The Japanese Nikkei stock index jumped 39% from its bottom in April 2003 through the end of October. This indicates that many investors believe the Japanese economy is on its way to a full recovery. Is it for real this time?
Japan has endured more than a decade of economic decline. The country is experiencing deflation, and attempts by the Bank of Japan to fight it have been ineffective. Politicians fail to enact meaningful reforms, yet voters continue to support them. Government debt is spiraling out of control. Japanese citizens have very long life expectancies, but begin to receive pension benefits at age 60. The nation has allowed serious problems to grow unchecked for years. For the recovery to be real, short-term economic upheaval is inevitable. Investors have to ask whether Japan is ready to face this unpleasant fact.
What happened to stop Japan in its tracks? Price bubbles had been building in Japanese equities and real estate for years, and the bubbles finally burst in the early ’90s. The stock collapse damaged Japanese citizens’ wealth and made a nation of savers even more reluctant to spend. It also drove Japanese investors away from stocks to the security of bonds. The collapse of land prices led to massive defaults on property-related bank loans. Companies maintained excess capacity, which drove down prices. Rather than lay off employees or go out of business, companies were bailed out by the government and by banks that continued to lend money the companies could not repay.
The Liquidity Trap
Japan has unsuccessfully battled deflation since 1999, because of a strengthening yen, low economic growth, a broken banking system and an inability to lower interest rates any further. In a declining price environment, consumers are gripped by a deflationary psychology. They are not motivated to spend because they know that prices will continue to drop. Lower consumer spending reduces corporate profits, which in turn lowers the aggregate level of wages. This further lowers spending, and the deflationary cycle continues.
It is very difficult for a country to pull itself out of a deflationary spiral. Central banks can tinker with short-term interest rates, lowering them when the economy needs stimulus and raising them when the economy shows signs of overheating. But when a country has deflation, and interest rates are effectively zero, there is no room for central banks to lower rates further. This leads to what is known as a “liquidity trap,” where attempts to increase the money supply have no effect on price levels.
Adding to the problem of excess liquidity is the mechanism by which it is transmitted, through the banks. The banking sector is mired in a mountain of bad debt, currently estimated by the Japanese government at more than $300 billion. Deflation makes it more difficult for borrowers to pay their debt, creating more non-performing loans. In addition, with near-zero interest rates, it is unprofitable for banks to lend. Growth is stifled as new money that is pumped into the economy is gummed up in the banks.
Instead of writing off the bad loans, the banks refinance the debt, thus extending still more credit to borrowers who will not be able to pay. When these bad debts are taken into account, many Japanese banks are woefully undercapitalized. Recently, the Japanese government began to assert itself in the banking sector by forcing write-downs of non-performing loans. However, it continues to bail out undercapitalized banks. In the future, the government must be willing to let companies fail.
Conservative Japan Adapts, Slowly
The Japanese are notorious for being averse to change. Recent signs are encouraging, however, with Prime Minister Junichiro Koizumi, elected in 2001, promising sweeping changes to fix the economy. He has made progress, but slowly, held back by the conservative old guard in his own party.
Recent elections demonstrate how the Japanese political landscape is changing. Voters are finally beginning to vote against the Liberal Democratic Party in meaningful numbers. A second party, the Democratic Party of Japan, is gaining ground by promising economic reform. It is encouraging to see Japanese voters start to push toward a two-party system.
Corporations are also beginning to recognize that they, too, must change. Foreign institutional investors are demanding that Japanese companies shore up their balance sheets and cut costs. Capital investment is increasing, and jobs are being exported to neighboring countries to take advantage of cheaper labor. The Japanese are becoming more open to foreign direct investment and to foreigners running Japanese companies, all in the name of an improved bottom line.
Nonetheless, many Japanese companies have not changed, continuing to get by with bank loans and government handouts. For the economy to improve, these so-called “zombie companies” with excess capacity will either have to lay off employees or be forced into bankruptcy.
Supporting An Aging Nation
Japan’s demographics clearly show an aging nation. It has the lowest birthrate of any developed country, and the longest-living population. There is also very little immigration. Many young skilled laborers leave to make their fortunes elsewhere. In a nation where people begin collecting pensions at age 60, it is clear that something has to give, or the country simply will not be able to support itself. Proposals have been made to increase the official retirement age, but no changes have occurred. For a country with gross national debt that is already approximately 140% of annual GDP, one has to wonder where the money will come from to pay all these pension liabilities.
For Japan to recover, banks must be able to lend profitably to good credit risks. They also must increase the rate at which they write off bad loans. Unprofitable companies will have to go bankrupt and workers will have to lose jobs and find new employment in higher-growth areas. Voters and corporations must continue to assert themselves and resist complacency. Finally, to rein in government debt, the normal retirement age will need to be increased significantly.
Until Japan’s large structural problems are addressed, true revitalization is unattainable. Is Japan’s recovery for real this time? Not yet.