J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 12
Wednesday, January 22, 2003

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Viewpoint: JGBs -- DIE ANOTHER DAY

The Bottom Line:

o The bull market in JGBs rages on, with yields falling to
near-record lows in 2003. The economic outlook is
deteriorating, there is upward pressure on the yen,
domestic investors have become extremely risk-adverse, and
expect the BOJ to step up its purchases of JGBs.

o Yet foreign observers and even some internationally minded
domestic observers have been saying for years that the JGB
market is a train wreck waiting to happen. First, there is the
often-quoted run-up in the government's debt burden, and then
there is the mind-boggling cost of a cleanup of the growing
mountain of debt in the private sector as well as in the
public sector. Japan's finances have deteriorated into
territory not seen by modern economists and could get a lot
worse before they get better.

o So why haven't JGBs crashed yet? Japan has a chronic excess of
savings over investment and record net foreign assets that are
producing a structural balance of payment surpluses. Cash-rich
domestic institutions are finding that the JGB market is the
lesser of many evils as at least a store of value. In
addition, the Bank of Japan continues to increase its
purchases of JGBs, as the "buyer of last resort." On the other
hand, foreign investors and individuals directly own only
token amounts of JGBs.

o But all the talk of a new "deflation fighting" BOJ governor,
inflation targets and full-scale reflation is making some bond
investors nervous. If these deflation countermeasures are
successful, the bond market rally is dead, and bond yields
could soar back to 1991 levels, or some 500 bps. Moreover,
just a 150bps rise in bond yields would wipe out half of the
profits of the major banks, thereby exacerbating an already
bad situation. On the other hand, a mere perception shift
regarding deflation could send bond yields plunging
100bps-plus in a sharp, but short-lived bull market correction
like the one seen in 1998.

o As regards the "bonds are dead" scenario, Money Watch has
trouble believing that the Koizumi administration or a new BOJ
governor are fully prepared to commit the scale of resources
required for a serious reflation effort and a cleanup of the
banking sector, at least for the time being. Our guess is that
it could cost as much as 100 trillion yen for such an effort.
Moreover, the Koizumi administration and its new BOJ colleague
would likely do everything in their power to make any
anti-deflation measures as "bond market neutral" as possible.
Thus, at least for 2003, the more probable scenario is a nasty
but short-term sell-off in the JGB market. Thus in 2003, the
Japanese bond market will just have to "die another day."

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Well-respected people in the know inside and outside of Japan have
been strongly suggesting for years that the next bubble to burst in
Japan will be the Japanese government bond (JGB) market. Moreover,
these people say Japan's unstable fiscal position represents a major
threat to domestic and global economic stability. The International
Monetary Fund, the World Bank, the OECD and just about any economist
you want to read will tell you that the Japanese economy remains in a
serious deflationary situation. But because of rapidly accumulating
government debt, the Japanese government's macro-economic policy
options are severely constrained, and the consensus (even among the
Liberal Democratic Party and the Koizumi administration) is that the
main burden of any serious measures to deal with deflation will fall
on the Bank of Japan (BOJ).

Yet, as the Japanese stock market ended 2002 at 20-year lows,
investors in the JGB market were pushing yields below 0.9 percent for
the first time since November 1998, as they apparently steeled for yet
another stock market "March crisis" in the new year. Economic
indicators are pointing to a deteriorating economy, there is upward
pressure on the yen as global investors move to reduce their US dollar
exposure, and there are expectations of further purchases
of JGBs by the BOJ. At this pace, JGB yields would be pushed down to
essentially zero by early 2004.

Past the Point of No Return for a Fiscal Crisis?
Fiscal policy has been schizophrenic, caught between repeated demands
for traditional fiscal stimulus, while pursuing reform goals that have
restrained public works expenditures and fiscal investment and loan
(FILP) expenditures and transfers to local government. The government
has, according to the OECD, met its self-imposed limit of 30 trillion
yen in new borrowing only through creative accounting. The debt burden
is already noticeable. Some 65 percent of central government tax
receipts go to servicing the debt, and long-term debt exceeds revenues
by over 15 times. At current run-rates, government debt could rise to
two times GDP by 2005-2006 and Japanese JGBs could become "junk
bonds" -- or downgraded to speculative grade. Total government debt in
fiscal 2001 was already almost 1.4 times GDP at 675 trillion yen. The
OECD projects that a primary surplus of 1.75 percent a year would be
necessary to stabilize the debt-to-GDP ratio at 180 percent by 2010,
and with the primary deficit currently around 6.5 percent of GDP,
significant fiscal consolidation is therefore required.

