Japan's déjà vu

A sense of weariness and déjà vu surround the global financial crisis in Japan. Two decades ago, Japanese policymakers were perhaps too deliberate in recognizing and acting to address market warning signs. Exceptionally low interest rates available to borrowers in the 1980s, poor risk management and lax regulatory oversight fueled bubbles in domestic securities and real estate. These bubbles burst in 1990, plunging Japan into its "lost decade" -- 13 years of slow growth, bank failures, and a serious credit crunch -- from which the country was only beginning to emerge.

These were years of enormous pain. The Nikkei fell from a 1990 high of 38,915 to a 2003 low of 7,607. Japan's GDP grew at an anemic 1.4% rate over this 13 year span, contracting in 1998 and 1999. Many companies vanished. Japan lost more than 10 major banks to failures or forced mergers, leading to today's dominance by Japan's Big Three (Mizuho Financial Group Inc., Mitsubishi UFJ Financial Group Inc. and Sumitomo Mitsui Banking Corp.). The government was criticized for being slow to recognize the threat's magnitude, but finally injected a total of nearly $138 billion into the banking system in 1998, 1999, 2003 and 2004 in a bid to restore confidence.

Sound uncomfortably familiar?

Though the current crisis emanated from the West, Japan was hurt quickly. The damage is significant and worsening. The Japanese stock market lost 45% in 2008, a steeper drop than the Dow's 34% decline over the same period, and exceeding the lost decade's worst single year performance, a 38% drop in 1990. While total Japanese financial institution exposure to U.S. subprime losses has been relatively "modest," nearly $27 billion, these institutions have suffered additional large knock-on losses from the fall in the stock market. Under the Japanese keiretsu system, banks retain significant cross-shareholdings in other listed corporations, and the value of these holdings has plunged. According to a 2008 report by Daiwa Institute of Research, banks in 2007 held 3.21% of total Japanese market capitalization. Their investments in Morgan Stanley and Merrill Lynch & Co. have taken hits, and Nomura Holdings Inc. recently declared nearly $5.5 billion in losses for the first nine months of its fiscal year, with write-offs from its acquisition of some Lehman Brothers Holdings Inc. assets contributing significantly.

Several Japanese banks have had to raise new capital from the markets: Since the Lehman bankruptcy, five major banks have obtained additional equity financing totaling more than $22 billion; another recently announced plans to raise $22 billion. The next key date for Japanese banks is their March 31 fiscal year-end, when capital losses will be measured. Accrued losses, the impending year-end and the potential for further stock market drop-related losses have made for cautious lenders, generating a new credit crunch.

Recent news illustrates the magnitude of the shock on Japanese manufacturing. Collapsing demand in the West and a suddenly rising yen have contributed to a 35% decline in December's export figures against those a year before, and industrial production has fallen nearly 10%. The yen has appreciated by 27.1% against the Euro and 18.2% against the dollar in just four months. Several large Japanese multinationals -- global conglomerates with large U.S. and euro-zone operations -- slashed guidance for the fiscal year end, largely in the auto and electronics sectors. Sony Corp. expects to lose $1.65 billion for the year and has begun cutting 16,000 jobs; Hitachi Ltd. expects a $7.8 billion loss and will cut 7,000 jobs; NEC Corp. forecasts a $3.26 billion loss and will eliminate 20,000 jobs; Toyota Motor Corp. projects an 18% decline in sales and analysts project a massive net operating loss; and the Nikkei reported Panasonic Corp. expects to suffer a $3.3 billion loss.

Further, bankruptcy looms. Japan's 2008 corporate bankruptcies exceeded 2007's total by more than 15%, and included a record 34 listed companies. Twenty-five were in real estate, felled by a local market bubble that burst -- another déjà vu. Cutbacks and losses will undoubtedly spur this trend.

