Tokyo Markets Have Low-Key Reaction to High Drama Over Rate Hike

High drama unfolded in Japan this week.

The maneuvering around the Bank of Japan's decision to raise rates for the first time in a decade will be recalled for years to come, even though the market's reaction was rather underwhelming. However, another drama unfolded that is likely to be less appreciated, although it could have much greater significance. It has to do with the general reform process in Japan and may have broader implications.

First, however, let's look at the rate hike. Bank Governor Masaru Hayami has been preparing the market for months for the eventuality of a hike in the overnight interest rate, which has stood near nothing -- around two basis points at an annualized rate -- since late February 1999. Like last month, there was an apparently orchestrated attempt by government officials to dissuade the bank from raising rates.

This time, however, the debate escalated. Members of the ruling Liberal Democrat Party threatened to amend the bank's charter and reduce its independence if it hiked rates. Wow! Can you imagine a U.S. congressperson threatening Alan Greenspan like that? Even former German Finance Minister Oskar Lafontaine or current French Finance Minister Laurent Fabius wouldn't challenge the European Central Bank, or their own national central banks, for that matter, so aggressively. Some members of parliament even indicated they would seek Hayami's resignation.

Hayami or one of his allies let it leak that a majority of the bank's board had come to favor a hike. Here's where the government blinked and lost its battle. Sensing perhaps that the bank would be damned if it raised rates and damned if it didn't, the prime minister and finance minister reportedly left town, sending an official with less gravitas to invoke an article in its charter that gives the government the right to request a month-long, nonbinding delay in any bank decision. The bank board voted, by what Hayami has indicated was a clear majority, to deny the government's request. The key overnight interest rate was raised 25 basis points.

The announcement took place after Japanese markets had closed for the week, but there's little reason to suspect a dramatic response anyway, as the markets appeared to have the interest-rate hike nearly fully discounted. The yen hardly moved and on Friday, the day of the rate decision, the yen posted its narrowest price range in nearly three weeks.

Although the small adjustment is unlikely to do much harm, it's unlikely to accomplish much good. At 0.25%, Japan's overnight money rate, comparable with the U.S. fed funds rate , is still extremely low by any standard. The fact that the overnight rate is still targeted below the discount rate indicates that conditions remain extraordinary.

Perhaps the government's biggest error was turning the decision into an issue of BOJ independence. On purely economic grounds, the bank's arguments seemed vulnerable. For example, its initial statement underscored its argument that deflationary forces are disappearing. It's difficult to follow this line of reasoning. Japan has three general inflation measures: GDP deflator, wholesale prices and consumer prices. The first was off 1.8% in first quarter, the second was 0.4% below last July's levels, and the third stood at 0.7% below last June's levels.

There was another drama playing out in Japan that could have far-reaching implications. Earlier this year, financially troubled Long-Term Credit Bank of Japan was sold to a group of foreign investors led by America's Ripplewood Holdings after the government had assumed many of the bank's bad loans and promised to absorb more if they lost over 20% of their value in the next two years. The bank's name was changed to Shinsei. (It should be noted in the interest of full disclosure that Mellon Bank has an equity investment in Shinsei through a Ripplewood-led consortium.)

Shinsei Bank helped precipitate last month's failure of Sogo, a large Japanese retailer, by refusing to go along with the debt-forgiveness proposals of the retailer's other creditor banks. Instead, Shinsei insisted that because the loans had lost more than 20% of their value, the debt had become the Japanese government's responsibility. At first, the government seemed prepared to bail out Sogo. After scrutinizing the situation, however, it backed down, allowing the retailer to fail -- the second-largest bankruptcy in Japanese history.

Initially, this scenario seemed to support an argument I have often made that the presence of foreign institutions in Japan, especially in the Fire -- finance, insurance and real estate -- industries would be integral in determining the course of reform. This week's drama, however, gives me pause.

Shinsei Bank's decision not to forgive Sogo's debt was widely criticized locally. There were even public demonstrations. Press reports over the past few days suggest that Shinsei Bank will now consider forgiving some loans extended to at least one troubled construction company, Hazama Corp. In an interview with the Yomiuri Shimbun newspaper, Shinsei Bank President Masamoto Yashiro indicated that the public's outrage over the Sogo case had been a factor in its decision to soften its stance of debt forgiveness.

Press reports suggest that Shinsei Bank may forgive 12 billion to 15 billion yen ($110 million to $138 million) of Hazama's debt. The remaining 28 billion to 31 billion yen of Shinsei's loans to Hazama will likely be jointly purchased by Dai-Ichi Kangyo Bank and Mitsubishi Trust and Banking Corp., which have already indicated a willingness to forgive Hazama for 90 billion yen ($328 million) worth of loans. The president of Shinsei Bank has reportedly indicated that the bank will seek a similar formula for Kumagai Gumi, another faltering construction company.

Clearly, forgiving the bad loans doesn't really address the problem but merely transfers it to the already fragile banking sector. The Japanese government has pumped in more than 7 trillion yen into the major banks directly to shore up their capital base, but they were still burdened with 17.8 trillion yen of problem loans at the end of the last fiscal year.

Ultimately, what may be involved here is what the political scientist Richard Sklar has called the "doctrine of domicile." It says essentially that subsidiaries of transnational corporations will seek to be upstanding citizens in whatever countries they operate. Although there are, of course, deviations and exceptions to the rule, in general, Sklar argues, companies will conform to the policies and customs of the host country. Shinsei Bank's owners must realize that the further worsening of its reputation in Japan would jeopardize its plans, which reportedly include, among other things, going public.