Japanese economic bubble

1. The Japanese economic bubble

In this section we would be analyzing the emergence and the collapse of the Japanese economic bubble, we would be looking at the various factors that contributed to it and would be analyzing the impact of the monetary policy in detail. But before we go into the details it would be worthwhile spending some time on the emergence of Japan from a devastated nation after World War II to become the second largest economy of the world.

2.1 A history of the Japanese Economy Post World War II

The Japanese economy started stabilizing itself after the World War II and the period from 1945 - 1950 was dedicated to establish economic stability. The Dodge Line austerity program in 1949 marked the beginning of serious reconsolidation, it's main objectives were to reduce inflation, redesign the Bank of Japan (BOJ), to balance the budget and establish a fixed interest rate of 1 US$ = ¥ 360, the price that was maintained till 1971.

The period from 1950 to 1970 is known as the High Growth Period (HGP) because the annual real GDP growth was on an average more than 10%. This growth was driven mainly by investment demand due to technological innovation that replaced the post World War II reconstruction demand. On the price front, consumer prices rose while wholesale prices remained generally stable, thus leading to the so-called ‘productivity difference inflation.' [1]

The period from 1970 to 1980 is very interesting in the economic history of Japan because of various reasons. It started with the ‘emergence of the Japanese archipelago' boom, saw the breaking of the fixed value of the yen and also how the Japanese economy fared in the two oil crisis of 1973 and 1979.

The emergence of the ‘remodeling the Japanese archipelago' boom period began when Kakuei Tamaka became the prime minister in 1972 and lasted till the emergence of the first oil crisis. This period was marked by an aggressive public investment in the Shinkansen rail road network, during this period the asset prices rose sharply and also the general price level due to the high growth of money stock and oil price hikes, the real economic growth also declined and marked the end of the high growth period.

The fixed exchange rate of ¥360 per US$1 was changed after the US started devaluing the dollar in the summer of 1971, and the Japanese government signed the Smithsonian Agreement which fixed the value of the Yen at ¥308 per US$1 and this lasted till the major currencies of the world started floating in 1973. Even after the Yen was allowed to float the Japanese government intervened heavily in the foreign exchange market as the government along with the business houses were worried that a steep rise in Yen prices would make the Japanese products lose their competitive value and hit the export growth. Despite this the market pressure drove the Yen to a high of ¥271 per US$1 in 1973 but the increased costs of imported oil caused the yen to depreciate to a range of ¥290 to ¥300 between 1974 and 1976. But with the re-emergence of trade surpluses the Yen climbed back to a new high of to ¥210 in 1978 and this was reversed by the second steep rise in the oil prices which caused the yen to drop to ¥226 by 1980.

The Japanese economy was totally dependent on oil imports and hence the first oil crises of 1973 shook the economy badly as the economy recorded a negative GDP growth in 1974 for the first time since the Second World War. The Japanese invested heavily in the conservation of energy and also in the alternative sources of energy and many energy intensive industries were able to reduce their dependence on oil and also enhance their productivity. This helped the Japanese economy tide over the second oil crises of 1979, it was able to maintain inflation within the single digit level while other economies were suffering from double digit inflation and slow growth.

2.2 The build up to the Japanese economic bubble

Japan experienced a lot of financial liberalization in the period from 1980 - 1985 this was the period when the asset prices started to rise again after the slump of the late 1970's this can be mostly attributed to the easy money policy and financial liberalization. The key features of the deregulation were as follows

* The government long term bond rates were liberalized through late 1970's so by early 1980's the ask-bid spread had narrowed considerably and the difference between the newly issued bonds and the market return rate became very narrow.

The above was achieved using the following

§ Offer government bonds at public auctions.

§ Permit secondary market trading of government bonds

§ Reductions in the amount of time banks were required to hold these bonds.

§ Eliminating the commitment on the part of BOJ to repurchase these bonds hence no longer holding true the fact of ‘no capita; loss' by banks.

§ Permitting the banks to sell these bonds and use them to innovate new type of deposit accounts.

* Introduction of new type of financial assets not subject to interest rate controls.