Japan has already had a larger budget deficit for longer and has
experienced a faster rate of debt growth than other countries that
have implemented substantial fiscal restraint. In other words, Japan's
public finances have entered territory not seen by modern economists.
In recent experience (i.e., of the 25 countries looked at by David
Asher of the MIT program in Japan and Robert Dugger of Tudor that went
into fiscal crisis in the 20th century), Japan is well past the point
of no return in terms of a fiscal crisis. The American Enterprise
Institute's John Makin ("Japan in Depression," January 2002) says
simply that Japan's Heisei Malaise is now a depression, with the
country being poised to follow a passive route to default.

The crisis would be preceded by a banking system collapse and massive
debt monetization by the BOJ that would result in a collapse of the
yen and the bond market. In "The Looming Japanese Crisis" (Adam S.
Posen, Institute for International Economics, May 2002), Japan should
have slipped into financial crisis by now, forcing the government to
choose between decisive pre-emptive action and outright financial
crisis. This would entail a vicious spiral of debt-deflation, a flight
of savings, surprise business failures, sharp declines in investment
and a major sell-off in the JGB market.

A More Sanguine View
Yet market-savvy hedge funds have bet against JGBs before and lost. As
was seen in 1987, and in subsequent premature market rallies during
the Heisei Malaise, foreign investors have a tendency to pull the
trigger too early. The JGB market in Japan has heretofore been
sustained by the combination of a malfunctioning financial system, an
aging society, a poorly managed corporate sector and substantial
wealth destruction in alternative asset classes to JGBs. JGB yields
continue to be supported by:

1. A chronic excess of savings. This has produced a current
account surplus largely unaffected by exchange rates. This has
helped produce record net foreign assets of 179.3 trillion yen
as of the end of 2001, up 34.7 percent from the previous year.
Personal financial assets have actually grown during the
malaise to 1,412 trillion yen, of which 83 percent is in bank
and postal savings deposits and insurance/pension plans.
Direct ownership of corporate and government bonds is only 3.3
percent of total personal financial assets, but nevertheless
worth 47 trillion yen.

2. A good part of these personal financial assets are recycled
back into government bonds as insurance/pension funds and
banks hold 51.5 percent of outstanding JGBs. Between 1995 and
2001, government bondholdings of the major and regional banks
jumped by 2.9-fold.

3. The BOJ and other government organizations hold 21.5 percent
of outstanding JGBs. The BOJ continues to crank up its monthly
purchases of JGBs. The BOJ is now purchasing JGBs at a pace of
1.2 trillion yen per month, or 14.4 trillion yen annually,
which represents 30-40 percent of each new issue. The central
bank's current bondholdings of 54 trillion yen represent 80
percent of the 68 trillion yen of bank notes in issue. The BOJ
has a self-imposed limit of keeping purchases of bonds within
the amount of bank notes in circulation, but if holdings of
short-term treasuries and financing bills were included, the
bank's government bondholdings would already be above their
self-imposed limit.

4. Foreign investor holdings of Japanese bonds are minimal.
Foreign investors hold only 3.6 percent of outstanding bonds,
and Finance Ministry statistics indicate they have been net
sellers of JGBs by 1.3 trillion yen in 2002.

5. The government's effective borrowing cost continues to
decline. While bond issuance is rising rapidly, interest
expenditures by the government have been essentially flat at
10 trillion yen because of falling long-term interest rates.
Moreover, the government's effective borrowing cost on
JGBs -- now roughly 2 percent versus market yields well below
1% ・ continues to decline as old issues mature and are
replaced with new issues.

6. The surplus on social security funds means the effective debt
burden is roughly half the reported debt burden. Some suggest
that the bond market's disconnect from the very rapid increase
and large nominal debt-to-GDP burden is because the nominal
debt burden overstates the problem. If the debt burden were to
net out the surplus on social security funds, the debt-to-GDP
ratio would fall to 45-50 percent.

