The Role of a Central Bank in a Bubble Economy - Section III

February 15, 1998

C. 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.

D. The Aftermath: 1991-1996

The share price collapse of 1990 presaged a severe economic downturn, which set in during the Spring of 1991, and which resulted in "the most serious instability in the financial system since the 1920s." The overheated economy of the bubble period left Japanese firms holding huge volumes of accumulated stocks in the form of capital investment, household durables, and buildings, leading to reductions in demand for new goods as the economy adjusted to the changes. Declines in real estate values, together with bad loan problems, contributed to low levels of new lending by financial institutions. A wealth effect also aggravated the downturn: just as when asset and stock prices were rising, consumers spent more because they had more to spend (on paper), so when the bubbles burst, consumers spent less. As the Japanese Economic Planning Agency put it, "it can be said that the burst of the bubble economy and the cyclical business mechanism had mutually reinforced each other and aggravated the recession."

These economic problems were aggravated by a resurgence of the yen against the dollar and other major currencies, which began in the first quarter of 1990 and which continued through 1995; after falling to approximately 150, the yen strengthened and by the Spring of 1995 was trading in the range of 80-85, although it strengthened considerably during 1996. The high yen placed severe strains on Japan's heavily export-driven economy.

The BOJ loosened monetary policy in the early Summer, 1991, as signaled by its decision on July 1, 1991 to lower the discount rate from 6.0 percent to 5.5 percent. There followed a series of further relaxations: to 5.0 percent in November 1991, 4.5 percent in December 1991, 3.75 percent in April 1992, and 3.25 percent in July 1992. In February 1993, the BOJ lowered the rate to 2.5 percent, equal to the lowest rate in recent times. In September 1993 it dropped the rate to 1.75 percent -- the lowest discount rate ever reached since the Bank was founded in 1883. In April, 1995, it dropped the discount rate to 1.0 percent, the lowest discount rate in its history. Despite these efforts, the growth in the monetary aggregates has been slow: M2 + CDs fell close to zero growth at one point in 1992 and growth rates continued far below the figures typical during the bubble period.

The Japanese economy continued to suffer during the early 1990s, and remained in recession until the end of 1993. Nominal GDP growth rates, which had been around 7 percent during the bubble period, fell beginning in 1990 and by 1991-93 were close to zero. Profits in the manufacturing sector fell 24.5 percent in 1991 and 32.1 percent in 1992. Bankruptcies began to rise starting in the latter half of 1990; by 1992, bankruptcies with debt more than Y10 million totaled 14,569 cases. Failures of real estate firms or of firms engaged in "active fund management" constituted more than half the corporate bankruptcies in 1991 and 1992.

Among the hardest hit by the collapse of the bubble economy were the commercial banks, especially those which had extended large amounts of real estate financing or which had speculated in the share market boom. Eventually, the losses showed up on the banks' books: reserves for loan losses in the banking sector grew dramatically beginning in 1991; and in the twelve-month period ending in March, 1993 these reserves grew by 35.87 percent. The rate of new lending by banks fell off quickly during 1990 and continued to fall though the first half of the decade. Bond ratings for the ten largest Japanese financial institutions fell rapidly beginning in 1990 and also continued to fall through the first half of the 1990s.

The banks, moreover, had been counting on being able to utilize unrealized gains on their securities portfolios as a means for complying with the capital adequacy guidelines that were about to come into force; the stock market plunge wiped out most of those gains, and, moreover, foreclosed the equity markets to banks as sources of new capital. Several of the big Japanese banks were forced to issue costly subordinated debt at 6-7 percent in order to meet their capital requirements.

The problems in the banking industry have not yet been fully resolved, as banks struggle with the painful process of dealing with their bad loans inventories. In 1994, banks wrote off non-performing assets of Y5.7 trillion, exceeding the previous high of Y4.3 trillion in fiscal year 1993. As yet, no major bank has failed, although a number have reportedly encountered serious difficulties. In December, 1994, the Bank of Japan supervised the takeover of two credit cooperatives, the Tokyo Kyowa Credit Cooperative and the Anzen Credit Cooperative, through the creation of a bridge bank with government support. The Bank's decision not to let these institutions fail and pay off depositors under the deposit guarantee program was based, largely, on concern for the potential systemic effects of a deposit payoff on public confidence in the banking system in general. The "jusen," or housing finance banks, suffered the most serious problems; these institutions, which were typically organized and sponsored by major commercial banks and staffed, in part, by former officials from the Ministry of Finance, lost tens of billions of dollars as a result of the collapse of the price bubble, and became one of the most contentious political issues of the day during 1995-86. As this paper is written, the troubles in the Japanese banking industry are far from resolved, and probably will not be finally resolved for a number of years to come.

Author:

Dr. Geoffrey P. Miller

email: millerg@turing.law.nyu.edu

Professor of Law and Director,

Center for the Study of Central Banks

New York University Law School

40 Washington Square South Suite 411G

New York, N.Y. 10012

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