Corporate Japan's Cashflow Vs the Calls Upon It

This week's release of Japan quarterly balance sheet and p&l survey by the Ministry of Finance reminds us again of how difficult it is becoming to sustain Japan's public finances, even at a time when the corporate sector is managing itself conservatively and well.

The Good News

The quarterly survey gives us the most detailed insight available into how corporate Japan is managing itself: uniquely, one can conduct a Dupont analysis on what amounts to virtually the whole corporate sector. And it is striking how much good news corporate Japan can eke out even in a tough global economic environment. Sales were down 1% yoy in 2Q, and down 0.9% on a 12ma, but operating profits were up 14.2% yoy.

In terms of operating margins, the last year has been a story of a marginally difficult trading environment (COGS/Sales up 0.3pps yoy) offset by much-improved discipline (SG&A/Sales Down 0.7pps), achieved mainly at management level rather than simply by sacking personnel (Personnel Expenses/Sales ratio fell 0.2pps).  

Meanwhile, the multiple of sales per employee to total expenses per employee has risen steadily from the recent nadir of 4Q11 and continues to recover. This obviously will tend to sustain labour markets.

The trading environment makes it difficult, but with total assets down 2.2% yoy whilst sales were down 1% yoy, a slow and modest recovery in asset turns is being made. There is evidence of balance sheet discipline: bills and A/R were down 1.1% yoy, whilst inventories were down 5% yoy: together these accounted for a quarter of the fall in total assets.

Finally, the financial leverage ratio (total assets/equity) fell to 2.81 in 2Q12 from 2.86 in 2Q11, and the net debt/equity ratio fell to 62.6% in 2Q12 from 67.5% in 2Q11, with corporate Japan cutting its net debts by Y24.3 trillion during the year.

The net result is that both ROE and ROA have just about been restored to where they were before the earthquake/tsunami/nuclear crises disrupted the economy. A job well-done then? In the uniquely difficult circumstances corporate Japan has been facing, yes.

The Consequences and Cashflow

But in a way, that's the problem, as we can see when we look at the cashflows. With ROE and ROA in recovery thanks to generally improving Dupont ratios, the Japanese economy should be enjoying the cashflow results. And so it is: using change in net debt plus investment in plant and equipment as a cashflow proxy, corporate Japan's cashflow rose 57.1% yoy in 2Q12, and 32% yoy over the 12 months to June, to Y63.0tr.

But the cash is being spent, with investment in plant and equipment up 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.

It is not just rising ROA which is responsible for that cash being spent:

1. Japan's capital stock is depreciating away: depreciation rose by 4.7% in the 12m to June. Simply to maintain current levels of capital stock demands re-investment of at least that much. To put numbers on it, depreciation allowances totalled Y8.53tr during 2Q, whilst investment in plant and equipment totalled Y8.3 tr. In the full 12 months, deprecation of Y36.66tr was answered by Y38.73tr in investment in plant and equipment. That investment accounted for 62% of cashflow.
2. Nonetheless, the amount of cash on corporate Japan's balance sheet, at 10.7%, is the highest it has ever been since the unwinding of the Bubble year's zaiteku financial games. Return on assets may be low at around 3.15%, but keeping cash on the balance sheet is even less attractive.

The result is that investment in plant and equipment is rising: 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.

But there are plenty of calls on corporate Japan's free cashflows, so that Y24.27tr needs to be put into two contexts.

First, how that net paydown of debt corresponds to movements in the Japanese banks' balance sheets. This will allow us to infer what must be happening to cashflows from the non-corporate sector. Bank of Japan data tells us that in the year to June, bank deposits rose by Y13tr, whilst the loan-book expanded by Y4.5tr – a net deposit inflow of Y8.5tr. But since we also already know from the MOF's quarterly survey of balance sheets that the corporate sector cut their net debt by Y24.27tr (ie, were responsible for a net deposit inflow of Y24.27tr), it must be that everyone else (mainly government and households) cut their deposits by a net Y15.8tr.

