"With this in mind, the G8 has demanded the Japanese economy be "fixed" ... and
fixed quickly at that. Without proper understanding of Japan's fundamental
problems, however, there will be further decline and, in fact, a sustained
crash of the Japanese market. This could easily bring a swift decline to the
euphoric European and US markets."

Since Kenichi wrote this, Japan's GDP decreased only 0.7% in 1999, but it increased 7.6% in 200, another 9.2% in 2001, and is headed for a 1.9% increase in 2000.

 

 

Subject: Kenichi Ohmae: Why Japan is Heading for a Major Crash

AFR
Saturday, June 20, 1998

Why Japan is heading for a major crash

By Kenichi Ohmae 

In 1619, the Spanish Empire's defacto financial centre, Genoa, was at the
brink of collapse. A key indicator of financial distress was the decline in
the official yield rate to 1.125 per cent. Move now to the first week of June
1998, and Japan's official bond yield has plummeted to a low of 1.115 per cent
... smashing the worldwide historical low held for 379 years. 

The golden questions are how� and when� do we expect Japan's recovery, and
what will be the effects on the rest of the world? Do we turn to her leaders
for answers? Leaders who have little understanding for her underlying
financial distress are of little assistance. The joint US and Japanese
intervention to rescue the yen during the week is nothing more than a morphine
shot; a temporary pain relief but no cure. 

Before tackling these issues, however, it is necessary to establish a common
frame of reference. That is, Japan's position in an interlinked global
economy. 

In the global economy there is no free lunch. American prosperity is self-
earned, so they say. In actual fact, however, without funds from the rest of
the world seeking refuge in Wall Street's gigantic bucket, the Dow Jones may
not even reach 8,000, let alone sustain it. Fortunately in the US, super-
liquidity has been confined to the stockmarket � unlike Japan in the 1980s
when liquidity spilled into expensive golf club memberships, Van Gogh
paintings, and above all, overpriced Tokyo real estate. 

With this in mind, the G8 has demanded the Japanese economy be "fixed" ... and
fixed quickly at that. Without proper understanding of Japan's fundamental
problems, however, there will be further decline and, in fact, a sustained
crash of the Japanese market. This could easily bring a swift decline to the
euphoric European and US markets. 

Unfortunately everyone, including the Japanese Government, is proposing a
"quick fix" to the deep-rooted problems of Japan's economy. History has
demonstrated that every time such a "fix" is implemented, problems are hidden
away ... only to grow bigger in the shade. The "quick fix" I refer to
encompasses the measures of "economic stimulus" or fiscal policy. 

In the past five years, and to no avail, Japan has spent more than $US600bn in
public works above and beyond the annual budgets. The recent $US30tr packages
set to bail out failing financial institutions and write off bad debts are, in
my opinion, nothing but a series of morphine shots to relieve a patient of
short-term pain. 

The US Government has asked Japan to stimulate its economy with an aggressive
budget of increased public works and simultaneous permanent tax cuts. The
former calls for a big government, and the latter, a small government. If such
a remedy were proposed for the US, it would not survive public scrutiny for a
moment. 

According to a wide spectrum of US Government officials (ranging from the
President and Secretary of Finance to the Ambassador to Japan), this
prescription is in the best interest of Japan. And I agree. Although their
reasoning copies that of Wall Street analysts and the so-called new rich. That
is, they do not want Japan, or Asia for that matter, to drag Wall Street down.

These expectations are way too high. Japan's economic problems cannot be
confined to its geographic borders in an interlinked global economy. As such,
it cannot be expected that the US economy be shielded and continue to prosper,
particularly � when we are referring to the two largest economies in the
world. 

In my view there are five issues, all independent, (at least initially) that
lead to the same conclusion ... the crash of the Japanese market. 

