Japan's scandal could damage U.S. recovery

THE BALTIMORE SUN

The United States' dependence on Japan's financial system is on display these days in the form of an unfolding brokerage-company scandal in Tokyo that may already be contributing to high interest rates in the United States, with the potential to do even more such damage and retard economic growth here.

The emergence of Japan as the world's top economic engine has been predicted for some time. That hasn't happened, and doesn't seem likely for a while yet. Even so, the vulnerability of our economy to the withdrawal of Japanese investment funds is great, and the odds that the securities scandal there will lead to such a withdrawal are high enough to be worrisome.

On its surface, the actions by at least 10 brokerages -- consisting chiefly of compensating customers for market losses -- would seem of little interest beyond Japan's island borders. But the affair has cost several top-ranking executives their jobs, turned the Tokyo Stock Exchange into Jell-O and, as it has unfolded further in the past several days, could easily affect national political leadership and possibly the government as well.

Making good on customer losses is considered bad form even in Japan, where customer commitments are taken very seriously. By paying off certain customers on certain investments, the brokerages have, in effect, subsidized and propped up investment values in Japan. The practice would be illegal in the United States but is not in Japan, although it's widely expected to be made so in light of the current scandal.

So, is a stock trading for 2,000 yen really "worth" 2,000 yen in light of this information? Share prices have fallen in Tokyo, providing that market's negative answer to this question. Some analysts say the declines have been healthy, bringing stock values back into line with long-term trends.

Further, the total of admitted paybacks is now in excess of $1 billion, which is peanuts compared with the trillion-dollar-plus value of Tokyo shares. Still, the declines have come at a bad time, and the Japanese market, often volatile to begin with, is seen as very susceptible to further drops.

Beyond the purely economic effect of the firms' actions is the widespread belief that some of the monies paid to customers were actually illegal political contributions and possibly money-laundering payments to criminal figures as well.

The names of the parties receiving the monies began to come out Monday, when one of Japan's major newspapers published a list of corporations and individuals said to have received funds.

Monday's report broke a conspiracy of silence within the government and among the brokerages themselves, which maintained that customer rights to privacy should prevail even in the face of growing pressure to reveal the names. Hours after the paper's list was published, the four leading brokerage firms involved in the flap came forward with their own list.

A quick scan of the names did contain some major corporations but did not reveal any fatally embarrassing political or criminal figures. Needless to say, however, the possible fallout from revealing who received the payments has been adding to the Tokyo market's uncertainty. And it's expected that more names will be revealed.

A government-toppling scandal would clearly affect market values inTokyo and elsewhere. But beyond this political impact, there are several other cause-and-effect linkages between Japan's stock market to the rest of its financial system.

First, the capital position of Japan's banks is directly tied to the values of their stock-market holdings, which are considerable. "Japanese banks are permitted to count as capital 45 percent of the unrealized gains on their huge stock portfolios," Edward Yardeni, the Wall Street economist, recently noted. "Every 1,000-point drop in the Nikkei Average [a major market index in Japan] trims 0.2 percentage points from the average capital-to-asset ratio of Japan's 12 large commercial banks."

Banks' capacity to lend money is tied directly to their capital reserves, meaning that declining stock values in Japan directly affect bank lending. "Last year's crash in the Japanese stock market depressed the capital adequacy ratios of Japan's major banks and forced them to reduce their lending activities, most significantly to foreign borrowers," said Mr. Yardeni, who is with C.J. Lawrence Inc.

Further, he noted, with international bank capital standards set to become substantially stiffer by 1993, Japan's large banks have even less ability to deal with stock market reductions.

Reduced Japanese lending to foreigners would sting, but not so badly as if the Japanese banks were forced to sharply curtail their domestic lending support to the real estate industry. If values on the Tokyo Stock Exchange are considered overvalued, they are still viewed as modest compared with the high valuations placed on Japanese real estate, despite some price retreats during the past 18 months.

A Japanese real estate implosion could make the U.S. S&L; collapse (and pending banking "crisis") seem tame by comparison. Although fear of such an outcome is not widespread, it's expected that Japanese financial institutions will adopt increasingly conservative policies to head off real estate problems.

The result could be a further inward turning of the Japanese financial system, subtracting more funds from foreign investments and withdrawing funds from U.S. government securities. This, in turn, reduces the effective supply of capital in the United States and supports higher interest rates.

If the U.S. financial system was in good shape, if our financial institutions were not on shaky footing and if our Treasury was not lurching from one deficit financing to the next, then Japan's problems could be largely forgotten on this side of the Pacific.

Despite reductions in key interest rates directly controlled by the Federal Reserve, most lending rates in the United States have remained high, when compared with underlying rates of inflation.

That's been especially true for consumer lending rates, and federal regulators have seemed content to let consumers do more than their fair share of rebuilding banking-industry balance sheets (especially considering it was business loans and not consumer losses that decimated their books in the first place).

The so-called credit crunch, consisting of many banks' apparent reluctance to loan money except to borrowers who don't need it, may also have kept interest rates up there. But it also appears there is an "uncertainty" component to interest rates and that a healthy portion of this can be tied to concerns over shrinking supplies of foreign capital.

Japan would be first on that list but would be joined by Germany, which needs to fund the huge rebuilding program in what was East Germany, a capital-hungry Eastern Europe and a war-torn Middle East that's also soaking up capital.

Temporary respites from growing federal deficits were provided by foreign payments for the Persian Gulf war and by delays in bailing out financial institutions. But these have ended, and financing demands on the Treasury are going to be heating up.

So, one hopes, will the private sector. But it's becoming clear that a truly vigorous recovery could put unwanted strains on the financial system, including unwelcome inflationary pressure. Forecasts of a slow recovery are bad news to many individuals and companies. But they may be more palatable to regulators who are running low on band-aids and bailing wire.

Higher interest rates may be of some short-term value to banks but are of little help to them in the longer run and of no help to the rest of us in any time frame. And even federal officials must wonder who's kidding whom if high rates cause improved banking balance sheets at the expense of multibillion-dollar hikes in the cost of paying interest on our national debt.

To the extent that Japanese stock-market follies are adding more dollars to our already heavy financial burdens, I suppose we have some cause for frustration. But we also can begin to better appreciate how vexing our past fiscal behavior has been to other nations, who've long paid a similar price for our mistakes.

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