This is important: excluding the corporate sector, Japan is running at a savings deficit. The data simply doesn't allow much room for a net flow of savings from the household sector any more.

Second, how does the corporate sector's Y24.27tr in free cashflow compare to the amount of debt the government needs to raise? Here are the sums: in the year to June, the amount of JGBs in issuance rose by Y21.5tr and the amount of short-term financial bills rose by Y4.86 trillion. In all, the government needed to sell Y26.36 tr of its debt. Essentially all of the corporate sector's free cashflow. . . . and then a little bit more.

I have previously noted that Japan's private sector savings surplus looks to be in terminal decline. Indeed, from what we know now, it is rather surprising that it managed even the Y15.72tr surplus recorded in the year to June. What our ramble through the corporate sector's balance sheet reminds us, though, is how precarious the balance now is, even at a time when the corporate sector is managing its operations and balance sheets well during a difficult environment.

It raises the question quite urgently: unless corporate Japan is willing to stop re-investing, and thus see its operational asset base shrink, can we expect it to continue to finance Japan's fiscal deficits? And if not the corporate sector, who?

Why Japan Is Investing Again

The most overlooked surprise of the week so far was 6.2% rise in Japanese capex planned by large companies for this fiscal year. That's the first anticipated capex rise since at least FY08, and the details get even more aggressive: large manufacturers plan to raise spending by 12.4%. Why is it happening?

It's not as if Japan's immediate cyclical or structural signals or the global environment especially inviting.

Japan's industrial sector modestly lost momentum during April and May, although the 6m momentum trendline remains positive. In May, industrial production rose 6.2% yoy, with exports up 10% yoy in yen terms and 13.8% yoy in volume terms. However, the inventory/shipment ratio jumped in April and retreated only mildly in May, leaving it still a full standard deviation above the long-term average, and capacity utilization remains about 0.2 standard deviations below the long-term average. This is not disastrous - there is no comparison with what happened in 2009 – but it is an unlikely foundation for the start of a new capital spending cycle.

The structural situation for Japanese industry is not particularly compelling either. The Ministry of Finance's quarterly survey of private sector balance sheets show not only that ROE remains at extremely low historic levels, but also that there's been only the mildest upturn in the crucial asset-turns ratio (sales/total assets). Although obviously there is some recovery from the disasters of 2Q and 3Q, for Japan's private sector as a whole, 1Q asset turns were just 1.01, which is unchanged from 1Q11.

The rest of the Dupont ratios aren't going anywhere good quickly, either:

• operating margins have recovered from the catastrophes of mid-2011, but at 3.04% for 1Q and 3.12% on a 12m basis, are still below pre-2009 levels. More, the ratio of cost-of-goods sold seems to have bottomed out in late 2010, and is modestly rising;
• financial leverage (total assets/equity) appears to have bottomed out at about 2.71x, after falling for the last 21 years. But net debt/equity has been steady at around 60% since around 2007. It seems unlikely that Japan's ROE will be rescued by higher leverage ratios any time soon.

So what is motivating Japan's sudden resurgence of investment spending? The intuitive answer is that last year Japanese industry discovered unexpected vulnerabilities, both at home (earthquake, tsunami etc) and abroad (Thai floods). The surge in capital spending is what it takes both to fix and diversify those supply-lines.

This may be part of the motivation, but if so, it has arrived at a very opportune moment. For there are two factors operating within the companies themselves, which are also mandating the rise in capital spending.

First, depreciation has accelerated sharply, rising by 6.6% in the 12m to end-March. This is the most rapid rise in depreciation since at least 2000 (where my data stops). Without a corresponding rise in capital spending, the capital stock of industrial Japan will shrink, and fast. In fact, even with capital spending rising 3.3% yoy in 1Q, those additions to capital only barely cover the depreciation write-offs. In other words, regardless of the health of the world's business cycle, if corporate Japan is going to attempt to maintain its position, it has no choice but to start investing.