This is not the first time I have raised this viewpoint. For instance, I
predicted that in 1992 a market correction would bring the net-present-value
of Tokyo properties to one-fifth of their peak, reached in December 1989. The
real market experienced the bottom of the market in 1995 but the Government
and financial institutions tried to conceal it. They froze the market by
changing accounting rules to avoid huge downward revaluations. They neglected
to understand that such reactive behaviour was nothing new to the global
economy. Actually, it was very similar to events in Houston, Los Angeles, New
York and London where excess supply of commercial buildings swiftly led to
depressed rents. Neither Japanese business nor the Government, however,
admitted that the same historical and economic certainty was occurring in
Japan ... a certainty soon to become the cornerstone of Japan's financial
problems. 

The "wishful thinking" mentality is perfectly understandable. I mean, the
value of Tokyo in the late '80s was estimated at more than that of the entire
US. For the market to fall 80 per cent in just half a decade is more than
anybody can adjust to. It is arguable that Japan's bubble was far beyond
reality and as such required an adjustment. 

But in the mid-1980s, Japan's prosperity appeared even sweeter as the Tokyo
stockmarket achieved an 80-times PE ratio. That ratio, according to the
analysts (who are now in hiding), was justifiable due to the appreciation of
the stocks and properties hidden in the books of the mighty Japanese
corporations. 

Today's reality is that the Nikkei is at 37 per cent, and Tokyo's properties
at less that 20 per cent of their peak value. The books of account, however,
have not been adjusted. This continued state of denial and implementation of
superficial economic revival techniques now means that any serious effort to
correct the books will cause the market to crash. 

Allow me to describe five possible scenarios: 

1. Accounting firms get serious and perform due diligence
Most prestigious accounting firms exist by name only in Japan. They by no
means practise professionally. They issue a "clean statement" at the request
of their client or otherwise at gunpoint to the Ministry of Finance. Most
bankrupted financial institutions had up to 10 times the "audited" bad and
non-performing debts. 

The first indication of accounting mismanagement came as a surprise in January
1997, and was later known as the "Kyotaru shokku".� Japan's largest sushi
chain operator, Kyotaru, filed the Japanese equivalent of Chapter 11, because
its accountant refused to continue to fudge the books. Concealed bad debts had
risen to $US1bn in diversified businesses unrelated to their core business. 

The big Japanese accounting firms are all affiliated with the globally
recognised firms. That is, Tohmatsu with Deloitte Touche, Asahi with Arthur
Andersen, and Century with KPMG. So, it is not that the world is not aware of
Japan's accounting practices. More to the point, in this profession, when
everyone is engaged in malpractice, why stand up and be the first saint? 

So, if the books are truly opened and the balance sheet adjusted to reflect
market reality, the shokku,� or the crash, will spill over the sushi counter
and most certainly be felt throughout the world. 

2. The Letter of Awareness is ignored
Japan was shocked when a prestigious and profitable company, Daido Concrete,
filed for bankruptcy and withdrew from the Tokyo Stock Exchange on February
28. The CEO, Hisatada Ishikawa, revealed by press conference that the company
had net debts of $US19.5bn, because it has given several banks shido nenshos�
(letters of awareness). 

The nenshos� were nothing but a series of unofficial letters, stating that the
company was aware that its Asian subsidiaries were borrowing money from them.
It is not an official letter of guarantee, nor is it an agreement to
collateralise its own assets. The paper has no legal significance. 

Most banks, during the bubble years, begged businesses to borrow more money,
even when they did not need it. As such, borrowers were reluctant to surrender
collateral. For consolation, the banks, in an easy-going manner, created
nenshos,� which simply state: "Yes, we are aware of our subsidiaries borrowing
from you". 

In the case of Daido, the nenshos� amounted to some $US150m that its
Indonesian and Hong Kong subsidiaries had borrowed from local branches of the
Japanese banks. 

Daido shokku� is a significant case because currently the total sum of amounts
committed by nenshos is unknown � unable to be estimated by the accountants or
top management. Some well-informed insiders say that the total amount of this
type of lending could be in excess of $US1tr. 

Recently, Japanese banks "secretly" ordered their branches to sum up the total
amount of nensho� lending. A branch manager known to me shrugged his shoulders
and commented that it is impossible to size them up because more than half of
the loans to "prestigious" companies do not have corresponding written
documentation. 

