Time For Hardball?

By Frank Gibney Jr. With Reporting by Tim Larimer/Tokyo and John F. Dickerson/Washington

When Junichiro Koizumi was invited to Camp David one day last June, the Japanese Prime Minister brought along his baseball glove, and the two ball-playing leaders of the world's most powerful economies had a mutually admiring game of catch by the pool. This week, as George W. Bush flies to Tokyo, the first stop in a one-week Asian tour that includes Beijing and Seoul, he has to be wondering if it's time to play hardball. Koizumi, despite his bold promises of reform when he took office 10 months ago, has accomplished little. Japan's decade-long economic slide is only picking up speed, and Bush Administration officials are concerned that further inaction in Tokyo may trigger an economic crisis with global reverberations.

Yes, we've heard tales of Japan's looming economic Armageddon before. But Washington is worried that the fallout from Japan's malaise could hamper a nascent U.S. recovery. Worse, there's no quick-fix option. The world's second-largest economy, Japan labors under the globe's highest level of public debt--140% of GDP. Across the nation, bankruptcies and unemployment are soaring. Practically everything else--stock values, consumer prices, confidence--is in free fall. The biggest crisis of all is the yen. With the Bank of Japan printing money to offset a liquidity crisis, the currency is sliding fast. It hit 134 to the dollar last week, a 15% decline since a year ago. The decline has prompted cries of foul from U.S. manufacturers over the competitive edge a weak currency gives Japanese products. But an equal concern is that an ever weaker yen will force devaluations throughout Asia, exacerbating trade tensions everywhere. Says Kenneth Courtis, Goldman Sachs Asia vice chairman: "It is now really important to get Japan back on track economically, because their problems are about to become ours."

When he arrives in Tokyo, Bush is unlikely to bash Koizumi in public. In keeping with his chummy, fraternal approach to fellow leaders, he is expected instead to toast Japan's help in the war on terror. But privately, Bush and his aides will try to persuade the Japanese to move quickly to avoid catastrophe. "We're not going to tell them how to reverse deflation," says a senior Treasury official. "But we'll certainly tell them they need to." The most important--and toughest--message will be that Koizumi must force Japan's insolvent banks to write off more non-performing loans before the nation's estimated $5 trillion mountain of public debt crushes the economy. Says a top Administration official: "There needs to be a sense of hurry-up."

Here's why: Although Bush won't see much of it, he is visiting a Japan that is being shaken to its roots by a decade of economic decline. The excess and hubris that once bought Rockefeller Center and Pebble Beach golf courses have been replaced by a growing malaise. Joblessness, bankruptcy, crime and suicide, once rare in Japan, are now just average headlines. In the recession-ravaged hot-springs resort town of Yufuin, citizens are hedging their futures by resorting to barter trade. Taxi rides, sake and even hospital bills can be paid for with a local scrip called the yufu. What backs it? Locals do odd jobs in return for yufu. "Our wealth is slipping away," moans Eisuke Sakakibara, a former Vice Minister in the once all-powerful Ministry of Finance.

This is the moment Japan watchers have long feared. Although the country is enduring its fourth recession since 1990, government largesse has prevented most citizens from feeling the pain. These days the debt crisis is squeezing almost everyone. In Tokyo's parks, permanent communities of homeless live under standard-issue blue tents. As for homeowners, real estate values have declined to 1982 levels, which means houses now are often worth less than their mortgages.

In a land that once guaranteed employment for life, no job is secure. In a recent Kyodo News survey, 70 of 100 Japanese business leaders said they plan to cut wages this year. Wide-eyed, unshaven men walk the subways begging for money. HELP ME, the signs around their necks read, RESTRUCTURED. That's Japan's euphemism for "fired." "We hope this is the bottom, but really, who knows?" sighs Masayuki Watanabe, 48, a meat wholesaler who closed his business three months ago when rumors of mad-cow disease chased away so many customers that it wasn't worth battling the steady increase in local taxes and other expenses.

