We’ve been here before. Or at least I have. I started my career covering Japan and have been involved with the market ever since. At some stage in the 1990s the Japanese banking system went underwater, although it took us some time to realise it.
You see, with banks in those days, all their assets were loans, held to maturity on the loan book. There was none of this treasury book, mark-to-market malarkey forcing them to declare losses every quarter. Quite the opposite, in fact. Loan book losses lag the real economy. Borrowers only default on loans after first getting behind on them for months. By the time the bank finally forecloses and sells off the collateral, it can be months, years even, before the truth is out. So although the stockmarket had been falling since 1990 and the property market since 1991-1992, the banks didn’t start to underperform the wider TOPIX index until 1997. From then on the sector rushed downwards, before finally bottoming in 2003, at less than a tenth of its 1990 peak value.
By November 1997, with banks in freefall and several high-profile financial bankruptcies taking place, the cat was well and truly out of the bag. The authorities started to inject taxpayers’ money into the system. This is roughly where we are today in America, although here in Britain we’ve yet to put our hands in our pockets. Between March 1998, when the Japanese government first lent ¥1.8trn (0.4% of GDP) and March 1999, the banks had applied for a total of ¥7.5trn (1.5% of GDP) of preference shares and subordinated loans. Note that 1.5% of today’s US GDP would be equivalent to about $225bn. Treasury Secretary Hank Paulson has promised $700bn to the ‘Troubled Asset Relief Programme’, where losses might exceed 20% – so that’s equivalent to a $140bn net injection. We’re getting there.
During this 12-month period of public money injection in Japan, bank lending utterly collapsed. A Bank of England report later concluded that this was for three reasons. Firstly, the stricter supervisory regime that came with the government handouts meant the banks were both less able and less willing to lend. And faced with depleted capital and concerns over borrower credit quality, banks also aimed to shrink the amount of loans outstanding, not lend more. Lastly, the weaker economy also caused loan demand to fall.
This is all very worrying for the West. It suggests that the stricter rules that come with bail-outs, and the economic weakness that will ensue as banks stop lending so liberally, will feed on itself and reinforce the collapse of credit availability we’re already seeing. Japan made its own situation worse by hiking the sales tax from 3% to 5%, but we’re already seeing the first signs that the British Government may have to raise taxes as the slowdown causes receipts to fall. This would be disastrous – but that’s unlikely to stop Alistair Darling.
Japanese GDP growth also collapsed, from 1.2% when the rescue plan was initiated to –1.6% a year later. The inflation rate also halved, but the real impact was felt in consumer credit, which was falling by 11% a year by late 1998. So is that what we have to look forward to? It certainly looks like it.
The good news is that Japan government bonds (JGBs) took off in this environment, only peaking in late 1998, a good six months after the financial injections started. This implies that gilts will be a good buy for several months. Even if governments need to issue more bonds, this new supply should be swamped by demand as the deflationary impacts wash through the economy. It took just as long for stocks to bottom out before starting a powerful 18-month, 80% rally. Again, this scenario makes sense – stockmarkets usually get going about six to nine months after bond rallies start. So by some time next year, perhaps even early next year, the stockmarket should bottom and, using low government bond yields as its valuation base, start an extended bull run. In 1998, the Tokyo stock index was able to run up for the next 18 months, because it was at a ten-year low, just as the FTSE is today.
The bad news is that the real economy dived into a deep recession that lasted throughout 1998 and 1999. A double-digit drop in consumer credit saw economic activity hit a brick wall, especially those activities financed by debt. And house prices? They officially rose last year for the first time since 1992, so they fell for almost another decade after the Japanese government bailed out the banking system. So that’s what the Japanese experience tells us to expect. Bank lending will collapse more than expected. A state bailout actually constrains banks from lending rather than facilitating it. That means the economy will slow sharply and possibly for two years rather than one. The government will probably make this worse by raising taxes rather than cutting spending. This will all be good for bonds, and later that will prove a boost for stocks, but the real world will get very tough for a few years yet. As for house prices… Phoof.
• James Ferguson is an economist and stockbroker with Pali International