1 - Gatton College of Business and Economics

Japan’s Economic and Financial Crisis: An
By Takeo Hoshi and Anil K. Kashyap
Japan’s Recession: Is the Liquidity Trap Back?
By Michael Hutchison
Summary by Andrew Blanford
Japan’s Economic and Financial Crisis: An
By Takeo Hoshi and Anil K. Kashyap
 Look at the macroeconomic problems triggering the collapse of the
financial sector and the sector-specific factors facing the Japanese banks,
insurance companies, and government institutions.
 The estimated losses of nearly 20% of Japan’s GDP will be corrected
through taxpayers
Output and Price Developments
 When you compare the expected GDP growth of 2% per year to the actual
GDP trend that Japan has experienced, GDP is 10% below the expected
 Despite the substantial GDP gap the slowing of the economy is more due to
stagnation and slow growth rather than a depression.
 Japanese economy has been in mild deflation every quarter since 1994
 Land prices had doubled from 1980 to 1991 and by 2003 had nearly
dropped to 1980 levels. Even larger price drops in major cities.
 Financial problems are disproportionately large relative to macro
Feedback from the Financial System to
the Real Economy
 Japanese banks continued to extend credit to firms with limited prospects
to repay the bank
 Kept many firms from exiting the market and allowed them to continue
 Zombie firms
 Lack of restructuring the mix of firms in the economy has been distorted with
inefficient firms crowding out the new more productive firms
 Zombie firms help explain overall slowdown in productivity
 Zombie infested sectors show sharper declines in productivity growth
Japan’s Policy Reaction to the Great
 Interest rate lowered to .5% in 1995 and then virtually 0 by 1999
 BOJ criticized for being reluctant to try non-standard monetary expansion
 Money-financed fiscal transfers or targeted exchange rate depreciation
 Japanese monetary policy and fiscal policy have been expansionary
 Macroeconomic policy could have been more aggressive and more
 Sequence of government agencies has been created to help banks with
the disposal of non-performing loans, but little has been done to restructure
troubled firms and remobilize resources of bankrupt firms.
Financial System Overview
 Japan is a bank-centered financial system
 3 sectors of Japan’s financial system
 Banks, life insurance, and government financial institutions
 Mergers and failures of banks have caused Japan to go from 11 major
banks to 7
 Account for about half of all private loans and deposits
 Insurance sector accounts for 20% of total system assets
 Japan Post is the largest deposit-taking institution in the world
 9 times as many branches as city banks combined
 3 sectors collectively account for 75% of total assets
Banking Sector Problems
 Banks have had low profitability for more than 10 years
 BOJ points out that the banking sector has had loan losses amounting to
80 percent of the increase in loans between 1986 and 1990.
Causes of the Profitability Problem
 Profitability problems of Japanese banks reflects other issues:
 Japan’s banking industry is too large in size
 Bank assets per person and bank assets relative to GDP each roughly twice as high in Japan as
the U.S.
 It has a poor record in offering new high-margin financial services
 Japan’s movement away from bank financing as firms shift to capital market financing
 Japanese banks are overly reliant on lending revenue
 It cannot compete profitably with money-losing government lenders
 Japan post has 40 times the offices of the largest banking group
 Government Housing Loan Corporation (GHLC) makes about 40 percent of all home
mortgage loans
 Many of its customers are insolvent
 Bank is consciously continuing to extend credit to insolvent borrowers with doubtful prospects
 Banks cannot solve long-term problems even if they can make it through the short-run
The Immediate Capital Shortage
 Japanese banks underserve, holding reserves sufficient enough to cover
only about 40 to 60 percent of bad loans. (Short 5 trillion yen in loan loss
 U.S. holds around 160 percent in their reserves
 “Double Gearing” between banks and life insurance companies
 Banks hold large amount of insurance company debt (subordinated loans or
surplus notes)
 Life insurance companies also tend to hold large amounts of subordinated bank
debt and stock
 Makes both the banks and the insurance companies appear better capitalized
than they truly are
 Japan’s banks will eventually be forced to close or raise more capital
Implications for Banking Reform
 Successful recapitalization of Japan’s banks should use market signals to
decide which banks deserve funding
 Banks want to attract arms-length financing to receive high lending priority
 Banks only raising funds from their customers or insurance companies get lower
The Life Insurance Sector
 March 2003, Japan’s ten major private insurance companies had assets of
roughly 152 trillion yen (30% of GDP, 85% of industry assets)
 Decline in the magnitude of “double-gearing” due to Japanese regulators
follow the international norms in prohibiting double-gearing between banks
and insurers.
