Will a Rudderless Japan Drift into Crisis?

Japan Needs a Captain

The upper house election in Japan last Sunday dealt a huge blow to the ruling Democratic Party of Japan (DPJ), leaving the country with a "twisted" parliament and no clear path forward. In contrast to the previous decades of nearly uninterrupted single-party rule, the new, messier political environment is a positive sign for Japanese democracy.

But this difficult transition to a new mode of governing comes at a time when strong leadership is needed to address a possible sovereign debt crisis that could hit within five years. Ironically, the DPJ's defeat last Sunday was partly the result of Prime Minister Naoto Kan's flip-flopping over a consumption tax that was meant to help stave off any problems emanating from its exceptionally large debt-to-GDP ratio (near 200 percent). Most voters support the tax but the prime minister buckled under criticism on the issue, fostering the impression that he is simply an opportunist. The party's loss may have made prospects for reform "an uphill battle."

I had the chance to talk with people from media, politics, government, business, and academia in Japan during the week leading up to election day. Consistent with the polls, many of the people I spoke with were undecided about which party to support, and the murky election result may delay financial reforms. Rating agencies Standard & Poor's and Fitch have warned of possible credit rating downgrades due to Japan's expected political gridlock, which may hinder the country's ability to reign in its sovereign debt.

Hatoyama's Parting Gift

Yet there is good news. While the lower house election last August was a rejection of the long-ruling Liberal Democratic Party (LDP), last week's upper house election was about real issues while also serving as a referendum on the DPJ's 10 months in power. A political monopoly has been replaced by a period of what Japan expert Gerald Curtis calls political "creative destruction." One DPJ staffer told me that the current, more pluralistic public debate over policy issues was the legacy of former Prime Minister Yukio Hatoyama.

Whether or not by design, the two administrations of Kan and Hatoyama have put on the table thorny issues, including the logistical details and strategic importance of the U.S.-Japan alliance and the previously unpopular idea of a consumption tax, which led to the downfall of the Ryutaro Hashimoto administration more than ten years ago. I was told the DPJ expression for this expanded public square is "the new public."

Meanwhile, the new smaller parties actually stand for something other than an unbridled thirst for power. In particular, Your Party, analogous perhaps to American libertarians, seeks an inflation target and to shrink the government thus unleashing Japan's entrepreneurial spirit and creating jobs. Your Party did quite well, gaining ten seats. It appeals to a common frustration in Japan with government in general and is populated with stars from Tully's Coffee Japan, JP Morgan Chase, and the Ministry of Economy, Trade and Industry (METI).

The outcome is a real multi-party system. But contrary to hollow calls for a revolution last fall, this is the new reality: the slow democratic politics of compromise.

Drifting into Troubled Waters?

Nevertheless, the slowness of Japan's new politics could launch the country adrift into a debt crisis. Although 95 percent of Japanese government bonds are held by domestic investors, several factors could create risks. First, with Japan's low savings ratio and low economic growth, if its aging population starts to draw on its savings, the government may be forced to rely on foreign funders who will demand higher interest rates. Second, a deteriorating Japanese current account, due to a stronger yen or weaker global demand for Japanese products, would also reduce a source of debt funding. Reuters has quoted one analyst as predicting a current account deficit by 2016. Finally, it isn't clear whether a consumption tax would generate enough revenue or whether the tax would only dampen an already stagnant economy.

But whatever happens, five to ten years seems to be the critical time horizon. The next lower house election will take place in 2013 and by 2015 Japan is expected to shift toward external funding of its debt and will therefore face higher interest rates.

"Three to four years from now I expect a sovereign debt crisis to hit Japan and long-term interest rates to surge," former Bank of Japan board member Teizo Taya said in a May interview with Reuters. Taya also believes that the five percent foreign holdings of Japanese debt would be sufficient to trigger a crisis if there were a sell off.