Given these factors, some (like Richard Katz) suggest that the
debt-to-GDP ratio could rise to as high as 400 percent before it
seriously threatened to be come a fiscal crisis.

Holes in the Security Surplus Argument
Since the social security system is in effect part of the government,
it is not correct to include the system's assets in measuring
government debt, but then exclude the liabilities. The social security
fund's assets, together with "yucho" postal savings deposits, have
been invested by the Ministry of Finance's Trust Fund Bureau. The
bureau's assets are primarily government bonds and loans to the FILP
and in effect are transfers within the government. Including only
those government assets outside the social security funds as genuine
wealth leaves the debt-to-GDP ratio at 90 percent.

Moreover, there is the issue of properly matching liabilities with the
social security fund assets. According to the International Monetary
Fund (IMF), the implicit liabilities in the welfare pension system are
around 60 percent of GDP, and this is a more "conservative" estimate.
Next there are the latent losses in the FILP. A working paper from the
National Bureau of Economic Research (NBER) in the US, "Paying for the
FILP," by Takero Doi and Takeo Hoshi, indicated that existing losses
and expected transfers to cover future losses are enormous. Their
research indicated that of the 357 trillion yen of net FILP funds,
some 267 trillion yen was loaned to insolvent recipients. Thus the
cost to clean up the FILP losses would be at least 75 trillion yen. An
earlier estimate of the nonperforming loans in the FILP put the number
at 84 trillion yen.

The Cost of Cleaning Up the Bank Sector
Japan's post-bubble crisis is not unique. It started by the bursting
of an excess credit bubble that was first triggered by a crash in the
stock market. This was followed by a collapse of real estate values,
then structural stagnation in the economy, followed by extreme duress
in the banking sector, and finally (eventually) a crisis in government
finances. Simply put, the Catch-22 of the JGB market is the
fragility of Japan's banking system. The major banks' real capital
position is dangerously low. If adjustments are made for more
realistic loan-loss provisions, for non-cash deferred tax assets, for
subordinated loans to life insurers, and taking into consideration
that losses on the capital value of equities held has to be deducted
from stated capital, the banks' "real" capital ratio would effectively
be zero. If you also factor out two injections of public funds (that
eventually have to be repaid), the capital level of the major banks is
in negative territory -- i.e., they effectively have net negative
equity. Such calculations by Moody's and Standard and Poor's have been
replicated by the Japan Center for Economic Research and other
domestic think tanks. A complicating factor in this dire picture is
banks and life insurance companies provide each other capital. Thus a
failure in one sector could cause failures or significant losses in
the other. Moreover, the banking industry has not made a profit since
fiscal 1993 if one excludes capital gains from stock and real estate
portfolios ("Financial Sector Profitability and Double Gearing,"
Mitsuhiro Fukao, Keio University).

The Inflation Targeting Debate
According to Joseph Schumpeter (of "creative destruction" fame), such
fiscal crises inevitably appear at major historical turning points. It
is symptomatic of larger social and economic crises that mark the
period of transition. However, as pointed out by another famous
economist, Hyman Minsky, debt deflation is very difficult to stop once
it has started and may not end until balance sheets are largely

This is exactly where the debate is now centered ・ how does one go
about eradicating deflation? IMF, the World Bank, the OECD, overseas
economists, the LDP and the Koizumi administration now believe that
the first step is inflation targeting.

While being severely criticized by many, including his own government,
BOJ governor Masaru Hayami has moved a long way over the last year
into unchartered territory, implementing a "zero rate" interest policy
and quantitative easing. The target for current balances of the
banking system has been raised from above 6 trillion yen to
10-15 trillion yen since December 2001, with actual balances remaining
at the upper end of the band. Moreover, they have allowed temporary
deviations to meet extreme demands for liquidity. To support its
financing operations, the BOJ has been going into the bond market and
purchasing JGBs to the tune of 1 trillion yen per month, and this has
recently been raised to 1.2 trillion yen. The central bank is
effectively underwriting about a third of Japan's general government
net borrowing requirement and now has begun underwriting the unwinding
or bank cross-holdings of equity, purchasing a total 2 trillion yen in
stock held by the banks.

