Commentary: Japan must plug financial cracks before the dike bursts

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Commentary: Japan must plug financial cracks before the dike bursts
By William Pesek Jr. Bloomberg News
WEDNESDAY, FEBRUARY 8, 2006
It's been dubbed the "Enron moment" for Japan, that seminal event suggesting that what investors knew about a company, and perhaps a broader business environment, was false.

Enron's demise in 2001 did just that in the United States. Japan's turn may have come in January, when prosecutors raided the offices of Livedoor in Tokyo.

Livedoor, founded by the anti-establishment entrepreneur Takafumi Horie, was Japan's highest-profile Internet company of late - the poster child of its New Economy. That was until Horie, 33 years old, was arrested on Jan. 23 on allegations of violating securities laws. Like Enron, Livedoor was accused of dressing up financial statements with off-balance-sheet transactions.

It's an open question whether there are other Livedoors out there. Most likely, there are more in a nation in which disclosure of off-balance-sheet activities - known as special purpose entities - is lacking, at best.

It's doubtful that Livedoor, if found guilty, would end up being the only practitioner of creative accounting in the country.

Either way, the Livedoor saga gets at a prickly, yet familiar question in Japan: Will cracks in the micro-economy undermine a recovery in the macro-economy?

There's little doubt that Japan is moving out of its 15-year funk. Banks are solvent again and companies are reorganizing amid rising competition from China.

The economy probably grew at an annual rate of almost 5 percent in the final three months of 2005. That's more than four times the pace of the United States' economy, where growth was an annual 1.1 percent. For the first time since 1997, the 11 regional economies in Japan are expanding simultaneously.

Yet hopes that Japan's gross domestic product will grow 4 percent or 5 percent a year are unrealistic. The country has a track record of shelving efforts to upgrade the economy when growth returns. And it's often forgotten that Japan's revival owes everything to China's boom and to restructuring in the private sector. To deepen the recovery, the government and regulators must implement policy changes.

The most immediate change is making sure the Tokyo Stock Exchange doesn't break down as it did in January for the second time in three months. It's one thing for stock markets in developing nations to fall prey to computer glitches. It's quite another thing for this to happen in Asia's biggest economy. What good is a recovery if your markets aren't ready to handle increased trading?

Another priority is reducing debt. "It's painfully clear that the longer Japan waits to address its fiscal deficit, the fewer plausible scenarios there will be to bring the debt-to-GDP ratio down - ever," said Carl Weinberg, chief economist at High Frequency Economics of Valhalla, New York.

Debt will become a bigger concern when the Bank of Japan stops holding short-term interest rates near zero. For all the hand-wringing about the U.S. budget deficit, it's just 2.4 percent of the gross domestic product, while Japan's is 6.9 percent. As Japanese rates rise, so will the government's financing burden. And higher bond yields could slow the economy.

There's also the issue of reversing the decline of Japan's birthrate. Last year, the number of deaths exceeded births for the first time since Japan began compiling such data in 1899. The question is how many Japanese will be around 50 years from now to pay off a debt-to-GDP ratio pushing 151 percent?

Political pressures aren't likely to allow for increased immigration. Nor will Japan readily accept declining living standards. The most viable option is encouraging women to have more babies. The birthrate now is 1.26 children per woman; a rate of 2.1 is needed to maintain the current population of 127 million.

The birthrate can only rise if companies, industries and households adopt supportive attitudes. And the government must take the lead to eradicate institutionalized sexism that still makes motherhood a career-ending proposition for too many women.

Jump-starting pension reform is also important. To bring the recovery to the next level, Japan needs to morph its aggressive savers into aggressive spenders. That means offering households more financial certainty for the future. Until Japanese are convinced that the national pension system won't crash before they reach retirement, the economy won't perform.

Finally, there's corporate governance, something Livedoor pushed to the front and center. If there are other Livedoors out there, then Japan may suffer a lack of investor confidence just as the United States did with the larger scandals at Enron and WorldCom.

Enron was the first major domino to fall. Then, in 2002, WorldCom brought things to another level, filing the biggest bankruptcy in U.S. history. Now Livedoor threatens to unleash a similar shake-out in Japan.

While Livedoor's market value reached $7 billion in December, Enron and WorldCom dwarfed the Japanese company on that basis. It's still an important question: Is what allegedly happened at Livedoor symptomatic of Japan's business dealings? If so, deficiencies in Japan's micro-economy will hold back the broader economy.

All this may seem frustratingly familiar to long-time Japan watchers. Officials in Tokyo are highly skilled at averting financial crises. Yet they often fail to fix financial cracks while the sun is shining. It's vital that Japan uses today's good times to make sure they last.