* Relaxations on the restrictions of issuance of collateralized and uncollateralized bonds and by the giving rise to a corporate bond market with unregulated interest rates which became a mainstay of the Japanese Financial market of the late 1980s

* Introduction of new deposit instruments such as Certificate Deposit (CDs) - with no interest rate regulations, Money Market Certificates (MMCs) and large time deposits - with relaxed regulations which were gradually removed.[2]

Bank of Japan at the same time lowered the discount interst rates from 7.25% in 1980 to 5.5% in 1981 and maintained this rate till 1985. These led up to the building of the bubble in the Japanese economy which was at its peak in the period from 1985 to 1990. But before we get to that it would be wise to look at a Major event in the world economic History called as the Plaza Accord.

2.3 Plaza Accord

The origin of the bubble economy can be traced to the G-5 Plaza Accord of September, 1985, an agreement designed, among other things, to coordinate economic policy in the major industrialized nations and to counteract protectionist forces. As part of the Plaza Accord, Japan agreed to stimulate its economy in order to enhance domestic demand for U.S. products. The signatories also pledged privately to intervene in foreign exchange markets to drive down a U.S. dollar widely perceived as overvalued. The United States experienced about a 50% decline in their currency while West Germany, France, the U.K. and Japan saw 50% appreciations. The Japanese yen in September 1985 went from 242USD/JPY(yenper dollar) to 153 in 1986, a doubling in value for the yen. By 1988, USD/JPYexchange rate was 120. The Plaza Accord initiated a process of international consultation that also generated the Baker-Miyazawa agreement of October, 1986, in which Japan agreed to implement specific simulative measures, and the Louvre Accord of February, 1987, in which Japan agreed to "follow monetary and fiscal policies which will help to expand domestic demand and thereby contribute to reducing the external surplus." In partial fulfillment of these commitments, Japan adopted fiscal stimulation measures in 1985 and 1986.

The Plaza Accord did not take monetary policy directly into account, and, indeed, the spirit of the Accord did not translate obviously into any particular monetary policy. For example, a decrease in Japanese interest rates might be considered consistent with the Accord, since it would tend to stimulate the Japanese economy and thereby increase demand for American goods. On the other hand, a decrease in Japanese rates would also tend to strengthen the dollar against the yen, in contravention to the spirit of the Accord (a reduction in Japanese rates would make dollars more attractive to foreign investors). The effects of interest rate policy were ambiguous.

In the end, the Plaza process resulted in a decision to decrease Japanese rates, largely because the other G-5 countries were anxious to lower their own rates, and also because the BOJ wanted to counteract the downturn in the Japanese economy that followed the yen's appreciation against the dollar. Both the Baker-Miyazawa agreement and the Louvre Accord contained specific Japanese commitments to lower interest rates. The BOJ reduced the official discount rate five times between January, 1986 and February, 1987, leaving it finally at 2.5 percent.

2.4 The formation of the bubble

Between 1987 and 1989, the BOJ conducted a lenient monetary policy, partly to comply with its promises in the Plaza and Louvre agreements, partly to offset the deflationary impact of a rising yen (the yen rose against the dollar from 251 at year-end 1984 to 122 at year-end 1987). The discount rate of 2.5 percent adopted in February, 1987 remained in effect until May, 1989. The money supply was growing at over 10 percent a year, much faster than GDP which grew between 4.8 and 5.9 percent between 1987 and 1989. Market interest rates were low. Nevertheless, inflation appeared to be virtually nil; the consumer price index rose only .4 percent in 1987, 1 percent in 1988, and 2.7 percent in 1989. Despite a moderately strong yen, Japanese exports and trade surplus with the United States continued to grow.

The Japanese stock market responded with a massive rally, accelerating a trend that had been ongoing since 1984. Starting at about 20,000 at the beginning of 1987, the Nikkei 225 rose quickly through much of the year. The rally was interrupted by the worldwide share price collapse of October, 1987, but by the Spring of 1988 the market had recovered and was surging to new highs. In 1988 the Nikkei 225 set new records and rose 39.9 percent in local currency terms, closing at over 30,000. By the beginning of 1989, Japanese share markets accounted for more than 42 percent of the value of all markets worldwide, up from 15 percent in 1980. While in part the run-up in Japanese share market prices was due to fundamentals, such as unusually rapid economic growth, the market appeared to be overvalued; the price-earnings ratio on Tokyo stocks at year-end 1988 was 58.67 and the average estimated yield was only .51 percent..

