J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 63
Tuesday, February 10, 2004
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++ Viewpoint: Implications of the Nikkei 225-US Bonds Link
The Bottom Line:
o Bank of Japan governor Toshihiko Fukui apparently believes
quantitative easing worked, and therefore, it must have the
power to give an additional push to Japan's economic recovery
and eradicate deflation. The consensus of domestic think tanks
seem to agree. They foresee impressive growth in Japan's
third-quarter GDP of 4.9 percent annualized, or higher than
that of the US. This would represent the fastest growth in
Japan since January 2002.
o Yet the Topix is looking top-heavy. In 2003, it rallied to
just above 1,100 but has again been unable to convincingly
breach this level. The index has now broken under its 13-week
moving average and is bouncing on its 26-week moving average.
There are several ostensible reasons for this: a) The yen's
strength continues to weigh on investor sentiment; b) there is
continued cross-holding unwinding by financial institutions
and selling by the trust banks; and c) a line-up of big new
issues is preparing to tap the capital markets, including
Shinsei Bank, NTT and Japan Tobacco.
o Ironically, the government's massive forex interventions may
also be a factor. The linkage between US long bond yields and
the Nikkei 225 has become especially close since 1997. Given
this linkage, a sharp rally in Japan would push up US long
bond yields and vice-versa. Through its forex interventions
and resulting purchases of US treasuries, Japan has been
instrumental in keeping a lid on US long bond yields. Because
of the close Nikkei/US treasuries linkage, the Japanese buying
of US treasuries, while keeping a lid on US bond yields, is
effectively inhibiting the rally in Japanese stocks.
o Nevertheless, the big picture remains positive for the
Japanese market. The Topix has seen a "golden cross" between
its 40-week and 80-week moving averages. Moreover, commodity
prices have finally pulled out of a 20-year bear market that
began in late 1980 and have entered a secular recovery. The
next to follow is bond yields, and even though central banks
(particularly the Federal Reserve) will delay shifting of
gears in monetary policy as long as possible, interest rates
will inevitably rise as the bull market in commodity prices
o In addition, it looks like conditions are now in place for a
major IT rally. The two major sectors that remain
significantly lower in weight to the S&P 500 than they were in
January 2000 are technology and telecommunications services.
With organizations like the Conference Board in the US all but
wild-eyed bulls on 2004 US economic prospects, and with
consumer and business confidence on the rebound, capital
expenditures could well surprise on the upside, thus setting
the stage for a full-fledged recovery in IT and telecom
services in 2004.
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++ Viewpoint: Implications of the Nikkei 225-US Bonds Link
In 2003, Japan's economy managed to recover and surprise critics
despite continued deflation. This has led some to insist that there
was no liquidity trap in Japan, and that despite the zero-interest-
rate policy, monetary policy made an important contribution to the
expansion. Moreover, monetary policy was able to provide stimulus
despite financial fragility in the banking system, which was unable to
fulfill its traditional banking role of being a money multiplier.
While the divergence between the monetary base and the money stock
continued to expand, the Bank of Japan's reluctant purchases of
Japanese government bonds, "unconventional" assets like asset-backed
securities and equities from the banks helped to change the
composition of the monetary base.
With the unemployment rate falling and construction orders rising in
December 2003, business confidence should continue to improve in 2004.
Accelerating global trade growth should continue to support demand for
Japanese exports, led by renewed economic growth in China and the US.
This, along with improving corporate profitability (the strong yen
notwithstanding), should continue to support Japan's economy.
Bank of Japan (BOJ) governor Toshihiko Fukui apparently believes
quantitative easing worked to stop Japan's deflationary downturn, and
therefore, it must have the power to give an additional push to
Japan's economic recovery and eradicate deflation. Domestic think
tanks seem to agree. They foresee impressive growth in Japan's
third-quarter GDP of 4.9 percent annualized, or higher than that of
the US. This would represent the fastest growth in Japan since January
2002. Third quarter numbers will be announced by the Cabinet Office on
Growing Belief in BOJ's Commitment to Reflation
The pall that hung over Japan's equity market in 2002 suddenly lifted
in March 2003, when the government decided to appoint Fukui, chairman
of the Fujitsu Research Institute and a former deputy governor of the
BOJ, to serve as the next BOJ governor, replacing outgoing governor
Masaru Hayami, whose term was ending on March 19. Given Japan's
deflation problems, the Japanese government, foreign governments and
investors had become increasingly frustrated with Hayami, whose
caution on the use of unconventional monetary policy was always
predicated with demands to the government to implement more effective
reforms first. BOJ observers both within and without Japan believed
that more aggressive, unconventional reflationary measures were the
only way for Japan to kick-start the economy. With unsterilized
intervention, for example, the money supply would grow more rapidly,
ostensibly stimulate economic activity and act as either a substitute
or a complement for fiscal policy. In addition, it would theoretically
put downward pressure on the yen, the object of the BOJ's forex
interventions in the first place. Finally, if done in sufficient
quantity, it would theoretically raise inflationary expectations.
