This report analyses why the Japanese economy, once seen as World No. 1, has lost its energy and confidence so rapidly and is taking so long to show any apparent recovery.

The report focuses on changes to the financial system since the mid 1980s, as the central answer to this question.

To put the conclusion first, the key reason is that Japan's historic attempt to change the financial system from one based on indirect financing to direct financing is still in transition. And the prospect of this reform succeeding is highly questionable.
 

Structured Credit Risk System

The past success of Japan's post-war economy has been seen to lie in the system of state-led capitalism, which many regarded as the most efficient "socialism" in the world.

Under this unique brand of capitalism the financial system was based on indirect financing which allocated capital to industry through banks, rather than via direct financing by investors through stock markets.

Of course Japan had stock markets and investors. But most stocks were cross-holdings by large related corporations within a group structure. Individual investors had a very small portion of the market.

Banks collected savings and passed them on as loans to companies under government guidance. Through this system both allocation of capital for industry and security of savings were guaranteed for the long term.

Since the indirect financing system did not rely on a stock market, in which credit risk is shouldered by investors, credit risk was enclosed within the banking system by well-established collaboration between banks and governments. Let's call it the Structured Credit Risk System (SCRS), borrowing this termnology from Yoshitaka Ishiguro.

Under this system, since any loss due to bankruptcy was carried by the financial institution, not one investor experienced any loss due to bankruptcy. The bankruptcy of Yaohan in 1997 was the first case in which investors suffered a real loss. This came about because the so-called Japanese Big Bang had started in 1996.

SCRS was underpinned by a number of unique practices:

• Main bank system: bank and company kept a long relationship - one not only of lender and borrower but also of consultation with the bank in management decisions;
• Cross holding of stock - most issued stocks were held within group companies; and
• Government-owned banks - such as the Industrial Bank and Long-term Credit Bank which carried out government industrial and financial policy.

SCRS also delivered excessive protection to investors. For instance bank savings were completely risk free unless the state went bankrupt. Investment in the stock market was a hobby for a handful of risk takers. Japanese people's reluctance to take risks can be seen as a product of this excessive protection.

SCRS was based on the idea that bank and company are efficient within an environment with no bankruptcy, because the costs associated with bankruptcy were too large for society to bear.

The miracle success of Japan's post-war economy was an outcome of this unique system.
 

Pressure from outside

The globalization of credit risk, as a result of the world-wide expansion of the Japanese economy, began to shake this unique system from the early 1980s. In particular a big trade imbalance between Japan and the US triggered a series of US attacks on Japanese protectionism.

The first attack came in the form of the Joint Japan-US Ad Hoc Group on Yen/Dollar Exchange Rate led by the Department of the Treasury in 1983. It was followed in 1989 by the Japan-US Structural Impediments Initiative which discussed elimination of impediments to free trade existing in the Japanese system. Then in 1996 Japan started to implement its financial "Big Bang".

Thus Japanese style capitalism was forced to accept the pain of destroying and internationalizing itself. In other words structured credit risk had to expose itself to the market.

In reaction to the high-yen recession brought about by the Plaza Accord (under which Japan and the US agreed on an appreciation of the yen) in 1985, the Bank of Japan lowered interest rates which brought an increase in the money supply. Excessive funds rushed into the stock and land markets, launching the bubble economy.

In 1991 the government was forced into a bitter political choice of tightening its monetary policy to stop the bubble, which promptly burst. Since then the economy has been crawling along the bottom for more than a decade.
 

Moral hazard - cause of bad loan problem

To look at some details of the process which led to the bubble, a method of liberalizing the financial system brought moral hazard to both the banking and corporate sectors.

The Joint Japan-US Ad Hoc Group on Yen/Dollar Exchange Rate required five items of liberalization to free the Japanese capital market. One of them was to liberalize interest rates.

Japan's expanding trade surplus since the early 80s caused a rise in stock prices. The corporate sector took advantage of this to issue stocks and corporate bonds to procure more funds than would have been needed to invest in plant, equipment and cash flow.

These excessive funds were saved in banks as big term deposits attracting a high interest rate brought about by the liberalization of interest rates. Many companies earned more profit through this financial technique than from the conduct of their ordinary business.

Meanwhile the banks lent the collected funds mostly to the real estate sector because land was the most secure collateral when land prices kept rising.

Thus both banks and companies were trapped by a moral hazard. But due to the traditional SCRS the credit risk attached to lending for real estate was enclosed within the system and not exposed to the market.

After the bubble burst, this enclosed i.e. hidden credit risk resulted in an endless bad-loan problem. Almost no one examined the credit risk in lending to the real estate sector due to the structured credit risk system. Everyone thought that they were risk free within the system.

In Japan today new bad loans are revealed one after the other even as the banks desperately write them off. Most commentators blame the bad loan problem on the continuing drop in prices, particularly of land and stocks. But this is a result rather than a cause of the problem. The real cause is the deep-rooted nature of SCRS.

It may not be an over statement to say that the cause of the bad loan problem was the population's over-familiarity with SCRS. They lacked the capacity to measure risk. This also explains why the bad loan problem, or even reform of the financial system itself, is taking such a long time. In other words, it could be a matter of education or generational change rather than a question of institutional reform.
 

Unknown size of bad loan problem

To measure credit risk is not easy for ordinary people. This is the reason why rating companies exist. But their presence is based on the premise that all credit risks are approachable, i.e. not "asymmetric" to them.

Even in the US, which has the most developed rating companies, the rating system developed a credibility gap. When Enron went wrong, Moody's gave the company a BBB+ rating (not a unsafe rating) as recently as five days before bankruptcy was disclosed. Moody's explained that it could not be responsible when a company deliberately hid information.

Big Japanese companies have greatly improved disclosure to investors in the last decade or so. But what about the sovereign risk of Japan's financial system itself. Because of the deep-rooted SCRS, it is difficult to hold that the financial system is symmetric enough in terms of the extent of liberalization of its capital market.

Yet when one hears the recent chorus of old guard politicians pressuring the Bank of Japan to buy corporate stocks in addition to government bonds in face of a free-fall in stock prices, he/she must realize that reform to implement free and open capital market in Japan is still stubbornly resisted by those politicians. And the system as a whole is becoming a messy mixture of old and new systems.
 

A parasite society

Moody's gave an A2 rating to Japan's yen-based long-term government bond as of 1 April 2003. According to Moody's definition this rating means a very low possibility of default (0% within 3 years, 1.5% by 5 year later, 2.0% by 10 years later).

But when looking at the asymmetry of accessible information on the financial system, even though the Koizumi government has been attempting a range of reforms, the above rating is likely to be a result based on a certain amount of hidden information. In other words, like the Enron case, the rating may be unreliable.

Kenichi Omae, a leading analyst and an ex-candidate for Governor of Metropolitan Tokyo who leads a nonprofit organization to foster people dedicated to changing Japan, said: "the time left is only two years" to avoid a disastrous outcome.

What will really happen after that?

Takeshi Kimura, who is a thinker for Heizo Takenaka, Joint Minister for Economy and Financial Services, predicts that a massive capital flight is likely within several years unless the reformists win a victory against the old guard.

As long as the current political structure including its gerrymandered electoral system is maintained, deepening chaos may be inevitable.

An article in a recent economic weekly coins a word to describe the current situation; a parasite society, in which no one - be they politician, bureaucrat, business-man, or voter - wants to take responsibility for the future of the country.

This situation, if it were true, can only be termed suicidal.