Great lessons to be learned from Japan’s balance sheet recession

Discussion Paper No. 22 August 6, 2009

Economic Research Department. Swedbank AB (publ), 105 34 Stockholm. tel +46-8-5859 1000

E-mail: [email protected] Internet: www.swedbank.se Cecilia Hermansson, +46-8-5859 1588, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 1478, ISSN 1103-4897

Great lessons to be learned from Japan’s balance sheet recession Japan almost came out of the woods, but went in again. After six years of positive economic growth averaging some 2 percent, GDP lost almost 4 ½ percent last year. During the first half of 2009, GDP has continued to shrink dramatically. Clearly, Japan has been hit harder by the global financial and economic crises than many other countries. Its production structure and dependence on ex-ports, along with a stronger yen, provide some explanations. Now, the worst seems to be over. Japan’s economy has started to stabilize, as industrial output is increasing for the fourth month in a row. However, several factors point to a fragile recovery with falling prices, wages and sluggish de-mand. Our growth forecast remains at -6 ½ percent for this year, and is mar-ginally revised upwards from ½ to 1 percent for 2010. The situation gives rise to political pressures to increase domestic demand and reduce dependence on foreign markets. Japan is looking for a new growth model, but the process of changing the economy will take time. There is no question there are lessons to be learned from Japan’s situation. At this time of global recession, Japan should be of great interest to other coun-tries’ politicians, companies and academicians. This discussion paper points out five good reasons to study Japan more in depth:

------------------------------------------------------------------------------------------------------- Contents: Page: 1. Why Japan has been hit harder than many other countries 3 2. The economic outlook: A fragile recovery at best 5 3. Another type of social contract 7 4. A possible change in political power 11 5. A limited number of stimulation tools 14 6. What we can learn from Japan’s post-bubble experiences 18 7. Political changes and a new growth model: Implications

for foreign companies 23

2 Discussion Paper No. 22 August 6, 2009

1) Japan is the world’s second largest economy in dollar terms (not count-ing the EU). Business opportunities are there even if they are somewhat hidden: They would increase with a new growth model contributing to a stronger domestic demand. To succeed, Japan must focus on the wel-fare of households and also continue with structural reforms to open up the economy to foreign labour and investment.

2) Possible changes in the political situation, if the DPJ wins the election at the end of August, might also contribute to changes in the rest of the world. For example Japan’s interest in financing the US deficit could decrease with consequences for the dollar, or new growth prospects in various consumption sectors as Japanese households become more of a focus for political decisions.

3) Japan had the experience of an asset price bubble bursting at the be-ginning of the 1990’s (the Heisei bubble) and also a subsequent balance-sheet recession lasting more than 15 years. How to use economic policy in the light of actors reducing debt and correcting balance sheets is of great importance for the US, the UK and many other countries all of which have a lot to learn from the Japanese experience.

4) The neglect of balance-sheet issues in economic theory contributes at times to the wrong policy measures. Monetary policy is less effective in supporting demand when there is a little interest in borrowing new money, as debt is being reduced. Fiscal policy focused on government spending is more useful to compensate the effects on demand of great wealth losses. Also, fixing the banking system is affected by whether there is a balance sheet recession or not, and if the banking crisis is systemic or local. Richard Koo’s contribution to economic theory and economic policy is based on the Japanese example and is extensively dealt with in this discussion paper.

5) Japan had a great economic success up to the Heisei bubble. After that, the economic situation has been sluggish. Even so, many Japanese companies have transformed themselves and adjusted successfully to a globalized intensely competitive world. Japan is of great importance to the Asian region, and as China, India and other Asian economies gradually catch up with industrialized countries in the West, the Japanese situation is being followed closely by neighbouring countries. Similarly, China’s importance for Japan is high and increas-ing. Japan’s road to a new growth model – if real – could influence the rest of Asia.

Cecilia Hermansson

Discussion Paper No. 22 August 6, 2009 3

1. Why Japan has been hit harder by the global recession than many other countries

Japan’s economy and its banking sector are not directly ex-posed to the global subprime crisis. However, the slump in GDP has been more pronounced than most other G7 countries as GDP fell by 13.5 percent in the fourth quarter of last year and 14.2 percent in the first quarter of this year in annualized terms. Exports have lost around 40 percent of their volume compared to a year ago. Industrial production reaches only two thirds of the volume seen last year.

GDP-growth (annual and annualized percentage change)

S o u r c e : R e u t e r s E c o W in

9 5 9 6 9 7 9 8 9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8- 1 5 . 0

- 1 2 . 5

- 1 0 . 0

- 7 . 5

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J a p a n , G D P , a n n u a l i z e d ( Q / Q * 4 )

J a p a n , G D P ( Y / Y )

There are four important reasons for this:

i) The product structure of Japanese exports is characterised by the large share of advanced manufacturing and durable goods, such as motor vehicles and electronics (about one third of total exports). These have been relatively hard hit by the recession.

ii) Exports and investment related to the export sector have been im-portant growth engines, as consumption is subdued. But invest-ment is now hit by overcapacity, low confidence and tighter finan-cial conditions.

iii) The share of exports going to other parts of Asia – including China – is more than a fifth of total exports and thus higher than for other G7 countries. As the rest of Asia slowed down markedly, this also effected Japan.

iv) Since August last year, the Japanese yen has appreciated by more than 30 percent in nominal trade-weighted terms. Many Asian cur-rencies have depreciated dramatically against the yen aggravating the deterioration of Japan’s corporate profits and trade balance.

