IMF Survey: What led you to examine the decline in Japan’s business investment?
Ramaswamy: Over 1991-98, the Japanese economy grew at an average of 1½ percent a year. In the 1980s, it had grown at 4 percent a year. Trying to explain what happened in the 1990s led me to look at business investment, and ultimately to ask why investment collapsed.
It is fairly well known that the collapse of Japanese equity and land prices in the early 1990s precipitated the crisis. What is less well known is that, unlike other countries that had had an asset price bubble burst—notably Sweden and the United Kingdom—Japan did not experience a subsequent collapse in private consumption expenditure. Instead, it experienced a severe decline in business investment.
The share of business investment in GDP fell from about 20 percent in 1990 to about 16 percent in 1998. To view this decline from an international perspective, the share of business investment in GDP in Japan was about 11 percentage points higher than in the United States in 1990. Now, following the slump that persisted for several years, the share of business investment in GDP is just about 3 percentage points higher than in the United States. The 1990s was not only a period during which business investment collapsed dramatically in Japan, but also a period in which the United States experienced a structural increase in investment. All this makes a study of the causes of the slump in business investment in Japan particularly interesting.
IMF Survey: What does your study aim to do?
Ramaswamy: Quite a few explanations have been offered for the decline in Japanese business investment. Some of these are based on fact, some, on study, and some, simply on observers’ biases and speculations. My study examined the principal explanations that have been offered so far and attempted to see to what extent they made sense in the Japanese context. The study also provided econometric estimates of the determinants of aggregate business investment in Japan.
IMF Survey: Why did Japan’s business investment decline so steeply in the 1990s?
Ramaswamy: There are four major theories. The first is that an excessive buildup of debt served as a drag on investment. Japanese firms got themselves indebted in a big way in the 1980s, as did Korea and other Asian countries. This theory argues that Japan in the 1990s faced the consequences of the buildup of that debt. A second theory is that the steep decline represented an unwinding of the overinvestment that had characterized the 1980s.
A third explanation attributes the slump to a credit crunch. This suggests the decline in business investment is an extension of the banking crisis that started in the early 1990s, but really came to the fore in 1997-98 before things improved in 1999. This explanation argues that the banking crisis led to a credit crunch—that is, it led to a drying up of funds for investment. And the fourth explanation links the fall in investment to deeper structural factors. It suggests that the decline in business investment is related to a long-term decline in the labor force and the process of deindustrialization that has taken place in the Japanese economy.
Photo Credits: Denio Zara, Padraic Hughes, and Pedro Márquez for the IMF, pages 369, 371, 374, and 382; Susumu Takahashi for Reuters, page 384.
IMF Survey: How is excess debt tied to Japan’s business investment slump?
Ramaswamy: Let me first say that it is not bad for firms to take on debt—investors are sometimes more willing to buy bonds than equity because they know bond purchases are a contingent contract and they are legally assured of a stream of earnings. So by issuing debt, firms may tap into an investor group they would not otherwise have access to. There’s also an extensive literature that argues that debt disciplines a firm’s activities, since it requires firms to pay a certain part of their profits or cash flows as interest and to pay the principal back on an agreed-upon date. Such constraints on cash flows discourage firms from diversifying into activities where they lack expertise.
The problem with debt is when you have too much of it. Excessive debt leaves firms vulnerable to any negative shocks. If things do not go well, firms will not have the cash flow to invest in physical or human capital. Debt is also a problem when actual inflation is lower than expected inflation. A contract is fixed in nominal terms, so it will have to pay much more in real terms when inflation is lower than expectations. Both of these things happened in Japan. The country had built up very high levels of debt compared with other industrial countries; when asset prices collapsed in the 1990s, the expectations on which the debt was initially taken out did not materialize subsequently. In the late 1980s, the Japanese, extrapolating from past experience, assumed their economy would grow at 4 percent forever. And, of course, that did not happen in the 1990s.
The combination of high debt levels and lower than expected inflation and growth rates caused enormous problems for firms. These problems were compounded at times by lax bank enforcement of debt contracts in the 1980s. When the firms didn’t pay back interest, the banks often rescheduled it. Then, in the 1990s, the banks had a crisis of their own and were unable to perform effective due diligence. Thus, problems that could have been nipped in the bud were allowed to fester and resulted ultimately in a massive collapse of business investment.
Overall, my study found that structural factors, notably the impact of the debt burden and the unwinding of overinvestment, were the dominant factors driving the slump in Japan’s business investment.
IMF Survey: How did the unwinding of overinvestment contribute to the slump?
