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FRBSF

WEEKLY LETTER

February 3, 1989

Japan's Stock Market
The Japanese stock market is now the world's
largest stock market. The market value of its
listed shares accounts for over forty percent of
total world equity. This compares with the
roughly thirty percent share covered by the New
York stock market.
Since 1982, Japanese stocks have grown almost
350 percent in value. Even the October 1987
global stock crash only temporarily slowed the
rise. At year-end 1988, the Tokyo stock market
stood more than 10 percent above its pre-crash
peak, compared to the U.S. Dow Jones index,
which was still almost 20 percent below its
previous high attained in August 1987.

stock prices in Japan. (For a discussion of the
possible causes of the worldwide phenomenon,
see the Letter of April 29, 1988.) During the week
of October 14, 1987, the Nikkei index fell 18 percent. This decline, however, was well below the
30 percent drop of the New York Stock Exchange
over the same week. (See chart.)
Dow Jones Industrial Average
And Nikkei Index

32,500

3,250
Nikkei -

3,000

.:.; .....:.....:.....:

2,750
,,'

2,500

27,500
25,000

. ....'
.....
:.~

2,250

.... 30,000

22,500

This Letter discusses the reasons for the Tokyo
stock market's apparent resilience and the prospects for its continued growth.

2,000

20,000

1,750

17,500

1,500

15,000

The crash

1,250

Between October 1982 and September 1987,
stock market prices in Japan grew more than
threefold, as measured by the Nikkei index of
225 selected stocks, the most widely followed indicator. Most of this rise can be attributed to the
rapid growth in Japan's economy; during this
period, real GNP averaged four percent growth
annually. However, the Japanese stock market
surged even during 1986, when the Japanese
economy was lagging, hurt by the rising yen.
One factor contributing to the continued rise was
the cuts in interest rates in 1986 and 1987 that
were intended to spur the economy but also
raised share prices by lowering the discount rate
applied to future stock dividends. In addition,
limited taxation of capital gains encouraged
investment in the stock market, particularly as
ongoing financial market deregulation made
funds more liquid for potential investors. Speculation in land also may have played a role, as
investors sought to buy shares in companies that
owned valuable real estate in a market of booming property values.
The worldwide crash in sfock markets in October
1987, however, also halted the upward trend of

12,500
86/Q1

86/Q3

87/01

87/03

88/01

88/03

What explains the relatively limited decline of
the Japanese stock market during the period
following the crash? Various factors related to
the structure of the market and the regulatory
involvement of the government apparently
played a role.
For one, Japan's Ministry of Finance (MOF) maintains a rather close relationship with the Tokyo
Stock Exchange (TSE) and its principal members.
Brokers routinely lend employees to the ministry,
and ministry workers are lent to the exchange for
extended periods. Most analysts believe that during the crash the MOF informally advised Japanese brokers and institutional fund managers not
to sell. In fact, most of the drop in Japanese share
prices during October was attributable to sales
by individual and foreign investors, rather than to
institutional investors. The Bank of Japan also
helped reduce concerns about a possible shortage of funds following the crash by indicating
that it would maintain liquidity, and in fact did
so. (The Federal Reserve adopted a similar policy
stance following the
stock market crash.)

u.s.

FRBSF
A second factor that limited stock sales and kept
prices from falling further in the Tokyo market is
its relatively high concentration of ownership.
Financial and nonfinancial institutions own more
than three-quarters of all shares, and a large
chunk of these shares are held by groups of
shareholders with close business relationships.
For example, companies often own shares in
the.ir customers or suppliers as tokens of longterm relationships and good faith. In addition,
complex webs of cross-shareholdings have arisen
because holding companies are banned. By curtailing share trading, the concentrated .market
structure limited downward pressure on prices.
Not only are shares concentrated in the hands of
institutions and industrial firms, but the marketing of them is controlled, as well. Share-holding
institutions closely follow the advice of the four
leading securities companies, Nomura, Daiwa,
Nikko, and Yamaichi, which account for 60 to
75 percent of the trading in Tokyo.
Share-trading rules also may have played a role
in limiting the decline of prices during the crash.
First, although the Japanese government does not
establish specific minimum margin requirements
for purchasing stock with borrowed funds, the
Tokyo Stock Exchange sets a minimum required
payment, which it adjusts depending on market
volatility. Similarly, the Tokyo Stock Exchange
suspends trading' in a stock if the stock's price
rises or falls by more than a predetermined percentage (10-20 percent), or if the number of buy
or sell orders exceeds the other by ten times.
Such a wide disparity in the numbers of buy and
sell orders could be viewed as a signal that stock
prices were under pressure since, unlike the specialist system of Wall Street, the saitori, or
"matchmakers," in Tokyo simply match up buy
and sell orders; they do not trade for their own
accounts.
In addition, the Japanese government had not yet
allowed trading in stock futures and options, nor
the use of computer-programmed trades at the
time of the crash. (The MOF allowed futLJres trading in 1988.) In contrast, futures and options
trading, .as well as computerized program trading, are believed to have exacerbated the decline
in the U.S. stock market.