Despite low exposure to the subprime crisis, Japan has been hit harder than most other countries


During 2000-2007, the yen depreciated by some 40 percent in real terms as a result of the carry-trade (i.e., borrowing at low interest rates in Japan, and exporting capital to higher-yield re-gions). After the unwinding of the carry-trades and possibly also finding the yen to be safe haven currency, the yen has appreci-ated, especially up to early spring this year. After a move in the opposite direction, the yen in real terms is around the average seen during the last 30 years. Even so, the development over the last year has been dramatic and worsened Japanese com-petitiveness in a weaker market. Obstfeld (2009) finds a nega-tive correlation between the real exchange rate and real GDP-growth, with a coefficient of -0.38.

The real and nominal trade weighted Japanese Yen


7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8

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N o m in a l N a r r o w E f f e c t i v e E x c h a n g e R a t e I n d e x R e a l N a r r o w E f f e c t i v e E x c h a n g e R a t e I n d e x

Overcapacity can be measured by looking at companies’ views on their production capacity in relation to demand. At the mo-ment (this year’s second quarter), the difference between com-panies reporting excess capacity and insufficient capacity is at an all time high of 21 for all industries, while the same measure for the production of motor vehicles is much higher at 65 (down from historically high of 66 first quarter).

Industrial shipment and inventories


7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8

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1 6 0 I n v e n t o r ie s S h ip m e n t s I n v e n t o r y R a t io

Japan’s export industry has worsened its competitiveness due to a stronger yen

There is still overcapacity and need for adjustment


Even if companies have reduced their inventories, the adjust-ment has been insufficient in comparison to the decrease in shipments. Thus, the inventory ratio has risen sharply, and even if it comes down a little, there will be a need to lower capacity even further. The Japanese corporate sector has lost confi-dence, as there is no longer any supporting from strong export markets and a weaker yen. Already last year, profits were hurt by higher costs for raw materials; costs that could not easily be transferred to customers and consumers.

2. The economic outlook: A fragile recovery at best

The worst may be over. Since February, the aggravation of the economic situation has decreased as growth rates of industrial production and exports have become less negative, and the Purchasing Managers’ Index has entered the growth zone. In June, industrial output rose for a fourth month in a row. The sectors contributing to the output revival were electronics manu-facturing, steel and iron production and chemicals. These de-velopments coincide with a weakening of the yen both in nomi-nal and real trade-weighted terms and a less negative situation in Japan’s trading partners, especially in the rest of Asia.

Industrial Production (%), Exports (%) and Purchasing Managers’ Index

S o u rc e : R e u te rs E c o W in

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M a n u fa c tu r in g P ro d u c t io n S A , In d e x , 2 0 0 5 = 1 0 0 [c .o .p 1 P u rc h a s in g M a n a g e rs ' In d e x E x p o r ts , T o ta l, S A , J P Y [c .o .p 1 2 m o n th s ]

There are three main reasons for near-term improvement in the economy:

1) Stabilisation in the export environment, and a rebound in the emerging markets especially benefiting Japan.

The export share to emerging countries – including interme-diate goods – is almost 50 percent in Japan, whereas the shares in Germany and Sweden are about 25 percent and

Even if the worst is over, growth will most likely be sluggish


18 percent respectively. The Purchasing Managers’ Index signals an improvement in industrial production and a sub-sequent improvement in exports to both industrial and emerging economies. The improvements have been espe-cially notable in China, Russia and India, which are impor-tant export markets for Japan.

2) There is an easing in inventory correction pressures. Japanese companies have made large cuts to inventories, although not to the same extent as shipments have been decreased. Even so, the inventory cuts made will ease pres-sures going forward. A not negligible part of the rebound in industrial production is likely to be the effect of restocking.

3) The stimulus packages give the economy a boost. The aggregate value of the stimulative measures decided in fiscal years 2008 and 2009 will be equivalent to 4.2 percent of nominal GDP, excluding support for the financial sector. The measures are designed to give effect quickly, and dur-ing 2009 the impact on growth will come especially from spending on public works.

We maintain our forecast from June for 2009. Japan’s GDP is set to shrink by 6 ½ percent. During 2010, GDP-growth will be 1 percent, a little higher than previous ½ percent as Asia is grow-ing somewhat faster. Despite some growth during the second half of 2009, it will be difficult to transfer these improvements into a sustainable recovery since:

1) The Japanese economy is dependent on US growth in-creasing; without a robust recovery there, Japan’s full-fledged recovery will have to wait.

The correlation between growth in the US and Japan is high. We do not foresee US GDP growth exceeding 2 percent un-til 2011, or in the later half of 2010. Credit markets are still not functioning well, and house prices are falling. Unem-ployment is increasing, and household spending is likely to be hampered by the need to correct balance sheets at the same time as disposable incomes are weakening.

2) Chinese growth is increasing, but it is not translating into much higher exports from Japan.

When strong US retail sales pushed up exports from China, Chinese imports were given a boost benefiting Japanese exports. Now, the engine for growth in China is spending on public works, and there are only a few sectors in Japan that will gain from these programmes (such as metal products, machinery, etc). There is also an increasing tendency to

We have revised up next year’s growth fig-ure but it is still weak


substitute Japanese imports by Chinese production, and there are claims that protectionism is increasing as well.

3) Global imbalances are still to be corrected, influencing Japanese medium-term growth prospects.

A fast return to the model of high consumer spending in the US and a build-up of a large current-account deficit, com-bined with large current-account surpluses in Asian coun-tries among others, is unlikely. Instead, there will be a re-duced demand from debtor countries affecting export poten-tial for creditor countries. This affects Japan’s medium-term growth prospects, as it takes time to find new growth en-gines/export markets.

4) The adjustments in manufacturing capacity and person-nel expenses will last much longer.

The Japanese output gap is measured at some 8-9 percent 2009/2010, and is therefore even larger than the gaps seen after the Heisei bubble1 collapsed in the 1990’s. Tankan and other surveys show that many companies have too much production capacity and too many employees. It will take several quarters to make the necessary adjustments. Also, it will take several years for the output gap to be eliminated or at least substantially reduced.

