The Japanese stock market has been in decline since the Spring of 2000 after it had been driven over...
The Japanese stock market has been in decline since the Spring of 2000 after it had been driven over the 20,000 level on the Nikkei Index by late domestic participants in the last bull run. Since then, we have witnessed the collapse of the new economy and in particular the so-called dot.com stocks around the world.
The current economic cycle in Japan appears to be turning down with industrial production peaking. Japan's key trading partner, the US, has moved into a lower economic gear and orders for Japanese goods in both the US and Asia are receding.
Japanese banks in the process of selling their vast holdings of Tokyo stocks have driven the market down to near 14-year lows. So why are banks reducing holdings in stocks at what appears to be a low point in the stock market cycle? And why do they have so much of their capital tied up in volatile stock market implements?
Let us first consider why banks hold so much equity. Historically, Japanese industry coalesced into industrial groupings latterly known as Keiretsu, where companies form a bonding or relationship by exchanging equity with one another (now referred to as the 'cross holdings'). Business was conducted largely on a non-competitive basis with the Keiretsu bank channelling cash from those in financial surplus to those in the Keiretsu who required funds.
Japanese bank lending requirements and conditions from borrowers were far less demanding than those in a Western economy that practised full-blooded capitalism. A member company of the group that needed funds was generally good for a loan as long as it was not doing something really stupid. This system allowed several companies such as Nissan to borrow huge amounts of money without generating profits for years.
The problem for banks began in the slump of the 1990s when the property prices - the principal collateral - collapsed, leaving a large number of bad loans and placing many banks in the hands of receivers and the rest hanging on by a thread. To compound the problem for Japanese banks, many of them, unlike their Western counterparts, held more than half their capital assets in stocks and shares.
The Bank of International Settlements deems that only half of the value of share portfolios be allowed for in calculating the critical capital asset ratio. To reach the required 8% ratio, a bank can either reduce the size of its loan portfolios (almost impossible in practice) or sell stock holdings. All of the newly-generated cash positions held can be included in calculating the capital asset ratio and it is this process of turning stocks into cash that has had such a depressing effect on the Japanese market.
Preparing a quick fix
The quick fix from the Japanese authorities is to come up with a system to enable banks to liquidate share portfolios without them coming out on to the market and damaging share prices. The lights have been burning late at the Liberal Democratic Party headquarters and the ideas so far mooted involve the Government issuing convertible bonds in exchange for bank share portfolios.
Also being considered are law changes on corporate buy-backs, which currently seriously constrain the number of shares that can be re-purchased by a cash-rich company. This latter remedy does not help many companies that are already committed to bank borrowing and have no surplus cash.
The possibility of a net to catch the cross-holdings has already resulted in the withdrawing for sale of Toyota stock being planned by various banks and in turn this has helped the stock market.
Selling of equities by banks has already led to a certain amount of tit-for-tat selling by companies holding bank shares, but this appears to have caused fewer concerns in the market.
The cross-holding selling has far greater implications than just depressing market prices because it will alter the structure of Japanese industry and the way business is conducted.
The existence of the special groups or Keiretsu is threatened and possibly heralds the end of Japan's historically benign and almost unique form of capitalism. The market will become more competitive, with banks becoming more demanding of borrowers. In turn, the banks will have to compete more aggressively for business across the whole of the market by offering better services.
This is not only a big change in the way business is conducted, but it involves a huge cultural change as well.
It is the beginning of the end of what may be described as Japan's corporate feudal system with all it entails in terms of lifetime employment and company loyalty. Change like this is a painful and time-consuming process, but Japan does have a historic record of big directional changes.
The question facing investors is whether the market correction has run its course and stocks hit the bottom. Generally, markets bottom before authorities take recuperative action such as making money cheaper and more freely available.
This is a tricky one for Japan because interest rates are already low and banks, given the constraints of their stretched capital asset ratios, are in no shape to lend and reflate the economy.
Governor Hayashi, guardian of Japan's money at the Bank of Japan, could as a last resort print money by a massive programme of bond purchasing, but this seems unlikely in the near term.
One of the more interesting developments recently is the notching down in the value of the yen against the dollar. For much of the term of the Clinton administration in the US, there was a reluctance to allow the Japanese to de-value their way out of economic problems, but recently the yen has fallen through the ¥110 level to ¥118 to the dollar with, seemingly, the approval of the US authorities. It is hard to imagine that in exchange for this stimulus that the US has not extracted some concessions and commitments to economic reform from the Japanese. The willingness to accept change is being demonstrated at present as the politicians attempt to wrestle power from the bureaucrats in the biggest post-war shake-up in Japan's governance.
Not only are civil servant numbers being reduced dramatically, but the number of ministries is also being cut from 23 to 13, and the power to formulate policy will be moved from the ultra conservative bureaucrats to the Prime Minister's office for the first time.
This major change in the balance of power is proceeding unnoticed by a market preoccupied by the day-to-day problems of bank selling pressures.
The first moves have been made to transform Japan into a more open and competitive capitalist economy. Tinkering with the over-supply of stock in the market is only a short-term fix. However, this will give stocks breathing space before the long-term benefits in the governance of Japan and its economic management become apparent.
Big changes are afoot in Japan and the belief that the cup is half full and not half empty could emerge in the coming months. Stocks could be considerably higher in a year's time, especially if there is a change of leadership in the summer elections.
Les Jones is the lead fund manager of the CCS Japanese Growth Fund
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