2002 Japan Conference: A Summary of the Papers

The chronic stagnation of the Japanese economy is a big puzzle. Once a shining light for both developing and industrialized nations, it has now become a case for bubble economies. Twelve years after its stock market bubble burst, a great country -- an economy with a strong labor force, large capital endowment, advanced technology, and stable government -- is still operating far below its potential productive capacity. While numerous arguments have been advanced to explain the recent plight of the Japanese economy, most have focused on lack of consumer demand, collapsing asset values, and non-performing loans. This paper offers a unique perspective by studying the roles of Japanese equity markets. In particular, we document a sharp fall in firm-level volatility and turnover and a noticeable increase in Japanese stock market volatility following the crash. We explore the possible causes of these events as they relate to information efficiency and the lack of corporate restructuring after the crash.

Campbell, Lettau, Malkiel, and Xu (2001) were the first to provide a comprehensive study of idiosyncratic risk for U.S. stocks. During the period from 1962 to 1997, there was a noticeable increase in firm-level volatility relative to market volatility. Accordingly, correlations among individual stocks and the explanatory power of the market model for a typical stock declined. Moreover, they found that all volatility measures (market, industry, and firm) move together counter-cyclically in the United States. In other words, firm-level volatility tends to increase during a recession. Contrary to U.S. results, this paper finds a sharp reduction in firm-level volatility relative to market volatility immediately following the Japanese market crash. Accordingly, correlations among individual stocks have increased. As a result, there is a reduction in market information efficiency using the R2 measure developed by Durnev, Morck, and Yeung (2001). In addition, we find that while market-wide volatility has increased, there is a significant drop in the variation of systematic risk across firms.

In order to understand the abnormal behavior of idiosyncratic risk in Japan, we examine the impact of Japanese bankruptcy as well as business group affiliation on firm-level volatility. If idiosyncratic volatility conveys signals about asset reallocation, then an increase in corporate bankruptcies should improve information efficiency. In fact, we discover a positive correlation between changes in aggregate firm-level volatility and corporate bankruptcies. There is also some evidence that increasing bankruptcies after 1997 have led to higher firm-level volatility. These results suggest that the sharp fall in firm-level volatility during 1990-6 could be attributable to a lack of corporate restructuring.

By comparing firm-level volatility of keiretsu (group-affiliated) firms and non-keiretsu firms, we find that a decrease in industrial production growth tends to increase the difference of firm-level volatility between non-keiretsu and keiretsu firms. That is, the lower the growth, the higher the firm-level volatility of non-keiretsu firms compared to keiretsu firms. This means that during the recession in Japan, there was a greater disparity in stock performance among non-keiretsu firms, indicating the presence of protection among group-affiliated firms. We find similar results when comparing the firm-level volatility between firms with main banks and firms without main banks. Thus, idiosyncratic volatility for firms with business group and main bank affiliations is much less responsive to economic conditions than that of firms without such affiliations. This suggests that weak firms with business group and main bank affiliations may have been protected during most of the 1990s.

This anomalous behavior of firm-level volatility in Japan may help us to understand the poor performance of the Japanese economy over the last decade, because disaggregated volatility measures could affect aggregate output in several ways. First, macroeconomic models of "cleansing recessions," such as those described by Caballero and Hammour (1994) or Eden and Jovanovic (1994), emphasize the impact of firm-level volatility on resource allocation during recessions. A recession may increase the arrival rate of information about management quality and thus increase resource reallocation from low-quality to high-quality firms. Such resource reallocation is enhanced in the United States, because firm-level volatility moves counter-cyclically. To the extent that Japanese market downturns are accompanied by a reduction in firm-level volatility, and thus a reduction in the arrival of firm information, it is more difficult for investors to distinguish low-quality from high-quality firms, thereby reducing the effectiveness of the cleansing mechanism. This view is consistent with recent empirical studies conducted by Durnev, Morck, and Yeung, who find that firms in industries with greater firm-specific return variation exhibit higher quality capital budgeting: their profitability indices (marginal Q ratios) are closer to one (or to a tax-adjusted benchmark).

Second, a reduction in firm-level volatility, as well as in the variation of systematic risk among firms, leads to a more homogeneous firm valuation. This implies that Japanese stocks were treated much less discriminatingly after the crash. Thus, both low-quality and high-quality firms had a similar cost of capital. As a result, high-quality firms were not able to leverage their advantage in obtaining low-cost capital as long as low-quality firms continued to have similar access to equity capital. In short, the bad firms were not held accountable, and the good firms were not rewarded. The "creative destruction" observed in the United States cannot take hold in Japan. This is consistent with a recent study by Wurgler (2000), showing that countries with stock markets that impound more firm-specific information into individual stock prices exhibit a better allocation of capital. Wurgler suggests that efficient secondary information market prices can help investors and managers distinguish good investments from bad ones.

The reduction in firm-level volatility also may explain the increasing trend in market-wide volatility. When idiosyncratic volatility drops, firms face increasing difficulty in raising additional financing from banks and securities markets. It becomes harder to distinguish the good from the bad firms. As a result, more and more companies are treated like "lemons" in financial markets, weakening their ability to sustain any economy-wide shocks. Such increasing vulnerability of firms to economic shocks induces higher market volatility.

Caballero, R. J., and M. Hammour, 1994, "The Cleansing Effect of Recessions," American Economic Review 84, pp. 1350–68.

Campbell, J.Y., M. Lettau, B.G. Malkiel, and Y. Xu, 2001, "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," Journal of Finance, 56: 1:43.

Durnev, A., R. Morck, and B. Yeung, "Dr. Jekyll and Mr. Hyde: Stock Return Variation and the Quality of Capital Budgeting Decision," New York University Working Paper, 2001.

Eden, B. and B. Jovanovic, 1994, "Asymmetric Information and the Excess Volatility of Stock Prices," Economic Inquiry 32, pp. 228–35.

Wurgler, J., 2000, Financial Markets and the Allocation of Capital, Journal of Financial Economics, 58, pp. 187-214.