5) Large output gaps will remain for years, and Japan is facing a longer period of deflation – once again.

Compared to many other countries where falling consumer prices is mainly an effect of a reduction in interest rates and lower commodity prices, the Japanese situation is not only disinflation but more likely a new phase of deflation. Low demand will result in falling prices, earnings and wages. However, compared to the collapse of the Heisei bubble, this time there is hardly any asset price deflation, even if land prices are once again falling. In addition, the financial system is in much better shape and balance sheets in the corporate sector have been reasonably corrected.

3. Another type of social contract At the same time as the economy is moving back into reces-sion, Japan’s political and social structures continue to change. Labour markets are becoming more flexible, as social contracts are finding new patterns. Many people are concerned about the

1 The Heisei bubble is the late 1980’s asset price bubble when land and stock prices started falling, ultimately loosing some 1500 trillion yen in wealth, which was equal to Japan’s stock of financial assets or three years’ GDP.

The Japanese society is changing


increasing income gaps between groups and the fact that Ja-pan’s relative poverty rate is among the highest in the OECD. Japan’s economic and political institutions appear to be sensi-tive to risk-aversion and accept collectivism. This has also made them more resistant to change, but when change occurs it is usually in response to a change in the external environment (Cargill & Sakamoto, 2008). Characteristics of these economic institutions are: The financial system, corporate governance, and the labour market consist-ing of lifetime employment, wage coordination and restraint, company welfare and life expectations. In the same way, the political institutions can be understood by studying the Liberal Democratic Party’s (LDP) dominance, the bureaucracy, the iron triangle between the LDP, the bureauc-racy and the corporate sector, and finally the constrained policy-making power of the Prime Minister. In the late 1970’s and the early 1980’s, Japan commenced fi-nancial liberalization, a change mainly driven by external forces, such as the end of the Bretton Woods system and slower global economic growth. The process was stable and smooth and in-cluded interest rate liberalization, internationalization, expanded asset and liability diversification powers for financial institutions, and expanded money and capital markets. However, Cargill and Sakamoto (2008) argue that the liberaliza-tion process was flawed, and thus the bubble economy was an accident waiting to happen. The key elements of the old finan-cial regime remained in place. There was no effort to enhance transparency. Regulatory authorities and banks continued to rely on insider information. The close relationship between fi-nancial institutions and the Ministry of Finance (MOF) and the close relationship between financial institutions and corpora-tions via the keiretsu system2 were regarded as a satisfactory financial disclosure framework. There was a self-reinforcing re-lationship between land prices, equity prices, bank capital and bank lending. Capital gains on equities held by banks were re-garded as “hidden reserves” or “latent capital”. The Bank for In-ternational Settlements (BIS) was convinced that hidden re-serves could partly be included when calculating capital re-quirements in banks. This situation, as well as loose monetary policy in general, led to a larger asset price bubble than in many other countries.

2 Crossholding of equities between corporations and between banks and corporations.

External pressure is the most common reason for change

Financial liberalization in the 1980’s …

…was a flawed process contributing to the asset price bubble


At the same time, as the economy went through extensive changes through financial liberalization, the political climate gradually and slowly changed. The sources for change came from corruption scandals, the decline of LDP’s dominance as some LDP supportive sectors stagnated and the population moved to urban areas. Electoral reform was implemented in 1994. The resultant system is beneficial to large parties, but seems to marginalize small parties. Many people lack trust in their politicians, as they feel that political parties are more con-cerned with power than the pressing needs of the population. About 50 percent of the voting population are non-party-identifiers. Over the years, not only economic policy and politics was blamed for Japan’s economic problems, but also structural fea-tures such as corporate governance, labour market practices and the relationship between the government and industry. Pri-vate companies in the export industry were the first to restruc-ture, as they were exposed to international competition. Even if Japanese-style management and labour market practices no longer exist in their original forms, corporate leaders and many workers still find value in lifetime employment, cooperative management-labour relations and cross-shareholding. Cross-shareholding has been decreasing since the 1990’s, but according to Cargill and Sakamoto (2008), the share has in-creased from 2004 (to guard against hostile takeovers). About 80-85 percent of companies still practice cross-shareholding, and a fourth of the shares traded in Japan were accounted for by cross-shareholding. Many criticize this practice as contribut-ing to market ineffectiveness, but Japanese companies main-tain that it contributes to stable, long-term business relation-ships. The current financial crisis in Japan may have been worsened by cross-shareholding, as manufacturing companies’ losses quickly spread to Japanese banks, despite initially rather good balance sheets in the financial sector (Posen, 2009). Before the 1990’s, many companies could avoid layoffs by transferring workers to subsidiaries and subcontractors. The benefits of retaining long-term workers outweighed its costs through loyalty, and offered incentives to invest in training and higher productivity. Wage flexibility was part of this relationship. The long period of low growth during the 1990’s and the bank-ing crisis changed labour market practices. Workers were given early retirement, bonuses and sometimes new employment elsewhere. The system of lifetime employment, seniority-based promotions and wage increases was reformed, increasing the share of merit-based wages. The old system is still in use, but is limited to core workers. Instead, more part-time and temporary workers are hired, thus creating an A and B team of workers on the labour market. There are signs of rising tensions in society

Cross-shareholding is still an important part of Japanese business life

The use of part-time workers are changing the way labour markets and social safety works


as income gaps are widening and poverty is rising. Japan has the fourth highest relative poverty rate (15 percent) among OECD-countries, while spending relatively little on social wel-fare3. The analysis needs to focus on many different types of gaps, such as:

• between the richer urban and the lagging rural population,

• between those that are permanently or regularly employed and those that have part time jobs or are temporary workers without safety nets,

• between the elderly with excess savings and the young families (often with part-time jobs) with tight budget restrictions,

• and between established people and the internet café people or the homeless.