The worse things get in Japan, the harder it is for a leader like Koizumi to get anything done. Although he cruised into office 10 months ago as the crusading anti-establishmentarian who would truly reform Japan, the dashing, outspoken Prime Minister with the finely tuned coif is in trouble. When he fired popular Foreign Minister Makiko Tanaka last month under pressure from anti-reform conservatives, his approval rating plunged 20% from last year's high of 80%. As confidence in his leadership sagged, the Nikkei stock average hit an 18-year low. "If he wouldn't support her, it's unlikely he'll make any other bold moves," concludes Masatoshi Sato, a senior strategist at Mitzuho Investors Securities in Tokyo.

Koizumi's challenge is to orchestrate another bailout of Japan's banks (the fifth since 1998) while forcing them to call in nonperforming loans. For four years, Washington has been urging Japan to resolve its banking woes by setting up a government bailout fund, as the U.S. did during its savings-and-loan crisis in the 1980s. But Japan's bank debacle dwarfs the S&L crisis in both size and political complexity. Real reform means unraveling decades of interlocking commitments blessed by a system that rewards support with favors.

It is not that Koizumi has done nothing. Analysts applaud his decision to guarantee only the first $75,000 in new time deposits, beginning April 1. The regulation is a warning that Tokyo cannot back the status quo forever. Still, as bankruptcies and layoffs increase, it's harder to introduce tough reform measures. "They are writing off loans, but the bad loans are growing faster," says C. Fred Bergsten, director of the Institute for International Economics in Washington. "That feeds a lack of confidence that brings more nonperforming loans--and that is a death spiral."

The ominous force currently ripping across Japan is the hollowing out of the nation's industry. When Aiwa came to the sleepy rice-farming town of Yahaba in 1968, a year before it became affiliated with Sony, six other companies followed and set up factories that brought new highways and bullet-train lines, civilization and riches. In January, Aiwa closed all its factories in Japan. Yahaba, a 2 1/2 hour bullet-train ride from Tokyo, is now just another township in despair. "People working at the Aiwa plant at first said [the slowdown] wouldn't affect them," says Genkichi Kon, who operated a snack shop at the factory. "Gradually, one by one, they were restructured, and in the end they gave up." Today, says Mayor Mitsuro Kawamura, most residents live off their savings.

Made in Japan? That may be a disappearing concept. These days most of Japan's manufacturing jobs are migrating to China, where quality is high and labor is cheap. Sony, for instance, makes all its first-generation PlayStations there--about 7 million of them last year--and has plans to move PS2 manufacturing to China as well. Nearly half of Toshiba's 45 plants are now in China, cranking out air conditioners, mobile phones, TVs and whatever the next hot product is likely to be. In an astonishing twist, Japanese engineers and factory managers are lining up at employment agencies in search of jobs in China. "They need experienced people," explains Tomoko Hata, a manager at PaHuma, a private employment agency that finds jobs in Asia for unemployed Japanese. "People here will take a job there even though the pay is half what they were making. They're desperate."

Japan's desperation is running deep enough now so that it is feeding on itself. One argument contends that a further devaluation of the yen would help cushion the country against the sharpest edges of Koizumi's structural reforms. On the other hand, tough-minded economists argue, the only way the country will reform is through a true crisis--the kind that gets unemployed workers to the barricades. Thus far, Japanese have been remarkably benign over their plight. But as joblessness and misery spread, there is bound to be a backlash.

Abroad, the overarching fear is that Japan's woes will ripple through the rest of the world, triggering a financial crisis of unprecedented proportions. When its economy dipped precipitately in 1997, Japan allowed the yen to devalue, eventually destabilizing currencies in the rest of Asia and touching off the December 1997 financial crisis. Leaders in Beijing and elsewhere are determined to avoid a similar contagion this time around.

Now comes a very delicate and dangerous dance. Officials in Tokyo last week hinted that a new bank bailout is around the corner. Meanwhile, though U.S. Treasury Secretary Paul O'Neill has warned against a weak yen, a quiet consensus is emerging that as long as the currency doesn't sink much below current levels, Washington will look the other way, despite calls from U.S. industry for pressure on Tokyo. That and Bush's plaudits for Koizumi ought to give the Japanese Prime Minister some leeway in his quest for reform. There is no longer much room for error.

--With reporting by Tim Larimer/Tokyo and John F. Dickerson/Washington