The markets in Japan have suffered severe shocks in recent weeks. WhatÆs your summary of the current situation?
The picture is grim. Export weakness is spilling over into the rest of the economy. Private capital expenditure is slowing. Simultaneously with a declining real economy we must be prepared for a slowdown in credit creation. Thus, the economy will be hit by a double blow: in the financial sector and in the domestic sector, after already being hurt by the spike in commodity prices over the past year.
Abroad, many observers have been praising the soundness of the Japanese banking system, buttressed by lots of liquidity. You donÆt agree with that?
No, I donÆt. Japanese banks have a crucial weakness, namely their high share ownership levels, dating from the bubble years. They have decreased their ownership to a certain extent, but they still own 15% of the listed stockmarket, where foreign ownership amounts to 30%. In other words, when the domestic stockmarket goes down, it strikes at the value of the shares the Japanese banks hold, and in turn at their capital base. If their capital base diminishes, they will be more reluctant to lend. If you reduce lending and withdraw liquidity, a mild industrial slowdown can become a severe one.
That sounds very worrying. What is your growth forecast for this year and the next?
We are forecasting 0.4% growth in calendar year 2008, negative 0.9% growth in 2009 and negative 1.1% in 2010.
WhatÆs the background to these disastrous shareholdings by the Japanese banks?
Back in the 1950s and 60s, JapanÆs high growth period, the banks and their corporate customers took shares in each other as an anti-hostile M&A measure. Initially, as stock prices and the land holdings that many companies had went up in price, the system worked. But when asset prices started collapsing after 1989, the banks proved vulnerable. The banks have been told to divest themselves of these shareholdings, but they havenÆt done enough. Generally, itÆs thought that when the Nikkei index drops below 9,000 the banks' capital adequacy ratios are increasingly endangered.
This sounds like it has the making of a deflationary spiral. Is that correct? Are we back where we were 10 years ago, when people were panicking about deflation, with no fundamental improvement?
Yes, I believe there is the threat of deflation. Just one year ago, we thought deflation had been defeated. The consumer price index (CPI) was up 2.4% year-on-year in July/August. But deflation is gradually emerging, although not yet. The concurrent contraction of the real economy and the financial side could lead to deflation. The monetary side is on the verge of contraction as demand for funds fall and the banks grow more cautious about lending.
So, the Western banks have been weakened by their derivatives and subprime exposure, while the Japanese banks have been weakened by something quite different, but the result is the same, namely combined monetary and real economy weakness?
Yes, thatÆs right. The problem is that the Japanese economy has not normalised itself, as reflected by the high level of share ownership by the banks. If those shares had been more aggressively divested it would have been better. In retrospect, this was a key weakness of Japanese banks û that they retained the equity exposure.
Can we say the Japanese have caused their own problems? With the zero percent interest-rate policy and a chronic trade surplus, Japan funnelled far too much cheap debt to the US via the carry trade, driving a US asset price bubble, which has now collapsed. That collapse has sparked a knock-on collapse in Japan, and triggered a general slowdown in Japan.
Yes. In 2005, at the height of quantitative easing there were no signs of inflation. At the time, observers explained it as people having greater faith in the central bankÆs monetary policy which suppressed inflation. However, we were wrong. Inflation was rising abroad behind out backs, namely in the commodity market and in stock prices. Central banks now know they have to look at all asset classes for signs of inflation, not just CPI and stock indices.
So, capital was flowing out of Japan and fuelling inflation across its borders. It no longer has to appear in CPI. IÆm wondering who will suffer most in the coming slowdown. Will we see serious damage in the small enterprise sector, for example, or will they still be insulated by the low interest rate policy?
