Tick, Tick, Tick: How Has Japan Fallen From Grace?

By Rohit Gupta

Originally published in National Accountant (Australia), June/July 2003, Smart Investor (Singapore), Mar 2003, and The News (Thailand), Mar 2003

In the late 1980s Japan, if not set to conquer the world, was certainly set to buy it! Japan Inc. invested $650 billion abroad, nearly half of it in the US, buying such icons as the Rockefeller Centre, Columbia Studios and the Pebble Beach golf course. However, since the burst of the asset bubble in the early 1990s the annual growth rate in Japan has averaged less than one percent, the deepest slump in any developed economy since the Great Depression.

The list of ailments includes the following:

• The Nikkei 225 is on the verge of a 20-year low, down 75 percent from a peak of 38,900 to below 9000 — levels last seen in 1982, when Michael Jackson's Thriller ruled the pop charts. The Nikkei is below the Dow for the first time since 1957, in contrast to the 1980s when it had briefly stood at 14 times the Dow.

• Land prices have declined for 11 years in a row and are now down to one-fifth of their late-1980s peak. During the 1980s the theoretical value of Tokyo's Imperial Palace grounds exceeded that of the whole of California.

• Unemployment stands at 5.3 percent, just below the post-war peak of 5.6 percent.

• Interest rates are down to almost zero.

• Enormous fiscal injections have resulted in the Government budget moving from a surplus of two percent of GDP in 1990 to a deficit of eight percent of GDP and Government debt of 140 percent of GDP (versus 60 percent in the US).

• Sovereign credit risk rating of Aa3 with a negative outlook — the same rating as Poland and South Africa.

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The country now faces the twin risks of deflation and economic contraction — a vicious circle. Prices are falling due to tepid consumption; companies produce less and sell more cheaply, causing them to cut back on staff and capacity, so people spend even less as they face unemployment uncertainties. The result is that companies carry large inventories and losses, chalking up more bad debts. The bad debt problem holds banks back from lending to new business — worse, even healthy SMEs are being denied new finance.

Crisis, What Crisis?

What about the theory that Japan is so rich it can buy its way out of a financial collapse? After all, the huge debt overhang is a case of Japan owning itself — this is not Argentina or Russia or Thailand.

No, it's not. It is potentially something far worse.

Japan has savings of $11 trillion. But total on- and off-balance-sheet claims (household, corporate and government) are estimated at about $30 trillion — six times Japan's $5 trillion GDP. In comparison, US total private and public debt is $19 trillion, or two times GDP. These ratios worsen month by month, with deflation running at four percent p.a.

At the same time, Japan is also the world's largest creditor, with $3 trillion in overseas assets — much of it liquid, in US Treasury Bills and bank loans to Europe. If Japanese banks were panicked into calling in overseas loans, an economic contraction would sweep the globe. Consider what happened on a far smaller scale in 1997: within three months of the collapse of Hokkaido Bank (assets of $80 billion), Japanese financial institutions pulled $118 billion out of the global economy, mostly from Asia — catapulting Thailand's problem into a regional crisis and bankrupting South Korea, the world's 10th largest economy.

London's Independent Strategy says: "There is no record of any government ever being able to repay debts equal to several times the annual output of its country in real money. Japan will be no exception."

A Two-Legged Beast

You can't put the economy on a stable footing without fixing the banks; similarly, you can't fix the banks without reflating the economy. The banks' problems mirror the economy's problem: companies cannot make a profit, so there is no solution to the bad-debt problem without a solution to Japan's basic economic problems.

Banks eliminate bad debt year after year, but companies have been defaulting ever faster, leaving financial institutions with more debt than before. Since 1992, Japanese banks have taken $660 billion of bad debt losses — yet in that time, remaining bad debt has increased from $103 billion to $340 billion. Even if banks' books were wiped clean tomorrow, new bad debts would continue piling up at $50–75 billion a year.

The Solution

Opinion on Japan is notably polarized, even among mainstream economists:

1. Lack of demand (liquidity trap). The conventional view is that the economy is floundering from a lack of domestic demand — people aren't spending enough, so Government should spend more to fill the gap. The prescribed cure: borrow, tax, or print enough money to stop deflation and make prices rise again.

2. Excess capacity (structural trap). This view argues Japan suffers from an outdated economic structure, too reliant on manufacturing and artificially propped up by near-zero interest rates. Overcapacity plagues industries like construction and retailing — many firms can never be profitable, but banks keep them alive, locking resources into low-return sectors. The fix: raise interest rates, let inefficient companies fail, and free up labour and capital for more productive enterprises.

3. A dual economy. A third view holds that today's woeful performance isn't a reversal of fortune so much as a revelation of the hollowness of Japan's 1980s success — even then, a small group of world-beating exporters coexisted with a large group of laggardly local firms hidden from view. Japan's leading automobile and electronics industries have since shifted most operations offshore, leaving behind the same troubled, uncompetitive companies that cannot survive without subsidies the country can no longer afford.

Bizarre as it may appear to outsiders, Japanese policy has been driven by two objectives — financing industry and ensuring economic autonomy and political stability. And it worked: four decades after the war left Japan in ruins, the country boasted the most formidable industrial machine, and a constant flow of subsidies to powerful political groups — farmers, small shop owners, construction companies — has bought 50 years of political peace.

The Way Forward

There is no single solution to Japan's ills. A depreciating yen, monetary expansion by the BOJ, fiscal reform, nationalization of the banks, privatisation, deregulation, or mass bankruptcies of "zombie" companies — none of these alone will bring Japan's economy leaping back to productive life. The Government needs to do all of these, over a period of years, and all of it will be painful.

Analysis by McKinsey Global Institute suggests that if impediments to competition are removed, productivity could grow by as much as 4.7 percent p.a. over the next 10 years — and even with the workforce declining 0.5 percent due to Japan's aging population, GDP per capita could still increase by a robust four percent p.a.

Rohit Gupta was Vice President at Citibank (Singapore) at the time of writing.

Originally published in National Accountant (Australia), June/July 2003.

See the original article on my Press & Media page →