At the same time, corporate Japan is awash with cash. In fact, the amount of cash on corporate Japan's balance sheet, expressed as a number of months' sales, is the highest it has been since the immediate aftermath of the bubble bursting (1991). Cash now accounts for 11% of corporate Japan's total assets – again, one of the highest proportions in Japan's post-bubble history. Japan's return on assets may be fairly paltry at around 3.4% (annualized 1Q11), but the return available on new equipment is unlikely to be worse than that on cash.  

What's more, the drag of cash on the balance sheet is going to get worse. Cashflows were up 72% yoy in 1Q and up 40% on a 12ma. In fact, corporate cashflows seem to have been in recovery since the nadir of early 2009, and that recovery does not seem to have been particularly compromised even by the disasters of 2011.

I think these twin considerations are important prompts behind Japan's reinvestment.

There is, of course, a radical alternative view, of corporate Japan's available choices. The 'hospice option' holds that the proper corporate response to an aging and shrinking population is precisely for companies to shrink their balance sheets and capital stock, whilst spinning off sufficient cash to allow for a peaceful demographic decline. By the look of things that's not where corporate Japan wants to go. 

What's Going Right for Japan

Japan’s leading indicators index for February surprised not only because it was comfortably better than the range of expectations, but because it was the strongest reading since January 2008, and was almost exactly a full standard deviation higher than the series average since 1990.  We’ve become utterly used to Japan being a neutral or negative contributor to world growth, so it’s easy to let this slip by unnoticed and unexamined.

But it’s only the latest in a bunch of data from Japan over the last three weeks which has surprised positively. Earlier in the week, the 0.7% YoY rise in cash earnings sounds miserable, but was far stronger than the 0.1% expected, let alone the 0.3% YoY fall recorded in Tokyo core CPI. Last week, housing starts annualized to their highest reading since August, retail sales rose 3.5% YoY (beating consensus and range),  and overall household spending rose 2.3% YoY (beating consensus and range). On the industrial front, March’s manufacturing PMI gave its best reading since August 2011 and the Shoko Chukin SME gave its best reading for a year.

So the jump in the Leading indicators index isn’t simply a blip: something is stirring in Japan.  But here are two cautions:

• Usually an upturn in the Leading indicators index is anticipated and confirmed by an earlier rise in the Leading indicators relative to the Coincident indicator.  This hasn’t happened yet.
• And do the Leading indicators really tell us about the future, or merely confirm the present? The evidence of the last 20 years or so calls its forecasting value into question.

Returning to those fundamental ratios with which I track all economies (return on capital, labour productivity, leverage, savings flows, monetary velocity, liquidity preference etc), there's only one which is currently surprising. But since it's 'terms of trade', it matters. 

And it matters for Japan particularly, because its international terms of trade have fallen so sharply and regularly over the last 20 years that one has to use a semi-log scale simple to show it correctly. One of the most baffling things about Japan has always been why it has been unwilling or unable to price its goods internationally.  Well, since May 2011, Japan's terms of trade have done a very good impression of stabilizing, after hitting bottom during the commodities frenzy of 2008.  It is tempting to see this as evidence that the bankruptcy of Elpida Memory is not in vain.

At the same time as the unexpected stabilization of Japan's terms of trade, the yen has also given back all the strength against the SDR of the last six months. The result is that not only is Japan's relative ability to price its goods better now than it was in, say, July 2011, but also the yen is less uncompetitive internationally than in July 2011. 

We have virtually no experience in how positively a stabilized terms of trade might affect profitability, cashflow and investment-morale of corporate Japan.  However, we can suspect that the reaction will be rather like that when you stop banging your head against a brick wall. Nice.  And  for now, that seems to be the reaction that Japan's data is picking up.