But this is not seen as enough. Japan's monetary base peaked in April
of last year, and in the July-September quarter, it was falling 3.9
percent quarter on quarter. Thus there is increasing pressure on the
BOJ to carry the anti-deflation/reflation ball, because of a general
view that the Japanese government has essentially tapped out their
ability for additional fiscal stimulus. Because the government has
already disbanded FILP and is in the process of transferring pension
fund assets to the Government Pension Investment Fund (GPIF), they no
longer have the option of having the public sector purchase ever
larger amounts of JGBs. Conversely, this increases the relative burden
on the private sector to absorb what has been a 1.6-fold increase in
the private sector take-up since fiscal 1999. In fiscal 2003, the
private sector will be expected to absorb 80 percent of new JGB

Fighting deflation has suddenly become a top priority of the "pain
before gain" Koizumi administration. Deflation is a cause for NPLs,
while NPLs in turn cause deflation. The US Fed, having studied Japan's
policy mistakes during the Heisei Malaise, appears to be fully
prepared to print more money as the classic prognosis for eradicating
inflation. Alan Greenspan has been quoted as saying that "there is no
meaningful limit to what we could inject into the system were that
necessary." Fed board governor Bernanke also has emphasized that "the
US government has a technology called a printing press that allows it
to produce as many dollars as it wishes at essentially no cost.
Increasing dollars in circulation ... will ultimately always reverse

Changing of the Guard at the BOJ
US economist Paul Krugman was one of the first to suggest that Japan
was in a liquidity trap and that conventional monetary policy was
ineffective under "depression" conditions. His prognosis was for the
central bank to be credibly "irresponsible" and convince market
participants that it was committed to a certain level of inflation.
This can be accomplished by:

a) Achieving structural reforms to close the savings-investment
b) Closing the savings-investment gap with government spending
in the form of fiscal stimulation.
c) "Radical" monetary policies, ostensibly through inflation

Japan has already tried (b) during most of the Heisei Malaise with
little lasting impact. The Koizumi administration promised significant
progress in (a), but has found the going tough sledding politically.
That leaves us with (c), and puts the ball in the BOJ's court. The BOJ
under Hayami has continued to insist that financial reforms must
precede any truly expansionary monetary policy, but Hayami's tenure as
BOJ governor expires on March 19. Thus the changing of the guard at
the BOJ represents a major opportunity for the Koizumi administration
to install someone who will support a complementary monetary policy to
financial service minister Heizo Takenaka's harder-line approach to
cleaning up the bank NPL mess.

From the recent press quotes, it is evident that the Koizumi
administration would like to appoint a dedicated "deflation fighter"
who is preferably from the private sector. Prime Minister Junichiro
Koizumi was quoted by Dow Jones as saying that the candidate needs
"first hand" experience in economic policy, preferably from the
private sector, and must work with the government in fighting
deflation. Finance minister Masajuro Shiokawa has listed four criteria
for the BOJ governor candidate:

1. That the person be from the private sector.
2. That they have a global view.
3. That they are committed to bringing deflation under control.
4. That they also ensure financial stability.

However, even if Koizumi can get his ideal BOJ governor candidate
approved by the Diet, that alone does not guarantee a sharp lurch
toward reflation by the BOJ. The majority of the BOJ board members
apparently still believe that "inflation is evil" under any
circumstances, if one is to take their respective public comments on
the issue at face value. This implies that a more aggressive
"anti-deflation" BOJ governor would have a problem getting the other
BOJ board members to vote along with more aggressive unconventional
reflationary measures.

NPL Cleanup Could Cost 100 Trillion Yen or More
Potential board resistance becomes even more of an issue when one
considers how much Japan would probably have to spend to actually
achieve its inflation targets. Even Krugman is the first to admit that
an inflation target can only work if it is high enough. Too low a
target is doomed for failure, in that deflationary pressures would
remain. In other words, if the output gap is, for example, 8-10
percent of Japan's GDP, any reflationary efforts must at least be that
large. Assuming an output gap in Japan of 9 percent, some 45
trillion yen or more of reflation would be required to bridge the gap.

