Japan must face need for change
Tuesday 04 July 1995
This gloom is unsurprising partly because counter-cyclical thinking is not encouraged in Japan - you are not allowed to be cheerful if everyone else is glum - but also because the rational reasons for feeling that the bottom might be in sight are not very powerful. After all, neither the US/Japanese accord on the car trade nor the latest package of measures from the government last week succeeded in improving business sentiment; the yen remains at a level where it is virtually impossible to export profitably and which threatens to plunge the economy back into recession; and politics are paralysed, with a weak coalition government, so no more vigorous measures are in the pipeline.
Unsurprising maybe, but interesting even for people who are not directly involved in Japanese finance for three reasons. First, Japanese markets show how difficult it is to clear debt and stimulate demand in a zero inflation world. Second, the weakness of the whole Japanese financial system as a result of the fall in the markets is a useful reminder to enthusiasts of bank finance (as opposed to Anglo-Saxon market-finance) that this is an inherently unstable system. And third, the weakness shows how difficult it is for societies that have been successful by following one set of policies to make structural changes that reverse most of those policies.
To understand the first point - the difficulty of boosting demand in a world without inflation - think of our own experience of falling prices in the property market. House prices have resolutely refused to move upwards and the level of transactions has remained very low. Each sign of a recovery is snuffed out by new sellers.
Now imagine a whole economy hit in this way. Retailers, wholesalers, manufacturers, all are hit by "price destruction". Consumer prices are falling at a rate of 1.6 per cent during the past three months compared with the previous three months, while producer prices are down 4.9 per cent on the same basis. The result is that while the real economy is inching upwards, the nominal economy is still shrinking. Cutting interest rates, the textbook response to this form of deflation, is ineffective. This is partly because neither consumers nor investors want to borrow at all, despite cheap money. And it is partly because the financial institutions are so burdened with previously accumulated bad debts that they are frightened to take on new ones. In a falling-price world the real value of bad debts rises the longer they are held, quite aside from the carrying cost.
This leads to the second problem, the inherent instability of the Japanese financial system. There are two aspects to this: the reliance on bank finance and the extent to which financial institutions (including banks) are direct investors in industry.
In Japan the debt/equity finance ratio of non-financial corporations is about 80/20, whereas in the US is close to 50/50. Personal sector financial assets in Japan are overwhelmingly in bank deposits: more than 60 per cent of personal savings are held in that form. In the US, by contrast, bank deposits are only 25 per cent of personal savings, with the rest in pension funds, shares and unit trusts.
The result is that while the banks are well-funded and their loans secure, the Japanese system is able to marshal large amounts of capital for the company sector, and do so more quickly than the UK or US stockmarket systems. But if those loans are insecure (and the fall in property prices alone has greatly undermined the position of Japanese banks) then the banks are even less able to advance new loans than are our stockmarkets.
If the banks are burdened with bad debts, the life assurance companies are burdened with bad assets. The income from the assets of the life companies is insufficient to service the returns they are obliged to give to their policy-holders. To cover the gap they have had to sell assets. The extent of these sales is shown in the graph, taken from a study by Smithers & Co, the London-based investment advisers. As you can see the faster the life companies have been selling, the further the Nikkei index has fallen - which of course reduces the value of their remaining holdings even further. At some level, new shareholders ought to be enticed into the market, but given the general gloom that level may be a lot lower than the present. The Catch 22 is obvious: share prices have to fall further to enable the Japanese financial system to de-gear, to replace debt with equity. But further falls in prices further undermine the solidity of the financial system.
The third element, the difficulty Japanese society is having in accepting change, is the hardest for outsiders to grasp. There are many facets: they include the commitment to large companies; the hierarchical structure of those companies; the highly regulated domestic market; and the encouragement of a narrow range of manufactured exports.
The problem now is that many of these features, which seem to have served Japan so well, need to be changed. Large companies elsewhere in the world have been cutting back both their size and their hierarchy; domestic markets have been deregulated; manufacturing has been shrunk. The problem for Japan is that it has to find ways of encouraging small businesses, creating a culture of entrepreneurship. It has to encourage a less formal approach within its large firms. It has to deregulate in a society which actually rather likes being told what to do. And it has to compensate for the fall in manufacturing by building up service exports.
Look how difficult it has been for Britons to accept that we might be economically better off with a smaller manufacturing sector and a larger service one, even though that is demonstrably the case. Now think how much harder it must be for Japan.
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