Critique of Central Banking

Henry C K Liu

Part I:     Monetary theology
Part II:        The European Experience
Part III-a:   The US Experience
Part III-b:   More on the US experience
Part III-c:   Still More on the US Experience
Part III-d:   The Lesson of the US Experience
Part IV-a:   The Asian Experience

Part IV-b: The Japanese experience

This article appeared in AToL on May 31, 2003

The domestic problems in Japan are caused by its economy's tilt toward export, compounded by export trade being denominated mostly in dollars, not yen. Japanese policymakers are quite aware of this unhappy situation and have been trying to propose a tri-currency (dollar-euro-yen) global financial architecture since 1997. This proposal has been turned down repeatedly by the United States. Japan could not open its domestic market to foreign imports because its does not have a domestic market to open. In place of a domestic market, Japan has a vertically integrated distribution system controlled by a few big commercial combines (keiretsu). Its entire postwar economy is structured for export.

Prior to World War II, the entire Japanese economy was structured for war production. After that war, the Japanese economic infrastructure was kept intact by US occupation policy but diverted from war production toward export. The relationship of Japanese banks to their clients is structurally different than what the New Deal set up for US banks, with an arm's-length relationship between lenders and borrowers. Japanese banks own substantial shares of their corporate borrowers, thus there is little financial advantage in corporate debt foreclosure.

This credit relationship is natural for a national banking regime and has evolved to achieve maximum efficiency for financing export production. Mitsubishi never has to compete for capital or credit the way General Motors does. It can always get credit at a rate that will ensure its price competitiveness in the export market. This is also why Japan is not well equipped to finance new entrepreneur ventures. Sony and Honda are maverick outsiders in the "Japan Inc" system, as is Softbank, the new financial giant for the information technology sector.

The reason dollar assets yield higher returns than yen assets is that yen assets are not structured for highest returns but for effective support of the Japanese export regime. Japanese banks are not profit centers. They are service institutions in support of a national purpose. In the past decade, however, major US corporations such as GE, General Motors and Ford have taken on the role of non-bank financial entities to provide low-cost loans as a key competitive pricing strategy, bypassing their traditional dependence on banks. Henry Ford was famously critical of banks as financial predators.

This trend of subordinating finance to enhance market competitiveness, not for national purpose but for corporate profit, is the Achilles' heel of the US economy. While Japan is being put through the wringer by the adoption of a central banking regime, the US non-bank financial sector is bypassing the regulatory limits of central banking. This more than any other factor gives validity to the anticipation that the US economy will follow the Japanese economy into a decade of deflation and stagnation, even though the US banks are relatively healthy by Bank for International Settlements (BIS) standards - unless of course the Federal Reserve adopts a monetary policy of aggressive inflation targeting beyond the banking system, with the bailout of LTCM as an obvious precedent. Fed chairman Alan Greenspan said in a speech before the Council on Foreign Relations in Washington, DC, last November 19: "Thus central banks are led to provide what essentially amounts to catastrophic financial insurance coverage.

Japanese culture, fundamentally influenced by Chinese culture, views the individual as an integral part of community and as such, while there is no equality in Japanese society in the Western liberal sense, the Japanese elite assumes an innate responsibility for the welfare of the people it leads. Thus a Japanese corporate leader feels personal shame in the corporation's misfortune and he is expected to punish himself before he allows the employees to suffer. US values celebrate individualism as the basic unit of society and thus put the responsibility of individual welfare on each person even though the US system has evolved in a way that the individual is increasingly powerless to control his/her own destiny. Thus US management would proudly lay off 10,000 employees to achieve short-term profitability with which to reward executives with fancy "performance" bonuses. The Fed would righteously use unemployment to defend the value of money (to fight inflation). It would declare the ease and immunity with which US business can shed unneeded workers on short notice as systemic strength. Greenspan has repeatedly criticized both Japanese and German companies for being "inefficient" because of the high cost and inflexibility their management faces in shrinking their workforce on demand.

Acting as postwar resident emperor, General Douglas MacArthur imposed "democracy" on Japan. And the Japanese adopted its form without its essence. From its founding in 1955 and for the next 38 years, Japan's conservative Liberal Democratic Party (LDP) won all national elections and selected every prime minister and nearly every cabinet member. From 1955 until 1993, the LDP held power without interruption, while the Japan Socialist Party (now the Social Democratic Party) acted as a token opposition force. This political landscape was known as "the 1955 setup". It allowed voters to see an obvious, ongoing struggle between the LDP and the Japan Socialist Party, notwithstanding under-the-table agreements. Other democracies have had similarly dominant parties, but few approach the LDP for longevity in power and complete dominance of the political scene. In fact, many political scientists have suggested that the LDP is very similar to the ruling communist parties in socialist countries.

