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.