NMA-Koo-1-06-21

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Richard Koo

EQUITY RESEARCH

Rebound from financial crisisshould not be mistaken for realrecovery

June 21, 2011

(issued in Japanese on 20 June 2011)

Asian investors also concerned about global economic outlook

Last week I had the opportunity to speak with investors in Singapore and Hong Kong.

Like their counterparts in the West, they were very concerned about the outlook for the

global economy.

Although both Hong Kong and Singapore enjoy strong local economies, investors wereworried about the growing signs of a global slump, including the fiscal problems in the

eurozone, a renewed slowdown in the US, and Chinese authorities’ moves to stamp

out inflation.

Stock markets around the world have been lackluster performers recently, and there

are even some who think Hong Kong real estate has peaked and is headed for a

correction following a period of impressive gains.

US slowdown attributable to end of heavy fiscal stimulus

In China the authorities are trying to rein in an inflationary bubble in textbook fashion—

by reversing overly aggressive monetary easing implemented in response to the

Lehman-inspired financial crisis of 2008. Western governments, meanwhile, are

pursuing fiscal consolidation. This is the chief reason for their slowdowns and is anextremely dangerous option given that their economies are in balance sheet

recessions, defined as a situation in which businesses and households have chosen to

minimize debt in spite of zero interest rates.

In particular, the slowdown in the US economy coincides with the gradual phasing out

of the Obama administration’s $787bn fiscal stimulus package of February 2009. At

present this program has a negligible probability of being renewed. This means those

people who have benefitted from this spending must become more cautious, and that

could lead to further weakness in the economy.

Limits to social security benefits as unemployed stay jobless for longer

As unemployed individuals in the US remain jobless for increasingly long periods of

time, they are exhausting both public and private resources. This is a problem that willonly grow worse with time.

A similar phenomenon can be observed in the eurozone, where the unemployed were

traditionally looked after by generous social security programs. Now the question is

how long countries can afford to continue these programs.

Spain, for example, has a depression-like unemployment rate of 21.3%. The only

reason this has not become a major social or political issue yet is the existence of

various social security programs.

But now that a substantial number of people have been without jobs for more than two

years, some are questioning how long these programs alone can continue to support

them.

Richard Koo is chief economist at

Nomura Research Institute. This is his personal view.

Richard [email protected]

To receive this publication, pleasecontact your local Nomurarepresentative.

ee Appendix A-1 for importantisclosures. Analysts employed

y non US affiliates are notegistered or qualified asesearch analysts with FINRA inhe US.

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Nomura | JPN Richard Koo June 21, 2011

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Fig. 2: Housing values may not return to pre-1998 trend until 2013

Note: Seasonal adjustments by Nomura. Trend regression formulas and assumptions are as follows: value of residential housing assets = 3,681.70 + (time x 88.241) for 1983–97trend line, and assumes a steady 6.38% y-y drop in asset values (the actual value in 2011 Q1) for post-bubble trend line.

Source: Nomura, based on Federal Reserve's Flow of Funds Accounts of the United States

Vicious cycle of falling asset prices and deleveraging

The recent declines in house prices imply significant progress in restoring housing values to the pre-bubble trend line.

If the downtrend that began in 2010 persists, housing prices will fall back to the pre-1998 trendline in the first half of 2013

(Figure 2).

That would mean the loss of an additional $2trn in household wealth and a return of house values to 2002 levels.

It would also mean a further decline in the ratio of household housing assets to debt to 1.48x, from 1.62x at present, and that

could easily spark another round of household deleveraging.

Financial crisis recovery should not be confused with end to balance sheet recession

Although Western economies have recovered from the financial crisis triggered by the failure of Lehman Brothers in September

2008, the balance sheet recession sparked by the collapse of the housing bubble in 2007 remains in full force.

The Lehman-inspired shock left much of the financial system dysfunctional, but those problems have been largely resolved as

government authorities supplied liquidity, injected capital, and provided guarantees for bank deposits.

Consumption and investment that were slashed as people prepared for the worst during the financial crisis have now returned to

normal levels. Hence the V-shaped recovery many countries experienced starting in the spring of 2009.