The seriousness of this situation has worsened, however. As the banks are not
legally protected for these loans, they claim defence by forming a "wolf pack"
to deal with trouble from their clients with nensho� loans. For example, Daido
refused to satisfy loan repayments on behalf of its overseas subsidiaries.
Daido preferred the subsidiaries to go bankrupt than to repay debts on its
behalf. 

As a result, and when Daido's short-term borrowings fell due for renewal in
Japan, all� the banks ganged up in unison, and refused to revolve their
lending. 

This practice is similar to that seen in the movie The Godfather �. That is,
the poor company could not survive without obeying the unwritten law of the
wolves. 

Note that nensho� loans are in addition to the already revealed $US1tr in bad
and non-performing loans, and the problem may or may not explode. The equally
big exposure of the Japanese banks will certainly add fuel to the fire once
the current feeble containment, or the wolf pack efforts, begins to erode. 

3. Interest rates rise
Japan is one of the few countries that performs better with rising interest
rates. This is due to the significant level of consumer savings. Japan is now,
however, experiencing historically low interest rates for the sake of saving
over-extended corporations. 

The 10-year government bond yield about 1.14 per cent and as previously noted
is now comparable with the one observed in Genoa in the early 17th century.
The popular Postal Savings now offers 0.35 per cent interest for a one-year
deposit, which is considered attractive compared with the banks' term deposit
of 0.30 per cent. 

The market theoretically sets interest rates. This is not, however, the case
in Japan. At present, the Bank of Japan cannot raise rates for fear of an
avalanche of failures of heavily geared companies, mostly in property-related
markets. 

This situation is akin to the terminal care of coma. The health of a patient
in a coma is not restored by a doctor's prescription. Life is merely
prolonged. What happens if the oxygen supply stops? 

Just as Japan's national savings has prolonged the life of over-geared
corporates, the savings supply will eventually be cut off as massive levels of
capital flee to higher yielding shores. In the first month after the
deregulation of the foreign currency exchange laws on April 1, as much as
$US20bn fled Japan for higher-yielding offshore instruments. 

Japan still has $US12tr in personal savings. So, one might say the oxygen is
still flowing. Ultimately, the Government would like to use excess savings to
solve Japan's internal problems. To do so, and to discourage savings from
gushing out, it must raise official interest rates. As the rate goes up to,
say, 5 per cent, the inevitable crash will erupt as massive corporate
bankruptcies occur well before consumer spending based on higher interest
payment rises. 

4. The yen continues to decline
The yen has weakened against the US dollar by more than 50 per cent in the
past two years. In addition to the spread in interest rates between the US and
Japan of about 4 percentage points, if one adds the appreciation of US
financial instruments, the return becomes increasingly attractive. Right now,
nothing seems hopeful enough to stop the decline of the yen. Japan's result
now becomes a "triple low": low interest rates, low value currency, and low
stock prices. 

The drive to place savings in more attractive overseas markets comes primarily
from high net-worth individuals and liquid corporations, and hence is
different from reasoning stated in item three. 

The result, however, is the same because, to stop it, the BoJ will have to
raise official interest rates. 

5. Liquidity crisis begins
The so-called "Japan premium" for Japanese banks to borrow in the interbank
market has fluctuated between 20 and 150 basis points. Since banks operate
with only about 25-basis point margin, the Japanese banks have been forced out
of the international market. 

The Fed and the BoJ are concerned, to say the least. If Japanese banks are hit
by a liquidity crisis, they may have to sell US government bonds. These bonds
have been held since the '80s when they were used to finance the US Budget
deficit. 

The situation became very serious in November 1997 when Sanyo Securities and
Hokkaido Takushoku Bank went belly-up, and the world financial community
became concerned about other possible casualties. Due to the excessive
liquidity the BoJ subsequently provided and with the help of Fed, the extent
of concern seems to have calmed ... at least temporarily. 

