Japan Should Heed Market’s Real Message

The stock market here has lost ground in very volatile trading since the recent announcement by the government that it wants to raise taxes in fiscal 1997 to cut the budget deficit.

Many veteran observers, including Federal Reserve Board Chairman Alan Greenspan, have responded to the decline by commenting that the Japanese are becoming too pessimistic and that the macroeconomic numbers do not suggest such a weak economy.

The first point to note is that the Japanese stock market is now polarized, with one end at or near historical highs and the other end at 10-year lows. Because of this polarity, the Nikkei average has ceased to be a useful indicator of where the market is going.

It is true that Japan’s macroeconomic statistics are not bad. Industrial production, exports and even corporate profits are recovering. But the stock prices of those companies that are benefiting from higher production and exports are already very high.

For example, the stock prices of Toyota, Honda and Canon are at or near their all-time highs. Thus, the market is not ignoring good statistics and becoming pessimistic in some irrational way. Rather, it is valuing good performances appropriately.

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The problem is with the domestic demand-oriented sectors that make up about 70% of the total market. The stocks of banks, construction companies and securities houses have been hit particularly hard during the latest sell-off.

Once stock prices started falling, people began to remember that the problems of the banking system are still with us and that the capital of Japanese banks is intrinsically dependent on the health of the stock market. Since it is believed that the banks will be OK as long as the stock market stays above 20,000, people allowed themselves to forget the banking crisis when the market remained above that level throughout most of 1996.

In the meantime, however, three commercial banks have collapsed in the last 18 months. The most recent casualty was Hanwa Bank, which failed with bad debts of 190 billion yen (or roughly $1.54 billion at the current exchange rate of 123 yen to $1). The disturbing fact is that the bank’s financial results released just before its collapse indicated bad debts of only 49 billion yen.

It was the same story with the other two banks. When Hyogo Bank went under, its bad debts mushroomed from 61 billion yen to a whopping 1,500 billion yen. When Taiheiyo Bank failed, its bad debts went from 27 billion to 170 billion yen.

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All of the financial results of Japanese banks are cleared with the Ministry of Finance before they are released to the public. This means that there was a concerted effort by the ministry to hide the losses. With such practices rampant, investors both inside and outside Japan are at a loss as to what they should believe. Certainly nobody accepts the accuracy of the figure of 35 trillion yen (roughly $285 billion) that the Finance Ministry has released as the total amount of bad debt in Japan.

The fact that the Nikkei has fallen below 20,000 (it closed at 18,067.04 on Friday) means that investors have suddenly been forced to face these ugly realities again. In some sense, therefore, what happened to the stock market was a return to somber reality from the exuberant forgetfulness of 1996. The message from the market, including a 10-year bond yield of less than 2.5%, is that the economy could use some more fiscal stimulation to keep domestic demand from collapsing.

But while the market has returned to reality, the policy debate has not. Instead, the Finance Ministry has won the politicians over to its side by arguing that Japan cannot afford any more fiscal stimulation to expand domestic demand because the nation’s budget-deficit problem is now worse than Italy’s.

The market is telling Italy and Japan quite different things, however. Italy has the highest interest rates among G-7 countries, and Japan has the lowest. High interest rates in Italy mean that there is competition between public and private users of funds (crowding out), and that there may be inflationary expectations as well. Such a country needs to cut the government budget deficit to make room for private-sector investment.

On the other hand, low interest rates in Japan are the result of a total lack of private-sector demand for funds combined with fears of deflation rather than inflation. Indeed, many banks and insurance companies in Japan are now begging corporate borrowers not to pay them back when their loans come due.

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Such a country has no reason to fear crowding out. Rather, the current record-low bond yield should be viewed as a historic opportunity for Japan to improve its long-neglected social infrastructure.

Unfortunately, policy debate in Japan has no tradition of listening to markets. This is particularly true of bureaucrats, who usually are highly suspicious of uncontrolled entities called markets. This means that Japan has a considerable amount to learn and that much more pressure from the market will be required to force policymakers to understand the real needs of the economy.