Turning Japanese: Avoiding insolvency

Although the government’s efforts have not been rewarded with either inflation or a healthy economy, it has resulted in the highest sovereign debt in the world at a whopping 200% of GDP. The only reason why Japan is immune from bond vigilantes is because most of the debt is held by locals at home

It appears that Japan is on a roll. Since the election of Abe Shinzo last fall the Japanese stock market has risen by 41% since last November. As the market has risen, the Japanese yen has fallen. Traders have knocked 15% off its value compared to the dollar. What ignited this change? Oddly enough, more of the same: Abe promised more free money and stimulus. He has proposed one of the largest stimulus packages in history. He has also appointed Haruhiko Kuroda an advocate of unorthodox monetary policies to head the Bank of Japan. The process is supposed to create inflation and end 20 years of deflation.


The fly in the ointment is that this programme is not really all that new. Various Japanese governments have been borrowing money to stimulate their economy for more than a decade. During that period the economy has never grown faster than 2% and usually has a negative quarter once a year. Before Abe took office, Japan was in the midst of its fifth recession in 15 years. The market has never risen above 18,000—less than half its 1990 high of 40,000. The recent run up is still less than a third of its all time high. Although the government’s efforts have not been rewarded with either inflation or a healthy economy, it has resulted in the highest sovereign debt in the world at a whopping 200% of GDP (gross domestic product). The only reason why Japan is immune from bond vigilantes is because most of the debt is held by locals at home.


Apparently the failure of the policy in the past does not mean that it should not be tried again. In fact, the plan of continued ultra loose monetary policy is imitated and admired. According to the president of the US Federal Reserve Bank of Chicago, Charles Evans, the reason it did not work was that there was not enough of it. According to Mr Evans the worry is that accommodative policies might be taken away too early: "It is the spectre of repeating the Japanese experience that now keeps me up at night.” The obvious question is after 20 years, what is early and what is enough?


But politicians in all countries love the idea of free money. It seems to boost equity markets and carry few risks. When there is at least the illusion of economic growth and stability, politicians in many countries do not feel the need to do anything. We saw in Europe that the momentum for structural reform exists only when it appears that there is the possibility of a collapse. Without market discipline policy makers only congratulate themselves on a job well done and do nothing.


This is a real problem with the issue of bankruptcy. It is a fundamental tenet of capitalism that bad companies need to fail. But failure is anything but pleasant for the people involved. Bankruptcy hurts the owners or shareholders, management and employees. All of these people lose money and jobs. Generally, the people who benefit from the process are the creditors, banks and bond holders, the people who supplied the loans and the credit in the first place.


Bankruptcy suffers from a fatal flaw. There are usually more and better organized shareholders, owners, managers and employees than there are banks, depositors, creditors, and bondholders. So the political power usually ends up with the former rather than the latter. Often even the banks join the constituency against bankruptcy. Bankruptcy forces them to recognize a loss that could conveniently be rolled over. The result is that governments and central banks will often do anything and everything to prevent bankruptcy.


In developed rule-based countries like the US, this is generally not a problem. While it is true that the Federal Reserve, Bank of England and the European Central Bank have been doing everything in their power to keep marginal companies afloat by providing an endless supply of cheap money; their authority does not extend to the bankruptcy courts.


In the US, these have been quite successful. During more placid economic times in 2008 there were 21,000 bankruptcies in the US. Not surprisingly these rose to 61,000 in 2009 at the height of the recession and have since fallen to 42,000. In contrast, the relationship based Japan, companies hardly go bankrupt. In 2007 they had only 1,100. This increased a bit in 2009 to 1,500 and decreased to 900 last year. The same problem exists in Europe. The northern more rule based countries had relatively high rates of bankruptcy compared to the more relationship based systems in southern Europe. In Luxembourg and Denmark, they had 316 and 182 bankruptcies per 10,000 businesses respectively. In Greece and Spain, the numbers were five and 18.


In emerging markets, bankruptcies that follow a legal process almost do not exist. In Brazil, for example, insolvency takes four years and recovers only 15% of the claims. India takes a little longer but recovers a bit more. It takes 4.3 years for a bankruptcy to wind its way through Indian courts but creditors get about 25% of claims. The OECD average is 1.7 years with a recovery rate of 70%.