Then, in 1993, a political earthquake transformed Japan from a system of stable one-party rule into one of mercurial political coalitions. For the decade since 1993, the LDP struggled to regain its position of dominance and for the most part succeeded. At the start of the new millennium, the LDP lacked a majority in the House of Councilors, the upper house of the Japanese Diet, but it is nevertheless strong and confident once again while the opposition is in disarray.

Politically, Japan by 1985 found itself needing new national goals, since it had caught up with the Western industrial powers in production if not in innovation. Unfortunately, Japanese political leaders failed to formulate a new national vision. The lack of leadership allowed the bureaucracy to continue to steer the nation along a traditional but obsolete path of export dependency, hiding the transfer of national wealth overseas with a speculative bubble of the 1980s. It was inevitable that this bubble would burst, as the economic benefits of this export "success" could not be repatriated back to Japan because of dollar hegemony. The bubble's burst fueled a distrust of the bureaucracy that had clung to denial, which continues today.

While it is valid to fault business and industrial leaders for management myopia, it should be recognized that they had no choice beyond playing according to the rules of the game set up by dysfunctional national policies. The political leadership must bear the responsibility for failing to set visionary goals for the nation. The current sentiment in Japan of being at a structural impasse and not knowing how to move forward in new directions is the direct result of the lack of focus on national goals for the past two decades.

The Plaza Accord of 1985 on exchange rates forced the yen's climb - from 242 yen to the dollar before the agreement to as high as 79 yen in slightly more than a decade. The structural damage of the rise of the yen had been undeniable. The United States reversed the notion of the need for stable exchange rates as envisaged by the Bretton Woods regime, and openly used exchange-rate policy as a way of addressing its trade imbalance. Instead of addressing its own fiscal irresponsibility, the US decided to solve its problem by forcing Japan to change its economic system through an exchange-rate policy. This approach of achieving a balance of trade through exchange-rate management triggered unwanted changes not only in the Japanese economy but also in Japanese society as a whole. Japan is still in the throes of this unwanted change, and the resulting anxiety has fostered a national sense of being in a blind fix.

The essence of this change for the Japanese is their inability to develop a heightened consciousness of themselves as consumers of the fruits of their efforts, instead of exporters. The Japanese political system and administrative apparatus has been heavily weighted in favor of export production since the end of World War II, while suppressing a consumer culture. It is a civic pride to produce but not to consume. The war of export was won by a denial of domestic consumption that fitted cerebrally the Japanese culture of self-restraint. To overcome this export fixation, the political system and administrative apparatus have to change. But culture changes only slowly. Further, the stagnation of the export economy reinforces the conventional wisdom that consumption in hard times would be foolhardy and only lead to financial ruin for the imprudent individual. <>Deregulation requires that consumers take responsibility for their own decisions. Thus as Japan takes steps to deregulate its economy, the government dilutes its power of persuasion to stimulate consumer spending. Neo-liberals argue that since the government can no longer protect the individual, Japan needs improved transparency, as embodied in the principle of disclosure, as an essential condition of a consumer-oriented society. Yet culture does not change as easily as government policies or corporate strategies. The flip side is for government to preserve its tradition of elitist opacity by insulating the public from economic pain, which was essentially what had happened.

The past decade in Japan has been one in which the public has been insulated from the pains of an economic decay that has been largely confined to the corporate level. It is the opposite of what happened in the United States, where the pain is felt directly and immediately by the defenseless public while companies consolidate through downsizing and merging. <>Both the Meiji Restoration of 1868 and the socio-economic restructure imposed by MacArthur after World War II were carried out under pressure from foreign powers. This latest opening of Japan has been triggered again by foreign pressure in the form of US-led globalization.

In April 1999, the Japanese government deregulated foreign-exchange transactions. After Japan's Big Bang, the country ended up with an open financial market where foreign banks and brokerages were the dominant players. If Japanese banks cannot serve the Japanese consumer because of their structural link to Japan Inc, US banks will.

Globalization in Asia means new players entering from outside the region. But resistance is still strong in Japan. Many there, along with others in Asia, interpret this development as another neo-imperialist assault by Western economic power as well as Western culture and values. And they are beginning to oppose it with a revival of nationalism. In Japan, it takes the form of a revival of the nationalism of the final years of the Tokugawa shogunate in the 19th century. Prime Minister Junichiro Koizumi may be Japan's first internationalist leader who came to power in the name of chauvinism.

