Financial Sector

October 2002

The anti-deflation package finalized by the government takes some major steps toward advancing the cleanup of nonperforming loans, but leaves unsettled one of the most controversial points: changing the rules on how banks count deferred tax assets as part of capital. Heizo Takenaka, economy minister and chief banking regulator, had originally envisioned a financial stabilization scenario under which banks would be pushed toward receiving early injections of public funds by two forces: a tightening of internal loan assessments and a tougher approach to evaluating bank capital. Takenaka's scenario called for a two-stage strategy; loan assessments will be strengthened in fiscal 2002 by adopting U.S. provisioning standards and then deferred tax accounting rules will be revised in fiscal 2003. Strong opposition from banking industry circles put the idea of overhauling deferred tax accounting up in the air, forcing Takenaka to change course. Although the anti-deflation plan calls for a "speedy discussion" of the deferred tax issue, it does not specify any timetable. Takenaka's initial plan proposed imposing a tight limit on how much deferred tax assets banks could count as core capital, capping the amount at 10% of Tier 1 capital. The idea of a specific ceiling does not appear in the anti-deflation package. At this point, the deferred tax assets of major banks total about 8 trillion yen, accounting for about 40% of their Tier 1 capital. If a 10% ceiling were imposed, major banks would turn undercapitalized, putting their capital ratios below the 8% line that is the regulatory minimum for banks with international operations. Stiff resistance by the banking industry, which involved the ruling coalition in this debate, ultimately forced a postponement of the issue of deferred tax assets. Meanwhile, changes sought by the banking industry in how the tax authorities treat bad-loan write-offs were also left for further discussion. The anti-deflation package places three issues on the future agenda: creating more flexibility for tax-deductible write-offs, reversing a suspension of loss carrybacks, and extending the carryforward period for accumulated losses from past unprofitable operations. The banking industry argues that the rigid stance of Japanese tax authorities on the deductibility of loan write-offs has increased nondeductible provisions, which is the primary cause for swelling use of deferred tax assets. The Financial Services Agency argues that loans to borrowers classified by banks as "at risk of bankruptcy" or worse should be eligible for deductible write-offs. The Ministry of Finance is taking a cool stance on easing the deductibility standards, saying enough flexibility has already been achieved. A system of loss carrybacks, which allows businesses to recover taxes paid on income earned in prior years, was suspended in fiscal 1992 because of concerns over Japan's deteriorating fiscal conditions. The FSA is calling for a restoration of loss carrybacks, as well as an extension of the five-year cap on the number of future years that loss carryforwards can be claimed, as part of the fiscal 2003 tax system revision. Tax refunds from prior years would give banks funds that could be channeled to pay for more bad-loan disposals. Restoring loss carrybacks would do little to bolster banks' bad-loan clean-up efforts as they have booked net losses over the past several years and thus have not paid corporate taxes. The item in the anti-deflation package that will have the biggest immediate impact on banks is the tightening of loan assessment standards in fiscal 2002. Regulatory examinations by the FSA will push banks to increase reserves to cover possible future loan losses. The basic approach to be adopted by FSA examiners will be the discounted cash flow method used in the U.S., where the value of loans is calculated as the present value of future cash flows. Most Japanese banks do not employ this approach, instead using default probabilities and other factors to automatically set loss reserve levels for particular classes of loans. The FSA wants Japanese banks to adopt the discounted cash flow approach for troubled loans that are classified as "requiring special attention." Major banks now have around 12 trillion yen of these loans on their books. Some analysts believe that using discounted cash flow would force major banks to increase their loss reserves by several trillion yen. The anti-deflation package also tightens loan valuations in other ways, requiring close reviews of the viability of restructuring plans at distressed companies and double-checks of the values assigned to property collateral. It also calls for banks to unify their assessments of major corporate borrowers. (October 31, the Nihon Keizai Shimbun)

