Annual Report on the Japanese

Economy and Public Finance


- No Gains Without Reforms III -

October 2003

Cabinet Office

Government of Japan

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Section 1 Problems Facing Financial and Other Companies

1. Declining Function of Indirect Finance
Japan's financial system depends heavily on indirect finance
    Japan's financial system is dominated by indirect finance mediated by financial institutions and other financial institutions.(2) For enterprises (non-financial companies), loans from financial institutions account for 39% of their outstanding debts. Direct finance through equity and bond issues account for 36%. The percentages are almost equal. However, Japanese financial institutions have traditionally held equity shares and bonds as issued by their client enterprises while building up close relations with them. Therefore, equity shares and other investments held by financial institutions may be combined with loans to constitute effective indirect finance. Consequently, the portion of debts at enterprises made up by effective indirect finance comes to 50%, against 26% for direct finance.
    This is because Japan has historically strengthened financial institutions in allocating funds for economic development. At the same time, financial institutions have built up close relations with client enterprises by purchasing and holding bonds and equity shares issued by these clients as well as providing them with loans. These institutions have thus provided direct finance within the framework of indirect finance. Furthermore, the development of direct finance might have lagged behind as the financial system has focused on indirect finance.
    Especially significant to indirect finance have been main banks, the predominant lenders to enterprises. An enterprise's main bank has traditionally built up long-term relations with the client through cross shareholdings and the dispatch of directors, and lent money to the client while continuously monitoring the financial conditions of the client. This has encouraged other financial institutions to provide the client with loans. When the client's business falls into financial difficulties, its reconstruction or liquidation is led by the main bank.

Declining function of indirect finance
    The function of indirect finance, which had supported Japan's economic development, has declined since the collapse of the bubble economy. For example, loans by financial institutions have continued to decrease. Loans in 2002 were only 82% of their 1991 level. Since enterprises' access to direct finance has been limited in Japan, this has meant a decline in the overall function of Japan's financial system as a whole.
    Apparent factors behind the declining function of indirect finance include the non-performing loan problem at financial institutions and excessive debts at enterprises.
    The collapse of the bubble economy led to massive non-performing loans at financial institutions. As the economic slowdown has continued, new non-performing loans have emerged year by year. Non-performing loans have served to deplete the capital base of financial institutions, threatening to injure their financial health. These institutions have thus reduced their risk tolerance and grown more cautious of providing loans for business investment and other purposes. As financial institutions have been faced with such difficulties, the function of main banks has been transformed.
    On the other hand, non-performing loans at financial institutions mean excessive debts at enterprises. Excessive debts have placed great pressures on their financial conditions. This means that financial institutions have seen rising credit risks. Enterprises have thus had difficulties in raising funds from financial institutions. As a result, enterprises have been forced to adjust their balance sheets by cutting their demand for funds for business investment and other purposes and by giving priority to debt repayment (see Figure 2-1-1).
    In this way, the reasons of both financial institutions and enterprises have been behind the declining function of indirect finance. We would like to demonstrate this point by analyzing the determinants of business investment.
Figure 2-1-1 Non-financial Enterprises' Business Investment (all industries)