Neo-liberals believe that Japan, along with the rest of Asia, will have no choice but to make major changes in response to the globalization process. The trend toward transparency challenges the belief that keeping certain things concealed is one key to social harmony. The Western notion of the rule of law is often touted as an indispensable component of modernization.

Yet Japan is based on a deep-rooted Confucius culture. In The Analects of Confucius, the sage is described as responding to the selfless rule of law by saying: "In our part of the country, those who are upright act differently. The father conceals the misconduct of the son, and the son conceals the misconduct of the father." This embodies the conflict between legalism and the hierarchical order of Confucianism in ancient China, a conflict still very much alive in contemporary China. Although this episode in The Analects concerns the relationship between parents and children, the application is much broader to include issues of governance. <>Traditionally, Asian, including Japanese, law-enforcement officers often let offenders off with a stern warning if circumstances warrant it. In the Kabuki drama Kanjincho (The Subscription List), the official in charge of the Ataka Barrier Station is charged with capturing the fugitive Yoshimune. He is so impressed by the efforts of Benkei, Yoshimune's retainer, to shield his lord that he turns a blind eye and allows the disguised hero and his retinue to pass. Japan also has heroes who flout the law, such the chivalrous robber Kunisada Chuji (1810-50), the Japanese Robin Hood.

Countries vary considerably as to how rigidly they apply the law. William Blake said that one law for the lion and the sheep is oppression. The West has often observed critically that China lacks the rule of law. In reality, the West merely is not happy with China's concept of rule of law. Americans also do not think that Japan meets their standards for genuine rule of law. Asians often describe the US way as the rule by law rather than of law. There's nothing in nature that says an advanced modern nation has to be a rigid constitutional state, and the United States' adherence to that principle may not be the reason it achieved its measure of power and influence in the world, among many other factors. Yet, as globalism proceeds, the rest of the world is compelled to measure its daily actions against US standards, merely because the US is the sole superpower.

Exchange-rate volatility since 1985 has had a huge impact on Japan. Stock prices have in fact been driven by exchange rates because of global capital flow and international banking standards. If a two-party system ever emerges in Japan, it will be based on two political ideologies: one that believes in free markets and small government, and another that believes there are flaws in a free-market economy and that government exists to minimize the resulting disparities in wealth and help society's weaker members, and that for this Japan needs high taxes. But Japan is some distance from reaching that point. For the foreseeable future, a one-party system with two opposing factions is likely to continue. Nor is the notion that the weak are the responsibility of the strong, at least within Japanese society, likely to disappear from Japanese culture.

After World War II, Japan developed into a country with small disparities in income, perhaps the smallest of any major economy in the non-communist world. That helped create a stable society, and it also took the steam out of calls for a redistribution of wealth or progressive income-tax regime. Japan has a de facto national socialist system in the descriptive, non-pejorative sense of the term. There has always been a voting minority of about 20 percent who are dissatisfied with the government, but that group does not constitute an identifiable economic or social class.

Since the end of the Bretton Woods regime, the relentless Japanese quest for trade surplus in dollars and not in yen has been a big mistake. Dollars can no longer be converted to gold and dollars cannot be spent in Japan. Dollars can only buy dollar assets such as the Rockefeller Center in New York. The Germans have been making an even bigger mistake with their quest for trade surplus in dollars. Everyone accepted deutschmarks before the birth of the euro. Japan and Germany should have incurred as large a trade deficit in their own currencies as their trading partners would accept. Trade yields currency. When export yields another country's currency, it is hard to benefit the domestic economy with it. It is hard for Americans to understand this because world trade yields dollars that are usable in the United States. It is also hard for the rest of the world to understand this because they did not catch on to the meaning of the dollar being no longer backed by gold.

Suggestions that Japan's bad bank loans may now equal almost half of the country's gross domestic product (GDP) have been greeted with official denial in Japan but have shaken the markets for more than a decade. Market estimates of non-performing loans (NPLs) now amount to 237 trillion yen (US$2 trillion), dramatically larger than published government data indicate. The Financial Services Agency (FSA), the main regulator, claims that bad loans at the banks total only 18 trillion yen, or 3 percent of GDP.

