Fukushima – The Burdens of Japan’s Financial System
Fukushima poses extraordinary challenges to Japan’s financial system which, as I argued in my last blog, may not be well prepared to meet them. The recently announced much bigger-than-expected quarterly loss of Daiwa Securities Group, Japan’s No. 2 brokerage, is a warning sign of the latent surprises that may easily invalidate whatever scenario is developed now for crisis solution. There are countless imponderabilities and the extent of the looming financial threats is an unknown unknown as Satyajit Das would probably call it. Currently, no one can foresee from where the next blow to the financial system will come, how strong it will be – or whether it will come at all. However, a comparison with the devastations after the breakdown of the bubble economy of the 1980s gives reason to modest optimism.
The dimensions of the damage
Commentators like to compare the effects of the Fukushima disaster with the Kobe earthquake of 1995, Japan’s worst earthquake in the 20th century after the Great Kanto earthquake of 1923. The damage in that case amounted to an estimated ten trillion yen or about 2.5% of Japan’s GDP. Estimates of the costs of resconstruction from earthquake, tsunami and nuclear emergency this time range from 25 to 50 trillion yen (up to $613 billion). There is an emergency budget of Y4,000bn from the Japanese government for the first phase of the public relief and rebuilding effort. Probably, this will be the first of several extra budgets. Economists believe that the government will need to spend at least Y10,000bn for reconstruction in the next 12 months.
These are estimates of the direct costs – of rebuilding housing and corporate facilities and social infrastructure. In addition, there are indirect costs which affect the economy as a whole: Those include losses from a decline in consumer confidence and demand, damages to production and output from power shortages and unraveled supply chains as well as the effects of a prevailing deep overall uncertainty about economic prospects.
25 to 50 trillion yen. Where will the money come from? There are several options. Government may cut benefit, issue bonds, increase the tax burden or use pension money in order to finance its contribution. Each of these will affect overall financial markets and conditions. The announced first Y4 trillion emergency budget will be financed from pension funds (Y2.5 trillion) and “money set aside to increase payments to families with children” as well as from governments emergency reserves. As was emphasized there will be no new issue of bonds increasing Japan’s public debt to GDP ratio which before March 11 already had been 226%. The question is whether this would hold for further successive rounds of emergency programs, too.
Private sector options are much more limited. The stock market is down. From March 11 to April 25 2011 the Nikkei 225 fell by about 5% and further losses must be expected. Mounting risks and declining ratings make bonds a more and more expensive alternative, and even before March 2011 credit supply had been sluggish with banks long hesitating to grant new loans and consumers unwilling to spend. In October 2010 the central bank had already launched an asset-purchase program designed to fight deflation and stimulate bank lending.
So far, central bank contributions are substantial. The day after earthquake and tsunami the Bank of Japan immediately poured a record Y15 trillion into money markets to ease liquidity concerns and offered same-day funds that were effectively available instantaneously rather than after a settlement period. In addition, the asset-purchase program of October was doubled to Y10 trillion and became part of the BOJ emergency program. Notably, it included a total of Y3.5 trillion of – from central bank perspective - unusually risky assets such as corporate bonds, exchange-traded funds and real-estate investment trusts. Part of this was used to buy TEPCO bonds up to the maximum of 100 billion yen for individual companies in reaction to rapidly deteriorating credit conditions for the utility and concerns over a possible default of TEPCO bonds. Furthermore, the BOJ announced to buy an additional Y1.5 trillion of government debt and will provide a 1 trillion yen loan scheme for banks in the quake-hit region.
Actually, TEPCO currently appears the biggest single challenge to the financial system. This has two aspects: One is size. TEPCO is too big to fail. It is the fourth largest electric power company in the world and the largest of 10 utilities in Japan with a regional monopoly in the Kanto region, Yamanishi Prefecture and the eastern part of Shizuoka Prefecture. Its headquarters are located in Tokyo and it has international branch offices in Washington, D.C. and London. Its market capitalization which declined dramatically since March is about 1 trillion yen – from almost 3 trillion in 2010.
The second aspect is its wide net of economic and financial ties. TEPCO is part of what was (or is) the Dai-Ichi Kangyo keiretsu, the industrial grouping including companies such as Mizuho Bank (as main bank), Itochu (the general trading company, formerly C. Itoh), Fujitsu, Hitachi, Marubeni and Nissan – to name only a few. Although keiretsu relations have become blurred in recent years companies from this group may feel a special obligation to support TEPCO in the current situation. The same may hold for the large number of investor firms which are connected to the utility through a system of small cross-shareholdings.
Outside observers are only gradually becomig aware of the enormous financial burden that earthquake, tsunami and nuclear crisis are placing on the utility and of the systemic risk involved. TEPCO announced that it expects to pay Y50 billion in initial compensation to nearly 80,000 residents who had been evacuated. Estimates of overall compensation claims range from Y2.4 trillion to up to Y10 trillion depending on the time it will take to bring the nuclear reactors under control. Many trillion yen more will be needed to clean and close the plant and to build a new one to replace it.
