Global Policy Forum

By Akio Hayashida and Junichi Maruyama

This is the second installment of a three-part series about the effects of the U.S. stock market slump on the rest of the world.

The continued fall in U.S. stock prices and the dollar's depreciation has battered the Japanese economy, which the government believes has finally started to bottom out after a protracted slump. "Banks are extremely vulnerable to the impact of falling stock prices at a time when they are running out of surplus funds," said Hironari Nozaki, a senior analyst of HSBC Securities (Japan) Ltd.

Declining share prices could deal a further blow to the Japanese financial system. According to an estimate by Daiwa Institute of Research, the 12 major banks probably will have latent losses exceeding 3 trillion yen if the 225-issue Nikkei Stock Average stays at the 10,000 level, with every additional 1,000-point drop increasing their losses by a further 2.2 trillion yen. Such potential losses dwarf the major banks' surplus funds, which have been depleted by write-offs of their massive nonperforming loans in recent years. As of the end of March, their surplus funds reportedly totaled only 1.7 trillion yen.

This means that the nation's leading banks have insufficient strength to cope with falling stock prices. The major banks also hold about 27 trillion yen worth of bad loans. To keep in line with the policy adopted by the administration of Prime Minister Junichiro Koizumi toward nonperforming loans, the banks will have to dispose of 15 trillion yen worth within three years.

A further fall in stock prices could bring the banks to the brink of collapse. "I'm very nervous that the Nikkei 225 may drop to 9,000. Even if the banks improve their financial strength through drastic restructuring, it won't be enough to counter such a plunge in stock prices," an executive of a major bank said, lamenting that his financial institution had no remedies for falling stock prices. Financial institutions are required to report latent losses if the value of their stock investments falls more than 50 percent below their purchase prices. However, if banks believe their stock investments will not recover, they have to report latent losses if the share prices fall by only 30 percent or more.

Even though the Nikkei climbed above the 11,000 level at the end of March, the banks were still faced with more than 1.8 trillion yen of latent losses. The banks also are required to deduct from their shareholders' equity 60 percent of unrealized latent losses for the banks'stock holdings. Due to the introduction of mark-to-market accounting practices, falling stock prices accelerate the banks' deteriorating financial condition. Furthermore, the financial industry has been made more vulnerable by volatile fund transfers in response to the government's March 31 abolition of its unlimited guarantee of bank deposits.

The government's lifting of the freeze on the introduction of the so-called payoff system has led to a large amount of money being transferred from time and savings deposits to ordinary and checking-account deposits, which will remain fully protected until the end of March. Under the payoff system, each depositor is guaranteed a refund of principal of up to 10 million yen for time and savings deposits plus accrued interest in the event of bank failure. As a result, the balance of checking deposits in domestic banks has increased by 63 trillion yen over the past year.

In May, the amount of funds deposited in checking accounts surpassed the amount deposited in time and savings deposits for the first time, despite the higher interest rates on offer for the latter accounts. An official of a major bank in charge of over-the-counter services said, "We're recommending government bonds and other financial products with principal guarantees because too much money has been collected in ordinary deposits, which makes it difficult for us to find investment vehicles."

Transfers of funds to the major banks from the smaller and comparatively financially weaker financial institutions have been accelerating, sparking concerns about the smaller institutions' financial condition. The concentration of bank deposits into ordinary and checking accounts from which funds can be withdrawn immediately--particularly during times of crisis--has destabilized the banks' fund-raising. Such a concentration makes it more difficult for financial institutions to extend long-term loans, and it may hamper the flow of funds throughout the domestic economy.

Despite such concerns, Koizumi announced Monday his intention to lift the freeze on the introduction of the payoff system to other deposits in April as previously scheduled. But the stock market slump may breach one of the preconditions for the full introduction of the payoff system--a stable financial system. Although bank managers should not presume to control all aspects of their operations, if adhering to the timetable for the full introduction of the payoff system threatens the stability of the financial system then it has surely deviated from its original purpose.

The government needs to adopt a flexible approach to cope with sudden changes in economic conditions. Japanese exporters have been hard hit by the yen's recent appreciation against the dollar after previously enjoying the benefits of a weak yen. A foreign exchange dealer at a bank said recently his telephone had not stopped ringing with demands from automakers, electrical appliance makers and other exporters for forward exchange contracts that fix the yen-dollar rate at the date the contract is entered into. According to the dealer, orders for 30 million dollars and 50 million dollars contracts have poured in at a much greater rate than normal.

Shortly before 1 p.m. on June 24, the yen was poised to advance beyond the 120 yen level against the dollar when the government and the Bank of Japan implemented a yen-selling, dollar-buying operation for their fifth market intervention this year. Just after the start of the market intervention, the banks reportedly were flooded with orders for forward exchange contracts to lock in the exchange rate.

The exporting companies were attempting to avoid further foreign exchange losses arising from the yen's appreciation by buying forward contracts. A foreign exchange dealer at a major bank said: "Not all of the companies were able to react to the sudden appreciation of the yen. They seem very concerned about it." The yen's continued appreciation is a major concern for the nation's large exporters, such as Toyota Motor Corp.

The nation's top automaker reported a 1.1 trillion yen profit for fiscal 2001, the first Japanese company to generate more than 1 trillion yen in earnings. However, as much as 410 billion yen in profits was due to the yen's depreciation against the dollar during the fiscal year, which increased the yen value of Toyota's foreign exchange earnings. Toyota has forecast an exchange rate of 125 yen to the dollar for the current fiscal year, but if the yen remains at current levels, the company will post 150 billion yen of foreign exchange losses this fiscal year. Japanese automakers are considering hiking prices for their new models to be released in the U.S. market in and after September to compensate for potential foreign exchange losses.

However, the automakers have been forced to review their strategy, including the timing of possible price increases, because consumer confidence in the United States may fall due to the stock market slump. According to Daiwa Institute of Research estimates, an average exchange rate for fiscal 2002 of 120 yen to the dollar will reduce the automobile industry's profits by 245 billion yen and the electrical appliance industry's by 125 billion yen. Overall, Japanese industry may lose more than 530 billion yen in foreign exchange losses. The earnings of domestic electrical appliance makers in their March account settlements were much lower than their earlier estimates as they failed to predict last year's bursting of the information technology bubble.

Concerning fiscal 2002, the prognosis from the IT industry remains gloomy. "Our earnings estimates are as pessimistic as possible," said Mitsubishi Electric Corp. President Tamotsu Nomakuchi. A Hitachi Ltd. executive warned, "Some in the industry are saying that even their most pessimistic projections may not be achieved due to the yen's appreciation."

According to Dai-ichi Life Research Institute, the nation's real economic growth rate this fiscal year will be reduced by 0.46 percent and the consumer price index lowered by 0.22 percent if the yen remains at its current level. The yen has appreciated by 10 percent against the dollar since the beginning of the year and the decreased imported inflation will accelerate the economy's deflationary trend, the institute said. Hiroshi Okuda, chairman of Toyota and the Japan Business Federation, expressed his concern with the yen's appreciation in a speech Monday. "The current high value of the yen makes it difficult, because exports drive the Japanese economy. Stock prices in Tokyo have fallen to a critical level and there are fears that the economy may be out of tune," he said.

Optimism in the business community over the government's declaration that the economy has bottomed out is fading fast. Hopes for a V-shaped recovery appear to be disappearing as quickly as the light of a candle in a strong wind.

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