The discrepancy is not from the bank data, but from different rules for measuring bad loans. In particular, the FSA ignores the effect of deflation when classifying problem loans. The FSA sorts loans into "good", "risky" and "bad" categories based on whether a company is able to pay interest. This classification system, useful in an inflationary environment, where nominal interest rates are high, is not useful in Japan's low-interest-rate regime where most companies could make interest payments - even if their business prospect is so hopeless that they would never be able to repay their loans. Such companies are corporate versions of the walking dead.

Bank economists have suggested that the risk level of a loan should be judged on whether a company's operating margins are good enough to repay the loan within term. On this basis, corporate data on listed companies suggests that more than a third of all bank loans are bad risks, even though most are not classified as risky by the government. Japanese banks have already written off bad loans to the equivalent of 13 percent of Japan's GDP in the past decade. There may be another 50 percent of GDP equivalent to go.

Other analysts dispute this method of loan classification, saying that Japanese banks have never extended loans on the basis of cash-flow analysis, but on assets such as real estate. Yet even on this basis, deflation has eroded asset value. Government officials also argue that no country in the world calculated bad loans from the ratio of operating margin to bank lending. The Bank of Japan (BOJ), the central bank, is uneasy with the fact that the "real" bad-loan problem is greater than FSA numbers show, given the weak economy and the impact of deflation. As a central bank, BOJ allegiance is to the value of its currency, rather than the health of the economy. Central banks take this view because they believe that the health of the economy depends on the soundness of money. They reject the notion that the health of the economy is the basis of a sound currency. Central bankers are not above arguing that the operation is a success, though the patient died.

Japan's institutional and economic history has been front and center mercantilist. Japan does not export to live. It lives to export. Yet since the Bretton Woods fixed-exchange-rate regime based on a gold-backed dollar ended in 1971, Japan has been exporting not for gold, nor for gold-backed dollars. It has been exporting for a fiat currency called the dollar that the United States can print at will and at no cost. Japan has been shipping its goods overseas in exchange for paper that cannot buy anything in Japan. The trade surplus in dollars is merely pieces of paper than can buy other pieces of paper called US Treasuries, or share certificates of US companies that compete with Japanese companies. Or certificates of ownership of dollar assets outside of Japan that pay dividends in pieces of paper that cannot be spent in Japan. The conventional wisdom is that Japan must earn dollars to buy needed imports such as oil and other commodities that Japan does not produce. But Japan exports way in excess of its import needs. Notwithstanding the fact that if Japan exports less, it will also need to import less oil and iron ore, there is no reason Japan needs to have a trade surplus, or that a trade surplus is of benefit to Japan.

Economist Hyman P Minsky asserts that an understanding of a country's institutional and economic history is essential for a clear understanding of its financial processes. Institutional and historical realities mean that a country cannot easily escape its relatively rigid past to join a global system without serious penalty. Japan's trade surplus in dollars is the serious penalty for its fixation with export in a trade regime based of another country's fiat currency. The United States, whose influence on financial globalization is paramount, enjoys the least upheaval to its national system in the transition to neo-liberal globalization because the global system is in essence an extension of the US system. And dollars, the scorekeeping instrument for world trade, can only be spent in the US on US assets. So no matter who owns dollars, the economic benefits of the dollar are firmly focused on the US economy.

Because of the BIS requirement on capital and loan classification, Japanese banks continue to suffer from the supportive loans made to Japanese corporations during the "bubble" era more than a decade earlier. Such loan policies were not a problem when Japan operated under a national banking regime. But under a central banking regime, Japanese banks have become by definition distressed institutions in deep crisis. Despite the fact that a large proportion of these loans have turned into NPLs by BIS standards, many Japanese banks have delayed the recognition of such NPLs until recently. Unlike US banks, which quickly wrote off their NPLs in the early 1980s to meet domestic regulatory requirements, though not without great pain to the US economy and the general public, none of the Japanese banks wrote off their NPLs until Sumitomo Bank took the lead in March 1995. Since then, top Japanese banks have begun to write off NPLs, voluntarily following Sumitomo, albeit only with strong pressure from the global investor community acting on bank share prices. The reason for this is that the US central bank can print dollars without directly affecting the exchange value of the dollars, a phenomenon known as "dollar hegemony", and the BOJ cannot.

Under a national banking regime, Japanese banks attracted investors not because they produce high returns, but because they were part of the national enterprise that strengthened the Japanese economy. Under a central banking regime, global investors are interested primarily in the profit margin of the banks, often to be achieved at the expense of the economy. When a liquidity trap immobilizes interest-rate policy as an economic stimulant, there is still an exchange-rate channel by means of which monetary policy can exert stabilizing effects. This is why Japan has been trying to push the yen down, not to increase exports, but to stabilize deflation at home.

