READY FOR THE GAME
Japan is slowly reclaiming its influence on Asian growth, but its banks have yet to catch up.
By Abe De Ramos

Josef Mirbach, CFO of the China operations of Hitachi Global Storage Technologies of Japan, will have a busy 2006. By the first quarter, the world’s second-largest maker of hard-disk drives will have completed the first phase of one of its biggest manufacturing investments in Asia to date. By then, the CFO will also have started funding the construction of the rest of the Shenzhen-based facility, which is estimated to cost at least US$500m, with total capacity of 80m. “We want to be close to our customers and be where the market is,” says Mirbach, referring to manufacturers of consumer electronics – from personal computers to DVD recorders to MP3 players – that are increasingly targeting the Chinese market.

The Hitachi GST investment harks back to the days in the 1970s and 80s when Japan was a major contributor to the growth of its export-oriented neighbors – and its banks were rich sources of financing for Japanese corporations and even local enterprises. In the past, Hitachi would have tapped a Japanese bank for its credit needs in China. This time around, it used internal cash flow and loans from Chinese banks “at very attractive rates”, says Mirbach. The company does not currently have relationships with Japanese banks in China.

Not surprising, since Japan has seen its influence in the region greatly diminished because of its economic troubles. “It is easy to forget that Japan used to be a major source of growth for the rest of Asia, not just as a merchandise importer, but also indirectly by providing foreign direct investment and bank lending,” says Rob Subbaraman, Asia ex-Japan economist at Lehman Brothers in Tokyo. But Japan seems ready to reclaim its old role. In the third quarter of 2005, real GDP grew 3% from 2.2% and 1.3% in the previous two quarters. The longest consecutive period of post-war economic growth lasted 57 months, says Masaaki Kanno, chief economist at JPMorgan in Tokyo. At 47 months into the current cycle – which started in early 2002 but has moved nearly impalpably – Kanno says this recovery is likely to exceed that record.

“Japan is likely to assert its trade links with Southeast Asia, and the economy appears to be making a structural revival after a decade-and-a-half of retreat,” says Daniel Lian, economist at Morgan Stanley in Singapore. This may already be happening. Exports from Asia to Japan grew 28% in the last five years. Meanwhile, foreign direct investments from Japan to Asia rose 55% over the same period; they are now back to their levels from ten years ago. Japan’s rising domestic demand itself is fueling these. Its imports from the region, says Andy Xie, chief Asia economist at Morgan Stanley in Hong Kong, “is due largely to Japanese companies producing consumer goods offshore, especially China, for the onshore market.” The Hong Kong Monetary Authority estimates that every one percentage-point increase in Japan’s GDP will correspond to a 0.76% growth in the rest of Asia.

Banks on the Mend

What remains to be seen is whether Japanese financial institutions can go back to where they were even ten years ago. Since the Asian financial crisis in 1997, the major banks have deliberately scaled down their overseas activities. Assets of Japanese banks in the form of loans overseas as of September are only 57% of their value five years ago, and 21% of their value ten years ago. Some analysts say that the overall situation will soon change. To be sure, the banks are still trying to gather their strength after 14 years in the doldrums. But at the same time that they are mending their domestic operations, they are also beginning to raise their exposure to Asian risk.

In November, the largest banks announced incomes that strongly affirmed the recovery of the sector. Earnings at Mizuho Financial Group, Japan’s second-largest bank in assets, rose 45% in the six months to September, while that of Sumitomo Mitsui, the third largest by capitalization, soared sevenfold. Less dramatic but no less significant, the Bank of Japan (BOJ), the central bank, announced that lending at major banks continues to improve, as the decline in the amount of outstanding loans eased. Such figures have led analysts to conclude that the six big banks in Japan, with assets totaling US$6.5 trn, will earn well above 2 trn yen (US$17 bn) this fiscal year, their best showing since 1985.

For now, much of the profits have been due to declining credit costs, or write-offs of non-performing loans (NPLs). It was only last May when the government declared that the system was safe from bad loans, after all seven major banks met the challenge to halve their NPLs by the year ending March, from the peak in 2002. After 140 trn yen in write-offs – which crippled the financial system for a decade – bad loans at Japanese banks, net of all loan-loss reserves, now stand at 1.2% of the total or 15% of balance-sheet equity, from 6.2% and 95%, respectively, three years ago, according to Fitch Ratings. “Looking forward, banks now face a more difficult challenge, though not as credit threatening, in generating greater sustainable profitability,” says Nigel Heath, analyst at Dominion Bond Rating Service of Canada, in a report.

On average, Japanese banks generate 60% of their profits from lending margins, which are heavily dependent on the monetary policy of the BOJ. The central bank has kept interest rates at zero for many years now, leaving banks with little room to make a profit out of their lending activities. The recent recovery in consumption, which has translated to higher asset prices – the stock market is at its highest level in five years, while urban property prices are rising – has led to speculation that the BOJ would finally end its quantitative easing policy. Kanno of JPMorgan, however, predicts the highest it could go is 0.25% by the end of 2006, lower still than his projected inflation rate of 0.5%. This implies that the BOJ feels that consumption needs further stimulus to sustain Japan’s resurgent reflation. “This is extremely supportive, and in my view asset prices will boom in 2006,” says Kanno.

