A Japanese Tale - REVISITED

'The Japanese Tale', to which this series is a follow-on, ended with a discussion of different possibilities for the resolution of the Japanese banking crisis. If the size of the shortfall in collateral in the Japanese banking system, which was estimated to approach $2.5 trillion, really is a good ball-park figure, it is clear that the Japanese financial system sooner or later has to implode. The burden placed on it as a consequence of the very deep collapse of property prices, exacerbated by what has been happening to equity prices since 1990, would be too great to bear indefinitely.

It would seem that neither the end of the declining property market nor of the bear market in equities appears to be in sight, which means the problem is getting even more severe as times passes. While only part of the missing collateral has so far materialised – or been acknowledged! – as unrecoverable loans, the way the Japanese economy has been going over the past few years one can expect a significant increase in unrecoverable loans and bad debts in their banking system during the months and years ahead.

This does not mean that the collapse has been total. If Greater Tokyo in 1991 was worth 120% of the whole of the USA and property prices collapsed by say 70% , then if an hypothetical owner of Tokyo sold his property at this point in time he could still buy 36% of the US with the proceeds – say a band stretching from the Rockies to Wisconsin and from Minnesota/ Dakotas in the north to Louisiana/Texas in the south.

Not bad at all for just one city, even in the currently depressed Japanese property market.

However, despite all this, the financial system sooner or later will implode because better than 20% of the estimated $11-12 trillion in household savings have been dissipated through property and other loans that have become irrecoverable. Note, though, that this still leaves more than $9 trillion in household savings intact – a good deal more than US GDP – and assuming about 30 million Japanese households it comes to an average of $400 000 per family of which an estimated $80 000 is no longer secured by collateral.

About $5-7 trillion of the total amount of household savings are said to have been deposited in Japanese banks – of which say about 40% is no longer secured and could be lost through unrecoverable loans – which means that there were about $5-6 trillion in other forms of hopefully more sound investments.

Therefore, despite the potential for an increase in bad debt as a result in the massive shortfall in collateral, this goes to show that even now there is in principle still great wealth locked up in property in Japan, savings accounts and in other financial assets. Japan are also enjoying good income on a national level from a positive trade balance.

Japan Inc is not bankrupt by any means. But they do have a large empty hole in their banking system – growing larger all the time – that has to be filled somehow. As long as there is fear about the state of the financial system and as long as interest rates remain painfully low, so that the propensity to save and prepare for the worst is uppermost in the Japanese mind, the Japanese consumer will not spend.

He – or rather 'she', since traditionally it is the mother of the household who looks after the finances – will save every available yen to ensure the maximum nest egg for the day of retirement and for any unforeseen circumstances, such as the breadwinner being laid off. At the same time, government's attempts to address the problem by means of the traditional solution of stimulating the economy are just adding to the cumulative deficit without really having much effect. Which means the overall situation in Japan will just keep on getting worse and worse, month by month.

The economic outlook for Japan therefore remains gloomy and by implication for the rest of Asia as well. The primary risk for the rest of the world if this continues, is twofold. The first is that with Japan and its economic satellites in recession or depression, world economic growth must taper off and could even turn negative. This will place a severe damper on western economies, reducing at first the growth in company earnings and eventually reducing earnings. The high price multiples of stocks in the US and elsewhere will have to be adjusted and the Dow Jones and other indices will take a tumble off their stratospheric highs.

A second and much more turbulent alternative would be if the Japanese repatriated their foreign investments in order to do something constructive about the condition at home – or if the situation there deteriorated to the extend that such repatriation becomes vital for Japanese economic survival. The effect on western bond and equity markets is likely to be so extreme that such a move would be perceived as an act of war.

The theme of 'A Japanese Tale' was that the situation in Japan may well have developed to the stage where Japan, as the world's banker, may well have to call in its loans simply to lick its wounds and to try and survive economically. The effect of this move on the global economy will be so severe that either the Japanese must present a very good and acceptable reason for doing so or, preferably, have the blame for their actions assigned to some other country, as explained earlier in 'A Japanese Tale' – with the US as the best candidate for this role.

Many Japanese still remember the signing ceremony on the USS Missouri in Tokyo bay in 1945 with bitterness in their hearts. If, in the process of self-preservation, they should deal the US economy a deep body blow, it would be for them some consolation for the loss of face suffered by the Emperor and the Japanese nation through the shame of their defeat and surrender.

Just as it took a long time for the South to accept and – perhaps – to forget Appomatox. It is not strange that the Japanese would feel bitter. It is only that their culture and traditions place a much greater premium on the obligation to wipe out the shame if at all feasible. Even if it costs them all they have.

In this series of articles we continue the exploration of options open to Japan that was started in the first article. Later we explore the possible developments in markets would provide an early warning that the showdown had started.

