Japan’s Zombie Businesses

When the Japanese real estate bubble burst in the late 80’s and early 90’s - there were several banks and businesses that took a big hit – but were considered too big to fail.

Throughout the 90’s and the early part of this century, these banks and businesses were flushed with funds by the Japanese government - and kept on artificial life support. They were neither dead nor alive, and that gave birth to the term – Zombie Businesses.

Since economic activity was depressed – there was a genuine lack of solid businesses that could borrow from the bank and then repay the money. 

Because of this – Japanese banks started depositing their money with competing banks or funded businesses – that had little chance of succeeding. This was done to show a semblance of activity and avoid bankruptcy.

Such an environment created an incentive for banks to loan out funds to risky businesses – that had little chance of repaying them –  rather than preserving capital.

So even though the businesses and banks were technically alive – in reality they were nothing more than zombies.

How does the Fed create money?

Recently I have talked a lot about the Fed printing money and flushing the system with liquidity. I have been using the term liberally, as it is easier to visualize a printing press, minting money, than the open market operations and other things, that the Fed carries out to actually create liquidity in the economy.

So, here is a brief and simple explanation of how it works.

How does the Fed create liquidity?

Open Market Operations

The most frequently used tool for creating money is Open Market Operations (OMO). Open Market Operations refer to the Fed buying and selling government securities in the open market, in order to increase or decrease money supply.

If the Fed has to increase money supply it buys government securities, and if it has to decrease money supply, it sells government securities.

For example, let’s say that the Fed gets it trading desk at the New York Fed to buy government securities from dealers. Because they bought securities from them, they will credit the dealer’s bank accounts.

Now, since the banks have more funds deposited with them, they have more funds to lend and so “new money” is created in the economy.

To take a few numbers, if the Fed bought securities worth a million dollars, the banks have a new million dollars to loan out from. By lending out this new million, the banks have created funds in the system which were not existent earlier.

Decreasing Reserve Requirements for Banks

Banks have to keep some amount of their deposits with the Fed as a measure of safety. If the Fed wants to create money in the economy, it can reduce the reserve requirements of the bank. When it reduces the reserve requirements, banks can keep less with the Fed and spare more to lend. Since, they have more to lend, than they had earlier, this creates money in the economy.

Central Banks in every country of the world have reserve requirements, for example in India, this rate is known as CRR.

Lowering Interest Rates

This is not exactly creating money, in the context that it is being used today, but, lowering interest rates is also a very frequently used tool by the Fed to create liquidity. By lowering interest rates, it makes money cheaper and therefore facilitates lending.

After a certain point, lowering interest rates stop working (the Fed can’t lower the interest rates below 0) and in such times, they resort to other means lsuch as the ones mentioned above.

2009 – The Year to Accumulate Commodities

When I reviewed my portfolio at the end of 2007 – I noticed that the companies, which banked on domestic Indian growth – outperformed the companies that banked on export led growth.

During 2008 – I bet on consumption led growth and accumulated such stocks.  I do not see the trend changing any time in the coming year also.

United States is the major export market for most Indian companies, and it doesn’t look like we will see a revival in the US any time soon.

Indian companies and consumers have been impacted by the global slowdown, but, the impact is not big enough to reverse the virtuous consumption cycle – that was triggered in the country, about a decade ago.

If anything, this consumption cycle will prove to be a boon for technology companies of the developed world. Companies like Microsoft, which are trading at all time lows, and have plenty of cash reserves – are the prime candidates to benefit from the domestic consumption in India, and other Asian economies.

Time to Accumulate Commodities

Commodities like oil, steel, iron ore, copper and gold are trading at prices that are much lower than the median prices of the last decade or so.

Recessionary fears have depressed commodities prices quite a bit – and the demand is expected to stagnate in 2009. The thing about commodities is that – they don’t have good substitutes. You need steel to do what steel does, and you need oil to do what oil does.

So when the economic cycle turns, and demand starts to pick up – commodities will be at the forefront of that rally. No one can predict when that will happen: but it is bound to happen sooner or later.

Conclusion

In a nutshell, in addition to the consumption led stocks that I had last year – I will add commodities and technology companies from the developed world.

Note: I am not a financial adviser and these are just my own investment opinions – not – buy recommendation for others.