Japan has been in an equilibrium of strong currency, stagnation, large fiscal deficit and deflation for two decades. The reason is to minimize interest burden of the huge debt load for the corporate sector. Even though the public debt has skyrocketed, the corporate debt has not fallen much. The reason is that real interest rate isn't so low in a deflationary environment. The low interest payment in nominal terms serves an accounting purpuse but doesn't actually decrease private debt burden. As long as Japan runs current account surplus, this equilibrium can continue, as Japan can control its interest rate. However, as global trade is stuck in a slow lane for the foreseeable future, Japan's surplus may vanish. As some point, Japan will lose control over its interest rate. When it happens, Japan will shift from strong yen, low interest rate to weak yen, high interest rate. The switch will be sudden.



Andy



Japan: not rising

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Japan had a political earthquake last week: the Liberal Democratic Party (‘LDP’) that ruled Japan since the end of the World War II lost most of its seats. The Democratic Party of Japan (‘DPJ’) won 308 out of 480 seats in the lower house. It already has a majority in the upper house. The DPJ is in a strong position to undertake structural reforms. When a country has stagnated for so long like Japan, a change in political regime brings hope. However, the DPJ is unlikely to turn around Japan’s economy anytime soon. The LDP, in the name of Keynesian stimulus, has spent all the money that Japan could on wasteful investment. The DPJ doesn’t have resources to undertake reforms. I am afraid that the DPJ has an impossible situation in its hand. Japan’s economic woes ahead will soon bring it down.






Anyone who doesn’t believe in the harms of financial bubble and believes in the magic of Keynesian stimulus should visit Japan. After its stock market bubble burst in 1989 and land market in 1992, its government under the LDP leadership has run up nearly 200% of GDP in debt to revive the economy. Nevertheless, its economy has stagnated. When the global credit bubble burst in 2008, it brought down Japan’s export machine-its only hope. Among all the OECD economies Japan’s looks most like in depression. Its nominal GDP declined by 8% in the first quarter of 2009 from one year ago. Even though its economy rebounded a bit in the second quarter, the nominal GDP for the whole of 2009 would still decline substantially and would likely be lower than the level in 1993. All the money that Japan has spent in a decade and an half has been wasted.






Many analysts blame Japan’s problems on the inefficiencies of its corporate sector. This is partially true. Japan has had a hyper-competitive export sector. The domestic demand-oriented industries are not efficient due to labor market practices. More importantly, the sectors that became massively levered during the bubble have been walking dead or zombies for two decades, weighing down the overall efficiency of the economy. Japan's inefficiencies are largely a consequence of Japan's choice to prop up these industries.






The return on asset (‘RoA’) in the US was twice as high as in Japan. But, with the benefit of the hindsight, the US's higher RoA was mostly a bubble phenomenon. Much of the US corporate profitability was due to financial engineering. In one aspect-export performance Japan’s corporate sector has done very well, much better than its US counterpart. Japan’s exports doubled in yen terms between 1993-2008 and their share in GDP nearly doubled to 16% from 9%, even though yen remained strong during the period. The performance of Japan's export sector shows that its inefficiencies elsewhere are largely due to system shortcomings.






Japan’s stagnation is mainly due to how the government has handled the debt overhang in the corporate sector, mainly in real estate, construction, and retail sectors, from the bubble era. In the 1980s, especially after the Plaza Accord, Japan’s corporate sector accumulated a massive amount of debt for financial speculation. The total corporate debt more than doubled to about yen 900 trillion, or 200% of GDP, between 1984-1992. After the land and stock prices collapsed, the net value of the corporate sector's financial assets switched from about 30% of GDP positive to 50% of GDP negative. If the change in the land holdings' value is included, the corporate sector's net worth may have dived by 200% of GDP. As corporate profit is about 10% of GDP in a developed economy, it would take two decades for Japan's corporate sector to earn its way back.






