Pop! Goes the Bubble

By Barbara Rudolph

Japan: land of the rising yen, unstoppable economic growth and perpetual bullishness. That was the image that emerged in the 1980s, as Japan's financial juggernaut rolled forward with seldom a pause or a setback. The most striking symbol was Tokyo's stock market, which consistently scaled heights that seemed unattainable by any global standard. Property values rose astronomically, yet inflation was virtually nonexistent. The money machine kept churning, as if powered by some magic force, difficult to fathom and nearly invulnerable to financial stresses and strains in the rest of the world.

Suddenly Japan is caught in a powerful downdraft of pessimism. A vexing combination of tightening financial conditions, trade tension with the U.S. and political weakness at the top has sent Tokyo's financial markets into a funk. The slide is threatening to choke the country's economic growth and sap the ebullient confidence that has filled Japanese investors and businessmen in recent years. "The pendulum has once again swung in Japan," says Richard Koo, a senior economist at the Nomura Research Institute. "It's now over to the doom-and-gloom side, when objectively speaking, Japanese companies remain the strongest in the world."

The most stunning measure of Japan's mood swing is the Tokyo market, where the Nikkei average closed at 30,372 last week, down 6.9% for the week and 22% from the all-time high it reached last Dec. 29. In a fit of near panic last Thursday, the market plunged 6% in just one morning session -- equivalent to a 162-point drop in the Dow Jones average -- before recovering later in the day to post an overall 3% loss. "We knew it had to come sooner or later. Many of us just stood there blankly," said a floor dealer. Another market watcher described it as a "bottomless swamp." The market edged upward on Friday as bargain hunters poured in, but a new era of wariness had clearly arrived. THE MARKET THAT WAS DREAMING A DREAM, blared a headline in Nihon Keizai Shimbun, a financial daily.

So far, the bad case of nerves has been confined mostly to Tokyo, but the anxiety could prove contagious; in the interconnected global economy, a downturn in Japan would tend to drag down other countries as well. On Wall Street, the Dow Jones average fell 37 points last week, to close at 2704.28, reflecting concern that bearish Japanese investors could pull back on their U.S. holdings. The Japanese Finance Minister, Ryutaro Hashimoto, declared on Friday that he was "extremely concerned" about the drop of the Tokyo market and the yen, which has fallen 7% against the dollar since mid-February. At week's end Hashimoto met in Los Angeles with his American counterpart, Treasury Secretary Nicholas Brady, to seek support in stabilizing the Japanese currency.

The weak yen has been a prime culprit in Japan's trouble, raising the threat of inflation and putting upward pressure on interest rates. The yen has sagged largely because of the quickening outflow of Japan's immense cash hoard to other countries, where Japanese investors have found investments more lucrative or stable than at home. Says Nomura's Koo: "We got into this mess because Japanese investors were always moving money abroad." Example: Ito- Yokado, a Japanese supermarket chain, agreed last week to pay $400 million for a 75% stake in Southland Corp., the Dallas-based operator of the 7-Eleven chain of convenience stores. At the same time, Japanese investors have developed a case of "Europhoria" about opportunities on the Continent, thanks in part to the sudden rise of capitalism in Eastern Europe.

Political instability at home has undermined the yen as well. Prime Minister Toshiki Kaifu, 59, who is outside the Old Guard of the ruling Liberal Democratic Party, lacks the political support to serve as a bold leader. "That poor gentleman," says one Japanese bureaucrat. "They are all trying to sink him. He gets no help." While Kaifu is moderately popular, he ! is not seen as someone who can dramatically improve relations with the U.S. or boost Japan's influence in the world. Says a disappointed financier: "Japan has not emerged as the superpower that it was expected to be."

In many respects, the erosion of the yen is driven by emotion rather than reality, since Japan's economy is still growing at a robust rate of about 4.5%. "It's really psychology, running in just the opposite direction of the underlying economic forces," says C. Fred Bergsten, director of Washington's Institute for International Economics. To prop up the yen, the Bank of Japan first tried intervening in foreign-exchange markets, spending $10 billion, or 17% of the country's currency reserves, to buy yen and dump dollars. Since that proved futile, the central bank last week boosted the key discount rate by a full percentage point, to 5.25%. That is modest enough by U.S. standards, but a huge increase from last May's 2.5% rate.

Besides seeking to buttress the yen, the Bank of Japan was trying to prevent an outbreak of inflation. Consumer prices are rising at a relatively modest 3% annual rate, but the official index fails to provide an accurate measure of many worrisome signs. Residential land prices in the booming city of Osaka rose 56% last year. So far in 1990, hotel rates have risen 9%, and the price of a bottle of Kirin beer is up 6.7%. Petroleum prices also rose last year, no small matter for a country that imports nearly all its oil.

