You can no longer safely shrug off Japan's economic crisis. It just might drag the world into a depression.
The world--including even the previously sanguine Japanese--is now catching on to the fact that Japan's 12-year slump has deteriorated into a full-blown crisis, threatening a wild global ride. Falloffs in various indicators in the world's second-largest economy resemble the plunge of such countries as the U.S. into the Great Depression of the 1930s.

What about the theory that Japan is so rich a nation that it can buy its way out of a financial collapse? After all, it is said, the huge debt overhang from the country's rotten banking system and the actuarial deceit of its postal- and insurer-based retirement systems is just a case of Japan owing itself. This is not Russia or Argentina or Thailand.

No, it's not Russia or Argentina. In fact, it is potentially something far worse.

"Japan is 42 times bigger than Thailand," says Kenneth Courtis (who is interviewed on page 58), vice chairman for Goldman Sachs in Asia, referring to the country dubbed the epicenter of the 1997 Asian crisis. That bout cut world output by $300 billion in a year. Japan represents the "largest economic crisis since the 1930s," says Courtis.



"The world is heading for a once-in-a-century economic crisis," says Ryoji Musha, a strategist for Deutsche Bank in Japan.

How so? Consider the notion that, with perhaps $11 trillion in savings, the Japanese have enough wealth to cope. It sounds as if they do--until you realize that the total on- and off-balance-sheet claims on the household, corporate and government sectors in Japan are about $30 trillion, according to estimates by Goldman Sachs. That sum is six times Japan's $5 trillion GDP. (The total of U.S. public and private debt is $19 trillion, two times GDP.)



Those ratios in Japan are being made worse month by month, year by year, by deflation, which at perhaps 4% annually in Japan (measured in consumer prices) is the most pronounced in the world. Deflation aggravated the Depression in the U.S. in the 1930s. And it can spread. Cheap Toyotas are already putting pressure on U.S. auto prices. What if Japan devalued the yen, taking it from 133 to the dollar to 140 or 150 These Toyotas would then be even cheaper for U.S. customers. Robert Jay Pelosky, the chief global strategist for Morgan Stanley, says: "This would send a price shock into the U.S. and Europe at a time when we [the U.S. and Europe] are flirting with deflation."

At the same time Japan faces a debt bomb at home, it is also the world's largest creditor. If its banks were panicked into calling in overseas loans, by, say, a run on deposits, an economic contraction would sweep America and the globe.

True, the specter of a withdrawal of Japanese money has yet to materialize despite having been raised for more than a decade. Some economists pooh-pooh the idea that lenders could or would move much of these funds home to low yields. And a lot of the $3 trillion in overseas assets is in the form of hard assets, such as factories, which cannot be repatriated.



Nevertheless, consider what happened on a far smaller scale in 1997. It took only the collapse of a midsize Japanese bank, Hokkaido Takushoku (with assets of $80 billion), to expand Thailand's problems into a regional crisis, says Thomas Byrnes, a sovereign-risk analyst for Moody's. Within three months of the bank's collapse, he says, Japanese financial institutions pulled $118 billion out of the global economy, mostly from Asia and Eastern Europe. South Korea, the world's tenth-largest economy, was effectively bankrupted by the withdrawal of Japanese money, he adds.

Mired megabanks
Bank Total assets ($bil)

Mizuho Financial Group 1,250

Sumitomo Mitsui 915

The Bank of Tokyo-Mitsubishi 830

UFJ Holdings 700
The four biggest of Japan's troubled banks alone have total claimed assets worth $3.7 trillion, (see table, left). It would not be only Korea and other Asian countries that would suffer if these banks' latent troubles erupted. Japan is the world's main source of capital. Much of its $3 trillion in overseas assets is in liquid instruments, such as $333 billion worth of U.S. Treasurys and bank loans to the U.S. and Europe worth $340 billion and $363 billion, respectively. Byrnes sees signs that Japanese banks have already begun to repatriate some of their money.

Is anyone paying attention? The business press is more preoccupied with Enron and maybe even Argentina. But there are some voices of concern, including that of Paul O'Neill, the U.S. Treasury secretary, who prodded the Japanese in a return visit to Tokyo in January.

Paul Volcker, the former head of the Federal Reserve Board and a famous worrier, says that he can't recall in his career a touchier global economic situation. "The U.S. situation is fragile: The stock market feels good, the short-run outlook is reasonably good, but it is fragile in that it depends on consistent and big imports of foreign capital," Volcker says. "This is not going to last forever."

How overleveraged is Japan? Just compare.
Japan's debts as % of GDP US debts as % of GDP

National debt 143 National debt 37

Off-balance-sheet claims on Japanese government 280 State and local governments 14

Bank loans (corporate and consumer) 132 Household debt 77

Nonbank-loan corporate debt 54 Business debt 70

TOTAL 609 TOTAL 198


Meantime, Edward Gramlich, a governor of the Federal Reserve, is calling for more U.S. savings to cut reliance on lending from abroad, which is now running at 4.4% of GDP.