The Japanese government did choose to let the corporate sector to earn its way back by (1) preventing bankruptcies and (2) stimulating demand. To achieve the first goal, the government kept interest rate near zero and Japanese banks didn't pursue mark-to-market accounting in assessing their borrowers' solvency. With a big chunk of the corporate sector zombie-like, the economy, of course, was always under downward pressure. The government had to run large fiscal deficits to prop up the economy. After the bubble Japan's economic equilibrium was stagnation and large fiscal deficit.






This strategy is flawed in three aspects. First, even as the corporate sector earns profit to pay down its debt, the government's debt is rising. At best, it is shifting corporate debt to government debt. In reality, the government's debt has been rising more than the reduction in private sector debt. For example, between 1999-2008 the corporate debt declined to yen 900 trillion from 1,090, the household debt to 380 from 420, but the government debt rose to 950 from 630. The total non-financial sector debt increased from yen 2,160 to 2,250 trillion during the period.






Second, the economic efficiencies don't increase in such an equilibrium. The existing resources in the zombie sector are essentially unproductive. Bankruptcies improve efficiency by shifting resources from failing to succeeding companies. When rules are changed to stop bankruptcies, the efficiencies are sacrificed. Worse, incremental resources are sucked up by fiscal deficits that are used for propping up the zombie industries. Japan has been trapped in a low productivity equilibrium.






Third, long period of stagnation could cause irreversible social changes for the worse. Collapsing birth rate, for example, is one consequence that is wreaking havoc on the Japanese economy. Japan's policy after the bubble was to let property price decline gradually. Hence, the living cost was also declining gradually. On the other hand, the economy stopped growing. It caused income expectation to adjust downwards quickly. The combination of high property price and low income growth pushed down Japan's birthrate rapidly. As a consequence, Japan's population is declining two decades after the bubble. Rising burden for caring the old will decrease Japan's ability to pay for anything else.






After two decades, Japan hasn't achieved its main policy goal of letting its corporate sector to work its debt down. The total non-financial corporate debt is about the same as two decades ago. At 180% of GDP Japan's corporate indebtedness remains one of the highest in the world. Japan's household sector has indeed de-levered. Its debt at 69% of GDP is one of the lowest among developed economies. But, the government debt has increased massively during the past two decades. Its current debt level at 194% is the highest in the world. Only super low interest rate is hiding the burden of its debt.






The DPJ is handed over a poisoned chalice. It wouldn't have the resources to do serious restructuring of the economy. Its twin goals are (1) to increase support for the household sector and (2) to shift decision-making power from bureaucracy to politicians. The government's debt burden makes it impossible for meaningful increase in supporting the household sector. The LDP has wasted all the money. The DPJ hasn't got any room to pay for either new social programs or economic restructuring. To show progress, the DPJ is likely to stage high profile confrontation with the bureaucracy. While it may be good for politics, it wouldn't do much to improve the economy.






The total indebtedness of Japan's non-financial sector is 443%. It is probably the highest in the world. The US's is 240%. The difference is that the US owes a big chunk of its debt to foreigners, while Japan's is all to its own citizens. Most analysts think that high government debt is bearable as long as there are enough domestic savings to fund it. Japan's situation has been so. The future may be different. Japan's declining labor force is decreasing its ability to export. At some point it may begin to run trade and current account deficits. When it happens, Japan's interest rate may rise substantially, which would cause a fiscal crisis. Such a crisis may occur under the DPJ's rule. It could be blamed for a crisis that the LDP has built up for two decades.






We can learn much from Japan's experience. The global economy, mainly the Anglo-Saxon economies, is facing the aftermath of a massive credit bubble. The remedies that most governments have embraced are to keep interest rate low and fiscal deficit high. These are the same policies that Japan pursued after its bubble burst nearly two decades ago. There are shocking similarities in how today's bubble economies treat bankruptcies and bad debts to Japan's. The US and others have suspended mark-to-market accounting rule to allow banks to stay afloat despite large amounts of toxic assets. It is the same 'letting them earn their way back' strategy that Japan pursued. The strategy fails to work as it keeps economy weak, which limits the earnings power of the financial institutions.






