Tuesday, May 19, 2009

But every now and again people throw up a controlled experiment

TO BE NOTED: From Bronte Capital:

"A tale of two banking crises: Japan and Korea

Economics may be a “science” but it lacks controlled experiments. Especially in macroeconomics you can’t repeat an experiment with one variable changed and see how the single variable changes the outcome. Economists have lots of statistical tools to deal with this – but those make the discipline either incomprehensible or diabolically boring. [Apologies to all those who taught me econometrics.]

But every now and again people throw up a controlled experiment – two situations that are very similar and differ markedly only in one major element. Yet strangely these situations seem under-studied.

What I want to do here is give a stylised version of Japanese and Korean economic history and how it pertains to the banking crisis both countries had. My knowledge of this however comes the way much of my stuff comes – from the history of the banks backwards. So I am sure to offend people with deep understandings of the political/economic history and I welcome someone telling me I am just wrong.

First however I need a stylised history of Japan starting with the arrival of Commodore Perry’s black ships in 1853.

Before Perry Japan was almost autarkic. There was a relatively weak central government and about 300 “han” – being relatively strong feudally controlled districts. The emperor did not effectively speak for Japan when Perry came in, guns blazing.

The Meiji Restoration changed this. Japan was reformed as a centrally controlled empire – with a ruling oligarchy ruling through the Emperor who claimed dominion over all of Japan. The “han” were combined to form (75?) prefectures with a governor appointed centrally.

The view of the new oligarchs was that Japan would get rich through (a) industrialisation and (b) unequal trade treaties to match the unequal treaties imposed on Japan by Perry et al. To this end they invaded Korea and started the military industrialisation that ended eventually with World War 2. There were major wars in Korea and against an expansionist Tsarist Russia (especially 1904-1905).

Ok – that is your 143 word history of Japan from Perry to World War 2. Like any 143 word history it will leave out important stuff. I just want to focus on how this foreign policy adventurism was financed.

Financing Japanese expansionism - and that financial system until today

Firstly it is simply not possible to expand heavy industrialisation of the type required by an early 20th Century military-industrial state without massive internal savings. Those steel mills had to be funded. And so they set up the infrastructure to do it.

Central to this was a pattern of “educating” (the cynical might say brainwashing) young girls into believing that their life would be happy if they had considerable savings in the form of cash balances at the bank (or post office). Japanese wives often save very hard – and are often insistent on it. The people I know who have married Japanese women confirm this expectation survives to this day.

Having saved at a bank (and for that matter also purchased life insurance from an insurance company loosely associated with the bank) the financial institutions had plenty of lendable funds.

The financial institutions by-and-large did not lend these funds to the household sector. Indeed lending to the household sector was mostly discouraged and was the business of very seedy loan sharks. To this day Japan has a relatively undeveloped credit card infrastructure with very high fees. These high fees are a throwback to the unwillingness of the institutions to lend to households.

Japanese banks instead lent to tied industry – particularly heavy industry. It was steel mills, the companies that built power plants, the big machine tool makers. Many of the companies exist today and include Fuji Heavy Industries, Kawasaki Heavy Industries and other giants such as Toshiba. Most of these super-heavy industrials were tied to the banks (and vertically integrated) called Zaibatsu.

Now steel is a commodity which has wild swings in its price. Maybe not as ordinarily wild as the last five years – but still very large swings. And these steel mills were highly indebted to their tied banks. Which meant that they could go bust.

And as expected the Japanese authorities had a solution – which is they deliberately cartelized the steel industry and used the cartel (and import restrictions) to raise prices to a level sufficient to ensure the heavy industry in question could service its debt.

The formula was thus (a) encourage huge levels of saving hence (b) allow for large debt funded heavy industrial growth. To ensure it works financially (c) allow enough government intervention to ensure everyone’s solvency.

When the Americans occupied Japan their first agenda was to dismantle the Zaibatsu. They were (in the words of Douglas McArthur) “the moneybags of militarism”.

Like many post WW2 agendas that agenda was dumped in the Cold War. The owners of the Zaibatsu were separated from their assets and some cross shareholdings were unwound – but the institution survived – and the Zaibatsu (now renamed Keiretsu) remained the central organising structure of Japan. Dismantling Japan’s industrial structure did not make sense in the face of the Korean War. The pre-war Zaibatsu had more concentrated ownership than post-war Keiretsu.

The point is that it was the similar structure before and after the war – and it allowed massive industrialisation twice – admittedly the second time for peaceful purposes.

Now the system began to break down. Firstly by 1985 steel was not the important industry that it had been in 1950 or 1920. Indeed almost everywhere you looked heavy industry became less important relative to other industrialisation. By the 1980s pretty well everywhere in the world tended to look on such heavy industries as “dinosaurs”. This was a problem for Japanese banks because they had lent huge sums to these industries guaranteed by the willingness of the State to allow cartelisation. You can’t successfully cartelise a collapsed industry.

Still the state was resourceful. Originally (believe it or not) they opposed the formation of Sony – because they did not know how to cartelize a transistor industry. Fifteen years later the UK Prime Minister French Prime Minister President would refer to his Japanese counterpart as “that transistor salesman” and he was not using hyperbole. Still the companies coming out of new Japan – technology driven mostly – did not require the capital that Japan had in plentiful supply. If you look at the companies coming out of Kyoto (Japan’s Silicon Valley) they include such wonders as Nintendo – companies which supply huge deposits to banks – not demand huge funds from them. [Incidentally in typical Japanese fashion the biggest shareholder in Nintendo is Bank of Kyoto. Old habits re-cross shareholdings die hard.]

