so long as it prevented
the economy tipping into a destructive spiral of falling prices. He said
deflation was the structural result of global productivity gains and would
likely spread from Japan to the United States and Europe.

Takenaka drew some comfort from the fact that real growth for fiscal 2002
was 1.6 percent, above the 0.9 percent the government had predicted. Much of
that was based on exports, which have predictably begun to slow again, and
on surprisingly robust consumer spending. In the first quarter of 2003,
consumer spending, which accounts for 60 percent of GDP, rose 0.3 percent
quarter on quarter. Real growth of about 1 percent a year over the past
decade meant that the economy was shrinking in nominal terms. Nominal GDP
for fiscal 2002 fell to 499 trillion yen, the first time it has dipped below
500 trillion yen in eight years. Political pressure had been building
against Koizumi to slow the pace of bank reform to relieve the pain of the
corporate sector, which may lead to the removal of Takenaka.

The yen has been testing two-year highs against the dollar recently as
investors continued to push the US currency lower on signals from the new US
Treasury Secretary, challenging Japanese resolve to stem yen strength in the
process. The BOJ has not confirmed any action in the market recently.
Following a policy of covert intervention in the first quarter of 2003,
strategists expect the first concrete evidence of any action in May will
come in the bank's figures, published at the end of the month. The BOJ,
however, is believed to have been active in the market to smooth if not stop
the yen's fall.

The longer the yen's rise goes on, the greater the prospect that Japanese
investors will sell dollars forward, exacerbating the yen's upward move. It
is difficult to stop Japanese funds from hedging their US exposure. A
further risk is that a strong currency could tempt investors to repatriate
funds back to Japan. Japanese investors have been pouring money abroad on
the perception the MOF will continue to draw a line in the sand on yen
strength and if such perceptions are damaged, an accelerated wave of yen
purchases will occur. Thus the perception that the MOF will let the yen rise
will cause the market to push up the yen.

Japan's population is poised to decrease at a rapid rate because of
demographics. Aggregate production is also declining because of changes in
labor utilization. Since the main sources of Japan's economic strength,
namely high saving and high investment, remain intact, Japan is still making
heavy investment for the future, but the major thrust is on upgrading the
quality of life and linkage with the Chinese economy. This linkage with
China brings mixed results for Japan. The positive side is to increase
aggregate production but the negative side is that it causes prolonged
deflation. Deflation dampens Japan's import capacity from the rest of Asia
except from China. The outcome is the rise of Northeast Asia and the
relative decline of Southeast Asia. The deepening economic linkage and
continuing political divergence between Japan and China is also becoming
difficult to sustain.

Population is one of the most important factors in a nation's economy. When
Japan incurs a trade surplus with the United States, an economy with twice
its population, it means that Japanese are consuming at a lower level than
Americans. Since production is a function of the size of the domestic
working population, the decrease in working population means fewer
work-hours each year, which translates into less production capacity. It
will weaken the country's capacity to supply goods and services both for
home consumption and for export. The average number of work-hours per worker
is also decreasing in Japan. Only 13 years ago in 1990, it was 2,053 hours
per year per worker, the highest among the Organization of Economic
Cooperation and Development (OECD) member countries. Three years ago in
2000, it shrank by 10 percent from the 1990 level to 1,848 hours to the
sixth-longest working hours among the OECD members. The myth of Japan
working hard and long hours is now an anecdote of the past.

Japan's production capacity at home peaked in 1997. Constraints in
population growth force less production at home and more imports. The share
of imported manufactured products in the total Japanese imports has risen
from 50 percent in 1990 to 61 percent in 1999, rising by 11 percent. This
increase in manufactured imports helped alleviate the structural labor
shrinkage.

The strategy of the Japanese system of moving production overseas,
particularly to the rest of Asia, and importing the final products seems to
be a rational solution. The basic trade pattern of Japan exporting capital,
technology and essential parts to Asia, building factories there, with the
final products imported back to Japan or re-exported to Europe and America,
enables Japan to concentrate on the high value added part of the production
chain. The Asia shift of Japan's trade is one of those Japanese efforts for
tackling the dwindling population while maintaining the same high level of
income. The size of the domestic market is related to the size of the
population. In the Japanese economy, personal consumption is about 60
percent of the domestic spending, by far the most important component in
Japan's economy, or for any country's economy. The peak of Japan's
population is forecast to come around 2007. It means that Japan's domestic
demand will still start to decrease after 2007, unless per capita
consumption starts increasing rapidly. The White Paper on the Japanese
Economy published by the Prime Minister's Office in November 2001 also
concluded that the growth rate for Japan's economy for the medium term is
between 1 and 2 percent annually.

A country's economy can have a sustainable source for financing needed
investment through state credits, rather than domestic saving, provided
there is adequate control on capital flow. With the world's largest
foreign-exchange reserve, Japan does not need to rely on domestic savings
for capital. In Japan, the wage earners' average annual saving rate was 28.7
percent in 2000, inclusive of semi-annual bonus payments. Such a high saving
rate, a result of cultural behavior, has created a high level of net
financial asset for an average household of more than 14 million yen
($130,000) in September 2001, almost three times the average Japanese annual
income. The decrease of net household assets from the year before was a mere
90,000 yen despite a collapse of the equity market. This means the average
Japanese has an income cushion of almost three years even in these hard
times. With this coupled with social welfare provided by the public sector,
the Japanese have a strong safety net. No other country accumulates such
high savings. Yet the average household saving decreased only slightly even
from rising unemployment and reduced bonus payments from the recession.

