Special report - Turning Japanese

Plummeting markets, falling property prices, banks refusing to lend to each other, the financial system in meltdown and requiring government intervention - sound familiar? While this clearly describes the current crisis in the West, it also fits events in Japan that began more than two decades ago.

"Everything we're hearing and watching in the UK and US is reminiscent of what happened in Japan in the 1990s," says Simon Somerville, head of Japan equities at Jupiter. "The banks were making some really bad lending decisions and losing between 80p and 90p in the pound."

As with the current liquidity crisis in the West, it all began with a booming economy. Robert Brooke, a consultant to the team that runs the Societé Generale Japan CoreAlpha fund, points to the effect of the Plaza Accord in 1985. This was an agreement between France, West Germany, Japan, the US and the UK to devalue the dollar against the yen and the Deutschmark.

It had the desired effect, reducing the value of US currency and effectively doubling the value of the yen to the dollar. "That was the key trigger to usher in flows of money," says Brooke. Consequently, Japan went on to experience one of the biggest asset booms ever seen, funded by the banks' lending.

One difference between the banks in Japan and the banking crisis in the West, suggests Somerville, is that there was little leveraging in Japan. Nevertheless, he says that the banks made some bad decisions and financed an asset boom that started in property. "People didn't think that Japanese prices and property could fall. Prices just kept going up," says Somerville. He says that, at one point, the land beneath the Japanese imperial palace was valued at more than the whole of California.

Andrew Rose, manager of the Schroder Tokyo fund, explains that the banks' lending was collateral based. They lent against land, believing that it would only rise in value. Meanwhile, equities rose to extreme levels, the Japanese were buying art and cash was free flowing. Property prices rose so much that households were taking 100 year mortgages because that was the only way they could afford to buy houses.

Inevitably, the bubble burst and the boom experienced in the late 80s and early 90s turned to bust. Somerville says that flats bought in Tokyo in 1991 or 1992 fell 70% in value. He says that there are property owners who are still paying mortgages on over-priced flats in the city and are still in negative equity. The property market fell for 16 years straight.

It took a while for the pattern of recurring recession to be established. At the end of 1989, Japan experienced a bear market with some element of recovery between 1990 and the late summer of 1992. From 1997 to 1998, however, there was sharp decline, reinforced in 2000.

The recession was dominated by the poor performance of the financial and banking sectors. Asset prices were strongly adjusted after the bursting of the bubble destroyed confidence and land and equity prices plummeted. In December 1989, the Nikkei was around 38,900. At its lowest point in April 2003, it was below 8,000. "That's an enormous decline," says Brooke.