The Japanese government unveiled a comprehensive economic package that calls for stricter assessments of major banks' assets, but it was unable to set timetables on key programs. The package was hammered out as a compromise between reforms-minded financial Services Minister Heizo Takenaka, who wants to take strict and decisive measures to fix the banking system, and bankers and politicians in the ruling coalition who want to cushion the blow. It calls for the government to set up a headquarters led by Prime Minister Koizumi to rehabilitate the country's troubled financial and industrial sectors. The government will also set up a special organization to buy debts of struggling companies from banks and extend further financial assistance to the debtors. Minister Takenaka was forced to compromise on the timing to adopt stricter accounting rules to assess major banks' assets, including deferred tax-effect assets. In the face of strong opposition from bankers and the ruling coalition, led by the Liberal Democratic Party, the specific timing was dropped from the package. For stricter assessment of major banks' bad loans, the government will introduce the discount cash-flow system. Under the system, the present values of bad loans will be assessed based on borrower's future profitability. As banks accelerate disposal of bad loans, they are expected to become more reluctant to extend fresh loans to problematic borrowers, which will likely force many of them to go under. The new organization, which will operate under the wing of government-affiliated Deposit Insurance Corp., will take over the role of helping struggling firms. The most controversial issue in compiling the package was whether to use stricter accounting rules to assess banks' assets. Banks are allowed to count deferred tax assets, as part of their core capital. If stricter rules for calculating capital were applied, those tax assets would shrink and deflate the capital-to-asset ratios of major banks, which must maintain a level of at least 8% to operate internationally. The comprehensive economic package also features measures to alleviate the pain expected from accelerating bad-loan disposal. The features range from tax reform to beefing up a safety net for the unemployed. (October 31, the Japan times, the Nihon Keizai Shimbun, Dow Jones)

With the government failing to incorporate tougher rules on deferred tax assets in its anti-deflation package, major banks may not voluntarily seek public fund injections by the end of the year. Economics and Financial Service Minister Heizo Takenaka had envisioned a plan to reform the banking industry through stricter assessments of loans as well as tougher rules on how banks count deferred tax assets as part of capital. He had expected these measures would prompt major banks to voluntarily seek public fund injections by year-end. But now this scenario may need to be changed. The anti-deflation measures include a framework that would allow for the government's strong involvement in the rehabilitation of major banks whose finances have deteriorated drastically. Tatsuya Ito, senior vice minister in the Cabinet Office, has cited ailing operations requiring aid and requests for public fund infusions as criteria for banks to receive special government support. Banks with a certain percentage of their preferred shares converted into common stock by the government are also included in the criteria. In addition, institutions deemed eligible for special government support would be forced to separate their outstanding loans into performing and nonperforming accounts. As for the fate of executives of banks that will receive support, the government said that their accountability will be clarified in a strict manner. But this represents a setback from the original plan. The original version had noted that if executive directors of banks asking for public fund infusions within this year stepped down of their own volition; the accountability issue would not be pursued. With infusions carried out next year and afterward, the government sought to demand that all executive directors step down and that their retirement pensions not be paid. The banks strongly objected to such a proposal. The impression that the government would force banks to accept early infusions of public funds has subsided with the latest proposed measure. The government still plans to bolster its involvement in banking operations by converting into common stock the preferred shares acquired in the past in exchange for public funds. Depending on upcoming developments, the government may opt to convert such shares into common stock and effectively nationalize the banks. For injections of public funds, the government has decided to use the existing Deposit Insurance Law for fund injections. At the same time, the government's anti-deflation package also states its plan to consider a new structure for the use of public funds. Although the ceiling for public fund infusions is set at 15 trillion yen under the current framework, the government, however, may consider changes to allow even larger infusions. (October 31, the Nihon Keizai Shimbun)

The Bank of Japan (BOJ) decided to take additional credit-easing measures. The central bank will raise its target for the balance of current accounts deposited at the BOJ by financial institutions to a range of 15-20 trillion yen from the current 10-15 trillion yen, and for the time being keep the deposits at around the middle of that new target range. The BOJ will also increase its outright purchases of long-term government bonds, one of the bank's operations for pumping liquidity into the market, to 1.2 trillion yen a month from the current 1 trillion yen. The bank will take additional monetary-easing measures for the first time in eight months since the end of February, hoping to alleviate the deflationary pressure expected to result from the government's drive to accelerate the disposal of nonperforming loans at banks. BOJ Governor Masaru Hayami stressed that the bank is cooperating with the government in its efforts to fight deflation and resolve the bad-loan problem. The BOJ is fully aware of the government stance, and has made the decision in accordance with the direction the government is moving in. The central bank intends to stem concerns in the market by supplying it with ample liquidity, as financial institutions are scrambling to procure funds; they fear that falling stocks and the acceleration of bad-loan disposals could rekindle concerns over the stability of the nation's financial system. (October 31, the Nihon Keizai Shimbun)

