Japan: What needs to change?

Despite questions over Yoshiro Mori's future, leadership may not be the problem

In this story: Ten failed attempts Bank reform the first step Calls for fundamental change RELATED STORIES, SITES

By Alex Frew McMillan
CNN.com senior writer

TOKYO, Japan -- Japanese markets are trading just off 16-year lows. Exports, normally a pillar of strength, are weak. There is constant speculation over when Prime Minister Yoshiro Mori will step down.

It's a far cry from 1989, when Japan briefly saw its economic output and its stock-market value surpass the United States.

News of Japan's beleaguered banks and its declining trade surplus, off 60 percent, are just the latest in a stream of negatives out of Tokyo.

The country remains the second-biggest economy in the world. But the giant fell long ago. It has spent a decade failing to get back up.

What needs to change? Experts call for wholesale reform. And they say any turnaround will be painful. They also say a change in Prime Minister will not be enough to solve the country's deep-rooted problems.

Ten failed attempts

"The most significant problem is time, because they've wasted the past decade," said Jesper Koll, chief economist with Merrill Lynch. "None of the problems are new. None of the problems are a surprise."

Japan's ruling Liberal Democratic Party last week produced a series of reforms for Mori's approval. It was the latest in a string of March reform packages.

Since 1992, the government has spent more than $1 trillion on 10 extra budgets. But the attempts to turn the economy failed.

Critics fault the government for being stuck in its ways and beholden to special interests. Past reforms revolved around public spending, such as construction projects that weren't always necessary.

"The vested interests tend to be in construction, companies that would be damaged by reform," said Richard Jerram, economist with ING Barings. There is also a strong farming lobby.

QUOTE "Japan over the last 10 years has been the biggest mechanism of wealth destruction in the world " - Jesper Koll, Merrill Lynch chief economist

Those interests successfully fought to protect the status quo. The result has been a government that resists change, and a Japan at a standstill. Economists expect Japan's output to grow less than 1 percent this year.

The Japanese government this week conceded Japan is seeing deflation.

When prices drop, the Japanese public is reticent to spend and invest. That has put a dampener on the economy in the past.

"Japan over the last 10 years has been the biggest mechanism of wealth destruction in the world," Koll said.

Bank reform the first step

One of the first areas crying for change is its banking industry. Experts call for banks to write off a huge number of bad loans on their books.

Estimates on the amount vary. But many peg it around $250 billion, or 6 percent of Japan's Gross Domestic Product.

Japanese banks have refused to call in many past-due business loans. As a compromise, they typically offer to build loan-loss provisions instead.

Reform proponents say the banks hurt the economy by propping up inefficient companies that should have gone out of business.

"You need to close down companies that are, in all honesty, bankrupt," Jerram said. He noted bad-loan estimates are based on official figures. The total may be as high as 10 percent of GDP, he said.

But closing down companies will put people out of work. Unemployment, at a record 4.9 percent, would rise. It becomes a political issue.

Though the government is stepping up its calls for bank reform, experts say Japan's uncertain politics make serious attempts difficult. The ruling coalition, led by the LDP, is likely too weak to take on unpopular issues.

"It's going to be very difficult for them to create strong incentives for banks to do this," said Jeffrey Young, economist at Nikko Salomon Smith Barney. "As a statement of policy intent, it's good, but I don't really see that it's practical."

QUOTE "For a sustained economic recovery, you need to deal with some structural changes " - Ron Bevacqua, Commerz Securities senior economist

The LDP has also introduced plans to boost stock prices by cutting taxes on investing. It also hopes to stimulate a slumping real-estate market.

The central Bank of Japan (BOJ) may step in as early as Monday. Businesses hope it will cut interest rates back to zero, a level it left last August. But Japan's cost of borrowing is already the lowest in the world.

Analysts call for the BOJ to inject more money into Japan's economy, what's known as "quantitative easing." They hope the bank will buy more government bonds, as well as set inflation targets, to jump start Japan with cash.

But those are short-term goals. Economists say a turnaround needs to go beyond banking and stock-market revitalization.

"For a sustained economic recovery, you need to deal with some structural changes," said Ron Bevacqua, senior economist at Commerz Securities.

Calls for fundamental change

Bevacqua noted that shareholders have no power over management at the companies they own.

A homeless man feeds pigeons in Tokyo. Unemployment is at 4.9 percent, a record.

With little to hold them to, "the corporate sector has invested in the wrong areas," he said. "There are too many fuel factories, car companies, too many people in the wrong services, transport, retail, wholesale."

Managers have no real incentive to operate efficiently. Some Japan watchers suggest top executives need stock-driven pay packages, instead of cash. That would tie performance to the profitability of the companies they run.

"The financial system, the legal system, the accounting system until recently offered no incentive for profit-maximizing behavior," said Alex Kinmont, equity strategist at Morgan Stanley Dean Witter.

Many analysts believe the current coalition has moved in the right direction with proposed reforms. But they also say Japan needs a strong government that encourages deregulation and competition.

Kinmont noted the current coalition is too unpopular and divided to lead that drive. Even if Mori does step down, he and other observers say it will make little difference.

"The question of who is prime minister is only relevant in so far as it reflects the internal makeup of the LDP," Kinmont said. Past reformers have still seen their efforts curbed by a lack of political support in the government they lead.

Reformists say it will take a power shift to bring true change. Even if that comes, any recovery would be very gradual. After years of crushed expectations, negative sentiment will be hard to turn around.

"The Japan investor has become very used to negative news and being disappointed in the last 10 years," said Keon Lee, regional economist with J.P. Morgan. "Their hopes have been dashed for so long."

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Prime Minister's office
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Bank of Japan

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