One government official echoed these views when I visited Tokyo last week, saying the current account was the figure to watch. But interestingly he said that while some had hoped the election of the DPJ would have provided the "shock" to the Japanese system to bring about economic reform, the DPJ's failures over money scandals, mishandling the U.S. alliance, and the consumption tax have killed that hope. Instead, he and his colleagues are looking to a debt crisis to provide the necessary shock for economic reform. Changes could occur in Japan's tax structure (reducing corporate taxes and increasing consumption taxes over time) as well as in its industrial policy to spur growth. Can't change occur without the need for a crisis?

"The Deadlocked Japanese Economy"

Underneath the sovereign debt risk is an economy that is in irons. Just as its political system faces drift, so does Japan's economy, according to a METI report released last month.

METI minister Masayuki Naoshima puts it this way last month when he unveiled his ministry's new industrial vision: "Some people say that the Japanese economy is recovering from the economic and financial crisis triggered by the Lehman Shock the year before last. However, in reality, many Japanese people probably find no improvement in the sense of stagnation they feel in their everyday lives. They even seem unable to see any new light for the future. I believe the reason for this lies in the uncertainty about 'what will drive Japan's revenue and employment in the future.'"

Naoshima goes on to underscore the economic conundrums Japan faces: People think that Japanese people save too much, thus dampening demand, but actually the household savings ratio is one of the lowest among major economies; on the flip side, domestic consumption is stagnant since wages haven't risen in the past decade; an export-led recovery may seem appealing but Japan's export ratio is low by international standards and stagnant wages in the past 20 years call into question the country's industrial structure; specializing in high tech products would also seem logical but Japan's global market share "has rapidly declined" and low levels of profitability suggest that the business model for Japanese industries that has "caused them to lag behind the world."

In response to these challenges, government officials told me last week that the broad strategy is to globalize Japan, making its social systems, ports, and infrastructure attractive to businesses that create value and jobs. Naoshima puts it like this: "If Japan wants to save itself from decline, Japan has no other choice but to aggressively push forward with globalization. However, if Japan pursues only globalization without taking action to stop the decline in its international competitiveness as a business location, Japan will lose both domestic jobs and added value."

A major element of this strategy will be to "globalize human resources." This means the country's education system must be modified in order to create a more worldly mentality among the next generation of leaders, thus slowing the inward-looking direction or "Galapagos syndrome" as I have called it. One of the most creative proposals I heard last week is to encourage university students to study abroad by offering a ten-year income tax break to those who take advantage of the program. As these more cosmopolitan leaders enter the job market, they must find companies with a more globalized governance structure, diverse board of directors, and global business strategy, one official told me.

Japan Needs More Mavericks

It's nearly a cliché to say that in Japan, the nail that sticks out gets hammered down. Harmony and conformity are prized in big organizations. But these qualities can also lead to stagnation. Entrepreneurship requires a bit of rebelliousness.

During my trip last week, I traveled to Numazu for a day to visit one of the most innovative breweries in Japan. Baird Brewing Company is a joint partnership company that was founded in 2000, and in recent years has received much acclaim for its high quality, creative beers. I had the great fortune to meet the company's founders Bryan and Sayuri Baird, a husband and wife team. Bryan graduated from Johns Hopkins SAIS in the early 1990s and came to Tokyo to enter the corporate world but had another calling. "I didn't know much about brewing at the time but I knew how to study," he said. Using passion and determination, he founded the company with some friends. For the first few years, his beers were dismissed as too challenging. His customers were initially afraid to try something new. For the same reasons, Bryan's competitors in Japan were brewing up pale, uninspired, safe lagers. Bryan stuck to his principles and kept making a great product that emphasized Japan's proud tradition of craftsmanship (monozukuri) until his customer base caught up with him.

"The Japanese people need to overcome their fears and be the nails that stick out," Bryan told me. Bryan is an entrepreneur who embodies what Japan needs—globalized human capital creating a business that adds value and jobs. Another notable maverick who has been globalizing Japan includes Rakuten CEO Hiroshi Mikitani who is making English the official language at Japan's biggest online retailer. Fast Retailing, Nissan Motor, and Toyota Motor also are moving in the direction of adopting English at the workplace.