The Japanese banks, however � particularly the traditionally better performing
ones � have been hit hard. Hit not only by all of the problems described
above, but in addition to the Asian liquidity crisis. Clearly their strength
to survive is to be tested from all angles. 

Independent of these problems at hand, the Government unleashed the cruel
tiger of the Big Bang into the domestic market. This is the same Government
still trying to rescue the banks. Obviously there is confusion, or at least an
anomaly of economic policy. 

Is it the Japanese Government's priority that competitive banks prevail and
the weak exit, or are they prioritising to save the entire fleet of banks? The
MoF has promised an end to bankruptcies of the major financial institutions.
Yet the "Big Bang" is supposed to mean the survival of the fittest. This is
clearly a contradiction of economic and political priorities. 

In reality, it does not matter. When they fall, they will all fall together.
That is the nature of traditional Japanese financial practices. That is,
Japanese banks form syndicates to finance large projects. As such, no bank
will be absolutely safe should one of its members fail. 

So, contrary to commercial principles, the banks act in harmony, but when it
comes to matters internal to themselves they threaten each other so that no
member can bail out without recourse to other members of the syndicate. Again
this behaviour is like that of the wolf pack. Wolves gang together to seek
prey, but in absolute hunger they will suddenly attack the pack's weakest
member. So far, they have eaten one by one from the bottom of the ranks. 

The situation has worsened now. The Japanese economy is classified as
deflationary as unemployment reaches a high of 4.1 per cent, and consumer
spending and confidence levels decline at alarming levels. As for policy
options? They have been exhausted because the MoF has implemented too many
phoney ones already. For instance, a frantic $US220bn credit line morphine
injection ensured a few bottom performers just made it over the line by the
end of the last fiscal year (March 1998). 

So, when the next round of liquidity crises hits, it is likely that the pack
itself will be tried for collective survival. The once glorious MoF and BoJ,
having been at the centre of public criticism and having produced several
staff for indictment, have no power, let alone credibility, to steer Japan
along the slippery road ahead. 

All these scenarios lead to the same conclusion. Japan is going to slide
further ... and perhaps even crash. There are, however, many reasons to
believe panic can be avoided. This is provided the Government can be honest
enough to explain the real situation � not only to the Japanese people but to
the rest of the world, as this is a matter of global concern and consequences.

First, the Government has more than $US4tr worth of assets and properties on
Japan's balance sheet. This already exceeds the amount required to extinguish
the financial problems of Japan, and may even be sufficient to cover all of
Asia's troubled debts. Furthermore, Japan's consumers have $US12tr in personal
savings in addition to $US28tr worth of assets. 

Unlike its Asian neighbours, Japan does not owe money. Japan's problem is
entirely internal. It is a simple case of internal mismanagement. Despite the
prevailing negative sentiment, Japan still retains a very strong consumer
sector, powerful industries with ample exporting capabilities, and above all,
diligent people. Trouble skyrocketed primarily because its government tried to
hide facts and attempt to rescue the wrong industries at the taxpayers'
expense. 

Essentially it is a relatively simple matter. Japan requires a political
vision strong enough to allow bad banks and corporations to exit, and smart
enough to open the economy to the globally competitive ones. In the process of
Japan's normalisation, the American and other markets will fall a little. But
... the recovery will be fast if� the enormous mount of wealth, currently
hijacked by the MoF to rescue the wrong people, is used for the benefit of
all. 

The solution is quite obvious: improve the quality of life at the lowest cost
of living, by allowing the goods and services to come from anywhere in the
world. So, instead of demanding that Japan spend more on public works and
artificial creation of jobs for special interest groups, the US Government
should work with the Japanese voters to secure long-term benefits for both
countries. This means, at least for a short while, it has to warn its own
passengers to fasten their seatbelts and prepare for turbulence. Given a good
pilot, the choppy ride is going to be over in a few years. 

� Kenichi Ohmae is managing director of Ohmae and Associates, and has written
many books on the globalisation of the economy, including� The Borderless
World (Harper Collins).