MW-19 -- THE RITES OF SPRING

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M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
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Issue No. 19
Tuesday, March 11, 2003
Tokyo

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Viewpoint: THE RITES OF SPRING

The Bottom Line:

o Here it is March again, and the Japanese stock market is again
being pushed to new lows. This has traditionally elicited
enough alarm in the LDP and cries of anguish from financial
institutions and corporations to prod the Japanese government
into the "rites of spring," where the ruling party lawmakers
flood the media and financial markets with new stimulus trial
balloons to see just what it will take to get a pulse from a
moribund stock market.

o After the end of the fiscal year, these proposals are often
delegated to working groups, with the majority of them never
seeing the light of day. Those that do survive get so watered
down by political negotiations and infighting amongst the
relevant ministries that they effectively become neutered
versions of the original. Thus, while there is always little
lasting market impact, that isn't the point. The point is to
get as good a print on the market indexes as possible on the
last day of the accounting year.

o Nukes on the loose in North Korea ・ especially attached to
long-range missiles -・is a scary thought, especially if you
live in South Korea or Japan. Most geopolitical and defense
analysts around the world list North Korea as the biggest
risk, with Iraq ranking No. 3 or lower. Moreover, Japan is
essentially defenseless against this threat, as a long-range
missile fired from North Korea could hit a major Japanese city
almost before Japan realized one had been fired. This threat
does not appear to be fully appreciated by Japan's stock
market, given the plethora of other problems behind the
"Heisei Bear Market."

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THE RITES OF SPRING
For 12 years, Japan's economy has been slowing sinking into a
structural malaise. Nine governments have come and gone, yet Japan's
situation continues to defy facile solutions. The barometers of what
ails Japan -- the stock market and bond yields -- continue to go their
separate ways. The market for Japanese government bonds (JGBs) is
still in the midst of what just might be the largest bull market ever
seen for Japanese bonds (with cash yields hitting 0.75 percent), while
the stock market retraced levels last hit in March 1983 when the
Nikkei index closed last week at 8,144.12. Late in the week,
saber-rattling by the US regarding Iraq, talk that North Korea would
be testing another missile in the near future, and the bank stock
sell-off as the major banks scrambled to procure 2 trillion yen in new
capital pushed the Nikkei below key technical support levels. The
technical breakdown in the Nikkei suggests another down leg is
imminent, one that could take stock prices lower by another 10 percent
in the foreseeable future. There's a good chance the 8,000 line will
eventually break, leaving no significant market support until 7,600,
or the May 1982 peak. We are thus on the cusp of another "March
crisis."

These market declines will create even more valuation losses for the
fiscal year ending March 31. Brokers are estimating that valuation
losses on stockholdings by the major banks are now two times as large
as they were at the end of the first half in September last year, at
some 5.84 trillion yen. Corporations with large holdings of bank
stocks are in the same boat. The life insurers held nearly 3 trillion
yen in bank stocks as of September 30, and current stock price levels
translate into unrealized losses on stockholdings for all but Nippon
Life, whose Topix-based break-even point is believed to be around 770
yen. Non-financial companies that had been expecting to report
after-tax profits will now be reporting more losses. Nippon Steel's
stock valuation losses have swollen to 42 billion yen, meaning
expected net income now looks like a 45 billion yen loss instead of a
forecast 25 billion yen gain -- 80 percent of which is represented by
valuation losses on bank stocks. But despite repeated warnings of
impending crisis, Japan's economic problems that just won't go away
are more like a dull, mind-numbing headache which arises from a
continuous string of "mini-crises" rather than a full-blown crash and
burn.

