MW-07 -- Why the Industrial Revitalization Agency Will Fail

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
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Issue No. 7
Wednesday, November 27, 2002
Tokyo

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Viewpoint: Why the Industrial Revitalization Agency Will Fail

The Bottom Line:

o Both the government and the banks are too sanguine about the
warning signals being broadcast by the stock market. The bank
stock sell-off is attributable to both: a) the absence of any
meaningful action by bank management to dispel the tsunami of
rumors and speculation roiling the stock market as managers
sit on their hands waiting for clearer policy signals from the
government; and b) the Koizumi Administration, which
instigated the speculation about possible bank
nationalization and announced a "Financial Revival Program" on
October 30, but have not been forthcoming with any concrete
policy measures to dispel investor concerns.

o On the other hand, the planned industrial revitalization
agency (IRA) would ostensibly be purchasing nonperforming
loans (NPLs) from banks other than the main bank, which
implies that the main banks would still be saddled with the
NPLs to their main debtors. It also implies that the main bank
would still have a more than equal voice in the fate of their
troubled borrowers, which in turn would inhibit the activities
of the IRA.

o Moreover, a key consideration for the success of the IRA is
political independence, and it has already failed this test
with the appointment of Sadakazu Tanigaki, an LDP politician
with a doubtful track record in reform and a penchant for
political compromise. Given both the track record of the new
institutions the Japanese government has heretofore
established to cope with the Heisei Malaise and the experience
in other countries where asset management organizations have
done poorly in corporate restructuring, the IRA will do little
to allay current investor concerns.

o The one flash of hope is that the Koizumi Administration
stumbles toward a "good account," "bad account" solution that
was used immediately after Japan's defeat in World War II to
clear the decks of NPLs by having all the players --
companies, financial institutions, shareholders, corporate
depositors and the government -- share the burden. However,
neither Heizo Takenaka nor Junichiro Koizumi are a Douglas
MacArthur, who had the luxury of a totalitarian occupation
regime to impose such a solution.

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TOO MANY UNCERTAINTIES
Both the government and the banks are too sanguine about the warning
signals being broadcast by the stock market. The bank stock sell-off
is attributable to both: a) the absence of any meaningful action by
bank management to dispel the tsunami of rumors and speculation
roiling the stock market as managers sit on their hands waiting for
clearer policy signals from the government; and b) the Koizumi
Administration, which instigated the speculation about possible bank
nationalization and announced a "Financial Revival Program" on October
30, but have not been forthcoming with any concrete policy measures to
dispel investor concerns. Bank stocks have been plunging, in some
cases to levels below 100 yen per share when converted to a 50 yen par
value -・a price level that usually puts a company on the short list
of bankruptcy candidates.

The media and market participants are openly speculating about the
inevitable "nationalization" of one or more of Japan's major bank
groups, and the next couple of weeks could be crucial with regards to
whether the alarming plunge in bank stocks can be reversed. Both the
banks and the government have a serious credibility problem, and if
they both continue to cope as they have heretofore, there is a growing
probability that a meeting of the Financial Emergency Response
Committee will need to be held. The Financial Emergency Response
Committee, of course, is where the prime minister could declare a bona
fide "financial emergency."

Actually, the "work schedule" and "action plan" for the Financial
Revival Program was supposed to have been released by now, but intense
political infighting has delayed its release so that plans for an
industrial revitalization agency could be put together. Opposition
within and without the LDP, the media and even in the foreign
investment banks pushed the Koizumi Administration to concurrently
create an agency that would be the platform for a major restructuring,
ostensibly on the arguments that: a) behind each NPL on the banks'
books is a troubled company; and b) an accelerated liquidation of NPLs
would only exacerbate already bad deflation, cause bankruptcies and
unemployment to soar and plunge Japan's economy into a deep recession.
The big bank groups in particular pulled every string they had to
prevent Takenaka from implementing the more stringent proposals of the
original Financial Revival Plan. In a meeting with the major banks,
the president of Mizuho Holdings asked, "Don't you mind letting
170,000 small corporations go bankrupt?" The implication of course was
that by forcing a major bank like Mizuho to raise its regulatory
capital by JPY2 trillion or to shrink its assets (i.e., loan book) by
JPY30 trillion, Takenaka would be sealing the doom of legions of
small- and medium-sized firms, which provide some 70 percent of the
employment in Japan and are traditionally a touchy subject within
the LDP.

