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The New Japanese Government, Debt and a Way Ahead

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The new Japanese prime minister and his cabinet being sworn into office this week will inherit a mountain of public debt. Indeed, gross government debt is at 180% of GDP, the highest for an industrial country. In the past, debt-management in Japan was in its most elemental form. Collateral was king, and repayment, albeit with low interest rates, was perceived to be the sole way. Japan's post-war expertise in debt with collateral was shaken with the avalanche of non-performing debt that triggered mass hand-wringing, and years of "reform" that are still working their way through the system. The command-and-control system on debt, involving the bureaucracy and many inter-linked "keiretsu" banking institutions has been falling away. Mergers and acquisitions have been creating institutions with differing names, but with their cores intact and largely unchanged. Thus, apart from a handful of genuinely new or newly recreated institutions, there is little apparent change in the finance sector of Japan. Further, there are signs that the Japanese economy, the world's second largest, may be sliding into a recession with serious global ramifications. Rising commodity prices are hurting Japanese manufacturers, inflation is at a decade high, and incomes remain stagnant. With the country still struggling to recover from the economic malaise of the 1990s, Japan's leaders are seeking innovative solutions to these new economic and financial problems. And, with a shrinking population, there is concern in policy circles about the relative growth of China and India, with their massive population of younger consumers, that Japan may not be the big kid on the block for too much longer.

Amidst all the focus on its internal debt, largely forgotten has been Japan's long history of external lending on concessional terms, especially to promote Japanese exports. From the perspective of a borrowing country like India, large-scale borrowing from bilateral and multilateral entities has resulted in India having a massive external (and separately, internal) debt load thereby contributing to the fiscal deficit because of tremendous debt-servicing costs. India's external debt stands at $221 Billion. The debt outstanding from Japan to India, about $24 billion, may be weighing down the potential of Japan's collaboration with India. But that could be rapidly transformed into economic opportunity for both countries via external debt for equity swaps. Through this program, sovereign debt can be retired or extinguished in exchange for equity investments in Indian companies. Having initiated, facilitated and organized the world's first debt-for-health research swap when I was Director of the Harvard University Center for Population and Development's debt swaps project now 18 years ago, I can attest to the multiple benefits accruing from a well-managed debt-swap. But all swaps are not the same, and recent financial turmoil from a similar-sounding derivative has nothing to do with what is being highlighted here.

In fast-growing companies, the evidence exists that return on equity has been a multiple of return on debt. In such swap program, the Japanese and Indian governments would enable professional fund managers to take private placements of both the annual interest of about a billion dollars and the principal in growing Indian companies, over time. Parameters would be required for bilateral "fairness," investment criteria and timing. Later, at appropriate opportunities, that equity could be sold to private investors on the Indian stock exchanges, yielding for Japan and India, much greater return than can be expected solely from debt-servicing. A simple case in point is Stanford University's equity stake in Google Inc. (a software laboratory space-for-equity swap done in the budding days of the company!) that has yielded thousands of percent of return. Similarly, although not every company can be a Google, India too will benefit significantly in the equity sales and retire debt, and lower the fiscal deficit that is contributing to inflationary pressure. Indeed, equity could be sold to sovereign wealth funds, the largest pool of investable cash on the planet. India has a stellar record on timely repayment of external debt obligations, so it would not be approaching this from any position of weakness, just from the point of innovation and leadership in a finance space that has been so troubling.

Such a program is a feasible way to enhance the return on currently outstanding debt instruments, rather than always finding new tax or deficit financing sources for investment via stimulus packages and for the looming pension and social welfare needs that are leading to a number of Japanese prime ministers having to resign abruptly. Japan's GDP growth rate, with a declining population, has been relatively slow at about 2% whereas India's has been about 8%. India's population is already at 1.1 billion, with the age pyramid indicating a vibrant consumer population as compared to Japan's aging society of about 110 million. Of course, India is starting from a much lower GDP base, and just mathematically it takes a lot of GDP growth to achieve a high rate when you have a large GDP denominator. But India's economy is not projected to remain much smaller for too much longer. In addition, the rupee has been steadily appreciating.

Therefore, two types of investment growth in India are occurring as it was in Japan in the 1950s. Debt-equity swaps enable participation in both those growth pathways - capital appreciation via equity, and rise in value via currency (rupee) appreciation. And, this is an effective way for Japan to be able to participate in most sectors of India's growing economy without itself being drawn into intense local competition with US and European companies. Already, foreign investors have achieved spectacular returns by investing in Indian companies, the current global downturn notwithstanding. Should, as is likely, Japan-India external debt-for-equity swaps work well, it would take India-Japan cooperation to the next level, and provide a robust model to dozens of other nations struggling with external debt amidst budding economies that are full of promise.