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Japan's Lost Decade and Its Financial System

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Japan's Lost Decade and Its Financial System BlackwellOxford,TWECThe0378-5920©March2631000OriginalJAMITSUHIRO 2003PAN’S World 2003 BlackwellUKArticle LOSTPublishing Economy FUKAO DECADE Publishers Ltd AND Ltd ITS (a BlackwellFINANCIAL Publishing SYSTEM Company)Japan’s Lost Decade and its Financial System Mitsuhiro Fukao Afterwcrossholdingprivatisedcompanieseak brieflyand toJapan haveexplaining createof shares weakstill a faces level-playing corporatethebetween causesa number banksgovernance, offield ofthe andproblemsamong Japanese other and deposit incompanies many asset-priceits financialtaking of the has financial large bubblesystem. weakened shareholders ininstitutions. Firstly,the the1980s, themarket of Besides profit thisbanks disciplinepaper margin arethe analyseslifeforegoing, of oninsurance banks entrenched why theis too companies. theweak small management.bursting corporate to covThis of erthe double governancethe Thirdly, bu increasedbb gearingle thedeveloped structuregovernment defaultbetween into ofrisk banksJapanesea guarantee followingfull-fledged and 1. financiallifethe of financialinsurance allbursting banking-sector institutionsINTRODUCTION crisisof companies the in bubble, hasthe liabilities lateto has andbe 1990s. thereforeremodelled. shouldthere In are orderbeweakened market removed.The to managementcope distortions the Once with market thisthe created of controlcrisis,financial banks by theof has systemtheJapanese Government shieldedgovernment- is stabilised,financial themselves hasbacked i njectedinstitutions a risk-ad financialby capital extensivejusted. institutions directly deposit cross-shareholdings, into insuranceand the the banking requirements premium sector especially should and on newbankswith be lendingintroducedlife have insurance writtento small so companies.as off and to enormous strengthenmedium There amountssized market has companies. been ofdiscipline bad extensive loans. Secondly, on However,banks, mutual banks and provision the thestill Japanes hugehav ofe capital postalexcessivee financial, savinmost stock sectorg large system investment liferemains shouldinsurance veryand be FTER the collapse of the bubble, most of the unrealised profit in holdings of Astock and real estate has disappeared. Banks have used up their unrealised capital gains to cover loan losses. Banks and life-insurance companies no longer have the equity buffer necessary for maintaining very large stock portfolios for cross-shareholding purposes. The Government used to have a ‘pocket’ to use at its discretion. The regula- tory rent in the financial sector derived from the deposit interest and branching controls was used to take care of failed financial institutions. Even if a failed bank had a negative equity, Ministry of Finance (MOF) officials could easily find a healthy bank for a merger. The Fiscal Investment and Loan Programme (FILP) also relied on this rent. The Government-sponsored financial institutions (GSFIs) could distribute a part of a large gap between the regulated deposit interest rate and the on-going lending rate as a subsidy to the preferred borrower. Even if a FILP finance project went sour, the Government could provide implicit subsidies with low interest loans. By phasing out deposit interest and branching controls in the late 1980s and early 1990s, MOF officials lost power to give credible commitment to the priv- ate financial institutions. In order to take care of bank failures, MOF officials now have to obtain an explicit budget allocation. The extremely strong public resistance to the use of what now appears a very small amount of public money (0.685 trillion yen), to solve the jusen problem in 1996 forced the MOF to postpone the resolution of the bad loan problem of the banking sector. GSFIs also need taxpayers’ money to provide low interest loans. However, the subsidised loans by GSFIs have made it extremely difficult for banks to earn a profit because they also lost rent from deposit-interest controls. Under the current MITSUHIRO FUKAO is from Keio University. He would like to thank Mariko Sakakibara, E. Han Kim and other Symposium participants for helpful comments. © Blackwell Publishing Ltd 2003, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA 365 366 MITSUHIRO FUKAO deflationary economic environment with large debt overhangs among borrowers, banks cannot cover the cost of loan losses with their thin profit margins. In order to resolve the bad-loan problem in the banking sector, banks have to raise lending interest rates to their main customers, i.e., small and medium sized firms. On the other hand, small and medium sized firms are also on the losing side. They used to receive at least a part of the regulatory rent from the banking sector as relatively low interest rates on their debt. Using the short-term money market rate as a benchmark, they are now paying about two percentage points more on their bank borrowing than they used to pay in the 1980s. As a result, the real borrowing cost of smaller companies remains relatively high in spite of the zero- interest policy of the Bank