Japan: Macro vs. Micro
Robert Alan Feldman
Morgan Stanley
May 12, 2003
A new firefight has broken out over the question of support for the equity market. The anti-reform faction of the ruling Liberal Democratic Party (LDP) has been calling for more expansion of the Bank of Japan balance sheet (through increased bond purchases, purchase of different instruments, direct purchase of bank stocks by the BoJ, etc.), more purchase of equities by the postal savings system, expansion of public works projects, etc. In short, the old stuff. In contrast, the Koizumi government has resisted such calls, focusing on longer-term policies to improve the basis of the economy. Although the details differ, the debate is old. The anti-reformers believe that macroeconomic policies alone can solve Japan’s problems, while the Koizumi camp believes that microeconomic policies should be the focus. Who is right? Corporate data give a hint.
A macro solution to Japan’s economic problem would require aggregate growth of sales to a level that justifies current levels of debt. What percentage increase of prices would be needed for this? The calculation is simple, using corporate data. The ratio of total liabilities to operating cash flow currently stands at 13.0x. If this were to be brought down to the target ratio of 10x that is to be used by the Industrial Revitalization Corporation of Japan (IRCJ), cash flow would have to rise accordingly. With depreciation taken as given, operating profits would have to expand. How much? With total liabilities of about ¥915.2 trl, and depreciation of ¥35.3 trl, a cash flow ratio of 10x would require operating profits to rise from the current level of ¥34.9 trl to ¥56.22. The increase is ¥21.3 trl. With the current operating profit margin of 2.82%, sales would have to rise from ¥1238.2 trl to ¥1995.1 trl. -- an increase of 61%! At the 2% inflation rate that is the upper end of the range now touted by inflation target advocates, it would take 24 years to achieve the target.
Let’s approach the same target from a cost-cutting point of view. To achieve the same ratio of 10x for the cash flow ratio, companies could cut costs, and increase the operating profit margin. With depreciation given, operating profits of ¥56.22 are needed, as above. This time, however, instead of growing the top line, the margin of 2.82% would have to rise. The needed level for the margin is 4.54%, at the current level of sales of ¥1238 trl. This margin level is not impossible -- just ancient. It was last seen in Japan in 1973. The average level of the margin in the 1976-1990 period was 3.69%. Should this latter level be re-achieved, then the required top-line growth for sales would be 23% -- requiring only 10 years at the top of the inflation target range.
What about liability cuts? Could assets be sold, liabilities repaid, and thus the ratio of liabilities to current cash flow brought down to 10x? Theoretically, this is possible. Assets are sold (most likely at a discount), and the proceeds are used to repay liabilities. The loss on the asset sales is taken out of shareholders’ equity. If the Japanese corporate sector took this route, would shareholders’ equity still be positive? When making this calculation, the first key assumption is the haircut taken on asset sales. With cash flow of ¥70.1 trl, liabilities would have to be reduced to ¥701 trl, a drop of some ¥213 trl from the current level of ¥915 trl. Assuming a haircut of 25% on the sales, raising ¥213 of funds to repay liabilities would require asset sales of ¥284 trl. (=213/[1-0.25]). The haircut (=¥71 trl) is deducted from capital. In the aggregate, this is not a problem, because total capital is currently ¥331 trl. This calculation, however, misses one important point: Not all industries or firms are alike. At a uniform haircut of 25%, some industries would have negative capital positions.
These calculations suggest that more work is necessary at the micro level than at the macro level. Cost ratios are so poor and liability ratios are so high that achieving revitalization targets would require either wholly unpractical levels of macro stimulus or wholly unacceptable time horizons. Macro policies are part of the solution, of course. However, the contention that macro policies alone can solve the problem with Japanese balance sheets ignores the facts of the Japanese corporate balance sheet. The heavy lifting of cost cuts and asset sales is obligatory.
Heavy lifting may become an important investment theme, as the positive initial reaction among investors to the formal opening of the IRCJ this week suggested. Yes, the firms selling the assets will incur serious losses. However, those buying the assets will reap corresponding gains, and will also begin new investment projects to make the newly bought assets more productive. Thus, balance sheet adjustment is not a zero-sum game. Indeed, it is likely to be a positive sum game -- especially for the investors who identify assets that can be revitalized. Macro policy will be important in facilitating resource transfer from loser companies and industries to winners. In the process, there will be significant opportunities for investors to benefit from resource transfer and revitalization.
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