As the global economy showing growth again in the third quarter of 2009, most governments are celebrating the effectiveness of their policies. Japan's experience makes us pause. Its economy experienced many such growth bounces in the past two decades but wasn't able to sustain any. The problem was that it used only stimulus, not restructuring to cope with the bursting of its bubble. After a big bubble there are serious structural problems that would hamper economic growth. Stimulus can only provide short-term support that makes structural reforms possible. When policymakers celebrate the short-term impact of stimulus and forget structural reforms, the economies will slump again. I think that the Anglo-Saxon economies will dip again next year.






China can learn a lot from Japan's experience also. Its bubble formed when its companies began to focus on financial investment rather than their core businesses. They borrowed money and pumped it into asset markets. They essentially provided leverage to the asset markets. When the leverage was rising, asset inflation happened, which allowed the companies to book profits multiple times their operating profits from their core businesses. That gave them more incentives to pursue asset appreciation rather than operating profitability. The corporate sector became a shadow banking system for financing asset speculation.






China's corporate sector is now behaving similar to Japan's two decades ago. China's businesses increasingly focus on asset investment rather than their core businesses. As I travel across China, it is rare to hear a business that is enthusiastic about its core business. But everyone seems excited about financial activities. In particular, property seems to become the main source of profit for most big businesses. The lending boom in the first half of 2009 seems to have been channeled mostly into asset markets by the corporate sector.






When an asset bubble boosts corporate profits, it seems benign at first. Nobody sees the harm. However, when businesses earn profits from the investments in each other rather than their corporate businesses, their operating profitability deteriorates, because they don't invest in their core businesses anymore. The accounting profitability is just a bubble. For example, property development has become the most important source of profit for China's corporate sector. If a manufacturing business is buoyant, the odds are that it is earning profit from property development. The banking sector reports high profitability due to its lending directly or indirectly to property development. Property development profit is actually from land appreciation. If property development profitability is measured according to the land price at the selling time, the development itself wouldn't be profitable. China's corporate sector derives a significant chunk, probably most of its profit from land appreciation. China's corporate borrowing one way or another goes into the land market.






A bubble happens because there is excessive money supply. Is the excessive monetary growth due to demand or supply? We can argue forever. When Greenspan said that a central bank couldn't stop a bubble, he meant that the money demand would rise regardless of interest rate. I disagree with this view. If a central bank targets monetary growth in line with nominal GDP growth, a big bubble couldn't happen. Aside from central banking failure, the most important micro element in a bubble is the 'shadow banking system'.






Regulators limit what banks can do by imposing a capital requirement on them. The international standard is 8% of total asset. There are accounting tricks for banks to minimize capital requirement. When a loophole in capital accounting is large, it could cause a disaster. For example, the loose restrictions on off-balance sheet holdings was a major factor for the global credit bubble. Most regulators are tightening up the accounting rules on capital requirement.






A less noticed and more important factor in causing bubbles is the so-called shadow banking system. Most analysts equate it to the hedge fund industry. It was providing leverage to financial speculation with little capital. The shadow banking system is much more than hedge funds. Industrial firms that engage in financial activities are more important. Entities like GE Capital, GMC, etc., provided massive leverage to asset markets with little capital. In the 1980s Japan's corporate sector tapped into the corporate bond market and raised massive amounts of capital for asset purchases. A shadow banking system is essential to a big bubble.






China's corporate sector increasingly looks like a shadow banking system. It raises funds from banks, commercial bills or corporate bond market and channels the funds into the land market. The resulting land inflation underwrites the corporate profitability and improves their creditworthiness in the short term. To limit the expansion of China's land bubble it must limit monetary growth to that of nominal GDP growth. Faster monetary growth is to accommodate and support the bubble. To understand the consequences, we only need to look at Japan today.