In politics, LDP star Taro Kono recently published a book on how he is going to revive his party. The main message is: As a nail that has stuck out in the LDP, he knows how the party can revive the economy. Japanese culture is famous for its perseverance and the country's history proves it. The country needs some major changes in order to prosper. For it to create real change, Japan needs more mavericks. And to pilot away from the rough waters, it will need a bold leader; it needs a captain.

Photo by quatro.sinko

South Centre Statement on the Impact of Economic Crisis on Developing Countries

South Centre Executive Director Martin Khor made the following statement (3/25) to a special UN General Assembly dialogue on the world financial and economic crisis and its impact on development:

1. The extraordinarily serious global economic crisis has its origins in the developed countries. Developing countries are not responsible, but they are severely affected, and in ways that are worse than the developed countries, as they also lack the means to counter the effects.

2. Developing countries are only in the past few months beginning to feel the effects of the crisis, due to the lag time in transmission. The crisis will certainly last longer than originally expected, and then it may take even more time before a full recovery.

3. There is thus growing anxiety in the developing world. When he met the British Prime Minister Mr. Gordon Brown, last week, as part of the preparation for the G20 Summit, the Ethiopian Prime Minister Mr. Meles Zenawi warned that African countries could face political chaos if the recession hits at full force. In developed countries such as Britain, the worst problem being faced in the downturn was unemployment. But in Africa, the recession means that "people who were getting some food would cease to get it and instead of being unemployed they would die", said Mr. Zenawi, as quoted in the Financial Times.

4. The developing countries are being hit through two transmission levels—trade and finance. The first transmission channel is through trade. There has been a sudden and steep fall in manufacturing exports, the fall being 30 to 50 percent in many Asian countries. Then there is the fall in demand, prices and export earnings for commodities, affecting especially low-income commodity-dependent countries. On 17 March, The Economist's commodity-price dollar index for all items had fallen by 40 percent compared to a year ago (with declines of 29 percent for food, 44 percent for non-food agriculture products and 56 percent for metals). Earnings from services are also falling, for example in tourism (in the Caribbean tourist arrivals are expected to fall by one third this season) and migrant workers' remittances (a 6 percent drop is estimated by the World Bank for 2009).

5. The second transmission channel is through finance. There is a rapid decline of bank loans to developing countries, whose companies may find it difficult to roll the many hundreds of billions of dollars of foreign loans due this year. There is a reversal of portfolio investment into developing countries, from large inflows in recent years to a sudden huge exit. Net capital flows to emerging markets fell from $929 billion in 2007 to $466 billion in 2008 and will fall further to $165 billion in 2009, according to the estimates by Institute of International Finance. Even FDI is rapidly slowing down because of difficulties in access to credit and economic contraction. If the past record is a guide, aid flows can also be seriously affected in the near future. Trade financing has also been affected by risk aversion, and is choking trade flows; a shortfall of $25 billion in trade financing was reported at a recent WTO meeting.

6. These trade and financial shocks are leading to stresses on the overall balance of payments, with a fall in foreign reserves, and a depreciation of the local currency in some countries. All these together threaten developing countries' ability to service their external debt and avoid a debt default situation. There are already 10 countries that have had to go to the IMF for emergency loans and many other countries are likely to be lining up in the near future.

7. All of the above are causing a stress on the real economy, with declines in GNP and industrial output, a reversal in poverty eradication and a slowdown in social development, as governments face reduced revenues and budgetary stress. Most developing countries are constrained from taking the fiscal expansion measures similar to those of developed countries.

8. There is a need for developing countries to examine the options for national policy on each aspect of the economic crisis and to seek the appropriate policies. However, only some policy measures can be taken at national level, especially if the country is too small to rely on the boosting of domestic-led growth. Regional-level measures are important. And most critical are the reforms, actions and cooperative measures required at the international level.

9. The South Centre views the two issues of reform international actions needed to counter the recession from the perspective of the problems and interests of the developing countries. What are the priority issues for the developing countries, on which action is urgently required?

