Japan's Money Power

The nation's cash pump supports equity and bond markets worldwide. What if it falters--or stops?

If global investors needed a wake-up call about the sheer power of Japanese money, they received a nasty one during the summer. During two weeks in July, the Dow Jones industrial average shed about 6% of its value, setting off tremors on bourses worldwide. At the time, market pros pinned the decline on disappointing corporate profits and fears of rising interest rates and a slowing U.S. economy. But 7,000 miles away in Tokyo lies another explanation.

Right around the time Wall Street was faltering, the Japanese central bank's purchases of U.S. Treasury bonds suddenly began a brief, and still unexplained, decline. As the yen rallied and long-term U.S. interest rates rose by 30 basis points, Wall Street's equity traders went into a funk. "The Bank of Japan was the culprit," says Michael J. Howell, chief strategist at London's ING Baring Securities Ltd. "The sell-off had nothing to do with economics at all,"

What it had to do with was sheer financial clout. Even after a lengthy recession and a domestic banking crisis that may end up putting America's savings-and-loan debacle to shame, Japan's influence on world markets is anything but diminished. Just ask any trader. All it would take to send Wall Street into another tailspin would be one hint from Tokyo that Japan might be better off investing its wealth in Asia instead of America.

And that wealth is immense beyond anyone's wildest dreams. For years, the Japanese have been piling up dollars--the main product of their export winnings--at a prodigious rate. These current-account surpluses now total an incredible $1.2 trillion, and they must be recycled abroad to keep the yen from soaring so high it leaves the Japanese economy in ruins. Indeed, that nearly became the case in 1994, when the Japanese money pump slowed down.

A meltdown in land and stock prices after the blowout of the 1980s "bubble" economy had left investors too stunned to send money abroad. Burdened with $800 billion in bad real estate loans, Japanese banks were unloading Manhattan skyscrapers and condos in Hawaii in a rush to repatriate their funds. This contraction in Japanese long-term capital outflows contributed to a spike in world interest rates and the biggest sell-off in the global bond market since the 1920s.

Early last year, events threatened to spiral out of control. With Japanese capital flows no longer propping up the dollar and with trade tensions mounting between Washington and Tokyo, the U.S. currency plunged to an all-time low of 79.75 yen in April. The drop pushed the Japanese economy close to a deflationary spiral, bringing the Bank of Japan, the U.S. Federal Reserve, and the German Bundesbank to the rescue. Central bankers ended the greenback's free fall by purchasing every dollar they could find on foreign exchange markets.

HUGE STOCKPILE. Since that tense moment, the Bank of Japan has slashed its discount rate to 0.5%, and a flood of Japanese money--some $130 billion, and perhaps far more--has poured into the world's capital markets in search of higher returns. As Japan has thus accumulated dollars and Deutschemarks for its Toyotas and Toshibas, its reserves of foreign exchange have ballooned.

The International Monetary Fund estimates the Japanese central bank now owns $211 billion in foreign currencies, more than twice what Germany holds and by far the largest official stockpile anywhere on earth. Most of the sum is being held in dollars, reflecting the U.S. currency's liquidity and its prominent role in Japanese trade. And most of those dollars have gone straight into U.S. Treasuries, much to the delight of investors. "Japanese money," admits Eisuke Sakakibara, director-general of the Ministry of Finance's international finance bureau, "has played a role in...propping up world equity and bond markets."

Other countries with big trade surpluses, including China and Taiwan, are also investing heavily in U.S. bonds. In fact, foreign investors bought more than 75% of the U.S. Treasury's net new issues of debt in the first half of 1996, estimates Kenneth S. Courtis, Tokyo-based chief economist at Deutsche Bank Group Asia Pacific. But he and other economists say that Japan's purchases of Treasuries dwarf those of its wealthy Asian neighbors--and everybody else. Even allowing for the summertime buying dip, J.P. Morgan Securities Asia Ltd. economist Jesper Koll estimates the Japanese are still putting an estimated $3 billion a month into Treasury debt.

