Flat on its Back.(Japanese economy)(Brief Article)

Something fundamental has changed in the way the world sees Japan. Last Friday, at the close of a nail-biting week in which Japanese stocks plunged to levels not seen in a generation, the Bank of Japan, led by outspoken governor Masaru Hayami, sounded an alarm about the nation's deteriorating financial health. In a strident report, the central bank pronounced Japan's bad-debt woes "more severe than ever." It forecast "substantial" new problem loans and warned that bank resources "have been exhausted." Echoing new Financial Services Agency head Heizo Takenaka, who in an Oct. 3 NEWSWEEK interview declared no Japanese bank "too big to fail," the BOJ pledged to work with the government "to prevent a financial crisis" and seek "steadfast resolution of the nonperforming-loan problem."

The report and the reaction to it spoke volumes. First, analysts did not have to bother reading between the lines of the BOJ pronouncement, which was unusually straightforward in a culture famed for indirectness. Second, the report did not land as a bombshell, because markets had been expecting it all week. In fact, the view of world markets on the prospect of major, disruptive reform in Japan has shifted 180 degrees since Prime Minister Junichiro Koizumi sacked his "gradualist" FSA chief on Sept. 30 in favor of Takenaka. Now everyone thinks it's coming. Foreign fund managers have yanked billions of dollars out of Japan, assuming that as Takenaka begins to whittle down Japan's mountain of bad loans, dozens of huge companies are going to go bankrupt.

Already the impact is being called the "Takenaka Shock." Some of Japan's most indebted big companies have seen the value of their stock fall to pocket change (following story), which also undercuts the wealth of banks, who are huge stockholders. "The [BOJ] report was in line with Takenaka's assertion that something big must happen," says Hironari Nozaki, senior analyst at HSBC Securities in Tokyo. "The markets are expecting a very severe policy against the banks."

Takenaka could unveil a batch of tougher regulatory policies as early as this week. Anticipating the shift, the BOJ's new report suggests stricter lending guidelines and proposes "an option to inject public funds into banks at risk." The new rules could lead to the nationalization of one or more megabanks as well. "Realistic measures to deal with credit and market risk may leave some major Japanese banks, which are already undercapitalized, practically insolvent," said the ratings agency Fitch last week. "Fitch is not predicting that all, or indeed any, will necessarily survive in their current form."

It's not only global market watchers who expect an early day of reckoning. Ordinary Japanese have lost faith in their banks, too. "Four years ago I withdrew all my savings," says Yukie Ushijima, a 36-year- old Tokyo housewife. "To me, they're companies whose job it is to funnel huge loans to big corporations. They are not good at their own business." Last week, at an invitation-only banking conference sponsored by Merrill Lynch in Tokyo, participants were perturbed when Mizuho president Terunobu Maeda read from a script nose down, with the top of his head facing the audience. "It was the worst ...