Is the Japan Problem Real? How Problems in Japan's Financial Sector Could Affect Developing Regions

November 1996 The burst of the Japanese financial bubble in the early 1990s has increased the bad debts of Japan's financial institutions. Japan accounts for about 20 percent of foreign aid to developing countries and for 10 percent of their exports, so Japan's economic health is important. The authors analyze the situation, assess the bad debt stock, and simulate the likely effects of crises in Japan's financial sector. They conclude that: a) a crisis that would shake up the world financial market is unlikely but Japanese authorities may have to restructure severely affected institutions, which could increase fiscal spending or debt stock; b) even with a limited bank run, the household sector's lack of confidence would send the country into a recessionary spiral, requiring the monetary authority to intervene with short term liquidity supplies; c) a financial crisis would depress world trade, raise interest rates, and turn the terms of trade against developing regions that export primary commodities; d) many Asian exporters of low-cost manufactures to Japan may be relatively unaffected; e) the simulation does not detect contagious effects in the U.S. financial market; f) damage could be contained once the monetary authority steps in to supply short-tern liquidity; g) coping with such problems would leave the Japanese economy in a less favorable position for confronting their aging population problem and fiscal pressures may reduce Japanese aid to low income countries.