global catalyst

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Part two: global catalyst

By David James

The Asian financial crisis might be easing, but its most important lesson remains. The fate of the world economy is heavily dependent on what happens in Japan, which holds about one-third of the world's savings. Japan's economic troubles can quickly become Asia's and the world's economic disaster.

This is of great relevance to Australia because the Australian dollar is heavily affected by what happens in Japan. Australia was initially spared in the Asian meltdown, although late in 1998 the Australian dollar was about to be targeted by hedge funds, the kind of attack that led to currency collapses in many South-East Asian countries and emerging economies. About the same time, however, the Japanese aggressively moved to reflate their banking system, and the attention of the global capital markets turned elsewhere.

The recent weakness of the Australian dollar is partly a result of manoeuvring between the world's two most powerful currencies, the yen and the United States dollar (these currencies have swung more than 60% in the past three years and may be about to swing sharply again). What Japan does next is likely to have a dramatic effect on all the world's currencies, including the Australian dollar.

A debate at the Pacific Rim Forum in Sydney in October suggests that if anything, the Japanese situation is now more confusing and potentially volatile than before the Asian crisis. Two of the world's top Japan observers, Kenneth Courtis, vice chairman of Goldman Sachs Asia, and Richard Koo, chief economist at the Nomura Research Institute in Japan, came to diametrically opposite positions about Japan's future: Koo believes Japan is turning the corner; Courtis that it has worse times ahead.

The two main causes of Japan's malaise have been tolerance of a low return on savings and the need to unravel hugely inflated asset prices (a related phenomenon because asset prices must finally reflect the underlying return on the asset). Japan has routinely earned only 1-2% on its savings, compared with 10-15% in Europe and North America. The Japanese return on equity is now 1.8% compared with 14.9% in Germany and 29.6% in the US. As R. Taggart Murphy comments in The Real Price of Japanese Money, cost-of-capital calculations are virtually unknown in Japan. Japan's recent economic difficulties have been a painful national lesson that the cost of capital does matter.

Japan's economic woes

Yen remains weak against the United States dollar. Hugely inflated asset prices have collapsed. The sharemarket fell to one-third of the value at its peak. Property prices have slumped. Corporate and government debt levels continue to rise. Government spending will reach 150% of GDP by 2005. Heavy government spending must continue, to prevent deflation. Consumer confidence remains low. By tolerating low returns on capital, Japan was able to develop global corporations in the 1970s and 1980s. Using the combination of cheap money and world-leading managerial expertise, Japan's business leaders created some of the world's most powerful corporations, many of which still enjoy dominant positions in the world market. But the strategy - the equivalent of a highly leveraged, fast-growth strategy - only works well on the way up. It can prove a disaster on the way down.

Japan experienced the downside for most of the 1990s: an implosion of asset prices and a painful winding back of corporate debt. And the pressure is unlikely to ease. Half the population is expected to be older than 65 by 2020, so the emphasis is shifting from capturing international markets and creating employment to achieving a satisfactory return from savings to fund retirement. The practice of allowing low returns on capital is becoming socially unacceptable.

The question being addressed by Koo and Courtis is whether Japan has yet paid the necessary price. Koo believes the answer is a qualified yes. He says Japan has experienced a 'balance sheet recession', which has occurred only once before in the West: the Great Depression of 1929-33. 'A balance sheet recession happens when companies all realise that their balance sheets are under water and they have to fix it.'

Koo says that at the end of the 1980s Japanese companies thought they were number one in the world. Then asset prices started collapsing virtually from the first business day in the 1990s. When Japanese managers realised asset prices would not improve for three or four years, the only solution was to rationalise. 'The Imperial Palace was not equal in value to the state of California. The state of Delaware, maybe, but not the state of California.'

Koo says the problem was that everyone realised asset prices were in trouble at the same time. Japanese managers started en masse to reduce debt and constrain consumption. 'When everyone does it at the same time, you get a balance sheet recession. It is a difficult recession to deal with, because it nullifies the effect of monetary policy. Everyone wants to pay down debt, so under such circumstances no one wants to borrow. As a result, the capital markets and banking system are awash with cash. It is what Keynes called a liquidity trap.'

Asset prices certainly did collapse. Golf club membership prices fell to 10% of their former level, share prices fell to a third of their peak, and property prices went into a long-term slide. In such a situation, the greatest challenge is to stave off deflation and prevent the economy from imploding. 'The miracle is that Japan has experienced zero growth. It should have been in depression long ago,' Koo says. 'It was done by the Government, which filled the gap.'

KENNETH COURTIS and RICHARD KOO: Same Japan, different verdicts, Photo: Jessica Hromas

Koo acknowledges that much of the enormous Japanese Government spending, which is expected to result in national debt of 150% of gross domestic product by 2002, has been profligate: bridges that go nowhere, teams of workers digging holes that are then filled up by other teams ... But he says that, in a balance-sheet recession, the quantity of money is more important than the quality.

It might be objected that this is the kind of thinking that got Japan into trouble in the first place. But Koo insists that the fall in asset prices is nearing its end, that the sharemarket appears to have come off its bottom, and that land prices are showing signs of appreciating. He says there are now two types of Japanese companies: those that are still in a difficult debt position, and companies such as Toyota, with clean balance sheets and a 'historic' opportunity to move forward. The caveat is that the Japanese Government continues its heavy fiscal spending, to make up for the lack of consumer demand and demand for borrowing.

