US rescue is only a start for Japan

THE SUDDEN decision of the United States - probably taken by President Clinton himself - to engage in direct purchases of yen in the foreign exchanges certainly had a dramatic market impact. Yet it raises as many questions as it answers.

Why did US Treasury Secretary Robert Rubin acquiesce in this intervention only a week after telling Congress that such action would quite likely be pointless? What role did the Chinese threat to devalue the yuan play in the decision? What, if anything, did US National Security Advisers say to the President about the consequences of an Asian meltdown?

Did the President receive any concrete assurances of key policy changes by Japan before making the decision? To what extent was the President influenced by the imminence of his visit to China, which starts this week? Or by the drop in US share prices as the yen declined?

Majority opinion in the financial markets takes a cynical view on all these subjects. Most investors seem to believe that the President, rather than Robert Rubin, was instrumental in launching the intervention, and that he was so influenced by devaluation threats from China, coming just ahead of his visit to Beijing, that he was willing to order purchases of yen without getting anything concrete from Tokyo in return.

Even if this cynical interpretation turns out to be valid, the US will be extremely pleased with the early impact of its decision. Its timing was impeccable, with short covering in the foreign exchange markets leading to a bounce of 8 per cent in the value of the yen over three days. With the President's personal credibility now tied up with the health of the yen, the US now has every incentive to trumpet loudly any impending policy change from Japan. And, under pressure from Washington, we can expect the rest of the G7 to follow suit - with their mouths, if not with their money.

It would be surprising if this barrage of G7 activity failed to strengthen the yen for a while, and it should therefore offer some respite to the other crisis economies in Asia. Clearly, the weakness of the yen had become the most potent single threat to Asian stability, and the US intervention will at least buy some time for policy-makers to address the situation. But, as Bob Rubin knows only too well, intervention will only work if it is followed by decisive policy changes in Japan.

The US believes the implementation of an emergency rescue package for the Japanese banking system is central to Asian economic recovery. This is far from clear - while a healthy banking system may be necessary for economic recovery to take place, it is almost certainly not sufficient. Japan's key problem is a shortage of aggregate demand, and the weakness of the banking sector is only one of many reasons why consumer and company demand has imploded.

For most of this decade, the sluggish growth in monetary aggregates has been triggered by an absence of money demand, stemming from a myriad of other causes outside the financial sector, not by a shortage of credit supply. Certainly, the weakness of the banking system has contributed to the dire state of the equity market and to the decline in consumer confidence. But even if a healthy banking system had been magically dropped into the Japanese economy in, say, 1992, GDP growth would have remained extremely subdued since then.

Only in recent months has the weakness of the financial sector taken on a more central role, now threatening to do active - and potentially fatal - damage to the rest of the economy. The banking failures of last autumn stunned the financial markets, with the collapse in market confidence leading to a tightening in effective monetary conditions which has destabilised the real economy.

This unintended shift in monetary conditions has had three key features. First, there has been a credit crunch in the money markets. Healthy banks have become increasingly reluctant to provide liquidity to weaker institutions, so funding costs in the Tokyo money markets ("Japan premia") have increased sharply.

Funding pressures meant that bank lending to companies in need was beginning to shrink as commercial banks were forced to cut their balance sheets. The Bank of Japan had no choice but to inject liquidity aggressively into the money markets. The resulting 30-40 per cent annual growth rates in the balance sheet of the central bank has tentatively brought the credit crunch under control, preventing renewed bank insolvencies in recent months.

But the injection of central bank liquidity into the commercial banking sector has not been passed on to the rest of the economy. In fact, the reverse has occurred. Banks are becoming increasingly risk-averse and have accumulated liquidity, while becoming much more circumspect about extending loans to small and medium-sized companies.

This is connected to the second cause of the unintended monetary squeeze. Alongside the credit crunch, a "capital crunch" has simultaneously occurred in the banking sector. A series of different events - the increase in capital adequacy ratios agreed at Basle, declining real estate values, the elimination of balance sheet reserves as the equity market has declined, and lately the weakness of the yen - have weakened the capital position of the banks, further eroding their ability to lend. Largely as a result of this, private sector money growth has slumped to all-time lows and companies are reporting that the availability of credit has become unprecedentedly tough.

The third element of the unintended monetary tightening has been a sharp increase in real interest rates, despite Herculean efforts by the central bank to achieve the opposite result. This has happened for two reasons - price inflation has turned negative and credit spreads have widened for small and medium-sized companies. For most companies, the real cost of borrowing has - perversely - ratcheted upwards.

The resulting monetary crunch in the Japanese economy could not have come at a worse time. Excess inventories are currently building at a record rate and companies are finding it increasingly difficult to finance this build-up of unwanted stock. The inevitable result will be a savage programme of inventory shedding, which may more than offset the benefits from the large fiscal easing planned for the next few months.

Ironically, an emergency programme activated now to address the strictures of the banking sector may actually make these immediate problems even worse. The closure of weak banks could potentially lead to the cancellation of crucial credit lines to those companies most at risk, thus increasing bankruptcy threats. Meanwhile, the closure and merger of troubled financial institutions is scarcely likely to stabilise the labour market or help restore consumer confidence.

The upshot is that even if the US now muscles the Japanese authorities into an impressive programme of financial sector restructuring, this has probably come too late to save the economy from a deep recession. A further easing in fiscal policy is urgently needed and this must be far larger, and more innovative, than anything the Japanese government has previously imagined.

Otherwise, last week's dramatic recovery in the value of the yen will prove to be nothing more than a dead cat bounce.