Bank credit in India has been driven by the growth in personal loans which hints at increasing household leverages. These leverages had probably led to exponential rise in the domestic asset prices. This may be attributed either to the changing mindset or overstated economic prospects. It is difficult to deny both possibilities with the information currently available.
In this current context, it would be useful to examine such comparable episodes in other economies even if there are differences in dynamics. The economic backdrop of Japan in the late 1980s appears broadly closer to the current Indian context.
Japan’s course in the 1980s has been marked by thrilling ascents and sobering falls. In that decade, the Japanese economy boomed, driven by exuberance in the equity markets and skyrocketing real estate prices. Japanese consumers enjoyed affluence and Japan seemed to be headed for global economic dominance. Some thought leaders were apprehensive about social costs of seemingly endless leverages, limitless prosperity, effects of affluence on youth and the increasing income divide.
In the middle of that decade, the yen appreciation dampened Japanese exports, prompting the Bank of Japan (BoJ) to cut its benchmark rate from January 1986 onwards—from 5% to 2.5% just over one year later.
The series of rate cuts was intended to stabilise the exchange rate as inflation was relatively muted despite the pronounced monetary expansion.
This monetary easing spurred higher demand for loans, which Japan’s banking sector was willing to satiate, resulting in accelerated leveraged flows from the household sector into equity markets.
The economy evidenced the coexistence of factors such as an increase in asset prices, an expansion in monetary aggregates, strong credit growth, an overheating economy and spiralling public debt. Both global and domestic investors interpreted the economy to be in Goldilocks with no perceptible threats and felt that the Japanese equity market would never fall.
Domestic investors continued to leverage through borrowings and poured money into what was then emerging as the world’s biggest equity pool. Foreigners were also aggressive as they wanted to reap the benefit of appreciating yen. In the lead-up to October 1987, the Nikkei 225 had soared 10,000 points in eleven months, almost at 60 times earnings on average.
The endgame
The endgame began when inflation started to creep higher. As asset-price inflation virtually slipped out of control, the Bank of Japan finally stepped in May 1989 to raise interest rates. The monetary tightening was too little and too late, so asset prices passed it off.
The final two years of the decade saw the stock market gain 60% fuelled by easy access to credit amid rising inflation and euphoric calls about rising revenues and earnings.
As 1990s commenced, Nikkei 225 crashed with more than $2 trillion wiped off the market across the first year of the new decade. By August 1990, when BoJ had implemented its fifth interest-rate hike, the Nikkei had dropped to just half of its peak.
What is now known as the bubble economy had certainly imploded. The broad social consensus that characterized the decade, viz. stressing economic growth as the prime national goal and personal advancement as the prime individual one, had fractured.
It is obvious that Japan’s asset price bubble was based on excessively optimistic expectations about future and BoJ should have been vigilant on the exchange rate by arresting yen appreciation instead of easing monetary policy when there had been fiscal profligacy.
By design or default, Indian policymakers appear to have taken a leaf out of the Japanese experience by choosing to contain rupee appreciation in these euphoric times and limit volatility by anchoring the exchange rate to a corridor and giving up the economic benefits of a flexible exchange rate policy regime.
Another lesson from the Japanese experience is that monetary policy should consider the state of equity markets in addition to the usual macro determinants and not choose to ease monetary policy when equity markets remain excessively exuberant.
V Thiagarajan is chairman, SYFX Treasury foundation. Views are personal.
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