Japan: Credit Crunch Coming

Liquidity constraint is the key word in 2008

It is time to get ready for a mini credit crunch at small and medium-sized enterprises (SMEs) and tiny businesses. The coming crunch should not develop into a severe credit contraction that envelops large corporations as in 1998, but could deal a body blow to the economy given that it exposes to risk these smaller businesses that vastly outnumber large firms and employ more workers in total. The money markets in the US were malfunctioning at the end of last year, and there is risk that non-financial sectors will also see liquidity constraints lead to freezing or postponement of capex; in Japan, once SMEs and tiny firms face liquidity constraints, their access to capex funds and working capital suffers and in the worst cases their survival is in jeopardy. The definition of SMEs varies, but the proportion of capex made by such firms is about 17% in the BoJ Tankan survey and 26% in the MoF Corporate Statistics, so this impact would be far from negligible. Our views on this issue, and on housing investment, explain why we are more bearish on the economy in 2008 than the market consensus.

What’s new

Unlike the US and Europe, which have been rocked by subprime issues, Japan to date has been suffering virtually no credit impairment. However, for reasons that are entirely unrelated to events in the US and Europe, we believe that the likelihood of a mini credit crunch in the Japanese economy is rising. Fears have already been materializing in consumer financing, but the recent revision of the credit guarantee system could depress the economy further by imposing new credit constraints on SMEs and mom-and-pop firms.

Tighter credit is showing up first in consumer finance. Consumer Financing Law (CFL) revisions were crystallized in December 2006 and take effect in stages between January 2007 (phase one) and mid-2009, raising the regulatory bars. The consumer financing business has already begun to see shrinking credit, as future reductions in loan rates and restrictions on lending relative to borrower income have been already legislated, as assessment standards become stricter. What we did not necessarily expect was that changes under this system would not only affect households, but also have a significant impact on the small businesses that rely on consumer financing to raise working and other forms of capital.

Since voluntary curbs on lending practices were instituted in 2006, the number of corporate bankruptcies has been gradually on the rise. The scale of the debts involved in each, meanwhile, has been gradually diminishing, which suggests that more SMEs and mom-and-pop businesses have been folding. The second phase of the CFL revisions on December 19, 2007 enforced limits on excessive lending. Specific measures are implemented as an independent set of rules for the industry; for example, total monthly repayments may not exceed 1/3 of monthly income or 1/36 of annual income. The aim of the system is to reduce the number of borrowers with multiple debts, but a side effect is that access to credit for SMEs and tiny firms will be constrained.

Looking ahead, lending to SMEs by banks and similar institutions may also be disrupted. Last October, the credit guarantee system was revised, reducing the portion of new loans among guaranteed loans (termed ‘maruho’ loans) underwritten by Credit Guarantee Corporations from 100% to 80%. This means that, since October, banks and others have had to underwrite 20% of the direct credit risk associated with such loans. There has not been a large impact so far, but the move is likely to choke off some of the credit supplied to SMEs and smaller firms.

In reality, banks and similar lenders have in the past been extending loans to SMEs on the condition that these are underwritten by Credit Guarantee Corporations. Banks have been able to lend comparatively smoothly to SMEs with this backing, regardless of the credit status of the borrowers. Use of the credit guarantee system was promoted aggressively as part of economic rescue package by the Obuchi administration in 1998, and delivered results which are fresh in the memory. Lenders must be more cautious now that they assume responsibility for 20% of the loan, and the need for additional safety measures such as evidence of collateral may arise. Most SMEs and family firms probably have scant wherewithal to provide this, or are already using their collateral to back other loans. This means that when credit guarantee-backed loans become due for repayment, lenders will need to charge appropriate spreads adjusted for the credit risk of the borrowers when loans are rolled over, and that it will become difficult to roll over when unsecured lending does not meet qualifying standards. Credit lines may thus be cut off. In any event, the SME and tiny firms that are the main beneficiaries of the credit guarantee system are likely to suffer in some form, from higher loan rates or tougher loan conditions.

Where we differ

The credit guarantee system applies only to loans for SMEs and tiny businesses, and the proportion of lending backed by these guarantees among overall bank and credit association lending is not high at about 6%. Loans to very small outfits also have a safety net (in the form of ‘the System that Guarantees Small Loans to Small Businesses’), so the market may be dismissing the impact of changes. However, the existing loan guarantees in the latter safety net are capped at ¥12.5 million in total, so it is debatable whether it serves the intended purpose – that is, it is likely that small businesses covered by that system are already benefiting from the credit guarantee system.