The government intends to maintain the basic framework of the financial and industrial revitalization plan proposed by Economic and Fiscal Policy Minister Heizo Takenaka. The government, top legislators of the ruling parties and top executives of major banks continued to debate measures to speed up the bad-loan cleanup ahead of the government's release of an anti-deflation package. The focal point of the debate was whether to adopt stricter rules on how banks' deferred tax assets are counted as equity capital. Takenaka has been calling for standards as tough as those in the U.S. The responsibility of bank management remains an issue. But the biggest issue is deferred tax accounting. Bank executives warned that banks would be forced to reduce lending and force borrowers to repay loans if the deferred tax accounting changes proposed by Takenaka are implemented. As tougher deferred tax accounting standards would mean that banks would have less equity capital, banks would have to reduce lending in order to prevent their capital ratios from declining. Ninety percent of the opinions during meeting were from bank executives concerned about the deferred tax accounting changes. Koizumi instructed Takenaka to smooth out the differences with the ruling parties based on his basic outline of tougher asset inspections and the injection of public funds into banks with insufficient capital. Takenaka, however, began to consider measures aimed at easing the impact that the deferred tax accounting change would have on banks. The timing of the accounting changes is unlikely to be included in the government's anti-deflation package. In his original plan, Takenaka insisted on implementing the changes next fiscal year. Although the details have not yet been worked out, the government is considering the idea of keeping the accounting standard as is until fiscal 2004, the target date the government has set for banks to thoroughly dispose of bad loans, and reconsider such changes later. Takenaka's original plan called for keeping deferred tax assets to less than 10% of a bank's Tier-1 core capital. Some in the government proposed gradually tightening this level to less than 50% in the first fiscal year and less than 40% in the second fiscal year. (October 30, the Nihon Keizai Shimbun)

The Tax Commission, an advisory panel to the prime minister, discussed tax incentives related to the disposal of nonperforming loans at banks. Ahead of the government's release of measures aimed at accelerating bad-loan disposals, commission members agreed to continue to examine such tax issues. The commission will discuss the idea of extending the period that banks can carry forward losses beyond five years, as currently allowed. The practice enables banks to deduct losses incurred in a fiscal year from taxable income in following years. Other issues discussed by the commission include reinstating loss carrybacks, which have been frozen since fiscal 1992, to refund corporate taxes in the past, and easing the conditions for when tax-deductible write-offs of bad loans are allowed. The U.S. extended the period that loss carrybacks are allowed to five prior years from two prior years after last year's terrorist attacks. The Ministry of Finance argues, however, that most banks have not paid corporate taxes due to booking losses, and that most banks would not be able to receive tax refunds unless loss carrybacks are applied to longer periods in the past. (October 30, the Nihon Keizai Shimbun)

In a joint statement, executives of seven major banks voiced opposition to the bad-loan disposal plan by Economics and Financial Services Minister Heizo Takenaka, especially the implementation of stricter deferred tax accounting rules. As for the possibility of filing a lawsuit against the government, the banks will consider the option after the final version of the Takenaka Plan is released. In regard to the thorny issue of revising the deferred tax accounting rules to match those in the U.S., the executives said they cannot accept such a change. The tax and accounting systems are entirely different in the U.S. and Japan. The banks also opposed the idea of separating nonperforming loans from banks' assets. (October 26, the Nihon Keizai Shimbun)

The nation's major banks may issue a joint statement to express their objection to Takenaka's plan of financial system reform measures. Speaking for the banking industry, the statement is expected to cite the discussions spearheaded by Minister Takenaka of economic and fiscal policy as well as financial services, because some of the proposed measures could significantly rattle banks' operations. By issuing a joint statement, the banking industry aims to urge Takenaka and the ruling coalition to be cautious in their deliberations. Japanese Bankers Association Chairman Masashi Teranishi aims to play a prominent role in the statement's compilation. While the banks plan to issue the statement after Takenaka's financial task force officially announces its financial rehabilitation measures, its release may be moved up. Bank leaders are also considering a plan to protest some of the proposed measures at a joint news conference. Japan's major banks are preparing for a fight as the Takenaka team steps up its efforts to hammer out drastic measures for the disposal of bad loans. (October 25, the Nihon Keizai Shimbun)