ENTER THE INDUSTRIAL REVITALIZATION AGENCY
The Koizumi Administration's political compromise was to tie the
Financial Revival Plan to a new industrial revitalization agency that
would be tasked with attempting to revive borrower companies cut off
by the banks. The agency ostensibly would be funded by investment from
the Deposit Insurance Corporation (taxpayer funds and borrowings from
the banks themselves), the Development Bank of Japan (taxpayer funds,
pension funds and postal savings), the Japan Finance Corporation for
Small Business (taxpayer funds), Shoko Chukin Bank (an 80 percent
government-owned financial institution for small- and medium-sized
firms) and private financial institutions. In addition, loans from
private financial institutions and the Shoko Chukin Bank would be
backed by government guarantees. Ostensibly, the corporate
revitalization division of the Resolution and Collection Corp. would
be rolled up into the IRA. On paper, problem solved. The IRA, to many
companies, would be god, deciding who is worth saving, and who is not.

While the first reaction by the "street" and the media was that the
Financial Revival Plan had been watered down, it still has enough
teeth in it to cause the banks to begin scrambling to accelerate NPL
disposal. For one, it clearly states that the government wants to
normalize the NPL problem by FY2004 by reducing the major banks' NPL
ratios by half. It also states that, in principle, discounted cash
flow (DCF) methods would be used to assess loans "needing special
attention," and that loan classifications will be harmonized among
creditors. (the Japan CPA Association already issued a Japanese GAAP
accounting guideline in April 1999 that recommended the employment of
DCF in assessing high-risk loans, but the banks have ignored these
guidelines). Finally, it promised a "rigorous" examination of
restructuring plans and collateral assessment, and another round of
Financial Services Agency (FSA) inspections by March 2003. With
Takenaka at the helm of the FSA, the meaning of "rigorous" is much
different than when the more compromising Yanagisawa headed the
agency ・ particularly since the major banks gave Takenaka such a hard
time about his Financial Revival Plan in the first place.

The banks' insincere concern about small- and medium-sized companies
was a deliberate play to the banks' supporters in the LDP. The
composition of the banks' NPLs, however, paint a much different
picture. According to the Bank of Japan's analysis, no less than
47.5 percent of NPLs are in the real estate and construction sectors.
If wholesale/retail is included, the ratio soars to 62.1 percent.
Moreover, this combined ratio rose by 4.7 percentage points in the
last year. A prior FSA probe of loans to 149 borrowers to which the
banks had the most exposure revealed that 81 percent of the debt was
by firms in these sectors, and some 30 percent of this was to just 34
borrowers. Other estimates show that the 25 most-indebted companies
have some 43 trillion yen in interest-bearing debts. These companies
make up most of the infamous "dirty 30" that was long ago identified
by reform proponents.

In other words, Mizuho's warning that tough action by Takenaka would
jeopardize the viability of some 170,000 small- and medium-sized firms
was a trumped up threat that bore little relation to the real heart of
the banks' NPL problem, which is actually more like 30 to 50
companies.

"DIRTY 30" WOULD NOT BE ELIGIBLE FOR THE IRA
According to the Kahoko Shimpo (www.kahoku.co.jp):

O The time-frame for reconstruction plans will be 3-5 years for
large firms, and 5-10 years for small- and medium-sized firms.

O Main banks, auditors and a special FSA restructuring plan
audit team will determine who is eligible for revitalization.

O The benchmarks for revitalization include: a) interest-bearing
debt to cash flow ratios compared to the industry average;
b) ROE; c) value-added per employee.

O The IRA would ostensibly only purchase NPLs from banks other
than the borrower's main bank.

But by these measures, the whole real estate, wholesale/retail,
textile and construction sectors would not make the grade, as in
fiscal 2001 they had aggregate interest-bearing debt to cash flow
ratios of 24X, 18X, 20X and 18X, respectively.

Moreover, the IRA would ostensibly be purchasing NPLs from banks other
than the main bank, which implies that the main bank would still have
a more than equal voice in the fate of their troubled borrowers. While
the scope of the IRA's purchases of NPLs could be extended to NPLs
labeled "at risk of failure," the government had at first envisioned
it purchasing NPLs "requiring supervision" and/or "requiring
monitoring."

LESSONS FROM GENERAL MACARTHUR
A marrying of the Financial Revival Program and the industrial
revitalization agency would represent the first time that the
government has actually tried an integrated, comprehensive approach to
the problem, at least during the Heisei Malaise.

Actually, the "new accounts," "old accounts" concept goes back to
immediately after World War II, when Japan's failed war effort
produced a mountain of bad debts, with losses reaching 20 percent of
Japan's domestic GDP (a level comparable to today). To liquidate these
NPLs, corporate and financial institution balance sheets were divided
into "new accounts" and "old accounts." The NPLs were piled up into
the "old accounts," and losses were realized.

These losses were offset by capital decreases and debt forgiveness.
Losses by financial institutions were covered by shareholder's equity
and a drawing down of bank deposits of large corporations. In other
words, everyone bore the burden, with the difference being made up by
the government.

If this is what the Koizumi Administration is stumbling toward, we
just may see some real progress. Keep in mind, however, that the
country was at the time being run by General Douglas MacArthur,
commander of Allied Forces during the occupation of Japan.