Lastly, prudential regulation of financial institutions in Japan limits the role of such institutions
as large active investors in the market. Institutional investors such as life insurance companies,
which typically do not have cross-share-holding
relationships with other firms, are not permitted
to keep more than 30 percent of their assets in
shares. These restrictions further lessen the extent
to which large blocks of shares are traded in the
market.

Resurgence
Since early 1988, the Tokyo stock market has
fully recovered from the decline of last year and
has surged to new highs. As of the end of December 1988, the Nikkei index stood at 30,159,
compared to its pre-crash peak of 26,646, a rise
of 13 percent.
Why has Japan's stock market been so resurgent?
Are the gains sustainable? Is another crash in the
offing?
The general growth of the Japanese economy in
the past year has been one factor in the recent
stock market surge. Despite a downturn in the
second quarter, the economy grew at an average
annual rate above five percent over the first three
quarters of 1988. Robust growth is expected in

1989.
Several government actions in 1988 also played a
significant role in bolstering market confidence
arid spurring more stock buying in Japan. In January 1988, the MOF postponed for one year new
accounting rules on special investment funds
called tokkin, which offer reduced exposure to
capital gains taxes. The new rules originally had
been proposed to dampen the speculative use of
these funds for tax avoidance. The postponement
was adopted in order to deter the large investmentinstitutions, which account for an estimated
70 percent of tokkin assets, from selling off their
holdings aheadof the end of the fiscal year in
March 1988, in order to realize capital losses
before the rules applied. The day the postponement was announced the Nikkei index rose 5.6
percent.
In April, the government further bolstered the
stock market by ending the tax-free status of $2.4

trillion in small, low-yield savings accounts,
known as maruyu. In response, some of these
funds moved into the stock market. Also, the
government has allowed life-insurance companies to boost from 3 percent to 5 percent the
proportion of their assets that can be placed in
tokkin investments. And the opening of stockindex futures trading should increase investor activity in the market by facilitating more
sophisticated investment strategies.

How sustainable is Tokyo's rise?
Many analysts argue, however, that these "fundamentals" still do not justify the heights to which
. the ja.pa.nese stock market ha.srisen. They contend that a speculative bubble is at work in
japan, and that it may soon burst. These financial
experts worry that should the bubble burst, investors would pull money out of other markets,
triggering another worldwide crash.
By American standards, japanese stocks do indeed trade at astronomical prices relative to the
earnings of the firms that issued the shares. On
the New York Stock Exchange, price-earnings
ratios run about 15 to 1, while in Tokyo the multiples are closer to 60 to 1. Nippon Telegraph and
Telephone has traded at 158 times its earnings.
Relatively low dividend yields are also cited as
evidence that shares are overvalued.
However, many japanese analysts argue that
these indicators do not represent good measures
of the true value of japanese firms. They attribute
the high-price earnings ratios in part to accounting rules that allow firms to understate earnings
and thereby reduce their taxes. In addition, because many japanese companies cross-hold large
blocks of stock issued by other companies,
which are seldom traded, few shares are actually
bought or sold. As a result, japanese companies

often treat their shares more like bonds, and act
to ensure investors steady, though low, dividends,
with the investor making money from tax-free
capital gains on rising share prices.
Although these arguments suggest that the recent
rise in prices is not due to a speculative bubble,
further rises on the order of past gains are not
likely, either. In fact, several factors may work to
slow down the market in the period ahead. Effective capital gains taxes will be raised as a
result of the recent tax reform legislation. The real
estate market has leveled off, in part because of
stricter government requirements for property
transactions, abolition of tax breaks on property
sales, and government "guidance" encouraging
banks to curb their property loans. This is dampening demand for real-estate related stocks. In
addition, because private bond markets are relatively undeveloped in japan, japanese firms are
expected to issue large amounts of equity in
coming months to finance capital expansions.
Because of new international guidelines on capital adequacy, japanese banks, which have relatively low accounting capital ratios, also may
need to raise new capital. By increasing the supply of equity shares, these factors may slow down
the market. Macroeconomic developments, such
as higher interest rates, also could slow the flow
of funds into equities.
On balance, ongoing financial market deregulation and the general good health of the japanese
economy should stimulate the continued flow of
investment into the stock market over the long
run, though possibly at a slower rate than in the
past.

Reuven Glick
Senior Economist

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be adilressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

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