San José State University
Department of Economics
Thayer Watkins
Silicon Valley
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The Bubble Economy of Japan

The story of the era of the Bubble Economy in Japan is given by Christopher Wood, a journalist who has covered Japan for the about two decades. Wood, as well as other observers, traces the problem to the quasi-feudalistic institutional structure of Japan. The most powerful institution in Japan is, by a large margin, the Ministry of Finance (MOF). Wood feels the feudalistic power of the MOF has inhibited the development of true financial markets in Japan. Presently capital is allocated on the basis of who knows whom instead of economic effectiveness. The commercial success of Japanese manufacturing has led to Japanese banks of enormous wealth but without the corresponding level of financial skill and expertise. Japanese banks typically rely upon the guidance of the MOF and consequently do not exercise sufficient independent judgment and have not learned to cope with financial difficulties. Banks have lent heavily with land as collateral. No one, apparently, questioned the wisdom of this despite the aggregate property value reaching levels four to five times the aggregate property values in the U.S. Barkley Rosser noted that in 1990 the aggregate value of all land in Japan was fifty percent greater than the value of all land in the rest of the world.

In 1985 the deregulation of interest rates on deposits began. Prior to that time bank were not allowed to pay interest on deposits. The removal of this prohibition led to competition between banks for deposits and hence to interest payments. Japanese banks did not raise interest rates they charged borrowers and thus did not offset the effect of the higher costs of their funds. They made up for the drop in their profits by selling the shares of stock they owned for a long time and counted the realized capital gains as profits. But because of the obligation of cross-holding of stock among the members of a keiretsu they immediately bought back the shares at the new higher price. This meant that they were able to count the capital gains as a profit, and had to pay tax on the capital gains and yet were back again with the assets they started with. They thus experienced a net loss of cash flow on the operation. Furthermore any decline in the stock market then would mean a disguised capital loss.

The Bank of International Settlements (BIS) has rules which are critical for Japanese banks. According to BIS rules, bank capital consists of two parts. Tier-one capital is the stockholders funds and retained earnings. Tier-two capital consists of such things as loan-loss reserves and "hidden assets." Forty five percent of unrealized capital gains on stocks can be counted as "hidden assets" and part of tier-two capital. This was a compromise of the BIS to accommodate Japanese banking. Some members of BIS did not want to allow any unrealized capital gains to be counted as part of bank capital. Although counting unrealized capital gains accommodated the Japanese banking system, it made the Japanese banks vulnerable to price fluctuations in the stock market. If the stock market goes down then the Japanese banks must scurry to raise capital to meet BIS standard of an 8 percent ratio of capital to liabilities.

The banks themselves are an important element of the stock market so a downturn in other stocks can adversely affect banks thus bringing about a further decline in stock prices. The structure smacks of a house of cards. The cross holding of stock can impede such declines but only for a limited time. Christopher Wood says, "Even after Tokyo's 1990 stock market crash, Japanese bank shares remain the most gross example of overvaluation in world's capital markets." (p.26) Wood notes that most Japanese city bank stock had price-earnings ratios of about 60 in 1991. The prestigious Industrial Bank of Japan (IBJ) had a price-earnings ratio of 100 and, with a market valuation of $60 billion, was perhaps the world's most overvalued company.

Wood remarks,

"In effect, the continuing startling overvaluation of Japanese bank stock is critical to the banks' own financial stability. They are in effect holding themselves aloft by their own bootstraps, a precar- ious balancing act that is the weakness at the heart of Japan's financial system. Should it ever fail, it would create the likelihood of a credit implosion with all the resulting decidedly unpleasant global implications." (p.27)

During the bull market in Japanese stocks banks issued new shares which allowed them to increase their assets. Between 1987 and 1989 city banks issued 6 trillion Yen of equity and equity-related securities. But when the Tokyo stock market crashed in 1990 these banks had a hard time maintaining the BIS required 8 percent capital ratio. Only one bank, Kyowa Bank, could maintain this ratio without resort to costly junk-bond-like financing. The number of regional banks that could meet the 8 percent ratio declined from 50 in March of 1990 to 4 in September of that year.

