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With every bout of weakness in the US economy, investor concern about a possible ‘lost decade' - a repeat of Japan's stagnation and deflation - resurfaces. Yet, similar initial conditions - the bursting of a sizeable asset bubble and excessive leverage in some sectors of the economy - need not lead to the same result. That's because despite the bubble, there was nothing inevitable in Japan's stagnation and deflation.

There was nothing inevitable about Japan's trajectory: The reasons for the long stagnation and deflation have less to do with the initial conditions - the bursting of the asset bubble - than with what happened after it burst. In the most general of terms, the following factors contributed to Japan's problems:

I.          Monetary policy, while in general expansive, was insufficiently aggressive and not consistent enough.

II.        Similarly, fiscal policy was characterised by much stop-and-go even though the overall stance was very expansionary.

III.       Even more importantly for its long-term trajectory, Japan's failure to reform the financial system. This resulted in widespread ‘evergreening' of loans to ‘zombie' companies - credit extension to insolvent entities. Healthy companies and sectors were thus starved of credit, which undermined the economy's productive potential and stunted growth.

IV.       External events - the Asian Financial Crisis in 1997, and periodic yen strength despite a weak Japanese economy.

So, given similar initial conditions, the above provides a useful checklist with which to assess the likelihood of the US following Japan.

I. Monetary Policy

Proactive, not just reactive: Monetary policy reacted early, and aggressively, against the deflationary threat. In fact, the Fed (and other central banks, such as the BoE) can be said to have acted pre-emptively to stave off such threats. This was one of the main lessons from studying the Japanese experience: be proactive to prevent deflation (see The Global Monetary Analyst: The Past, the People, the Policies, October 26, 2011). The palpable consequence of this proactive stance is that real interest rates are now negative - something the Bank of Japan never really achieved. That is, the effective monetary policy stance is much more stimulative now than it ever was in Japan. In addition, we think the Fed's stance will be consistent - that is, it will not exit prematurely as the Bank of Japan did twice (in August 2000 as it prematurely exited its Zero Interest Rate Policy; and in March 2006 as it exited QE too early).

II. Fiscal Policy

So far, so good? Similarly, fiscal policy has been very aggressive from early on. In addition, it has been consistently expansionary - until now. As fiscal policy decisions are less streamlined and more susceptible to the vagaries of the political process than central bank decisions, we worry that the US will tighten fiscal policy next year - prematurely, in our view. It thus risks repeating the mistakes of Japan's fiscal policy, where premature tightening contributed to the economy sliding back into recession (for more details, see Global Economics: Back to the Future? September 14, 2011).

Fiscal policy begets monetary incentives: enter ‘fiscal dominance': Note the different trajectories of the public debt ratio. Debt in the US rose rapidly in response to the crisis as discretionary expansionary fiscal packages came on top of the automatic stabilisers. In Japan, by contrast, public debt climbed relatively slowly, mostly as a consequence of the stagnation of the economy and the concomitant stagnation in tax receipts - indeed, after 1997, nominal GDP stagnated, courtesy of very weak real GDP growth and deflation. Intriguingly, this difference in the debt trajectories implies strikingly different incentives for monetary authorities. The near-explosion of US public debt essentially demanded QE for fiscal policy to have the desired expansionary effect; it also made averting deflation an instant imperative for the Fed. By contrast, the BoJ no doubt did not feel compelled to act aggressively because Japan's debt situation was comfortable. Finally, monetary policy is now a hostage of fiscal policy, as the inflation-targeting regime gives way to a fiscal dominance regime (see The Global Monetary Analyst: Is Modern Central Banking Ancient History? October 19, 2011): when public debt is high, raising interest rates can destabilise the economy.

III. Financial Sector Reform: Of Zombies and Long-Term Dynamic Efficiency

How capitalism works... Capitalism generates growth because prices give signals to entrepreneurs and investors about where to allocate scarce resources; and because failing entities free up resources that successful ones can draw upon to grow - a process called ‘creative destruction'. For more than a decade after the bubble burst, Japan's financial system impeded creative destruction.