During the Heisei Malaise, the Japanese government has produced a
litany of new institutions that fail to perform as envisioned. The
Resolution and Collection Corp. (RCC) has undergone two reiterations
since 1994 and still is ineffective in making a significant dent in
the NPL mountain, ostensibly because the price at which it purchases
bad credits from the banks (to date, an average 7.2 percent of the
book value of these credits) is too stringent for the banks. It has
recovered only 1.25 trillion yen of credits, mostly those left over
from the Housing Loan Administration Corp. and the old Resolution and
Collection Bank.

The Bank Shareholdings Repurchase Corp. has also failed to purchase
significant amounts of stock held by the banks because the banks have
to pay into the corporation to account for future losses when the
stocks are resold.

One would assume that the primary job of the Deposit Insurance
Corporation (DIC) is to insure the safety of depositor funds up to a
certain limit. However, as defined in Article 1 of the Deposit
Insurance Law, its charter includes financial assistance for failed
financial institutions. As Japan's financial crisis has deepened, it
has become a vehicle for propping up the banks with gobs and oodles of
taxpayer money, and ironically, funds provided by the banks
themselves. The DIC has provided 8.3 trillion yen to the nation's
banks through the purchase of preferred stocks, subordinated bonds,
and loans. Moreover, it has provided monetary grants and asset
purchases of 22.9 trillion yen to some 163 failed financial
institutions since fiscal 1996, the vast majority of which have been
regional banks and credit cooperatives.

THE EXPERIENCE OVERSEAS
The success of similar asset-management companies used in overseas
banking crises is not encouraging. In other countries, there have been
essentially two main types of asset-management companies used in
banking crises: those set up to expedite corporate restructuring and
those established for the rapid disposal of assets.

A study by the World Bank ("Use of Asset Management Companies in the
Resolution of Banking Crises," Daniel A. Klingebiel, Financial Sector
Strategy and Policy Department, World Bank) of seven cases suggests
that such companies and organizations tend to be ineffective at
corporate restructuring and are good at disposing of assets only when
they're used to meet fairly narrow objectives in the presence of
certain factors, such as:

a) An easily liquefiable asset (such as real estate),
b) Mostly professional management,
c) Political independence,
d) Adequate bankruptcy and foreclosure laws,
e) Appropriate funding,
f) Good information and management systems, and
g) Transparent operations and processes.

Where there were successes, (such as in Sweden) it was helped by the
fact that the assets acquired had mostly to do with real estate, not
manufacturing, which is harder to restructure. They also represented a
small fraction of the banking system's assets, which made it easier
for the asset-management company to remain independent of political
pressures and to sell assets back to the private sector.

The IRA has already failed the political independence test.
MoneyWatch's suspicions/concerns about political independence for the
IRA were confirmed when it was announced that Sadakazu Tanigaki had
been named to head the IRA. The hastily assembled group of IRA
administrators is the result of a compromise between hard-liners and
the governing LDP. An LDP member in good standing, Tanigaki has held a
number of key posts, including head of the Science and Technology
Agency and the National Public Safety Commission, but his track record
on reform is less than stellar. While running the Financial
Reconstruction Commission in 2000, he tried to assemble a taxpayer
bailout for Sogo department store, but an uproar in the Diet prevented
it. When push comes to shove, it is very likely that Tanigaki will
compromise rather than resist his LDP peers. Thus, initial indications
are that the new IRA will be a very political animal indeed. This is
definitely not a good sign.

AT LEAST 10 MORE DAYS OF POLICY VACUUM
The government has promised both an action plan for the Financial
Revival Program and the framework for the industrial revitalization
agency by the end of November. While the nationalization debate within
and without the government is making investors extremely nervous,
there are actually several nationalization scenarios. The sudden
introduction of "special support financial institutions" in the text
of the Financial Revival Plan has some speculating that a "special
crisis management bank" will be used in the nationalization of a bank.

In this case, the value of regular voting stocks held by shareholders
would basically become zero. The other nationalization scenario is
where the government would conduct capital infusions by converting
their preferred shares into regular voting shares, and end up in some
cases owning up to 50 percent of the bank. Here, the concern is that
shareholders would be required to assume responsibility through
capital reductions.

Given the extreme indebtedness of the relatively few companies that
account for the majority of the banks' NPLs, the industrial
revitalization agency, even if it performs as designed, will do little
to help them. Moreover, it won't help the main banks of these
borrowers if, as reported, it only buys loans from financial
institutions that are not the creditor's main bank. In the worst case,
it could end up as a supercharged agency for helping medium- to
small-sized businesses and a vehicle to prolong the life of
politically sensitive zombies like Daiei.

-- Darrel Whitten

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Written by Darrel Whitten info@asianbusinesswatch.com

Edited by J@pan Inc staff (editors@japaninc.com)

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