The main reasons for the hesitance of Japanese banks to write off NPLs can be attributed to the policy indecisiveness of the Ministry of Finance (MOF), which still holds a view on the function of banks along national-banking lines. The MOF is reluctant to recognize and address the NPL problem as defined by a central banking regime, for it sees no useful purpose in such an exercise. Also, the Japanese tax system does not permit tax deductions for loan writeoffs. Banks also were deluded by anticipation of pending economic recovery from counter-cyclical government fiscal measures. The dual role of banks as shareholders and creditors of the borrowing entities also presents a disincentive. There is also the problem of insufficient capital for banks to write off the loans to satisfy BIS requirements.

The BOJ addressed the insufficient-capital issue in 1995 by increasing the nation's money supply to lower interest rates, a move that increased the net interest income of Japanese banks because of larger spreads on loans over cost of funds. In this new monetary-policy environment, many banks were supposed to be able to generate sufficient profits to write off NPLs. Japan's equity and real-estate bubbles collapsed within a short time of each other, with equity prices dropping more than 50 percent in early 1990 and land prices beginning a long slide downward in 1991. After raising official interest rates to counteract overheating financial markets, the BOJ began lowering interest rates from more than 6 percent in March 1991 to 0.5 percent by October 1995.

Despite this favorable operating environment for banks, the quality of Japanese banks' assets continued to deteriorate because of what John Maynard Keynes identified as a liquidity trap. A liquidity trap is created when further increases in money supply by the central bank (monetary base) cannot further affect output, prices, interest rates or other variables. Increases in the money stock are entirely neutralized by increases in liquidity preference to hold money.

The idea of a liquidity trap originated with Keynes during the Great Depression. Keynes postulated that once the interest rate fell below 2 percent, its effect on monetary expansion might be "push on a string". While rates might be low, banks might still have difficulty lending because the low interest-rate spread would reduce credit risk tolerance. Soon the banks would only lend to those who did not need to borrow.

Under current circumstance, the BOJ can stop interest-rate and price decline by purchasing foreign currencies to push the foreign-exchange values of the yen down, or by purchasing corporate bonds and stocks, or other assets. But the BOJ as a central bank is committed to preserve the market, not to eliminate it. So it sticks with the traditional central-bank instrument of interest-rate policy. It seeks to control the price of money rather than prices in general in the economy, making the liquidity trap a reality.

International capital markets started to charge a "Japan premium" on inter-bank loans. In addition, Japanese banks faced difficulty in complying with BIS capital-adequacy ratio as the depreciation of the yen increased the value of their overseas assets and liabilities. This also increased the banks' reluctance to provide loans to less creditworthy small and medium-sized companies that had no access to credit markets beyond their main banks. To address the banking and credit crunch problems, public funds totaling 60 trillion yen (12 percent of GDP) finally were set aside in 1998-99 to recapitalize banks. Also, the low short-term rates created problem for non-bank long-term financial institutions, such as insurance companies.

The increasing number of bankruptcies, as well as the collapse of Hokkaido Takushoku Bank in November 1997, illustrated the seriousness of the NPL problem, which is currently estimated to be near $2 trillion. Over the past 18 months, the Japanese government has enacted laws to use public funds to purchase preferred stock of Japanese banks in order to provide the banks with the much-needed capital to write off additional NPLs. The Resolution and Collection Corp (RCC), an agent established to purchase loan assets and to collect the debt, has been expanded to purchase NPLs from Japanese banks.

On July 7, 2001, commenting on the bad-loan problem, Prime Minister Koizumi was realistic: "I do understand that it is impossible to get rid of all existing bad loans within two to three years but we are working on reducing that," he said. "I think it is a bit premature to say that the government does not have total grip on bad loans. What we are working on is the bigger issue of the economy." The bigger issue, of course, is economic growth.

In a government package released three months earlier, in April 2001, Japan set a deadline for top banks to eliminate loans to borrowers in, or at risk of, bankruptcy - worth 11.7 trillion yen - in two years, or three years for new NPLs. Some estimates valued the problem loans at banks at as much as 150 trillion yen. The worries about banks have been a key factor in a prolonged stock market slump. Koizumi warned that Tokyo stock prices were poised to remain depressed for the time being. It is worthwhile to note that no serious analyst expected Japan to resolve its NPLs within two years from 2001.