In other countries like the UAE, insolvency and even bouncing a cheque are considered crimes. A single bounced cheque can result in a three year prison sentence. Whether it is a crime or if a legal process does not exist, often the only way to go bankrupt is to just leave the country. In some countries this has become institutionalized. Criminal gangs are hired by nervous creditors to wipe out all of the assets before other creditors know about a company’s financial problems.


In China private firms usually just shut down, but state-owned firms have developed the process of managed insolvency to a high art. Insolvency though is really not the right word, because the companies never really shut down.


According to the World Bank, more than one in four Chinese state firms lose money. Many of these firms are owned by local governments. These governments are not likely to see both their investment and the largest local employer go under. So they find ways to keep them afloat.


One example is Shandong Helong, a manufacturer of rayon and other fibres for clothing. Shandong is located in the city of Weifang which owns 16% of the firm. During better times, the company, like many other state firms, moved into other lines of speculative businesses often real estate. Shandong was no exception. It overextended itself in real estate and cargo port development. The increase in commodities prices for its fibres added to its woes.


In order to make up some of its losses it borrowed from a state-owned bank. Some of these loans to the tune of 1.7 billion yuan ($272 million) were guaranteed by Weifang. But these loans did not prove sufficient, so it took advantage of some of the recent reforms and borrowed $60 million in commercial paper from investors. When the firm continued to lose money, these loans became questionable. Defaulting on a state-owned bank loans is easier than defaulting on commercial paper. Unlike state-owned banks, investors in the commercial paper might cause social unrest. Besides it is hard for banks to enforce their claims. These claims have to be enforced in the courts of Weifang, which are not about to bring judgment against a local firm. So the holders of the commercial paper were paid and bank loans in the amount of 919 million yuan ($147 million) were ignored.


Some of these managed bankruptcies can go on for years. The state-owned firm Huludao Zinc Industry (HZI) started losing money in 1998. Part of the problem was that the factory had huge social costs. To get around this problem in 2002 HZI was stripped of its debts. The debts were placed in Huludao Nonferrous Metals Group (HMNG) in exchange for a controlling interest in HZI.


As a state-owned business HMNG was able to access loans from state-owned banks. Although it lost 700 million yuan ($112 million) between 2003 and 2005, it was still able to get loans worth 4.5 billion yuan ($720 million) from the banks plus a dividend of another billion yuan ($160 million) from its subsidiary HZI which was profitable at that time. Sadly by 2007 HZI’s days of making money ended.


To solve this problem, the Chinese relied on a favourite tactic. They merged the money losing companies HMNG and its subsidiary HZI with a stronger and larger firm, in this case Metallurgical Corporation of China. Both companies were relieved of their debts and listed, but the listing did not make them profitable. Between 2007 and 2008, HZI amassed another 1.6 billion yuan ($256 million) worth of losses. Despite its terrible balance sheet, it’s was still able to borrow another 1 billion ($160 million) and its immediate parent HMNG was able to guarantee 3 billion yuan of its subsidiary’s HZI debt.


The debts came due last September when MCC announced that its two subsidiaries were in deep trouble. HMNG had defaulted on a one billion yuan loan and it had guaranteed 90% of a 2.5 billion yuan overdue loan of HZI. The punch-line is that after the announcement MCC shares dropped 11% while the shares of its partially-owned subsidiaries HMNG and HZI rose!


Chinese investors, like their American counterparts, all assume that the government will bail them out. In this strange world good news is bad, because it means that government money might stop flowing. While bad news is good because the government will step in. The result of this distortion is that the economy loses efficiency. Money gets lent to the most inefficient of firms and is withheld from younger and more entrepreneurial companies. The rotten firms lose money and can’t hire, so employment gets stuck. Without constant signals as to which firms are good and which firms are bad, information within the market is corrupted which furthers the distortion. The end is quite predictable. Either continued recession as in Europe, sub-par growth the US and declining growth in China. So eventually, by preventing the destruction of capitalism everyone turns Japanese.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

Free Helpline
Legal Credit