Bank of Japan Intervention Begs the Eight Trillion Yen Question

Buoyed by the unprecedented decision of the Bank of Japan to spend up to eight trillion yen (£42bn) supporting the country's ailing financial system, Japan's stock market rose 2% yesterday even as shares around the world fell.

The central bank stunned observers the previous day by announcing plans to buy up stock held by 10-20 commercial and regional banks over the next two years. That drastic proposal left many analysts wondering whether the stronger than expected remedy signalled a worse than feared diagnosis of Japan's financial woes.

"For a developed country's central bank to jump out and buy equities is completely bizarre," said Garry Evans, strategist at HSBC Securities. "Reading between the lines, the Bank of Japan sees some sort of crisis looming."

Japan's banking system has been on the verge of collapse for almost 10 years. A ¥1,400 trillion drop in asset values since the collapse of the bubble economy in 1989 has meant non-performing loans accumulated faster than the banks have been able to write them off. By the reckoning of the financial authorities, the total of those soured loans is now ¥52 trillion. Some private sector estimates say the figure is more than twice as high, which would make many banks insolvent.

So fragile is the system that the settlement of accounts in March and September has become a half-yearly trauma for banks worried that a late slide in stock prices could erode what is left of their capital bases.

The financial authorities have become old hands at patching up the system just in time to wobble through each potential crisis. The usual method has been for the government to talk up share prices with promises of new economic packages, tax breaks or restrictions on short-selling.

This month looked to be following the familiar pattern. Equity prices have dropped close to 19-year lows, the banks are nervous and the government has once again hinted that it will draw up a new anti-deflation package, which could be announced as early as today. A worrying situation, but certainly nothing unusual.

Then came the Bank of Japan's unexpected proposal to start buying corporate stock from banks - a radical move for a bank and a governor usually considered arch-conservatives.

The closest recent comparison occurred in Hong Kong at the height of the Asian financial crisis, when the territory suddenly started buying equities to prevent a meltdown in stock prices. That decision proved very effective and made a tidy profit for the taxpayers because the bank bought at the bottom of the market.

But the Bank of Japan is not, on the surface, at least, faced by anything like the same degree of peril. The economy is showing signs of a weak recovery, share prices have improved slightly in the past week and business confidence is picking up.