...and how Japan's financial system destroyed creative destruction: This process of creative destruction was stifled in Japan because the financial system kept extending credit to insolvent firms (for more details, see the grey box). This ‘evergreening' of loans to ‘zombie' firms starved efficient enterprises and industries of credit and inhibited investment, productivity improvement and job creation - with grave consequences for the economy's dynamic efficiency and ability to grow. Important recent research (see Caballero, Hoshi and Kashyap (2008), Zombie Lending and Depressed Restructuring in Japan, American Economic Review) estimates that the rise of zombie firms decreased investment by 4-36% per year, depending on the industry considered.

Supply trumps demand in the long run: In our view, this factor is more important in the long run than monetary or fiscal policy mistakes because it mostly affects the supply side of the economy. Hence, it explains the sheer duration of the Japanese episode in a way that demand-side explanations cannot (for an analysis of the deeper, structural factors behind Japan's stagnation, see Robby Feldman, Deflation: Will America and Europe Follow Japan? September 6, 2010). At the same time, it also helps to explain why demand-side policies were less effective: while for example monetary policy affects the price, and hence the quantity, of credit, it cannot influence the efficiency of the banking system's credit extension - that is, whether a given quantity of credit flows to the right recipients.

There are no zombies in the US: Equally importantly, this insight bears on the question of whether the US today will follow Japan into a decade or more of stagnation and deflation. Crucially, there is no such mechanism at work in the US today. (Indeed, the fact that the US corporate sector finances itself predominantly through markets, rather than banks, always made the existence of such a channel much less likely.) Investors who limit themselves to assessing the similarities and differences of the two cases based on the optical likeness of charts are bound to miss this point.

IV. External Events

It is generally hard to predict financial crises and misaligned exchange rates. In the present case, however, there are no prizes for guessing the external event that could derail the US recovery: the eurozone debt crisis.

Summary: the US won't become Japan - thanks to Japan: Not least because of Japan's experience, and because Japan's experience had been studied closely outside of Japan, monetary and fiscal policy have - so far at least - avoided making the same mistakes. Perhaps more importantly in the long run, the same is true for regulatory policy: financial system reform and recapitalisation of banking institutions in the US was swift, and aggressive. To be sure, there are plenty of near-term downside risks as well as medium-term headwinds for the US economy. But we believe that the US stands a good chance of avoiding a Japan-type outcome of stagnation and deflation.

BOX: Japan's Stagnation: An Analytical Perspective

Macroeconomics and Macroeconomic Policy

The trigger of Japan's stagnation is well-known: an asset price (both land and equity) bubble developed in the 1980s, which burst at the end of that decade (nominal/real equity prices peaked in December 1989/December 1989; nominal/real land prices peaked in 3Q91/1Q91).

Not least thanks to the considerable benefit of hindsight, we are able to say that the policy response was insufficiently aggressive and insufficiently consistent. Although stabilisation tools were deployed - both fiscal and monetary policies were, in general, very expansionary on average - policy-makers were at best reactive, and there was a lot of stop-and-go.

This was particularly the case on the fiscal side, as big expansionary packages were often followed by considerable tightening (most prominently in 1996/97, which contributed to the economy backsliding into recession; see Global Economics: Back to the Future? September 14, 2011). Monetary policy is guilty of acts of omission as well as commission. The latter include two premature exits: from ZIRP in August 2000 and from QE in March 2006.

External shocks, by and large unrelated - or seemingly unrelated - to developments in the domestic economy were the Asian Financial Crisis in 1997, and periodic episodes of yen strength. Currency moves were often seemingly divorced from what the state of the economy would have needed; for instance, the yen appreciated strongly in both nominal and real terms during 1993-94 and 1998-99.

The Financial System

During the build-up of the asset bubble of the 1980s, Japanese banks lent heavily to small- and medium-sized enterprises (SMEs), with real estate as collateral. Many of these loans essentially stopped performing as the land price bubble deflated from the early 1990s onwards. This was exacerbated by the fact that banks were allowed to count their holdings of shares in companies as capital. During the build-up of the bubbles, this boosted their capital and hence their lending. As equity prices tumbled, bank capital suffered.

Seemingly perversely, banks responded by continuing to lend (‘evergreening') to essentially insolvent borrowers (‘zombies'). However, this response was rational, given: a) political pressure to continue lending to SMEs so as to avoid bankruptcies and job losses; b) recognition of losses for the banks would have impaired their capital and made it difficult to meet their Basel-mandated capital requirements; and c) regulatory forbearance, which allowed banks to extend these loans despite mounting evidence of borrower insolvency.

