Why Japan's Crash Won't Happen Here

Would you invest in a company that doesn't have to disclose its debts, has no real independent board of directors, and is located in a country where minority shareholders have no power over corporate policy? Japanese investors face this very thing, and the banking system that has funded their companies' growth is in a shambles. Investors who point to the performance of the Nikkei index as a potential blueprint for a U.S. crash are missing some important points.

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By Bill Mann (TMF Otter)
September 7, 2001

There's a saying that most people are incapable of projecting a path that differs from whatever the current economic situation might be. Take the end of the 1990s, for example, when a company such as Juniper Networks (Nasdaq: JNPR) was trading at 1600 times its free cash flow and yet people were somehow capable of making a convincing argument why it should go higher.

Now that the stock markets have shredded many portfolios, there seems to be no way out of our current economic funk. Ah, but rest assured, dear Fool: There has never been an economic driver -- not a war, depression, or bubble -- that was permanent. Eventually the economy, and thus the market, will rebound. As I said in Wednesday's column, the fact that the bobbling-head pundit crew has no clue when this will be won't stop them from making prediction after prediction, but the fact that things will change is definite.

One of the recent themes among market watchers is that the U.S. is in danger of going through the same long-term depression Japan -- where certain policies have contributed to its major market index, the Nikkei 225, recently hitting a 17 year low -- is enduring. It's possible, but it's important to point out the differences between the United States and Japan to show why most comparisons are too simplistic.

They say a picture is worth 1,000 words (not adjusted for inflation). A chart posted on overlays two lines: the Nikkei 225, and its bubble that broke in 1990, and the S&P 500 as it sits today. They match up pretty nicely. Scary, isn't it?

Well, it shouldn't be. Just because the charts LOOK the same does not mean they are the same. But forget charts for a minute. The simple reality is that several of the problems dogging Japan simply do not exist in the United States. The U.S. markets certainly could collapse to a 17-year low just like Japan is suffering now, which would put the S&P 500 at 168 points, a loss of another 84%. I don't rate that as a high probability occurrence, however. What people are afraid of is the prospects of a long bear market, and Japan shows us one is possible in this day and age. 

Above all, avoid discussing bad things
Japan, in many unsubtle ways, has committed financial suicide by virtue of policies that would simply not fly  here. Japan's government has no clue how to jumpstart its economy. Even if it did, it lacks the political courage to do it. The difference between the two may not ensure protection from a long-term downturn, but I think that it is clear that certain Japanese policies have exacerbated, if not prolonged, that country's downturn.

1. Poor shareholder disclosure
The state of shareholder rights in Japan is a disgrace, and individual investors have not taken kindly to having minimal information from publicly traded companies and no power to effect change. For example, companies do not need to write down capital losses if they are still investing in a project. Thus, the amount of equity listed by a company may have no connection whatsoever to the actual book value or earnings potential of those assets.

Japanese companies also have enormous cross-holdings, and are thus protected from shareholder revolt. Managements are given free reign to run their companies as they see fit, and have long favored the interests of employees over shareholders. More than two-thirds of all Japanese companies hold their annual meetings on the same day, limiting the ability of individual shareholders to force change. Independent boards of directors are nearly unheard of, and even the legal recourse by shareholders against a company's management is curtailed.

In short, investors find it difficult to determine the financial strength of a company. In the absence of good information, both Japanese and foreign investors have elected to stay away. Only 5% of all Japanese household assets are in stocks.

2. Ignoring problems
The Japanese government has magically turned a big problem into a monumental one, issuing stimulus after stimulus -- at times even taking savings deposits and investing them in corporations -- without forcing banks and producers to fix the core issues that got the country in trouble to start with. What has ensued is a structural crisis in which the status quo is prized over efficiency.

The structure of the Japanese banking system was entirely different than that of the American one. Banks were expected to loan in order to provide industry with the cheapest possible source of credit, not based upon profitability or on the ability of companies to repay the loans. The Japanese populace was thus encouraged to save heavily, and the banks funneled this money to companies. Up until 1990, this system worked great, and Japan was believed by some to be on the verge of overtaking the United States as the world's economic superpower.

But the result of this policy was that companies were not required to make efficient use of the capital available to them. Unlike the United States, where equity financing and debt issuance are primary sources of funds for companies, in Japan the banks have borne the load. As we have learned here, when there is too much capital chasing too few opportunities to earn money, the value of that capital drops like a stone.

Japanese banks were unwilling to foreclose on bad loans, and the government has done little to force them to do so. In fact, the government of Japan has been unwilling to let banks or businesses fail. Instead, two years ago, the government bought $70 billion of its largest banks' preferred shares to try to improve their liquidity. The banks, however, did nothing to foreclose on the assets of their existing debtors in default.

Now those bad debts nationwide are estimated at between a low of $260 billion by government sources and more than $600 billion by some economists. The banks have nowhere near the resources needed to cover these bad loans, and the government is already saddled with its own debt of 130% of Japan's gross domestic product.

Japan is in a mess that has been in the making since World War II. The United States, meanwhile, has several distinct advantages that protect it from such a scenario. One, our companies are much less able to hide detrimental information, and our laws go much further to protect minority shareholders. Two, the United States' banking system is based upon capital efficiency, not nationalistic goals.

Banks in the U.S. are much more willing to foreclose on bad loans because their shareholders demand it. Only in rare circumstances, such as the S&L collapse and the Citibank (NYSE: C) crisis of the early 1990s, does the U.S. government interfere. In general, when a company is eligible to fail, there is little pressure upon the banks to put their assets at risk to keep it from doing so.

This may seem Machiavellian, but ruthlessness is exactly what makes the U.S. economy much more efficient. The current economic woes are directly attributable to poor capital allocation in the late 1990s. Our willingness to allow companies to fail will help rectify this imbalance much faster than Japan has proven able to. While the economic effect of a long-term recession would be severe, the mechanisms to avert such a prolonged downturn are deeply entrenched in the U.S. -- and nonexistent in Japan.

Bill Mann can't find his thorax. His stock holdings can be viewed online, as can The Motley Fool's disclosure policy.