Early last month a masked man wearing a lamé cloak and a silver turban, decorated with half-moons and stars, sat down outside the Japanese Ministry of Finance (MoF). He announced that he would set himself on fire to protest the use of ¥685 billion ($6.5 billion) in taxpayers’ money to bail out insolvent housing loan corporations (jusen).
The man’s bizarre suicide threat is just the most dramatic example of the widespread protests in Japan – including a protracted sit-in by opposition MPs in parliament – over the government’s rescue of the jusen.
But such protests miss the bigger picture: Japan’s public finances are in general disarray. The one-off bail-out of the jusen represents only a tiny part of the problem. Far more worrying is the total size of Japan’s growing public debt. The government will spend ¥16.4 trillion in 1996 alone to service this debt. Because of falling tax revenues and a politically motivated tax cut in 1994, the proportion of revenues raised through bond issues will leap from 17.7% in fiscal year 1995 (ending March 31 1996) to 28% in FY1996.
Economists see disaster looming in the Japanese government bond (JGB) market unless new sources of tax revenue are found. “Japan is not far from where Italy, Canada and Sweden were a few years ago in terms of its public finances,” says Russell Jones, chief economist at Lehman Brothers Tokyo. “The Japanese bond market is an accident waiting to happen – in fact, the accident is already taking place.”
Jones points to a rise in the coupon rate on the 10-year benchmark JGB from 2.5% in July 1995 to 3.265% in March 1996. He also raises questions about the enormous volume of bonds coming on stream and the ability of the domestic market to absorb new government and corporate issues. In the draft budget alone, the government has called for ¥47.4 trillion in new bond issues, and this is likely to rise if tax revenue goals, which have recently tended to be overestimated, are not met. As of the end of FY1995, the government will have ¥222 trillion in outstanding debt, an increase of ¥47.4 trillion on the previous year.
For the time being, MoF officials have no choice but to increase JGB issuance. Japanese politicians are unlikely to agree to raise the consumption tax (a less-onerous version of the European value-added tax) which currently is a gentle 3%. Exacerbating the government’s fiscal troubles is a ¥5 trillion income-tax cut spread over three years, a concession forced on the government in 1994 in return for a rise in the consumption tax to 5% starting in April 1997. This reduction in the income-tax take is partly responsible for the failure of revenues to increase this year and for a projected drop in tax revenues by 4.4% in FY1996. Japan’s ratio of public debt to GDP, at present 49%, is expected to rise to 57% within five years.
Also complicating matters for MoF bureaucrats is the improbability of their being able to push through any significant increase in the official discount rate. Higher interest rates would mean more attractive bonds with higher coupons, but they could also stall Japan’s nascent economic recovery.
Revolt of the pension funds
The MoF can always count on Japan’s big life insurance companies to absorb large volumes of JGBs. Japanese life insurers are legally obliged to make their pay-outs from interest income and have opted to stick to yen-denominated, safe JGBs. Their aversion to foreign securities is well-known; it dates from the late 1980s when, partly under pressure from the MoF, they invested heavily in US treasury bills and then lost huge amounts when the dollar dropped from ¥240 to ¥100.
The pension funds, however, which have traditionally been major clients of the life insurers, have different imperatives. They are responsible to a workforce that is ageing faster than any other in the industrialized world and cannot afford to be over-cautious about returns. The low coupon rate is driving them away from the life insurers and, thanks to liberalization, they can now find a new home for their funds. Investment advisory companies, a generic term which includes foreign funds, offer higher returns through investment in foreign securities, and are now permitted to manage Japanese pension money.