2. Effects on Business Investment
Changes in determinants of business investment
    We have conducted a panel data analysis of business investment by listed manufacturing enterprises between fiscal 1988 and 2001 to specify the determinants of business investment (see Appended Note 2-1).
    Basic determinants of business investment would seem to include capital productivity and capital cost. We have devised a model that treats business investment as an explained variable and the return on assets and interest rates on debts (that are respective proxy variables for marginal capital productivity and capital cost) as explaining variables.(3) Considering the presence of capital stock adjustment pressure, we have added capital stock to the explaining variables. In order to grasp how business investment has been influenced by the enterprises' financial situation, we also added cash flow, long-term borrowings and bond issues to the explaining variables. In a bid to check whether the enterprises' relations with main banks have had any effect on their corporate finance, we adopted a dummy variable.(4) The periods for the analysis are the bubble period (fiscal 1988-92), the post-bubble period (fiscal 1993-97) and the recent period (fiscal 1998-2001).
    The main results of the analysis are as follows (see Table 2-1-2):
    First, capital productivity had a significant positive effect throughout the three periods from fiscal 1998, while capital cost had a significant negative effect after the bubble period. This reaffirms the basic determinants' real effects on business investment.
    Second, capital stock had an insignificant negative effect in the bubble period and a significant one after that period, indicating that capital stock adjustment pressures affected business investment after the collapse of the bubble.
    Third, cash flow had a significant positive effect in the bubble period, a significant negative effect in the post-bubble period and no significant effect in the recent period. This is consistent with the fact that enterprises used cash flow primarily for debt repayment while holding down business investment in the post-bubble period and lacked the will to expand business investment in the recent period (see Figure 2-1-3).
Table 2-1-2 Business Investment Behavior and Financing (Manufacturers)
Figure 2-1-3 Manufacturers' Business Investment (for all sizes of enterprises)
    Fourth, long-term borrowings had an insignificant negative effect in the bubble period and a significant negative effect in the post-bubble period. This indicates that excessive debts forced enterprises to curtail business investment and give priority to debt repayment in the post-bubble period. Long-term borrowings had no significant effect in the recent period, hinting that excessive debts were no longer a serious problem for manufacturers.
    Fifth, bond issues had a significant positive effect in the bubble and post-bubble periods. This may be because the enterprises that could issue bonds depended on bond issues for business investment while cash flow and long-term borrowings had negative effects on business investment. They were blue-chip companies with huge gross assets (see Figure 2-1-4). However, bond issues had no significant effect in the recent period, indicating again that cash flow and long-term borrowings were no longer financial constraints.
Figure 2-1-4 Gross Asset Sizes and Debt Details (Comparison with sector average)
    Sixth, the relations with main banks had no significant effect in the bubble period, a significant positive effect in the post-bubble period and a significant negative effect in the recent period. This indicates that enterprises with main banks could increase the post-bubble borrowings for their business investment beyond their repayment capability as it turns out. But in the recent period, there is a possibility that so-called main bank relations relatively constrained enterprises' financing ability in opposition.
    As indicated by the findings above, while listed manufacturers based their business investment decisions on capital productivity and capital cost in principle, excessive debts tended to force them to put priority on debt repayment in the post-bubble period (fiscal 1993-97). On the other hand, main banks increased lending to ease financial constraints in the period. Lending in this period might have included what are so-called oigashi, additional loans to keep heavily indebted companies afloat.
    In the recent period (fiscal 1998-2001), cash flow, long-term borrowing outstanding, bond outstanding and other variables indicating financial constraints had no significant effect on business investment. This would seem to reflect general restraint in business investment. The relations with main banks had a negative effect on business investment in the recent period, suggesting that massive non-performing loans forced banks to reduce their risk tolerance and grow more cautious about lending money. Financial institutions' cautiousness has been criticized for what is called kashi-shiburi, reluctance to lend money.

3. Effects on SMEs
Decline in trade credits for SMEs
    Small and medium enterprises disclose less business information and have less access to the capital market than larger enterprises. Consequently, they would seem suitable for indirect finance where financial institutions lend money to enterprises while conducting appropriate examination of their financial conditions.
    But financial institutions' outstanding loans to SMEs have continued their downturn, falling from ¥235 trillion in 2000 to ¥199 trillion at the end of 2002. Cash flow, financial institutions' lending attitude and interest rates on borrowings indicate that SMEs have generally remained in a severe financing environment since the late 1990s (see Figure 2-1-5). A decline in financial institutions' risk tolerance has apparently been combined with rising credit risks for heavily indebted SMEs to exert a downward pressure on SME loans.
Figure 2-1-5 Present State of SME Finance
    SMEs have had difficulties in raising short-term funds for daily operations as well as long-term funds for business investment. Enterprises can take in trade credits in addition to financial institution loans in short-term finance. Trade credits for SMEs declined far faster than for large and leading medium enterprises in the 1990s. The average collection period (credits divided by sales) for SMEs has also shortened (see Figure 2-1-6 (1)).
    Even though lending rates have dropped under the easy monetary policy in place since the 1990s, financial institution loans and trade credits for SMEs have declined as discussed above (see Figure 2-1-6 (2)).
    This attests to a severe financing environment for SMEs.
Figure 2-1-6 Trade Credits for SMEs

Policy measures for facilitating SME finance
    Given such situation, the government created a safety net guarantee and lending system in December 2000 in a bid to facilitate SME finance.(5) It also launched the guarantee on loans backed by accounts receivable(6) in December 2001 and the refinance guarantee system for cash flow facilitation(7) in February 2003.
    Further, the Bank of Japan decided in June 2003 to add asset-backed securities to securities subject to outright purchases in money market operations. The assets include accounts receivable. The decision entered into force in late July.(8)
    ABS and other securities backed by accounts receivables amount to only about 2% of outstanding accounts receivable in Japan. But bills and accounts receivable capture 17% of assets at enterprises (non-financial companies). The ABS market thus has a great potential for development (See Figure 2-1-7). Therefore, the BOJ measure is expected to help SMEs diversity fund-raising means. This would also help prevent a decline in trade credits by encouraging SMEs to increase accounts receivable for securitization.
Table 2-1-7 Portions of Liquid Assets and Debts
    We have just reviewed the effects of problems at financial institutions and enterprises on business investment and SME finance. One finding is that massive non-performing loans and excessive debts have prevented indirect finance from working well. The effects have been more serious for SMEs that limit disclosure of financial conditions than for large enterprises that can raise funds through issuing securities.
    In order to overcome the difficulties, Japan must resolve the non-performing loan problem at financial institutions to normalize indirect finance. Enterprises, for their part, are required to reduce excessive debts, turn around their business conditions and increase their profitability. In Sections 2 and 3, we analyze and consider present efforts and problems in respect to rebuilding finance and enterprises.

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