For more than a year, U.S. and European investors have witnessed the decline of equity markets and watched their once-healthy portfolios take on a more emaciated appearance. But things could be worse for these investors: They could have invested in Japan throughout the 1990s. Japan’s stock market – and its economy – have been basket cases for more than a decade. The Nikkei 225 index, which hit a peak of 38,916 in December 1989, closed at 10,980 on Aug. 29, 2001. That marked the first time the index dipped below 11,000 since 1984 – the year when Ronald Reagan was still in his first term as president and the Dow Jones Industrial Average had yet to reach 1,500. In the aftermath of the Sept. 11 terrorist attacks in New York and Washington, the Nikkei continued to slide. On Sept. 30, the index closed below 10,000 for the first time since 1983. Analysts say Japan is about to enter – or has already entered – its fourth recession in a decade. Can investors hope for an economic turnaround in Japan anytime soon? Wharton faculty and people who analyze Japan’s economy and markets for U.S. investment firms in Tokyo say the economic outlook remains dismal. But they add that some sectors of the Japanese economy may be attractive for long-term investors. Finance professor
“The long-run solution involves actions that will hurt them in the short term,” says Marston. “The prime minister has been talking about some serious radical restructuring, and in doing this you’re going to throw people out of work. There will be a further decline in consumer confidence. Things will get really ugly before they get better. They have to bite the bullet and introduce reforms that are necessary.”
Ian Macdonald, the Tokyo-based manager of T. Rowe Price’s Japan Fund, says he is encouraged that Koizumi’s cabinet is in place and has expressed a commitment to reforms. “The Koizumi government is a Japanese government which for the first time has said, ‘Enough is enough, we have to admit we’ve done things wrong,’” Macdonald says, adding that officials have “done a lot to get the public on their side.”
Origins of the stagnation
Japan’s current economic plight had its origins in 1989 and 1990 when its real estate bubble burst, taking stock prices down with it. In the decades prior to 1989, Japan was enjoying its economic “miracle” of tremendous growth. U.S. and other Western companies fretted that Japan’s version of capitalism and corporate management was superior to their own, and many sought to imitate the Japanese way of doing business.
But with the collapse of the asset bubble, Japan’s shortcomings were laid bare for all to see. “There are so many distortions to their economy that it’s very difficult to innovate, it’s difficult to change,” says Wharton finance professor Marshall Blume. He lists a few: the coziness of business and government; inflexible labor markets; a rat’s nest of government regulations that makes it hard, among other things, for struggling companies to eliminate jobs; and an aging population.
Chris Walker, senior economist at Credit Suisse First Boston in Tokyo, says that other problems include a cyclical downturn from the worldwide recession, low productivity growth due to continuing government subsidies to “economic losers,” a lack of deregulation, a dysfunctional banking system that does not provide effective financial intermediation and a dearth of consumer confidence. “This last is quite rational, by the way, in light of rising unemployment and so-far ineffectual government response,” Walker adds.
To take just one example, Blume says, consider Japan’s problem with its aging population. “The people who are retired are very content with the status quo. They have a lot of political clout. They just want to live their lives out. They are resistant to structural change. You keep those people happy and you stay in power. One of the normal solutions to a problem like [an aging populace] is to allow immigration. That doesn’t happen in Japan.”
Japan’s retirement system is not as strong as those in America and Europe, Blume says, forcing Japanese citizens to be some of the world’s thriftiest savers. Such ‘tightfistedness’ is especially prevalent during hard times – which is precisely when governments look for consumers to stimulate demand in order to ignite growth.
Japanese consumers may not mind deflation, since it increases the value of the yen in their pockets. But deflation does not help the Japanese government reduce its debt. Marston notes that public debt is now about 130% of Japan’s gross domestic product. “It’s usually 50 to 60% of GDP,” he says.
Ayako Yasuda, a professor of finance at Wharton and a former financial analyst at Goldman Sachs in Tokyo, says that Japan’s problems are more serious today than they were 10 years ago “because now the government has an alarmingly huge overhang of public debt and it will now start working out those debts. There is a new uncertainty created by the imminence of big changes. The selling off of long-held stocks by banks and corporations is putting downward pressure on the Nikkei … So instead of stagnation, Japan is headed for changes now, but it can go south before going north again.”
The nearest precedent to today’s situation in Japan is the Great Depression in the United States in 1929, but there are some key differences, says Walker. “Whereas asset prices in the U.S. had essentially hit bottom within two years of the beginning of the Depression, land and equity prices in Japan are still falling 10 years after the beginning of the event,” Walker says. “America’s big mistake in the 1930s was to erect steep tariff barriers, and Japan has not done that. Japan’s mistake has been to continue funneling money to the least productive parts of the economy, which has kept productivity growth near zero.”
The banking problem
Japan’s asset collapse severely damaged the nation’s banking system. During the heady days of economic expansion, banks had made huge loans to real estate projects, and those loans were coming back to haunt lenders in the 1990s. No one has been able to determine a precise figure to portray the extent of the banks’ non-performing loans, but Marston says that Japan’s Ministry of Finance for years has sought to downplay the severity of the problem.
Marston says the government should have “closed down the banks in trouble, recapitalized the ones that were salvageable and went on from there. That’s what we did with our savings and loans, but the Ministry of Finance didn’t want to do that. They didn’t want to kick out managements that were poor. The banks in the 1990s ended up crippled by the crisis.” Japan has taken some steps to shore up the banking industry, but those measures have not been enough, Marston says.