Reconstruction Maths for Naoto Kan

Take a look at the chart below. It is the calculation I make of how much 'spare cash' the Japanese economy is spinning off every month.  That is, when each household has paid its monthly bills, how much - if any - of its wage packed is  left over to be banked. Plus the positive cashflow after investment - if any - of  corporate Japan.   This is the private sector savings surplus (or deficit), and it's the crucial cashflow indicator of any economy.  Why? Because it monitors the net cashflow of the private sector into, or out of,  the financial system. Over the last 12 months to Feb 11, Japan's net cashflow came to just under Y48 trillion. Hang on to that number.  

When the financial system gets this cash, it can, by definition, do only one of two things with it: it can use it to buy foreign assets, or it can use it to buy government bonds.

So if an economy is running a savings surplus (and almost all are right now, including the US, UK, China, and the Eurozone) then the fundamental job of a financial system is to find something to do with the cash. (Choose your bubble.) Conversely, if an economy is running a private sector savings deficit, the fundamental job of a financial system is to create a cashflow (by selling such government or foreign assets as it has) to keep the private sector show on the road.

(There's a tendency, when an economies veer from savings surplus to savings deficit, to discover  which part of the financial system has been mispricing its products. Korea is a serial offender: in every dive from surplus to deficit over the last 13 years, another bit of the financial system has dropped off - merchant banks, bond investment trusts, credit card companies and associated insurance schemes, and now savings banks.)  

Japan is in surplus to the tune of around Y48 trillion. And that is also the frame which PM Kan has to keep in mind as he ponders how to pay the reconstruction bills from the multiple catastrophes of March 11.  And it is truly finely balanced. Before the catastrophe, Kan was working with a constraint of issuing no more than Y40 trillion of new government bonds a year - comfortably, but not too comfortably within the immediate cashflow available to buy them.  But the latest estimates of the immediate reconstruction bills comes in at a further Y25 trillion, of which the government anticipates shouldering Y10t trillion.  That would take new  issuance right up to, and slightly beyond, the economy's available Y48 trillion net positive cashflow.

But that's assuming that the available cashflow stays stable. But it won't - it'll slump. After Kobe in 1995, corporate cashflows crunched hard, and we should certainly expect something similar and worse this time.  As a clue, since March 11,  Japanese companies have tried to borrow Y8.4 trillion from Japan's top seven banks - and this is in a banking market where there were Y6.9 trillion of net repayments made in the 12m to Feb 2011! Clearly, corporate Japan knows its free cashflow is drying up fast. And these cashflows can't be replaced or even significantly offset by the household sector. Last year by my calculations (from MOF's quarterly private sector balance sheets) corporate Japan generated Y57 trillion in free cashflow, whilst  private consumption in Japan is running at only around Y280 trillion a year. It would take a heck of a slump in private consumption. . . .

Conclusion? We'll see Japan's financial system selling foreign assets this year (and next) to cover the reconstruction bill.  Australia, don't say you weren't warned.

In Which Old Japanese Habits Die Hard

Fresh off Bloomberg:

Bank of Japan Governor Masaaki Shirakawa is under fire for refusing to consider 1930s-style purchases of government bonds to fund reconstruction from the nation's record earthquake.

"If this isn't a special situation, what is?" Kozo Yamamoto, a Diet member of the opposition Liberal Democratic Party, said in an interview this week. Yamamoto advocated a Y20 trillion reconstruction program funded by BOJ debt purchases. A group of ruling party lawmakers submitted a similar proposal to Finance Minister Yoshihiko Noda on March 18. . . . "

No doubt Mr Shirakawa has been going through the disastrous history of the BOJ's open-ended and unfunded commitment to 'Earthquake Bonds' after the 1923 Big One. What happened that time was that BOJ was only partially indemnified against losses on those bonds, and as they financed - among many many other things - an astonishing loss of inventory, the losses on the bonds were far higher than anyone had dared anticipate or envisage. As a result, the Earthquake Bonds and associated losses cluttered up the financial system for years, and eventually brought down the banking system in the 1927 crash.  See Parts 1, 2, 3 below.