Instead of being mired in a low-interest-rate environment, Japanese banks should diversify their services for a broader market, say analysts. Heath stresses that banks must differentiate their products and services. Pursuing the same customer groups has led to “intense price competition and erosion of profit margins.” They could differentiate themselves in any of three ways: lending more to consumers, reaching out to riskier small and medium enterprises, and increasing the proportion of fee-based incomes. “The important point is that the risk aspect is coming back,” says Kanno. “Individuals have started to take risk, and firms are taking more risk, while cash and liquidity are abundant.”

Large Japanese banks have missed out on lending to SMEs and consumers; smaller regional banks acted faster on these segments. But they are catching up, as they seek opportunities to acquire or tie up with consumer-finance firms. “Megabanks are keen to bolster their retail operations,” says Katsuhito Sasajima, banking analyst at JPMorgan. “Banks are targeting the market for consumer loans that charge 10% interest. This market is very small, but has substantial growth potential given that household savings rates are dropping precipitously.”

Banks are also beginning to appreciate the value of fee-generating businesses. These services – ranging from insurance to investment banking – account for just 16% of total income for the average Japanese bank, versus 30% for Citigroup or 50% for UBS. Even then, this is mostly coming from trust and securities operations, as opposed to direct fees from corporations and individuals. This is both a function of culture and regulations. “Banks tend to be very ‘nice’ to their customers,” says Hironari Nozaki, analyst at Nikko Citigroup in Tokyo. “They don’t tend to require any commissions for the services they are extending.”

Regulations have prevented banks from selling commission-based products. This changed when the BOJ allowed banks to sell insurance in October 2001 and over-the-counter securities last December. “These regulatory changes have been the reason for the strong growth in their fee income recently,” says Brett Hemsley, analyst at Fitch Ratings. “They’ve also got investment-banking type of services that are provided by the corporate banking department. Banks never used to bother with this before at all.”

These activities should pick up the slack that currently plagues the large-corporate segment, the traditional source of profits for banks. This market has been lagging, and will likely continue to lag, for two reasons. First, margins from corporate lending have been razor-thin since the 1990s, both because of the BOJ’s zero interest-rate policy and the stiff competition in the industry. Also, corporations are in fact not borrowing; most, like Hitachi, choose to fund their activities with internal cashflow. “Most corporates are still very cautious in increasing their loans,” says Naoko Nemoto, credit analyst at Standard & Poor’s. “There are companies that want to invest more, but it will be offset by most others that like to reduce their debt.”

Statistically, there are indications this is changing. Takehiro Sato, economist at Morgan Stanley in Tokyo, expects capital expenditure to rise 12% in 2006. The BOJ also noted in October that the rate of decline in loan balances of big banks is abating, and so is the rate of growth of loan balances at smaller banks. “This narrowing of the gap, between lending-growth and lending-decline rates at regional and major banks, indicates moves by major corporations to repay loans are coming to a conclusion,” says Nozaki of Citigroup. Nonetheless, as lending to big corporates inches its way to positive territory, Japanese banks are increasingly looking overseas to generate margins.

Back to Asia

“The home market will remain saturated and be extremely competitive in terms of lending opportunities, so you will see the banks moving overseas to look for opportunities,” says Hemsley of Fitch Ratings. “As we see more Japanese companies move into China or the rest of Asia and expanding their manufacturing operations there, we will see quite significant opportunities in the medium term (for banks).” Nozaki estimates that foreign assets now account from anywhere between 5 to 10% of major banks’ total assets, compared with a peak of about 20%.

In the six months to September, Mizuho Financial’s lending to the Asian market rose 23% to 1.6 trn yen from 1.3 trn yen in the same period last year. Meanwhile, Sumitomo Mitsui’s loans to Asia, including Indonesia, Thailand, South Korea and Hong Kong, rose to 1.6 trn yen from 1.4 trn yen on March 31. Japanese banks have also returned to the loan-syndication market, participating in deals with a total amount (which includes other lenders’ allocations) of US$45 bn this year, from US$21 bn in 2002, according to Dealogic, a capital-markets data provider. “It appears that mega banks have shifted gears to a more aggressive stance,” says Paul Sheard, chief Asia economist at Lehman Brothers.

On the ground, Japanese banks are establishing new branches from Shanghai to Moscow to Prague to New York. They have also been tipped to be interested in acquiring stakes in China’s largest bank, Industrial and Commercial Bank of China, which hopes to be privatized by 2007. In the United States, bankers have noted the increasing participation of Japanese banks in the leveraged-loan market, willing to put somewhere around US$50m per deal.

In Asia, Bank of Tokyo-Mitsubishi, Mizuho Corporate Bank, and Sumitomo Mitsui are teaming up with the state-owned development bank, Japan Bank for International Cooperation, to extend baht-denominated loans to Japanese companies in Thailand, eyeing carmakers with assembly and manufacturing plants there in particular. Similar arrangements are being considered for China and Malaysia. In India, bankers have noted an increasing amount of purchases by Mizuho and Sumitomo of bonds issued by medium- to large-sized companies.

Analysts are quick to point out that these are not just anecdotal evidence of Japanese banks’ revival. “This trend will continue because deposits are increasing and there remains not much lending in Japan,” says Nemoto of S&P. But apart from their own push, the revival of the Japanese economy also means more investments overseas, and therefore greater demand for funding them in the future. Nozaki of Nikko Citigroup, for example, is betting that car companies will be expanding in China in the near future. And the indisputable guarantee that Japanese investments overseas will continue? The nation’s demographics. “Companies are constrained in their domestic investments by the long-term prospect of a declining population,” says Nemoto. Adds Kanno of JPMorgan: “The shift of production and sales from purely domestic to overseas is going very fast, and this is good for the rest of the world.”