Japan veers off the road to recovery

Crippling debt could send the economy into further trouble
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The Independent Online

The global cycle is strong, corporate profits are rising, confidence is back up. In other words, Japan could be in deep trouble.

The global cycle is strong, corporate profits are rising, confidence is back up. In other words, Japan could be in deep trouble.

As observers of the world's second- biggest economy have been saying for the last couple of months, after a particularly turbulent decade, Japan has now reached a turning point. The problem with turning points is that, like shares, they can go down as well as up.

The biggest issue the country has had to tackle is the legacy of its infamous bubble era. The headline victories for Japan Inc were real enough, but underneath was lurking an unholy tangle of cross-shareholdings, gigantic loans, deceptions and cover-ups.

To its credit, Japan spent the 1990s realising that the route back lay in clearing up the mess. Various economic and political reforms have gone some way towards doing that by lancing those boils. As the obstacles have been removed, the prospect of recovery has looked more solid. But has the rejoicing come too soon?

In the past few months, three stumbling-blocks have emerged, and the rejuvenated economy looks on course to crash into all of them. The first, and most critical, is the bad debt problem, which was exposed by the collapse of the Sogo chain of department stores, and the subsequent questions about forgiveness of debt. The incident revealed a safe haven for the many Japanese corporations unable to repay their vast loans, but it also set a dangerous precedent for the banks.

In April this year, Japan's Civil Rehabilitation law came into effect, allowing companies teetering on the edge of bankruptcy to shelter their assets from creditors under the umbrella of the courts.

It was assumed this would be a last resort for small companies, which could easily be restructured or bought. Suddenly, though, it became a useful tool for debt-ridden bigger companies to grapple back some power over the banks.

The banks are weighed down by colossal debts to the state purse, via the steady flow of loans made in the 1980s and 1990s. They rely, therefore, on repayment from the corporations, or the whole structure unravels. This year, the number of bankruptcies has soared.

The threat from Sogo was potent. Crippled by debts of nearly 2 trillion yen (£15bn), it applied for protection from the courts. Its creditors realised the whole lot would now have to be written off. Although the blow was severe, it is the promise of worse to come that now looms over the banks.

To keep the indebted companies from going to the courts, Japan's banks have forgiven over £20bn since Sogo fell in July. A large chunk of that arose from forgiving the debts of conglomerate Kumagai-gumi, which was a fervent buyer of London property.

Chris Rigg, Japan strategist at Commerzbank, says: "Banks should soon announce a sharp rise in bad debts ... Moreover, bad debt reserves could be insufficient. They have been based on debt-forgiveness programmes under which only part of the debt was forgiven."

But the Sogo affair sent out an even more worrying signal. Traditionally deemed "too big to fail", its failure raises question marks over some of Japan's biggest companies. Compared to trading group Daiei and airlines like JAS and All Nippon Airways, Sogo was small-fry. These groups are also debt-ridden, but by almost 10 times the Sogo figure. If the banks are forced to forgive those, the crash would be resounding. James Fiorillo, of ING Barings, has predicted it could take banks like Daiwa, Nippon Trust and Yasuda Trust seven years to settle the debts.

But if the debt-forgiveness panic takes hold, nearly all the banks will find their reserves unable to take the strain, obliging them to raise the money on the capital markets. If they end up doing that at once, the current share-price lows for the banks will seem like halcyon days.

According to Mr Rigg, all the banks - except Tokyo Mitsubishi - could be at risk. If Mizuho, which by assets is the biggest bank in the world, takes a tumble, Japan's recovery will be forgotten. Adding to the mix are memories of the collapse of Yamaichi Securities in 1996. Japan has seen how its financial edifices can collapse despite the protective web.

The second stumbling block will trip a far wider number of industries than banking. By next March, companies will be required to evaluate their assets at market value rather than at original purchase price. Analysts are calling it a "big bang". Corporate Japan will have to come up with transparent balance sheets.

The final issue, as outlined in new analysis from Commerzbank, is that when the Bank of Japan (BOJ) raised interest rates it was jumping the gun. The move was taken on the basis of enough signs of recovery to warrant abandoning the zero-rate policy.

"Our view is simple," says Mr Rigg. "The interest rate hike does not signal the end of the beginning - it is a mistake. This realisation by markets should mean it will come to be remembered as the beginning of the end, as BOJ governor Masaru Hayami's mistake."

This raises the fear of a crash. In 1994 the market was poisoned by a premature rate decision; in 1996 the same effect was sparked by a 2 per cent rise in consumption tax. On both occasions the authorities destroyed the recovery before it could take hold.

Any one of these problems would shake the fragile structure of Japan. In combination, they could mean disaster. The kind of disaster that it will take more than high-profile tears and resignations to solve.