The difference is that this time, even right from the off, there seems to be no suggestion that BOJ will be indemnified in any way against losses.

So we'd better start asking: what happens if a central bank gets into difficulties? The answer, as the Philippines central bank will tell you, is that you recapitalize the central bank by widening banking spreads. Another reason to believe that the financial upshot of the earthquake will be a reform of Japan which re-introduces and re-invigorates the financial repression with which Japan is so familiar.

Japan - How to Count (and track) the Costs

There are no shortages of estimates of the economic cost of Japan's multiple catastrophes - every economist in the region has been asked to produce them, and they have little choice but to meet demand.  Now at this stage, you'd expect me to decry the spurious precision of these estimates, and lament the stupidity of those who ask for them. After all, one of the real eye-openers of the last 10 days was the admission by the guy in charge of Three Mile Island when it melted down that he didn't have an accurate knowledge of what had happened inside that reactor until five years after the accident. It took that long for the reactor to cool down sufficiently for anyone to have a good look at the damage.

But despite this, the guesses economists are making today are valuable, because they at least erect a framework around which our understanding of the consequences can grow, and from which it can evolve. They're not accurate, they're in no way reliable, but they are helpful in tracking how our understanding changes.

And in the meantime, here's my advice on how to count the cost.

First, there are estimates of the damage - both the cost of reconstruction, and the cost of lost production.  No-one really knows yet, but let's call it 'x'.   Mainly, this is presented as a percentage of GDP, and, if you're lucky, there's a time-frame with it (over the next year at least).

These are more or less educated and informed guesses. But even if they were right, they'd not tell you what you need to know.

Because, second, there are the cashflow implications of the cost - ie, the extent of  corporate reaction to the disasters.  We can track this directly using the Ministry of Finance's quarterly survey of private sector balance sheets and p&ls. More than ever, over the next couple of years, these surveys will be far more important than the quarterly GDP numbers.  Judging by the what happened after the Kobe earthquake of 1995, this number will be a significant multiple of 'x' - probably 8x to 10x.  This cashflow impact really matters, because it will show up in the liquidity of the financial system, the appetite for government bonds, and the extent of repatriation of capital.  In other words, on interest rates, bond yields, and the direction of the yen.

So the third thing you need to know, or forecast, is policy reaction to the cashflow crimp. Does the cashflow crimp potentially limit JGB issuance? And if it does, will we find Bank of Japan simply printing money to fit? Or, as I suspect the form will be, 'accepting for discount the bonds of the newly-formed Reconstruction Agency within 12 hours of issuance'

Japan's Last Big One, Part 3

The previous two posts detailed the way in which the government tried, and failed, to finance the aftermath of the Great Kanto Earthquake of 1923 – a failure generated by an initial underestimate of the sheer size of the problem, and the unwillingness fully to acknowledge it long after the problem had become obvious. In the absence of effective government policies, the burden fell on the banking system which was unable to carry such a weight. As the banking system buckled under the pressure, the result was the financial and political implosion of the Japanese banking crisis of 1927, which ultimately discredited Japan’s democracy and opened the way for the aggressive nationalistic militarism of the 1930s and 1940s.

During the 1920s, Japan’s banking industry was in no fit state to trade through the bad debts haunting the money markets and the ‘earthquake bills’ which were cluttering up both their balance sheets, and, just as importantly, Bank of Japan’s balance sheet. In the aftermath of both the implosion of the post-war Bubble in 1920, many banks were already on shaky ground. Japan had lots of banks, mainly extremely small, local, and corrupt. In 1922 Japan had 1,794 ordinary banks in Japan, averaging less than three branches each, and averaging Y4.4 million in deposits (about Y21 billion in today’s money). This multiplicity of tiny banks came at a price – local banks tended to use local deposits for the benefit of the local power-broker’s business scheme. If and when those schemes went belly-up, the bank and its depositors would suffer.

