Japan's banks and their problems are currently a key focus of attention in Tokyo, and with upcoming ...
Japan's banks and their problems are currently a key focus of attention in Tokyo, and with upcoming events in Japan likely to make any difficulties even more acute, it is clearly an important aspect of managing portfolios of Japanese equities.
The fundamental difficulty is that Japanese banks are encumbered with bad debts, and in the current economic environment, they are unable to make profits that would allow them to escape this situation.
Banks need to look as profitable as possible and are therefore unwilling to write off existing bad loans, preferring to allow their debtors to reschedule and restructure their debt. So non-profitable companies that should have been left to fail remain in business, which restrains the economy as a whole. This in turn means the banks are still unable to make money, and are unwilling to lend to more dynamic businesses that could provide more of a venture capital culture to lead the Japanese economy out of its current gloomy state.
Problems with banks in Japan are not new. A large proportion of the bad debt causing problems now has been around since the collapse of the Japanese bubble in the early 1990s. Various plans have been put forward to deal with the problem since then, but with little success.
The hope was that things would be different after the major crisis in 1998 when the Government ended up taking control of the insolvent Long Term Credit Bank and appointing a special commission to oversee the cleaning up of the sector as a whole. But the results since then have again been disappointing.
A large part of the difficulty is the reluctance of banks to reveal the full extent of their bad loans, which makes it difficult to assess the scale of the problem. Many analysts believe the true figure could be as much as twice the official amount of around $284bn.
There are several reasons for the recent interest in Japan's banks. In mid-February, the Government minister in charge of financial affairs, Hakuo Yanagisawa, expressed a desire that banks should write off bad debts directly from their balance sheet over the next 12 months, with the Government setting up a secondary market for their disposal.
This stance was supported by the head of Japan's financial regulatory body who suggested that writing off these loans should be the banks' main priority, even if that meant posting losses.
Although this particular news was welcomed by equity markets, with banking stocks rising as a result, the general downward direction of Japanese stocks is another key reason why banks are a particular focus of attention now.
Banks in Japan have been able to conceal some of their problems because they are permitted to value equity on their balance sheets at its purchase price.
However, this year will see the introduction of new accounting standards that will require the accounting for equity at current market value - bad news for many banks, which, in an environment where equity markets have been declining for the last 12 months, will be exposed to large losses.
Since the banking crisis of 1998, banks have been able to rely on funds of public money provided by the Government as a safety net, but a third upcoming problem is that much of this is to be withdrawn during 2001. There will be still be money designated for emergencies, but the way in which this fund will work is much less transparent than the existing arrangement.
With the Japanese public becoming increasingly dissatisfied with the use of public funds for bailout purposes, this new arrangement is worrying for banks and potential investors in them.
The banks have partly responded to the problem over the past year or so by trying to merge themselves into bigger corporations. The intention is to improve profitability but the slow pace of implementation of the mergers and joint ventures has meant little real progress on this front.
Details on how the Government's new bad debt write-off suggestion will be implemented are sketchy so far. Critics have pointed out that it is not clear who will buy the bad loans sold on the secondary market, and there is concern over the amount of public money that will be required to make them look more attractive for potential buyers. In any case, many observers believe this is not really a long-term solution, that bad debt write-off alone will not stimulate the economy, and that genuine structural reform is the only way that will break the cycle.
One popular idea is for the banks to be temporarily nationalised. Another suggestion is for the banks to have their equity portfolios exchanged for portfolios of Japanese Government Bonds. This would remove the concern of imminent losses from the new mark-to-market accounting regime and eliminate market fears of an oversupply of equity that could result from banks selling their portfolios in the market.
Others suggest that another sensible way to move forward would be to try to reform the sectors responsible for the bad debts - the construction industry for example. The number of construction companies in Japan is much higher than is realistically required, but the industry carries considerable political influence. Trying to close down unprofitable firms to free up the banks is a politically dangerous option.
