J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 44
Tuesday, September 16, 2003
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++ Viewpoint: Investors Search for Latecomers to the Recovery
The Bottom Line
Top-Down: What to do with all that debt?
o On September 12, the Finance Ministry released the
consolidated balance sheet of the Japanese government for
fiscal 2001, which showed the government had net liabilities
of 200.25 trillion yen without public pension liabilities.
With public pension liabilities, however, net liabilities were
more like 844 trillion yen, which represents an increase of
16.5 trillion yen from the previous year, reflecting the
falloff in tax revenues, increased social insurance costs and
increased issuance of government bonds.
o This is only one reflection of the government's growing
funding burden, and it is why the Japanese government and the
Bank of Japan (BOJ) have to tread very carefully with regards
to the sharp backup in Japanese government bond (JGB) yields
of late. The government is considering hiring a bond-market
expert from outside the government to advise on risk
management for debt securities, as they are both aware of
their increased funding requirements and the potential
negative impact that increased government bond issues would
have on current interest rates.
o While BOJ governor Toshihiko Fukui is right in saying that the
higher rates are not particularly problematic as long as stock
prices are rising, the fact is that a 100-basis-point backup
in rates will shave some 5 trillion yen off corporate profits
and probably push more heavily indebted companies into
bankruptcy. For the banks, the higher stock prices and higher
interest rates are positive, but the fact remains that the
average Moody's financial strength ratings for the Japanese
major banks remain between D- and E+ compared to other G-7
banking systems where average ratings trend in the A- to C+
range, while profitability and return on equity for Japanese
banks are but a fraction of other G-7 countries.
Bottom-Up: Is most of the good news already discounted?
o As more evidence of a recovery has emerged, the stock market
has reacted with less and less enthusiasm, even though trading
volumes remain high. Investors are increasingly shying away
from some of the early leaders and turning to latecomer
sectors and stocks. One classic latecomer during the entire
Heisei Malaise has been the department stores, which have
underperformed the Topix but for a period between 1992-1996.
The top-down story here is glum, as structural changes in
Japan's economy appeared to move against the department
o The top-down news in terms of revenues is still bad.
Nationwide department store sales declined for the 16th
consecutive month, while the seven majors are expected to
report yet another year of lower revenues in fiscal 2003. If
this is the case, why are some of these stocks soaring? It
appears to be a simple case of an overly bearish consensus and
just a little good news -- in other words, a micro-level
version of the factors driving the current rally in Japanese
equities as a whole.
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++ Viewpoint: Investors Search for Latecomers to the Recovery
The gap between general account expenditures and tax revenues has
widened markedly in recent years. Combined with massive fiscal
stimulus to kick-start Japan out of the Heisei Malaise, this has
caused government bond issuance and debt to soar. Though the total
amount of expenditures peaked in fiscal 2000, general expenditures
have declined for three consecutive years through fiscal consolidation
efforts. On the revenue side, the amount of total tax revenues peaked
at 60 trillion yen in fiscal 1990, but have fallen during the Heisei
Malaise due to the economic slowdown and successive tax cuts. The
balance of outstanding government bonds in fiscal '02 was 604.8
trillion yen; it is expected to grow to 742.5 trillion yen by fiscal
With the increase in tax revenues in the latter half of the 1980s as a
result of the bubble economy, Japan finally succeeded in formulating
the fiscal 1990 budget without issuing special deficit-financing bonds
for the first time in 16 years. Government bond issues, which amounted
to 34.7 percent of total expenditures in fiscal 1979, gradually
declined in the 1980s and recorded a low of 9.5 percent of total
expenditures in fiscal 1991. The Fiscal Structural Reform Act, drafted
and approved by the Diet in November 1997, was aimed at: (a) bringing
the fiscal deficit down to below 3 percent of GDP by fiscal 2003; and
(b) terminating the issue of special deficit-financing bonds by fiscal
These goals of course were unattainable. In May 1998, the Diet amended
the Fiscal Structural Reform Act to allow the government to issue
special deficit-financing bonds in an emergency situation. In
addition, the fiscal consolidation target initially set in fiscal 2003
was delayed by two years to fiscal 2005. Moreover, in December 1998,
the government decided to suspend the effect of the Fiscal Structural
Reform as the massive fiscal expenditures were apparently having
little effect in restoring the economy to sustainable growth. By 2003,
Japan's fiscal finances were back to where they were in fiscal 1979,
with the dependency on bonds to fund the annual budget back up to 45
All the while, older maturing government bonds have to be redeemed.