An informal decision by Japanese life insurers earlier this year to decrease their guaranteed returns to pension funds from 4.5% to 2.5% triggered the possibility of a flight of funds towards trust banks and investment advisory companies. For example, earlier this year, the Japanese Pension Welfare Service Corporation, a big public-sector pension fund, threatened to withdraw some ¥5 trillion it has placed for management with life insurance companies. By February, funds run by the Japan Securities Dealers Employees Union and the National Labour Banks Employees Union had decreased the amounts they entrusted to life insurers, and pension funds at Nissan and Nippon Electric Corporation threatened to follow suit. Although the outflow from the life insurers is still quite small, the writing is on the wall: any organization which relies on low-yielding JGBs cannot count on the loyalty of its clients.
For the time being, however, the MoF has found in the Bank of Japan (BoJ) an unusual ally in its efforts to maintain demand for JGBs. Starting in mid-1995, the BoJ has been engaged in what is known as rinban (buy-and-hold operations) usually with one- or two-year-old JGBs, averaging as much as ¥500 billion in purchases every month. Creating demand is only a secondary reason for the BoJ’s buying JGBs. The main reason is that with the official discount rate at 0.5% and the overnight call rate as low as 0.43%, bond purchase is the only way the central bank can inject liquidity into the economy. Nevertheless the practice has some economists worried. Tetsufumi Yamakawa, senior economist at Goldman Sachs (Japan), says: “If the market perceives the BoJ’s buying of bonds as a price-keeping operation, when and if the BoJ stops doing so, there could be disappointment in the market.”
Faced with a saturated domestic market in which most purchasers of JGBs have simply bought and held their bonds, the only way the MoF could reduce the cost of the national debt was to reform bond-issuing and trading mechanisms, thus making JGBs more versatile in the hope that this will attract new investors.
The reforms include a rationalization of settlement dates, which at present follow a totally unpredictable pattern based on a now-abandoned 19th-century lunar calendar; the introduction of a five-year JGB futures market in order to even out a yield-curve that is concentrated on trading in the 10-year benchmark bond; the creation of a genuine repurchase agreement (repo) market to replace a clumsy domestic version called gensaki that has been hamstrung by a sales tax and restrictions on interest on collateral; and the borrowing of a US technique called strips (separate trading of registered interest and principal securities) which involves stripping out of a bond’s interest payments for sale.
An active advocate of these changes is Yo Takeuchi, director of MoF’s government debt division, who unabashedly describes himself as “a salesman for JGBs”. He tells visitors: “The Japanese flag means good quality – risk-free and at a bargain price.” If Takeuchi, decked out in light-grey suit, wine-coloured striped suspenders, striped shirt and a red tie crowded with tiny yellow elephants and giraffes, looks more like an intruder from Wall Street than a MoF bureaucrat, that’s not an entirely inaccurate impression. Educated at the University of California, Berkeley, Takeuchi appears to be strongly wedded to the introduction of efficiency to the Japanese bond market even though moves towards transparent and rational rules are likely to ruffle feathers in other parts of the MoF.
“We are not a Bangladesh,” says Takeuchi, pointing disparagingly at a Japanese bond-dealing settlement calendar on the MoF operations room wall. “Even Bangladesh doesn’t have a five-day and 10-day settlement system.” The calendar shows the days of a week linked to dates ending in five and zero, a pattern that can be traced back to the settlement of rice futures during the Edo period (1600-1868).
Despite its antecedents, this system is of relatively recent origin. It was introduced in 1987 as a means of putting an end to rampant speculation triggered by the lowering of long-term interest rates to 2.55%, just five basis points above the discount rate. On just one day that year, trading volume in the 10-year benchmark bond reached ¥8 trillion though only ¥3.1 trillion of that bond had been issued. Five-and-zero-day settlement brought speculation under control by forcing settlement of accounts and slowing down trades. One problem with the system is that it often conflicts with the western calendar, Japanese holidays, and the securities association’s own rules that require periods for paperwork to range from no less than three trading days to no more than six. In the past year exceptions had to be built in, because of 72 settlement days 27 ended in neither a five nor a zero. Moreover, the sheer number of exceptions required a committee of the Nihon Sogo Shoken KK (Japan Bond Trading Co Ltd) to determine settlement days ahead for each year. Worse still, the system results in delays of 15 days or more in the delivery of a bond. For example, a bond purchased on May 2 is only likely to be delivered on May 20.