Banks play a major role because they wear many hats in the economy, adds Yasuda. For one thing, many banks loans were collateralized by real estate, and because new, post-bubble real estate transactions would reveal the extent of the decline in the market value of their loans, the banks’ earlier resistance to writing off bad loans delayed the clean-up of the bubble. In addition, banks are the most important – and until recently were almost the exclusive – sources of external financing for small- and medium-sized businesses, so their problems have created a severe credit crunch for this segment of the economy and led to a record number of bankruptcies.
Moreover, large companies have better access to capital markets than smaller companies, but banks have historically held a significant number of shares of these companies – shares that were kept on the books at inflated prices. “Their attempts now to unwind these positions to cover for their debt losses create an enormous downward pressure on the stock market, thus compounding the crisis,” Yasuda says.
Monetary policy options
The Bank of Japan has lowered interest rates many times in an attempt to light a fire under the moribund economy but the effort has been for naught. Japan’s target discount rate stands at 0.1%, virtually at zero, which leaves the central bank little additional ammunition to stimulate spending.
Walker says the central bank should seek a positive rate of inflation, which would bring down real interest rates from the current 2.5% level (the yield on the 10-year bond is about 1.4% and inflation is negative 1.1%). “This could be done by announcing a target rate of inflation and following up with open market bond and foreign exchange purchases,” Walker says. “The central bank still refuses to consider this option, but deflation and recession are intensifying and circumstances could force a change.”
Yasuda says there is great debate over whether the Bank of Japan should engage in so-called “monetization” – printing money to help finance the government budget, with the deliberate intent of inducing inflation. “There seems to be an agreement that that is the only ‘ammunition’ left in the hands of the central bank, aside from inflation-targeting, which is also not without its share of critics,” she points out. “But there are sharp disagreements among economists, central bankers and government officials about whether the bank should do it. The question is whether the potential risk of a huge devaluation of yen, a rise in default-premium on Japan’s debt, and/or uncontrollable inflation as a result of monetization will be worse than the risk of prolonging the deflationary recession any further. Either scenario is an equally uncharted territory under the post-war world economy as we know it today, so it is impossible to get it right with any guarantees.”
To help Japan, Walker says U.S. and European officials should “tolerate some yen weakness and continue to encourage Koizumi … to stay the course on reform. Generally speaking, they are already doing this.”
A broken machine
Macdonald notes that the more distant roots of Japan’s economic woes can be traced back to the years immediately after World War II. Strong, centralized bureaucracies in government ministries have long wielded enormous power in directing economic activity and in propping up companies that should have been allowed to fail. These include what Macdonald calls “the walking dead” – banks, construction companies and other poorly run businesses that have been kept alive by government largesse.
“It’s a machine that worked well for 40 years, postwar,” Macdonald says. The political and economic systems put into place following the war gave power to bureaucrats. “Japan is the way it is by design … The whole system has been set up for the benefit of the bureaucracy and the government at the expense of the individual.” Macdonald adds: “Everybody wanted it this way. Only now are people really saying, ‘we’ve got to clean the slate.’”
Steps for reform
To turn things around, Macdonald says Japan must first institute political reforms. “Laws need to be changed in Japan to allow many of the reforms being discussed to take place, be it taxation or the vested interests of politicians themselves.”
Macdonald points to massive public works projects designed primarily to keep constituents happy. “Regional constituencies have been supported by public works,” he says, and national and local governments continually fight over tax dollars. “They have been doing that for decades. The hope was they could pump up good [economic] numbers through multiple stimulus packages over the years. They were buying time.”
Political reform should be accompanied by corporate and social reform. For example, the government should write off the bad debts of the banks and other companies that were incurred as a result of the asset bubble, Macdonald advises. The government should seek changes in corporate law to tighten up questionable accounting practices that allow companies to hide losses and high fixed costs on consolidated groups of companies.
In some ways, Japan has already begun to change.
One important sign of reform is a commitment by corporations to become more efficient and competitive, which means that providing lifetime employment to workers is no longer a sacrosanct policy, Macdonald says. Consumer electronics companies that once eliminated offshore jobs in hard economic times in order to protect employees at home now show few qualms about shutting down onshore factories. The job cuts that arise from such decisions, however, mean that the government must institute social reforms – the establishment of a stronger safety net for people thrown out of work. Indeed, the unemployment rate in Japan is at an historically high level of 5% and is expected to continue to rise.
The outlook
The weakness of Japan’s economy, which was already heading into a “quagmire” months ago, will be exacerbated by the ripple effects of the Sept. 11 terrorist attacks in the United States and remain weak for several years, Macdonald says. But he sees significant long-term potential in Japanese stocks, particularly automobile and technology companies, which he says are highly competitive globally. Domestic sectors that look attractive include leisure and entertainment, retailing, software, and household and personal products.
Could the kind of prolonged economic stagnation that has occurred in Japan happen in the United States? Probably not, the faculty and analysts say.
It is unlikely that the recessions in the United States and other countries have much in common with the decade-long stagnation in Japan, Yasuda notes. “First, their slowdowns are not directly related to Japan. They are cyclical industrial declines, coming off years of high investment in technology, plants and equipment,” she says. “Second, the inflexible labor market prolonged the recession in Japan, because companies could not lay off workers easily. In the U.S., the labor market is much more flexible. Third, the Federal Reserve has had the benefit of learning from the bubble of Japan, so it has paid closer attention to asset prices than the Bank of Japan did to maneuver the economy to a soft landing.”
Plus, when it comes to spending, Americans are fundamentally different from the Japanese. “One thing we can say about American consumers is they don’t need much prodding to head to the malls,” Marston notes.
In the meantime, Japan will work, slowly and methodically, to turn around the world’s second largest economy. Says Macdonald: “Japan did its thing for two generations. To unwind that is tough.”