The MOF gave permission in June of 1990 for banks to sell subordinated debt (junk bonds) and by September they had raised 2 trillion Yen. But a major part of this was from insurance companies which may have raised the funds by selling off stock. Thus the move to remedy the banks capital problem may have depressed stock prices and through its effect on the tier-two capital of the banks worsened the situation. Wood notes,

"The other buyers of the subordinated debt were the finance subsidiaries of companies in the banks' own financial keiretsu groups. In a typically Japanese arrangement, the banks lent money to these traditional customers at cheap rates and the companies then turned around and lent the banks their own money back at a slightly higher interest rate. This sort of gimmickry is clearly contrary to the spirit of BIS, which is meant to bolster real capital strength. It also shows that the Japanese banks have not yet learned the lesson that such games, where the money goes around in circles, buy time but do not solve the basic problem of the lack of capital at a time when credit is tightening and credit risk rising." (p.28)

During the "Bubble Economy" Japanese banks borrowed extensively in the Euro-dollar markets, 186 trillion Yen by June of 1990. Despite being the largest banks in the world these Japanese banks were having to pay a premium in their borrowing, the so-called "Japanese rate".

From the borrowed funds Japanese banks lent extensively. They lent out 69 trillion Yen. They provided $30 to $40 billion to finance American leveraged buyouts, including $10 billion of the $25 billion LBO of RJR Nabisco. Japanese banks opened American branches which earned very low rates of return, about 2 percent on equity. They did most of their lending in the peak of the American real estate market and consequently suffered extensive losses when property values declined and loans went bad. By 1992 the Industrial Bank of Japan (IBJ) and the Long-Term Credit Bank (LTCB) each had three to four billion dollars of loans on property that was "under water;" i.e., not meeting payments.

The collapse of the Tokyo stock market collapsed the banks tier-two capital and put them under pressure to find capital. They no longer could find easy capital to borrow and had to liquidate many of their overseas holdings, often at a loss.

Japanese banks were also adversely affected by the decline of property values in Japan. In 1990 Japanese banks held about 22 percent of the mortgages in Japan. In addition, many of the loans to small businesses are backed by property and 75 percent of the banks lending is to small businesses.

There were other financial intermediaries in the property-backed loan market. The Housing Loan Corporation, a government agency, provides interest rate subsidized mortgages. Employers also sometimes provide subsidized home loans. There are also leasing companies, consumer-finance companies, and mortgage companies active in the mortgage market but these institutions are largely dependent upon the banks for their funding so they represent the indirect participation of Japanese banks in the mortgage market.

Banks had lent 90 trillion Yen to these institutions by March of 1991. Any loans by these nonbank lending institutions which go bad will end up in the portfolios of the banks. Wood asserts that property, directly or indirectly, support as much as 80 percent of the total loans of Japanese banks.

