The grim deflationary logic of credit contraction shouldn't be underestimated.
Greed and Fear: Compounding the Credit Crunch in Japan
By Christopher Wood
Special to TheStreet.com
10/25/98 4:00 PM ET
Greed & Fear would love to be bullish, but a brief visit to Tokyo this week leaves us with the opposite impression.
The world may be celebrating the likely decision of major Japanese banks to accept government money. But the euphoria will again prove short-lived, and is, in fact, creating another selling opportunity in the Tokyo stock market.
The likely decision by the banks to take taxpayers' money simply won't end the escalating credit crunch that's behind Japan's alarmingly sharp economic deterioration. And this isn't just Greed & Fear's view. It is, far more important, the view of the Bank of Japan. Central bankers and other informed observers chuckle at the naivete of Japanese politicians in assuming that provision of public money will stop credit lines from being cut.
Instead, the view is that cautious bank managers will continue to do what they deem as responsible, namely rearrange their balance sheets by cutting private-sector loans in Japan as they seek to bolster sagging capital adequacy ratios. This means reducing the size of their balance sheets.
This can only compound the deflationary trend in Japan, which has been further aggravated by the massive jump in the value of the yen. Bank lending in Japan is already declining at an annualized rate of 2.7%. By the end of this fiscal year, it is widely accepted, the annualized rate of loan shrinkage may well have increased to 5%. This is not bullish for the Japanese economy nor, indeed, for the rest of Asia.
Debts Under the Bed
If this seems overly gloomy, it's fair to say that the new banking legislation puts a safety net under the banking system by providing pots of public money. This helps address the concern of retail depositor panic in Japanese banks.
But the key problem with the legislation is that banks, which receive public money, won't be made to disclose properly the true condition of their loan portfolios or, indeed, to write those bad loans off. The reason for this, of course, continues to be the Liberal Democratic Party's proximity to many of the major bad creditors, most notably in the construction industry. The festering of these sick banks will continue to contaminate the entire financial system, as has been the pattern since 1990.
Meanwhile, most banks continue to hide problems in their nonbank subsidiaries, as became clear with the bankruptcy of Long Term Credit Bank's affiliate Japan Leasing. This year, new accounting laws are also forcing banks to consolidate their accounts, which means incorporating the likes of nonbanks. This is having the practical effect of forcing the banks to reduce lending even further.
Finally, the concern with meeting capital adequacy ratios is typically Japanese in that it's all about form, not substance. Thus, the Ministry of Finance's continuing obsession with capital adequacy ratios ignores the fact that banks are still being allowed to mark shareholdings at book or market. Virtually all the banks will, as a consequence, continue to mark those assets on a book basis. As a result, the world will still have no idea of the true condition of Japan's banking sector. Yet the size of the problem is already large enough, with problem loans estimated at around 100 trillion yen, or more than 20% of GDP. This is, of course, just the private-sector problem. There are also the escalating problem loans in the public sector via the infamous Fiscal Investment and Loan Programme. This is the government's version of a piggy bank. It is essentially a device for rechanneling the excess savings of the Japanese public for the purpose of operating a government-funded financing plan.
Bank Nationalization Looms
The endgame has therefore not yet arrived in Japan. The longer Japanese politicians continue to dance around true consolidation of the Japanese banking system -- which would see the number of major banks at least halved -- the greater the likelihood that the Japanese financial crisis ends in full-scale nationalization of the banking sector.
Such an outcome would put the banking system on a collision course with the government-owned post office savings system, which has been drawing deposits away from the banks in recent years.
Deflationary Spiral
Meanwhile, the grim deflationary logic of credit contraction shouldn't be underestimated.
The banks will continue to cut credit lines to private-sector companies. This, in turn, will cause companies to sell bank shares, since it will no longer make sense for them to own bank shares if banks can't be relied on to give credit. That means the continued unwinding of the cross-shareholding system. Corporate deposits will also likely be switched out of Japanese banks into foreign banks as and when credit lines are reduced and concerns about credit risk mount. Foreign banks in Tokyo are already reportedly beneficiaries of deposit flows, as has happened elsewhere in Asia.
The process of credit contraction will also tend, in the short term, to cause further strengthening in the yen. Greed & Fear has been a long-term bear of the yen and remains so. A yen collapse is the logical outcome of the present crisis, as a consequence of massive monetary easing to combat the deflationary trend and massive fiscal spending to bail out the banking system.
But we are not at that point yet. The bank bailout is not yet full-scale nationalization, while the central bank's easing policy remains accommodative rather than downright proactive. The huge technical recovery of the yen caused by unwinding of cross trades will now likely have knock-on ramifications. Japanese institutional investors that have offshore dollar portfolio investments, such as life insurance companies and investment trusts, will be tempted to hedge those investments, since a large portion remains unhedged at present. Likewise, reflecting the desire to rein in their lending, Japanese banks will continue to reduce their foreign-currency-denominated assets.
All of this will tend to increase yen strength in the short term, suggesting a test of the Y110/US$1 level. Asian stock markets, especially Hong Kong, continue to view the strong yen as bullish. This is completely illogical. However, sometimes markets can be illogical in the short term. Remember Tokyo in 1989. The strong yen has exacerbated deflation in Japan, making it harder for Japan to get out of the current downward spiral of contracting credit, declining consumption, falling wages and plunging industrial production. The longer Japan takes to recover, the less hope the rest of Asia has for a revival in Japanese demand.
New Direction
The near-term picture remains bleak, but we are nearing the endgame in Japan. Politicians have, by and large, taken over policy formation from the bureaucrats, which is remarkable. And more and more "younger" politicians, both inside and outside the LDP, realize what needs to be done. Their hour may not come, however, until full-scale nationalization of the banking sector becomes necessary. At that point, ironically, relief may be at hand for the rest of Asia.
Bank nationalization would at least give the politicians the option of negotiating debt relief with Association of Southeast Asian Nations countries, for example, which could prove hugely bullish for those countries' smaller stock markets. Japan would finally atone for World War II, while assuring itself of better regional economics. Such theorizing may seem far-fetched, but it is the direction we could be heading in.
Meanwhile, no one should lose sight of Japan's core problem, which remains lack of profitability.
The present miserable 1% return of equity for Japanese companies is a sorry reflection of the inefficiency of the huge amount of capital expenditure undertaken since the mid-1980s. In this sense, Japan symbolizes the overinvestment and excess capacity that are the root of the Asian crisis.
To address the issue of lack of profitability, Japanese companies need to write off the last decade's investment spending against their book values. Tax breaks are necessary to encourage them to do just this. It is therefore discouraging that Japanese bureaucrats are not even thinking in these terms. Likewise, there is an equal lack of imagination displayed in boosting the one area that will eventually have to lead any upturn. That is housing.
With negative equity growing by the day, housing starts continue to decline in Japan. The obvious solution is for radical tax relief on mortgage financing and the like. The LDP, with its obvious need to attract urban votes if it wants to stay in power, should be taking action on this front. But so far the progress in this area is pathetic.
Japan will recover. But a catalyst is still required to force change. When that day finally arrives, it will be bullish for Asia. This week's celebrations, however, are premature. The paint is still drying.
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