The 1985-1994 Global Real Estate Cycle. Page 7

# _2.4 Land Price Inflation and Japanese Net Long-Term Capital Flows_

How could high and rising land prices possibly affect Japanese international capital flows? After all, foreigners have been playing a very marginal role in the Japanese property market. If an owner sells his highly appreciated property, and as long the buyer is also Japanese, the macroeconomic impact on the rest of the world should be zero. The existence of a link between the explosive fluctuations in real estate asset prices and Japanese net long-term capital flows has been successfully established empirically by Werner [1994]. Traditional models of capital flows are based on national accounting identities; they lead to the automatic conclusion that net capital outflows are equal to the current account surplus. In fact net capital outflows were larger than the current account surplus in Japan during the global real estate boom (see Figure 2). The basic national accounting identity is:

## (X-M) = (S-I) + (T-G) = - F

The current account surplus (X-M) is equal to the sum of net private investment (S-I) plus the public sector deficit or surplus (T-G); it is also equal to net capital qutflows which are recorded as a negative value in international finance statistics. It is the behavior of each term of these identities that needs explanation. How did Japan borrow its way into such epxlosive gorwth in overseas investment? Werner has shown that real estate asset appreciation has played the critical role in Japanese net capital outflows. He demonstrates this link by shifting to a theoretically more sound behavioral macroeconomic portfolio model of international capital flows, in which he introduces land-related loans.<sup>7</sup> He finds that the rate of change on the volume of real estate related loans has a statistcally significant effect in explaining net capital outflows (see Figure 4). Werner's finding is that "through its interaction with the banking system, Japan's "land bubble" appears to have been a major factor contributing to the movement of Japanese net long-term capital flows" (Wemer [1994], p. 175).

There have been two links between land inflation and bank credit in the Japanese financial environment First, banks made land-related loans directly to real-estate companies or indirectly through loans to the non-bank financial institutions which are in Japan the main loan channels to real estate companies. Such lending rose very sharply and, as just noted, fueled a joint land and equities asset price inflation. Second, Japanese bank have traditionally relied on real estate collateral rather than project quality and cash flow to make loans. After 1985, the soaring value of land has provided the collateal against which Japanese firms could borrow at home to buy assets abroad. Much of this investment was portfolio investments (US bonds and other securities), yet a very large volume also went to direct real estate investments. 8 7 Werner's analytical strategy is to compare the explanatory powers of two versions of his capital flows model, without and with land loans. In the first version the aggregate financial portfolio of Japan is: W= M + B + F (high power money, domestic bonds plus net foreign assets). In the second version the total portfolio V is redefined to include land loans L: V - M + B + F + L. L is taken as exogenous and influenced by central bank supervision. (See Werner [1994]).

The spread of the boom around the world was summarized at public hearings by the head of the real estate department of Credit Lyonnais: "We were told that French real estate was not expensive compared to British real estate, which was cheap compared to US real estate, which was cheap compared to Japanese real estate"..."For the fit time, in 1989-1990 there were transnational influences. Remember the Japanese investors coming to Paris and buying blocks of buildinp"..."'The mother of all corporate headquarters operations was the Shell building. It was a wonderful operation for the Paris market you start renovating a building and, even before work on it has started, the entire facility has been sold to investors. This operation had a unquestionable stimulating impact on the entire **market" (Peene** testimony, see Assemblee Nationale [19941, pp. 590-1). In the US, it is estimated that Japanese real estate investments during the period 1985-1993 amounted to S77 billion, with one third of this flow going