In addition to the above financial institutions there are also secondary regional banks called sogo banks and shinkin banks (the rough equivalent of U.S. credit unions). In the U.S. banks are required to keep reserves to offset possible bad loan losses. In Japan banks are not only not required to establish reserves for bad loans, they are effectively penalized for doing so. Setting aside funds to cover bad loans would reduce the tax liability of the bank and so the banks have to obtain permission from taxing authorities to create bad loan reserves. Consequently in 1991 Japanese banks had reserves of only 3 trillion Yen for total loans of 450 trillion Yen. Japanese banks tend not to report that a loan is in default because it makes the accounting profits look bad. The accounting profits therefore hide the fact that some loans have not paid interest for as long as a year. Banks pressure the borrowers to come up with 30 percent of the interest owed because this allows them to avoid reporting their loans as being bad. This practice of not admitting problems or trying to solve them using gimmickry has become a concern of the Bank of Japan, the central bank of Japan. The Bank of Japan has admonished banks to recognize the size of their problems and to start creating loan-loss reserves, but the bank seemed to have adopted a strategy, as Wood says, of "keeping their fingers crossed." The land market in Japan is heavily influenced by tax rules. Years ago, the Japanese government established high taxes on capital gains on land to discourage speculation. For any land held less than two years after purchase the capital gain is multiplied by 150 percent and this amount added to current income in computing the sellers income tax. If land is sold two to five years after its purchase then 100 percent of the capital gain is added to income for tax purposes. Effectively this is a 90 percent tax rate on property held less than two years, a 75 percent tax rate on property held two to five years, and a 50 percent tax rate on property held more than five years. This tax system discourages people from marketing land and consequently those who need land for some project find they have to pay exorbitant prices to get someone to part with it. Very little land changes hands and then as often as not to relatives. Consequently the valuation of land is artificially inflated. This artificial valuation of land would not be of much significance if it were not for the fact that people borrow money based upon their holdings of land. Wood reports the case of a house occupied by former prime minister Kiichi Miyazawa. The house was owned by political supporters of Miyazawa. The property occupied about one sixth of an acre. Its estimated value in 1991 was 2.7 billion Yen, or roughly $22 million. This was a very high value for a residential house but it was used to borrow 13.2 billion Yen from seven banks in 1989. This was roughly $96 million. This begins to qualify for the term "astronomical." In November of 1991 the Ministry of Construction reported that houses and apartments in metropolitan Tokyo had in the preceding year lost 37 percent of their value and plots of land in the suburb of Saitama had lost 41 percent. The bubble in property values would not have been significant except for the fact that the use of land as collateral for loans and the fact that the taxing authorities tend to use those peak prices in valuing property subject to the inheritance tax. During the "Bubble Econonmy" there was a uniquely Japanese episode of speculation in golf club memberships. At the peak the total market value of golf club memberships was about $200 billion (that is billions not millions). There is even a Nikkei Golf Club Membership Index. Life insurance companies around the world are partly involved in providing insurance against risk and partly in providing savings programs. In both activities they end up having to invest heavily in financial securities. Life insurance companies in Japan own more stock than does any other type of financial institution. In 1990 they owned 13 percent of the stock on the Tokyo stock market compared to 9 percent held by banks. At that time they reported total assets of 130 trillion Yen, or about $900 billion. But with the decline in the stock market this has fallen. Wood reports an estimate that all the capital gains of the insurance companies would be wiped out if the Nikkei falls to 12,500. At one time that was unthinkable, but with its level fallen from about 19,000 in December of 1994 to below 15,000 in June 1995 it is no longer unthinkable. Also others estimate that the average cost of stock shares held by insurance companies corresponds to a Nikkei level of 18,000 rather than 12,500. During the era of increasing stock prices the insurance companies could make use of accounting rules to report whatever profit rate they wanted because they had discretion as to how they valued the stock they held. They could value it at its cost and report no capital gains or at market value and report the full amount of the capital gains. The reported rates of return on managing their portfolios of stock could thus be quite misleading. There is a special problem for Japanese insurance companies. Japanese law requires that they pay policyholders out of income rather than capital gains. This has led to some strange financial ploys that were of dubious economic justification but served to transform capital gains into current income, such as trading stock for bonds that paid high interest but gave little payment at maturity. Japanese insurance companies were at risk in the property market also. Six percent of insurance assets were property and many of their domestic loans were backed by property. When Japanese insurance companies became involved in foreign investment they subjected themselves to considerable risk. One such risk had to do with fluctuations in exchange rates. In March of 1987 Japanese insurance companies reported currency losses of 2.24 trillion Yen or about $18 billion. Japanese insurance companies are involved in the cross-holding of bank stock. During the rising stock market it did not matter much that these shares paid little in the way of dividends, but the situation is different. For example, Dai-Ichi Life, the second largest life insurer in Japan, announced in 1991 that it would reduce its holdings of the Bank of Tokyo, the Industrial Bank of Japan, and Mitsui Taiyo Kobe Bank. Japan's stockbrokers were prime beneficiaries of the Bubble Economy and were hard hit by its collapse. The profits of the four biggest; Nomura, Daiwa, Nikko (Mitsubishi) and Yamaichi; fell by 60 percent in 1990. Others experienced a drop of 80 percent and more. In 1991 virtually all Japanese stockbrokers except Nomura lost money. Nomura is an interesting case. It was created in 1925 in Osaka as a spinoff from the bond department of Daiwa Bank. During the Bubble Economy Nomura was not only the most profitable financial institution in Japan it was the most profitable company of any sort. One of the scandalous incidents of the Bubble Economy is the discovery that the prestigous Industrial Bank of Japan (IBJ) lent 240 billion yen to an Osaka restaurant owner, Onoue (Nui), on the basis of forged certificates of deposits. Using the funds from these loans Miss Onoue in the late 1980's became the biggest speculator in the Tokyo stock market and the largest individual stockholder in the Industrial Bank of Japan. Miss Onoue had spent her early adulthood working as a waitress in bars and restaurants of Osaka. Later, with funds from some mysterious backer, she purchased two restaurants. She began speculating in the stock market and during her heyday as a speculator purchased as much as 120 billion yen of stock in one day. She was a major speculator in the market. She belonged to a strange Buddhist sect and would hold mysterious midnight rites in her restaurants to seek divine help for her stockmarket activities. Many stock market professionals attended these midnight rites, perhaps to find out if the secret of her success was supernatural or perhaps just to keep her business. She was known as the Dark Lady of Osaka. Although IJB was her major source of credit it was not her only source. She was charged with borrowing against 340 billion yen of forged CD's. Onoue was alledged to have ties to the Yakuza (organized crime in Japan). She was also alledged to have ties to the Burakumin community (descendants of the untouchables of Japanese feudal society) and some of the directors of IJB were also said to have such ties.