As the Japanese economic historian Nakamura Takafusa wrote: “Companies . . . commonly went to great length to cook the books so that their assets and liabilities tables showed a profit even when the company was awash in red ink.” Banks aided and abetted these practices – hardly surprising considering that the companies were also likely to own the banks.

This underlying weakness was magnified by combination of the unacknowledged losses from the 1920 bust, the earthquake bills mess, and extended deflation. Increasingly, the banking system was quietly freezing in distress. Four years after the Great Earthquake, the cracks in the system could be hidden no longer.

By the beginning of 1927, the government was moving on two fronts to deal with the banking industry’s problems, addressing both the banks’ immediate financial problems, and also the regulatory and capital weaknesses obvious in the system. In April 1927 it introduced a new Banking Law, in an attempt to consolidate the industry and ensure its capital adequacy and operational probity.

But first, in January 1927 two bills were introduced into the Diet to deal with the recurrent problem of the roughly Y200 million in uncollectible outstanding Earthquake Bills. The first indemnified BOJ for Y100 million losses from uncollectible bills, and proposed issuing a Y100 million five year bond to do it. The second bill would allow the government to lend Y100 million in public bonds to banks still holding Earthquake Bills, whilst the debtors would be given 10 years to pay off, in instalments, the remaining bad debts.

This willingness to open the public purse to the banking system was political dynamite. The government faced accusations that it was bailing out mismanaged but politically well-connected banks and enterprises at the expense of the taxpayer. The opposition wanted to know which banks held the earthquake bills; the government refused to say. In the absence of disclosure, rumours abounded.

Quite a few centred on a trading company called Suzuki Shoten and the Tokyo office of the Bank of Taiwan – which, as its name suggests, was a note-issuing bank for Taiwan (at that time a Japanese colony). Together, these two became the ground zero of the 1927 banking crisis.

Founded in Kobe before World War One, Suzuki Shoten was a small trading company dealing mainly in Taiwanese products, and financed largely by Bank of Taiwan. Bankrolled by Bank of Taiwan, the company massively over-traded: indeed, at one point it was bigger even than Mitsui. Naturally, when the 1920s bust came, Suzuki found itself holding huge inventories at a time when prices were falling. Its vast profits disappeared into equally imposing losses, and Bank of Taiwan threw good money after bad. Naturally, Suzuki Shoten was responsible for a huge amount of “earthquake bills” after 1923. By April 1927, loans to Suzuki Shoten stood at Y396 million (at the time, Japan’s national budget came to Y1.5-1.6 billion). Its borrowings from Bank of Taiwan came to Y250 million, out of a total BOT loan book of Y720 million. By the time one adds Suzuki-affiliated manufacturing companies, the total owed by Suzuki to Bank of Taiwan was about Y350 million. In other words, about half Bank of Taiwan’s loan-book. This was not so much a disaster waiting to happen, but a disaster that had already happened.

The collapse of Bank of Taiwan triggered a fully-blown banking crisis which rapidly closed all banks in Tokyo and Osaka temporarily – a closure which literally bought time for Bank of Japan to run its printing presses sufficiently fast to meet the demand for banknotes as customers withdrew their deposits. The note issue doubled and Bank of Japan lending tripled in a matter of days. In an echo of its initial response to the earthquake, the government imposed a three-week moratorium on all financial obligations. But in the end, this was insufficient: 44 banks were bankrupted, representing the loss of deposits equivalent to around Y36 trillion today.

The political blow to Japan’s Taisho democracy was immense. Had Japan reflated massively after this financial catastrophe, the worst of the depression and indeed starvation of the 1930s might have been avoided. But the political damage was too deep – opening the way for something much worse. In June 1928, the Japanese Army in Guangdong blew up a train carrying Chinese warlord for Manchuria and Inner Mongolia, Chang Tsolin. When Prime Minister Tanaka appealed in vain to the Emperor to for the perpetrators to be court martialed it was clear his political support was over. A new regime took over, and the days of a crushing and inappropriate financial orthodoxy began. That financial orthodoxy, based on a return to the gold standard, was ruinous both to Japan’s economy, and to what was left of the credibility of the political system. What happened next - the end of Japan’s experiment with democracy and its succumbing to nationalistic militarism - ripped China and Asia apart for the next 15 years. Still today we live with the consequences.