The Bank of Japan would have moved sooner to raise interest rates and stave off inflation, but it was stymied by the Ministry of Finance, which wanted to delay the increase in an effort to prop up stock prices and sustain economic growth. The battle between the central bank and the Finance Ministry was unusually public and sparked widespread anxiety among investors. "For the first time in memory, there was an open dispute. That was very un-Japanese, and it caused a lot of uncertainty," observes Robert Hormats, vice chairman of Goldman Sachs International. By midweek the Finance Ministry agreed to the rate increase. But not everyone cheered the end of easy money. Says Hormats: "Once the Japanese established a tighter monetary policy, it took the wind out of the stock market."

Fighting inflation is a relatively new challenge for the Bank of Japan. For most of the 1980s, inflation was a faint, distant threat. Low oil prices kept increases at bay, even while property values soared. The rampant speculation in land prices, in fact, which made slivers of land in downtown Tokyo worth a fortune, was a powerful engine for the stock market. Investors could use their real estate holdings as collateral for buying stocks on margin. Then they could turn around and use their stocks as collateral to buy more real estate.

Prices for Japanese stocks eventually reached levels that seemed ludicrous by comparison with other markets. Even today, Tokyo shares sell for an average of 45 times annual earnings, in contrast to a multiple of 15 in the U.S. Despite the difference, many investors believed Tokyo stocks would never plunge from those levels because the market was perceived to be much more carefully controlled and even manipulated by the Japanese government and industry. A handful of securities firms control most stock trading, the theory went, and they would be able to prop up prices should any serious selling begin. On Black Monday in 1987, such intervention helped keep Tokyo's losses under 15%, in contrast to a 22.6% drop in the Dow, giving credence to the notion that Japan was a special, blessed case. In the final analysis, though, the Tokyo market appears as vulnerable as any other to the laws of supply and demand. "It was a classic bubble," says John Makin, director of fiscal policy studies at the American Enterprise Institute in Washington.

What the Tokyo market's downturn proves is that Japan is no longer isolated from financial forces outside its borders. Japan's first spate of trouble came late last year when West Germany raised its interest rates to battle inflation. The Bundesbank acted out of concern about the high costs of monetary union with East Germany, but the effects of its move were soon felt in Tokyo as well as in every other financial capital. Since Japan's government bonds vie with West German securities for the funds of global investors, Japan was eventually forced to increase its own interest rates to compete.

The increase in credit costs has prompted economists to predict a slowdown for Japan's growth. While only a few predict a recession, many economists believe high interest rates could dampen consumer spending. High rates and the depressed stock market could also discourage capital investment by Japanese corporations. Virtually all equity financing planned by major Japanese firms was suspended temporarily last week in an effort to prevent bogging down the market. Companies ranging from Sumitomo Metal Industries to Matsushita Electric Industrial postponed major plans to raise funds.

Another source of concern among the Japanese is the increasing tension in negotiations aimed at closing the trade imbalance between the U.S. and Japan. While Tokyo's global merchandise trade surplus shrank from a peak of $96.4 billion in 1987 to $77.1 billion in 1989, much of that decline came from increased trade with European and Asian countries. Despite Japan's increasing imports of American products, the U.S. trade deficit with Japan has remained largely unchanged, stuck at the current level, around $50 billion.

Since most Japanese feel their country has made ample attempts to open its marketplace to U.S. goods, the increasingly noisy drumbeats from Washington have created fear that the bilateral relationship is faltering. "There is a great deal of concern about the outright hostility in Washington that exists against Japan," says Sam Nakagama, a Manhattan economist. "Americans don't seem to care about this, but it is paramount in Japan." Trade negotiators reached an agreement last week to allow Japanese universities and government agencies to import U.S. supercomputers. But the two sides have made little progress so far in related talks over satellites and lumber products.

Japan now stands at the beginning of a period in which it must re-evaluate its financial position. The country is still flush with cash, having posted a current-account surplus of $69 billion last year, but that is down from $87 billion two years earlier. (One reason is the surge in Japanese travel, which boosted the country's deficit in tourism spending from $3.7 billion in 1985 to nearly $20 billion last year.) Japanese moneymen are not likely to start selling off their investments all over the world, since those were made with long-term goals in mind. But some of the boldness may go out of Japan's acquisitiveness as the country adjusts to its new financial conditions at home.

In the meantime, the Tokyo market may be in for a few more rounds of volatility. Most forecasters expect the market to fall even further. No matter where the yen and the Nikkei finally settle, the recent churning in Tokyo's financial markets suggests that Japan is a less independent -- and probably less dominant -- economic power than it had been considered.

That message was driven home last week, when the Tokyo stock exchange was forced to acknowledge a loss of prestige as well as profit. Because of falling share prices and the softening yen, the exchange has yielded its huge lead as the most valuable stock market in the world. As measured in terms of total market capitalization, the Tokyo exchange is now worth about $2.9 trillion. That means it has been chopped down to Wall Street's size.

CHART: NOT AVAILABLE

CREDIT: TIME Chart by Joe Lertola

CAPTION: CHAIN REACTION

With reporting by Gisela Bolte/Washington, Barry Hillenbrand and Seiichi Kanise/Tokyo