But the BOJ under Hayami had consistently resisted this pressure,
believing there was already excess liquidity available to financial
institutions, which could not or would not use the excess funds they
already had (as huge current account balances at the BOJ). Moreover,
Hayami believed that government needed to achieve more in terms of
bank reforms before the central bank would embark on "risky and
untried" monetary policy options. Since Japanese short-term interest
rates under the zero-interest-rate policy effectively fell to zero,
the BOJ has been conducting experimental monetary policy. When Fukui
assumed his post, the BOJ immediately held a rare emergency meeting to
discuss nervous financial markets in the wake of the beginning of the
Iraqi conflict. The BOJ decided to expand its ability to buy shares
held by banks and started discussions about purchasing asset-backed
securities to stimulate growth in a market for securitization of
accounts receivable from small businesses.
When the BOJ first adopted "quantitative easing" in 2001, its focus
for monetary policy shifted from interest rate targets to current
account balances and other liquidity targets. By January 2003, current
balances at the BOJ had soared from 5-6 trillion yen to 20 trillion
yen, but with no apparent favorable impact on the economy or on the
stock market. In March 2003, the BOJ again raised its target for
excess liquidity from 22-27 trillion yen to 30-35 trillion yen.
Foreign investors, encouraged by the appointment of a new, more
flexible BOJ governor and a very "soft-landing" type of bailout
for Resona Bank in May, began to suspect that the BOJ's increasing
large and overt interventions in the currency markets were also not
being sterilized, i.e., prevented from influencing the domestic
monetary base through further increases in current account balances.
This view was not particularly discouraged by the central bank.
Current account balances, after all, continued to swell as the BOJ
continued to raise the ceiling.
But the real issue is why the expansion from 5 trillion yen in
current account balances to 20 trillion yen failed to produce the
same dramatically favorable impact on stock prices as the expansion
from 20 trillion yen to more than 30 trillion yen did in 2003.
The dramatic change in direction appears primarily attributable to a
shift in investor (mainly foreign investor) perceptions regarding the
BOJ's actions. The massive net buying of Japanese equities in 2003 was
instigated by the conjecture that a "new, more flexible" BOJ would
initiate more aggressive reflation measures.
Indeed, the sharp back-up in Japanese government bond (JGB) rates in
the second quarter of 2003 was itself evidence of a shift in future
expectations for inflation. JGB yields had been pushed down below 0.5
percent, implying that investors had all but given up on Japan being
able to reflate its economy and eradicate deflation. But as the
economy began to recover and bond yields soared, speculation even
began to circulate about the possible exit strategies the BOJ might
take when its stated goal of eradicating deflation was achieved and
what benchmarks the BOJ would use in declaring victory over deflation.
"The Bank of Japan aims at putting Japan's economy back on a
sustainable growth path by firmly maintaining the quantitative easing
policy based on clear and concrete commitment with reference to the
consumer price index," Fukui said.
Topix is Looking Top-Heavy
Despite all this bullishness, the Topix has tried to breach 1,100
twice and failed. In July 2002, the Topix tried unsuccessfully to
breach the 1,150 level, and thereafter plunged by 33 percent to March
2003 lows. In 2003, it rallied to just above 1,100 but was again
unable to convincingly breach this level. Another attempt in
December-January ended with a lower high, and the Topix has now broken
under its 13-week moving average and is bouncing on its 26-week moving
If business sentiment in Japan is improving, foreign investors are
still bullish, and GDP and corporate profit numbers for the third and
fourth quarters are expected to be good, why is the Topix so top-
One explanation could be that the supply-demand situation is
still delicate and could deteriorate further.
a) The yen's strength continues to weigh on investor sentiment.