Although the MoF does not officially take credit for the elimination of this arcane system (effective later this year), a spokesman for the Nihon Sogo Shoken, an association of securities dealers and bankers, conceded that the adoption on October 1 of a rolling eight-day settlement system was agreed to by his organization “through guidance from MoF”.
As Takeuchi puts it: “An Edo-era financial structure is a great hindrance to us in reducing the cost of issuing. Now that the JGB settlement is linked to the international financial system, we can anticipate more purchase of JGBs by foreigners.”
The new system will regularize settlements to a seven-day period so it is still a far cry from the same-day settlement that can be had with computerized trading abroad. According to a bond dealer at a foreign securities house, the MoF had to compromise with the industry because some smaller organizations were not able to handle a shorter settlement period. The process of harmonizing settlement days with practices abroad has gone relatively smoothly, but so far not much else has.
Shadow without substance
When a five-year JGB futures market was introduced on February 16, some 15,000 contracts were traded that day. Two trading days later, however, this was down to 135, and today the market is moribund. “Right now what we have is shadow without substance,” says Takeuchi. A futures market has been established, again at the apparent prodding of the MoF, but for the time being the ministry does not issue a five-year cash bond, largely out of consideration for the three long-term credit banks (Industrial Bank of Japan, Long Term Credit Bank and Nippon Credit Bank), which together with three other banks were given the specific right to issue five-year bonds during a time of more stringent market regulation. The view in the financial industry in Tokyo is that the MoF will eventually issue a five-year cash bond, possibly as early as 1997, but not until the long-term credit banks have found alternative sources of income, possibly from bonds with a duration of between two and three years.
“It is very difficult for us to issue four to six year bonds now,” says Takeuchi. Although demand has increased for the medium-term instruments in recent years to about 20% of the trade volume of the benchmark 10-year bond, in one one-week period in late February there was just one trade executed for a four-year JGB.
As Cameron Umetsu, senior economist at UBS Tokyo, put it: “Considering Japan’s is the second-largest government bond market in the world, it is still strikingly immature.” Umetsu lauds the launching of the five-year futures market but says: “We are still a long way from a fully liquid yield-curve.”
Various sources pointed out that the 15,000 contracts on the first day of the five-year futures market were largely congratulatory trades. The real test of the success of the market will come later this year when an old 10-year benchmark bond will become available for trade as a five-year bond.
Although Takeuchi says he is “determined to bring diversity into the JGB market,” at every step entrenched procedures seem to stand in his way. For example, there is at present no real bond repo market. Instead there are two repo-like markets, one of which, called gensaki, is hindered by the application of a tax of 4bp per transaction.
Although the gensaki market follows similar principles to other repo markets, the sales tax (which translates into a levy of about 2% on any bond traded once a week over a one-year period) has prevented the market from taking off. At present, primarily JGBs of less than one-year maturity (which are exempted from the transaction tax) are traded on the gensaki market. In 1994, the total gensaki turnover of JGBs with maturities over one year was about ¥66 trillion – a pittance compared with the fully developed US repo market.
“For us and the financial institutions, the repo market is very important,” says Hiroyuki Kudo, senior managing officer at the Bank of Tokyo’s securities business division. “The repo market in the US is the biggest money market, eight times larger than the Federal funds, and the biggest short-term money market in the world.” The view among Tokyo bond analysts is that a Japanese repo market would bring to JGBs what they most lack: liquidity. Although trade is no longer concentrated as heavily in the 10-year benchmark bond as it used to be in the late 1980s when fully 95% of trade was taken up by the benchmark, if institutions could borrow a bond safely for a short period, demand would be created for a wide variety of JGBs along the yield curve.
