All of this supported banks’ reserve positions and enabled further credit expansion with very little knowledge of how prudent the loans were.
During the 1980s the United States began to feel threatened by Japan’s growing economic strength and responded by pressuring Japan to reform its system. From the U.S. point of view, Japan had benefited for three decades from the special economic partnership and American security guarantees while it closed off its domestic economy to competition from American goods and investment. But with China having opened up its economy and the Soviet Union beginning to falter, the United States had less reason to give Japan special treatment.
The trade balance was decidedly in Japan’s favor, and Japanese companies were out-competing their American rivals in areas where Americans had long reigned supreme (such as cars). As a result, the United States leaned on Japan to liberalize its financial system and smooth the path for foreign investment. Washington also pressed Tokyo to reverse its policy of maintaining a weak yen to make Japanese exports more attractive and allow the yen to appreciate. Japan complied with some U.S. requests, letting in multitudes of foreign investors and closely coordinating monetary policy with the United States. In 1986, after allowing the yen to appreciate relative to the dollar, Japan dramatically lowered interest rates once the appreciation had gone too far, from 5 percent to 2.5 percent, in order to devalue the yen. This in turn caused rampant lending and sent economic growth back up to the 7-8 percent range.
Other reforms meant to make the system more transparent and to monitor risk were half-hearted and uneven, so it was not clear how much the hidden risks were expanding. Japan had not seen a bank fail in the postwar era (given that the government was funneling personal savings directly into the banks), so there was little sense of urgency about the need to reform. Reform certainly did not penetrate the fog surrounding the dealings among the keiretsu, the Ministry of Finance and political leaders. As banks continued to lend hyperactively and investors continued to speculate with borrowed money, few people knew much about the quality of the loans that were piling up.
Suddenly, in 1990, the bubble popped. The Bank of Japan had been raising interest rates since 1989 to dampen the bubble, then exports fell as the American economy slowed, and finally investors who had come in following the U.S.-imposed reforms sensed the prevailing winds and bolted. By 1992, stocks had fallen by roughly half and real estate prices had begun steadily sliding downward. The collapse of the asset bubble caused a chain reaction in which Japanese banks and corporations saw their balance sheets erode rapidly and scrambled to pay their debts, causing private demand to decline.
The collapse in asset prices revealed that many of the loans that had been granted when credit was free and easy (both by public and private institutions, in Japan and abroad) were of very poor quality. Non-performing loans (NPLs) mounted in Japan’s private banks and in the major public banks and agencies. NPL ratios ranged from 6 to 12 percent of total loans, depending on the type of institution. Trust banks, long-term credit banks, regional banks and credit cooperatives recorded the highest NPL ratios. (By contrast, American banks come under close federal scrutiny if NPLs rise above 1 percent.)
By 2002, Japan’s Financial Reconstruction Commission calculated that the total value of NPLs at troubled major and regional banks amounted to 43.2 trillion yen (about 8 percent of GDP). But the highest estimates by academics claim that by the late 1990s, the total value of Japan’s private and public financial institutions’ NPLs reached as high as 25 percent of GDP (around 120 trillion yen). The Ministry of Finance set up special programs to administer the rising tide of bad loans, but they were not able to resolve or dispose of very many of them. Meanwhile, the entire financial system was dragged down in the attempt to pay down the debt.
A handful of Japanese banks failed in the first few years of the 1990s, but the government did not yet perceive a crisis. The Bank of Japan tried to ease the pain by again loosening monetary policy, cutting its discount rate from 6 percent to below 0.5 percent from 1991 to 1995 in order to flood the system with ample credit. But only when major banks and securities houses neared insolvency in November 1997 and bank runs threatened to bring down the whole system did the government launch a full-fledged emergency policy, unleashing massive amounts of public funds to rescue ailing institutions and attempt to stabilize the country’s finances. The government infused troubled institutions with capital (12.5 trillion yen from 1998 to 2003), took NPLs off banks’ books and stored them in resolution and collection houses, forgave debts, and bought shares held by banks to prop up bank balance sheets — all at great expense. Eventually, the financial crisis contributed to an economy-wide recession and the Ministry of Finance launched a series of multi-trillion-yen supplementary budgets and stimulus packages meant to pick up the slack.
Deflation and Debt
The problem for Tokyo was that, try as it might, none of these financial stabilization or stimulus policies worked particularly well.