Yet as the yen continues to push toward new highs despite massive
intervention, Fukui declared in December that the yen's rise might not
be that damaging to profitability of Japanese companies. Third-quarter
numbers at the major companies -- including the trading companies,
Matsushita and Toyota -- showed that companies which had been diligent
in continuing reforms and keeping a lid on costs were able to report
robust increases in profits despite the yen's strength.
b) There is continued unwinding of cross-shareholdings by financial
institutions, which could well intensify leading up to the March-end
c) There is a line-up of big new issues waiting to tap the market,
including Shinsei Bank, NTT and Japan Tobacco. Shinsei Bank's new
issue is already trading in the grey market with indications between
425 and 525; the price is due to be set on February 9, and listing is
slated for February 19. Ripplewood Holdings plans to sell 440 million
shares, implying a windfall of 231 billion yen at a stock price of 525
per share. As for the holdings of NTT and Japan Tobacco, both have
been previously put off due to poor market conditions. Both of these
issues would also represent a capital call of several hundred billion
The New Nikkei-US Treasuries Link
The massive interventions in the forex markets by the BOJ and the
Finance Ministry could be a factor. The linkage between US long bond
yields and the Nikkei 225 has become especially close from around
1997. For most of the decade, the Japanese economy has been in a
deflationary recession, which in turn appears to have contributed
largely to the global downtrend in long-term interest rates. Within
three years, both Japanese stock prices and US long bond yields had
fallen to levels not seen in decades. After the Nasdaq bubble burst in
2000, the Federal Reserve lowered interest rates 12 times over 18
months, all to no apparent avail. Part of the reason it did not work
was the influence of deflationary influences from Asia.
By the year 2002, the Fed was also beginning to use the "D" word
(deflation) and looked very closely at Japan's experience with it
during the Heisei Malaise. The Nikkei-US treasuries relationship
has some very important implications vis-a-vis Japan's current
policy of exchange market interventions and the sustainability
of Japan's stock market rally. In other words, this relationship
suggests that yields on US 10-year bonds need to go a lot higher
before Japan's stock market can rally significantly. Conversely, a
significant rally in the Nikkei ostensibly means higher US long bond
yields, which would not be taken as a positive by the US equity
Massive Intervention Impedes Market Rally
The ironic part of Japan's massive (27.58 trillion yen) intervention
to keep the yen's appreciation as mild and as limited as possible is
that it is in effect impeding a further rally in the Japanese stock
market. Japan has, through these interventions, built up a massive
stockpile of $741.2 billion in foreign currency reserves, $556.4
billion of which is invested in foreign securities, the bulk in turn
of which is US government debt securities. Japan's massive
interventions to keep the yen's appreciation from harming Japan's
economic recovery is also helping the US maintain its reflationary
efforts by keeping a lid on US bond yields. However, the link between
the Nikkei index and US bond yields means that the more US treasuries
Japan buys as the result of forex intervention, the more Japan is
effectively hindering the rally in Japanese stocks.
This also implies that a significant sell-off in US treasuries
(i.e., a rise in US long bond yields) arising from an upside
surprise in US economic growth or a renewed sell-off in the US
dollar could instigate a renewed rally in Japanese stocks. However, as
long as the Fed continues to convince bond market investors that they
will be "patient" in shifting their monetary policy, low US bond
yields will put a cap on the upside for the Japanese market.
Interpreting G-7 Statements
According to the text of the Group of Seven statement at its Boca
Raton, Florida, meeting, "growth projections for 2004 have been
revised upward to their highest in three years. Fiscal and monetary
policies have helped bring about these welcome changes." In other
words, massive stimulus in the form of fiscal and monetary policy is
finally beginning to work. At the same time, "we reaffirm that
exchange rates should reflect economic fundamentals," the statement
says. "Excess volatility and disorderly movements in exchange rates
are undesirable for economic growth."
The excess volatility statement seemed to be a nod to European
worries that the euro's recent rise to record levels against the
dollar could imperil its export-led recovery. In a thinly veiled
reference to Asian countries that peg their currencies to the dollar,
the statement called for greater flexibility in exchange rates of
nations where flexibility was limited. Media reports quoted
"officials" as saying the new language should clarify for currency
markets which countries they are admonishing. It does not appear that
Japan is the target of these statements.
