More Bang For the Yen?

Japan's financial reforms are more cosmetic than real.

As Asian currencies and equities dropped last year, International Monetary Fund analysts and global fund managers discovered yet another important "Asian value": denial. Thai banks "can't imagine what will happen if they tell you the truth," a director of a Hong Kong-based investment management company told Dow Jones News Service in October. "As long as they still say there are no problems, I say stay away."

This failure to face reality is largely the result of an inability to define reality. Lax reporting and disclosure standards make a true accounting of Asia's bad debts extremely difficult. When capital allocation decisions are based on political rather than financial criteria, the incentives are to keep such reporting ambiguous.

But don't ask Indonesia's President Suharto and his Asian colleagues to shoulder all the blame on this point. After all, they had a highly regarded model: Japan.

Japanese government officials and business leaders have been suffering their own extended case of denial since the bursting of an economic bubble in 1991. For nearly the entire past decade, bad loans and stock market losses have been swept under the nation's tatami mats. The reflex to cover up has been aided by vague reporting practices and widespread fears that a public comeuppance would reveal too much about the links between bad loans and government officials. The nation's leaders also simply waited and hoped that the export machine, hero of so many previous domestic crises, would lift Japan's economy again, and that rising equity and real estate markets would make all bad things go away.

Unlike Thailand, Indonesia, and the others, Japan's currency devaluation stretched out over the past three years (rather than about three weeks), from a peak of [yen]80 to the dollar in 1995 to nearly [yen]135 in January. But Japan shares with its less-developed Asian neighbors the same kind of outdated, autocratic financial sector, leashed closely to politicians and their bureaucratic henchmen.

Modernizing and opening up these institutions are the ostensible goals of Japan's "Big Bang." The namesake of more narrowly focused security-market deregulation in England in the mid-1980s, Japan's Big Bang implies that a thunderous liberalization of the financial sector is taking place. That's what Japanese leaders want everyone to believe, but it's not that at all.

True, the package of official reforms will induce more competition in banking and securities markets and offer attractive opportunities for foreign financial expertise. But critical components of the fossilized structure responsible for a long list of financial market problems remain beyond the reach of reform.

Some of the most significant change is promised by two important measures. Foreign exchange controls will be eliminated April 1. At the same time, brokerage commissions were deregulated on trades greater than [yen]50 million (about $400,000). Commissions have been both standardized and steep for decades, one of many factors freezing individuals out of equity markets.

In addition, this spring, banks may once again establish holding companies (a structure banned by the United States during the postwar occupation). Barriers between banks and brokerages will be eliminated sometime in early 2000. And by late 2001, the insurance market may be opened to banks and brokerages as well.

These are all good things. They will almost certainly increase competition and spur some much needed innovation in those two now noticeably state-run industries. The new currency policy, for example, allows any individual or business to swap yen for foreign currency. Official commentators frequently mention that this means McDonald's and L.L. Bean can accept payment in dollars. Though a public boost to continuing "internationalization" rhetoric in Japan, that kind of talk shifts attention from the much bigger benefits that would result from yet freer exchange.

Japanese save a lot--roughly 12 percent of disposable income, or about three times the comparable U.S. rate. Only about 10 percent of total personal financial assets flows into stocks and securities. (Americans place more than 50 percent of their financial assets in stocks and other securities, according to Bank of Japan comparisons.) Sadly, more than half of Japan's considerable savings sits in deposit accounts earning only about 1.5 or 2 percent. Better access to foreign currencies, through retail banking and securities markets, will offer better access to much higher returns available overseas.

Despite all that savings to target, Japanese financial institutions have so far failed to offer the kinds of retail products widely available to investors in the United States. (The type of money management account pioneered years ago by Merrill Lynch, for example, is one of the "innovative" new products several firms now are planning to offer.) There are complex reasons for this, and not all of them are addressed by Big Bang measures.

Still, most observers agree, banks and brokerages can't help but get more dynamic. The big four securities firms get an average of nearly one-third of their income from stock commissions. For second-tier brokerages, commissions total 40 percent of income. Eliminating these standardized income sources should not only reduce investors' expenses but also send securities managers scrambling to develop new products to gain competitive advantage.

Many of those new products will very likely come from foreign firms. Financial industry managers in Japan are woefully inexperienced at chasing higher returns, managing risks, and marketing sophisticated financial products. Even in pre-Big Bang conditions, the hip bank for new ideas was Citibank, whose customers still are the only ones with access to a 24-hour ATM network. As reform unfolds, there is an unusually hospitable environment for foreign expertise. Last fall, Swiss Bank Corp. announced a joint venture with Long-Term Credit Bank of Japan to enter the retail securities market. Smith Barney, Bankers Trust of New York, and Barclays Bank also announced tie-ins with Japanese partners.

The biggest move came from Merrill Lynch. Already an established competitor in institutional accounts, the brokerage announced plans to establish a retail network in Japan. That prospect sent a "chill of fear through the domestic industry," according to Japan's most prominent business newspaper. A big part of that network will be built on the rubble of Yamaichi Securities' bankrupt branches. Yamaichi, Japan's fourth-largest brokerage, failed last November, leaving several thousand unemployed. That not only gives Merrill Lynch a public relations edge, it also helps illustrate for the Japanese that, in competitive systems, something new and better often springs from failure.

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