Many have mistaken rebound from financial crisis and impact of fiscal stimulus for real recovery

On the other hand, the balance sheet recession that began when the housing bubble burst in 2007 remains in full force as

house prices continue to fall, forcing people to deleverage.The only effective prescription for a balance sheet recession is the kind of aggressive fiscal stimulus that was implemented on a

global basis in 2009. Even though those policies helped restore economic stability, the impact of those policies is now rapidly

diminishing as their expiry nears.

Unfortunately, many people are unable to distinguish between a recovery from a financial crisis and a recovery from a balance

sheet recession. Having mistaken a rebound from the financial crisis for a full-blown economic recovery, they began arguing in

favor of fiscal consolidation in 2010 based on the belief that fiscal stimulus had successfully “primed the pump.”

As a result, many governments, including that of the US, will not renew the fiscal stimulus packages and other economic

measures implemented in 2009, and economies are beginning to decelerate as these policies wind down.

Adjustments may dip below trendline and overshoot on downside

We should view the correction in asset prices and the resulting balance sheet adjustments in the private sector as an extended

process that will not wind down in a few months or a few quarters. At the very least I think the process will take several years.

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($bn, seasonally adjusted quarterly data)

Value of residential housing assets Trend from 2010 onwards

Trend from 1983 to 1997

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And even if asset prices and outstanding debt return to pre-bubble trendlines, there is no guarantee that they will stop there: we

need to consider the possibility that they will drop below the trendline and overshoot on the downside. Of particular concern is

the fact that private-sector deleveraging efforts and falling asset prices constitute a feedback loop with adverse implications for

the economy.

The more the private sector deleverages, the weaker the economy becomes. That weakness accelerates the decline in asset

prices, which in turn forces a further round of deleveraging.

Fig. 3: Cash/deposits and debt at Japanese companies

Source: Bank of Japan's Flow of Funds Accounts

Deleveraging also overshot in post-bubble JapanJapan provides a good example of an economy in which a post-bubble correction broke below the pre-bubble trendline and

overshot on the downside. Japanese corporate liabilities (bank borrowings and capital market funding) rose sharply above the

historical trend during the bubble period starting in FY85, as Figure 3 shows. But corporate liabilities stopped growing and

deleveraging began as soon as the bubble burst in 1990–91. Until 1997 this deleveraging process continued at a very gradual

pace.

People were concerned about the large outstanding debt in 1997, but the expectation was that as long as they stopped adding

new debt and the economy continued growing, the value of the debt would eventually fall relative to the size of the economy.

Even though Japan suffered a severe drop in asset prices during this period—particularly in commercial real estate—asset

prices in 1997 had merely fallen back to the levels of 1985. Those who had not participated in the bubble were largely

untouched.

Japanese corporate debt returned to trend in 1997This gradual deleveraging process continued until 1997, by which time corporate debt had fallen back to the pre-bubble (pre-

1986) trendline. People’s expectations that debt would return to trend via a gradual deleveraging process seemed likely to be

validated.

In addition, prices in Japan’s commercial real estate sector had fallen faster than rents, making available yields quite attractive

on a global basis. The resulting opportunity attracted a huge number of so-called asset strippers from New York as well as

overseas Chinese investors to Japan’s real estate market.

As noted earlier, by 1997 commercial real estate prices had fallen back to pre-bubble (1985) levels, reassuring overseas

investors. And the fact that foreigners were buying local property helped convince Japanese policymakers that the bottom for

real estate was finally in.

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Cash and deposits(asset, lhs)

Bank borrowings and capitalmarket funding (liability, rhs)

BubbleBubblecollapses

Premature fiscalconsolidation

Financialcrisis

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Double-dip recession triggered by fiscal consolidation spurred new round of private-sector deleveraging

The Hashimoto government then assumed that all was well and embarked on an aggressive strategy of fiscal consolidation. But

the simultaneous deleveraging in the public and private sectors tipped the economy into a double-dip recession, and GDP

contracted for five consecutive quarters. That, in turn, triggered a whole string of problems in the financial sector, including bank

failures and a credit crunch.

Foreign investors responded to the crisis by leaving Japan en masse. Land prices, which appeared to have stabilized, resumed

their slide. This time the decline continued until prices had fallen back to 1973 levels, harming households and businesses that

had not participated in the bubble and triggering an unprecedented deleveraging in the private sector (Figure 3).

