NEW YORK (CNN/Money) - In a surprise move that may have global implications, Japan's central bank said Wednesday it will buy stocks directly from banks in a bid to shore up Japan's ailing financial system.
The late-day move gave a boost to the Tokyo stock market, where the Nikkei average bounced from a 3 percent loss to close down about 0.7 percent. But at the same time, it left many market watchers deeply disturbed. Although it is an open secret that the Japanese government has sometimes moved to prop up stocks through pension-fund buying, buying shares openly is unprecedented.
"This kind of intervention can work in the short term," said SoGen Funds manager Jean-Marie Eveillard. "But from a long term point of view it has terrible implications: Investors understand that the market is artificial, and accordingly they pull back."
But clearly the Bank of Japan must do something to try and turn the Japanese economy around, and so far traditional methods have failed. If the BOJ's gambit works, it could be hugely supportive for markets and businesses not just in Japan, but also in the United States.
As the U.S. economy has weakened, frustration over the burden Japan's decade of poor economic performance has placed on the world economy has mounted.
In Tokyo last week, Glenn Hubbard, the chairman of President Bush's Council of Economic Advisers, said the BOJ must take more action to fight the deflationary forces crippling the Japanese economy, the world's second-largest.
What Hubbard said was significant, according to Adam Posen, senior fellow at the Institute for International Economics in Washington, because it reverses the current White House's hands-off approach on the Japanese economy.
"It was a big indication of how seriously [the administration] is taking the situation," said Posen.
With the Nikkei recently falling to its lowest levels in nearly 19 years, fears that the world's second-biggest economy could fall from stagnation into crisis have picked up.
The financial turmoil that would result would damage markets the world over, and companies doing business with Japan would suffer. The yen would also suffer, driving down the cost of Japanese goods and hurting U.S. exporters. Finally, Japan is a huge holder of U.S. Treasurys, and there is a chronic worry that the longer the Japanese economy suffers, the higher the chances that those Treasurys get cashed in. That would lift interest rates here, hindering economic growth.
Much of what is wrong with Japan's economy stems from its weakened financial system, and it is this that the BOJ's plan attempts to address. Japanese banks have been stymied by two problems over the past decade. First, they have an estimated $430 billion of bad loans, extended during the Japanese investment bubble that ended in 1990, on their books. Second, they also bought stock in companies they do business with -- a traditional Japanese practice used to cement relationships -- during the bubble.
With the Nikkei down 75 percent from the peak it hit in December 1989, the shares the banks own are deep under water. But the banks have been loath to do what they should have done long ago -- sell the shares. To begin with, selling would mean realizing losses that in many cases haven't shown up on their books yet. On top of that, banks worry that by selling the shares they'd only drive down the market further, worsening their overall losses.
The BOJ's move is meant to clear up the problem of the bank's problem portfolios, which in turn could put banks in a better position to deal with their problem loans. The plan also is meant to allay the fear that falling share prices could put some banks below minimum capital requirements -- which could put them in the same fix as George Bailey before Mr. Potter got foiled.
The BOJ plan represents the kind of market meddling that investors hate to see, but, argues Brown Brothers Harriman global fixed-income portfolio manager Richard Koss, in this case desperate measures are called for. "The Bank of Japan is in a situation where it has to do everything they tell you not to do in central bank school," he said. "It needs to liquify the system, and get Japan out of a deflationary trap. It's painstakingly begun to do that."
Still, the BOJ has only lightly sketched out its plan, and its chances of success are very much up in the air. Banks will still have to realize painful losses on the stocks, assuming that the BOJ will be paying market prices. They may need some other form of government "encouragement" to get them to sell. Moreover, the BOJ said nothing about exactly how much money it would commit toward its stock buying operation.
Absent further details, what the plan may amount to is an attempt by the BOJ to get the market through a difficult patch. There's a recent tradition of the Tokyo market getting spooked each September as rumors circulated that banks would unload shares at the end of the month, when the Japanese fiscal half-year ends. (The same thing occurs in March, when the fiscal year ends.) Knowing the BOJ is willing buy any shares the banks might shed is enough to calm a jittery market.
But if the BOJ's plan is just showmanship, it's not going to help fix Japan's broken economy.