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IMF pins Japan's economic ills on weak banks

TOKYO: If you want to know when Japan's recovery will take off, watch the country's battered banks.

The International Monetary Fund has been sifting through Japan's dismal economic performance over the past decade and has concluded that, of the many reasons behind the slump, none is more important than the role played by the banking system.

By the same token, the impact of the government's massive deficit spending and the Bank of Japan's super-low interest rates will remain muted until the banks have been nursed back to health and start increasing their lending, especially to smaller firms.

"The overall message is, in sum, that continued progress with the banking reform now under way and vigorous corporate restructuring are central to any sustained revival of the economy," IMF economists Tam Bayoumi and Charles Collyns wrote in an overview to "Post-Bubble Blues", a synthesis of recent Fund analyses of Japan's economic and financial woes.

The need for a shake-up of bloated banks and protected companies is a standard part of nearly every economist's policy prescription for Japan, which is battling to haul itself once and for all out of its deepest recession in half a century.

What marks out the IMF study, though, is its closely reasoned argument that the present weakness of the banking system is as much a cause as it is a consequence of Japan's economic misery.

"Banking system problems are indeed at the heart of the current weakness in activity," Bayoumi concludes.

This is because banks play a much more important role in financial intermediation in Japan than in, say, the United States and Britain, where capital markets are more highly developed.

Thus, during Japan's late 1980s boom, increases in bank lending with land as the main source of collateral magnified the impact of rising asset prices on the economy.

The reverse process happened with similar force when assets fell hard in the 1990s: undercapitalised banks responded by curbing lending to maintain capital adequacy standards.

"The central role played by financial intermediation in the slump...generates a compelling reason for the limited effectiveness of standard macroeconomic policies," Bayoumi says.

MONETARY EASING BLUNTED

In other words, borrowing costs may be zero and the Bank of Japan can leave as much surplus cash in the money markets as it chooses, but if banks are reluctant to lend the stimulative effect of loose monetary policy is dampened.

"To the extent that banks have responded to their own difficulties by reducing their loans to the private sector, such behaviour will have tended to offset the benefits of monetary easing," the IMF concludes.

Many economists in Tokyo play down the weakness of bank lending, which has been falling sharply since 1997.

The year-on-year decline in fact accelerated in February to 6.3 percent from 6.0 percent in January, but economists said this is because firms are financing investment from rising cash flows.

But the IMF analysis is more cautious. It says Japanese firms rely much more heavily on external funding than US or German corporations and their investment, at least at the margin, is still largely funded out of bank lending.

Moreover, although large firms have increasingly turned to the bond market for finance over the past 15 years, banks remain the main source of corporate credit.

Monetary modelling by the IMF underscored the importance of bank credit as a transmission mechanism for monetary policy.

Whereas a 10 million yen ($93,310) increase in bank lending increased private demand by more than five million yen, funding through securities markets and public-sector loans had no significant impact on demand.

The message for Japan's policy-makers is clear, Bayoumi and Collins say: While it is very encouraging that corporate and financial restructuring seems to be gathering momentum, a premature tightening of fiscal and monetary policy must be avoided until the banking system is fully back on its feet.-Reuters