Praying for a miracle

Tokyo’s glitzy, neon-bright Ginza district still swarms with early evening shoppers and diners. White-gloved taxi- drivers in spotless cabs, with antimacassars on the headrests, still sit patiently in the disciplined traffic that clogs the city’s main arteries. And local bankers still flock to the numerous golf courses as soon as they can cast off the regulation dark suit and tie.
It is hard to reconcile this outwardly prosperous appearance with a country where falling equity and land prices have wiped a staggering ¥1,000 trillion ($8.5 trillion) off the value of Japanese assets during the 1990s – a figure twice the size of the country’s annual gross domestic product. There is little to indicate that a decade of recession and deflation has produced the highest general government debt in the developed world, and no hint of how Japan’s slow-burning crisis will end.

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Can the second most-economically powerful country continue to muddle through? Or is it heading, in the words of Massachusetts Institute of Technology (MIT) economics professor Rudi Dornbusch, for a “rendezvous with bankruptcy?”
By most measures, the overall credit situation of Japan Inc. is continuing to deteriorate. In late January, the rating agency Standard & Poor’s warned that credit risks are rising “across the board”. The number of debt defaults, already at a record level, “is bound to increase in 2001,” while credit downgrades are “likely to continue outnumbering upgrades”. Jesper Koll, chief economist for Japan at Merrill Lynch, predicts “bankruptcies will skyrocket”. The level of debts owed by bankrupt companies was already breaking records in 2000. A new wave of failed companies will be a further blow to creditor banks still punch-drunk from the 1998-99 financial crisis, and struggling with their own seriously weakened balance sheets.
Even the creditworthiness of the government itself is being more closely scrutinised. A restructuring of Japanese government bonds (JGBs) may seem scarcely conceivable, but two international rating agencies (Moody’s Investors Service and Fitch) have downgraded the ratings they assign to domestic sovereign debt since 1998. Although this does not imply a much greater probability of default, it removes the triple-A badge of distinction so coveted by the most strongest nations.
Perhaps, more significantly, the cost of insuring against a JGB default in the derivatives market is now materially higher than for debt of any other member of the Group of Seven (G7) industrialised countries. A dollar-denominated, five-year credit default swap on JGBs cost 19 basis points – effectively, an insurance premium – in early February. A similar maturity default swap on US Treasury debt trades at a theoretical price of 1bp, in part because creditors rarely actually seek such protection. Even the government paper of highly-indebted Italy only commands a bid/offer default swap price of 4-7bp. Default swaps on the sovereign debts of Greece and Australia – countries that are a few notches below triple-A – cost 8-14bp and 5-8bp respectively. Clearly, the market no longer judges the risk of a Japanese government default to be a zero probability – as it once did.
There are two main reasons why the general credit situation in Japan seems to be taking a turn for the worse, after a period last summer when the situation looked to be stabilising. One is the weakening in the economy. After the recession of the late 1990s, Japanese output growth seemed to be clawing back to around 1.5% in 2000 and was widely predicted last autumn to settle at around 2% this year and next. In recent weeks, however, output forecasts have been revised down.
Economists at JP Morgan now believe that Japan’s GDP probably expanded by a little over 1% last year, and will be less than that in 2001. This is the kind of anaemic average growth achieved between 1992 and 2000, compared with an average of nearly 3% for the major industrialised countries. Japanese consumers are still reluctant to spend heavily, because of concerns about their future prospects, while a recession in the US would hurt Japanese exports. A return to low national growth will in turn cut company earnings and make it impossible for many more struggling companies to avoid bankruptcy.
The second reason why insolvencies are set to rise, with all the worrying implications for creditors, is that corporate restructuring is gaining momentum. Government reforms have started to speed up, after years in which the political establishment refused to accept that the collapse of Japan’s extraordinary financial bubble in 1990 had left the country with a problem – a state of denial that resulted in “the lost decade”. Deregulation and the government’s waning commitment to bailing out troubled companies are forcing them to merge or refocus on their core businesses. This is leading to closures and job losses. In the financial services industry, the “Big Bang” reforms are ending the divisions that kept firms specialising in particular types of lending or securities trading. Before long, everybody in the financial field will be able to do almost everything. New boutique firms are setting up venture capital, hedge fund and asset management operations. Foreign banks are building up and competition is growing. These reforms, and the financial crisis of 1998-99, are producing mega-mergers in the Japanese banking industry.