The bubble economy was not limited to the stock market. Sharp price rises were also observed in real estate markets, especially in Tokyo, beginning in 1986, where prices more than doubled in four years. Residential prices in Tokyo rose by approximately a 70 percent annual rate in 1988, while Tokyo commercial real estate rose by close to 80 percent. Tokyo prices stabilized in 1989, other areas, such as Osaka and Nagoya, began to increase rapidly; and prices in Tokyo began to increase again in 1990.

The causes of the real estate boom are still being debated, but the main factors appear to have included the following. First, the heavy concentration of economic activity in the Tokyo area created an upward pressure on the value of the fixed supply of land. Second, the Bank's loose monetary policy increased land prices, both by stimulating economic activity and by driving down the price of mortgage loans. Third, Japan's banks, facing competition from the securities industry for their core commercial lending business, sought to develop new markets in small and medium-sized firms, and especially in real estate development, in order to maintain their asset size in a more competitive environment. Fourth, people wanted to buy real estate in order to shelter earnings against inheritance and income taxes. Fifth, once the trend toward price increases was well-established, demand fed on itself, increasing because of speculation rather than fundamentals.

The property and equity market booms were closely related. Increases in real property prices enhanced the collateral value of individual assets, thus facilitating loans secured by property for the purchase of buying securities. At the same time, as increased demand drove up security prices, securities held by an investor (usually, a corporation) could be used as collateral for loans for the purchase of property. Increases in real estate values placed home ownership out of reach for many younger Japanese; they continued to live with their parents and saved money, both because of lower housing costs, and because they needed to save more if they were ever to own their own homes; these increased savings, in turn, channeled even more funds into equity market investments. In addition, many corporations and banks had extensive portfolio holdings of either equity securities or real property; increases in the value of their holdings would be translated into increases in their share prices.

Because of the phenomenal price-earnings ratios being realized on the Tokyo market, new issues of equity securities could bring in funds at very low cost. It was not actually necessary to sell equities in order to raise capital; a huge market in warrants developed in the Euromarket, where buyers snapped up rights to purchase equity shares in Japanese corporations in the future. It must have seemed inevitable to many purchasers of these warrants that they would realize a hefty profit at time of exercise.

Some corporations went to the market, moreover, not to fund current operations or to invest in plant or equipment, but simply to obtain cash which they could bank for future needs. Other firms began to speculate in stocks in order to realize profits rather than to concentrate on their core businesses -- a strategy known as "zaitech".

The huge boom in equities had a mixed effect on the banking industry, traditionally the leading source of financing for Japanese corporations. Many of the banks' best customers substituted equity financing for bank financing, since they could obtain funds more cheaply in the equity markets than through a bank loan. Thus the banks continued to lose market share to securities markets, a phenomenon which had been underway even before the speculative economy took hold, and which was accelerating in any event as a result of extensive deregulation in the Japanese financial system since 1984.

At the same time, the banks themselves were profiting from the boom. Japanese banks were under a deadline to comply with the capital adequacy rules adopted under the auspices of the Bank for International Settlements in Basle; as part of the Basle Accords, they could count 45 percent of unrealized appreciation in their portfolios of equity securities as Tier II capital for purposes of the risk-based capital rules. As the stock market soared, the banks found their capital positions strengthening in a most satisfying way. In addition, the banks themselves issued substantial amounts of new equity, further strengthening their Tier I capital positions.

The loss of many larger corporate customers to securities markets was a blow to the banking industry, but the enormous amount of real estate development that was occurring as a result of the asset boom gave the banks a new source of loan customers. At the same time, the increased supply of bank financing for real estate-based loans further increased the demand for real estate, driving up its price even further. The cost to the banks, which would not become fully apparent until after the bursting of the bubble, was that they were exposed to downturns in asset prices, as well as to the business losses that their borrowers would experience when conditions worsened.

