Grim Outlook for Japan Economy: Barclays Economist

Japan needs to open up to foreign capital and labor to avoid a double blow from slowdowns in the financial and domestic sectors, says Barclays Capital's chief economist

By Dan Slater

Japan's globalisation has so far been outbound only. The next step is to open up the economy to foreign capital and labour—or face another fight with deflation, says Kyohei Morita. In an interview with FinanceAsia, the chief economist at Barclays Capital also notes that unless the global economy recovers, the Japanese economy is in for a double blow with a slowdown in the financial sector as well as the domestic economy.

The markets in Japan have suffered severe shocks in recent weeks. What's your summary of the current situation?

The picture is grim. Export weakness is spilling over into the rest of the economy. Private capital expenditure is slowing. Simultaneously with a declining real economy we must be prepared for a slowdown in credit creation. Thus, the economy will be hit by a double blow: in the financial sector and in the domestic sector, after already being hurt by the spike in commodity prices over the past year.

Abroad, many observers have been praising the soundness of the Japanese banking system, buttressed by lots of liquidity. You don't agree with that?

No, I don't. Japanese banks have a crucial weakness, namely their high share ownership levels, dating from the bubble years. They have decreased their ownership to a certain extent, but they still own 15% of the listed stockmarket, where foreign ownership amounts to 30%. In other words, when the domestic stockmarket goes down, it strikes at the value of the shares the Japanese banks hold, and in turn at their capital base. If their capital base diminishes, they will be more reluctant to lend. If you reduce lending and withdraw liquidity, a mild industrial slowdown can become a severe one.

That sounds very worrying. What is your growth forecast for this year and the next?

We are forecasting 0.4% growth in calendar year 2008, negative 0.9% growth in 2009 and negative 1.1% in 2010.

What's the background to these disastrous shareholdings by the Japanese banks?

Back in the 1950s and 60s, Japan's high growth period, the banks and their corporate customers took shares in each other as an anti-hostile M&A measure. Initially, as stock prices and the land holdings that many companies had went up in price, the system worked. But when asset prices started collapsing after 1989, the banks proved vulnerable. The banks have been told to divest themselves of these shareholdings, but they haven't done enough. Generally, it's thought that when the Nikkei index drops below 9,000 the banks' capital adequacy ratios are increasingly endangered.

This sounds like it has the making of a deflationary spiral. Is that correct? Are we back where we were 10 years ago, when people were panicking about deflation, with no fundamental improvement?

Yes, I believe there is the threat of deflation. Just one year ago, we thought deflation had been defeated. The consumer price index (CPI) was up 2.4% year-on-year in July/August. But deflation is gradually emerging, although not yet. The concurrent contraction of the real economy and the financial side could lead to deflation. The monetary side is on the verge of contraction as demand for funds fall and the banks grow more cautious about lending.

So, the Western banks have been weakened by their derivatives and subprime exposure, while the Japanese banks have been weakened by something quite different, but the result is the same, namely combined monetary and real economy weakness?

Yes, that's right. The problem is that the Japanese economy has not normalised itself, as reflected by the high level of share ownership by the banks. If those shares had been more aggressively divested it would have been better. In retrospect, this was a key weakness of Japanese banks—that they retained the equity exposure.

Can we say the Japanese have caused their own problems? With the zero percent interest-rate policy and a chronic trade surplus, Japan funnelled far too much cheap debt to the US via the carry trade, driving a US asset price bubble, which has now collapsed.