Evergreening of loans manifested itself in various ways: a) bank loans were being extended disproportionately to underperforming sectors such as real estate, construction and retail; b) firms with low profit rates and poor stock market returns tended to get additional credit; and c) an increasing share of firms receiving loans at below market rates.

Despite regulatory forbearance, there were periodic failures of financial institutions, recurring financial crises and associated credit crunches.

The Consequences of Zombies

As banks rolled over outstanding loans to ‘zombie' companies in the construction, real estate and retail/wholesale sectors, they reduced the availability of credit to manufacturing and new businesses - the (potentially) efficient parts of the economy. That is, not only were productive firms in other industries starved of credit, but zombie firms also congested the industries they operated in, inhibiting entry by more efficient firms. As a result, "the depressed restructuring that has accompanied the financial crisis [...] left Japan with a dysfunctional banking system that misallocate[d] funds and a perverted industrial structure in which subsidized inefficient firms [were] crowding out potentially profitable ones." According to important recent research by Caballero, Hoshi and Kashyap (2008), the estimated effect of the rise in the proportion of ‘zombie' firms was to suppress investment by 4-36% annually depending on the sector considered.

This also explains why aggregate demand remained weak despite generally supportive demand policies by the Bank of Japan and the fiscal authorities. Policies to stimulate demand will have short-lived effects on the economy unless they can set in motion a chain reaction of job creation and productivity improvements. Such a process also requires ‘creative destruction': non-viable firms exiting allows more productive firms to enter and make profits and releases resources (capital and labour) upon which the more productive firms can draw to grow. More to the point, it is not sufficient for monetary policy to engineer lower real interest rates if the credit based on those interest rates does not flow to the right sectors and firms.

Questions and Objections

Q: Is evergreening not the same as a credit crunch?

A: No, these are two different things. A credit crunch occurs when financial institutions tighten credit supply, leaving unsatisfied credit demand by corporates and/or households. That is, it is about the aggregate amount of credit extended to the economy not being sufficient. Evergreening, on the other hand, concerns the efficiency - or otherwise - of the allocation of a given supply of credit; i.e., whether a given US$100 of lending extended flows to the right companies and sectors. It is possible to have a credit crunch without major implications for the efficiency of credit allocation: this occurs when credit is tightened first to the least-efficient firms.

Q: Is QE evergreening? After all, companies are kept alive thanks to the Fed engineering low interest rates that would have to close otherwise.

A: No, QE is not evergreening. First off, when corporate financing is mostly capital markets-based, as is the case in the US, credit decisions are largely made by the market - which is likely to be far more objective than a bank which, as the example of Japan shows, may have different incentives. Second, and more importantly, the fact that a company is able to obtain cheaper credit in the market than would have been the case without QE does not constrain the availability of credit to other companies. That is, there is no crowding-out effect.

Q: How can you say that there is no credit allocation problem in the US? After all, consumers are unable to get credit or remortgage.

A: This problem is more akin to a credit crunch:

•           It is about the aggregate level of credit extension, not about whether credit flows to the right sectors, firms or individuals.

•           The macroeconomic consequences are very different. The implications of a clogged remortgage or consumer credit channel for the dynamic efficiency of the US economy are likely to be small. The inability of households to remortgage affects the disposable income of the household sector and hence aggregate demand; it has little bearing on whether the US economy is able to generate the right jobs in the right companies and in the right sectors.

Russia
WTO Accession at Last
November 14, 2011

By Jacob Nell | Moscow & Alina Slyusarchuk | London

Russia joins the club: After an 18-year accession process, Russia is poised to become the last major economy, accounting for over 2% of global trade, to join the WTO. On November 10, the Working Group - in effect the WTO membership - approved the package of measures setting out the terms of Russia's accession.  Russia will now join the WTO, following approval by the WTO Ministerial Conference in December 2011 and ratification by the Russian parliament before June 15, 2012.

A positive for the economy... We see Russian accession as unambiguously positive for the economy.  A World Bank study estimated that the direct effects of accession would add 3.3pp to GDP in the short run - 2.4pp from increased services FDI, 0.6pp from tariff reform and 0.3pp from improved market access - and 11pp in the long run, when the effect on investment is taken into account.