End of March TEPCO had cash reserves of about Y700 billion. Unlike BP, with which it is sometimes compared, it has few overseas assets it can sell, and its ability to raise electricity rates or cut costs is limited as well. Tapping foreign financial markets has become difficult as the decision of SNB demonstrated to put the firm on its “black list” for Swiss banks no longer accepting TEPCO bonds as repo collateral. TEPCO may cut dividends or not pay them at all. Another option for the utility is to seek limiting its liability under the 1961 Act on Compensation for Nuclear Damage which exempts plant operators from paying compensation for accidents caused by a “grave natural disaster of an exceptional character or by an insurrection.” The rest will come from public and private sources.
The Japanese Government is said to consider making low-interest loans available to TEPCO through the Development Bank of Japan (DBJ) and the Shoko Chukin Bank (Central Cooperative Bank for Commerce and Industry). In addition, TEPCO sought a Y2 trillion loan from seven banks and has also approached big life insurers such as Nippon Life and Dai-Ichi Life. For various reasons, both groups have a strong interest in keeping the utility alive:
Both hold TEPCO stocks. The following figure demonstrates how in this respect among the big Japanese financial groups Mizuho, Sumitomo and Mitsubishi UFJ are affected. Under the Japanese system of cross-shareholdings the percentages held are small. In September 2010, Sumitomo Mitsui Banking Corporation held 2.7% of TEPCO and Mizuho Corporate Bank only 1.8%. However, with the nearly 80% decline in TEPCO shares since March 11 these rates translate into considerable book losses – for the Sumitomo Group of Y80 billion, for Mizuho of Y50 billion and for Mitsubishi UFJ of Y30 billion. It was bad luck for the banks that March 31 was the end of the fiscal year leaving no time for provisions or for share prices to recover.
All three groups will make considerable loans to TEPCO: Mizuhi Corporate Bank offered Y500 billion, Sumitomo Mitsui Banking Corporation Y600 billion and Sumitomo Trust and Banking another Y300 billion, and Bank of Tokyo-Mitsubishi UFJ Y300 billion.
Big insurers face a similar situation: With 4% shares Dai-Ichi Life is TEPCO’s biggest shareholder with book losses of Y100 billion end of March 2011. Nippon Life is holding 52.8 million TEPCO shares. Like the banks both are considering possible loan requests from the utility. Observers expect a sort of division of labour with banks providing short-term funds and insurers offering long-term funds for capital investments.
It is not only stock markets. In fixed-income markets TEPCO is a dominant player. Normally, instead of relying on bank loans TEPCO is turning to the corporate bonds and CP markets which offer better terms. Backed by high credit ratings the utility used to be the biggest issuer of corporate bonds in Japan. Banks, life insurers, pension funds and individuals hold more than 5 trillion yen in TEPCO corporate bonds. These were popular among conservative investors because they were seen as safe haven and a proxy for Japanese government bonds. Soaring cost of credit protection on TEPCO debt, lower ratings and rumours about nationalization made them become pessmistic.
Lessons from the Breakdown of the Bubble Economy
With respect to the ability of the financial sector to meet an extraordinary challenge like the prevailing one, a comparison not with Kobe, but with the breakdown of the bubble economy of the 1980s and the resulting financial devastations may provide valuable insights.
At the height of the boom in stock and land prices in Japan in December 1989 the Japanese stock market made up 42% of the total capitalization of world stock markets. (Details …) Total property had an estimated value of Y2,000 trillion which was over 5% of GDP. Shares and property at inflated prices served as collateral for successive rounds of bank lending and a loose monetary policy provided a most favourable environment of cheap credit which further fuelled speculation. Single golf club membership rates in the Kanto area – a common indicator of the state of the economy in Japan – rose to the equivalent of $2 million.
When the bubble burst, the Nikkei fell within months from its peak in December 1989 of Y38,915 by 48% to 20,221 in October 1990 which was only the beginning of a long-lasting decline. Banks suddenly faced a massive overhang of bad debt with the biggest problems resulting from their links to the country’s around 37,000 nonbank financial enterprises: End of FY 1990 they had lent some Y90 trillion to nonbank and housing loan companies. Many of those loans were never repaid: In FY 1994 city banks’ non-performing loans ranged from Y298.6 billion for Daiwa Bank over Y945.8 billion for Sumitomo Bank to Y1,116.2 billion for Fuji Bank, Y1,192.9 billion for Dai-Ichi Kangyo Bank and Y1,410.7 billion for Sakura Bank. The list is not exhaustive.
Somehow, they managed and the system survived. There were restructurings and consolidations as well as massive government support, but in 2007 Y8.8 trillion of about Y12 trillion injections by the Deposit Insurance Corporation (DIC) had been repaid and from official side the situation generally was considered as healthy.
The overall conclusion from these experiences is a modestly optimistic one. Financially Japan can cope. The breakdown of the bubble economy in the 1990s had confronted Japan’s financial system with even bigger challenges and those were met. There are good reasons to believe that despite the government’s huge budget deficit and prevailing weaknesses in the financial system this will happen once again. The prerequisite is, of course, that earlier problems were solved and not merely disguised behind altered structures.