Japan's populace also feels the pain. Where many expected the crisis' impact to be confined to white-collar jobs, massive layoffs have had a real, dramatic effect on workers. Empty taxis troll for customers; once-bustling restaurants and bars are vacant. Worse, haken mura -- tent villages -- were built in Tokyo to house hundreds of newly unemployed homeless, displaced from employer-funded housing and without other means of shelter. Village residents and labor unions have held demonstrations before the Diet building to appeal for aid. The local press says that layoffs targeted the socially vulnerable, and the media regularly airs frustrated demands for government action. Despite his promises that Japan will be first to emerge from the global recession, Prime Minister Taro Aso faces approval ratings below 20% and increasing calls for an election to put him and his Liberal Democratic Party out of office.

Heizo Takenaka, a professor at Keio University and the architect of Japan's Takenaka Plan, which helped Japan to emerge from the lost decade's bad-loan crisis, gave the Nikkei three lessons-learned for policymakers in times of financial crisis: (i) failure to act quickly can exacerbate a crisis; (ii) capital infusions must be accompanied by rigorous diligence of institutions receiving public funds; and (iii) politics cannot be permitted to overshadow or forestall economically sound crisis response. Takenaka believes this crisis is not a time for "weak leaders," noting low and falling domestic stock valuations may indicate the financial community's lack of confidence in the ability of Japanese policymakers to manage the situation. Says Takaneka: "Strong political leadership is essential. Only a government that has the courage to implement sensible policies can overcome such a confidence crisis."

The need for decisive action has been clear, but the response from Japanese policymakers is perceived as slow and somewhat piecemeal. The government announced modest steps last fall to support social welfare, community development and small and midsized enterprises. New measures were unveiled in a $480 billion spending package in December. All told, the initiative amounts to $833 billion. The December package includes $111 billion of fiscal stimulus (including spending to support employment, reduce taxes, provide social benefits and prop up the markets and smaller enterprises) and $366 billion to stabilize financial markets and provide for corporate financings including investments in financial institutions and loans to larger businesses. The underlying budget was approved Jan. 27.

The Bank of Japan recently announced a $33 billion program to buy corporate commercial paper and short-term corporate obligations from banks. The measure intends for banks to proactively use proceeds to make loans.

It is hard to discern a clear strategy within this agglomeration of measures. Rather, the package appears to provide the government the maximum level of discretion to attack the problem as it sees fit. The same observation perhaps could be made of recent U.S. legislation, suggesting no government has a clear grasp of how to resolve the crisis.

Until the recent wave of disastrous corporate financial results, many held that the Japanese corporate community was fundamentally sound and likely to weather the crisis with less damage than the West. Balance sheets and cash positions were strong, and the financial system wasn't overburdened by distressed assets. The appreciation of the yen and falling prices abroad gave Nomura and others reason to anticipate a renewed wave of outbound investment. Indeed, such expansion, begun in early 2008, was well under way until Lehman Brothers failed.

Recent crippling losses have changed things. It now appears it will take much more time for most big Japanese multinationals to work through their troubles and rebuild financial strength, which will likely mean a delay in the expected outbound wave of deals -- not good news for the U.S. deal market.

Has this shaken Japanese faith in the leadership of its primary ally and its free market business model? No Japanese leader at Davos blamed the crisis on "inappropriate macroeconomic policies of some economies and their unsustainable model of development characterized by prolonged low savings and high consumption; excessive expansion of financial institutions in blind pursuit of profit," as did Chinese Premier Wen Jiabao. It is hard to find even a muted public criticism of the U.S. by Japanese opinion leaders. But they must think the U.S. has lost some standing?

Policymakers and economists in all markets debate the nature and timing of appropriate state intervention. Nowhere is the subject more pressing than in Japan, where nearly 20 years after losing a generation of economic progress, Tokyo again faces circumstances demanding decisive, thoughtful action. Stakes are high: Government officials sit in the eye of a converging storm of social unrest, political uncertainty and deteriorating national enterprises. Japan has long been the embodiment of the perils of hesitancy in the face of crisis. Aso has declared Japan's intent to play a large role on the global financial stage. Japanese in boardrooms, on trading floors and huddled in makeshift tents await word on the role the state will play addressing risks at home.

Howard Chao heads O'Melveny & Myers LLP's Asia practice. Mangyo Kinoshita is counsel in the firm's Tokyo office and a member of its M&A practice group. Hideaki Kikukawa and Kensuke Yamazaki provided research assistance for this article.