[OPE-L:7422] explaining Japan's decline

From: Rakesh Bhandari (rakeshb@stanford.edu)
Date: Wed Jul 17 2002 - 01:32:18 EDT

The Hindu Business Line

Tuesday, Jul 09, 2002

Explaining Japan's decline

C. P. Chandrasekhar
Jayati Ghosh

It is twelve years since the Japanese economy entered a phase of slow growth
after decades of rapid expansion. During these years it has experienced four
recessions, the last of which still afflicts the country's economy. In this
edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh examine some of
the factors that explain the decline of this erstwhile economic superpower.

PROVISIONAL GDP figures released in June 2002 suggest that the Japanese
economy grew by 2 per cent during the first three months of the year. Coming
after three consecutive quarters of contraction in 2001, this evidence has
rekindled hope among some observers.
They see Japan as being on the verge of a recovery from the fourth recession
that has afflicted it in the 12 years since the asset bubble of the second
half of the 1980s collapsed in 1990. Others are still pessimistic, based on
recent experience in which similar cause for hope was quickly sunk by real
If the trend rate of growth of GDP experienced by it during the period
1970-90 had been maintained, Japan's GDP would have been close to 50 per
cent higher by the turn of the last century (Chart 1).

This is significant, since Japan's breakneck expansion since the Second
World War had in fact slowed after the oil shock in 1973.

As Chart 2 shows, as compared with annual rates of growth of 9.4 and 8.3 per
cent recorded during 1946-60 and 1960-75, growth during 1970-90 was a much
slower 4.1 per cent. It is from this slower rate, which was creditable when
compared with that in the US for example, that Japanese growth has slumped
to 1.6 per cent during 1990-2001 and 1.2 per cent during 1995-2001.
For a population that had almost forgotten the sufferings of war, because of
rapid and prolonged post-war growth, the more than decade-long collapse of
the economy has indeed been painful.
Long accustomed to guaranteed and lifelong employment, the Japanese have had
to contend with a rising unemployment rate, which nearly tripled from just
above 2 per cent in 1990 to close to 6 per cent at present (Chart 3).

Anecdotes about increasingly insecure Japanese households cutting back on
consumption are now legion. Combined with a reduction in investment, which
triggered the downturn in the first place, this has meant chronic deflation.
Inflation rates that fell from three to zero per cent over the first half of
the 1990s, have been negative in most years since 1996 (Chart 4).

The principal puzzle emerging from the prolonged period of near-stagnation
coupled with periodic recessions is the failure of conventional
counter-cyclical policies to deliver a recovery.
Over these dozen years, the Japanese government has launched almost as many
reflationary initiatives, by increasing deficit spending and prodding the
central bank to cut interest rates and maintain an easy money policy. The
general government fiscal balance, which showed a surplus of close to 2 per
cent of GDP in the early 1990s, has been in deficit since 1993. And the
level of that fiscal deficit has risen from just 2.5 per cent of GDP in 1993
to 5 per cent in 1996 and 8.5 per cent in 2001 (Chart 5).