Ramaswamy: The first step for the study was determining whether there had been overinvestment. This is not easy to measure. A sharp increase in the capital output ratio may signal overinvestment, but this could also occur when, for example, a country moves from low-technology to high-technology industrial production. I wanted to determine whether Japan’s capital output ratio increased in relation to its trend growth. Beginning in the late 1980s, you do see a large gap developing between actual and trend investment levels (see chart, page 384). This provides one measure of overinvestment. The recent narrowing of that gap suggests that, by now, a significant part of the overinvestment has been unwound. But the remaining gap indicates there may still be some way to go before investment can really pick up. Another way to gauge overinvestment is to draw a comparative picture. While international comparisons cannot be pushed too far, the contrast between business investment in Japan and the United States discussed earlier offers some pointers about the extent of overinvestment in Japan in the 1980s.
Then, you ask yourself, why did Japan overinvest? One reason is that monetary policy was quite loose in the latter part of the 1980s, because Japanese monetary policy was influenced in part by international agreements that attempted to stabilize the dollar. But that is a complicated argument, because inflation was very low and the monetary authorities presumably thought things would be okay, because inflation did not shoot up.
The second explanation is the boom in Japan’s stock market. Many Japanese companies were able to issue equity very cheaply and finance their investment. And in the latter half of the 1980s, banks started lending heavily to the small sector and for real estate investment. These banks had lost their large corporate clients. With financial globalization, their traditional clients were able to issue their own equities and bonds. So the banks turned to new clients and extended large amounts for sometimes questionable endeavors. Essentially, this is just what happened in other countries that underwent financial liberalization, such as Sweden and the United Kingdom.
Business capital-to-output ratio and the efficiency of investment
Note: Potential GDP is generated using a production function approach.
Data: OECD; and NIKKEI Telecom
The third reason for overinvestment has to do with the banking crisis. It is not a particularly strong explanation of the trend decline in investment, because the banking crisis really hit hard only in 1997 and 1998, whereas investment had been falling before that. But, even in the early 1990s, there might have been a relationship between bank lending and investment. In Japan, banks can count a portion of their capital gains on equity holdings as part of their bank capital. When equity prices collapsed, bank capital also declined. In that sense, banks’ capacity to lend might have been adversely affected even before the banking crisis flared up fully.
In fact, econometric estimates showed a strong correlation between equity prices and business investment in Japan. This link can take place through two channels. If equity prices collapse, it is more expensive for firms to make investments by issuing equity. But it also means the banking sector can lend less because bank capital has eroded.
The fourth reason—the structural explanation—has two elements. All industrial countries have experienced a decline in the share of employment in manufacturing. In the 1970s and 1980s, Japan’s decline was not as steep as that in the United States or Europe. But beginning in 1994, there was a very sharp decline in Japan’s manufacturing sector for a wide variety of reasons. Since there is a strong correlation between the rate of investment and the size of the manufacturing sector, the drop in investment might in part be linked to the shrinking manufacturing sector. Also, Japan’s labor force is growing more slowly than that of other industrial countries. As a result you would expect that the potential growth of the economy would be negatively affected—it would be lower because the labor force is growing at a lower rate. And this, too, suggests that investment could not have continued growing at the same pace as in the 1980s.
Ultimately, this paper argues that if you want to look at what happened to investment, you must look at the structural factors. Excess debt, overinvestment, and the collapse of asset prices all played major roles in the business investment slump. Cyclical factors are much less important in explaining the slump in business investment in the 1990s.
IMF Survey:Looking ahead, what do you see as the prospects for investment?
Ramaswamy: The current rate of private investment in Japan right now is in the neighborhood of historic lows. This, as well as international comparisons of investment rates, suggests that the process of capital stock adjustment is more or less complete. The payoff period for the earlier sins appears to be coming to an end.
IMF Survey:Are there lessons to be learned for Japanese policymaking?
Ramaswamy: Yes, there are indeed a number of lessons that can be learned from this study. Good corporate governance is needed, not only for a strong economy, but also for macroeconomic stability. Japanese firms extended themselves into activities in which they had very little expertise and built up huge amounts of debt in the 1980s, because the institutional infrastructure whereby shareholders can question management when profits decline did not exist in practice.
A strong financial system, especially in cases in which bank lending is important, is also a prerequisite for macroeconomic stability. In the case of Japan, some of the problems of overinvestment could have been minimized if banks had carried out adequate due diligence earlier.
But Japanese policymakers have learned their lessons. A lot has been done in the past year and a half to strengthen the banking system and corporate governance. The institutional infrastructure to sustain a revival of investment and growth is being put into place. I am personally quite optimistic about growth prospects in Japan in the coming years.
This paper will be a chapter in a forthcoming book to be published by the imf,Post-Bubble Blues: How the Japanese Economy Responded to Asset Price Collapse, edited by Tamim Bayoumi and Charles Collyns.
The next issue of the IMF Survey will appear on December 13, 1999.
Ian S. McDonald
Senior Editorial Assistant
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