The Financial Services Agency (FSA) will allow foreign securities firms without local branches to operate in Japan, paving the way to participate in domestic securities trading on the Tokyo Stock Exchange and other markets. By removing regulations that have hindered foreign entry, the FSA aims to lure funds into the nation's sagging markets. The Agency also will strengthen monitoring to guard against illegal activity and intends to revise the Securities and Exchange Law and other pertinent legislation in next year's ordinary Diet session. Currently, foreign securities firms are not allowed to operate in Japan unless they set up local branches and register with the government. The FSA plans to allow foreign brokerages without local branches operate in Japan, merely requiring them to register representatives. About 50 foreign securities firms are now allowed to operate in Japan, with only 20 of them participating in securities trading. The new rules are expected to reduce the burden on foreign brokerages trading in Japan, making it easy for even small companies to enter the market. Their entry is also expected to boost competition with Japanese brokerages. However, the FSA is concerned that the deregulation could prevent it from thoroughly supervising securities firms and make illegal activity easier if an unlimited number of foreign firms without local branches are allowed entry. Because of this concern, the agency plans to join forces with overseas financial regulators and stock exchanges to create rules designed to strengthen supervision. (October 25, the Nihon Keizai Shimbun)

The financial system reform plan crafted by Economic and Fiscal Policy Minister Takenaka aims to revitalize banks that receive public funds or are effectively nationalized by separating out all bad loans and leaving new management with a portfolio of only healthy assets. According to the details of the reform plan, financial authorities will encourage banks to file for injections of public funds before the end of the year by adopting a relatively relaxed stance on management accountability. Takenaka's plan also calls for the government to hammer out new guidelines on the liquidation and rehabilitation of companies weighed down by excessive debt. The report entitled "An Action Plan To Bring the Bad Loan Problem To A Conclusion - Economic Revitalization Through Public Assistance To Major Banks" -- was actually put together by Takenaka. But objections raised by the dominant Liberal Democratic Party and other sources forced Takenaka to delay its formal release. The Takenaka Plan is expected to serve as a basis for the financial system policies to be included in the comprehensive anti-deflation package o be released by the government at the end of the month. One of the central points of the reform plan is the use of public funds and effective nationalization of certain banks. In principle, banks receiving public funds or are subject to effective nationalization would be required to appoint new representative directors. At the same time, bank assets would be divided into two accounts: a "new" account that would hold all healthy assets and an "old" account that would serve as a bucket for all bad assets. The new management team would assume control of the "new" account. The idea of splitting assets into "old" and "new" accounts is a favored method of corporate reorganization, but it has never been adopted for a bank not in bankruptcy proceedings. Although the details are not clear, one of Takenaka's options will clear away "old" account assets through sales to the Resolution and Collection Corp. Largely because major banks continue to raise objections to the idea of public fund injections, the reform plan offers to take a lenient stance on management accountability if banks file to receive public funds before the end of the year. In such cases, the financial authorities would allow banks to arrange the voluntary retirement of top executives. However, Takenaka envisions are getting tough on representative directors and directors if it becomes apparent that a bank is undercapitalized after December. The reform plan also calls for a strict review of the loan portfolios and capital bases of major banks. If it is found that a bank's own internal loan assessments are overly lax or that internal remedies are insufficient, the financial authorities would issue an order for corrective action. The plan calls for a provisioning system that would peg loan loss reserves taken against loans classified as "requiring special attention" to future cash flows, among other factors. Also, the standards for bank classifications of loans to large, ailing companies would be unified. Independent appraisers would be called in to assess the true market value of property collateral. On deferred tax accounting, Takenaka wants to adopt standards that are as tough as those used in the U.S. in fiscal 2003, where deferred tax assets are limited to a ceiling equivalent to 10% of core capital. In regard to previous injections of public funds, the government would convert preferred shares into common shares as the conversion period arrives, effectively nationalizing banks that cannot repay money received from the government. In addition, the government would create a special supervisory panel to monitor the performance and oversight of banks after injections of public funds. This comes in response to widespread criticism that post-recapitalization monitoring was insufficient after the previous two rounds of public fund injections. (October 24, the Nihon Keizai Shimbun)

Japan's major banks are largely opposed to the financial stabilization measures being considered by the task force created by Heizo Takenaka, minister for economic and fiscal policy as well as financial services, saying a sudden change in rules would have a major impact on the markets and investors. Based on the move by the task force to postpone the release of its interim report on the stabilization measures, the banks now plan to urge the task force to reconsider its plan to revamp how deferred tax assets are treated. Under deferred tax accounting, tax payments that are to be returned in the future after bad loans are disposed of can be booked as assets and included in equity capital. If the task force's proposals to overhaul deferred tax accounting are implemented, major banks' capital ratios will all drop significantly. Japanese Bankers Association Chairman Masashi Teranishi voiced his opposition. The tax changes "are like having the rules of soccer changed to the rules of American football." The use of deferred tax assets as equity was approved beginning with the fiscal year ended March 31, 1999. If changes are implemented and the inclusion of tax assets in equity capital is made along stricter lines similar to those in the U.S., many of Japan's major banks will likely see their capital ratios fall below 8%, the benchmark for financial soundness. (October 23, the Nihon Keizai Shimbun)