There are some 12 million part-time workers on the Japanese labour markets. The number of non-regular workers exceeds this amount. All in all, these groups have grown to about a third of the regular workers. As the regular or permanent employees get their safety nets (health care and social security benefits) through their employers, and the non-regular workers do not, while their wages also are lower, there is an increasing inequal-ity – and also a subdued purchasing power – in the population due to the recession.

Part-time and Full-time employment (index 2005=100) and unemployment rate (percent of labour force)

U n e m p lo y m e n t , R a t e , T o t a l , S A P a r t - t im e e m p lo y e e s , a l l i n d u s t r i e s , I n d e x , 2 0 0 5 = 1 0 0 [ m a 1 2 ] F u l l - t im e e m p lo y e e s , a l l i n d u s t r ie s , I n d e x , 2 0 0 5 = 1 0 0 [ m a 1 2 ]


9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8

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As Japan’s GDP falls and capacity is being cut, unemployment is rising. The Japanese Research Institute foresees the rise in unemployment from today’s 5-5 ½ % to some 7-8 %, if compa-nies avoid labour hoarding, and the need to reduce capacity is

3 The poverty rate means the share of persons living in households with less than 50 percent of the median equivalent household income. Only Mex-ico, Turkey and United States have higher rates than 15 percent. Japan’s share of social spending of GDP is 19 percent, while Sweden has a share of 31 percent of GDP and a poverty rate of 5.3 percent (OECD, 2008)

Inequality on the labour market is increasing


fully taken into consideration. However, even if the social con-tract between employers and employees has weakened over the last decade, it has not completely broken down which means that most projections for the unemployment rate do not exceed 6 % during 2010. Most likely, the real problem of unemployment is much larger than the figures show, as there is underemployment and dis-couraged workers. A married woman, who loses her job, is not counted as unemployed. The ratio of job offers to applicants has declined, and as average hours worked fall, the average wages (including overtime pay and bonuses) also fall. To limit the spread of the slump in external demand to domestic de-mand is a task for politicians. In a longer term perspective, pov-erty reduction and improved social welfare is also important for the economy, and for Japan’s challenging demographic situa-tion.

4. A possible change in political power As social tensions are building up, traditional political parties have been slow to grasp the need for change. Many voters have little confidence in politics and the politicians – a long term situation that has not changed recently. Politics is mainly seen as a power struggle, without much consequence for ordinary people. Since 1993, Japan has had ten Prime Ministers. Also recently, the average time spent in office has been short. Mr Taro Aso – a right wing nationalist within the LDP – is the third Prime Minis-ter in office since 2006, as he replaced Yasuo Fukuda who re-placed Shinzo Abe. Kunichiro Koizumi, before Abe, was the longest serving post-war Prime Minister (2001-2006) (after Sato in the 1940’s and Yoshida in the 1960’s) and was probably also one of the most reform-oriented. Even if Koizumi still is rela-tively popular, he has also been criticized lately for looking too much to the supply side, while disregarding reforms that would have increased demand, and the well-being of the rural popula-tion. Mr Aso’s popularity is low and shrinking, after a short boost dur-ing the spring G20 meeting. After the LDP lost seats and control to the Democratic Party of Japan (DPJ) in Tokyo’s metropolitan elections in July, Mr Aso dissolved the Diet, Japan’s lower house of parliament, and declared a general election for August 30th. He also apologized for his political failures. Due to his low popularity, the economic crisis and a new leadership in the DPJ, the probability of a change in Japan’s political power has in-creased. Excluding 11 months in 1993-94, the LDP has been in power for the last 54 years. Thus, a likely change in power is

The unemployment problem is worse than figures show

Political parties have been slow to grasp the need for change

Prime Minister Aso has declared a general election for August 30th


creating uncertainties regarding Japan’s economic and political future. Several questions are therefore relevant, such as:

o What type of party is the DPJ? DPJ’s former leader, Mr Ichiro Ozawa, who defected from the LDP in 1993 is still closely associated with DPJ, even if he re-signed as leader in May after a scandal involving fund raising by illegal donations from a construction company. His successor, Yukio Hatoyama, is letting Ozawa wield power behind the scene. The party may not have a very strong identity, and there is a broad spectrum of views represented. It has strong support from labour unions and can be characterised as centre-left, with a view on having a large rather than a small government. Both Hatoyama and Ozawa are ex-members of LDP factions of Ta-naka and Takeshita, who both were geared towards shrinking the gaps between rich and poor, and between urban and rural areas. Others in the party are ex-socialists. Generally speaking, while the LDP focuses more on the corporate sector, the DPJ focuses on the household sector.

o Can DPJ win a majority in the lower house? The probability of the DPJ winning an outright majority has in-creased due to the weak economy and the low popularity of the LDP. However, the DPJ needs to more than double its seats in the lower house to gain a majority. With regard to foreign policy, the LDP has a higher rating among voters, so depending on ex-ternal shocks that may arise, the outcome is still uncertain. The DPJ has been active in establishing strong ties with China and South Korea, but has so far been unsuccessful in deepening its relations with the US. There may be room for the creation of coalitions among parties in the upper house, and possibly also the creation of new par-ties (LDP members loosing tolerance for the old party). The election for half the seats in the upper house – where the DPJ has a majority – is scheduled for summer 2010.

o How would the DPJ’s economic policies differ from the LDP’s?