Japan's government is in an inescapable debt-death spiral by virtue of the fact that nominal GDP is falling at an annual rate of about 5 percent. Stabilizing the Japanese government's debt-to-GDP ratio would require that nominal GDP rises at a rate equal to the interest rate on its outstanding debt, or about 1 percent. The fact that nominal GDP is falling at a 5 percent rate means that Japan's debt-to-GDP ratio will rise at least 6 percent a year, even without a sudden need to recapitalize insolvent banks. That debt-GDP ratio is now 130 percent, and at 6 percent a year it will double in just over a decade. That fact will itself accelerate the collapse of Japanese government bonds unless deflation is reversed.

Actually, the debt burden of Japan's government is worse than the 130 percent debt-to-GDP ratio widely reported in the press. First, accelerating deflation will cause that ratio to rise even more rapidly as government revenue collapses. Further, the contingent liabilities of the government, including its responsibilities to protect bank depositors, will jump abruptly once the increasingly likely crisis in the banking system emerges.

The Japanese government possesses assets that could be sold to improve its ability to deal with large losses in the banking system. The problem with such sales, for example the sale of government-owned shares in Japan Tobacco or NTT (Japan's telephone company), is that they further depress the value of these shares on the stock market. This is just another example of the dangers of a deflationary environment in which assets that had been viewed as reserves can no longer function as liquid reserves because attempts to realize liquidity further depress their value.

Japanese deflation gathered pace in the first quarter of 2003 as year-on-year prices fell 3.5 percent - their fastest drop on record. The fall may fuel fears that Japan, which has managed to co-exist with relatively mild deflation since the mid-1990s, could be sliding into an accelerating deflationary spiral. Japanese prices - as measured by the gross domestic product deflator, considered a more accurate measure than the consumer price index, have been falling continuously since 1995. Annual price falls have averaged between 1 and 2 percent for most of that time. Recent figures showed deflation accelerating in fiscal 2002, a year in which Japan was technically growing out of recession, to minus 2.2 percent, a record for a full year. The figures were released along with GDP data showing that growth in the first quarter 2003 fell to almost zero, leading some economists to conclude that the economy was on the brink of yet another recession. Nominal growth fell 0.6 percent in the March quarter, or minus 2.5 percent on an annualized basis.

The issue of deflation has split government officials with disputes over its causes and disagreement over its effects. Heizo Takenaka, the new minister of state for economic and fiscal policy and head of FSA, has acknowledged that falling prices pose a threat but takes the position that banking reform is need to cure it. He said: "Deflation remains severe. While pursuing structural reform we must also press on with efforts to end deflation." On the other hand, Eisuke Sakakibara, former vice finance minister, also known as Mr Yen, said Japan could live with mild deflation so long as it prevented the economy tipping into a destructive spiral of falling prices. He said deflation was the structural result of global productivity gains and would likely spread from Japan to the United States and Europe.

Takenaka drew some comfort from the fact that real growth for fiscal 2002 was 1.6 percent, above the 0.9 percent the government had predicted. Much of that was based on exports, which have predictably begun to slow again, and on surprisingly robust consumer spending. In the first quarter of 2003, consumer spending, which accounts for 60 percent of GDP, rose 0.3 percent quarter on quarter. Real growth of about 1 percent a year over the past decade meant that the economy was shrinking in nominal terms. Nominal GDP for fiscal 2002 fell to 499 trillion yen, the first time it has dipped below 500 trillion yen in eight years. Political pressure had been building against Koizumi to slow the pace of bank reform to relieve the pain of the corporate sector, which may lead to the removal of Takenaka.

The yen has been testing two-year highs against the dollar recently as investors continued to push the US currency lower on signals from the new US Treasury Secretary, challenging Japanese resolve to stem yen strength in the process. The BOJ has not confirmed any action in the market recently. Following a policy of covert intervention in the first quarter of 2003, strategists expect the first concrete evidence of any action in May will come in the bank's figures, published at the end of the month. The BOJ, however, is believed to have been active in the market to smooth if not stop the yen's fall.

The longer the yen's rise goes on, the greater the prospect that Japanese investors will sell dollars forward, exacerbating the yen's upward move. It is difficult to stop Japanese funds from hedging their US exposure. A further risk is that a strong currency could tempt investors to repatriate funds back to Japan. Japanese investors have been pouring money abroad on the perception the MOF will continue to draw a line in the sand on yen strength and if such perceptions are damaged, an accelerated wave of yen purchases will occur. Thus the perception that the MOF will let the yen rise will cause the market to push up the yen.