Government bonds are redeemed through the Special Account for
Government Debt Consolidation Fund. A certain amount of the budget is
systematically transferred to this account every year, either through
a) a fixed-rate transfer of 1.6 percent of total government bonds
outstanding at the beginning of the previous fiscal year, b) a
transfer of not less than half of the surplus of the general account,
or c) a discretionary transfer from the general account budget when
necessary. Proceeds from sales of Nippon Telegraph and Telephone (NTT)
and Japan Tobacco (JT) stocks are also transferred into this account.
On September 12, the Finance Ministry released the consolidated
balance sheet of the Japanese government for fiscal 2001, which showed
the government had net liabilities of 200.25 trillion yen without
public pension liabilities. With public pension liabilities, however,
net liabilities were more like 844 trillion yen, which represents an
increase of 16.5 trillion yen from the previous year, reflecting the
falloff in tax revenues, increased social insurance costs and
increased issuance of government bonds. Including government-
affiliated corporations and independent administrative institutions,
the total net liabilities of the government are more like 884.9
The Interest Burden Falls
While debt has ballooned, the interest burden of funding this
debt has actually fallen, from 15 percent of total expenditures to
under 11 percent, as Japan's interest rates have fallen to
historically low levels. National debt service costs in fiscal 2003
are expected to be 16.8 trillion yen, or 20.5 percent of general
account expenditures, of which interest payments will be around 9.1
billion yen; that implies an effective interest rate on outstanding
debt of around 1.5 percent. However, total debt servicing costs
(including interest payments and costs associated with retiring debt)
will probably rise to 18.4 trillion yen in fiscal '03.
In addition, until 2000, the government had a big "cookie jar" they
could dip into at will. This cookie jar was the Finance Ministry's
Trust Fund Bureau, where by law all postal savings (239 trillion yen),
pension reserves (over 200 trillion yen) and surpluses in other
accounts were pooled. The Trust Fund Bureau invested these funds in
government bonds and the Fiscal Investment and Loan program, known as
zaito. From April 1, 2001, however, a new bill effectively abolished
zaito's access to the nation's savings and instead required the
related government organizations to fund their activities with
government-guaranteed bonds. While a transition period was established
for the zaito bonds to be purchased with these funds, the full impact
of this additional funding requirement will be felt after 2008.
This is why the Japanese government and the BOJ have to tread very
carefully with regards to the sharp backup in JGB yields of late. The
government is considering hiring a bond-market expert from outside the
government to advise on risk management for debt securities, as both
the government and the central bank are aware of their increased
funding requirements and the potential negative impact that increased
government bond issues would have on current interest rates. The
government's borrowing costs are already rising. The interest it paid
on its monthly sale of 10-year JGBs in September was 1.6 percent,
versus the record low of 0.5 percent in June. As tax revenues this
year will drop to 41.8 trillion yen -- the lowest since 1987 -- Japan
plans to sell 36.4 trillion yen in new bonds in the fiscal year; in
the following year it may need to sell bonds worth 51.1 percent of
total spending. In addition, the BOJ, while deciding to maintain its
current monetary policy at the latest meeting of its policy board, has
decided to extend the period in which it will conduct repurchases of
bond futures from six months to a year and has decided to leave its
current account balance targets at 27-30 trillion yen.
Higher Rates are Manageable while Stock Prices Rise
BOJ governor Fukui sees no problem with the higher rates as long as
stock prices are rising. But rising stock prices do little to support
heavily indebted companies that have already effectively been shut out
of the equity markets. Teikoku Data Bank numbers show that August
bankruptcies incurred 1.173 trillion yen in irrecoverable debts, the
first time that figure has surpassed the 1-trillion-yen mark in five
months, even though the number of bankruptcies was down for the eighth
consecutive month. With rising rates, these companies will be even
more starved for credit, as total outstanding loans by private banks
dropped to 399.4 trillion yen, the lowest since the BOJ began
compiling statistics in July 1991. The long-term prime rate has
already been raised 35 basis points to 1.85 percent, following an
earlier 35-basis-point hike in July.
