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Emerging characteristics of Japanese finance: responses to the challenges of the post-bubble era.

Japan has had an extraordinary period of economic growth since the late 1940s and is now the world's second largest economy, led only by the U.S. Fueled by high savings and investment rates, Japanese growth was particularly high until the 1973 oil price shock. Economic growth rates were somewhat lower for the rest of the 1970s and the 1980s, but they were still high. Partially as a reaction to the "endaka" (high yen) crisis of 1985, a bubble" economy developed in the late 1980s. Japanese government ef-forts to end the late 1980s bubble in Japanese asset prices resulted in the most severe and the longest post-war recession for the Japanese economy in the early 1990s.

Concurrently with the recession in the early 1990s, Japan underwent significant changes in its political system. The Liberal Democratic Party, for the first time in this post-war era, no longer governs Japan. While it is clear that Japanese society faces major social, political and economic changes, there are still many unanswered questions about the significance of these changes. Specifically, of interest here are questions relating to the Japanese economy and financial system. Is the Japanese economic growth rate going to regain its prior high levels in the second half of the 1990s? More importantly, how can the Japanese economy and its financial markets be expected to change as they recover from the early 1990s recession?

The unusual characteristics of the Japanese economy and its financial markets are finally becoming better known outside of Japan. However, they are facing significant changes, making many Western perceptions obsolete once again. In order to assess these changes, we will review the nature and determinants of recent economic growth in Japan, the structure of Japanese finance and prospective changes in the Japanese economy.

The Nature of the Japanese Economy and Financial System

The high rates of economic growth in Japan in this post-war era can be traced to the extraordinarily high savings rates in Japan that provided the funds necessary for productivity enhancing investments in capital goods and proven foreign technology. For example, in 1993 Japan accounted for 56 percent of total net savings in the developed world (the figure for the U.S. was 5 percent). With an economy much smaller than the U.S. economy for most of this post-war era, Japanese capital investments were consistently higher. Consequently, Japanese productivity and wages grew on average twice as fast as in the U.S., and the Japanese manufacturing sector grew to be the most efficient in the world.

These high savings rates in Japan have been facilitated by the large percentage of wages that are paid as lump sums in June and December and by the fact that most interest income from savings has been largely tax exempt in Japan. High savings rates were also encouraged by the relatively poor social safety nets and old age pensions, and the poor availability of housing and consumer finance. The Japanese have had to save for everything. Finally, Japanese government policies have been designed to encourage this positive feedback loop that goes from savings to capital investments to higher wages and bonuses, and back to higher savings, and so on. High savings rates also result in a low cost of capital for Japanese firms, making future cash flows more valuable for them and making it logical and rational to take a long-term perspective in business decisions.

The nature and structure of Japanese finance reflect the unique historical evolution of the Japanese economy. Japan is an island nation with one of the highest population densities in the world. Not only does this place a premium on the use of physical space (the Japanese did perfect just-in-time inventory management), it also means that the Japanese people have learned to live in close proximity with each other. Japanese society places much emphasis on group identity. In addition, as Japan is a fairly homogeneous country that was closed to non-Japanese for many centuries, the Japanese often think of themselves as being part of a unique group.

Government and Business Cooperate

Japanese business and finance reflect these social characteristics in many different ways. For example, most large Japanese business firms are associated with a group of other large business firms in vertical or horizontal "Keiretsu". In fact, it has even been contended that all of Japanese society (business, government and politics) operates like a large organic Keiretsu with no one, clearly defined power or decision making center, but with Japanese business and government working together, especially against non-Japanese competitors.

Members of a Keiretsu have strong business ties with each other that are often cemented by long-term cross-holdings of equity. At the end of 1990, banks and other companies owned more than half of the outstanding shares on the Tokyo Stock Exchange. One implication of these extensive cross-holdings of equity is that hostile takeovers are highly unlikely in Japan. Most keiretsu firms have a "main bank", often a member of the keiretsu, that provides significant and committed financing and closely monitors the firm on behalf of other owners and members of the keiretsu. One implication of these financial arrangements is that Japanese firms often operate with much higher levels of debt than comparable U.S. firms.