BOJ began to act against the land and share price bubbles in 1989. It tightened monetary policy in a mild way at the end of May, 1989, when it raised the official discount rate for the first time in nine years -- from 2.5 percent to 3.25 percent. In addition to raising the explicit discount rate, the BOJ appears to have adopted a more restrictive monetary policy in its open market operations around this period in mid-1989, at least if market rates are an indication: short term interest rates rose a full percentage point between January and June, 1989. On October 11, 1989, the BOJ raised the discount rate again, from 3.25 percent to 3.75 percent, following rate rises by the Bundesbank and other central banks. The indications of a more restrictive monetary policy at the BOJ could be seen in short term rates, which climbed throughout the Fall of 1989, closing the year at 6.25 percent.

Despite the rising rates, the market continued at near-record levels. By the end of August, 1989, the Nikkei 225 had topped 35,000, continued in this range through November, and then rose again through the end of the year. The property boom continued as well. Although administrative guidance from the Ministry of Finance had reduced the amount of credit available for Tokyo land purchases, thus holding prices in the capital fairly steady in 1989, prices rose by over 90 percent in the adjacent prefecture of Chiba, 37 percent in Osaka, and 28 percent in Kyoto.

The market ended 1989 on a buoyant note. The Nikkei 225 was trading at an all time high of 38,957 on 29th December 1989 and closed the year at 38,915 and appeared poised to jump over the psychologically important 40,000 level soon after the new ear. Asset prices continued upward. Fueling the run-up in share and asset prices was a sense of euphoria that seemed to infuse the entire market. Although the economy was racing and unemployment was a minuscule 2.2-2.3 percent during the Fall 1989, there were few signs of inflation; consumer prices were rising only at about 2.3-3.0 percent. Japan appeared to have achieved the impossible: it was sustaining full employment, low inflation, high economic growth, a large trade surplus, and enormous rises in property and share values. No wonder the market was euphoric; it was difficult at this time to find a measure of economic performance that counseled caution -- other than the sense that this sort of condition was too good to be true.

2.5 The Bubble Bursts: 1990-91

The market began to break after the first of the year. Late in January, the Nikkei 225 fell 5 percent in three days, but the event was attributed to index arbitrage rather than market fundamentals. In mid-February, 1990, the market fell 4.3 percent in three days. Financial journals began to note the slide, although one puzzled that the fall was occurring "for no apparent reason."

Meanwhile, interest rates began to rise quickly. Overnight rates rose 40 basis points from the first of the year to mid-March, 1990, and the benchmark long-term government bond rate rose more than 150 basis points, to approximately 7.3 percent. Commercial banks, recognizing the trend, raised their prime lending rates from 4.88 percent to 6.25 percent. The BOJ hiked its discount rate again on March 20, 1990, from 4.25 percent to 5 percent. Meanwhile, the Nikkei 225 continued to free-fall throughout the Spring of 1990.

The Iraqi invasion of Kuwait on August 2, 1990 destabilized the equity market, as investors worried about war, inflation, and higher oil prices. The Nikkei 225 lost 11 percent in a single day before stabilizing. Responding to the these concerns, the BOJ hiked the discount rate again in mid-August, 1990, to 6.0 percent, which would prove to be the peak interest rate for this period of tightening.

Despite the allied response to the invasion, the Nikkei continued its decline through the end of 1990. At one point in December, 1990, the market fell below 22,000, and was trading in the range of 24,000 at year-end.

The tightening of monetary policy during 1990 began to show up in the monetary aggregates toward the end of that year. The growth of M2 + CDs, which at the beginning of the year was over 10 percent per annum, fell toward the end of the year, and continued to fall through 1991 and 1992; the measure of broadly defined liquidity showed a similar, although less pronounced, trend.

Land prices in major cities fell beginning in 1990 and continued falling through 1994; at the beginning of 1992 prices were down nearly 20 percent from their levels the previous year. Prices in six major cities fell from approximately 100 percent of nominal GDP at their peak in 1990 to only slightly only over 50 percent of nominal GDP at year-end 1993.l

[1] IMES DISCUSSION PAPER SERIES: Asset Price Bubble in Japan in the 1980s: Lessons for Financial and Macroeconomic Stability, Shigenori Shiratsuka.

[2] Thomas F. Cargill & Takayuki Sakamoto, Japan Since 1980, Cambridge University Press 2008

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