2002 Reports

Idiosyncratic risk and creative destruction in Japan

Hamao, Yasushi; Mei, Jianping; Xu, Yexiao

The dramatic rise and fall of the Japanese equity market provides us with a unique opportunity to examine market- and firm-specific risks over different market conditions. Contrary to the U.S. experience, we document a surprising fall in firm-level volatility and turnover in Japanese stocks after the market crash. Accordingly, correlations among individual stocks have increased and the number of stocks needed to achieve a given level of diversification has declined. As a consequence, we suggest that it has become more difficult over the past decade for both investors and managers to separate highquality from low-quality firms, making the Japanese market less efficient. Moreover, changes in firm-level volatilities are positively related to corporate bankruptcies, indicating that improvements in information efficiency occur when regulations on corporate bankruptcies are relaxed. These results suggest that the sharp fall in firm-level volatility during the 1990-1996 period could be due to a lack of corporate restructuring. This is more evident for firms with business group and main bank affiliations, whose firm-level volatility is less dependent on economic conditions than that of firms with no affiliations. Thus, we argue that a lack of "creative destruction" may have led to Japanese market inefficiency and a vicious cycle of capital misallocation.