Yet the Japanese economy has not been able to extricate itself from the
recessionary bias that has characterised it through the 1990s.
Mainstream explanations for this predicament, now internalised by sections
of Japan's government as well, revolve around its failure to reform what is
considered to be a badly designed and unviable financial system propped up
by the state.
As has been noted by some observers, however, there are two problems
associated with such explanations. First, they leave unanswered the question
as to why during the years of rapid post-war growth the same Japanese
financial system was considered to be have been the engine that triggered
and sustained that growth, and therefore a "model" that was worth emulating.
Second, it does not take account of the fact that the asset price bubble and
its collapse, which preceded the period of deflationary bias, followed and
in all probability was triggered, inter alia, by a process of financial
The financial system that underlay Japan's post-war growth was one in which
government regulation and control was the key. Interest rates on deposits
and loans were controlled, with the government using differential interest
rates as a mechanism to target the growth of specific industries. Similarly,
the design and pricing of insurance products were state guided, keeping
larger objectives in mind.
The net result of such control was that: either i) the government had to
ensure financial agents a portfolio of activity that ensured that they
earned returns adequate for self-sufficiency and growth; or (ii) the
government had to canalise resources garnered through taxation or other
means to the financial system to ensure the viability of individual
financial agents.
The government's implicit or explicit guarantee of such viability implied
that it guaranteed depositors' savings as well, making bank deposits and
insurance products rather than stock market investments the preferred form
in which household savings were held.
This system was permissive on some fronts and limiting on others. Thus, it
required firms to approach banks that were flush with funds drawn from
household savings for finance. In turn, banks were in a position to use the
resulting leverage to ensure that their funds were profitably employed and
properly managed.
Inasmuch as the government "permitted" the banks to play this role, Japan
saw the emergence of the main bank system where "a bank not only provides
loans to a firm, but also holds its stock.
Typically, a firm develops a relationship with a particular bank and relies
on its steady support in funding over the long term. In return, the firm
uses the bank for major transactions from which the bank earns fees and
Thus, unlike in the US, where the performance of individual stocks and the
threat of take over when stock prices fell, or "the market for corporate
control", was the means to ensure effective deployment and efficient
utilisation of capital, in Japan, it was the link between direct and
indirect ownership and management that was the means to realisation of these
goals. And the state was expected to monitor the monitors, who were the main
The limiting role of the system was that it limited the ability of banks to
undertake investments in areas that were not in keeping with development
Thus, investments in stocks or real estate purely with the intention of
making capital gains were foreclosed by regulation. Banks, insurance firms
and non-bank financial institutions had their areas of operations defined
for them. Regulatory walls that prevented conflicts of interests and
speculative forays that could result in financial crises and hamper the
growth of the real economy clearly separated these areas.
During the years of high growth, this system served the Japanese economy
well. It allowed banks and firms to take a long-term perspective in
determining their borrowing and lending strategies; it offered entrepreneurs
the advantage of deep pockets to compete with much larger and more
established firms in world markets; and it allowed the government to
"intervene" in firm level decision-making without having to establish a
plethora of generalised controls, which are more difficult to both design
and implement.
Above all, when the rate of expansion of world markets slowed after the
first oil shock, and Japan, which was highly dependent on exports for its
growth, was affected adversely both by this and by the loss of
competitiveness that an appreciating currency involved, the system allowed
firms to restructure their operations and enter new areas so that profits in
emerging areas could neutralise losses in sunset industries.
Not surprisingly, Japan's economic system was bank debt-dependent for
financing investment and highly over-geared. Bank debt accounted for 95 per
cent of Japanese corporate borrowing in the mid-1970s, as compared with a
much lower 67 per cent in the US.
And while outstanding bank loans amounted to 50 per cent of GDP in the US in
the 1970s, from which level it gradually declined, the debt-GDP ratio in
Japan had touched 143 per cent in 1980 and rose to 206 per cent by 1995.
This feature was, however, not a problem because the government worked to
stabilise the system. As one observer put it:
"A combination of international capital controls, willingness to use
monetary policy swiftly to defend the currency, and the absence of other
countries simultaneously following the same development strategy shielded
Japan from serious problems."
In the event, Japan's economic success between 1950 and 1970 resulted in its
system of regulation, which was "unusual" from an Anglo-Saxon point of view,
being looked upon with awe and respect.
Even now, but for the fact that Japan fares so poorly, the overwhelming
evidence of accounting fraud, conflict of interest and strategies to ensure
stock price inflation emanating from leading US firms such as Enron,
Andersen, Merrill Lynch, WorldComm and Xerox, makes the Japanese system
appear far more robust.
The question, however, is why the system failed to serve Japan as well
during the 1990s. The answer lies in the fact that the system was changed
and considerably diluted as a result of American pressure during the 1980s.
The pressure came from three sources.
First, from international banks and financial institutions that wanted Japan
to open up its financial sector and provide them space in its financial
Second, once these external agents were permitted to enter the system, they
wanted a dilution of the special relationship that existed between the
government, the financial system and the corporate world, since that implied
the existence of internal barriers to their entry and expansion.
Third, these agents and even some Japanese financial institutions affected
adversely by the deceleration of growth in the system, wanted greater
flexibility in operations and the freedom to "innovate" both in terms of
choice of investments and instruments with which they transact.
There was one principal reason why Japan succumbed to these pressures: its
dependence on world, especially US, markets to sustain growth. When faced
with US opposition to protectionism against Japanese imports, Japanese
investors sought to Americanise themselves by acquiring or establishing new
production capacities in the US in areas like automobiles.
In return for the "freedom" to export to and invest in the US, Japan had to
make some concessions. But US demands were quite damaging. They began by
requiring Japan to reverse the depreciation of its currency.
Following the celebrated Plaza accord, arrived at in New York in September
1985, the yen, which had started to appreciate against the dollar in
February 1985 from a 260 yen-to-the-dollar level, maintained its upward
trend to touch yen 123-to-the-dollar in November 1988.
Though the year following that saw movements that signalled a strengthening
of the dollar relative to the yen, the downturn soon began again resulting
in a collapse of the dollar from an end-1989 value of 143.45 yen to its
April 1995 level of below 80.
Any economy faced with such a huge appreciation of its currency was bound to
stall, more so an export-dependent one like Japan's.
This trend, which resulted in the hollowing out of Japanese industry,
undermined the principal area of business of the banks as well, which were
faced with the prospect that some of their past lending could turn
It was in response to this that the Japanese banks joined the chorus against
financial controls, demanding that they be permitted to diversify away from
their traditional areas.
Regulatory changes in the form of a revision of the Foreign Exchange Control
Law in 1980 and permission for commercial banks to create non-bank
subsidiaries (jusen) to lend against real estate investments was the
government's response.
Besides expanding overseas operations, the principal areas into which the
banks diversified were lending against real estate and stock market
investments. The rate of growth of real estate lending rose from 7 per cent
in the second half of the 1970s, to 18 per cent in the first half of the
1980s and 20 per cent in the second half.

