Japan and Korea: moral hazard lives on

News that both Korea and Japan are committing to more bailout packages, hasnÆt exactly been greeted with enthusiasm in the financial markets.

Long lives moral hazard. That's the perception one can't avoid when both Korea and Japan announce yet more bailout packages to prop up their local financial markets and economy. These efforts alone are unlikely to sustain a turnaround for the markets.

In the case of Korea, investors are losing patience in the reform process. As for Japan, the latest package raises more questions than answers. If both countries are still in denial, their stock and currency markets will likely remain weak until determined reform resolve emerges.

The common excuse

Korea's Ministry of Finance recently decided to put another W3 trillion ($2.4 billion) of the country's W65 trillion pension money into the ailing stock market, after an injection of W1.8 trillion last October. The justification sounds familiar: the market is not working properly due to global uncertainty and a falling yen, rather than domestic factors. Hence, the government is obliged to stabilize it.

But the latest rescue package seems to show desperation more than anything. Since the Asian crisis in 1997, Seoul has been trying hard to show that it is dedicated to true reform. But after a good start, it strayed from that path. Foreign investors have lost patience and fled in droves.

Korea's balance of payments data show that net portfolio investment inflow has dropped steadily from a peak of almost $4 billion a month in March 2000 to only $200 million recently. The risk of net outflow is rising. Domestic confidence is also falling, aggravating the selling pressure on Korean stocks, with the KOSPI losing half of its value over the past year.

Investors are right to be worried. Korean exports, a major economic growth driver, have fallen sharply since the last quarter last year. With domestic demand also weakening, economic restructuring will become more crucial to putting the country back on track after some initial pains. But Seoul seems to think that the recent stock market sell off was a result of speculative pressure and that its latest bailout plan would be able to ward it off!

The recent hiccups in corporate reform cannot dispel investors' concern that Seoul's "too-big-to-fail" policy is still well and alive. The government's requests of banks to sustain the chaebol, notably the Hyundai bailout in March, have compromised the health of the banking sector balance sheet with that of the corporate sector's. With reform stuck and the domestic financial system impaired, Korea's asset prices and the exchange rate will continue to experience downward pressure in the coming months.

The Japanese inertia

Japan has announced similar measures to prop up stock prices and encourage its banks to write off bad debts.

But Tokyo's plan looks like yet another futile exercise. The latest plan will give the biggest banks two years to write down 13 trillion yen ($106.33 billion) worth of bad loans. Banks are also required to cut their holdings of shares in other banks and companies to less than 100% of their capital base from the current 130%. This will involve an estimated 11 trillion yen worth of stock sales. To contain the downward pressure on stocks, the government will buy these shares and bundle them in a mutual fund for sale to the public later.

This important exercise is meant to be a quid pro quo: it will stabilize the Japanese banks' balance sheet by removing some of the volatile equity assets and replacing them with stable cash for the banks to use to write off bad loans and get tough on delinquent debtors. Unfortunately, such a plan raises more questions than answers.

First, where will the financing of this operation come from? If Tokyo taps into the Deposit Insurance Fund (DIF), as some suggest, it will only transfer risk from individual banks to the DIF. This will defeat the purpose of the DIF, which is to diffuse systemic risk. Second, what will prevent the banks from refusing to sell off their shareholding?

Third, who will manage the mutual funds? If it is going to be the government, then the operation will amount to nationalizing corporate assets, which will hardly inspire confidence. The government could also be stuck with the stocks if the public refuses to buy the mutual funds.

Japan's new package may help repair some of the woes in the banking sector balance sheet, and it may stop a stock market crash as banks restructure, but the operation does not change the bearish outlook in the economy and the yen over the next few months.

Korea and Japan need to be realistic about delivering structural reforms. Tinkering won't revive these sick markets because investors are losing patience. The recent stability of the yen exchange rate and the Japanese stock market are unlikely to be sustainable just yet, because the market's hope that the new Prime Minister Koizumi would be able to implement reform will likely be disappointed. This is because Koizumi san will be constrained by the conservative LDP Big Wigs in policy moves.

More importantly, we have not seen any of the companies' year-end financial reports yet, even though we are three weeks into the new fiscal year. These reports are most likely held back because of the LDP election (on 24 April). With a stock market level between 13,000 and 14,000, many financial institutions will likely report negative net worth. With the election now over, we should see some very negative earnings reports flow out soon.

The recent Tankan report also showed that most companies experienced worse-than-expected business conditions in the first quarter. These poor financial results will trigger fears about financial instability, again, in the system and push the Nikkei and yen back on their downtrends. The bottom line is that denial to reform would only keep markets sick until determined resolve emerges.

Chi Lo, regional head of research (NE Asia), Standard Chartered Bank Global Markets, Hong Kong.

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