The threat of massive end-of-reporting-year valuation losses has
created one of the most obvious manifestations of the state of denial
in Japan in what has become the annual rites of spring. Whenever it
appears that the risk of a full-blown crash and burn is rising, ruling
party lawmakers circle the wagons and flood the media and financial
markets with new stimulus trial balloons to see just what it will take
to get a pulse from the moribund stock market. Often, these actions
are timed to get the best end-of-fiscal-year stock prices on March 31
in order to help Japanese companies and financial institutions avoid
reporting even larger valuation losses on equity securities held.
Usually, a Liberal Democratic Party (LDP) panel will bring up issues
that have been floating around for months or even years, dust them off
and leak them to the media as new "countermeasures." After the end of
the fiscal year, these proposals are often delegated to working groups
for deliberation, with the majority of them never seeing the light of
day. Those that do survive get so watered down by political
negotiations and infighting among the relevant ministries that they
effectively become neutered versions of the original. Last week, there
were trial balloons from the LDP about delaying the September 2004
deadline for banks to reduce holdings of stocks to below their stated
capital ratios, and a hint by Financial Services minister Heizo
Takenaka that the introduction of impairment accounting for fixed
assets, now scheduled for introduction from fiscal 2005, would be
delayed. Last year, it was a surprise move to squeeze the short
interest out of the market. What will it be this year?

Measures Taken
Here's a list of selected actions taken by Japanese authorities to
support banks and stocks since the late 1990s:

o Periodic "PKOs" where pension funds have been jawboned into
buying stocks by the government.
o Twice delaying the end of the blanket guarantee on bank
deposits.
o Twice pumping taxpayers' money into major banks.
o Allowing banks to calculate the value of shareholdings based
on the monthly average instead of the last day of the fiscal
year -- a global no-no.
o Announcement of a stock-purchasing organization.
o Cracking down on short-selling, unveiling new rules at end of
fiscal 2001.
o Allowing so-called "double-gearing," where the stakes insurers
and banks hold in each other bolster their reported capital.
o Share-buying by the Bank of Japan.
o Creating the Industrial Revitalization Corp. (IRC, or perhaps
more fittingly, the corporate zombie hospital) to purchase
subordinated nonperforming loans (NPLs) set to start around
May.

In addition, in past years, LDP officials have coerced public pension
funds into using postal savings and pension funds to support the
market. But these efforts to jawbone and, in some cases, strong-arm
stocks higher have had but a temporary effect on the steady slide in
stock prices. These actions, plus the ill-timed decision by the
Government Pension Investment Fund to increase its risk exposure to
domestic equities, have created cumulative losses of 3 trillion in the
GPIF.

Takenaka had his "fiscal responsibility" hat on last week when
addressing a Diet budget committee, as he tried to discourage calls
for more fiscal stimulus. On the surface, the Japanese government is
determined to realize a primary budget balance by 2010. But with
outstanding public debt now close to 700 trillion yen, Takenaka warned
that Japan now faces a possible "loan-shark hell," where the
government is forced to borrow more money just to pay the interest on
outstanding debt. Here's the scenario: Stock prices fall so far that
pension funds, banks and life insurers have to sell to stay solvent,
and companies lose billions in valuation losses. Funds continue to
flow into JGBs, giving great relief to the government, which, while
issuing record amounts of bonds at near-zero interest rates, still
enjoys a relative stable cost of servicing this debt because the
average interest rate on outstanding debt continues to decline.
Individual debt burdens increase with deflation and falling wages,
particularly on home loans. Eventually, the whole economy gets locked
into ultra-low interest rates to the point that any significant rise
in interest rates would itself precipitate a financial crisis. In
other words, any combination of policies to push the yen significantly
weaker and/or push interest rates higher by fostering inflationary
expectations actually could be the trigger for the financial crisis,
or full-scale debt liquidation.

Japan's "War Discount"
Nukes on the loose, especially attached to long-range missiles, in
North Korea is a scary thought. South Korean apologists claim that
North Korea is not a crazed rogue state but an "embattled regime
trying to reverse 50 years of isolation and failed domestic policies."
Rand Corporation analysts claim that North Korea's selective probes,
challenges and saber-rattling against South Korea and Japan are
tactical and essentially defensive in nature. This argument goes that,
even if it wanted to, North Korea doesn't have the overall capability
to inflict irreparable damage on South Korea. Its current
brinkmanship, according to former Clinton Pentagon officials, is
"purely rational for a nation with no assets being threatened by the
world's major power." North Korea supposedly renounced international
terrorism in 2000, has not been conclusively linked to a terrorist act
in nearly 15 years and "sells missiles only as an indispensable source
of income."

Right. Just like the drug dealer selling drugs in the schoolyard. Pity
him, because he only needed the money.

