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| Explaining
Japan's Decline |
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Ever since
the asset bubble of the second half of the 1980s burst
in 1990, the Japanese economy has undergone a phase
of slow growth during which it has experienced four
recessions. A slight reversal of this trend is visible
in the provisional GDP figures released in June 2002,
which suggest that the Japanese economy grew by 2 per
cent during the first three months of this year. Coming
as it does after three consecutive quarters of contraction
the previous year, this evidence has rekindled hope
among some observers. They see the country as being
on the verge of a recovery from the fourth recession
that has afflicted it over the last twelve years. Others
are still pessimistic, however, for recent experience
has shown that similar cause for hope has been quickly
sunk by real developments.
If the trend rate of growth of GDP in Japan during the
period 1970-90 had been maintained, the country's GDP
would have been close to 50 per cent higher by the turn
of the century(Chart 1). This is significant to note,
for Japan's expansion at a breakneck pace since the
Second World War had in fact slowed after the oil shock
of 1973. As Chart 2 shows, as compared with annual rates
of growth of 9.4 and 8.3 per cent recorded during 1946-60
and 1960-75, the growth rate during 1970-90 was much
slower, at 4.1 per cent. It was from this slower rate,
which was creditable in itself when compared with that
in the US for example, that Japanese growth slumped
to 1.6 per cent during 1990-2001 and 1.2 per cent during
1995-2001.
Chart
1 >> Chart
2 >>
For a population that had almost forgotten the
suffering brought about by war,, thanks to the
country's rapid and prolonged post-war growth, the more
than decade-long collapse of the economy has indeed
been painful. Long accustomed to guaranteed and lifelong
employment, the Japanese have had to contend with a
rising unemployment rate which has nearly tripled during
this period, from just above 2 per cent in 1990 to close
to 6 per cent at present(Chart 3). Anecdotes about increasingly
insecure Japanese households cutting back on consumption
are now legion. Combined with a reduction in investment,
which triggered the downturn in the first place, this
has meant chronic deflation. Inflation rates that fell
from 3 to 0 per cent over the first half of the 1990s,
have been negative in most years since 1996(Chart 4).
Chart
3 >> Chart
4 >>
The principal puzzle that emerges from the prolonged
period of near-stagnation coupled with periodic recessions
is the failure of conventional counter-cyclical policies
to deliver a recovery. Over these twelve years, the
Japanese government has launched almost as many reflationary
initiatives, by increasing deficit spending and prodding
the central bank to cut interest rates and maintain
an easy money policy. The general government fiscal
balance, which showed a surplus of close to 2 per cent
of GDP in the early 1990s, has been in deficit since
1993. And the level of that fiscal deficit has risen
from just 2.5 per cent of GDP in 1993 to 5 per cent
in 1996 and 8.5 per cent in 2001(Chart 5). Yet the Japanese
economy has not been able to extricate itself from the
recessionary bias that has characterized it through
the 1990s.
Chart
5 >>
Mainstream explanations for this predicament, now internalized
by sections of Japan's government as well, revolve around
the country's failure to reform what is considered to
be a badly designed and unviable financial system propped
up by the state. However, as has been noted by some
observers, there are two problems with such explanations.
First, they leave unanswered the question as to why,
during the years of rapid post-war growth, the same
Japanese financial system was considered to have been
the engine that triggered and sustained that growth,
and therefore a 'model' that was worth emulating. Second,
they do not take into account the fact that the asset
price bubble and its collapse, which preceded the period
of deflationary bias, followed and in all probability
was triggered, inter alia, by a process of financial
liberalization.
The financial system that underlay Japan's post-war
growth was one in which government regulation and control
were the key. Interest rates on deposits and loans were
controlled, with the government using differential interest
rates as a mechanism to target the growth of specific
industries. Similarly, the design and pricing of insurance
products were state-guided, keeping larger objectives
in mind. The net result of such control was: either
(i) the government had to guarantee financial agents
a portfolio of activity that ensured that they earned
returns adequate for self-sufficiency and growth, or
(ii) the government had to channelize resources garnered
through taxation or other means to the financial system
to ensure the viability of individual financial agents.
The government's implicit or explicit guarantee of such
viability implied that it guaranteed depositors' savings
as well, making bank deposits and insurance products
rather than stock market investments the preferred form
in which household savings were held.
This system was permissive on some fronts and restrictive
on others. It required firms to approach banks that
were flush with funds drawn from household savings for
finance. In turn, banks were in a position to use the
resulting leverage to ensure that their funds were profitably
employed and properly managed. Inasmuch as the government
'permitted' the banks to play this role, Japan saw the
emergence of a main bank system where "a bank not
only provides loans to a firm, but also holds its stock.
Typically, a firm develops a relationship with a particular
bank and relies on its steady support in funding over
the long term. In return, the firm uses the bank for
major transactions from which the banks earns fees and
profits." Thus, unlike in the US, where the performance
of individual stocks and the threat of takeover when
stock prices fell or "the market for corporate
control" were the means to ensure effective deployment
and efficient utilization of capital, in Japan it was
the link between direct and indirect ownership and management
that formed the means to realizing these goals. And
the state was expected to monitor the monitors, who
were the main banks.