of Japan. Thus, most small and medium sized firms cannot readily afford to pay higher interest rates to banks. Probably, the only way out from this impasse is a mild inflation. If the Bank of Japan could stop deflation with strong monetary expansion, it would be possible to have a higher nominal lending interest rate and a lower real borrowing rate. 2. THE REAL ESTATE BUBBLE AND FINANCIAL CRISIS In this section, I briefly review the process of the asset price bubble and the developments of the financial crisis in the 1990s. a. The Origin of the Problem In order to examine the origin of Japan’s financial problems, let us briefly review the magnitude of the Japanese asset price bubble in the 1980s. The market value of the Tokyo Stock Exchange 1st Section as a ratio to nominal GDP had remained in the 20–40 per cent range from the early 1950s to the early 1980s. However, stock prices started to rise in the mid-1980s and reached 150 per cent by the end of 1989. After the crash of the bubble, this ratio fell to about the 50–70 per cent range. In relation to nominal GDP, residential land prices almost doubled in the second half of the 1980s, and the commercial land prices tripled in the same period. After the bubble, the fall of the commercial land price index was extremely sharp. It fell to only 20 per cent of the peak level relative to nominal GDP. The asset price bubble was created by the following three factors: loose monetary policy; tax distortions; and financial deregulation.1 In countries where these three factors were in place, asset price inflation was often observed. In this respect, the Japanese case was not an abnormal phenomenon. However, the magnitude of the asset-price bubble in Japan was enormous and the impact of its collapse was extremely severe. 1 See Shigemi (1995) and BIS (1993) on the causes of asset price inflation in major countries. © Blackwell Publishing Ltd 2003 JAPAN’S LOST DECADE AND ITS FINANCIAL SYSTEM 367 (i) Easy monetary policy Japanese monetary policy in the late 1980s was clearly too loose. Policy makers put too much weight on stabilising the appreciating yen and too little weight on stabilising the asset price bubble and the overheating economy. The Bank of Japan (BOJ) tried to tighten monetary policy in late 1987 so as to counter the overheating economy and rising asset prices. However, the sharp fall in stock prices on Black Monday in the United States in October prevented this move. The BOJ did not raise its discount rate until May 1989, and it failed to stop the asset-price bubble at an early stage. Stock prices defied the intention of the BOJ and continued to rise until the end of 1989. Land prices hit their peak in early 1990. If the BOJ had acted in late 1987, it could have alleviated the severity of asset price deflation in the 1990s. (ii) Tax distortions The Japanese tax system favoured debt financed real estate investment until the end of the bubble, as the following examples illustrate. 1. The marginal rate of inheritance tax has been very high in Japan. It was 75 per cent over 500 million yen until 1988, and it is still 70 per cent over 2 billion yen. However, the evaluation of land for taxation used to be about one half of the market value, and the debt was evaluated at its face value during the bubble period. As a result, wealthy individuals borrowed money to buy land so as to reduce the inheritance tax. 2. Capital gains on land were not taxed until the time of its sale, and interest payments can be deducted from taxable income for companies and for those individuals who are investing in condominiums and offices. Moreover, the effective property tax rate on land was very low, about 0.1 per cent of the market value, until the early 1990s. As a result, a large number of real estate investments were carried out for tax planning purposes. (iii) Financial deregulations The financial system in Japan was liberalised very gradually. The driving forces behind this liberalisation process were the massive issuance of govern- ment bonds in the late 1970s and the increasing internationalisation of financial markets. Ceilings on bank deposit interest rates were liberalised gradually from large-denomination to smaller ones from 1985 to 1994. Restrictions on the issuance of corporate bonds were gradually liberalised during the 1980s. As a result, large listed companies, which are traditional customers of Japanese banks, gradually shifted their funding from banks to the capital market. Banks faced a prospect of profit squeeze due to rising funding costs and a declining customer base. In view of the declining rent from the traditional business of retail deposit taking and commercial lending to large firms, banks tried to increase their middle-market business. Most banks started to increase real estate lending. In expanding such © Blackwell Publishing Ltd 2003 368 MITSUHIRO FUKAO lending, banks exclusively relied on collateral and paid little attention to the cash flow of underlying business. This was because the nominal land price in Japan had been on a rising trend since the end of World War II, and the pace of land-price inflation was higher than government bond interest rates on average.
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