Japanese and U.S. business leaders urged the Japanese government to quickly implement a large-scale disposal of nonperforming loans using the state-run Resolution ad collection corp. (RCC). Seventy corporate executives from the world's two biggest economies said in a joint statement that the government should take prompt, coordinated action to expedite a large-scale disposal of nonperforming loans to ensure that nonperforming assets are shifted to productive use in the real economy. The statement was adopted at the end of a two-day annual U.S.-Japan Business conference held in Tokyo. The business leaders also agreed that the injection of public funds, which has been discussed as a possible measure to shore up banks' capital, should be linked to the disposal of these bad loans. A large portion of the statement was dedicated to asking the Japanese government to take necessary measures to lift the country from its prolonged economic woes. The statement also urged Tokyo to make efforts to facilitate foreign direct investment that it can play a significant role in revitalizing the Japanese economy and industry. (October 23, the Nikkan Kogyo Shimbun, the Japan times)

A top U.S. Treasury Department official said that it is important for Japan to tackle both the banks' bad-loan problem and the deflation demon. They should be addressed together, as they are intimately related" said Undersecretary for International Affairs John Taylor. Echoing comments by the Bank of Japan, Taylor said the bad-loan problem is preventing the central bank's easy monetary policy from being fully effective. However, he said the BOJ could take more steps, including continuing to expand the monetary base. Taylor said he wasn't privy to an interim banking report being hammered out by a task force appointed by banking and economy czar Heizo Takenaka. However, Taylor said he has high expectations for the report, which will address how Japan will tackle nonperforming loans and highly-leveraged borrowers. He reiterated that Washington strongly supports Tokyo's efforts to deal with its economic and deflation problems. Taylor expected that there would be a serious effort to address the problem because that's what has already been stated. Washington has pressed Tokyo to come to grips with the banking mess and price declines and take aggressive steps to fix the problems. Unlike the previous administration of President Bill Clinton, the U.S. didn't call on Japan to take specific measures. Taylor said it's up to the Japanese government whether it wants to use public funds for banks. But, if used, he said Tokyo ought to ensure the institutions were truly strengthened. While Prime Minister Koizumi is grappling with the bad debt and deflation problems, lawmakers and some officials are increasingly calling for fiscal measures, including large-scale tax breaks, to absorb the shock that an NPL cleanup would cause. Asked about the U.S. stance on Japan's tax and fiscal policy, Taylor didn't make specific proposals to Japan on tax policy. Apparently trying to avoid being at odds with the Koizumi administration, he said mid-term fiscal consolidation was important, as was fiscal stimulus in the shorter term. Koizumi has already announced that the government will provide over 1 trillion yen in tax breaks next fiscal year. To put the nation's finances in order he has avoided the tendency of past governments to cobble together stimulus packages, mainly public works spending, whenever there's an economic downturn. Reiterating a U.S. policy, Taylor said he couldn't comment on foreign exchange policy as that was the sole purview of Treasury Secretary Paul O'Neill. There has been speculation that Washington might tolerate a weaker yen if Tokyo gets its act together on its economy and NPL woes, but there was no indication of such talk. Attending Monday's talks were Taylor, Japan's Vice Finance Minister for International Affairs Haruhiko Kuroda and Financial Services Agency Deputy Commissioner for International Affairs Makoto Hosomi. Taylor also said he would be meeting with others, including BOJ officials, during his Tokyo visit. (October 21, Dow Jones)

The Japanese government postponed the release of a key report on cleaning up the debt-clogged banking system after politicians complained that the proposed steps were too strict on the banks. The delay would disappoint markets eagerly awaiting details on the nation's most urgent economic problem. Takenaka put together a task force of hardliners earlier this month to find solutions to the banking mess. The team's interim report was to outline their basic stance and how they planned to proceed with the bad-loan cleanup. It was expected to touch on key issues, including the quality of banks' capital, loan-loss reserves and corporate governance. Tightening the screws on weak banks would likely cause some institutions' capital to fall below international adequacy requirements. That would force them to bolster their capital bases by raising funds on their own or accepting another infusion of taxpayers' money. The government pumped 9 trillion yen into banks during the late 1990s financial crisis by purchasing their preferred shares. The delay in the report - the second yet - puts tough-talking Takenaka in a bind. The banking czar will be hard-pressed to explain that the postponement doesn't signal Japan's renewed attack on the banking sector mess has been thwarted by vested interests and politicians guarding their turf. Markets are likely to take the delay as a foreboding sign that Takenaka's plans might could get watered down to the point that effective reform of the banking system and the debt-loaded corporate sector is compromised. When Takenaka took over, the market anticipated a tough bank reform plus tough corporate (borrower) policy. However, as the market headed south, the combination turned into a tough bank reform plus a soft corporate policy. Eventually, it may end up in a soft bank policy and soft corporate policy. (October 22, Dow Jones)