The Bank of Japan is providing the biggest part of this cash. But a growing share is coming from individuals, while insurance companies and other big private investors are under pressure from the Ministry of Finance to join in the recycling effort. Japanese commercial and investment banks, meanwhile, are lending billions more at dirt-cheap interest rates to multinational corporations, government institutions, and even U.S. hedge funds.

BURNING QUESTION. The primary object of the Japanese campaign is to keep capital flowing abroad and the yen in a manageable range. But many economists and money managers believe that were it not for the excess Japanese cash flow, many Western industrialized economies would have a hard time financing budget deficits, keeping interest rates down, and encouraging investors to put savings into stocks. "We've had a global stock market frenzy," says Deutsche Bank's Courtis. "Cheap money in Tokyo has been at the center of it."

As central bankers and finance ministers convene in Washington Sept. 28 for the World Bank and IMF annual meetings, the burning question before them has to be whether the Japanese money pump will falter once again. On that front, some economists are starting to grow concerned. After all, since peaking at $130 billion in 1994, Japan's current-account surplus has been heading steadily south in the face of a strong yen, a recovering economy, and pressure from Washington to boost imports. The surplus includes balances for trade in goods and services as well as foreign aid payments. This year, Merrill Lynch & Co. estimates, the surplus will fall to $73 billion. By 1997, it could be down to $52 billion. A few analysts--but not the Ministry of Finance--even see current-account deficits looming by 2005.

In addition to the declining surplus, many economists expect the Bank of Japan to raise interest rates next year if the slow recovery finally gains speed. The combination of higher rates and a more lively economy could leave Japan with less cash to recycle abroad.

If all this happens just as the Federal Reserve is raising U.S. rates, as most economists expect, a transpacific credit squeeze could give stock and bond markets around the world a rude shock. A Japanese pullback could boost U.S. bond yields by 25 to 50 basis points, estimates George Magnus, London-based chief international economist for Union Bank of Switzerland. Not only would markets suffer, but the higher rates would translate into rising costs for home mortgages and a wide range of other loans. "This wouldn't be a great picture," says William P. Sterling, a longtime Japan-watcher and chief strategist at the New York fund-management firm BEA Associates.

With luck, however, that scenario won't come to pass. Merrill Lynch economist John Praveen, for one, notes that Europe and other Asian economies, with current-account surpluses of their own, would probably fill any global capital deficit Japan might leave. And Japan has a vested interest in keeping the recycling mechanism humming along.

Even with declining export earnings, Japan will still need to recycle more than $120 billion in surpluses this year and next--on top of the $1.2 trillion it has already piled up. The cumulative surpluses virtually guarantee that the dollar will continue its long-term decline against the yen. But with both President Bill Clinton and Japanese Prime Minister Ryutaro Hashimoto facing elections this fall, neither side wants to see their markets or economies in turmoil.

That means the Clinton Administration, which once found a handy trade weapon in talking the dollar lower, is more likely now to continue its recent emphasis on stability. And Japanese officials indicate they will also do whatever it takes to maintain the dollar's value around its current level of 110 yen for now by keeping interest rates low at home. In Tokyo and Washington these days, says Kiichi Miyazawa, the former Japanese Minister of Finance and Prime Minister, "there is a kind of tacit understanding that 10% on either side of 100 is acceptable." Adds Sakakibara of the MOF: "We both want a stable currency market. And having a strong equity market helps us."

QUICK TRADES. Expectations that this tacit deal will stick for a while, plus some moves by the MOF to ease Japanese investment abroad, help explain the continuing stampede of foreign borrowers into the London and Tokyo bond markets.

The World Bank, for example, plans a $1 billion Eurobond offering in London next month, its biggest ever targeted at Japanese investors. Many of the buyers are likely to be individuals. Other borrowers are tapping the Euroyen market, where the value of bond issues soared to $53 billion in the first half. This year, the Japanese should easily absorb more than the $95 billion in Euroyen debt they bought in 1995.

The action is no less frantic in Tokyo's Samurai bond market, where foreigners issue yen-denominated paper. Mexico is about to unveil a $700 million offering, its third this year. With everyone from the African Development Bank to Walt Disney Co. issuing new paper, some $26 billion in Samurais have been raised so far this year, nearly twice 1995's pace. Corporations generally swap the yen proceeds of their Japanese bond sales for dollars, boosting demand for greenbacks and keeping the capital recycling system in high gear.

