Bubble Economy

Book By Christopher Wood

Article & Review by GlobalMacroForex

This book was written in 1992 just as the Japanese economic bubble was starting to burst.  It’s amazing that Christopher Wood’s predictions were so accurate and (unfortunately) true.  The extent of the bubble’s rise and the following correction (20+ years of misery, nicknamed the ‘lost decades’ ) truly were misunderstood by the market at the time. 

This is the Nikkei 225, the most prominent Japanese stock index.

Woods identifies many reasons for the bubble including:

·      Central Bank policy

·      Banks as the primary credit creators

·      Bank equity tied to the stock market

·      Bank Euromoney borrowing to fund overseas lending

·      Overpriced land used as collateral for loans

·      Overpriced tradeable Gold Club memberships

·      Life insurance companies owning equities

·      Political and corporate scandals

Let’s dive right in…

Central Bank Policy

Woods criticizes the insane policies of the Bank of Japan.  The Ministry of Finance appointed Satoshi Sumita to head the Central Bank who negotiated the 1985 Plaza Accord.  This agreement was made in America, with the goal of lowering the USD/JPY exchange rate.  By artificially propping up the yen, it fueled an investment bubble in property and equity shares.

Yasushi Mieno then took over as head of the Bank of Japan.  He hated the easy credit policies of his predecessor and hiked rates, which was just enough to pop the huge bubble.

Main Bank System

One of the primary causes of the crisis in the view of Christopher Woods is the overreliance on bank credit.  Unlike America, which has a liquid and deep bond market, Japan essentially exclusively relied on bank credit.  To make matters worse, the banks held shares of equities, making their capital positions very depend on market conditions.  Banks collectively owned 9% of the entire Tokyo stock exchange’s market capitalization in 1990.

“This is the fatal flaw of Japan’s financial system.  The capital of the world’s biggest banks, and therefore, their ability to lend, goes up and down with the short-term whims of the Tokyo stock market.”

Woods points out how when the Bank of International Settlements (BIS) started to force Japanese banks to comply with higher equity to liability ratios, some banks sold stocks and then rebought them to book the gain as equity capital increases.   This trick obviously only works in a rising market and disastrously caused selling when these banks’ loans turned sour.  Once the asset prices fell, it took banks nearly 20 years to start loaning again.

In addition, Woods questions Japan’s laws and cultural stigma on bankruptcy.

“Bouncing a check is commercial suicide in Japan”

He points out the Japanese culture of assuming ever larger market share but being unwilling to admit failure due to the large stigma attached, combined with loose laws from the BIS and local regulators, created a climate where banks had many loans on their books that were really nonperforming/delinquent but weren’t being classified as such.

Under the Japanese main banking system, the biggest lender in a bankruptcy assumes the debts of nearly all other creditors.  This leads to a situation where the largest main banks are not only being less willing to recognize loan losses, but also even further leveraged.  With this massive leverage, a small number of sour loans can topple banking giants.

Land Boom

Japan had a ridiculous bubble in land prices.  At the end of 1989, Japan’s combined real estate had a market value of 4 times the entire US market.

“While other countries previously had currencies backed by gold.  It is not unrealistic to say Japan is a land standard.”

The average size of a bank home mortgage had exploded from ¥5.6 million to ¥11 million in 1990.  The decline in prices to “back-to- earth” levels was quite painful over 20 years as this graph from RightWayCharts shows,

Banks were fueling this run-up in the land.  There were bank loans of 66 trillion yen in March 1991, two-fifths of which went directly to property and construction companies.  And two-thirds was collateralized with land.  Banks were all too willing to extend loans guaranteed and collateralized with land because the prices were rising quickly.  Once land prices started to crash and loans went sour, banks were stuck with depreciating assets, causing them to be forced to liquidate shares.  This further exacerbated the crash since the banks owned such a huge percentage of the equity market.

Interbank Euromoney Borrowing

“Euromoney” is a term used to refer to bank deposits outside of the nation that issues the currency.  The name originates from American dollars being loaned around Europe.  Used in this sense, it doesn’t mean the actual Euro currency.

Japanese banks were borrowing Euroyen and Eurodollars to fund a whole variety of loans, including not only the domestic Japanese real estate loans but loans on property abroad as well.  These short-term interbank loans need to constantly be rolled over and so are subject to extreme interest rate shocks when the markets turns to a risk-off environment.  In addition, the eurocurrency markets are even more risk-prone than onshore interbank lending to credit shocks because onshore regulators guarantee bank deposits.  Unlike the eurocurrency bank market which would need to set up foreign currency swaps to get the liquidity in a credit crunch.

The Japanese went on an overseas real estate lending binge with these cheap Euromoney interbank loans.  In 1991, 12.4% of total American banking assets, valued at $408 billion, was owned by Japanese banks. In addition, there was a heavy concentration of loans made on property in California.  24.5% of total bank assets in California by June 1991 was owned by the Japanese banks.  Unloading all these foreign assets when interbank lending dried up was a serious challenge.

Life Insurance Companies

Life insurance companies owned 13% of the companies traded on the Tokyo stock market at end of 1990.  As Japanese policyholders cashed in life insurance policies this caused massive selling of equities.  Life insurance companies are supposed to be stable and reliable vehicles to protect one’s family should horrible circumstances come to fruition.  Many Japanese households were not aware they were really speculative hedge funds; gambling away their savings on the stock exchange.

Life insurances companies had no choice but to sell to meet their debt/payout obligations.  These concentrated holdings represented a “fair weather friend” to banks whom they frequently had cross shareholder holdings with.  (The bank would buy shares of the life insurance company and vice versa.)

Golf Club Memberships

Between 1989 and 1991, 160 new golf courses were created with 2000 more under construction.  For a tiny archipelago, the prices of these memberships were soaring.  The memberships were being traded like securities in a nation that perpetuated the myth that 99% of the population was middle class.  This chart from The Economist magazine shows the price of these memberships after the bubble burst,

Conclusion

The main lessons to be drawn from the Japanese bubble are the dangers in allowing central banks to grant easy money and the business community’s over-reliance on bank credit.  Central banks shouldn’t always be handing out what bankers want.

Also, there is a need to diversify the types of assets being securitized for bank loans as these assets will all fall uniformly in value.  Similar to the United States real estate bubble, there is a huge error in thinking that just because an asset has always risen in value in the past, that it will always continue to rise.