The DPJ’s main political objective is to reduce social inequality and therefore its policies include increases in disposable in-comes, such as child-care allowances, and an end to high school tuition fees and motorway tolls. Unemployment insur-ance will be applied to all workers, including part-time workers. There is also a new system of supplements for individual farm incomes. Measures to counter global warming include cuts in

The DPJ is viewed as a centre-left party

DPJ’s chance of winning a majority has increased

DPJ has a a larger ocus on households


greenhouse gas emission of 25 percent versus 1995 levels by 2020 and 60 percent or more by 2050. Fiscal spending would total 21 trillion yen for the next two years. Funding is assumed to come from reviewing subsidies to local governments and cutting government costs. The DPJ intends to redirect funds away from “wasteful public-works investments”. The Aso administration has stated it would raise the consump-tion tax rate presently at 5 percent in 2011, but the DPJ’s mani-festo promises a four-year freeze on consumption-tax hikes.

o How would financial markets react? Change contributes to uncertainties that affect financial markets in various ways, such as the outlook for growth, interest rates, currencies and equities. On the growth outlook: To increase disposable income for households may increase consumption growth, but it is likely that new stimulus measures would be needed to increase the growth rate in a sustainable way. If there are uncertainties on how to fund the increased fiscal spending, households’ mar-ginal propensity to consume may not increase permanently. The reduction of spending on public works may have short term negative effects on growth. Extended unemployment insurance may increase costs for the corporate sector and reduce invest-ment activity. On the other hand, extended unemployment in-surance could increase household consumption. On interest rates: There are uncertainties with regard to funding of the economic policies, and more Japanese government bonds may have to be issued, possibly raising yields even if it would be temporarily. As companies have cleaned up their bal-ance sheets, the demand for borrowing will be higher than dur-ing the Heisei bubble. Thus, contrary to the earlier situation, in-terest rates can be affected by government spending without proper funding. On the yen/dollar: The DPJ has shown less interest in funding the US deficit, which if that remains the case after taking over power, could have effects on the dollar and US bond yields. On equities: The outcome of the Japanese election for stock markets is all about stability and the corporate climate. A change in power may not be a positive thing, although an elec-tion won by the LDP will not result in much cheering either. Compared to a year ago, the Tokyo stock exchange (Nikkei 225) has lost almost a quarter of its value, despite the im-provements seen since March.

Financial markets are now preparing for increased uncertainty


Tokyo stock exchange, Nikkei 225 index


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o What sectors could benefit or lose from a change in power? Equity markets may react negatively to the diminished focus on corporates, as the household sector receives more attention, but it is still unclear what the effect would be. Many Japanese companies have quietly shifted production overseas to overcome trade barriers or to take advantage of cheaper labour costs, so these companies are relatively unaf-fected by domestic policies. There are also Chinese and Brazil-ians on short-term visas who get lower pay, thereby bringing cheap labour to Japanese factories. Either way, companies try to avoid domestic labour markets and regulations. A change in political power would not be critical to the already global manu-facturing sector, although domestic oriented services and con-sumer industries would be affected. Consumer stocks may be positively affected by new economic policies, if the marginal propensity to consume actually in-creases. Low-priced products might get a boost from enhanced support to families with low incomes. Environmental policies may benefit environment-related automobile production, de-pending on how long-term oriented the policies actually will be.

5. A limited number of stimulation tools Japan has been hit harder than many other countries by the global recession and the financial crisis. Even if the Japanese economy is set for a recovery as the export environment im-proves, growth prospects still look bleak. The question is what Japan can do with its monetary and fiscal policies in a situation where interest rates already are low and public debt is at an un-comfortably high level.

The tool box to stimulate the economy is not that large anymore


Monetary policy In the fourth quarter of last year, the consumption deflator turned negative and in February this year, the Consumer Price Index (CPI) went in the same direction: South. There is a risk of a new period of falling prices, with negative consequences for the economy. Annual CPI inflation is likely to be negative both in 2009 and in 2010. Part of the development occurring at the moment can be explained by improving terms of trade, as commodity prices have come down substantially compared to a year ago. Other reasons include the appreciation of the yen vis-à-vis other major currencies, falling wages and a low domestic demand. In the case of Japan, with deflation prevailing in the recent dec-ade, economic policy must again focus on returning to price stability as there is a risk of deflation. Declining prices increase the cost of servicing debt, increase bankruptcies, reduce con-sumption and increase incentives to save. Declining prices also reduce the ability of monetary policy to affect the economy.

Inflation according to CPI and consumption deflator (quarterly figures, annual percentage change)


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C o n s u m e r P r ic e In d e x

C o n s u m p tio n D e fla to r

During 2006, the Bank of Japan (BOJ) abandoned the Zero In-terest Rate Policy (ZIRP) and by 2007 it had moved the policy rate up to 0.5 percent. Towards the end of 2008, the BOJ took it down to 0.1 percent in two steps. Although there is one poten-tial step left to move down to a new period of ZIRP, the BOJ will look for alternative measures, as the board has indicated that ZIRP will prevent the money market from working effectively. On July 15th, the BOJ board, including Governor Masaaki Shirakawa, voted to hold the policy rate unchanged.

Deflation is likely to remain for some time

Zero Interest Rate Policy is not expected but the current level will prevail


Short and long term interest rates


9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9

Perc

ent

0 . 0 0

0 . 2 5

0 . 5 0

0 . 7 5

1 . 0 0

1 . 2 5

1 . 5 0

1 . 7 5

2 . 0 0

2 . 2 5

2 . 5 0

B a n k o f J a p a n p o l ic y r a t e

1 0 - y e a r g o v e r n m e n t b o n d

The BOJ has started a new period of quantitative easing policy (QEP): government bonds are bought, thus transferring cash into financial markets. The range of collateral that financial insti-tutions can submit to the BOJ to borrow funds has been ex-panded. The BOJ also buys subordinated debt from Japanese banks in order to increase banks’ capital bases following falling share prices, given that shares constitute a key element in the capital bases. In addition, QEP also includes purchase of com-mercial paper and corporate bonds (up to 1tr yen) and provides access to liquidity on longer-terms maturities in the money mar-ket. At this stage, there is not room for the BOJ to start normalizing interest rates. The risk of expanding the BOJ’s balance sheet as credit risks of individual firms are taken on must be considered along with distortions of markets and overheating. The excep-tional policies must eventually be withdrawn. However, the ex-piry date needs to be extended until financial conditions be-come less tight. If the risk for a depression and a longer period of deflation increases, and the outlook deteriorates, the BOJ may have to expand its operations by relaxing the eligibility cri-teria for corporate bond purchases, extend maturities even fur-ther and increase the purchase of government bonds. The risk for a depression and a new period of deflation means that monetary policy must be accommodating, although with a goal of not contributing to an ineffective allocation of resources in the economy. Once again, there is a risk of “zombie banks and companies” staying alive artificially, but there are not really any alternatives to this policy.

