The Road to Recovery A View from Japan

• Author: Kenneth Kang/Murtaza Syed
• Position: Deputy Division Chief/Economist in the IMF's Asia and Pacific Department
• Pages: 24-25

Strategy for addressing both liquidity and solvency issues is needed

Page 24

Through most of the 1990s and early 2000s, Japan grappled with a fi nancial crisis whose origins were in some ways similar to the turmoil affl icting the United States today. The storyline from a decade and a half ago in the world's second largest economy evokes an unmistakable sense of déjà vu: the bursting of a property bubble fueled by excess liquidity, lax fi nancial regulation, and over-optimistic projections of asset prices precipitating a real estate and banking crisis.

Compared with the fallout and policy response over the past year, events were considerably more drawn out in Japan. Although the bursting of the bubble in Japan left the financial system saddled with large nonperforming loans (NPLS) and weakened the economy significantly, it took a while before the full scale of the problems became evident.

In 1997, six years into Japan's problems, mounting losses on failed real estate loans and falling share prices led to the interbank market freezing up and a wave of failures in the financial sector, featuring some of the country's largest banks. Faced with a financial system paralysis that threatened to undermine the entire economy, the Bank of Japan (BOJ) scrambled to unlock credit markets. The government also orchestrated large-scale interventions with public funds, struggling with a now-familiar dilemma: how to promote orderly deleveraging while minimizing costs to the taxpayer and limiting moral hazard. In Japan's case, the crisis was successfully resolved, but not before a "lost decade" of economic stagnation and a prolonged bout of deflation.

If anything, today's crisis appears more daunting, given its global scope, the complexity of the distressed instruments involved, and the much weaker international setting.

Highly leveraged financial institutions have been joined by highly indebted households this time around, compounding the weakness in domestic balance sheets. Nevertheless, both crises were grounded in broadly common ills, so that Japan's eventual success-and early difficulties-in overcoming its challenges are likely to provide useful insights.

Reflecting the breadth and gradual unfolding of the crisis, Japan's strategy evolved over a number of years, at first centering on innovative and exceptional measures by the BOJ to provide liquidity, including expanding the range of collateral, direct purchases of assets, and quantitative...