In effect, households and businesses that had expected only a modest correction panicked when the double-dip recession hit in1997 and rushed to reduce debt. The massive deleveraging that resulted weakened the economy and triggered a further decline

in asset prices, and the situation soon snowballed out of control. This vicious deflationary cycle continued until 2005.

The US also demonstrated how dangerous this kind of situation can be in 1937, when the nation experienced a double-dip

recession at a time when the private sector was already deleveraging. Faced with a fresh slide in the economy, people who had

assumed that the worst was over quickly changed their stance and became far more cautious.

In that sense, the support for fiscal consolidation observed in Western nations in 2010 is a worrying development, as a double-

dip recession in these countries could sharply accelerate the pace of private-sector deleveraging.

Cash and deposits reveal behavior of Japanese corporations during balance sheet adjustment period

Figure 3 also illustrates cash and deposits held by Japanese companies during this period. The graph shows that from 1990 to

1997, a period characterized by gradual deleveraging, there was no major change in cash and deposits. From 1997 onward,

however, there was a clear uptrend in cash and deposits.

What the data indicate is that post-bubble corporate balance sheet adjustments were accomplished not by drawing down cash,

deposits and other financial assets but by paying down debt.

No matter how difficult conditions became, companies did not draw down the cash and equivalents required for their day-to-day

businesses. After 1997, when banks stopped lending, they actually went out of their way to increase cash balances.

Bitter experience of double-dip recession heightened Japanese companies’ self-preservation instinct

Japanese corporations responded to the post-Lehman credit crunch by greatly increasing their holdings of cash and deposits

while scaling back borrowing, which had been gradually increasing since 2005.

In effect, the bitter experiences of Japanese companies starting in 1997 led them to adopt a business approach that could

quickly be shifted into self-preservation mode in the event of a major problem like a double-dip recession or credit crunch.

In the two years from end-FY08 to end-FY10, Japanese companies increased cash and equivalents by ¥18.5trn. That is almostas much as the ¥21.0trn increase over the 18-year period from 1990 to the end of 2008.

I think it will take a great deal of time for companies to relax their focus on self-preservation and resume a more forward-looking

stance. And the recent earthquake may have exacerbated the problem.

Cash and equivalents also growing at US companies, but not at an unusual pace

In the US, corporate cash and deposits rose by about $400bn between the end of September 2008 and the end of March 2011,

from $1.12trn to $1.52trn (Figure 4). At an exchange rate of 80 yen to the dollar, this represents an increase of some ¥32trn,

which seems large. But I do not think this number is out of line when we consider that the credit crunch faced by US companies

in the wake of the Lehman-inspired financial crisis was far more severe than anything experienced by Japanese businesses.

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Fig. 4: Cash and deposits and debt at US corporations

Note: Seasonal adjustments by Nomura.

Source: Nomura, based on Federal Reserve's Flow of Funds Accounts of the United States

At one point, some US economists attributed the weak economy to companies’ increased cash hoardings and refusal to invest.

However, US businesses have long been more sensitive to final demand than their Japanese and European counterparts, and it

is hardly surprising that they would grow more cautious at a time when households—which provide that final demand—are

deleveraging.

Cash and equivalents at US corporations have also been in an uptrend since around 1996. Viewed in the context of that trend,

the $400bn increase, while large in absolute terms, is not unusually large.

Japanese companies hold almost twice as much cash and deposits as US businesses

In absolute terms, Japanese companies held cash and deposits totaling ¥211.6trn at the end of March 2011, whereas the

corresponding figure for US businesses was ¥121.4trn ($1.52trn). (Some of this large disparity may be attributable to

differences in business practices.) Meanwhile, Japanese companies have debt of ¥406.7trn versus a substantially larger figure

of ¥583.2trn ($7.29trn) for US firms.

Given that Japanese corporate debt at the peak of the bubble amounted to ¥610trn, this means they have eliminated a third of

their debt over the last 20 years. In contrast, US companies have nearly tripled their debt over the same period, from $2.5trn to

$7.3trn. Businesses in the two countries have thus moved in opposite directions.