Japan's population is poised to decrease at a rapid rate because of demographics. Aggregate production is also declining because of changes in labor utilization. Since the main sources of Japan's economic strength, namely high saving and high investment, remain intact, Japan is still making heavy investment for the future, but the major thrust is on upgrading the quality of life and linkage with the Chinese economy. This linkage with China brings mixed results for Japan. The positive side is to increase aggregate production but the negative side is that it causes prolonged deflation. Deflation dampens Japan's import capacity from the rest of Asia except from China. The outcome is the rise of Northeast Asia and the relative decline of Southeast Asia. The deepening economic linkage and continuing political divergence between Japan and China is also becoming difficult to sustain.

Population is one of the most important factors in a nation's economy. When Japan incurs a trade surplus with the United States, an economy with twice its population, it means that Japanese are consuming at a lower level than Americans. Since production is a function of the size of the domestic working population, the decrease in working population means fewer work-hours each year, which translates into less production capacity. It will weaken the country's capacity to supply goods and services both for home consumption and for export. The average number of work-hours per worker is also decreasing in Japan. Only 13 years ago in 1990, it was 2,053 hours per year per worker, the highest among the Organization of Economic Cooperation and Development (OECD) member countries. Three years ago in 2000, it shrank by 10 percent from the 1990 level to 1,848 hours to the sixth-longest working hours among the OECD members. The myth of Japan working hard and long hours is now an anecdote of the past.

Japan's production capacity at home peaked in 1997. Constraints in population growth force less production at home and more imports. The share of imported manufactured products in the total Japanese imports has risen from 50 percent in 1990 to 61 percent in 1999, rising by 11 percent. This increase in manufactured imports helped alleviate the structural labor shrinkage.

The strategy of the Japanese system of moving production overseas, particularly to the rest of Asia, and importing the final products seems to be a rational solution. The basic trade pattern of Japan exporting capital, technology and essential parts to Asia, building factories there, with the final products imported back to Japan or re-exported to Europe and America, enables Japan to concentrate on the high value added part of the production chain. The Asia shift of Japan's trade is one of those Japanese efforts for tackling the dwindling population while maintaining the same high level of income. The size of the domestic market is related to the size of the population. In the Japanese economy, personal consumption is about 60 percent of the domestic spending, by far the most important component in Japan's economy, or for any country's economy. The peak of Japan's population is forecast to come around 2007. It means that Japan's domestic demand will still start to decrease after 2007, unless per capita consumption starts increasing rapidly. The White Paper on the Japanese Economy published by the Prime Minister's Office in November 2001 also concluded that the growth rate for Japan's economy for the medium term is between 1 and 2 percent annually.

A country's economy can have a sustainable source for financing needed investment through state credits, rather than domestic saving, provided there is adequate control on capital flow. With the world's largest foreign-exchange reserve, Japan does not need to rely on domestic savings for capital. In Japan, the wage earners' average annual saving rate was 28.7 percent in 2000, inclusive of semi-annual bonus payments. Such a high saving rate, a result of cultural behavior, has created a high level of net financial asset for an average household of more than 14 million yen ($130,000) in September 2001, almost three times the average Japanese annual income. The decrease of net household assets from the year before was a mere 90,000 yen despite a collapse of the equity market. This means the average Japanese has an income cushion of almost three years even in these hard times. With this coupled with social welfare provided by the public sector, the Japanese have a strong safety net. No other country accumulates such high savings. Yet the average household saving decreased only slightly even from rising unemployment and reduced bonus payments from the recession.

Sustained by the abundant supply of domestic saving, Japan's investment has remained high even in the decade of low growth. Private-sector investment is 16 percent of gross domestic expenditure (GDE), which is the highest level among developed countries. Public investment is about 6 percent, housing is at 5 percent, making total investment 27 percent. Japan's private-sector investment constitutes a high level of research and development expenditure. In 2000, Japan's R&D expenditure was 3.2 percent of the GDP, again the highest level among the developed countries. The United States spends 2.5 percent and the European Union 1.9 only percent.

Japan's high saving/investment mechanism is also used in enhancing its economic linkage with China. China has an abundant supply of increasingly high-skilled, educated and young workforce, which is a rapidly decreasing category in Japan. Japan in the 21st century, with its rapidly aging and dwindling population, can establish a mutually beneficial economic relation with China, even though wage levels between the two economies may converge in time. Japan-China economic relations are in a way an extension of Japan's economic relations with Asia, but the nature and the degree of the ongoing changes in the bilateral economic relations are very different from the rest of Asia.

