In December 1997 the government set about relieving these economic worries, responding to the worsening situation with a string of measures including a 2 trillion yen (16 billion U.S. dollars at 125 yen to the dollar) tax cut and the infusion of 30 trillion yen (240 billion dollars) in public funds to stabilize the financial system. Prime Minister Ryutaro Hashimoto's pronouncement that "a worldwide financial crisis originating in Japan must be avoided" has set the tone for the government, bringing about hopes for amelioration of the economic unease.

Nonperforming Loans in the Post-Bubble Era
At the root of the loss of faith in Japan's financial institutions and the finance system as a whole is the bursting of the bubble economy. The bubble grew during the waves of speculation of the later 1980s, which saw land and stock prices skyrocket. The Tokyo Stock Exchange's benchmark Nikkei average of 225 issues hit an all-time high of 38,915 yen at the end of 1989.

Financial institutions are allowed to count a portion of the latent profits accruing from increases in the value of their stock holdings as their own capital. During the bubble economy, this led to a boom in banks' capital-adequacy ratios--a measure of their capital, reserves, and surplus funds as a percentage of assets, which include securities and outstanding loans. Higher ratios meant more lending ability for the institutions, and the late 1980s saw them rush to extend loans with real estate used as collateral. The institutions' international operations saw a similar boom in foreign-currency-denominated loans, backed by the strong yen and an abundance of capital.

But stock prices headed south beginning in 1990. In August 1992, after the speculative bubble had collapsed almost completely, the Nikkei index bottomed out at 14,309 yen--close to a third of its high mark recorded only three years earlier. Land prices began falling in 1991, returning in short order to their pre-bubble levels. These developments led to a drop in the latent profits of stocks held by banks and a consequent drop in their capital-adequacy ratios; this blow was coupled with many of their loans becoming unrecoverable as the value of the real estate backing them plummeted.

In response to this, the financial institutions began focusing their efforts on clearing away these bad debts. According to a report issued by the Ministry of Finance on January 12, 1998, however, the nonperforming loans reported by the banks themselves still amount to as much as 77 trillion yen (616 billion dollars) in all.

Falling Yen, Sinking Stocks, and Corporate Failures
A look at recent economic trends shows somewhat of a rebound, supported in part by individual consumption. Gross domestic product grew by 2.4% in fiscal 1995 (April 1995 to March 1996) and 2.9% in fiscal 1996. The Tokyo Stock Exchange has also begun to see some improvement: During 1996, when financial instability had yet to surface in earnest, the Nikkei average hovered between 19,000 and 20,000 yen.

The following year, however, saw a turn for the worse. The April 1 hike in the consumption tax rate from 3% to 5%, the end of the special income-tax cut that had saved taxpayers around 2 trillion yen each of the previous three years, and a hike in the payment rate for medical care all contributed to stagnant individual consumption. The April-June quarter, the first of fiscal 1997, saw GDP contract by an annualized rate of 10.7%. The July-September quarter provided only a weak rebound, with annualized growth hitting 3.6%; the nation's economic troubles have become more clearly defined.

The Tokyo Stock Exchange kicked off 1997 just above 19,000 and remained close to that level through the first half of the year. But since July, when the Thai baht's sudden drop in value touched off currency and stock-market troubles across Asia, the TSE has been in a steady decline along with many of the world's bourses.

Japan's financial world suffered a further crisis of confidence on November 3, 1997, when middle-tier brokerage Sanyo Securities Co. announced its bankruptcy. The crisis soon worsened with the news of the collapse of Hokkaido Takushoku Bank, a major commercial bank, on November 17 and the failure of Yamaichi Securities Co., one of Japan's "Big Four" brokerages, on November 24. The failures of these major players sent the Nikkei average plunging below 16,000, and the bankruptcy of Toshoku Ltd., a food trading firm listed on the Tokyo Stock Exchange's First Section, on December 18 sent the index below 15,000 four days later--its first time below that mark in 29 months.

Meanwhile, the Japanese economy's sluggish performance contrasted with the United States' brilliant economic performance led currency traders to dump yen for dollars. Foreign investors in particular began reducing their yen holdings following Sanyo Securities' failure, pressuring the currency downward. With the additional impetus of South Korea's financial worries, early December 1997 saw the yen drop to 130 to the dollar for the first time in over five years.

Tighter Lending Squeezing the Economy
For banks and other institutions, falling values in both stocks and the yen are major detriments to their financial health. Their capital-adequacy ratios are pressured by both factors: Falling share prices shrink their latent profits, thus reducing capital levels, and a weakening yen boosts the value in that currency of dollar-denominated overseas loans, inflating the asset side of the equation.