The restrictive role of the system was that it limited
the ability of banks to undertake investments in areas
that were not in keeping with development goals. Thus
investment in stocks or real estate purely with the
intention of making capital gains was foreclosed by
regulation. Banks, insurance firms and non-bank financial
institutions had their areas of operations defined for
them. Regulatory walls which prevented conflicts of
interests and speculative forays that could result in
financial crises and hamper the growth of the real economy
clearly demarcated these areas.
During the years of high growth this system served the
Japanese economy well. It allowed banks and firms to
take a long-term perspective in determining their borrowing
and lending strategies; it offered entrepreneurs the
advantage of deep pockets to compete with much larger
and more established firms in world markets; and it
allowed the government to 'intervene' in firm-level
decision-making without having to establish a plethora
of generalized controls, which are more difficult to
both design and implement. Above all, when the rate
of expansion of world markets slowed after the first
oil shock of 1993, and when Japan, which was highly
dependent on exports for its growth, was affected adversely
both by this and by the loss of competitiveness entailed
by an appreciating currency, the system allowed firms
to restructure their operations and enter new areas
so that profits in emerging areas could neutralize losses
in sunset industries.
Not surprisingly, Japan's economic system was bank debt-dependent
for financing investment and highly overgeared. Bank
debt accounted for 95 per cent of Japanese corporate
borrowing in the mid-1970s, as compared with a much
lower 67 per cent in the US. And while outstanding bank
loans amounted to 50 per cent of GDP in the US in the
1970s, from which level it gradually declined, the debt:GDP
ratio in Japan had touched 143 per cent in 1980 and
risen to 206 per cent by 1995. This wasnot a problem,
however, because the government worked to stabilize
the system. As one observer put it: "A combination
of international capital controls, willingness to use
monetary policy swiftly to defend the currency, and
the absence of other countries simultaneously following
the same development strategy shielded Japan from serious
problems."
In the event, Japan's economic success between 1950
and 1970 resulted in its system of regulation, which
was 'unusual' from an Anglo-Saxon point of view, and
was looked upon with awe and respect. Even now, but
for the fact that Japan is faring so poorly, the overwhelming
evidence of accounting fraud, conflicts of interests
and strategies to ensure stock price inflation emanating
from leading US firms such as Enron, Andersen, Merrill
Lynch, WorldComm and Xerox, makes the Japanese system
appear far more robust.
The question remains, however: why did the system fail
to serve Japan as well during the 1990s? The answer
lies in the fact that the system was changed and considerably
diluted as a result of American pressure during the
1980s. The pressure was applied in three stages. First,
international banks and financial institutions wanted
Japan to open up its financial sector and provide them
space in its financial system. Second, once these external
agents were permitted to enter the system, they wanted
a dilution of the special relationship that existed
between the government, the financial system and the
corporate world in Japan, since that implied the existence
of an internal barrier to their entry and expansion.
Third, these agents, along with some Japanese financial
institutions adversely affected by the deceleration
of growth in the system, wanted greater flexibility
in operations and the freedom to 'innovate' both in
terms of choice of investments and instruments of transaction.
The principal reason behind Japan succumbing to this
pressure was its dependence on world, especially US,
markets to sustain growth. When faced with US opposition
to protectionism against Japanese imports, Japanese
investors sought to Americanize themselves by acquiring
or establishing new production capacity in the US in
areas like automobiles. In return for the 'freedom'
to export to and invest in the US, Japan had to make
some concessions. But the demands made by the US proved
to be quite damaging. It began by requiring Japan
to reverse the depreciation of its currency. Following
the celebrated Plaza Accord, arrived at in New York
in September 1985, the Japanese yen, which had started
to appreciate against the US dollar in February 1985
from a 260 yen-to-the-dollar level, maintained its upward
trend to touch 123 yen-to-the-dollar in November 1988.
Though the following year saw movements that signalled
a strengthening of the dollar relative to the yen, the
downturn soon began, resulting in a collapse of the
dollar once again from an end-1989 value of 143.45 yen
to its April1995 level of below 80. Any economy faced
with such a huge appreciation of its currency was bound
to stall, more so an export-dependent one like the Japanese
one.
This trend, which resulted in the hollowing out of Japanese
industry, undermined the principal area of business
of the banks as well, which were faced with the prospect
that some of their past lending could turn non-performing.
It was in response to this that the Japanese banks joined
the chorus against financial controls, demanding that
they be permitted to diversify away from their traditional
areas. The government responded by effecting regulatory
changes in the form of a revision of the Foreign Exchange
Control Law in 1980 and granting permission to commercial
banks to create non-bank subsidiaries (jusen) to lend
against real estate investments. Besides expanding overseas
operations, the main areas into which the banks diversified
were lending against real estate and stock market investments.
The rate of growth of real estate lending rose from
7 per cent in the second half of the 1970s to 18 per
cent in the first half and 20 per cent in the second
half of the 1980s.