The bad-loan task force set up by Minister Takenaka is eyeing a plan to ease tax rules on bad-loan write-offs as losses on their taxes. Takenaka's team is also considering tougher standards on how banks can count tax payments that they expect to be returned in the future as equity capital. The task force is slated to present an interim report and compile its final report by month's end. In preparation for the interim report's release, the task force has been discussing issues such as beefing up asset appraisal standards as well as the potential infusion of public funds into banks. It intends to include in the final report specific measures aimed at revamping tax code provisions related to the cleanup of nonperforming loans. Under existing rules, banks can carry out tax-deductible write-offs of bad loans only when a borrower has been legally declared bankrupt or with debt waivers approved by tax authorities. Even if a bank incurs a loss after setting aside provisions for loans to borrowers that have effectively gone bankrupt, it is not treated as a loss on a tax basis. This constitutes one factor making banks hesitant to dispose of their bad loans. The government Council on Economic and Fiscal Policy is calling for looser tax standards for bad-loan write-offs. Specifically, it wants standards to be eased so that loans assessed by banks as being irrecoverable can be treated as a loss for tax accounting purposes even if the borrower's failure has not yet been legally recognized. While tax-deductible write-offs of nonperforming loans will not directly lead to an immediate improvement in the finances of banks, losses from the disposal of bad loans will be defined more broadly as losses for tax accounting purposes. Because banks will then face less of a tax burden, an easing of the standards will make it easier for financial institutions to carry out bad-loan disposal. The Finance Ministry says tax-deductible write-offs of nonperforming loans are already allowed now even if a company has not been legally declared bankrupt. But banks counter that existing standards are somewhat unclear. The task force is also eyeing a plan to change how bank losses arising from the cleanup of bad loans are treated. In Japan, such losses can be rolled over and deducted from taxable income for five years. Such losses can be rolled over for 20 years in the U.S., while in the U.K. and Germany they can be rolled over indefinitely. Because such regulations in Japan are strict from an international perspective, the Takenaka task force seeks to extend the rollover period to 10 years or more as a way to encourage the speedy disposal of bad loans by banks. The Finance Ministry opposes the idea, however, citing the tax revenue drop that may result. In light of how such changes would work in relation to nonfinancial firms as well, negotiations are likely to run into difficulties. The biggest remaining issue is how to treat deferred tax assets. Under deferred tax accounting, tax payments from the disposal of bad loans that are to be returned in the future can be booked as assets and included in equity capital. This has been criticized as providing banks with the means to inflate their equity capital. Such deferred tax assets are said to constitute nearly 40-50% of banks' equity capital. The inability of banks to write off most losses from the disposal of bad loans is believed to be a major factor contributing to the sharp increase in deferred tax assets. Consequently, the task force intends to carry out sweeping changes to the tax structure as it relates to writing off bad loans. (October 22, the Nihon Keizai Shimbun)

The U.S. welcomed efforts by Japan to clean up its banking system and fight deflation, with both sides agreeing in high level talks that growth in both countries is vital for the global economy. In their one-day talks, deputy finance officials from the U.S. and Japan discussed economic and financial developments, including structural issues and non-performing loans, Japan's Finance Ministry said in a statement. "The U.S. side expressed strong support for Japan's carrying out its current comprehensive policy agenda towards revitalization of the Japanese economy, including measures to strengthen Japan's financial and corporate sector, and to overcome deflation," the statement said. The financial talks, a part of the Japan-U.S. Economic Partnership for Growth meeting, took place as Tokyo is working toward compiling its latest package of measures to spur a cleanup of the bad loans in the banking system and stop deflation, which has ravaged the economy for years. Washington has pressed Tokyo hard to come to grips with the banking mess and price declines and take aggressive steps to fix the problems. Washington seeks to keep the momentum going in Tokyo for tough policy prescriptions. Attending the talks were the U.S. Treasury's Undersecretary for International Affairs John Taylor, Japan's Vice Finance Minister for International Affairs Haruhiko Kuroda and Financial Services Agency Deputy Commissioner for International Affairs Makoto Hosomi. A Japanese Finance Ministry official later said the U.S. side didn't "have any specific remarks" on Bank of Japan policy after Japanese officials explained the nation's current fiscal and monetary policies. The FSA explained the steps Tokyo has taken so far to fix the banking sector. But regulators didn't go any further than that, as they were still awaiting the release of an interim banking report by banking and economy minister Heizo Takenaka and his task force. Takenaka's report was originally slated for release last week, but is delayed. As for remarks on the financial system, the U.S. just confirmed figures on the sector's problems. (October 21, Dow Jones)