Another disadvantage of the gensaki market is that the borrower cannot specify the bond of choice but has to take whatever is available. Although a bond-lending market known as the taishaku market exists parallel to gensaki, it appears to have developed primarily in order to avoid the transaction tax as well as the long waiting periods that the lunar-calendar-based settlement system throws up.
Since this market evolved on its own, it has existed in a state of legal limbo in which lenders have accepted unsecured transactions mostly in order to avoid both tax and lengthy settlement periods.
Bureaucrats who won’t let go
Although Takeuchi’s department has been supporting the creation of a new Japanese-style repo market, expected to start at the beginning of this month, the launch has been resisted by taxation officials. Whereas the new market will require payment of funds roughly equivalent to the value of the bond being borrowed, parties will be able to avoid the transaction tax as there will be no sale. Although individuals connected with the formulation of the new repo market are unwilling to talk on the record, it would appear that interdepartmental negotiations over the creation of the repo market have involved considerable bureaucratic haggling over the past year. Initially, tax officials demanded that borrowers in the new repo market paid a fee equivalent to 100bp above the call-market rate. The idea appears to have been to discourage borrowers who might want to avoid the transaction tax. (This is in spite of the fact that the tax at present is so steep that it has effectively discouraged the growth of just such a market.)
The total amount of tax raised from JGB transactions on the gensaki market was less than ¥30 billion in 1994, so the real issue – as one securities dealer involved in formulating the new repo market argued – may be not so much the revenue as the reluctance of MoF bureaucrats to relax their grip on securities transactions. “The idea that securities could be traded without the government being there to take its share seemed to bother them,” the industry representative told Euromoney. Nevertheless the new repo market is expected to be a success. As Marshall Gittler, bond analyst at Merrill Lynch in Tokyo, puts it: “The new repo market will definitely fill in some missing links in the JGB market.” Certainly, the ¥221 trillion of JGBs in circulation is likely to be increased if they can be lent out in an easy and safe manner.
Perhaps farthest down the line in streamlining the flow of JGBs is the strips market, which the MoF would like to see inaugurated in April 1998. “Canada was able to save 100 basis points in placing its debt once it introduced strips,” says Takeuchi.
The MoF, which used to view foreign financial institutions as “the enemy”, recently invited two US brokerages to join a Japanese brokerage and a Japanese life insurance company on a committee aimed at setting up a strips market for Japan. The Americans were invited because strips are essentially an American invention and US institutions have the greatest experience with the system. The separation of interest-bearing coupons from a bond gives a purchaser of the strips a clear idea of earnings on interest and thereby permits institutions to plan their cashflows more precisely, thereby lowering their risks.
“We need a technical adjustment,” says the MoF’s Takeuchi. “We are now doing an official study on how to introduce a strips market.” The greatest hurdle, again, appears to be tax laws. At present interest rate income attracts a 20% withholding tax for foreigners from non-tax-treaty countries and 10% for Japanese. What with Japanese politicians being distrac-ted by the jusen scandal and an election likely later this year, it is not clear at the moment if the law on withholding taxes can be revised in time to start strips two years from now.
In spite of the major innovations initiated by the MoF, Lehman Brothers’ Jones remains sceptical about the Japanese government’s ability to continue to place its debts at present levels. According to Jones, the pick-up in the Japanese economy alone is already a negative factor for JGBs. “Thanks to the recession, people weren’t buying very much last year, so money was available to fund government finance at low interest,” says Jones. “Now that the economy has picked up, there is greater demand for funds so the government now has to pay more for it, just like everyone else.”
Jones is equally unimpressed by the MoF’s streamlining of the mechanisms of the bond market: “They are trying to Americanize the bond market, to turn it into something like the US T-bill market. That will take the sand out of the machinery, but by doing so they will also make the bond market more responsive to actual conditions in the economy.”
And that, according to Jones, will mean an increase in long-term interest rates.