Japanese export to China in the first six months of 2002 grew 11 percent year to year to $17 billion and import fell 0.8 percent to $28 billion. Export to the rest of Asia fell 2.5 percent to $82 billion and import fell 11.8 percent to $78 billion. Export to the United States fell 9.9 percent to $57 billion and import fell 16.8 percent; and export to the EU fell 17.2 percent to $29 billion and import fell 16.8 percent to $28 billion. Total export fell 7 percent to $195 billion and import fell 14.2 percent to $157 billion.

China's export to Japan rose in 2001 by 15 percent and imports by 11 percent, against a background of overall negative economic growth in Japan. The biggest (29 percent) import item from China to Japan is machinery, followed by textiles (27 percent).

The year 2001 was the first time in history that machinery became China's biggest export item. China is the only country in the world that has succeeded in establishing a healthy trade surplus in machinery products with Japan. This is the most significant change in the Japan-China economic relations. At the same time, China remains extremely competitive in the export of apparel, textile and shoes, the traditional domain of exports for the developing countries. China's competitiveness is not limited to manufacturing. Japan imported 750,000 tons of vegetables from China in 2001, a tenth of the price of domestic production.

Lunchbox prices have, as a result, fallen. Prices of Japanese lunchboxes (obento) have fallen by 15 percent as a direct result. Some Japanese convenience stores have built organic farms in China in order to use the vegetables into the lunchbox sold in those stores in Japan. Vegetables and fish prices are falling in Japan because of imports from China, benefiting consumers. But it has dealt a blow to the numerous Japanese farmers' income. Clothing prices have also fallen by 30-50 percent.

The deflationary impact on the Japanese economy coming from China trade will be long-lasting. From food and apparel to electronics, prices in Japan will face falling pressures until the price levels of the two countries reach some kind of equilibrium after many years. Thus Japan has a vested interest in helping China to raise its wage levels. Slow growth from a shrinking and aging population, shrinking export markets, together with deflationary impact from China will depress the profitability of Japanese corporations in the foreseeable future, placing the Japanese economy in a long transition period of slow growth and low profit margin. <> However, China trade is expected to continue to benefit Japan. According to the World Bank, Japan's benefit by China's entry into the World Trade Organization (WTO) will be $61 billion by 2005, much larger than that of North America, which is $38 billion. Hitachi plans to invest $1 billion in China by 2005. China's share in Hitachi's global production of $40 billion will be 25 percent, the largest production share outside Japan, four years from now. The highest-technology hardware and software of Hitachi are to be manufactured and developed in China. Hitachi has built a research lab for ubiquitous network technology state-of-the-art technology in Beijing. Panasonic runs more than 40 companies for production in China. China will become the high-tech consumer goods center of Asia, with Japanese companies playing an important part in it.

With the rapid merging of the two economies, tremendous changes are occurring. The new competitiveness of China led Japan to impose protectionist measures against three agricultural products: onions, rush (a plant used for making tatami mats) and shiitake mushrooms from China in early June 2001, to which China retaliated by raising tariffs on selected Japanese industrial products. After a seven-month impasse, the trade friction was solved with a tacit orderly marketing agreement under the table, a classical Asian solution that upset free traders. From shiitake mushroom to the ubiquitous network software, the Japanese economy and the Chinese economy are merging in an inexorable way. From the lowest-tech to the highest-tech sector, the economies of the two countries match and marry very well. The merger is creating a new economic power in the world and will have significant impacts in world economic history, with a revival of Asia as an economic and cultural center, as it was in the 17th century.

Japan is already the largest trading partner for China and the largest foreign direct investment country in China, behind Taiwan and Hong Kong, which are also Chinese. Although for Japan, the United States is by far the largest trading partner because of Japan's big export to the US historically and for now, the trend shows that China could surpass the importance of the US and become the largest trading partner for Japan in the near future. On the import side, it is already clear that by this year, China will provide more goods to Japan than the United States. The main obstacle for Japan-China economic cooperation is the US-Japan political-military alliance.

China's restoration of its political and military strength is a natural and inevitable result of its long-overdue economic development. Instead of trying to resist changes accompanied by the economic revival of China, the US-led residual Cold War security framework needs to be reconsidered to reflect new conditions in international security in East Asia. To balance the growing economic ties between Japan and China, the economic cooperation of the ASEAN (Association of Southeast Asian Nations) Plus Three framework needs to be further pursued to promote peace and prosperity in East Asia and the world.

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