Academic journal article Journal of Money, Credit & Banking

Unique Symptoms of Japanese Stagnation: An Equity Market Perspective

Academic journal article Journal of Money, Credit & Banking

Unique Symptoms of Japanese Stagnation: An Equity Market Perspective

Article excerpt

THE CHRONIC STAGNATION of the Japanese economy is puzzling in many respects. More than 10 years after Japan's stock and real estate market bubble burst, the country is still operating far below its potential productive capacity. It is remarkable that the Japanese economy--second largest in the world--did not grow at all in real terms in 1991-2002. Furthermore, since 1994 Japan has experienced deflation of about 1%-2% a year despite the Bank of Japan's "Zero Interest Rate" policy. While the government's aggressive fiscal stimulus packages have led to skyrocketing budget deficits, unemployment has risen to an unprecedented level of 5.5% in recent years.

Several recent studies consider the Japanese relationship-based main bank system, as compared to a more market-oriented system, as a factor contributing to the prolonged stagnation of the Japanese economy (Kang and Stulz 2000, Morck and Nakamura 1999). Peek and Rosengren (2002) argue that Japanese corporate affiliations (keiretsu) and the main bank system were an effective way to increase credit availability and reduce agency costs when the economy was strong. But, they argue further, during difficult economic circumstances, the same affiliations may impede needed economic restructuring, insofar as they insulate severely troubled firms from the market discipline that otherwise would be imposed by creditors. They find evidence of "ever-greening" (i.e., main banks continue to lend to clients with deteriorating economic health).

This paper follows the seminal paper by Tobin (1968) by documenting several unique financial symptoms of Japanese economic stagnation from an equity market perspective. As Tobin pointed out, there is a close relationship between the stock market and business investment. In developed economies, equity markets play an important informational role. Investors use differences in stock prices to help differentiate good from bad firms, and their stock investment decisions directly influence how resources are allocated across firms. Therefore, the behavior of equity markets should offer some useful insights into the causes of Japan's economic decline and stagnation.

Since stocks prices are generally affected by overall market movement, our focus will be on idiosyncratic risk. Numerous papers have found idiosyncratic risk to be related to information efficiency and capital allocation. Recent finance studies demonstrate that a reduction in firm-level volatility may adversely affect the capital allocation process. Wurgler (2000) presents evidence that countries with stock markets that impound more firm-specific information into individual stock prices exhibit a better allocation of capital. He suggests that efficient secondary market prices can help investors and managers distinguish good investments from bad ones. (1) Durnev, Morck, and Yeung (2001) also find that firms in industries with greater firm-specific return variation exhibit a higher quality of capital budgeting, in that their profitability indices (Tobin's marginal Q ratios) are closer to one (or to a tax-adjusted benchmark). Moreover, macroeconomic models of "cleansing recessions," such as those described by Caballero and Hammour (1994) and Eden and Jovanovic (1994), emphasize the impact of firm-level volatility on resource allocation during recessions. A recession may increase the arrival rate of firm-specific information about management quality and thus promote resource reallocation from low-quality to high-quality firms.

In this paper, we first document a sharp reduction in firm-level volatility immediately following the Japanese market crash (1990). In contrast, U.S. firm-level volatility moves counter-cyclically (i.e., it increases after a market crash or during a recession). (2) To the extent that Japanese market downturns are accompanied by a reduction in firm-level volatility, it makes it more difficult for investors to distinguish low-quality from high-quality firms, thereby reducing the effectiveness of the cleansing mechanism. …

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