Big corporations and multilateral institutions are not the only borrowers taking advantage of cheap Japanese credit. Hedge funds from around the world have been bulking up on short-term yen bank loans at 1% interest or less and turning an easy profit by putting the funds into U.S. Treasuries yielding six percentage points more. And Sumitomo Bank Ltd., with most of its bad property loans written down, is reported to be planning to invest up to $1 billion of its own capital in hedge funds in the U.S.

Even Japan's risk-averse life insurers are jumping back into the Treasury market. Lured by the rich spread between Japanese and U.S. rates, Sumitomo Life Insurance Co. added $1.3 billion worth of Treasury bonds to its portfolio last year and expects to add the same in 1996. So confident is Sumitomo bond trader Nichihisa Tanimoto of the Bank of Japan's commitment to a weaker yen that he's no longer trying to hedge his currency risk. "With the strong dollar," he figures, "we are in a stable investment climate."

Now, the betting is that even more Japanese investors will return to the U.S. bond market, which will help free up cash to keep the rally on Wall Street going. Japanese are also plunging back into equities abroad: Economist Koll estimates that they bought $4.4 billion worth in the first half of 1996 alone. And foreign investment in factories overseas is on a roll, totaling $14 billion in the first seven months of the year.

China and Southeast Asia attracted much of the investment, as Japanese manufacturers continue to open offshore factories to cut production costs and improve their access to foreign markets. But California, an obvious target for Japanese multinationals trying to catch up in such high-technology industries as software and multimedia, is also attracting a growing share.

FASTER PACE. Softbank Corp., the acquisitive software retailer and computer publisher, spent $1.5 billion in August for 80% of Los Angeles-based Kingston Technology Corp., the world's biggest maker of memory add-on modules that boost the processing power of personal computers. Softbank has also pumped $200 million into Internet upstarts, including a 37% stake in Yahoo! Inc., the top World Wide Web search-engine service, and is now readying a $500 million venture fund, backed by Japanese and other Asian investors. "A lot of small start-ups really benefit from the Japanese capital," says Martin Beresford, president of San Francisco-based Nichibei Associates, which brokers such deals. "The pace of Japanese money coming into Silicon Valley is accelerating."

Over the long haul, however, such investment may actually turn Japan into a less dominant player in global capital flows. From VCRs to autos, a growing volume of consumer and capital goods that were once shipped out of Japan are being shipped in. And with Japan's personal-computer market booming, the country is experiencing a wave of imports of everything from Microsoft Corp.'s Windows 95 software to Singapore-made disk drives.

Over time, Japan may even remake itself into a net importer by tapping its $9.7 trillion in household savings to boost its long-term growth. But that is not the only force that may eat into savings. Since 1992, Japan has run through roughly $550 billion worth of public-works spending, tax breaks, and housing loans to jump-start the economy. This year, Japan's budget deficit will expand to about 4% of gross domestic product, easily outstripping the U.S.'s expected 1.9%.

The official Japanese budget gap doesn't even include a whole range of off-the-books government liabilities. One of the biggest obligations is that for JNR Settlement Corp., the holding company formed to assume the debts of the six railways spun off from the breakup of the Japanese National Railways in 1987. The company has inherited a staggering $255 billion in debt, thanks to the 60% drop in land prices since 1992. The government will probably pass the debt on to taxpayers through a bailout program.

Another factor likely to strain Japan's savings: the needs of its aging population. The percentage of those 65 or older has jumped from 8% in 1975 to 14% now. By the year 2025, some 26% of Japanese will be senior citizens. The graying of the population will force Japan to divert a greater portion of its economic output to social security and medical payments. Salomon Brothers Inc. estimates that such social outlays, which currently absorb 13% of GDP, will account for twice as big a share by 2025.

But slowing Japan's export colossus and draining its huge savings pool will take years. In the meantime, the recycling engine will hum on. In little more than a decade, Japan has achieved something that has never occurred in modern economic history: a cumulative current-account surplus of more than $1 trillion. Japan will be recycling its capital--and keeping overseas markets aloft--for a long time to come.

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