Lecture given at the Paris Chamber of Commerce and Industry
by Professor Takatoshi Ito, Tokyo University
on July 1st 2009 at Comité d’Echanges Franco-Japonais in Paris

“The global crisis and the Japanese economy”

Professor Ito discussed what happened on financial markets in the past year and the impact of these events on the Japanese economy.
The current crisis which originated in the US housing market boom and bust cycle is similar in this respect to the crisis experienced by Japan between 1993 and 2003.  Japan’s experience could guide US policymakers.  Things are however happening at a much faster pace in the US, but in Professor Ito’s opinion the US economy has yet to hit bottom and the crisis will last another two to three years.  The root of the problem lies with the mortgages granted by US banks to low-quality borrowers, known as subprime loans, which the US administration promoted to help the poors’ purchase houses.  Banks were quite willing to grant these loans they then packaged in securities and sold to investors, thus getting rid of the risk involved.

This is the first difference with the Japanese experience, where non-performing loans remained the banks’ problem until 1995 or so, with the consequence that the crisis which started in 1990 exploded from 1995 on.  In the US, securitization allowed banks to go down the quality ladder of borrowers, with the result that starting in 2005, when the housing market began to slow down, banks started to lend to “ninjas” (no income, no jobs or assets).  Ninjas could borrow from banks because banks transformed the mortgages in securities and sold to investors, often in Europe, mainly in the UK and in Germany, to a lesser extent in France.  These securities were marketed as “senior debt securities”, in which the share corresponding to mortgages likely to be repaid was only 20 percent of the total.

The problem was first detected in 2006, two years after banks started making loans to ninjas with a two-year grace period, products which amounted to time bombs.  These loans peaked in 2005 and 2007 logically saw the beginning of the crisis, and the slowing down of the global economy.  In 2008, senior debts securities were no longer attracting buyers, and some of the investors even went back to the banks they had bought them from and asked them to take them back. Investment banks became aware at that point that they held a tremendous amount of bad assets.  The US administration acted in a manner similar to what Japan had done a few years earlier, launching a rescue package and asking healthy banks to take over bad investment banks.  This is how in March 2008 JP Morgan acquired Bears Stearns with guarantees from the Federal Reserve. Lehman Brothers was at that point rumored to be in danger but failed to find an acquirer, mostly because the US administration was not ready to provide the same guarantees to the potential buyers, among which were the Korea Development Bank, Bank of America and Barclays.  Lehman Brothers’ bankruptcy in September 2008 was an experience similar to what happened in Japan in November 1997, when both Yamaichi Securities and Hokkaido Takushoku failed and Japanese banks had great difficulty in borrowing money on the international market. The same thing happened to US banks and they started selling assets to find cash.

Japan did not feel immediately concerned by this situation as few Japanese banks had bought subprime securities.  But everything changed after Lehman Brothers’ failure when the crisis became global as US banks started selling Japanese, Korean, European stocks.  They brought their revenues back to the US and this caused the US dollar to go up.  In September and October 2008, the Japanese yen was the only currency following suit.  Two factors explain this anomaly:  first, the fact that US banks which had massively borrowed in Japanese yen to take advantage of low Japanese interest rates when investing in Russia and elsewhere repaid their loans, and second, the so-called “kimono traders”, the wealthy Japanese wives who had invested family savings in Australia and New Zealand dollars which offered better interest rates decided to repatriate their savings.  From September 2008 to January 2009, the Japanese yen was the world’s strongest currency, followed by the US dollar.

In the meantime, US consumers started to save instead of spending and Japanese exports to the US fell by 40 percent in the last quarter of 2008 and the first of 2009, causing industrial production in Japan to fall by the same percentage, and GDP by 12 percent.  In the three quarters between September 2008 and June 2009, the Japanese GDP shrank by 6 percent, more than in the US and France.  Japan was not affected by the subprime crisis but by its after-effects. 
The Japanese government blames the current problems on its export-dependent economy, but it is a long-term structural issue.  In the short-term, the Bank of Japan tries to stimulate the economy, a daunting task, even though the prime rate has gone down from 0.5 to 0.1 percent.  The Japanese government could purchase securities, but it is not in a position to be as active as the Federal Reserve Board in the US.  It also has very few fiscal incentives left as it has tried almost everything in the 13-year stagnation period experienced by Japan.  The public debt to GDP ratio currently stands at 160 percent, while it was only 65 percent in 1990.  A new stimulus package featuring cash handouts and loan guarantees was recently voted, but it has not succeeded in bringing the growth rate up. Unemployment stands today at 5.2 percent, a very high level for Japan, where unemployment peaked at 5.4 percent in 2003.  The situation is very bad, in spite of some signs of recovery, such as the opening of car lines. 

The political situation is getting interesting as elections have to be called in the Lower House by the end of September, and the Prime Minister, Mr. Aso, is striving to find the best timing, while his popularity rate is steadily declining.  These elections are expected to see a landslide victory of the Democratic Party of Japan which already controls the Upper House.  Several scenarios are possible, ranging from a clear victory by the DP in the coming elections, which would allow it to do whatever it pleases, to a split within the LDP, with the creation of a new party by supporters of former Prime Minister Koizumi, who is still very popular, in order to give a new impetus to the structural reforms which his successors failed to pursue.  Everything should be clearer by the middle of July. 

Questions from the audience: 

Queried about the tankan improvement, Professor Ito answers that Japan’s current situation is neither very bad nor as good as one could expect.
Responding to a listener eager to know if he agrees with the statement that the yen’s improvement is mostly attributable to the fact that hedge funds had heavily borrowed in Japanese yen, Professor Ito says that the Japanese government has never implemented any restriction on the currency market.

Answering a question on Japanese banks’ balance sheets, he asserts that they are generally clean, but may see unrealized capital losses on their balance sheet if stocks plunge as Japanese banks generally own the equity on their balance sheet.
A listener wants to know when in Professor Ito’s opinion, the crisis will end, keeping in mind the fact that US housing prices stand today at 115, using 2000 as 100, against 126 in 2006, and that real estate prices in Japan today are on a par with those of 2000.  Professor Ito explains that since the situation in the US progresses four times faster than in Japan, the housing market should therefore bottom out within the next three to four years, especially in view of the fact that while housing prices doubled between 2000 and 2006, they are currently down by 20 to 25 percent, and should go down and other 20 to 25 percent. The difference between the US and the Japanese market lies in the fact that in the former immigrants are willing to buy housing while the Japanese demographic growth is too weak to sustain the Japanese housing market.
Asked to explain why in his mind the US did not learn from Japan and which structural adjustments he recommends, Professor Ito states that supervision, or prevention, is worthier than mitigation.  Consequently, a better regulatory framework is needed, and the British FSA or the European Central Bank could be possible models.  In his opinion, an institution too big to fail is too big to begin with. 
In response to a question on the extremely high public debt/GDP ratio, Professor Ito explains that the ratio is not per se reason to panic as 95 percent of the Japanese public debt is held by Japanese institutions which believe that something will necessarily be done.  Banks and pension funds hold 50 percent of the public debt, and the only way to improve this ratio would be to raise VAT, currently standing at 5 percent. 
A member of the audience wants to know whether Professor Ito shares his feeling that Japan’s foremost problem is the poor quality of its politicians.  Professor Ito replies that in his view the main problem with the Japanese political system is its excessive emphasis on seniority.  It ought to be modified to allow young and gifted politicians to act.