10. Among the priorities for the South are (1) establishing an international system that fosters financial stability for developing countries; (2) having access to adequate and stable financial resources, as private flows and exports decline; (3) avoidance of financial and debt crises and proper management of crises if they occur; (4) unimpaired access to markets for goods and services; (5) avoiding collateral damage from policies taken by developed countries in response to the crisis; (6) formulating policies for the short and long term for recovery and development, and being able to maintain and expand policy space to implement these policies.

11. There is need to review and reform the international financial and economic systems to ensure the problems that led to the crisis are not repeated and that the international system does not prevent but positively encourages developing countries to have the adequate policy space to deal with the crisis nationally.

12. There are dangers that some crisis measures taken by developed countries may have adverse effects on the South, and thus a need to prevent or offset these actions. For example, developed countries' agriculture subsidies used to be the main distortion in world trade but these are now accompanied by huge subsidies to financial institutions and emerging subsidies to manufacturing (the auto industry). Developing countries lack funds to match these subsidies; they should be allowed to take measures to prevent subsidized service providers like banks and subsidized goods from overwhelming their domestic markets. In the area of tariffs, developing countries should be allowed to exercise their right to use the policy space to raise their applied tariff if it is below the bound tariff. A moratorium against raising applied tariffs would be imbalanced because there is little difference between the applied and bound rates in developed countries, unlike the developing countries.

13. Private investors and public agencies in some developing countries invested in or lent to private and public institutions in developed countries. Developed countries' governments should assure that the assets of developing countries are protected. Pressures from interest groups that exclude developing countries' assets or loans from bailout plans (for example, the suggestion that AIG should only honor claims from nationally owned institutions) should be resisted.

14. New forms of trade protection that affect developing countries should not be introduced. The fiscal stimulus programs should not exclude goods and services from developing countries, as has happened with the Buy American clause in the recent US stimulus package. Developed countries are mainly exempted from the clause due to their membership of the WTO plurilateral procurement agreement, of which most developing countries are not members. There is also need to guard against a new trade protectionist element being proposed in the climate policies and legislation of some developed countries; if this is introduced, it could have a further adverse effect on developing countries' exports and add more stress in this crisis period.

15. A high priority for developing countries is to establish international measures to foster financial stability and avoid activities driven by speculation. The crisis originated from banking deregulation and excessive liquidity creation, causing speculation to be rife in capital and currency markets. Developing countries have been hit by these speculative activities leading to violent fluctuations in capital flows. But because of highly costly self-insurance taken in large stock of reserves, these swings have not created the kind of dislocations seen in 1997 in Asia. An important part of the solution is to reinstall firewalls and regulations to avoid speculative capital flows unrelated to real economic activities (trade and investment) and to establish a system of currency exchange where currency rates reflect underlying fundamentals. This should be a major priority in the reform of the international financial architecture.

16. In the absence of reform and an international system regulating these flows, developing countries must have the policy space and be allowed to undertake national policy measures to regulate capital flows and to defend themselves from speculation. However the required policy space to take the required measures is hindered by (1) IMF-World Bank conditionality that mandates an open capital account; (2) Many North-South free trade agreements that (a) mandate the free and unregulated inflow and outflow of funds; (b) liberalization of financial services, including the entry of foreign institutions for "new financial instruments;" (c) liberalization and deregulation of investments. These barriers (the loan conditionality and the FTA provisions) to the required regulation should be reviewed. Existing FTAs should be reviewed to consider amending clauses that prevent the required regulation. Current negotiations on FTAs such as the EPAs between the EU and the African and Pacific countries should fully take this into account.

17. A major plank of the new financial architecture is the reform of the IMF. Its policy conditionalities have previously not been appropriate in assisting developing countries deal with crises. These include: (1) the policy of an open capital account system, that deregulates capital flows (increasing financial vulnerability) and discourages or prevents capital controls over inflows and outflows; (2) pro-cyclical monetary and fiscal policies that have magnified contractionary conditions; (3) trade policy linked to extreme liberalization of imports and industrial policy based on non-state intervention, which have damaged domestic agriculture and industry in many developing countries. A preliminary review of recent crisis loans to 10 countries (including some developing countries) by the IMF show that contractionary financial and fiscal policies (such as a significant increase in interest rates, and a reduction of government spending) are still maintained as part of the loan conditions.