This is evidence of how healthy Japanese balance sheets have become over the last two decades. Japanese companies now

hold cash and equivalents worth more than half their liabilities, while US firms are unable to cover even a quarter of their

liabilities.

Fed’s policy options are narrowing

With QE2 set to be discontinued at the end of June, the Fed faces some very difficult choices amid a decelerating economy.

The paucity of policy options is reminiscent of the situation facing the BOJ ten years ago.

Fed chairman Ben Bernanke understands that monetary accommodation during a balance sheet recession has little impact

apart from the portfolio rebalancing effect. After all, neither employment nor the money supply has grown meaningfully despite

aggressive quantitative easing and two and a half years of zero interest rates.

The portfolio rebalancing effect did lift stock prices and commodity prices initially, but there has been no corresponding recovery

in the economy or corporate earnings.

Unfortunately, that means the increase in equity and commodity prices was little more than a bubble created by central bank

actions. Some of those assets now appear to be correcting, as it is difficult to justify current share prices on a discounted cash

flow basis without a full-fledged economic recovery.

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Bank borrowings and bonds (liability, rhs)

Cash and d eposits(asset, lhs)

Secondary effects of S&L crisis,collapse of commercial real

estate bubble

Collapse of Internet bubble

Collapse of housing

bubble

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BOJ implemented quantitative easing in 2001 knowing it would not be effective

It will be difficult for the Fed to persist with current policies when both Mr. Bernanke and market participants are aware of the

limitations of quantitative easing. In 2001 the BOJ understood there was no reason why quantitative easing should have any

effect, and that is why the Bank objected so strongly to the calls for quantitative easing by a handful of politicians, academics,

and media pundits.

Meanwhile, it was clear to the BOJ then and to Mr. Bernanke today that political factors would thwart the fiscal stimulus needed

for a real economic recovery.

Faced with a government unable to implement the necessary fiscal stimulus, the central bank cannot sit back and do nothing.

That is why the BOJ reluctantly undertook quantitative easing in 2001, all the while knowing it would not work.

I suspect the Fed chairman, who must do something despite his awareness of the limitations of quantitative easing, is in a

similar predicament. While this is just speculation on my part, I think he may be considering leaving the $600bn in liquidity in the

market as long as possible while, on a microeconomic level, seeking a way to better target the funds supplied by the Fed.

Bernanke once argued that smaller banks needed more capital

One such targeted area may include re-capitalizing the small and medium size banks in the US. Mr. Bernanke argued that

smaller US banks needed more capital when he testified before Congress with me last July.

According to the Fed chairman, the Troubled Asset Relief Program (TARP) that was first applied to the large banks in

November 2008 was extremely unpopular because it was caught in a political cross-fire and the authorities failed to convince

the public that the program was actually needed. As a result, little was done to address the shortage of capital at smaller banks.

But the problems in the US banking sector will continue until this issue is dealt with.

When the BOJ faced exactly the same problem in 2009, it had banks issue subordinated loans that were then underwritten by

the BOJ in order to address a capital shortage and overcome the credit crunch. This highly unusual policy came about when the

Aso administration’s proposed injection of capital into the banks, designed to resolve the credit crunch that followed the

Lehman-inspired financial crisis, was largely ignored by banks. The banks ignored the policy because they had developed a

strong distrust of the FSA following the drastic changes that began during the Koizumi administration.

Ultimately, few banks took advantage of the BOJ’s program, as Japanese banks were not deeply involved in the subprime mess

and were therefore able to recover quickly from the subsequent financial crisis. In the US, in contrast, many smaller financial

institutions continue to suffer from a shortage of capital.

I suspect that initially the Fed intended to discontinue QE2 as the economy gradually recovered, but was forced to reconsider

after the gloomy jobs report released at the beginning of June. With the usual macroeconomic monetary measures proven to be

ineffective, the Fed now needs to come up with new microeconomic policies for the post-QE2 era. Here it all depends on the

kinds of ideas that emerge. In this area, it will not be surprising if the Fed begins providing assistance to smaller financialinstitutions, which it has been concerned about for some time.

Richard Koo’s next article is scheduled for release on 12 July 2011

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Appendix A-1

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