Japan Bond Sale Rumors Spark Doomsday Fears

For years, Japan’s ownership of many billions of dollars worth of U.S. Treasury bonds has carried with it an implied threat: If the Japanese ever chose to sell en masse, they could conceivably cause a market meltdown.

On Friday, rumors of such a premeditated dumping of U.S. bonds by Japan--supposedly ordered by the country’s Ministry of Finance--swept through Wall Street, triggering the worst one-day selloff in bonds since last September and sending yields soaring.

Japanese government officials quickly denied the rumors, and many American economists argued that such an organized campaign by Japanese investors would amount to a doomsday weapon: By driving U.S. interest rates sky-high and causing a general market panic, Japan would risk ruining not only the U.S. economy but also the world economy and its own.

But if only a desperate nation would use a doomsday weapon, the worrisome issue for some Wall Streeters is that Japan’s economic and political woes have increasingly taken on just such desperate tones.

A growing number of U.S. analysts now fear that Japan, the world’s second-largest economy, is careening toward or is already in a depression--an economic contraction far more severe and long-lasting than the typical cyclical recession.

Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis, has been among the most vocal analysts sounding an alarm about Japan’s plight. “I think they are headed into a depression,” Sohn says flatly. “Their stock market may be telegraphing it.”

Indeed, the Nikkei-225 index of the Tokyo Stock Exchange on Friday fell 398.12 points to 15,044.18, its lowest since August, 1992. Once a symbol of Japan’s prowess, the Nikkei peaked at just under 39,000 in 1989, then crashed in 1990-91 with the bursting of the country’s “bubble economy.”

The destruction of that bubble--a spectacular inflation of stocks and real estate values caused by easy money and overconfidence in the ‘80s--has left Japan staggering for five years with anemic growth, rising bankruptcies, collapsed real estate prices, record low bond yields and banks loaded with bad loans.

“The average recession lasts 11 months in the United States. Japan’s is already 3 years old,” says Lawrence Krause, Pacific economic cooperation professor at the University of California, San Diego.

But as economists struggle with exactly how to characterize Japan’s situation, and the potential global repercussions if the nation’s downward spiral continues, they also point to some glaring ironies.

Japan’s economy has stagnated, yet the yen is the world’s strongest currency. While Japan’s current unemployment rate of 3.2% is its highest ever, it remains among the lowest in the industrialized world, and certainly does not conjure images of the bread and soup lines of a 1930s-style Great Depression.

Even so, few economists would disagree that Japan faces serious threats to its long-term well-being. And because the country cannot seem to arrest the horrendous deflationary forces that have been ongoing since 1990, many analysts argue that the Clinton Administration’s threat of trade sanctions in the dispute over Japanese auto exports is misguided and ultimately harmful to the world economy.

“Japan is in a very dangerous situation, and I don’t think it helps things one whit that the U.S. is adopting [this] trade stance,” contends David Resler, economist at Nomura Securities in New York.

The Administration, of course, undoubtedly views the situation from another perspective: With Japan already reeling, this is the time to hit hard on the trade issue. A weakened Japan would seem more likely to cave in and finally open its closed markets to foreign competition, thereby deflating another bubble--the country’s gigantic trade surplus.

But some experts say the White House may be underestimating the anger building in Japan, especially within the country’s all-powerful government bureaucracy, as the United States pushes Japan to the wall on the trade issue.

The idea that Japanese investors might retaliate by dumping their huge portfolio of U.S. bonds, built up as Japan recycled many of its trade-surplus dollars into U.S. assets over the past 20 years, has in fact been raised in Tokyo recently.

“There is definitely talk about it,” says one Tokyo-based economist for a large Wall Street brokerage. “Some politicians here are really pissed off” about the U.S. trade stance, he said.

It isn’t known exactly how many Treasury bonds are in Japanese hands. But the Federal Reserve Board calculates that foreigners overall owned 20% of all Treasury issues at the end of 1994, with a face value of around $700 billion. In 1994 alone, Japanese investors, including the Bank of Japan, accounted for 38% of foreigners’ total net purchases of Treasuries.

