Monday, 14 March 2011

Japan's Last Big One, Part 2

The previous post looked at the immediate government response to the Great Kanto Earthquake of 1923 - the declaration of a 30-day moratorium on short-term debt, subsequently backed up by a general discounting of 'earthquake bills' by Bank of Japan, itself receiving only a partial indemnity from the government.

In the short term, the rescue measures saved many companies, but the cost to the financial system was only revealed over time. First, this de facto BOJ guarantee for bad debts allowed banks – who were still reeling from the implosion of the post-War 1920 bubble (the result of a collapse in Japan's terms of trade) - to avoid making credit judgments they didn’t want to make, and generally encouraged fraud. Second, it would also lead to a rise in bank loan/deposit ratios and, conversely, a rise in corporate leverage ratios. At the end of WW1 banks’ LDR stood at 94.2%: by 1923 it stood at 115.7% - a level it would not reach again until after WW2. The aftermath of the earthquake provided banks with a final chance to re-leverage, courtesy of the government’s guarantees. They would soon (in 1927) discover that those government guarantees did not solve the underlying problems of their portfolios. For the next 17 years, banks basically built this ratio down – in a way which was bound to be deflationary.

As for corporate leverage, 1923 marked the start of a build-up in leverage ratios which continued throughout the 1930s (mainly reflecting the rise in debt securities markets). Taking the Dupont financial leverage ratio (total assets/equity) we find the ratio for Japan's principal enterprises rising from around 1.35 in 1922 to just under 1.80 by the end of the 1920s. Releveraging in a deflationary environment might be though to be asking for trouble. As we shall see.

Third, and crucially, the technique of rolling debts, adding liquidity, and giving a guarantee that would deal with only part of the problem, didn’t work. The government had indemnified BOJ for losses on these bills to the tune of Y100 million, but this clearly was insufficient to deal with all the bad debts left behind by the earthquake. The amount of “earthquake bills” has been estimated at Y2,100 million, equivalent to 18.7% of all bank loans. Frankly, I don’t know how this estimate was arrived at – most probably it follows the “lost merchandise” figure, about which we have already been skeptical.

In practice it came to less than that. The face value of the bills payable at the end of March 1924 and rediscounted by BOJ came to Y431 million. That’s only about 4% of bank lending, but it was also 33.5% of all industrial bonds outstanding. By November 1924, the unpaid amount of “earthquake bills” had fallen to Y276 million (21% of bonds outstanding), but their liquidation was slow and even at the end of 1926, there were still at least Y207 million outstanding of these identifiably bad loans circulating in the system, equivalent to 11.2% of all outstanding corporate bonds.

These earthquake bills stressed the financial system in at least three ways. First, they cluttered up BOJ’s balance sheet, leaving it less able to lend to other parts of the financial system. Secondly, this amount of bad debt undermined the overall health of the money market, thus muting any impact BOJ could have made still further. Third, the earthquake bills also undermined banks’ balance sheets: because they had to depend on foot-dragging political decisions of the government with regard to loans, banks holding these bills were gravely weakened.

And this, of course, was the problem - Japan's financial and fiscal system in the early 1920s were in no fit state to handle these sorts of stresses. When misfortunes come, they come not single spies, but in battalions. The story of how these stresses concatenated to produce the Japanese financial crisis of 1927 - and all that followed from it - will continue tomorrow.

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