Fiscal policy There is a limit to the effects of monetary policy at the moment. Thus there is a need to add stimulus via fiscal policy. Although, the banking crisis in the 1990’s has already lifted public debt to

Too early to use the exit strategy


some 180 percent of GDP, the finance minister, Mr Kauro Yo-sano, has prepared a new fiscal stimulus package so that the total value of measures taken both during FY 2008 and FY 2009 will amount to 4.2 percent of nominal GDP. The effects on the economy will come mainly during 2009 and 2010. The most recent package includes a new social safety net for non-regular workers, vocational training, full use of the govern-ment financial institutions to ease the credit crunch, a large ex-pansion of the use of solar energy, improvements to health care and medical services and subsidies to local governments for the revitalisation of regional economies. There are some positive aspects of the package, such as the focus on domestic demand and on the “B-team” on the labour market. The idea is to temporarily relax gift taxation so that wealth more easily can be transferred from the older to the younger generation thus facilitating buying real estate. How-ever, there is a risk that subsidies to local governments will lead to more public works projects that are not really needed. Even so, such measures may prevent unemployment from rising more than otherwise. The stimulus packages that are implemented to increase do-mestic demand are a response both to the global recession and as a reaction to the earlier political model where the supply side, rather than the demand side, was the policy focus. Re-gardless of whether the budget is presented by the LDP or the DPJ, there is now a tendency for both parties to focus more on the demand side of the economy. The IMF calculates that Japan’s gross public debt will rise above 230 percent of GDP by 2014, and net public debt to about 135 percent. If there is a need for further stimulus in 2010, the measures must be well targeted and reversible. Ja-pan needs a medium-term consolidation strategy. There will also be growing pressure from the ageing population, and a need for a pension reform. Even if 95 percent of the debt is fi-nanced domestically, the issuance of government bonds will in-crease by some 30 percent during 2009. Domestic savings are high enough to reduce short term financing risks, but with an ageing population, the medium-term risks will increase. Japan’s experience of the Hashimoto government trying to in-crease the consumption tax despite a fragile economy, shows the need to keep stimulating the economy until the recovery is robust. There is a need for an exit strategy, but most likely there will be a need for more stimulus measures before the slump is over.

The focus on domestic demand is a response both to the global re-cession and to counter earlier models

More stimulation measures are most likely needed before budget consolidation starts


6. What we can learn from Japan’s post-bubble experiences

There are differences between Japan and the US, on both the causes and the effects of the crises. Even so, lessons can be learned, and the Japanese experience can add value to both policy makers and economic theory. The main differences are:

Both countries experienced a bursting of an asset-price bubble. House prices, shares and other asset prices thus fell dramatically. However, in Japan the bubble was blown up much more, possibly prolonging the period of correct-ing balance sheets.

In Japan, many companies had borrowed extensively, whereas in the US the subprime problem originated in the household and financial sectors.

The securitization of assets has increased the complexity of the financial crisis today, with many types of distressed securities, compared to the Japanese crisis when debt consisted of corporate loans. As securities now should be marked to market, this leaves governments and banks with less room to adjust valuations.

Whereas in Japan, the bursting of the asset-price bubble in 1990 sent the real economy on a downward slope, but banks were willing to lend until the credit crunch in 1997. In the US, the subprime financial crisis first created a credit crunch, and the real economy did not start weaken-ing until later.

Bankers’ willingness to lend as seen by Japanese corporate borrowers

S o u r c e : R e u te r s E c o W in

8 6 8 8 9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8

Per

cent

- 3 0

- 2 0

- 1 0

0

1 0

2 0

3 0

4 0

Japanese experiences should be of interest to the US


The current export environment is much more severe now as the global financial crisis and recession make it more difficult for any country to rely on exports to combat the re-cession. However, in Japan exports contributed relatively little to the recovery, even if a favourable export environ-ment helped the transformation of Japanese companies and increased private investment.

Despite the differences, the economic substance is basically the same. Banks hold distressed assets and have lost a large part of their capital. The need to reduce debt and correct balance sheets applies to both crises. Richard Koo (2009) defines Japan’s crisis as a balance-sheet recession. As actors reduced debt, demand for taking on new loans fell. Until 1997-98, Japan did not have a major problem with the supply of loans, as seen in the graph above. Koo ar-gues that there is a need for a different economic policy mix when a country’s private sector is minimizing debt, compared to the normal condition when profits are maximized. In the post-bubble phase, repairing damaged balance sheets means that monetary policy becomes less effective. It’s more important to increase government spending: to compensate for the loss of demand due to falling asset prices and the deleveraging going on. Many economists have analysed Japan from a banking crisis point of view, with a low supply of funds and a liquidity trap. That would be correct from the point of view of a normal phase without debt reduction. Instead, the main problem was low de-mand for borrowing as companies were not interested in taking on new debt. Thus, monetary policy was less effective. As fiscal policy was used extensively, Japan’s demand did not fall in line with the loss of wealth. Contrary to many beliefs, Ja-pan was quite successful in maintaining GDP growth, despite the massive deleveraging taking place in the economy. Koo calculates that 315 trillion yen was used to support an economy that had lost 2,000 trillion yen. Without that support, GDP would have contracted substantially over a number of years. Koo argues that the main reason for the recovery in the mid 2000’s was that companies by then had finished correcting their balance sheets, and started substituting debt reduction for profit maximization. Adam Posen (2009), on the other hand, believes that policy activism supported the economy, and that Prime Minister Koizumi made a difference with structural reforms and that Economy Minister Takenaka forced banks to write off non-performing loans. Koo rejects that view by arguing that the pri-vatization of the post office did not make much of a difference,