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.

Japan's Last Big One, Part 1

This is the first of a three parter on the impact and financial aftermath of the Great Kanto Earthquake of 1923. How did Japan's bureaucrats respond, what was short and longer-term financial and economic impact, and what were the longer-term costs. As you read these, bear in mind that a) Japan's goverment debt/GDP ratio is already 200%+, and MOF expects that by 2014 32% of all tax revenues will go on debt service, and b) only three weeks ago, the FSA was still thrashing out how to account for the roughly Y1.39tr in losses stemming from the collapse of the 'jusen' housing finance system in the 1990s.

The catastrophic Great Kanto Earthquake struck on 1 September 1923, leveling most of Tokyo and Yokohama. The casualty statistics are shocking: 91,000 killed, mostly in Tokyo and Yokohama; 13,000 missing; 52,000 injured; 69,000 houses lost or damaged. At the time it was estimated that 3.4 million people were directly effected – approximately 6% of the population.

The damage to national wealth was put at Y5,274 million, approximately 4% of total estimated national wealth of 1924, and 44% of 1923 GDP. Of that total, Y2,136 million worth of merchandise was lost and Y1,874 million worth of buildings, equivalent to 8.2% of the total building-stock. Perhaps we should be skeptical of these numbers: the Y2,136 million claimed as loss of merchandise and inventory seems an astonishingly high number (particularly when compared with the Y869 million lost in household goods), and suggests there was no shortage of people willing to inflate their losses in response to government relief actions.

(To compare: between December 1989 and September 1990, Japan’s stockmarkets lost Y270 trillion in value – an amount equivalent to roughly 60% of GDP.)

This estimate of losses does not, however, include the impact on the stockmarket. In the event, however, these seem to have been surprisingly light. The bond market reopened for business on October 16 (in IBJ’s banking hall), spot transactions started again in the ruins of the exchange on October 27, and futures trading restarted on November 15. But, buoyed by a Y13 million rehabilitation loan from IBJ, when TSE proper reopened on November 15, its shares, which had been quoted at Y121.9 on August 30, opened at Y107 – a loss of only 12%.

The government’s bureaucratic responses, and its immediate provision of liquidity were as one might expect. The government provided relief financing and, cut duties on the import of reconstruction materials. Not surprisingly, this resulted in a flood of speculative imports, which in turn blew out the trade deficit in 1924 to record proportions (6.7% of GDP), which in turn cut the gold reserves, drove the yen down from around 49 at beginning of 1923 to 38.5 by October. Such negative developments (from the point of view of a political leadership unwilling to abandon its gold-standard aspirations) constrained the government’s role in reconstruction.

More significant, in the longer term, was the government’s arrangements to contain the immediate economic and financial damage. On Sept 7, the government declared a 30 days moratorium on all obligations contracted before Sept 1 and payable during September, for all debtors having their residence or place of business in the stricken area. In addition, when that moratorium ran out, BOJ was empowered to rediscount all bills discounted by banks and maturing before Sept 1925, which were covered by the moratorium, with the government offering to indemnify BOJ for losses on these transactions up to Y100 million.

In other words, when the deadline for payment of a note issued or to be paid in the earthquake region came around, the note could be taken into a bank to be discounted. The bank would subsequently take the note to BOJ, which would rediscount the note stamping it with the words “Earthquake Bill.” In the event that the debt turned out to be bad, or simply not paid on time, the government would guarantee BOJ up to Y100 million.

Many companies were saved by this procedure, but at a cost to the financial system which was only revealed over time. And we'll turn to that in Part 11. . . .