Amid growing pressure from both the Japanese government and overseas authorities, the Bank of Japan is poised to step up additional monetary easing ahead of its Oct. 30 monetary policy meeting. It was only last week that the BOJ's policy-setting board voted unanimously to leave the current guidelines for money market operations unchanged. But officials inside the central bank now believe that it will become imperative to work closely with the government to curb the deflationary pressures to be unleashed by an accelerated cleanup of nonperforming loans in the banking system. The spotlight is now shifting to the policy steps that the BOJ might take, but the options are limited. Three principal scenarios are examined.
Scenario 1: Raising Current Account Balances. Last week, Finance Minister Shiokawa proposed raising the target for noninterest-bearing current-account deposits at the central bank. Minister Shiokawa said that if the target for current-account balances is raised by a set amount every month as the year-end approaches, even the public will be able to understand. In fact, the BOJ has relied on the target for current-account deposits as its principal easing lever when it has needed to step up monetary easing in the past. By raising the target level and increasing its provision of liquidity to the money market, the BOJ hopes to encourage money to permeate through the economy via bank lending. With the recent stock market plunge fueling a growing demand for funds, the view in the money market is that the BOJ could easily raise its target for current-account deposits to 20 trillion yen, up from the current level of around 10-15 trillion yen. BOJ insiders say that raising the current-account deposit target is the most realistic easing option. The problem is that bank lending stubbornly refuses to expand and there is no sign of an upturn in consumer prices, despite heavy doses of liquidity already provided by the central bank. The view is strongly held inside the BOJ that simply pumping up its liquidity provisions will have only a limited effect as an anti-deflation prescription.
Scenario 2: Increasing JGB Purchases. Another idea is to increase its purchases of long-term Japanese government bonds (JGBs), while also raising its target for current-account deposits. Proposals are being floated to add about 200 billion yen to the 1 trillion yen of long-term JGBs that the BOJ now purchases on a monthly basis. Pumping up bond purchases is also seen as a way for the BOJ to demonstrate to the financial markets its commitment to cooperate with the government. Bond market participants are already envisioning the possibility that the government will have to expand its bond issuance beyond the 30 trillion yen ceiling imposed by Prime Minister Koizumi as it attempts to use fiscal levers to jump-start the economy. By purchasing more JGBs, the BOJ could signal its readiness to prevent a rapid deterioration of supply-demand conditions in the bond market. However, the danger is that confidence in the BOJ as the nation's central bank could be damaged if the perception is created that the bank is directly underwriting government bonds as part of the government's issuance management strategies. The BOJ will seriously consider this potentially dangerous side effect.
Scenario 3: Inflation Targeting. Heizo Takenaka, minister for both economic and fiscal policy as well as financial services, advocates introducing an inflation target that would require the BOJ to aim for a certain price level or degree of inflation. The BOJ is strongly against the idea. Inflation targeting is supposed to spur economic activity by sparking expectations that prices will rise, thus severing the vicious cycle of falling prices and shrinking economic activity. While inflation targeting has been used in New Zealand and the U.K., among other places, there are almost no precedents under a deflationary environment and the actual impact is uncertain. The underlying worry at the BOJ is that if it were to adopt inflation targeting, it could come under pressure from the government to drop any limits on its purchases of long-term JGBs or to purchase stocks, real estate, or other risky assets that could damage the central bank's balance sheet. As part of the bad-loan cleanup, the BOJ has already outlined a program to purchase banks' shareholdings to help insulate their balance sheets from the impact of stock market swings. But the BOJ insists that this program is completely separate from monetary policy. (October 16, the Nihon Keizai Shimbun)