The result was a speculative boom triggered by a mad
rush into the new areas. Even as GDP growth was slower
in the 1980s as compared to the 1950s and 1960s, the
six-largest-cities-index of real estate prices tripled
between end-March 1985 and end-March 1990, from 33.6
to 100 (Chart 6). Similarly as Chart 7 shows , there
was a massive speculative boom in stock markets, with
the yearly high of the Nikkei stock market index rising
from 12,500 in 1985 to 38,916 in 1989. By 1989 it was
clear that the asset bubble was bound to burst, and
in a belated effort to halt the frenzy and respond to
householder complaints that acquiring housing was virtually
impossible, the Japanese government stepped in by controlling
credit and raising interest rates. The net result was
a collapse in both real estate and stock markets. The
real estate index fell to half its peak level by 1995
and to a third by 2001. And the Nikkei, which registered
a high of 38,713 on 4 January 1990, fell soon after
to an intra-year low of just above 20,000, continuing
its downward slide thereafter right up to 1998. A slight
recovery in 1999 was followed by a further fall in 2000.
Chart
6 >> Chart
7 >>
As a consequence of this collapse and prolonged decline
there was a huge build-up of bad debt with the banking
system. At the beginning of 2002, the official estimate
of non-performing loans of Japanese banks stood at Yen43
trillion, or 8 per cent of GDP. This, despite the fact
that over nine years ending March 2001, Japanese banks
had written off Yen 72 trillion in bad loans. There
is still a lot of scepticism about official estimates
of the extent of bad debts. In September 1997 the Ministry
of Finance announced that the banking sector held Yen
28 trillion in non-performing loans, but soon after
that, using a 'broader definition', it arrived at a
figure of Yen 77 trillion, which amounted to 11 per
cent of outstanding private bank loans in Japan and
16 per cent of its GDP. And in 1998 the Financial Supervisory
Agency placed problem debt at Yen 87.5 trillion and
debt already declared bad at Yen 35.2 trillion, which
added up to a total of Yen 123 million. Whatever the
figure, in the past this would not have been a problem,
as it would have been met by an infusion of government
funds in various ways into the banking system. But under
the new liberalized, market-based discipline, banks
(i) are not getting additional money to finance new
NPAs; (ii) are being required to pay back past loans
provided by the government; and (iii) are faced with
the prospect of a reduction in depositor guarantees,
which could see the withdrawal of deposits from them.
Accumulation of such bad debt inevitably leads to a
credit crunch, as banks are strapped for cash and turn
wary in their lending practices. Overgeared corporations
with outstanding loans in their books were no longer
favoured customers, resulting in a collapse of investment
and a fall in utilization for lack of long and short-term
capital. In addition, insecure Japanese consumers
have chosen to hold back on consumption. The rate of
growth of private consumption expenditure had fallen
by 2000 to a fourth/third of its 1993/1994 values (Chart
5). In the event, growth decelerated sharply, and periodic
recessions became the norm.
The point to note in all this is that, with growth having
slowed and with the increasing difficulty in showing
a profit before interest and tax, firms were unable
to meet their past commitments. As a result, the bad
loans problem has only aggravated. This explains why
huge provisioning against past bad loans by the banking
system has not adequately reduced the ratio of non-performing
loans. The government has sought to resolve the problem
and spur growth, over the last decade, by increasing
its own expenditures. With growth, it argued, the performance
of firms would improve, making it possible for them
to clear at least a part of their debts. Unfortunately,
the depth of the slump was such that the government's
effort to increase deficit spending, on a budget, which
has always been small relative to the size of the Japanese
economy, has not worked. Deceleration has persisted
despite the fact, noted earlier, of a rising fiscal
deficit on the government's budget.
It is not only the higher deficit spending formula that
has not worked. With the credit crunch created by the
bad loans problem seeming to be the proximate explanation
for Japan's decline, the argument that a badly designed
and managed financial system was responsible for the
crisis has gained currency. This amounts to saying that,
rather than return to the regime that prevailed before
the liberalization of the 1980s, Japan must liberalize
its financial sector further, allowing some banks and
financial institutions to down their shutters in the
process, if necessary. This strategy would only worsen
the crisis in the short run, with depositors turning
more nervous and intensification of the credit crunch.
Yet, Japan is once again surrendering to external pressure
and adopting precisely such a strategy. In fact, Prime
Minister Koizumi rose to power in 2001 on the slogan
that he would reform the Japanese system along these
lines. However, the immediate results of whatever he
tried were such that he has been unable to proceed any
further. Extended reform, to the extent that it has
occurred, has not worked either. With the crisis persisting
and evidence accumulating that he is not pushing ahead
with his reform agenda, even Koizumi's personal political
ratings have taken a beating.
In practice, the real beneficiaries of further reform
in Japan will be the international financial institutions
who will be there to pick up the pieces as the system
goes bust, so that they can finally play the dominant
role in an economy into which they were unable to enter
during its miracle growth years. This is likely to be
the denouement of this decade-long drama, unless, of
course, policies change substantially in Japan. But
to expect that of a country which based its earlier
miracle growth primarily on an expansion into world
markets is perhaps to expect too much.
July 09, 2002. |
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