Roughly speaking, a 100-basis-point increase in long-term rates
would raise the interest-bearing debts of all corporations by
some 5 trillion yen, and if government borrowing costs rose by a
similar amount, the government's interest rate burden would rise
by 15 trillion yen. According to stress tests run by the International
Monetary Fund (IMF), the 20-percent-plus rise in stock prices has
generated gains for the major banks worth 37 percent of their stated
shareholder equity, but more like 100 percent of the capital net of
deferred tax assets (DTAs). Conversely, a 100-basis-point rise in bond
yields would cause losses worth 17 percent of their stated equity and
43 percent of DTA-adjusted capital. Thus while the market rally has
helped the major banks pull back from the brink of de facto net
negative equity, continued gains in bond yields (to 2.5 percent as
suggested by some) would: a) threaten the budding economic recovery;
b) stunt the stock market rally; c) cause bankruptcies to rise; and d)
lead to renewed losses at the major banks. This is why the IMF is
warning that, while a renewed systemic financial sector crisis seems
unlikely for Japan in the short term, expeditious and forceful action
is required to avoid further deterioration. Government intervention
will be required to reduce the risks still inherent in Japan's banking
The fragility of the banking system stems from stock problems and flow
problems. The stock problems include continuing asset-quality
problems, including large nonperforming loans, a weak capital base and
exposure to the stock market. Thus the rebound in the stock market has
worked to alleviate a degree of the banks' "stock" problems. The flow
problems include a lack of underlying profitability that has inhibited
the banks from dealing with asset-quality issues in a timely manner,
and the dearth of new loan growth. The average Moody's financial
strength ratings for the major Japanese banks remain between D- and
E+, compared with other G-7 banking systems where average ratings
trend in the A- to C+ range. In addition, profitability and return on
equity for Japanese banks are but a fraction of other G-7 countries.
Bottom-Up: Good News already Discounted?
Despite the fact that the latest April-June GDP numbers were revised
upward a substantial 1.6 percentage points and indicated annualized
growth of 3.9 percent -- the highest growth in two and a half years --
stock prices fell on the 10th when the numbers were announced and fell
again on the 11th. It is likely that the stock market will have the
same reaction (none or even negative) to more incremental good news.
This is because the run-up since April has already discounted what
investors expected would be good news coming down the pipeline. On
July 2, the day after the positive surprise in the central bank's
quarterly tankan business survey, the number of stocks hitting new
highs reached 366. But the number of stocks hitting new highs after
the revised April-June GDP number was only 62. As essentially all of
the brokers now have bullish year-end market targets, investors are
increasingly searching for interesting latecomer sectors and stocks.
Can Japan's Department Stores Revive?
The major department store stocks have consistently underperformed the
Topix for the entire Heisei Malaise, with the exception of a period
between 1992 and 1996. The combined market capitalization of the top
seven firms has shrunk from well over 3 trillion yen to around 1.4
trillion yen. Part of this has been due to the negative impact that
the Heisei Malaise has had on personal consumption. The department
stores were also losing market share to other retailing formats during
the period. These stocks came to be viewed as "structurally recessed
industries." Ill-advised diversification strategies, such as a foray
into golf courses by Mitsukoshi and the excessive building of outlets
and diversification by the bankrupt Sogo reflected badly on the
management of department stores.
But just as the department stores in the US saw a revival several
years ago, are Japan's department stores also due for a bit of a
revival? They just might be if they can successfully target Japan's
new seniors while at the same time attract singles in their 30s.
Japan's department stores, long under siege and squeezed by
price-discounting retailers while attempting to rationalize costs, are
trying to strike back. They are reducing the prices of more upmarket
garments by simplifying their distribution systems, relocating their
production bases to cheaper labor markets and developing private
brands. The idea is to revitalize sales of high-quality goods, which
had evaporated with the success of lower-end players. As a result,
there have been marked changes in the retail prices shoppers find in
the stores. One of the characteristics of this lower price regime in
department stores is the fact that they have adopted the method of
providing clothes under a private brand label to spur recognition and
The fiscal year that just ended saw revenue declines for all the
majors. Their forecasts for fiscal 2003 indicated there was not
much hope for a major turnaround. Top-down, monthly department
store sales have been glum. In July, nationwide department store
sales were down 2.3 percent year on year for the 16th straight
decline, following a 2.1-percent decline in June and a 3.2-percent
decline in May. The unusually cool summer in Japan was tough on the
However, the department stores are showing some resilience.
Takashimaya lifted its estimate of consolidated pretax profit in the
fiscal first half ended August. Daimaru also upgraded its profit
estimate for the fiscal first half. These firms have been cutting
costs. For example, Marui could become the first company in the
industry to realize the long-sought ideal of making labor
expenses variable, as they move to make pay determined by
performance rather than seniority. In addition, the stock rally
is helping sales of big-ticket items. Even clothing sales,
because of the department stores' focus on luxury brands, have
survived the cool summer relatively well. In addition, the
upgrades in GDP for the April-June period and the fact that the
sector has been a long-standing latecomer have contributed to
improved sentiment in the sector.
In particular, the stock market has rewarded Takashimaya and
Daimaru's earnings surprises with year-to-date stock price
performance double that of the overall market's rebound. Investors are
also rooting for the promised rationalization measures at Marui,
making these three majors easily the best performers in the sector
year to date and among the best performers in the whole market.
Conversely, Mitsukoshi's September 1 merger with four regional
department store subsidiaries has hurt its stock price, particularly
because it was partially responsible for a downgraded profit outlook
for the first half to August 31.
-- Darrel Whitten
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