...and a framework for modernisation: More generally, WTO accession will signal the authorities' commitment to an open, rules-based investment and trading regime. It should increase confidence that the government's modernisation agenda to improve the investment climate will be implemented, since many of the reforms are now commitments under the WTO agreement.

1. The Agreement

A wide-ranging set of changes: The scale of the impact of WTO accession is very broad, with significant sector and macro impacts.  There will be an average cut of 22% in the tariff on merchandise goods imports, a widespread increase in market access for services and the elimination of a number of barriers to trade.

2. The Impacts 

Sectoral impacts: According to the World Bank, Russia's WTO accession should be positive for multinational providers of services looking to enter the Russian market in such sectors as telecoms, distribution, insurance and banking, it should help Russian exporters such as metals and chemicals companies to increase their market access and exports, and it should be negative for some inefficient Russian producers that rely on tariff protection, in sectors such as food processing, textiles and construction materials.  However, the detailed sectoral impacts of Russia's WTO accession are multiple and complex, and beyond the scope of this note.    

Trade volume to rise... The removal of some barriers to Russian exports should increase exports, while the 22% cut in tariffs over time should increase imports, with a particular effect in 2012 on accession.  Overall, we think that the direct impact on trade will be an increase in both exports and imports, and a reduction in net exports.  However, we see the effect as small in relation to other issues.  In particular, WTO accession, if supported by an appropriate policy environment, could support a strong increase in investment, particularly productivity-enhancing FDI.  In the case with strong investment, there is significant scope to increase Russian exports, particularly of commodities, and to replace imports in areas such as cars, food and medicines with domestic production.     

...and Asia's share to increase: Russia already has a diversified structure of trade, reflecting its multiple borders and ports, and the global market for commodities.  The main change since the collapse of the Soviet Union has been a sharp decline in the level of trade with the former Soviet Union, down from 25% of trade in the mid-1990s to under 15% today.  The main trading partner is the EU, which accounts for about half of total trade, but the fastest-growing element of trade is with the Asia-Pacific region, where China has emerged this year as Russia's largest trading partner with over 10% of total trade turnover.   Looking ahead, we are sceptical that trade within the FSU will increase from current levels, since: i) FSU countries have in many respects similar endowments and to that extent have less scope for mutual gains from trade; and ii) The removal of trade barriers through WTO accession and ongoing integration with the global economy is likely to support a further redirection of trade to reflect comparative advantage, with, for instance, a growth in imports of manufactured goods from China and the Asia-Pacific region, and exports of commodities to the fast-growing, commodity-poor Asia-Pacific region.

Investment - the big prize: We see the biggest scope for change in the sources of investment in Russia.  According to Rosstat, most FDI into Russia is financed from Cyprus or various Caribbean countries.  We think these data suggest that the proportion of FDI into Russia financed by multinational companies remains quite low. 

A catalyst for growth? The opportunity is that the shift to a more rules-based system and commitment to an open trading regime will spark a pick-up in FDI, as appears to have happened in China in the years following WTO accession.  The impact on GDP and welfare can be substantial. The studies find that, in the case of China, the catch-up in the productivity of the services sectors as a result of higher foreign ownership and investment and capital stock increase would result in GDP being 22.5% higher welfare gains of 16% by 2020.  In the case of Russia, as we mentioned earlier, a World Bank study estimated that the direct effects of accession would add 3.3pp to GDP in the short run, aggregate exports would increase by 13% and returns to mobile factors, particularly to capital and skilled labour, would improve (by 4.9% and 4.7%, respectively), while gains in the long run, if investment increased significantly, could amount to 11pp of GDP.

Generally, we see WTO accession as supportive of reform, since the external commitment to the WTO will provide support for implementing some difficult but growth-supporting policies in the face of domestic lobbies that are more comfortable with the status quo. 

Additional Implications

Russia has signed up to the open trading system: Some have argued that Russia has been an international anomaly in using tariff barriers to protect domestic industry, and a risk to the open trading system, since the various Russian uses of the tariff risked triggering retaliatory protectionism.  However, Russia is now joining the WTO, which implies a commitment to an open trading and investment regime, and with a tariff which will be, according to the World Bank, broadly average for acceding countries.

