Policy Update 008

What Lies behind Sagging Stock Prices: A Long-term View Needed to Address the Issue

TSURU Kotaro
Senior Fellow, RIETI

The stock prices have been weakening since the latter half of last year, and on April 14th, the Nikkei Stock Average finally hit its lowest level since the bursting of the bubble economy. The business community is deeply concerned about the stock prices that continue to sag, and on the same day Japan's three major business lobby groups, including Nippon Keidanren, proposed to the government a one-year freeze on taxes on capital gains and dividends to invigorate the stock market. Unfortunately, discussion of stock price moves tends to be an afterthought and hardly ventures beyond generalized views of the markets. However, despite such restrictions I would like to discuss what lies behind the recent stock price moves and how to deal with the situation.

One reason the sense of crisis regarding the sagging stock prices has heightened is because the stock market seems to show no signs of recovering despite the Iraq War, which has jittered the stock market since the bombing started in mid-March and has shown signs of an early end. The global stock market has been dominated by a bearish sentiment, inspired by the unsettling world situation, but Japan's weakness still seems more profound than other markets. This proves that Japan's weakening stock prices cannot be explained by world affairs alone.

One reason particular to Japan is the cloudy domestic economic outlook since last fall. But further "culprits" of Japan's sagging stock prices are the two selling forces caused by the "return of government portion of corporate pension funds" and the "sales of cross-holdings". The corporate pension fund is a procurement system where the corporations deduct the pension premium from the employee's salary and manages the state-contributed portions of the collected funds. But the scheme is a defined-benefit pension plan (meaning the yield is predetermined), and the fund managers have failed to secure a yield high enough to cover benefit payments, because of the recent low interests and falling stock prices, forcing corporations to cover the losses. This covering of losses has reached a limit, and funds have been forced to dissolve, prompting the government's decision to allow corporations to return to the government the portion of their corporate pension fund, which they had formerly managed and paid out on behalf of the government. In order to return the state-contributed portion, the corporations must cash the assets which they had been managing (or combine assets to correspond with TOPIX), triggering sales for cash in the market. Until now, only the return of the future portion was allowed, or the amount of funds the firms have to accrue in their employee pension fund in the future. But when return of the past portion and of reserves becomes possible in October, the selling is likely to increase.

Sales of cross-holdings have been taking place for the last few years, but even without the Bank of Japan talking about it and buying up bank shares, moves to decrease share holdings to counter the risk caused by stock price fluctuation on wasted equity capital have been the most important management issue for the banks. On the other hand, corporations which own bank shares are also worried about the bank share prices which continue to decline, triggering further sales of cross-holdings. But what one must take note of here is that the fall in bank shares was most likely caused by major banks themselves, which recklessly increased their capital ahead of the end-March fiscal year close. In reality, the recent corporate finance theories say that issuing stocks does not necessarily mean a cheap way of fund-raising. In other words, market participants will view moves to seek a capital increase which are not necessarily advantageous to existing stock holders as a sign that the banks have some bad news that it wants to hide from its share holders ("the lemon problem" of Nobel Prize laureate Prof. Akerlof), and will consequently seek a risk premium. Share prices will hence be undervalued and fund raising costs will rise, and in extreme cases, capital increase itself may become difficult. This "episode of capital increase" by the mega-banks reminds us of the basic economic principle, "no free lunch."

When viewed from this perspective, it is unlikely that the "increasing murky outlook (of the economy)", which is the fundamental key to stock price movements, and the selling pressure from "pension funds" and "cross-holdings", will change any time soon. On the other hand, it is the well-performing "blue-chip shares" held by funds and banks that are affected by these selling pressures, and it is the decline of these blue-chip shares that the business community worry about. But if the fundamentals are strong the price of these shares will rebound fast, and it is not correct to be overly concerned about the supply and demand balance issue. Then what is the fundamental perspective needed to deal with the situation?

First, there is little meaning in taking stop-gap measures to address short-term stock price movements as the effect will be limited. Therefore changes in tax policy, as proposed by the three business lobby groups, will only create confusion. Calls from the ruling LDP to freeze mark-to-market accounting rules and to delay the planned start of permanent impairment accounting are mere stop-gap measures which do not fundamentally address the problem. As seen in the three-month easing of share buyback restrictions implemented in late March, it is extremely worrying to see such stop-gap measures go unchecked. Truly effective measures should not be such short-sighted attempts, but should be the proposal of a large political framework which will efface uncertainty over the future of the Japanese economy and the spiral of deflation. Moreover, such measures should not only address the cause of short-term selling pressure but also address the problems in the banking sector that form the "dark clouds" over the economy, and the pension problem, which is the source of insecurity about the future.

Secondly, the Nikkei Stock Average is only one of many indicators, and it is dangerous to debate the entire Japanese economy and stock market based on this indicator alone. There are still many companies which are doing well using technology and management that no one else can imitate. But evaluations of such firms are affected by the negative outlook of the macro-economy. The true purpose of the stock market is to evaluate individual firms based on their business performance and their outlook. The key to reviving the Japanese economy is for the stock market to take a close look at the companies individually, and create a positive cycle of building and increasing the number of such creative companies.

>> Original text in Japanese

May 12, 2003

May 12, 2003