If one also considers that the Japanese government would probably have
to spend at least 50 trillion yen to make the newly formed Industrial
Revitalization Corporation (IRC) an effective vehicle for removing
NPLs from the balance sheets of the banks, the negative implications
for the bond market become obvious. If the BOJ were to merely purchase
more JGBs, the required expenditures for inflation targeting and the
IRC would be roughly half that of a reflationary strategy that
involved an explicit effort to devalue the yen while buying up NPLs at
the same time. In a recent Asahi newspaper interview with Nobuyuki
Nakahara, former Bank of Japan policy board member and on the short
list of new BOJ governor candidates, he said the BOJ should:

1. Increase the monetary base by 5-6 percent per annum;
2. Increase BOJ purchases of JGBs from the current 1.2 trillion
yen per month to 2 trillion yen as a first step;
3. Make effective use of fiscal stimulus to stimulate demand by
focusing on policies that increase productivity, promote the
mothballing of excess plants and promote research and
4. Use tax cuts to stimulate personal consumption. Personal
consumption accounts for some 60 percent of Japan's GDP. Offer
consumption tax returns when consumption per individual
exceeds a pre-determined level. For example, if the "standard"
annual consumption tax level per individual were 300,000 yen,
give the consumer a 50,000 yen tax break if they pay 350,000
yen in annual consumption tax.
5. Make additional JGB issuances to fund fiscal-stimulus programs
bond-market "neutral" by having the BOJ purchase an additional
amount of JGBs in the market that is equivalent to the new JGB
6. Work with the government to make a serious effort to clean up
the NPL problem.

One impediment to accelerating the NPL cleanup is the fact that
deferred tax assets account for a significant amount of the banks'
total reported capital, at a nominal value of some 9 trillion yen. The
government should return this 9 trillion yen to the banks (i.e., give
them real cash), and issue an equivalent amount of JGBs that would be
purchased by the BOJ.

A Market-Neutral Reflation Policy?
In other words, the countermeasures suggested by Nakahara would be
bond-market friendly, thereby avoiding a nasty crash in the bond
market that could only exacerbate the situation. If countermeasures
such as those suggested by Nakahara were successful in fostering
inflationary expectations, however, it would represent a major secular
turning point in the bond market. This is because Japanese bond prices
are currently being priced for annual deflation of a couple of
percentage points for the next 10 years or more. Moreover, as pointed
out by Mitsuhiro Fukao in an NBER working paper, the end of deflation
could trigger the long-predicted budgetary crisis in Japan. Suppose
Japan had gross debt of 200 percent GDP, mostly financed by short-term
liabilities by the time that deflation is eradicated. Most of its
foreign assets are long-term at fixed rates, so Japan could not count
on higher interest-rate income with rising interest rates. If, because
of inflationary expectations, domestic rates were to rise to the same
level as 1991, there would be a 500 basis point rise that would
ostensibly raise the government's interest payments to 10 percent of
GDP, or 50 trillion yen, versus the current level of around 10
trillion yen. Fifty trillion yen is about the same as total national
government tax revenue excluding social security contributions.

The Japan Center for Economic Research calculates that if the
government were to provide just 5 trillion yen in public funds a year,
a collapse of the banking sector could be avoided. However, it could
very well lead to a fiscal collapse. Conversely, if a credit blowup
were to occur, the required debt monetization would be enormous. The
very prospect of such a monetization and its consequences on monetary
growth could push up inflationary expectations, and slam drunk the
bond market. In other words, it could instigate a negative spiral of
an all-out bank rescue>substantial BOJ monetization>tanking JGB
prices>rising inflationary expectations>a further sell-off in JGBs>
yen depreciation>and more downward pressure on JGBs. Conversely, just
a 150-basis-point spike in JGB yields would wipe out half of the
profits of the major banks.

Thus the JGB market's fate in 2003 appears to be intricately linked
1) The fate of Japan's major banks, and
2) The emergence (if any) of inflationary expectations arising
from attempts to reflate Japan's economy.

Money Watch does not believe that the Japanese government is as yet
prepared to commit the level of capital resources needed to implement
successful inflation targeting nor a full-scale NPL cleanup through
the IRC, given the track records of both the BOJ and the government
during the Heisei Malaise. Given no dramatic anti-deflation measures,
deflation could continue at a moderate rate. If the current "muddling
through" mode can be maintained, any sell-off in the JGB market could
be more like the 100-plus-basis-point move in 1998, i.e., a sharp but
short-term correction in a continuing (for the time being) bull
market. In other words, the bond market will just have to "die another

-- Darrel Whitten

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Funds, Managing Small to Medium-Sized M&A Opportunities in Japan and
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