WHY JAPAN MUST SCRAP AND BUILD

It will be harsh, but a weaker yen and a rise in interest rates is the only way to rebuild

Japan's economy, says Tadashi Nakamae Tokyo EXCESS capacity and deflation are the fundamental issues facing the Japanese economy. According to most estimates the economy carries no less than 30 per cent excess supply capacity and 30 per cent excess employment. In response to this supply-side problem, Japan's government during the 1990s stubbornly resorted to demand-side policies. These were always doomed to failure. An excess of supply, not a shortage of demand, is the fundamental cause of Japan's woes.

To reduce overcapacity, Japan needs supply-side reform, just as the United Kingdom and United States needed supply-side reform 20 years ago. The big difference is that Thatcher and Reagan were confronted by supply capacity shortages and the associated problem of inflation. The solution then was to raise supply capacity by boosting capital investment. The supply-side reform that Japan needs today, in contrast, will require a substantial portion of the existing capital stock to be scrapped.

Such reform will produce dire short

term effects, but will create the conditions for a prompt return to economic growth. Paring the 30 per cent excess from the economy will boost productivity by 40 per cent. Companies that survive will see their profits rise correspondingly. With increased profitability will come new capital investment and the creation of new jobs. The release of resources from hitherto inefficient companies and industries, combined with further deregulation, will facilitate the creation of new industries, primarily in the service sector. In this way, the massive unemployment created in the initial stage of reform will be absorbed into the new economy.

What about the problem of deflation? On the one hand, reducing capacity and employment, insofar as it is a cost-cutting process, will make deflation worse. On the other. the key instrument of supply-side reform in Japan will be an increase in the interest rate, which, by boosting demand from interest earners, will actually be reflationary.

The government's greatest policy failure during the 1990s was the zero-interest rate

policy, Low interest rates have buttressed feeble companies, kept non-productive employees in work, and allowed the government to squander cheaply borrowed funds on wasteful construction projects. Those who have paid for these excesses are firstly interest earners, and secondly strong firms.

In 1990 households held fixed-income assets totalling Y600 trillion ($5,000 billion) and earned interest income of Y32 trillion. By 1999 savings had risen to Y840 trillion, but interest income had fallen to Y10 trillion. Thus, in just nine years interest income dropped Y22 trillion, or 4.4 per cent of GDP. But the putative loss to households far exceeds this figure. The return on fixed-income savings fell from 5.3 per cent in 1990 to just 1.1 per cent in 1999. If returns had not fallen, households would have received Y45 trillion in interest income in 1999, Y35 trillion greater than actually realised. Similar calculations for pensions and insurance show that households would have earned Y14 trillion more on these assets. Altogether, higher interest rates would have annually created Y49 trillion, or 10 per cent of GDP. in interest income. Low interest rates have savaged consumption, especially among the elderly, who hold more than 70 per cent of Japan's net savings and are averse to spending their capital base.

For healthy firms, low rates have been equally damaging. Their restructuring efforts have borne little fruit, because weaker companies, kept on life-support by low rates, have prevented them from increasing market share. Only when the government stops supporting weak firms will strong firms be able to lead the wider economy to recovery.

To date. the Koizumi government has concentrated on public-sector reforms and largely neglected the private sector. While overhauling the public sector is important. only private-sector reform will revitalise the economy. Furthermore, by focusing on the public sector, Koizumi runs the risk of squandering his political capital in ceaseless battles with the vested interest groups that oppose reform.

In the one area of private-sector reform that he has touched upon — non-performing loans — he plans to eliminate bankrupt and nearly bankrupt companies from the market by accelerating banks' write-offs. But this approach does not sufficiently address the problem, because it relies on banks' arbitrary bureaucratic decisions rather than market forces. The politically weakest firms — instead of the financially weakest — would most likely be forced to retire from the market.

The market solution to the non-performing loan problem is to let rising interest rates force feeble companies into bankruptcy, and thereby ensure that banks write off loans to those companies.

So what can the government do to steer the interest rate upward? For the interest rate to rise, the yen must depreciate and stimulate massive capital outflows. However, at present, the expectation that Japan will continue to run a large currentaccount surplus prevents the yen from falling. To this end, the Bank of Japan should accelerate quantitative easing, and the Ministry of Finance, which controls currency policy, should adopt a stance in favour of devaluation. Throughout the 1990s, both authorities acquiesced to demands from America and Asia — particularly China — to keep the yen strong despite accelerating deflation. The time has come for Japan to pursue its own interests and abandon this policy.

But even after currency devaluation and higher interest rates purge the banks of their non-performing loans by forcing the weakest firms out of business, much of the economy's excess capacity will remain. Assuming the lending rate climbs to 6 per cent from today's 2.4 per cent, the write-offs for bankrupt listed companies will be Y30 trillion, just 20 per cent of all listed companies' borrowings. And in our estimate these affected firms employ only 5 per cent of the workforce and account for a mere 3 per cent of capital expenditure. To fully eliminate Japan's excess capacity and employment, surviving firms will have to rationalise as well. By increasing import costs for importdependent domestic firms, the lower yen, helped by further deregulation, will create a more competitive environment for domestic-oriented industries, which currently face little international competition. Increased competition will in turn prompt a renewed wave of corporate restructuring.

Higher interest rates will also enable a politically feasible reduction in the government's budget deficit. As long as officials try to cut spending with sheer political will, they will face ferocious opposition from vested interests. But as higher interest rates make current spending levels untenable, political resistance to fiscal austerity will dissipate.

It is difficult to foresee any means whereby Japan might accomplish supplyside reform other than through a weaker yen and higher interest rates. If official policy fails to shift in this direction, Japan will have to wait until market perception of the current-account surplus changes. Eventually, as the goods-and-services surplus shrinks and heads toward deficit, the market will see the writing on the wall, and the major support underpinning the strong yen will be removed.

One way or another, the yen will begin to weaken, and interest rates will rise. The immediate consequences will be dire. Bankruptcies and unemployment will soar, and gloom will pervade the economy. But just at that moment the process of supplyside reform, leading to sustainable economic growth, will have finally begun. Thereafter, when the current global recession subsides, do not be surprised if Japan's economy is the first to recover.