'It is a once-in-a-lifetime opportunity to move forward,' says Koo. 'You can borrow money at the lowest rate in the history of mankind, and the competition can't follow you because they are still in debt repayment mode for three to four years. When 10-20% of the companies are moving forward, it puts tremendous pressure on the other 80% that are still cleaning up their balance sheets.'

Courtis does not offer such a benign prognosis. He says Japan has simply shifted the source of its profligacy from the corporate sector to the Government and off-balance-sheet arenas. He says Japan's debt levels have never before been incurred by a peacetime economy.

'The Japan of today makes the Italy of yesterday look like a paragon of fiscal rectitude,' Courtis says. 'In 1991, gross government debt was at 50% of GNP (gross national product); by 2002, it will be 150% of GNP. That is $US4 trillion they have spent - the equivalent of the GNP of France, Germany and the United Kingdom combined.'

Courtis agrees with Koo that Japan has experienced a depression, commenting that asset prices relative to cash have performed in a similar fashion to the 1930s, but he thinks that the debt problem has not been solved. He estimates that the off-balance-sheet debt is 130-180% of GNP, and the total is close to five times GNP.

'We find with company after company, 25%, 30%, 40% holes in the balance sheet. The consequence is either that other companies pick it (the debt) up, the Government picks it up, or Mr and Mrs Suzuki are told that they are not going to get their entitlements. Increasingly, it is going to be one of the last two options.'

Courtis describes the situation as 'extremely fragile', adding that the Government has to run a deficit of 3-4% simply to stop fiscal policy contracting. In a deflating economy and with an ageing population, there is little likelihood that demand will pick up. Instead, the Japanese will be saving hard to fund their retirement.

Courtis describes the situation for the Japanese-middle class person: 'My life insurance has been cut back, my pension has been cut back, we know restructuring is going to continue, and my house has fallen in value. We should save everything we get.

'Bankruptcies are running this year at 3.5%. It is very difficult to see consumers coming back soon, and, with the world economy slowing, I don't see how net exports can continue to make up the gap. And when you are carrying a Himalaya of debt, it is like trying to swim the (English) Channel with pneumonia: it can kill you.'

Courtis versus Koo

Richard Koo says:

Japan is turning the corner. The fall in asset prices is coming to an end. The sharemarket appears to be rallying. The property market is showing signs of improvement. Consumer confidence is improving. Kenneth Courtis says:

There are worse times ahead for Japan. The debt problem has not been solved. Debt has just shifted from the corporate to government sector. Total Japanese debt is close to five times gross national product. Consumer confidence will continue to be low. Virtually everything the Government owns will have to be privatised. The yen will continue to weaken against the US dollar. The two economists agree that heavy government spending is inevitable to prevent further deflation. They agree that the effects of monetary policy are distorted in an environment of falling asset prices. Koo says monetary policy is rendered impotent in a balance sheet recession, because no one wants to borrow. 'What Japan needs is a borrower, not another saver. If the Bank of Japan comes in as a saver, it just makes the situation worse. The Government has to be there to take up the slack.'

Courtis says the need to restore balance sheets is made more difficult by the pressures on monetary policy. 'Real interest rates are very close to zero. As long as you run real interest rates at this level it seems impossible to run up asset prices. Yet you need to run up asset prices to restore balance sheets.'

The two diverge, however, when it comes to forecasting how Japan will respond to the malaise. Koo hopes that domestic demand will pick up and asset prices will stabilise. He says that every survey of consumer confidence has shown significant improvement since it bottomed in 1998. 'If you talked about it two years ago, everybody was prepared for the worst, but two years later the worst has not happened. Mr Suzuki is not all that happy, but a lot of it has been discounted. The Japanese are back.'

Courtis says the only solution will be an enormous sell-off, and write-down, of public assets. 'Virtually everything the Government owns will have to be privatised. With these demographics (the ageing population and falling taxation revenue), you won't be able to get government debt down to 60%. The ports, roads, rail and postal system will all be for sale.'

Courtis expects a dramatic fall in the yen, to 160 against the US dollar. This may create big trade problems for the rest of Asia. He also predicts that the Japanese will buy back (monetise) the public debt. 'The weakened yen won't be the same competitive threat as when you are competing head-to-head in the same space, because Japan has not been investing in IT.

'But the day of reckoning will come. You aren't going to get the pension like you thought, you are not going to get health care like you thought, you aren't going to get your insurance like you thought, and the wages for your son are not going to be like you thought.'

Koo disagrees. 'The Bank of Japan will not monetise the debt, that is not the problem. The problem is that there are too many lenders and not enough borrowers. They tried to monetise the debt and borrowers refused it.'

What is clear is that the dangers posed by Japan have not gone away, and that the situation is dangerously uncertain. The divergent views of Koo and Courtis can be interpreted as an indication that there is great potential for the kind of currency volatility that led to the Asian crisis.

Moriyosho Akiyama, chairman of the Japanese Management Association, told BRW in mid-1997: 'With the yen at 120 against the US dollar, globalisation will be off in Japan.' These words proved prophetic when, soon after, exports in Thailand collapsed as Japan brought its Thai production back onshore. The baht went into free fall, and the Asian financial meltdown was the result. The lesson is unmistakable: in the global economy, Japan's problems can easily become the rest of the world's problems.

http://www.brw.com.au/stories/20001103/7731.htm

-- Martin Thompson (mthom1927@aol.com), November 03, 2000


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