Japanese financial institutions and markets were basically structured by the post-war U.S. occupying forces to be like the U.S. financial system. However, they have evolved to reflect the needs of the Japanese economy. This evolution of Japanese financial institutions and markets has been influenced greatly by Ministry of Finance and the Bank of Japan regulations. Interestingly, the Japanese approach to financial regulation has been to describe what is permitted (with other activities forbidden), while the Western approach has been to specify what is prohibited (with other activities permitted).

Banking and Finance Systems

The Japanese banking system consists of private and government financial institutions. Government institutions include the ubiquitous Post Office, the Export-Import Bank, the Japan Development Bank and a number of specialized financial institutions. Private financial institutions include insurance companies, housing finance companies, securities companies and specialized financial institutions for small businesses, long-term credit, agriculture, forestry and fishing. Japanese commercial banks include eleven city banks (similar to money center banks in the U.S.), about sixty regional banks and a number of foreign banks. Although the essential features of the Japanese banking system are still intact, the system is undergoing significant consolidation because, with the bursting of the late 1980s bubble in asset prices, many financial institutions faced bankruptcy, and some still face it today.

There are large and liquid money markets in Japan with active trading in the interbank market and in commercial paper, CDs, repos and government bills. Although the domestic corporate bond market is relatively underdeveloped, the market for government bonds is large, with especially active trading in the "benchmark" issues.

Japan has eight stock exchanges and an electronic over-the-counter (OTC) equities market, but the Tokyo Stock Exchange (the second largest in the world after New York) reflects over 90 percent of the listed value and trading volume in equities. Japanese equities are characterized by low dividend yields and high price/earnings ratios, possibly because of extensive cross-holdings and because of conservative accounting among Japanese firms. Japanese equity markets are fairly liquid and seem to be informationally efficient, even though they seem to exhibit the same empirical regularities as do U.S. equity markets. Futures and options are traded over the counter and on organized exchanges in Tokyo and Osaka. There are numerous securities firms in Japan, but the big four (Nomura, Diawa, Nikko and Yamaich) dominate most aspects of the securities business in Japan.

The Late 1980s Bubble in Asset Prices

Following the 1985 Plaza Agreement that resulted in the doubling of the value of the Japanese yen, the Japanese economy went into a significant recession in 1986. In response to this "endaka" (yen shock), the Japanese government seems to have followed an easy-money policy, with large increases in the liquidity available to Japanese firms. This started a cycle of asset price inflation that accelerated in the late 1980s. During that period, Japanese firms were borrowing extensively at low rates to speculate in stocks and property. As these assets increased in price, they were used as collateral for loans to buy more property and equities, which further drove up their prices. This positive feedback loop of asset prices, their collateral value and borrowing for speculation in the same assets was a major driver of the asset price bubble of the late 1980s.

As an example of the high prices of Japanese assets in late 1988, an 80 percent mortgage on Tokyo real estate alone would have been more than enough (at $7.7 trillion) to purchase all of the land in the U.S. (at $3.7 trillion) and all publicly listed companies in the U.S. (at $2.6 trillion). These high asset prices, combined with an appreciating yen, fueled the explosive growth of Japanese foreign investment. Not surprisingly, during the late 1980s, in addition to the domestic boom in financial asset transactions, the Japanese also bought large proportions of new treasury bonds issued to finance the U.S. federal deficit, as well as significant amounts of urban real estate and many high-tech and other U.S. and non-Japanese companies.

However, this late 1980s asset price bubble also created many problems in Japan, including a deterioration in the distribution of wealth and in the quality of economic decisions. Consequently, the Bank of Japan started a campaign to reverse the unusual late 1980s rise in the prices of real estate, securities and other financial assets. However, as asset prices fell, increasingly larger numbers of borrowers defaulted, with serious consequences for Japanese firms and financial institutions, many of which had to be rescued or even had to declare bankruptcy. This precarious condition of the Japanese financial system significantly inhibited Japanese economic recovery in the first half of the 1990s.