Despite many differences, economic substance is the same

Japan should be analysed from a balance-sheet, rather than a banking crisis point of view


and that of the 100 trillion yen of the non-performing loans dis-posed of in 1992-2007, only 11.7 trillion yen were written off during Takenaka’s reign. 4 Koo thinks that economic theory should acknowledge that there are differences in policy needed depending on whether the economy is experiencing a post-bubble situation (which he names the yin phase) or if the economy is in a phase before the bubble has burst (the yang phase). In the textbooks, the often used assumption is that companies are profit maximizing. Bal-ance sheets are usually not of any interest. Keynes included liquidity preference in his economic theory, but focused only on the lenders and not on the borrowers. As he argued that fiscal policy was needed to fight the recession, he got the remedy for balance sheet recessions right, but not their cause. Fischer’s debt deflation theory was driven by distress selling of assets and a fall in prices, whereas a balance-sheet recession is driven by a fall in corporate borrowing where distress selling and deflation could be an outcome, though not necessarily. Fisher’s cure was for central banks to reflate, but without bor-rowers that policy is likely to fail.

Macroeconomic theory with and without balance sheet recession Pre-bubble Post-bubbleYang Yin

Phenomenon Textbook economy Balance sheet recessionFundamental driver The "invisable hand" Fallacy of compositionCorporate financial condition Assets > Liabilities Assets < LiabilitiesBehavioral Principle Profit maximization Debt minimizationOutcome Greatest good for greatest number Depression if left unattendedMonetary policy Effective Ineffective (liquidity trap)Fiscal policy Counterproductive (crowding out) EffectivePrices Inflation DeflationInterest rates Normal Very lowSavings Virtue Vice (paradox of thrift)Remedy for banking crisis Fat spread and Capital injection and

quick disposal of NPLs cautious disposal of NPLs Source: Koo (2009)

As the US is facing a balance-sheet recession, it is interesting to look at the economic policies needed in such a climate as they differ from a normal phase. Thus, here follows Richard Koo’s conclusions for economic policy, as balance-sheet reces-sions are incorporated in economic theory:

4 Policy certainly matters, but there has been a tendency to reduce the importance of balance sheets. There is a great uncertainty regarding the valuation of the non-performing loans that probably explains some of the differences in views on Takenaka’s reforms.

There is a difference if companies are reducing debt or maximizing profits


1. Monetary policy Policymakers must pay attention to the fall in demand for funds, and not just the fall in supply. The deleveraging process will take time. Also, after balance sheets have been cleaned up, the aversion to borrowing money will have increased. Therefore, in-terest rates will remain relatively low. The level of the interest rates will not be as important during a balance-sheet recession, as otherwise. At the moment, there are no interest-sensitive sectors left in the US that will drive growth. To bring the cur-rency down would be a positive impact from monetary policy, but it would not be possible for all countries to improve their trade balances simultaneously. Posen (2009) is of the opinion that monetary policy did not re-move deflation in Japan. He also finds that deflation was not as destructive as many worried it to be. Both Posen and Koo argue that we need to understand deflation better in order to come up with the right policy tools. Central banks cutting interest rates will help the banking sector as fat spreads facilitate recapitalisation, i.e., lowering the rate at which the central bank supplies liquidity to the banks while al-lowing them to keep their lending rates higher. Monetary policy can also be used to unclog the financial plumb-ing during a financial crisis, i.e., credit easing. In the US, the Federal Reserve has bought commercial paper, mortgage backed securities and other securities. Asset purchases help fi-nancial institutions delevage as they unload risky assets and in-vest in assets carrying lower risk weights. That could be benefi-cial as the situation for banks improves, but it also increases the risk for the central bank as its balance sheet increases with po-tentially non-performing loans. So long as the Federal Reserve and the US government are providing liquidity and capital sup-port to the banks, the losses for the central bank can be mini-mized, but gradually the trust in the Federal Reserve may erode with negative effects for the dollar. A better alternative than to use the central bank would be to use the Treasury’s balance sheet to buy risky assets, but to get an approval from Congress on the same amounts would be difficult. To use the Federal Reserve’s balance sheet to bring down long-term interest rates and help to finance the budget deficit by purchasing US treasury securities (quantitative easing) seems redundant. The savings necessary for fiscal stimulus is likely to be generated within the country as the private sector delever-ages and moves to assets with lower risk. Interest rates will re-main low as the demand for loans will be weak.

Deleveraging takes time and the demand for loans falls

Monetary policy helps the banking sector, but is not as effective in increasing demand

Quantitative easing is probably redundant – savings will be generated within the country


Monetizing government debt could trigger hyperinflation, and the fear of this could make foreign and domestic investors pull their money out of the US bond market, causing interest rates to increase rather than fall. Thus, the small benefits of slightly lower bond yields should be weighed against the significant risk of investor flight resulting in higher bond yields.

2. Fiscal policy To sustain incomes, the government will have to borrow and spend the excess private savings that are being built up during the deleveraging process. Regardless of the size of the multi-plier, increased government spending will be necessary to avoid a depression when private sector wealth has been eroded. Adam Posen (2009) notes that even wasteful spending buys time and unemployment will be prevented from rising as much as it otherwise would. Government spending is more effective than tax cuts, as the latter tend to increase private sector saving without increasing overall demand. Fiscal stimulus packages and the recession itself will increase the national debt, as private debt is transferred to public debt. When the economy has recovered, public debt will be reduced by the contribution from the private sector as it becomes health-ier. A depression would be a worse alternative than building up public debt. The financing of the budget deficit will come from financial insti-tutions as they are looking for assets with low risk. This will hold down bond yields, increasing the benefits of carrying out infra-structure projects at this stage instead when bond yields have normalized. The exit strategy to start medium-term budget consolidation is important. However, the Japanese experience shows that if deficit cuts are commenced before the full-fledged recovery is in place, the crisis could worsen, increasing the costs for fiscal stimulation.