In any case, Japan’s holdings are certainly formidable. Yet many analysts say that however much the Japanese might want to use the bond-market threat for leverage, a sudden massive liquidation of U.S. bonds would only deepen Japan’s economic woes by further depressing the dollar’s value.

That would play right into America’s hands in the trade battle by making Japanese goods even more expensive abroad.

Dumping U.S. bonds “doesn’t seem to [jibe] with what would be Japan’s interests at the moment,” says Edward M. Graham, senior fellow at the Institute for International Economics in Washington.

Robert Brusca, economist at Nikko Securities International in New York, argues that it would be counter-intuitive for Japanese institutional investors to bail out of their U.S. financial assets with the dollar now at 84.30 yen, which is not far above its all-time low.

Most economists say the dollar is extremely undervalued and that natural corrective forces will eventually lift the buck again.

“Japan knows that this isn’t the exchange rate they’re going to be able to exist with,” Brusca says. “So it would be the dumbest thing for financial Japan to take exchange-rate losses if industrial Japan can’t survive at these rates.”

On Friday, even as the U.S. bond market was slammed and the 30-year T-bond yield soared to 6.72% from 6.61% on Thursday, a steady dollar suggested Japanese investors weren’t selling. Bond traders noted that yields had been rising since Wednesday on fading hopes that the Fed will ease credit soon.

But some Wall Streeters worry that the U.S.-Japan trade battle could yet provide a convenient excuse for Treasury bond liquidation by Japanese banks and insurance firms that are in severe financial straits and have little else they can sell to raise cash--given still-plunging Japanese stock and real estate prices.

Indeed, economists who fear a full-blown depression in Japan say the weakness of the nation’s financial system is the biggest symptom of serious trouble brewing.

For the past five years, the government has continually put off the day of reckoning for the bad loans and soured investments on the books of Japan’s financial institutions. Instead of allowing banks to fail as the United States does--and the financial system to be purged--Japan has attempted to ignore the problem.

That has created a vicious circle: Banks have large loan losses, but they generally don’t recognize them. Yet bank managers, knowing full well their poor financial state, are afraid to make new loans. So money isn’t recycled, and the economy weakens further.

“Although Japanese banks have written off about 10 trillion yen of bad credits in the past two fiscal years, not much progress has been made in reducing the absolute amount of problem loans, which still total about 40 trillion yen [$470 billion],” says Kenneth Leung, economist at Bankers Trust Co. This is equivalent to a stunning 9% of Japan’s gross domestic product.

The government last Thursday unveiled a new plan to address the banking crisis, but it was almost immediately attacked by critics as having few specifics. Banks may be allowed to fail, but not any time soon. And the use of public funds to bail out bad banks wasn’t addressed--even though most U.S. analysts say there is virtually no other way to solve the crisis.

“If the government were to take over the finances of the bad banks, the problem would be over,” contends UCSD’s Krause. But the Japanese bureaucracy appears to believe there is no public support for such a U.S.-style bailout.

What if Japan is indeed on the verge of a modern-day depression? While it’s conceivable their liquidation of U.S. bonds, should it occur, would send U.S. interest rates soaring, Norwest’s Sohn argues that the longer-term impact would be inherently deflationary for the world by slowing growth.

The collapse of real estate and securities wealth in Japan, he says, is “clearly one reason why they are not able to buy as much from us, or Europe, or other countries.”

But others say that growth elsewhere, especially in the Third World, would ultimately make up for a shrinking Japan. That Third World growth, in fact, is being fueled partly by the export of production and technology by Japanese firms from Japan to other countries, to take advantage of lower costs.

Japan’s crisis, says Krause, “is a financial problem. But the expertise of its companies is still there. They still have value.”

As the falling Nikkei shows, however, that value is dwindling by the day.

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Japan’s Bear Market: Five Years of Pain

The Nikkei-225 stock index of the Tokyo Stock Exchange reached its all-time high of just under 39,000 at the end of 1989, coinciding with the peak of Japan’s “bubble” economy. After crashing in 1990 with the global bear market, Japanese shares have remained mired at depressed levels as most other world markets have rallied dramatically.

Nikkei-225 index, quarterly highs and latest:

Friday’s close: 15,044.18

Source: Bloomberg Business News