Mention was made in 'A Japanese Tale' of the possibility of a bond issue, which would almost certainly have to be backed by gold to be acceptable to investors in the ret of the world. The two possibilities discussed so far, and which are not mutually exclusive, are therefore repatriation of Japanese foreign investments and a bond issue that will have to be backed by gold to be acceptable to investors.

Before we turn to that discussion, there is something else that should be brought to light. The matter of Japanese foreign investments and the possible effects of their repatriation have been widely discussed. However, there is another potential source for problems for the rest of the world; one that may well turn out to be a modern day Japanese equivalent of the Trojan horse.

Interbank loans – a Japanese Horse

I now venture into an area where my knowledge is limited to an explanation once given to me. I have to keep it simple since I am imparting just about the full extent of what I know. Readers should accept that it is the principle behind a mechanism that is illustrated here, not the actual details of the mechanism itself. Any flaws in what follows here are obviously the result of my imperfect understanding of how this mechanism works, yet I do believe that the essential danger that is revealed below is real, even though the details of the explanation are not exact.

Banks lend money with due regard to the overall degree of risk. This risk is evaluated in terms of the assets held by the bank and in terms of the bank's own capital, or the shareholders' funds and reserves. This means that if someone deposits say $1000 in a bank, the bank is not restricted to lending only that $1000, but can lend a total amount that is substantially more than the increase of $1000 in the assets held by the bank.

To keep matters simple, let's assume an upper limit for the risk of default of say 5% on general loans; the bank would still be in a quite sound position in terms of its asset base if it lent out up to 20 times the amount of the deposit. The fact that it can effectively create perhaps as much as $20 000 in credit for the $1000 dollar deposit really illustrates how very important individual savings are for the economy and for the banking system.

However, banks are not only dependent on deposits to increase its asset base – and thereby its ability to make more loans. A bank can borrow funds from another bank. Say our bank borrows $1000 from another bank. Its assets again increases by $1000 and as before it can now make new loans up to $20 000, using a 20x multiplier based on the 5% perceived risk. Therefore, even though deposits and interbank loans cost the bank interest at a rate not much below what it gets on its loans, the bank can significantly increase its profits by attracting deposits and obtaining interbank loans at a time when there is strong demand for credit. Consider the following.

With a deposit, or interbank loan, of $1000, on which the bank pays interest, the bank can lend up to about $20 000, asking a slightly higher interest. If the full $20 000 can be lent out, then the bank is really coining it – the interest earned on nearly $19 000 is then pure profit. This applies to loans to companies and individuals. Based on exactly the same reasoning, it is even more attractive for a bank to make interbank loans to other banks.

As mentioned before, the multiplier is determined on the basis of perceived risk. Since banks are typically considered to be much more sound than individuals and companies, a much larger multiplier applies to loans made to other banks. Assume the perceived risk is as low as 2%, which means the multiplier is as high as 50.

A deposit of $1000 now enables the bank to lend up to $50 000 to other banks. Granted, this is done at a lower rate than the bank could charge an individual or a company, but by doing interbank loans the interest on perhaps as much as $49 000 becomes pure income. What a bargain for the lending bank!

The multipliers used in the examples are for illustrative purposes only. The actual values a bank uses would vary across different categories of loans. Further, when demand for credit is not high enough for it to lend out all the cash that its asset base allowed, the actual multiplier in force at any time could be substantially less than the maximum the asset base could justify. Nevertheless, the above reasoning shows why banks are so eager to lend money to whoever applies for it, provided the risk represented by the new loans does not add significantly to the total risk for that category of loan. If risk is increased substantially, the bank has to reduce the multiplier it uses for that category and thereby forgo the chance to make even more profit.

Similarly, if the bank suffers bad loans, these have to be made good from its own capital. Then, since the capital base is reduced, it can absorb less risk which means the ability of the bank to offer loans is also reduced. This is one of the dilemmas faced by Japanese banks that makes them so reluctant to admit the magnitude of the bad debt situation and which also curbs their ability to make new loans that carry any significant risk..

Mention was made of the advantage to a country's economy if its people save a good part of their income – this enables the banking system to make more loans to those who want them. If the loans are put to good productive use such as funding new plant or working capital, the whole economy – and thus indirectly also the people who saved their money in the bank – benefits from the savings.

A problem arises if a people have a low savings rate, since this places an upper limit on the amount of credit the banks can easily provide. If demand for credit exceeds this limit, the bank has to obtain interbank loans – probably from a foreign bank, since most local banks would also experience the same asset squeeze – in order to increase its asset base to where it can satisfy the demand for credit.

Any foreign bank that has the liquidity is of course eager to make such interbank loans, as we have seen, since it can then apply a higher multiplier to underlying assets, thereby adding substantially to its income.