In fact, the political angle is a problem in a more general sense. All these plans may have their merits and could be supported by the more reform-minded politicians in Japan but with Government elections taking place this July, reformers have been generally been sidelined so as not to draw attention to problems in the financial sector.
As a result, the Government's response has been limited to the more politically acceptable option of suggesting methods of supporting the Japanese stock market - which arguably does nothing to address the deeper problem.
Not surprisingly given the analysis above, we are maintaining an underweight position to banks in our Japan equity portfolios. Fundamentally, these are not companies that we view as good investments for the medium to long term - although recent Government announcements may support banks in the short term and we have recently reduced our underweighting.
Some banks are better than others and we do hold certain banking stocks that we expect will outperform the sector on a medium-term basis.
One example of this is Sumitomo Trust & Banking, the leading trust bank in Japan. It has a healthy balance sheet and could benefit most from the proposed restructuring of the sector, since its weaker rivals may well be encouraged to sell their profitable custodian businesses.
Other parts of the financial sector are also suffering. Life Insurance companies in Japan are generally in financial difficulty and many are close to bankruptcy. The widespread problem in this sector is that by the end of the 1980s, many of these firms were selling annuities paying out some 4% pa. With interest rates barely above zero and the recent poor performance of Japanese assets, continuing to pay this level of income has become practically impossible.
As noted above, the economic picture in Japan is gloomy at present. With official GDP figures showing that Japan was again in recession in the second half of last year, it is not clear what drivers will move the economy out of its current downtrend. The Government is unlikely to provide any more fiscal stimulus, and attempts at further monetary stimulus are viewed by many commentators as being increasingly ineffective.
This means the interest for investors in Japan is to be found at the corporate level, where companies are restructuring themselves to meet the challenges they face. An increasing number are realising that improving profitability and capital efficiency will be the only way they can survive. We believe that with news of restructuring continually appearing, we are in a process of the ancient regime gradually collapsing.
Recent evidence of restructuring in Japanese companies includes:
l Sega, the well-known game and software maker, has announced it will pull out of the games machine business and reduce its staff by 300
l Japan Tobacco has announced it will sell off the Burger King franchise in Japan
l Mitsubishi Motors has announced it will sell one of its four factories and reduce staff by 9,500 over the next three years;
l Family Mart, a major chain of convenience stores, announced it will close 500 of 5200 stores over the next year
l Mycal, a supermarket chain, will close loss-making stores and reduce staff by 2,700
Looking at a company like Nissan, it can be seen what is possible: the recent turnaround of a firm that had some $30bn of debt is nothing short of remarkable. While implemented by foreign managers, this has set an example to which other companies in Japan can aspire. Over the past two or three years, the increasing trend of companies buying back their equity, substantial improvements in operating profit margins and free cash flow, and increased levels of ROE (which we believe are not yet reflected in stock prices) all point to qualitative changes occurring.
We believe certain technology-related stocks are also likely to provide investment opportunities later in 2001. Growth in digital appliances should lead the global electronics markets over the next few years, and Japanese companies are generally considered leaders in the field and best placed to benefit from the trend.
Additionally, trends in inventory and production of electronics components are approaching the bottom of their cycle, which could mean the second half of 2001 sees an period of increasing production and decreasing inventory similar to that which drove the market upwards through 1999.
In terms of portfolio positioning, in the current difficult environment, a somewhat cautious position is appropriate, and we are generally overweight foods/pharmaceuticals and other defensive stocks. However, we also believe that it is potentially dangerous to be too defensive in this type of environment, and we have maintained a small overweight to tech-related companies, with a view to buying more of the most competitive technology stocks when the opportunities arise.
Japan's current economic situation is not encouraging, and the state of the country's banking sector is a key reason for this. That said, we believe that changes are occurring at a micro economic, corporate level and that a culture of survival of the fittest is emerging. The challenge for investors in Japan is discovering the companies that are genuinely implementing these changes, and this is likely to form the key to investment outperformance in Japan over the next few years.
Joji Maki is head of Japan Equities at Baring Asset Management
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