Sustained by the abundant supply of domestic saving, Japan's investment has
remained high even in the decade of low growth. Private-sector investment is
16 percent of gross domestic expenditure (GDE), which is the highest level
among developed countries. Public investment is about 6 percent, housing is
at 5 percent, making total investment 27 percent. Japan's private-sector
investment constitutes a high level of research and development expenditure.
In 2000, Japan's R&D expenditure was 3.2 percent of the GDP, again the
highest level among the developed countries. The United States spends 2.5
percent and the European Union 1.9 only percent.

Japan's high saving/investment mechanism is also used in enhancing its
economic linkage with China. China has an abundant supply of increasingly
high-skilled, educated and young workforce, which is a rapidly decreasing
category in Japan. Japan in the 21st century, with its rapidly aging and
dwindling population, can establish a mutually beneficial economic relation
with China, even though wage levels between the two economies may converge
in time. Japan-China economic relations are in a way an extension of Japan's
economic relations with Asia, but the nature and the degree of the ongoing
changes in the bilateral economic relations are very different from the rest
of Asia.

Japanese export to China in the first six months of 2002 grew 11 percent
year to year to $17 billion and import fell 0.8 percent to $28 billion.
Export to the rest of Asia fell 2.5 percent to $82 billion and import fell
11.8 percent to $78 billion. Export to the United States fell 9.9 percent to
$57 billion and import fell 16.8 percent; and export to the EU fell 17.2
percent to $29 billion and import fell 16.8 percent to $28 billion. Total
export fell 7 percent to $195 billion and import fell 14.2 percent to $157
billion.

China's export to Japan rose in 2001 by 15 percent and imports by 11
percent, against a background of overall negative economic growth in Japan.
The biggest (29 percent) import item from China to Japan is machinery,
followed by textiles (27 percent).

The year 2001 was the first time in history that machinery became China's
biggest export item. China is the only country in the world that has
succeeded in establishing a healthy trade surplus in machinery products with
Japan. This is the most significant change in the Japan-China economic
relations. At the same time, China remains extremely competitive in the
export of apparel, textile and shoes, the traditional domain of exports for
the developing countries. China's competitiveness is not limited to
manufacturing. Japan imported 750,000 tons of vegetables from China in 2001,
a tenth of the price of domestic production.

Lunchbox prices have, as a result, fallen. Prices of Japanese lunchboxes
(obento) have fallen by 15 percent as a direct result. Some Japanese
convenience stores have built organic farms in China in order to use the
vegetables into the lunchbox sold in those stores in Japan. Vegetables and
fish prices are falling in Japan because of imports from China, benefiting
consumers. But it has dealt a blow to the numerous Japanese farmers' income.
Clothing prices have also fallen by 30-50 percent.

The deflationary impact on the Japanese economy coming from China trade will
be long-lasting. From food and apparel to electronics, prices in Japan will
face falling pressures until the price levels of the two countries reach
some kind of equilibrium after many years. Thus Japan has a vested interest
in helping China to raise its wage levels. Slow growth from a shrinking and
aging population, shrinking export markets, together with deflationary
impact from China will depress the profitability of Japanese corporations in
the foreseeable future, placing the Japanese economy in a long transition
period of slow growth and low profit margin.

However, China trade is expected to continue to benefit Japan. According to
the World Bank, Japan's benefit by China's entry into the World Trade
Organization (WTO) will be $61 billion by 2005, much larger than that of
North America, which is $38 billion. Hitachi plans to invest $1 billion in
China by 2005. China's share in Hitachi's global production of $40 billion
will be 25 percent, the largest production share outside Japan, four years
from now. The highest-technology hardware and software of Hitachi are to be
manufactured and developed in China. Hitachi has built a research lab for
ubiquitous network technology state-of-the-art technology in Beijing.
Panasonic runs more than 40 companies for production in China. China will
become the high-tech consumer goods center of Asia, with Japanese companies
playing an important part in it.

With the rapid merging of the two economies, tremendous changes are
occurring. The new competitiveness of China led Japan to impose
protectionist measures against three agricultural products: onions, rush (a
plant used for making tatami mats) and shiitake mushrooms from China in
early June 2001, to which China retaliated by raising tariffs on selected
Japanese industrial products. After a seven-month impasse, the trade
friction was solved with a tacit orderly marketing agreement under the
table, a classical Asian solution that upset free traders. From shiitake
mushroom to the ubiquitous network software, the Japanese economy and the
Chinese economy are merging in an inexorable way. From the lowest-tech to
the highest-tech sector, the economies of the two countries match and marry
very well. The merger is creating a new economic power in the world and will
have significant impacts in world economic history, with a revival of Asia
as an economic and cultural center, as it was in the 17th century.

Japan is already the largest trading partner for China and the largest
foreign direct investment country in China, behind Taiwan and Hong Kong,
which are also Chinese. Although for Japan, the United States is by far the
largest trading partner because of Japan's big export to the US historically
and for now, the trend shows that China could surpass the importance of the
US and become the largest trading partner for Japan in the near future. On
the import side, it is already clear that by this year, China will provide
more goods to Japan than the United States. The main obstacle for
Japan-China economic cooperation is the US-Japan political-military
alliance.

China's restoration of its political and military strength is a natural and
inevitable result of its long-overdue economic development. Instead of
trying to resist changes accompanied by the economic revival of China, the
US-led residual Cold War security framework needs to be reconsidered to
reflect new conditions in international security in East Asia. To balance
the growing economic ties between Japan and China, the economic cooperation
of the ASEAN (Association of Southeast Asian Nations) Plus Three framework
needs to be further pursued to promote peace and prosperity in East Asia and
the world.