The Organization for Economic Cooperation and Development (OECD) acknowledged the need for the Japanese government to inject public funds into banks as they dispose of their bad loans. The Paris-based club of 30 industrialized countries, including the U.S. and Japan itself, met to review Japan's economic policy, focusing on how the nation could end the current deflation. All participants agreed on the need for injecting funds into banks. The OECD's secretariat noted that the Japanese economy is now on a recovery track, and that it would continue to expand at a moderate pace, though the recent weakness in stock prices and mounting anxiety over the U.S. economy do not permit an optimistic view. The secretariat forecast that the Japanese economy will post positive, though small, growth for 2003. Accelerated disposal of problem loans at banks could result in an increase in corporate bankruptcies and unemployment, aggravating deflation over the short term. Meeting participants called for the Bank of Japan to ease monetary policy further to provide a safety net for such developments. Specifically, they urged the central bank to raise the money supply by increasing the scope and value of assets. The OECD also recommended that Japan trim budget deficits, create a broader based tax system with lower rates, and promote competition by giving the Fair Trade Commission more power. Many expressed hopes that the installment of Economic and Fiscal Policy Minister Takenaka as financial services minister would lead to speedier disposal of nonperforming loans, according to a participant. The OECD is slated to issue a formal report on the Japanese economy in December. (October 15, the Nihon Keizai Shimbun)

The United States expressed its full support for a plan to eradicate bad loans at Japanese banks proposed by Minister Takenaka, Japan's new financial services agency. Chairman of the White House's Council of Economic Advisers, Glenn Hubbard, said that Takenaka is an excellent reformer with strong commitment to the agenda that Prime Minister Koizumi set out. Hubbard pinned strong hopes on a new package of economic measures, based on Takenaka's proposals, to accelerate the disposal of bad loans and revitalize Japan's economy. At a regular State Department press briefing, spokesman Richard Boucher expressed support for Takenaka's banking reform initiative. Takenaka has pledged to drastically dispose of bad loans by even letting major banks and companies fail if they are no longer viable. His hardline approach, has triggered a sharp fall in the Tokyo stock market, in anticipation of a steep rise in bankruptcies. The Japanese government plans to announce the outline of a new economic package. The U.S. has long wanted Japan to revitalize its economy by fixing the bad-loan problem. It seems to be giving Takenaka a helping hand with the praise, apparently in a bid to prevent Japan from backpedaling on economic reform. Hubbard said that it is necessary to inject public funds to strengthen banks' capital bases and accelerate their bad-loan disposal. Hubbard called on the Bank of Japan to offer a more expansionary monetary policy to end deflation and help support the government's economic reforms. Hubbard said that it is very hard for Japan to right itself and have a meaningful recovery until the deflationary pressures are stopped. (October 13, the Japan times, the Nihon Keizai Shimbun, the Asahi Shimbun)

Japan's economic policy on bad-loan disposals and tax cuts has yet to take shape due to conflicts between government agencies and a lack of leadership of Prime Minister Koizumi. The Council on Economic and Fiscal Policy (CEFP) and the Ministry of Finance are at odds over the size of tax cuts slated to be implemented next fiscal year and the lowering of corporate tax rates. The two issues are the focal point of fiscal 2003 tax cuts. Meanwhile, a feud within the cabinet is heating up, with the prime minister keeping a low profile. After the CEFP meeting, Finance Minister Shiokawa stressed that the government's top economic panel has agreed not to cut corporate tax rates next fiscal year. Analysts say that Koizumi is intentionally delaying a conclusion on the two issues so that he can respond flexibly to the economic situation until year-end. However, Shiokawa is eager to reach a conclusion. The veteran politician is well aware that negotiations with the ruling parties will not proceed without a decision on the framework for tax reform. Even if the government agrees on the main points of tax reform, it will need Diet approval to put them into action. It will also require deliberations with the Liberal Democratic Party's high-powered Tax Research Council, a de facto designer of tax reforms in the past. The CEFP, which is charged with working out economic policy independently of the interests of government agencies and political parties, has not budged either. Takenaka and private-sector members of the council are insisting on tax cuts of at least 2.5 trillion yen for fiscal 2003. The debate over tax reform, however, is fitting into the perennial pattern of the Finance Ministry deciding the larger framework and the LDP tax panel making the final conclusion. Analysts warn that the tax reform discussions could end with the Finance Ministry, for which restoration of fiscal health is a top priority, getting its way. But the biggest reason that economic policy is still in midair is the prime minister himself, who, as head of the CEFP, has not made a decision on the key issues. (October 12, the Nihon Keizai Shimbun)