A V Rajwade: Japan's currency and economy

WORLD MONEY/ Improvements in economic conditions have strengthened the financial system

In recent times, one has witnessed some curious parallels between Japan and India: the domestic currency appreciating against the dollar despite massive intervention by the central bank; reserves amounting to something like 20 per cent of GDP calculated at the nominal exchange rate; one of the highest ever GDP growth rates in the third quarter of the fiscal year that just ended; and slow growth in bank credit.

To be sure, on the last two points there are some minor differences. In respect of Japan, the third-quarter growth rate was the highest for 13 years and in our case the highest in memory; again, Japanese bank credit has been falling for seven successive years "" it is, however, expected to show some expansion in the current fiscal year (incidentally, the Japanese fiscal year coincides with ours).

As for the yen's exchange rate against the dollar, it has recently decoupled from the euro and the pound "" it has appreciated in recent weeks even as the euro has fallen. And, the exchange rate is important to the recent improvement in the growth rate, which is export-led.

The driver, however, is not the US, but the giant neighbour across the Sea of Japan. Booming Chinese demand for Japanese goods is the prime mover of export growth.

In fact, Japanese exports to Asia have been much stronger than to the rest of the world; about half the Japanese exports are today destined for Asia as against just about a quarter to the US.

Japan's trade with China is another parallel to India's experience. First, there was the fear that cheap imports from China would flood the domestic economy; the actual experience of both Japan and India has been that exports to the booming Chinese market have led to a bilateral trade surplus.

In the case of Japan, the first surplus with China was recorded in February 2004. The overall current account surplus for the month was a little in excess of $ 20 billion, a jump of 46 per cent compared to February 2003. Chinese demand has helped absorb excess capacity in a number of industries and industrial investment has also jumped, adding to GDP growth.

Corporate profit margins in the current fiscal year are projected at 4.5 per cent, the highest since statistics on the point started being compiled in 1982. No wonder the Nikkei index has registered a 47 per cent increase in the fiscal year just ended. The applecart of export-led growth and corporate profitability could, of course, be upset by the exchange rate.

One result of the general improvement in economic conditions is the strengthening of the financial system. The life insurance sector has been helped by a change in regulations permitting insurance companies to reduce the returns guaranteed at the time of issuance of policies.

The insurance sector had huge liabilities arising from guaranteed returns of, say, 4 per cent a year when the bond yields have been just about 1 per cent for several years now. Perhaps the most dramatic improvement has been in the banking sector, even ahead of an increase in bank lending.

Bank stocks have gone up sharply (another parallel to India) on the back of a steep rise in profitability in the year just ended. The apparently-unending cycle of new non-performing assets cropping up even as provisions are made for past ones, seems to have at last come to an end. The end to falling prices is also improving corporate profitability.

Wholesale prices rose last month for the first time in four years "" and the yield on the benchmark 10-year bond has gone up from 1.2 per cent at the end of February to 1.55 recently. After huge public investment ($ 300 billion) in rescuing the ailing banking sector, the Japanese authorities are perhaps giving a sigh of relief.

To be sure, they have come in for more than their share of criticism with respect to two banks "" one nationalised last year, and the other sold in 2000.

As for the first one, Ashikaga Bank, the story is parallel to that of Resona Bank (see "Deflation jeopardises Japanese banks", World Money, July 21, 2003). Much of the capital consisted of the so-called "deferred tax assets", consisting of tax paid on income from written-off loans that can be adjusted against tax on future profits.

For deferred tax assets to be included in the capital, the requirement is that there be prospects of adequate profits to absorb the credits in the foreseeable future.

In the case of Ashikaga, last year the auditors felt that such was not the case and the authorities were forced to nationalise the bank.

The second case is likely to lead to a much bigger political controversy. It concerns the Shinsei Bank (the former Long Term Credit Bank). It was sold to a private equity group by the Japanese authorities in 2000 for $ 1.2 billion, after having spent ¥ 4 trillion (almost $ 40 billion) in recapitalising it.

Recently, the new management floated a third of its capital on the market and the price placed a $ 7 billion valuation on the bank as a whole. No wonder the transaction has been described as the most profitable private equity deal ever!

Post-floatation, the share price jumped another 60 per cent "" one individual investment banker, who was one of the managers of the investor group, alone pocketed a $ 1 billion profit on the transaction. No wonder the Japanese public and politicians are incensed.

Email: avrco@vsnl.com