Corporate debt to gross domestic product (GDP) in Japan is at its highest level since the 1990s and fears are growing that defaults could surge in struggling sectors, which could have an impact on smaller and regional banks.
The Bank of Japan’s (BoJ’s) most recent financial stability report suggested that the probability of default at companies in the services sector, in areas such as accommodation and food, will rise sharply over the next few years.
The pandemic led to a 9% year-on-year rise on loans and debt securities owed by non-financial corporations in the fourth quarter of 2020, according to Capital Economics. At the same time, banks’ provisions for loan losses are equivalent to just 0.3% of their assets.
“The big question is to what extent the firms that have borrowed money will be able to pay it back,” says Marcel Thieliant, senior Japan economist at Capital Economics. “Japanese banks have pretty low profit margins. Their ability to deal with rising loan losses is quite limited by international standards.”
Japanese banks have pretty low profit margins. Their ability to deal with rising loan losses is quite limited by international standards
Most of the loans provided to companies last year were backed by the government, either by public lenders or covered by a public credit guarantee, and there is concern about what will happen when the large public transfers paid to struggling firms over the past year ends.
Direct public transfers to companies totalled about Y13.5tn ($123bn) for the fiscal year ending in March, according to the BoJ, which amounts to 2.5% of GDP.
“We saw a relatively big increase in government-guaranteed loans, but not much bigger than that during the global financial crisis. The applications have come down a lot since last year, but the peak was clearly last spring,” Mr Thieliant says.
“There will definitely be some zombie companies who will just survive on government-guaranteed loans,” he adds.
Struggling sectors
During the fourth quarter in 2020, sales at accommodation and food companies were down 16% year-on-year, according to Capital Economics — a much steeper drop than the 4.5% drop across all industries. “Sectors such as [these] remain in trouble and sales are still very weak,” Mr Thieliant says.
“The longer sales remain weak, the longer those firms will have to paper over the cracks, and the higher the debt will pile up. And eventually, many will not be able to cope with it.”
But while the services sector continues to struggle, Mr Thieliant points out that bank lending to those industries accounts for a relatively small share of overall lending. Loans to restaurants, hotels, and personal services accounted for 3.3% of business loans in the fourth quarter last year.
So far, the pandemic has had a limited impact on loan defaults. Write-offs were equivalent to just 0.2% of banks’ assets in the six months ending in September 2020, according to Capital Economics.
“Loan losses are a lagging indicator — they often peak one or two years after a recession. So we will not know the true extent of the problems for a while,” Mr Thieliant says.
“The big issue is that the Japanese economy is shrinking. The banks have to compete for a shrinking pool of borrowers. And this is particularly the case in the more rural areas that are depopulating quite rapidly,” he says. “This issue is reflected in steadily declining net lending margins, which have basically halved over the past two decades.
“The Japanese banking system is a two-tier system: you have the big mega banks, which are doing a lot of business outside of Japan. [This] is helping them to earn healthy profits — and their capital ratios are pretty strong.
“And then you have a whole array of smaller regional banks, which are doing very little business outside of Japan and are not benefiting from the global economy. Those regional banks are the ones that are in trouble,” he says. “They have higher lending margins. For some regional banks, the Covid-19 crisis could certainly be a turning point.”