Jackson-Vanik repeal: The US Congress could now repeal the Jackson-Vanik amendment, which makes granting of MFN status to Russia dependent on an annual review of emigration policy, since otherwise US companies will not be able to take advantage of the benefits of WTO membership. 

OECD next? Russia has also moved from being a borrowing country to being a donor country, even as a number of DM countries have moved or are at risk of moving in the other direction. Russia will now have joined all the big international economic institutions - G7/8, G20, IMF, IBRD, BRICS - to which it aspires, with the exception of the OECD. 

3. The Timing

Why did accession take so long? We see three main blocks as responsible for the long accession process: 

•           Block 1 - perception of no gain for a commodity exporter: Many Russia policy-makers did not see a major benefit from WTO accession. Russian exports are dominated by oil and gas, which are generally tariff and quota-free.  In addition, Russia already had most favoured nation status, and so the main benefit of accession for good exporters is the right to bring anti-dumping actions, which is helpful but not transformative. In addition, Russia does not export much in the way of services, which would benefit more from WTO accession.

•           Block 2 - structural subsidies: Russia's economy when accession started was in some ways radically inconsistent with WTO membership, in particular as a result of the massive domestic energy subsidies, which Europe in particular perceived as discriminating against European companies.

•           Block 3 - infant industry: Many argued that Russian banks and companies were weak, and needed protection from foreign competition for an extended period.  This group received vocal support from producer groups that stood to lose from increased competition and freer trade. 

Why did Russia join now? We see two reasons why WTO accession is now set to proceed, when previously it did not. First, the underlying blocks have been removed, and second, the accession agreement has worked around the final Georgian and Customs Union hurdles.    

•           Removal of block 1 - the imperative of diversification: After the 2008 crisis, when Russia contracted by 7.8%, more than any other major G20 economy, there was a broader policy consensus that Russia needed to develop a more diversified economy and reduce its dependence on commodities. WTO accession became a key tool to support this process, in particular by supporting the development of services and Russia's broader integration in the global economy.

•           Removal of block 2 - energy sector reform: It is only in the past couple of years, following a long process of price and structural reform, that the electricity and gas sectors have started to operate on a commercial basis, thereby removing a key obstacle to accession.

•           Removal of block 3 - increased relative strength:  Russia is now in a comparatively strong position compared to most other countries, with low debt, high reserves, a current account and fiscal surplus, a stronger real exchange rate, profitable and well-capitalised banks, and a higher share of global GDP. In some cases, Russian negotiators have also secured protection for particular sectors, notably banking (where the agreement includes a prohibition on opening bank branches, and a cap of 50% on foreign ownership of the banking sector) and the automobile sector (where the recent large-scale ‘investment in return for preferential tariff' deals, which are inconsistent with WTO rules, have been granted a waiver up to 2018).  More generally, if a Russian sector is still inefficient and only able to compete with protection after 18 years, this suggests that the industry may never grow up. In this case, comparative advantage says that Russia will be better off concentrating resources on what it does well, and buying more of the goods and services which domestic companies produce inefficiently from more efficient foreign companies.

Clearing the final hurdles: Russia has been close to accession since about 2007, but, apart from the give and take of negotiation, over such issues as tariffs on timber exports and preferential schemes for automobile investment, there were two final hurdles which had to be cleared: 

•           Georgia: Russia's trade embargo on Georgia followed by the 2008 war significantly complicated the accession negotiations. Georgia is already a WTO member and every WTO member has to agree for any country to join.  In addition, Georgia claims sovereignty over South Ossetia and Abkhazia, including control over their trade and customs policy, while Russia has recognised them as independent states.  With Swiss mediation, Georgia and Russia eventually reached a deal allowing independent monitoring of the South Ossetian/Abkhaz customs borders on November 9, which paved the way for the Working Group to approve the terms of accession.

•           Customs Union: From July 1, 2011, Russia has been in a customs union with Belarus and Kazakhstan, with a single external tariff, so our understanding is that a change in the Russian tariff in fact implies a change in the single external tariff of the Customs Union.  At one point this was thought to risk delaying Russian entry to the pace of the slowest, but in fact Russian entry is now likely to accelerate the entry of Kazakhstan and Belarus in the near future.

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