They will have to rely on cheap money for survival. Many of them are still weak and will continue to be so. Small, non-manufacturing companies in Japan have to thrive for Japan to thrive, and many such companies are directly or indirectly dependent on private consumption. So private consumption has to thrive, but I am bearish about that. We have found that the path connecting corporate profitability to households is seriously eroding. Why? One reason is globalisation. Not only are Japanese companies offshoring, but 30% of the market capitalisation is held by foreigners. This means that 30% of dividends generated in Japan are going offshore. In addition, foreign shareholders are very vocal. They criticise company managements when managers pay out too much money in salary costs, ending up with smaller profits. In the past, company profits used to be distributed to employees since shareholders were silent û but thatÆs no longer the case. Japanese company managers have been taught by foreign shareholders that wages are costs (they werenÆt viewed that way in the past). So they are suppressing wages in favour of shareholder dividends, which are flowing out of Japan.
ItÆs almost incredible to see Japan getting steadily poorer in a relative sense over such a long time. A recent report by the Organisation for Economic Cooperation and Development (OECD) said that JapanÆs ranking in terms of per capita income fell from the fifth highest in the OECD in 1992 to 19th in 2002. This is very unusual by the standards of Western economies, where long-term income growth tends to remain positive, even when punctuated by violent financial crises.
Yes, it is strange. But a major factor is the terrible demographic situation. In a country with positive demographics, the governmentÆs liabilities get diluted over time per head of the population. But in Japan, the opposite is happening. JapanÆs population has been shrinking since 2006, which will continue to put downward pressure on GDP. In 300 years, at the current rate of decrease, JapanÆs population will be extinct.
Bankers often call for M&A to boost consolidation and increase productivity to stimulate GDP growth. Do you agree?
Very much so, but itÆs not happening fast enough. Some people say that former prime minister KoizumiÆs reforms were excessive and have led to the current slump. In fact, we need more reform. The most important lack is that Japan has globalised to the outside, but has not allowed globalisation to come inside its own country. There is not enough foreign direct investment and immigration to offset a slowing Japan. We need fresh labour and fresh taxpayers.
Could robots or automation substitute for demographics? Or is the problem that they canÆt consume?
We do need them, along with FDI and immigration. Theoretically, robots can consume, since they depreciate. Depreciation is a form of consumption in economic terms.
You mentioned the Koizumi reforms were inadequate. Why is that?
Koizumi wanted to cut the budget deficit. Also he was obsessed with the Post Office privatisation plan. But we should have done more. We have to ask: why did Japan grow during the Koizumi cabinet? It was purely down to exports. It was exports which underpinned GDP growth at the time. So Koizumi was very lucky, since exports are purely dependent on external factors û other countriesÆ ability to absorb exports.
So the relationship of Japanese exports to GDP growth was the flip-side of the debt explosion to GDP in the US?
ThatÆs right.
JapanÆs debt-to-GDP is already the highest in the developed world. How much can Japan spend in terms of fiscal stimulus to maintain GDP levels in the downturn?
The absolute level of debt is not the primary problem. The primary problem is the upward trend of the debt-to-GDP ratio: that the growth of debt is higher than the rate of GDP growth. This is a theoretical nightmare. ItÆs unsustainable. The options are the following: declaring a debt default, or increasing the consumption tax. But new Prime Minister Aso has said he will not raise the consumption tax for two years. Considering the strong need for stable tax revenues to finance ever-increasing social security-related expenditure, we have to raise the consumption tax rate. If this is delayed, it may need to be even doubled to 10%. Until then, Japan will simply issue more government bonds.
Is JapanÆs sovereign rating under threat?
No, because of the large amount of financial assets held by Japanese households, namely Ñ1,500 trillion ($15.7 trillion), which is three times as large as annual GDP. The government could tax those assets, for example, to repay the national debt should it really be on the verge of default. But we should note that these assets are the accumulation of the post-war era. Now that the savings rate is actually pretty low, mainly due to the aging of the population, it could be the case that the government debt grows faster than the household financial assets in the future. Then things become very hard to deal with.
Do you see any ray of light for the Japanese economy?
There is no source of cyclical recovery domestically. Japan needs the global economy to recover, which will buoy JapanÆs exports, even if the benefits probably wonÆt extend to Japanese households. Now that the global economy is suffering, we need a fiscal policy, which must be efficient and effective. Otherwise it may simply raise interest rates, which will suppress future growth.
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