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Non-Performing Loans as a Result of Deflation By Yutaka HARADA (Vice President, Policy Research Institute, Ministry of Finance)
Few Empirical Studies on Cause and Effect There are various arguments on relationships between non-performing loans (NPLs) in the banking sector and deflation or long-term economic stagnation in Japan. Some argue that Japan's long-term stagnation since the 1990s has been caused by the delay in the disposition of NPLs and, therefore, solving the NPL problem will lead to Japan's economic recovery. Others insist that creation of new NPLs due to deflation is the main cause for the delay in the disposition of NPLs, and that the NPL problem could not be solved without stopping deflation. Either argument is logically possible, but there has been virtually no empirical study to determine which is the case, due to the lack of long-term data on NPLs. Even if it is true that deflation delays the disposition of NPLs, there would be no consensus as to how to deal with deflation. The purpose of this paper is to show empirically whether NPLs, defined as firms' excess debts relative to their cash flows, are causing deflation and recession or vice versa. NPLs are firms' excess debts relative to their cash flows (profit plus depreciation). A firm's debt, however large it might be and however small its collateral might be, is not an NPL so long as there is enough profit for the firm to pay it off within a reasonable period of time. Having defined NPLs this way, we can consider possible channels in which deflation causes NPLs and vise versa. First, let us take up a possible channel in which deflation cause NPLs. A firm's profit is its revenue minus material cost, capital cost and labor cost. When revenue declines due to deflation, profit will decrease by the same percentage, even if all the costs decline at the same rate as deflation. If the rate of deflation is 2%, then profit will decline by 2%. Furthermore, there are reasons why profit is likely to decrease faster than revenue. First of all, the amount of principals for debts does not decrease by deflation. Second, it is often the case that interests do not decline by the same percentage as deflation. This is because interests tend to be fixed for a few years and also because the nominal interest rate cannot go below zero. Third, it is quite difficult to cut wages because nominal wages have downward rigidity. As profit is normally a very small percentage of total revenue, profit could be reduced drastically for the three reasons cited above. Thus, we have identified the mechanism in which deflation leads to a decline in profit and an increase in excess debt. Furthermore, we can think of the effect of the decline in profit, which leads to a decrease in corporate investment, affecting aggregate demand due to the multiplier effect.
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