Although the Bubble Economy ended essentially in 1990 it wasn't until January 29, 1993 that a Japanese prime minister acknowledged that the "Bubble Economy" had collapsed. In the first three months of 1993 the price level fell by 1.1 percent, which represents a rate of deflation of almost 4.5 percent per year. By August 1993 wholesale prices were falling at an annual rate of 4.2 percent. In the second quarter of 1993 Japan's GNP declined at an annual rate of 2 percent. The Japanese economy was in serious trouble. The bureaucracy's attempt to deal with the problem typically involved trying to use some scheme, a quick fix, rather than correcting structural flaws. The government tried to raise prices in the stock market by ordering public sector financial institutions to buy stocks. The banking system suffered severe losses from loans used to buy property, but the bank tried to pretend these losses had not occured. Employees were paid with unsold company inventory. Government policy discourages Japanese companies from reducing their labor force, but this puts such companies at risk of financial collapse.

Despite the recent economic problems of Japan, the leaders take the position that Japan has developed a special type of economy that is in between free market capitalism and socialism and superior to both. Japanese leaders have offered advice on economy policy to the Chinese and Russian governments that is contrary to the advice of the U.S. and Western Europe. When China asked Japan for advice on how to privatize its public enterprises Japan advice was to hold off on privatization. One of the top bureaucrats in the powerful Ministry of Finance, Eisuke Sakakibara, emphasizes that in Japan a corporation is a community that is organized around the interests of labor rather than that of the stock holders.

The role of the banking rules in Japan concerning the inclusion of the value of stock shares in the capital is treated elsewhere.


'Fifth Generation' Became Japan's Lost Generation

Source: The New York Times, June 5, 1992.

Picture caption: "Ten years ago we faced criticism of being too reckless," said Kazuhiro Fuchi, Fifth Generation's head. "Now we see criticism from inside and outside the country because we have failed to achieve such grand goals."

Tokyo June 4.--A bold 10-year effort by Japan to seize the lead in computer technology is fizzling to a close having failed to meet many of its ambitious goals or to produce technology that Japan's computer industry wanted. After spending $400 million on its widely heralded Fifth Generation computer project, the Japanese Government said this week that it was willing to give away the software developed by the project to anyone who wanted it, even foreigners.

Machines That Would Think

That attitude is a sharp contrast to the project's inception, when it spread fear in the United States that the Japanese were going to leapfrog the American computer industry. In response, a group of American companies formed the Microelectronics and Computer Technology Corporation, a consortium in Austin, Texas, to cooperate on research. And the Defense Department, in part to meet the Japanese challenge, began a huge long-term program to develop intelligent systems, including tanks that could navigate on their own. Now, with a debate in the United States about whether the Government should help American companies compete, the Fifth Generation venture is a reminder t;hat even Japan's highly regarded Ministry of International Trade and Industry can make mistakes in predicting what technologies will be important in the future. The problem for Japan is that the computer industry shifted so rapidly that the technological path the Fifth Generation took-- which seemed a wise choice in 1982-- turned out to be at odds with the computer industry's direction by 1992. In a sense, Japan's ability to stay the course in pursuit of a long-term payoff-- usually considered one of the country's strongest assets-- turned into a liability. A similar challenge for Japan may now be arising in high-definition television. Japan's HDTV system, which has been in development for two decades, is now coming to market just as some engineers believe that major shift to digital television technology will make the Japanese analog approach obsolete. Yet interest in joint government-industry projects continues in Japan. Another computer technology program, called the Real World Computing project, is getting underway. Executives here said that such programs could lead to valuable results even if no useful products emerge from the pipeline. A benefit of the Fifth Generation project, for instance, is that it trained hundreds , perhaps thousands, of engineers in advanced computer science.

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