The banks however still had plenty of Yen, and they lent it where they were next most willing – to landholders. The lending was legion and legendary – with golf clubs being the most famous example of excess. [At one stage the listed exchange for golf club memberships had twice the market capitalisation of the entire Australian stock exchange.]

Another place of excessive lending was to people consolidating (or leveraging up) the property portfolios of department stores. Think what Bill Ackman plans to do to Target being done to the entire country – and at very high starting valuations.

Meanwhile the industrial companies became zombies. I have attached 20 year balance sheets for a few of them here and here. These companies had huge debts backed by dinosaur industry structures. They looked like they would never repay their debts – but because they were so intertwined with the banks the banks never shut them down. As long as interest rates stayed near zero the banks did not need to collect their money back from them. As long as they made token payments they could be deemed to be current. There was not even a cash drain at the banks at low rates. The rapid improvement in the zombie-industrial balance sheets in the past five years was the massive boom in heavy industrial commodities (eg steel, parts for power stations etc). Even the zombies could come alive again… only to return to living dead status again quite rapidly with this recession.

Anyway – an aside here. Real Japan watchers don’t refer to the banks as zombies. They refer to the industrial companies as zombies. (Although most of the Western blogosphere does.)

Most of the banks had plenty of lendable funds and a willingness to lend them. They did not have the customers – and the biggest, oldest and most venerable of Japanese companies were zombies. So were the golf courses, department stores and other levered land holders. I get really rather annoyed when people talk of zombie banks in Japan – it shows a lack of basic background in Nihon.

Note how this crisis ended.

1). The bank made lots of bad loans – firstly to heavy industrial companies and secondly to real estate related companies (golf courses, department stores etc).

2). The loans could not be repaid.

3). The system was never short of funding because the Japanese housewives (the legendary Mrs Watanabe) saved and saved and saved – and the banks were thus awash with deposit funding.

4). The savings of Mrs Watanabe went on – indeed continued to grow – with zero rates.

5). Zero rates and vast excess funding at the banks made it unnecessary for the banks to call the property holders and (especially) the industrial giants to account for their borrowings. Everything was just rolled.

6). Employment in the industrial giants of Japan thus never shrank (Toshiba alone employs a quarter of a million people). The economy continued to sink its productive labour force into dinosaur industries and dinosaur department store chains.

7). The economy stagnated – but without collapse of any of the major banks and without huge subsidies to the banking system. [The number of banks – mostly regional banks – that failed during the crisis was not large given the depth of the crisis.]

Now lets look at Korea.

Korea was occupied by Japan until the end of WW2. They chose to industrialise in the pattern they understood – a Japanese pattern. For Keiretsu substitute Chaebol and you have the idea. The Chaebol were private heavy industrial conglomerates tied to financial institutions and with intense government support.

And the Chaebol suffered the same fate (slow irrelevance of heavy industry) as the Japanese heavy companies except they were called to account and many of them failed.

The reason is the different banking structure. Korea started its Chaebol industrialisation later than Japan – and the one multi-generational part of the formula (educating young women that they should save and save and save) was just not done as well. This is a multi-generational process.

The result is that the Korean banks – unlike their Japanese counterparts – were short funds. Endless funding at zero interest rates was simply not possible. Given that the banks eventually collapsed – with many becoming government property and with the government winding up as the largest shareholder in almost all banks. This was a spectacular crash – as opposed to a slow-burn malaise. Chaebol failed. In some instances their founders were imprisoned. The strongest Chaebol is the one most associated with new industries (Samsung). It survived and prospered – but others did not.

Korea had a much worse recession than Japan. Vastly worse. Japan was just low growth for a very long time. By contrast the Korean economy crashed and burned. But it also recovered very fast and at one point (1999-2000) the Korean Stock market was 1932 Great Depression cheap. It bounced.

It is my contention that the main difference between the Korean and Japanese crashes (and Korea’s case recoveries) was the funding of the banks. In this view Korea’s was so sharp because the banks simply ran out of money – and that caused massive liquidations across the economy – systemic failures.

The recovery was also sharp because the systemic failure meant that businesses that shouldn’t have failed (because they were profitable worthwhile businesses) got into deep distress. Real companies died not because they deserved to die but because the system in crisis killed them. There was a case for bailing out those companies – and the rapid recovery told you this was something systematic – not business specific. The massive upward movement in the stock market at the end of the crisis was the secondary proof that good businesses were killed. It was also probably the best investment opportunity globally in the last twenty years.

The economic decline in Japan was so gradual and so sustained precisely because there was no systemic failure and no reason to reallocate resources from bad businesses to good businesses. Zombie companies could exist for decades – and there was no renewal. A little bit of failure would have been a good thing – creative destruction. And the survival of bad businesses in Japan is part of the reason the stock market never bounced there. No investment opportunities.

Policy question: how do you ensure the creative destruction without putting the good bits of the real economy to the sword?

Investment question: what bits of the USA (and the rest of the world) will wind up looking like Korea and providing the best investment opportunity in two decades? And what bits will look depressed for two decades before going into a bit of a decline?

For discussion. And thanks for bearing with a long post.



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