So when might the piper get paid? Insurance on time deposits worth more than $75,000 at Japanese banks is supposed to expire at the end of March. A crunch could come at that time if enough money exits the system. A recent drop in savings of 9.5% at smaller financial institutions (in anticipation of the end of these deposit guarantees) is a sign that this may already have begun.

If a panic were to cause Japanese to flee yen-based holdings, the U.S. dollar might soar in value, creating a dollar bubble that could fuel a temporary speculative stock market boom. It might feel good at first, but as post-1980s Japan and the post-2000 internet and telecom sectors show, bubbles have nasty aftereffects.

After three yearly downgrades, Japan has a sovereign credit risk rating of Aa3 with a negative outlook, the worst of any developed nation. Moody's Byrnes sees no default within five years, but he admits that Japan is in "uncharted territory." John Makin of the American Enterprise Institute in Washington, D.C., whose bearish views are being picked up on Wall Street, cautioned in a recent essay: "Ratings agencies in Russia, Latin America and Asia have repeatedly demonstrated their inability to signal coming crises for the debt of governments because they persistently heed the admonitions of governments that it would be ‘irresponsible' to warn investors to get out of assets whose value is about to collapse."

Independent Strategy, an analytical outfit in London that's headed by David Roche, a columnist for FORBES GLOBAL, says: "There is no record of any government being able to repay debts equal to several times the annual output of its country in real money. Japan will be no exception."

A shrinking majority opinion still believes that Tokyo can muddle through. One common scenario, mentioned by Masatoshi Kikuchi, a Japan strategist for Merrill Lynch, calls for one to two years of contraction accompanied by steady economic restructuring and followed by a recovery in late 2003. This would be followed by a gradual paydown of Japan's debts. (Although, as Kikuchi admits, "Nobody knows the true debt total because it is extremely politically sensitive.")

Another scenario: Japan could simply continue decaying until it descends to the status of a developing country, much as Argentina did after World War II. "We are very afraid of Japan becoming another Argentina," says Taiichi Sakaiya, who was Japan's economics minister until recently.

A popular and seemingly painless step is to have the Bank of Japan try to reinstill inflation through the money supply. But, Volcker says, "My long experience says that it would be hard to produce inflation in a deflationary world economy."

The central bank has in fact been buying government debt, bypassing the banks and pumping money directly into companies; it's also been filling the banks with more money at 0% interest than they can digest; all to little effect. The next step would be to print money to buy all the bad debt, which would cause the yen to plunge to its lowest level in decades.

A true solution would likely entail nationalizing or recapitalizing the banks, bankrupting more than a third of Japanese companies (and much of the rural support base of the ruling party) and selling off the underlying assets at 10% or so. The banks' refusal to reprice assets has prevented the market from finding a bottom even as hundreds of eager vulture funds lie in wait (see page 16).

Radical deregulation of distribution and retail and better legal accountability are other moves that make economic, if not political, sense. The trickiest knot to untie, however, may be demographic. Japan could deal with its aging, soon to be shrinking, population by letting in 700,000 immigrants a year, essentially the number its work force is losing; other developed nations are fitfully adjusting to population plateaus by tolerating considerable influxes. For Japan, a wealth of potential improvement in productivity resides not far away, in China. Yet for historical and cultural reasons, it has barely been tapped.

As O'Neill said in Tokyo, the Japanese do have the ability to act boldly and effectively when they resolve to do so. Recent isolated examples of this--though ones that took significant foreign instigation--can be found at two significant companies, Nissan Motors and Shinsei Bank.

Nissan was losing money for most of a decade before Carlos Ghosn stepped in as president. Within two years he took it to record profits. Nissan just won the auto of the year award at the Detroit auto show. To get there though, he had to shut down five factories, fire 20% of the staff and cut out half of his parts suppliers. Shinsei Bank has become a highly profitable financial institution but only after half its assets were written off by the government and a large contingent of outside experts came in to shake up its inbred corporate culture.

Japan's reform-talking prime minister, Junichiro Koizumi, has repeatedly promised to do "whatever is necessary to avoid a financial crisis," but after nine months in office he has produced little beyond rhetoric. "This government that won in a landslide [by promising] to bring significant reforms has not done anything," says Michael Petit, the man in charge of sovereign-risk analysis for Japan at Standard & Poor's. "There are a lot of vested interests, so that it's extremely difficult to get anything done."

However, the pace of deflation that's already gripping Japan makes a grind-it-out scenario for recovery less likely by the day. When asked if Japan faced the danger of a Russian-style collapse, Shoichiro Toyoda, the honorary chairman of Toyota Motor, says, "It is already in the middle of one," but he complains that the country's leaders don't recognize it.

The world can only hope that when George W. Bush visits this month, he will focus those Japanese minds.