3. Fixing the banking system It is important to distinguish between local and systemic bank-ing crises as well as whether or not there are private demands for funds, i.e, if the economy is in a yang or a yin phase. Whereas the Japanese banking crisis was local and ordinary before 1995, it became more systemic after 1996. The US sub-prime crisis since 2007 is also systemic, with weak or non-existent demand for funds. There is thus a need for capital in-jections and a slow disposal of non-performing loans as de-mand remains low. Rushing to dispose of “bad” loans will only

Monetizing debt can trigger hyperinflation and the fear may affect the dollar

Even wasteful spending can prevent unemployment

Financial companies looking for lower risk will finance the deficit


destroy value. Richard Koo shows four types of banking crises and four ways of dealing with them:

Yang YinNormal demand Weak demand

for funds for fundsQuick NPL Normal NPL

Ordinary disposal, pursue disposal, pursueBanking accountability accountabilitycrisis Slow NPL Slow NPL

Systemic disposal disposal Fat spread Capital injection

Source: Koo (2009) If the government buys toxic assets from the banks, they still have made losses and capital has been eroded. If, on the other hand, the government injects capital, the banks can increase lending as their capital bases will have been repaired. Many as-sets held by the banks have no market price, so it is reasonable to go slowly on the disposal of bad loans/assets. A contract be-tween the authorities and the banks to write off bad assets while capital injections are being made could last for a decade. So long as the process is monitored and credible, trust will gradually come back. The risk, as Adam Posen (2009) points out, is that it is politically more difficult to spend money on banks even if needed, than on creating jobs. That is why both the US and Japan have worked on a second-best solution for fixing the banking system. Posen also notes that the US – just like Japan – may give away money with too little conditionality and without closing non-functioning banks.

7. Political changes and a new growth model: Implications for foreign companies

Japan is still the world’s second largest economy in dollar terms, even if China has passed in terms of purchasing power parity (PPP). Despite many years of low growth, the market size for goods and services is great. Increased potential for foreign companies is conditional on the way Japan moves forward:

Whether or not the country moves towards a growth model, where domestic demand becomes more impor-tant.

The effects of political change on households and com-panies, financial markets and external relations.

Capital injections may increase lending - buying toxic assets may not

Central banks increasing their balance sheets is a second-best solution

China may be more in focus, but Japan’s market is still large


The economic relations between China and Japan, and the possibilities to fulfil Japan’s goal to remain Asia’s centre for research and innovation.

The opening up of labour markets and foreign inves-ments, both formal and informal barriers.

The modernization of services, to improve welfare, em-ployment possibilities and productivity.

The ageing of Japan’s population and how the Japanese situation could constitute both business opportunities and knowledge transfers to foreign companies.

The impact of Japan starting its budget consolidation within a few years (if the economy has sufficiently recov-ered) and how that will influence growth and business opportunities.

The normalization of interest rates, and a return to a situation where they become market oriented.

The implications for foreign companies are that the recovery may take time and economic growth will remain sluggish. Defla-tion and falling wages could remain longer than in many other countries. Short term business opportunities may look bleak, but underly-ing processes of reducing dependence on exports, and to in-crease the willingness to consume, could gradually counteract some of the negative outlook. Finding a model for growth is a process that will take time, even so every step could be valu-able. The medium and long term prospects could improve if Japan’s reform process was intensified. The challenges to growth are large: Budget consolidation, social security, pensions, the in-creased burden for the shrinking labour force to support the elderly, and policies to deal with increased income inequality. Not unlikely, these challenges will increase the need for innova-tion with potential for foreign companies to trade and learn.

Cecilia Hermansson

Short term prospects look bleak …

… and medium term prospects are dependent on the willingness to reform


Referenslista Bank of Japan. (2009), “Statement on Monetary Policy”, July 15th 2009. Cargill, T.F and T. Sakamoto, (2008). Japan Since 1980. Cambrigde Univer-sity Press, NY, USA. IMF (2009), Country Report No. 09/210. International Monetary Fund, Wash-ington, D.C. Karlsson, A. (2009)) Forskning och innovation i Japan – en överblick. PM 2009:002. Institutet för Tillväxtpolitiska Studier, ITPS. Koo, R.C. (2008).The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. Revised and Updated. John Wiley & Sons (Asia) Pte. Ltd. Obstfeld, M (2009), Time of Troubles: The Yen and Japan’s Economy, 1985-2008. NBER, Working Paper 14816. OECD (2008), Economic Surveys, Japan. April 2008. Volume 2008/4. Posen, A.S (2009), Seven Broad Lessons for the United States from Ja-pan’s Lost Decade. Remarks presented at Japan’s Lost Decade: Lessons for the United States. The Brookings Institution, March 26, 2009. Sommer, M. (2009), “Why Has Japan Been Hit So Hard by the Global Re-cession?”, IMF Staff Position Note. 2009, March 18. International Monetary Fund, Washington D.C.

Economic Research Dep. 105 34 Stockholm, tel +46-8-5859 1031 [email protected] www.swedbank.se Cecilia Hermansson, +46-8-5859 1588 Magnus Alvesson, +46-8-5859 3341 Jörgen Kennemar, +46-8-5859 1478 ISSN 1103-4897

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Economy & Finance

Great lessons to be learned from Japan’s balance sheet recession