18. A reform of the IMF is thus crucial. Without the reform, it is premature to expand its resources. The IMF should not impose or promote an open capital account or prevent regulation of capital flows. It should not deal with trade and industrial policies and other development-related policies. The reform process should lead to its creditor role being confined to providing short-term loans to countries to deal with temporary balance of payments difficulties. In that area, its policies should be counter-cyclical and not pro-cyclical. Countries should not be requested to provide loans to the IMF to augment its resources because this would compromise the ability of the IMF to carry out its surveillance function and to discipline the policies of countries that provide the loans. It can obtain resources from the market or from the issuance of SDRs, instead of obtaining loans from governments. The imbalances in the system of governance, with its present serious imbalance in voting rights and decision-making, should also be addressed.

19. One major source of financial instability is that the international reserve currency is the currency of a single country (the United States). This causes instability as availability of reserves for the world economy depends on the reserve currency country (the US) having growing current account deficits. This problem is worsened under the present crisis because of: (a) the absence of multilateral discipline over exchange rate and macroeconomic policies of the US; (b) developing countries' increased vulnerability to fluctuations in capital flows and exchange rates; (c) pro-cyclical behavior of financial markets; (d) developing countries holding large stocks of foreign reserves at very high costs. As an alternative, an international reserves system based on the SDRs could be established. The IMF could distribute SDRs to itself to make it available to members, and there should be greater automaticity in access to it.

20. The new financial architecture should include establishment of a multilateral fund or funds. This could be similar to the two oil facilities set up in the 1970s to assist countries cope with the oil price increases and to prevent a global recession. The fund can assist developing countries counter the recession and to offset the multiple losses of financing caused by reduced exports, migrant remittances, service payments, loans, investments, trade financing, etc. The shortfall facing developing countries may total many hundreds of billions of dollars a year. The fund should thus be of a major amount. The channels of funding and its multiple uses should be determined together by the international community.

21. Developing countries should also be encouraged to explore and expand regional financial cooperation. Examples of this are the Chiang Mai Initiative and its extension in Asia, and the Bank of the South in Latin America.

22. The new financial architecture should also deal with the threat of new debt crises facing developing countries. The current account and overall balance of payments of many developing countries and their foreign reserves are or will be coming under increasing stress, due to a crisis that was not of their doing. The reform process should establish as a priority an international system of debt standstill and debt workout for countries that face debt servicing difficulties. Proposals on this (which originated at UNCTAD) had been rather extensively discussed, including at the IMF, but did not lead to any conclusions. Given the present crisis, this should again be a priority proposal. A new round of debt elimination and debt relief should also be looked at now.

23. For many of the poorer countries, dependence on commodities has revived as a serious problem because the positive conditions and high prices of the past several years have vanished. The stabilization of commodity prices and fair remuneration to producing countries has thus become a priority crisis issue for developing countries. International cooperation on resolving commodity issues should thus be on the reform agenda.

24. The crisis provides an opportunity to address the deficits and imbalances in the governance of global finance and economic issues. The United Nations used to play a central role in policy formulation and in reaching and implementing agreements. However in recent years, too much faith and power had been given instead to the markets and to international financial institutions which supported the drive towards "marketization" and "financialization." At the national level, in developed countries in the centre of the storm, the pendulum has swung, with the leadership and interventionist role of the state being emphasized. The international counterpart of this national-level development should be the strengthening of the role of the United Nations, including its General Assembly and its economic arms, particularly ECOSOC. Greater authority provided to a strengthened and more effective UN should be a crucial element of the new global economic architecture.

25. The UN General Assembly high-level conference in June is an important opportunity for discussion and follow-up actions on the wide range of issues of the crisis and how it affects development, and the remedies required. The South Centre is willing to contribute to the success of this very important event.