The result of this was a speculative boom triggered by a mad rush into the
new areas. Even as GDP growth was slower in the 1980s than in the 1950s and
1960s, the six-largest-cities-index of real estate prices tripled between
end-March 1985 and end-March 1990, from 33.6 to 100 (Chart 7).
Similarly, as Chart 8 shows, there was a massive speculative boom in stock
markets with the yearly high of the Nikkei stock market index rising from
12,500 in 1985 to 38,916 in 1989. By 1989 it was clear that the asset bubble
was bound to burst, and in a belated effort to halt the frenzy and respond
to householder complaints that acquiring housing was virtually impossible,
the government stepped in by controlling credit and raising interest rates.
The net result was a collapse in both real estate and stock markets.
The real estate index fell to half its peak level by 1995 and to a third by
2001. And the Nikkei, which registered a high of 38,713 on January 4, 1990,
fell soon after to an intra-year low of just above 20,000, and continued its
downward slide thereafter right up to 1998. A slight recovery in 1999 was
followed by a further fall in 2000.
The net result of this collapse and prolonged decline was a huge build of
bad debt with the banking system. At the beginning of 2002, the official
estimate of the non-performing loans of Japanese banks stood at Yen 43
trillion or 8 per cent of GDP.

This is despite the fact that over nine years ending March 2001, Japanese
banks had written off Yen 72 trillion in bad loans. There is still much
scepticism about official estimates of the extent of bad debts.
In September 1997, the Ministry of Finance had announced that the banking
sector held Yen 28 trillion in non-performing loans, but soon after that,
using a "broader definition", arrived at a figure of Yen 77 trillion, which
amounted to 11 per cent of outstanding private bank loans in Japan and 16
per cent of its GDP.
And in 1998 the Financial Supervisory Agency placed problem debt at Yen 87.5
trillion and debt already declared bad at Yen 35.2 trillion, which added up
to a total of Yen 123 million.
Whatever, the figure, in the past this would not have been a problem, as it
would have been met by infusion of government funds into the banking system
in various ways.
But under the new liberalised, market-based discipline, banks are i) not
getting additional money to finance new NPAs; ii) being required to pay back
past loans provided by the government; and iii) faced with the prospect of a
reduction in depositor guarantees, which could see the withdrawal of
deposits from banks.
Accumulation of such bad debt inevitably leads to a credit crunch, as banks
are strapped for cash and turn wary in their lending practices.
Over-geared corporation with outstanding loans on their books were no more
favoured customers, resulting in a collapse of investment and a fall in
utilisation for lack of long and short-term capital.
Added to that, the insecure Japanese consumer has chosen to hold back on
consumption. The rate of growth of private consumption expenditure had
fallen by 2000 to a fourth/third of its 1993-1994 values (Chart 5).
In the event, growth decelerated sharply, and periodic recessions were the
The point to note is that with growth having slowed and firms finding it
increasingly difficult to show a profit before interest and tax, they were
unable to meet past commitments.
As a result, the bad loans problem has only increased. This explains the
fact that huge provisioning against past bad loans by the banking system has
not adequately reduced the ratio of non-performing loans.
The government has over the last decade sought to resolve the problem by
increasing its own expenditures in an effort to spur growth. With growth, it
was argued firm performance would improve allowing them to clear at least a
part of their debts.
Unfortunately the depth of the slump was such that the government's effort
to increase deficit spending, on a budget, which has always been small
relative to the size of the Japanese economy, has not worked. Deceleration
has persisted despite the fact, noted earlier, of a rising fiscal deficit on
the government's budget.
But it is not only the higher deficit that has not worked. With the credit
crunch created by the bad loans problem appearing as the most proximate
explanation for Japan's decline, the argument that a badly designed and
managed financial system was responsible for the crisis has gained currency.
This amounts to saying that, rather than return to the regime that prevailed
before the liberalisation of the 1980s, Japan must liberalise its financial
sector further, allowing some banks and financial institutions to down
shutters in the process, if necessary.
This would only worsen the crisis in the short run, with depositors turning
more nervous and the credit crunch intensifying.
Yet, Japan is once again surrendering to external pressure and adopting
precisely such an agenda. In fact, Prime Minister Koizumi rose to power in
2001 on the slogan that he would reform the Japanese system along these
lines. But the immediate result of whatever he tried were such that he has
been unable to proceed any further.
Extended reform, to the extent that it has occurred, has not worked either.
With the crisis persisting and the evidence that he is not pushing ahead
with his reform agenda accumulating, even Koizumi's personal political
ratings have taken a beating.
In practice, the real beneficiaries of further reform would be the
international financial institutions who would be there to pick up the
pieces as the system goes bust, so that they can come to play a dominant
role in an economy into which they were unable to enter during Japan's
miracle growth years.
This is likely to be the denouement in this decade-long drama, unless
policies change substantially in Japan.
But to expect that of a country which based its earlier miracle growth
primarily on an expansion into world markets may be to expect a little too

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