The total balance of credit guaranteed loans at the end of F3/07 was some ¥29.3 trillion (¥8.5 million per loan), and the amount of guarantees authorized during the year was about ¥13.7 trillion (¥11.6 million per loan), which implies an average turnover period of a rather short 2.1 years. This rapid turnover means that there is frequent refinancing. So, although demand to refinance existing loans will increase as the end of March approaches, when corporate funding become tighter, we expect higher loan rates as discussed above, and more cases of credit lines being withdrawn.

Upcoming events

Tightening of SME financing can already be seen from a number of data points. The corporate finance-related DI in the December BoJ Tankan, for example, showed a one point drop from the September reading in the DI for lending attitudes of financial institutions for both medium-sized and small firms (indicating less willingness to lend). The small firms’ financial position DI also dropped by one point more than that for large firms (so their funding situation is getting worse). A similar pattern emerges from the July-September survey of nationwide trends at small businesses by the National Life Finance Corporation. In the same survey, the financial position index for these firms this term dropped by a relatively large 3.4 points from the previous reading in April-June. Overall, however, we do not have an impression of severe credit contraction for SMEs. The BoJ’s bank lending data up to November does not show a meaningful drop in lending after the system for shared loan underwriting responsibility was introduced in October. However, these figures come only just after the new system arrived, and the future impact may be greater. BoJ bank lending date for December come out on January 11, and SME loan data for the same month are due at the end of January. Even if these do not confirm an accelerating decline, SME financing is likely to become increasingly tight in the January-March quarter.

Policy implications

The credit tightening above is a prime example, alongside the recent crash in housing investment, of a policy-induced problem (‘kansei fukyo’). The objectives of the system changes are probably right, in other words, but the bureaucrats have not paid sufficient heed to the implications for the real economy. The system of shared responsibility for loan underwriting is also a move in the right direction, in that it encourages lenders to monitor credit risk more strictly when loaning to SMEs. If risk management is inadequate, costs to the nation’s taxpayers ultimately increase as Credit Guarantee Corporations foot the bill. But the timing of this system change could hardly have been worse, with the economy now on the brink of a negative spiral. This recent measure to jack up the risk liability of the lending institution to 20% also seems too sudden, and could have been phased in more gradually. The authorities are likely to be on the back foot, addressing the problems created by the changes in the financing of SMEs and small businesses hurriedly and only after they emerge, when it is too late. The same is likely for the revised consumer finance regulations and the revised regulations for credit guarantee system, repeating the errors made in handling the changes in the system for verifying building standards.

On the monetary policy front, we have already rescinded our forecast for a rate hike during 2008 due to deterioration in the home and overseas economies. Since the end of last year there has been a stream of data from the US pointing to a possible recession, such as durable orders, new home sales, ISM manufacturing figures and job data, and declines in the US stock market have brought bearishness to Japan. This has come together with a strengthening yen. Under such conditions, we think that the market’s near-term focus is likely to switch from a rate hike to a rate cut. The market consensus is currently for hikes to be resumed in the second half of the year, but we view that as too optimistic. Rising energy prices are generating upside risk for the core CPI, and year-on-year inflation in the January-March quarter on this measure may well be close to 1% (about 0.8%), but rising prices at a time of slack demand serve to lower real incomes and may exacerbate demand weakness. This does not build a case for tighter monetary policy. The recent JGB rally should therefore be sustained even if prices in the near term move up.

Risks

According to news reports (Nikkei Shimbun, December 18, 2007), the Ministry of Economy, Trade and Industry (METI) wants to augment the functions of the Credit Guarantee Corporations and bring in a new system to guarantee collection of accounts receivable. The aim is to make it easier for SMEs to transfer sales credits to financial institutions and turn them into cash. For the sales credits of large companies with high credit standing, this type of business is already well established, but low creditworthiness has prevented a similar development for SMEs. If such a system proves to be effective, about ¥73 trillion in SME accounts receivables could be turned more easily into cash and this could ease funding problems considerably, making our credit concerns redundant. But to implement such a system would require related bills to revise legislation such as the Small Business Credit Insurance Law, and the chances of this getting approved by the end of the fiscal year, when demand for funds picks up, are extremely remote. There is a swathe of budget and budget-related bills (so-called sunset bills) in process, and the possibility that regular Diet proceedings will be dissolved from mid-January leaves very little time. We need therefore to focus on the downside risks ahead.

By Takehiro Sato Tokyo
Morgan Stanley
January 7, 2008