Faced with the need to maintain their capital-adequacy ratios, banks are tightening their lending, reducing the scope of new loans or cutting them out altogether and moving to recover past loans. This credit crunch is affecting even transactions among financial institutions. The collapse of Sanyo Securities Co. forced this cautious stance: The brokerage declared bankruptcy after becoming the first firm ever to default on repayment of funds obtained on the call market, where short-term interbank loans are carried out. After that, the call market sawinstitutions denying loans to firms with questionable stability and even rescinding loan offers that had already been made. Hokkaido Takushoku Bank, like Sanyo, collapsed after the market did not provide it with the funds it needed to remain afloat.

The failure of Toshoku is seen as a typical example of a bankruptcy spurred by tight lending. Although the trading company's main bank did its best to support the firm, other banks failed to extend needed loans, leading to the Toshoku collapse. One private credit-investigation organization found that through the end of November, 1997 saw 169 bankruptcies, accounting for a total of 315 billion yen (2.52 billion dollars) in debt, attributable to tightened lending policies.

Analysts fear that this reluctant lending on the part of financial institutions will adversely affect not only the financial system, but the Japanese economy as a whole. A credit crunch will reduce companies' access to funds, leading to less plant and equipment investment and lower productivity. As the business environment grows sluggish, stock prices will fall. This in turn will shrink lenders' capital-adequacy ratios, bringing about greater financial unease and expanding the credit crunch, completing the vicious cycle. Despite the danger of this downward spiral, banks and others continue to tighten lending in preparation for the government's April 1998 introduction of "prompt corrective action."

This step will give financial authorities the power to order institutions with low capital-adequacy ratios to improve, or even suspend, their operations. A quick way for firms to bolster ratios is to increase their capital holdings, but this is difficult while the stock market remains sluggish. Banks are therefore opting to hike their capital-adequacy ratios by reducing overall assets, in part by clamping down on lending. Falling share prices are also increasing the credit crunch as banks' latent profits from stock holdings take a beating. According to the calculations of one private think tank, if the Nikkei index is at the 16,000 level in March 1998, Japan's banks will have to reduce assets, including loans, by a total of 26 trillion yen (208 billion dollars) to maintain the capital-adequacy ratios they had at the end of March 1997.

Government Moves to Head Off a Crisis
Fearing the shadow that a credit crunch could cast over the nation's economy, the government hammered out a string of plans in December 1997 to revitalize the economy and stabilize the financial system. The first of these plans, a 2-trillion-yen (16-billion-dollar) cut in national and local income taxes, aims to spark an economic recovery by boosting consumption; the reduction will be included in the fiscal 1997 supplementary budget and financed through the issue of deficit-covering bonds.

The second measure is intended to stabilize the financial system with the infusion of some 30 trillion yen (240 billion dollars) in public monies. Bonds will be floated to supply 10 trillion yen (80 billion dollars) for a deposit insurance mechanism, with the availability of an additional 20 trillion yen (160 billion dollars) to be guaranteed by the government. Of the total, 17 trillion yen (136 billion dollars) will be earmarked for the protection of failed institutions' depositors, and 13 trillion yen (104 billion dollars) for preferred stock purchases to shore up viable institutions' capital-adequacy ratios. Measures to strengthen capital levels, including preferred stock purchases, will not be aimed at bailing out individual financial institutions, but rather at upholding the overall credit framework. They will only be applied when the nation's financial functions are faced with serious obstacles, or when institutions' fund-raising difficulties or consecutive failures pose a threat to economic activities.

The third step is the flexible application of the "prompt corrective action" beginning in April 1998. These measures impose capital-adequacy requirements on Japanese banks: Those engaged in overseas business will ber equired to maintain a ratio of at least 8%; those confining their activities to domestic business will need to keep the figure at 4% or greater. The Ministry of Finance has announced its intent to put off punitive measures for one year for domestic operators unable to clear the 4% hurdle, as long as they have a ministry-approved plan to meet the requirement by the end of that period. The ministry has also relaxed the computation standards for financial institutions' capital-asset ratios.

The administration presented bills for the tax cuts to be included in the fiscal 1997 supplementary budget and for the financial system stabilization measures to the national Diet in the session that opened on January 12, 1997, expressing hopes that they would be approved within the month. Now that these plans have been set in motion, there are some signs that the credit crunch is beginning to ease. While keeping an eye on the results of these measures after their implementation, the government intends to continue working toward the stabilization of Japan's financial system and the revitalization of its economy.

Ministry of Foreign Affairs

Japan Information Network

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