Reversal of fortune: Macroeconomic policy, International Finance, and Banking in Japan
reallocation of resources is going perversely from productive to unproductive 335
firms. The continuing support of these zombie firms by Japan’s banks is an 336
important factor in the banking sector’s poor performance. Ahearne and Shinada 337
argue that banks should be provided with incentives to withdraw their support, 338
and force firms to meaningfully restructure or, in some cases, to close. 339
5 Some difficulties posed by recovery 340
Despite the two middle quarters of 2004 experiencing negative growth, Japan is 341
once again in the midst of a fragile recovery as it has been on at least in five other 342
occasions in the past 15 years. This latest recovery is somewhat different from 343
some of those in the recent past because, notwithstanding continuing deflation, it is 344
being driven by domestic consumption and non-residential private investment, and 345
not by exports. Even so, Japan’s sustained escape from economic stagnation is 346
fraught with difficulties. As the papers in this Symposium discuss in detail mac- 347
roeconomic policy, international finance, and the banking system, individually and 348
together, pose major problems for the future of Japan’s economy. 349
The very large volume of outstanding government debt as a proportion of GDP 350
makes it likely that as the Japanese economy attempts a sustained recovery, long- 351
term interest rates on government debt will rise. The most immediate impact of this 352
rise in interest rates will be on the Japanese banking system’s balance sheet. 353
Japanese banks have returned to profitability and the nominal value of their 354
outstanding NPLs is declining. Nevertheless, there continues to be a contraction in 355
bank lending (OECD 2005). In consequence, Japanese government debt continues 356
to be an important part of the banking sector’s assets. As noted by both Kawai and 357
Mitsuhiro Fukao, a rise in interest rates will impose a significant capital loss on the 358
Japanese banking system. What has been gained after long effort from the writing 359
off of NPLs, the unraveling of cross-holding equity relationships between borrower 360
and lender, and the infusion of government capital may be quickly lost.3 361
The likely rise in long-term interest rates will do more than just pose difficulties 362
for the banking system. Because of the government’s very large outstanding debt, 363
the rise in rates not only reflects, but also reinforces public concern about the 364
sustainability of Japan’s fiscal position. At the very time that new government 365
expenditures might be needed to shore up the banking system, however, the im- 366
peratives of public finance require, as Ihori observes, a continuing paring of ex- 367
penditures and a raising of revenues. 368
The likely rise in interest rates will complicate Japan’s recovery on yet a third 369
front. Rising rates in Japan will put still further pressure on the yen to appreciate. If 370
Ito is correct, the Ministry of Finance has the tools to cope with this problem, but 371
McKinnon suggests that in the face of American counter-pressure, the political will 372
to intervene cannot always be counted upon. Fatum’s and Hutchison’s findings, 373
however, imply that even if the political will is there a good outcome is not assured. 374
The difficulties just outlined can be mitigated by continued, credible gov- 375
ernment steps towards fiscal consolidation that aims, as Ihori suggests, at the 376
3 Saxonhouse and Stern (2003) discuss how the US Treasury and the Board of Governors of the
Federal Reserve System dealt with a similar problem in the 1940s and what lessons Japan might
learn from this experience.