Pyongyang continues to up the ante, resuming its uranium enrichment
programs, restarting nuclear reactors, sending jet fighters into South
Korean airspace, trailing US planes in international air space and
test-firing engines for long-range Teaspoon missiles. Japan needs to
come up with some risk management fast, even if a diplomatic solution
is the hoped-for avenue to diffuse the North Korean threat. Japanese
defense minister Shigeru Ishiba said recently that Japan could launch
a military strike if it had firm evidence that North Korea was ready
to attack Japan with ballistic missiles. The fact, however, is that
Japan has no effective way of deflecting or destroying incoming
missiles once they are fired. Four Aegis-class cruisers are built to
intercept planes, not missiles. The maximum range for Japanese
missiles that could be used is 100 km, and Japanese aircraft would
need in-flight refueling from US planes to reach North Korea. Thus
Japan should worry not just about nuclear weapons that North Korea may
have or get in a few months, but also about medium-range missiles that
could carry conventional ordinates, or more nasty things like sarin
gas or anthrax.

Even before a diplomatic solution is found, Japan should be scrambling
to prepare for both nonmilitary and military sanctions. Japanese
visitors to the hermit kingdom are not allowed to forget Japan's past
tyranny. The US, along with Japan -- the largest food donors to North
Korea -- remain "the enemy." If North Korea was the poor little
misunderstood hermit kingdom the apologists claim, why has it secretly
continued a hidden uranium program, disguising it so well that US
intelligence officials are still not sure of its location? If full
production begins, North Korea could develop five or six plutonium
bombs from existing stocks of nuclear fuel and could begin developing
uranium-based weapons as early as 2004.

North Korea: Tactical Genius, Strategic Idiot?
The danger is that Pyongyang may misjudge the Perry Report and set too
high a price for stopping missile exports or nuclear development. The
Perry Report explicitly rejects paying such a price, because it would
just whet North Korean appetites and would be rejected by the US
Congress, many of whose members are already angered by North Korean
coercive diplomacy. In such circumstances, North Korea might be
tempted to launch another missile test in an effort to reinforce its
bargaining position. If it did, Congress would almost certainly demand
that sanctions be re-imposed and payments for fuel halted under the
nuclear agreement. North Korea might then say it was free to reprocess
its plutonium. North Korea has short-range variants of the Scud
missile that are well tested and have ranges of up to 500-600
kilometers for a payload of 500 kilograms. These missiles can reach
all of South Korea with nuclear, biological or chemical warheads, if
North Korea has developed such warheads for missile delivery.

The longest-range missile currently deployed by North Korea, according
to US scientists, is the Nodong missile, with an estimated range of
1,300 kilometers for a payload of about 700 kg. Such a range would
allow North Korea to target all of Japan. North Korea is believed to
have flight-tested the Nodong only once, in May 1993. The only test of
a longer-range missile occurred in August 1998, when the three-stage
Teapot Dong 1 (TD-1) missile was launched over Japan in an attempt to
place a small satellite in orbit. This effort was not successful due
to a failure of the missile's third stage. The test did demonstrate
for the first time North Korea's technical ability to launch missiles
with multiple stages, as well as its access to solid-fuel technology,
which was used in the third stage. However, the missile cannot be
considered operational without further testing.

Desperate Measures for Desperate Men
Even if North Korea's selective probes, challenges and saber-rattling
against South Korea and Japan are tactical and essentially defensive
in nature, desperation (such as effective economic sanctions) could
lead the North Korean regime to take such risks. Its Nodong and Teapot
Dong missiles could decimate Japanese cities before Japan knew they
were fired. Yes, it would be virtual suicide to initiate such
aggression, as the US and even China would undoubtedly move to
neutralize them. However, the response would be too late to avert a
first-strike disaster for South Korea and Japan. This risk has never
been clearly identified and quantified in the Japanese stock market,
even after 1998 when a Teapot Dong missile was fired over Japan. Amid
rising tensions between the US and North Korea, and refocused interest
on North Korea by Japanese media, if testing of ballistic missiles
were to resume, it would only add to the general pall that has hung
over financial markets since the US-threatened (and seemingly
imminent) military action against Iraq.

-- Darrel Whitten

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STAFF
Written by Darrel Whitten info@asianbusinesswatch.com

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

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