Let's take a closer look at this process. Someone deposits $1000 in a foreign bank. This bank uses the full deposit to make interbank loans to US banks. Because the multiplier on interbank loans is 50, it can provide loans of up to $50 000 in this way. The asset base of the US banks increased by $50 000, which means that they can lend 20 times that amount to individuals and companies. This means the $1000 deposit in the foreign bank can, under ideal circumstances, give rise to credit extension in the US of a full $1 million.

Now, the $1000 increase in the assets of the foreign bank does not have to be a deposit; it could also be money that the bank had borrowed through an interbank loan from another bank. The chain of multipliers that come into play is not limited to only two banks. Let us look at the following example:

A household in Japan deposits the equivalent of $1000 in a Japanese bank. The bank is approached by a Swiss bank for an interbank loan of $50 000, which it can now provide on the basis of the deposit that had just been made. The Swiss bank needed this money because it was approached by a US bank for an interbank loan. With the interbank loan from Japan added to its assets, the Swiss bank now lends the US bank the full amount that can be justified by the increase in its asset base, which is the $50 000 multiplied by 50, because it is an interbank loan to a US bank. The US bank therefore receives the amount of $2.5 million, which in turn allows the US bank to provide credit to American individuals and companies to the tune of $50 million, using a multiplier of 20. The $50 million is spent in the US, giving the economy a tremendous boost, and it all becomes possible because a Japanese household had deposited $1000 in a Japanese bank..

All good and well, so far. The US economy is booming along, but now there hangs a shadow over the good times. What happens when the Japanese family decides to buy, say, a home entertainment centre and withdraws the money they had saved from the bank to do the purchase. Seen very simplistically, the Japanese bank now has to ask the Swiss bank to return its interbank loan of $50 000 and the Swiss bank asks the US bank for the $2.5 million that it has been using as the base to provide new credit within the US. The US bank is now obliged to approach the people and companies to whom it had lent the $50 million and to ask them to pay up. Now the funds flow in reverse from the US to Switzerland and from Switzerland to Japan in the exact same amounts as before.

The consequences for the people and the economy who have enjoyed the easy credit at the end of this chain are obvious.

The illustration is very simplistic, but it serves to describe the way the mechanism works, which is the objective. A more complete discussion would require reference to minimum capital requirements for banks, as required by the Bank for International Settlements and how this influences a bank's capacity to extend credit in various categories. Further, the whole aspect of the multiplier is oversimplified in this example; different categories of loans have different own capital and asset requirements, while the multiplier is not really a simple fixed value as explained here.

For example, the explanation given here did not include a concept known as 'fractional lending' – the idea that as deposits are made in a bank, which enable the bank to extend more credit, the credit itself sooner or later ends up as new deposits in some bank, irrespective whether it is the same bank or not. These new deposits in turn add to the receiving bank's asset base, which in turn enables it to extend new credit. Further, the real limiting factor on how much credit can be extended by a bank is not so much its asset base; the bank's own capital – shareholder's funds – is a very significant limiting factor in this geared-up process, since this capital must protect deposits against risk of default on a loan. With 'fractional lending' the effective multiplier can increase substantially.

By now we are beginning to move well beyond my level of knowledge, not merely my basic level of understanding!

From the above it nevertheless is obvious that any country which is to a notable degree dependent on foreign interbank loans for the extension of credit, becomes increasingly vulnerable to the original source or sources of funds at the beginning of the chain that was just described here and on global liquidity in general.

On the other hand, the greater the amount of savings in a country and the greater the amount of money the country earns on its balance of payments, the greater is the role that country can play in the interbank lending market as a provider of funds to other banks. It would therefore seem that Japan is probably a major source – with Taiwan and a few other relatively minor contributors – of interbank funding in the world's banking system.

Obviously the chain of events need not be that long. A US bank could obtain an interbank loan directly from a Japanese bank. In that case the $1000 deposited in the Japanese bank enables only $1 million of new credit in the US, which is still phenomenal gearing. If the Japanese household withdrew its $1000 from their bank, the final effect in the US would still be quite disproportionate as $1 million of loans would come under pressure.

Keep in mind that the total loan book of Japanese banks was reckoned at $7 trillion. While practically all of it may have been lent within Japan or as direct loans in South East Asia and elsewhere, even a very small portion of that amount in the interbank system could have massive leverage in countries where demand for credit far exceeded their rate of savings, thereby requiring banks in that country to rely on interbank loans to augment their asset base in order to feed that demand.

The question now is to what extent has the US been dependent on foreign interbank loans to fund the credit spree that has been going on the last few years. This question and its implications are examined in the next part of the series.

© January 1999 Daan Joubert
All rights reserved.

(Part 2 next week)