The Profitability Problem
 Life insurance firms are exposed to stock market and face competition
from the government just like banks
 Japan Post also sells life insurance and holds about 1/6th of the market
 Postal program exempt from taxes
 Biggest profitability problem for Japan is self inflicted because of the overly
optimistic assessment of anticipated investment returns
The Capital Shortage Problem
 Like banks, insurance companies have made bad loans
 On a smaller scale than banks but still 422 billion yen in loans (only 1.1 percent of
 Capital buffer held by insurers known as “solvency margin”
 Complicated and involves estimating the risks from insurance underwriting,
interest rates, asset management, and business administration and the
comparing the risk with the insurer’s ability to pay, based on the quality of assets
 10 major insurers all reported solvency margins in excess of 300 percent
compared to the 200 percent minimum
 Companies with solvency margins below 200 percent eventually have
Implications for Reform
 7 major life insurance companies failed between April 1997 and April 2003
 Resolved using a formal bankruptcy procedure
 No public money has been used for the insurance sector
 Any further problem for insurance companies are not likely to impose direct
costs on taxpayers
 Indirect risk of the banks being affected by insurance company decreases
will decline with the decline of double-gearing
Japan’s Recession: Is the Liquidity Trap Back?
By Michael Hutchison
 Bank of Japan (BOJ) has lowered interest rates to fuel demand.
 Response to rising unemployment, price deflation, sluggish growth and recession
 Short-term interest rates lowered from 8.3% in early 1991 to almost zero by
1999 with the two-year government bond rate was .48% and the corporate
bond rate was .8%
 So why still a slump?
 Paul Krugman’s “liquidity trap”
 Alternative Explanation: the credit crunch associated with Japan’s banking
Liquidity Traps
 Liquidity trap is when interest rates are at or near zero
 Krugman strongly argues this to be Japan’s case and thinks that the BOJ
bring inflation and inflationary expectations up to 4% and keep them there
for 15 years.
 Poor long-run growth prospects are linked to unfavorable demographic
 Makes investment demand so low that a negative short-term real interest rate
would be needed to match saving with investment
 Krugman uses two pieces of evidence to support his claim
 Short-term interest rates have reached a minimum point, virtually zero
 Injections of liquidity by the central bank have not been very effective in raising
the growth rate of the broader money aggregates
Alternative Explanation: Credit Crunch
 Focuses on the contraction of the supply of bank credit caused by
nonperforming loans accumulating in the financial system
 Two part argument
 Decline in bank capital due to accumulation of bad loans held by Japanese
 Banks respond by reducing the amount of loans.
 Building capital-asset ratios by restraining lending takes a long time and induces a credit
squeeze. (Origin)
 Cautious lending attitude of Japanese banks due to bankruptcies,
nonperforming loans, and recession.
 Liabilities due to bankruptcies 2.7 trillion yen
 Firms become less desirable potential borrowers to the bank
 Bank’s self-reinforcing effect to tighten credit conditions
The Credit Crunch Continued…
 Tankan
 BOJ survey asking about the “lending attitude of financial institutions.”
 Indicated sharp tightening of credit conditions to both large and small enterprises
 “Lending attitudes” had become much more stringent
 Credit crunch implies that liquidity boosts do not increase credit and
aggregate lending
Which is Right?
 Evidence leans toward the credit crunch explanation
 The overall negative publicity about the Japanese financial system and
economy contributed to the pessimistic atmosphere in Japan in the late
 60 trillion yen (12% of GDP) was set aside to recapitalize banks.
 Along with bank recapitalization easing the credit crunch, if the BOJ keeps
interest rates low, economic growth should follow.
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