Challenges Facing the Current Japanese Economy

The recession of the early 1990s was Japan's longest and most severe post-World War II economic slowdown (three consecutive quarters of negative real GNP growth in 1992). This downturn in the Japanese economy was accentuated by the sharp rise of the yen in 1993-1994. In early 1995, the Nikkei 225 was still at less than half of the high reached on December 29, 1989, and Japanese equity trading volume was only about a third of the peak volume reached in 1988. Although the keiretsu structure in Japan is weakening slightly, there continue to be extensive cross-holdings of equity among business firms and bankers in a keiretsu.

The Domestic Economy-A Shift in Emphasis

Major political changes are taking place in Japan, with many cases of corruption and scandals being exposed, especially after the collapse of the late 1980s asset price bubble. The one-party (LDP) rule of Japan seems over, and the social compact in Japan seems to be shifting. The Japanese people now seem to be demanding significantly greater openness in business and political affairs and an economic shift away from individual sacrifice for the production sector, developments that will make consumer demand a driver of future Japanese economic growth.

In view of these changes and the high international value of the yen, Japanese plans for economic recovery emphasize a shift to domestic consumption, deregulation of finance and industry, high value-added production within Japan (components made in Japan with final assembly overseas) and to Asian exports and investments. In response, Japanese companies are restructuring - some successfully (e.g., Matsushita). Also, with a reduction in the role of middlemen, major changes are taking place in the inefficient Japanese distribution system. In retailing, there is a significant move to value by the Japanese consumer, as confirmed by the rise of the discount stores (e.g., Daiei). Japanese multinationals face special challenges because they are based in a culturally and ethnically homogeneous nation. In contrast to "greenfield" investments, Japanese acquisitions in North America have mostly been unsuccessful, Japanese exports and foreign investments are now increasingly directed to Asian countries in contrast to the earlier focus on Europe or the Americas. (Exports to Asia are already 30 percent more than to North America).

While they are still more regulated than those in the U.S. and the U.K., Japanese financial markets are being deregulated fairly rapidly. Because of the continuing recession, growth of domestic lending by Japanese banks was stagnant in the first half of the 1990s. (It actually fell slightly for the fiscal year ending March 1994.) Japanese banks would like to be deregulated so they can develop alternative sources of revenue (e.g, fixed rates on bank deposits in Japan are being eliminated). As an interesting note, the Japanese Post Office seems to be a major beneficiary of the deregulation of Japanese financial markets. With over 24,000 branches, it has increased its share to a third of all Japanese retail deposits (Y 187 trillion).

The Japanese financial system still shares many features with the U.S. financial system. However, in response to its culture and history, it has also evolved to have a significant set of features that make it unique. Equity cross-holdings among keiretsu member firms and banks is the norm. Japanese corporate debt and price/earnings ratios are relatively high. The Japanese economy suffered from an asset price bubble in the late 1980s and a major recession in the first half of the 1990s. Consequently, most Japanese firms that have avoided financial distress are being restructured significantly.

Major features of the Japanese business strategy for economic recovery in this post-bubble era seem to include increased domestic consumption and deregulation of finance and industry; a shift to services, information based industries, and other higher value-added components and goods; and greater globalization of Japanese companies, with a shift of trade and foreign investment to Asia and away from North America and Europe.

These changes in Japanese industry and finance present many strategic and business opportunities. For example, Japanese and foreign businesses need to develop effective responses to the deregulation, restructuring and globalization of Japanese business that is accompanying the increased emphasis on the individual consumer, investor and voter in Japan.

Raj Aggarwal holds the Edward J. and Louise E. Mellen Chair at John Carroll University, Cleveland. The author would like to thank the Mellen Foundation and John Carroll University for research support. The author is solely responsible for the contents.
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Author:Aggarwal, Raj
Publication:Business Credit
Date:Nov 1, 1996
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