If currency market traders take these statements as a sign that G-7
finance ministers are still unwilling to join forces to halt the
greenback's two-year decline, the US dollar's sell-off still has a
long way to go, especially if there was no behind-the-scenes agreement
that the US dollar has fallen enough. But it is hard to imagine that
the Fed or the government would significantly shift current monetary
or currency policy until the November presidential elections, unless
of course they were forced to by market developments.
The wish of the G-7 monetary authorities is for a more "stable" US
dollar, particularly against the euro, as the US tries to convince the
financial markets that the Bush administration was committed to
cutting huge deficits which many feel are a threat to global
stability. As long as US bond yields remain subdued, it is likely that
the upside of the Japanese market, assuming the link between the
Nikkei index and US bond yields continues, will be more limited than
what the current Japan bulls suggest (i.e., market gains of over 20
percent in 2004).
A Strong IT Recovery?
The big picture remains positive for the Japanese market. The Topix
has seen a "golden cross" (a bullish sign where a shorter moving
average crosses upward through a longer moving average) between its
40-week and 80-week moving averages. Moreover, commodity prices have
finally pulled out of a 20-year bear market that began in late 1980,
and have entered a secular recovery. The next to follow is bond
yields, and even though central banks, led by the Fed, will attempt to
delay the shifting of gears in monetary policy as long as possible,
interest rates will inevitably rise as the bull market in commodity
prices continues, and the global economic recovery broadens.
The Fed's reluctance to change course on rates reflects the continued
risk for the global equity markets of a recurrence of 1987, where a
sharp rise in commodity prices caused bond yields to soar amidst a
falling dollar, leading to a crash in the stock market. So far, the
rise in global commodity prices has been prevented from pushing up
bond yields by extraordinarily loose monetary policy, aided by massive
purchases of US debt by foreign governments such as Japan. It is thus
key that the major central banks manage to make this transition from
"deflation" to "inflation" as smooth as possible, without a crash in
the US dollar and without a surge in US bond yields to two-digit
For sector allocations, the fact that commodities, stocks and bonds
were rising last year indicates that the global economy, led by the
US, was already in the early stages of recovery. In their latest
communique, the G-7 acknowledged that the global economy is in
recovery. This recovery was already being signaled by the strong
performance of the industrials, basic industry and energy sectors in
2003. Indeed, according to the US Conference Board's latest forecast,
the US and major world economies are on the threshold of a genuine
economic boom and will likely record their best years since 1984.
This recovery, however, has so far been a "jobless recovery," with
consumer and business confidence lagging behind the early stages of
the recovery. However, as the Conference Board points out, "given the
acceleration in corporate profits and the decline in the US
unemployment rate -- headed back to 5 percent or lower -- business
investment in manufacturing and technology could actually exceed
the gains of the early 1990s." In addition, consumer confidence
is now rising -- further verification that the recovery has taken
root. The Conference Board's consumer confidence index rose
briskly in January, with the expectations index and the present
situation index showing good gains. Consumer confidence in the
US is now at its highest level since July 2002. Thus, if the US
can manage to avoid a dollar rout and keep interest rates under
control, US and global equities have very solid fundamental
support for a continued rally.
Typically, the industrial, energy and basic materials sectors tend to
outperform in the early stages of the economic recovery, and that is
indeed what occurred in 2003. These sectors peaked with the onset of
2004. The weight of the energy sector in the S&P 500 is now 3 percent,
which is higher than it was in January 2000, while the basic materials
sector has regained 90 percent of its prior weighting. The "jobless
recovery" in the US did little harm to housing demand, which was
actually soaring, providing a major underpinning for a US economy on
the mend. As interest rates inevitably rise, however, it will stunt
the housing expansion as well as other interest-rate-sensitive
sectors, including consumer durables such as automobiles. In addition,
consumer cyclical stocks in the US already turned sharply higher in
March 2003 and as a group have surged 47 percent since.
Actually, the two major sectors that remain significantly lower in
weight to the S&P 500 than they were in January 2000 are technology
and telecommunications services. The weight of the tech sector in the
S&P 500 plunged from 28.2 percent in January 2000 to 15.7 percent by
October 2002, and since has recovered to 18.5 percent, a full 34
percent below peak weightings. The telecom services sector fell from
7.8 to 4.1 percent and continued falling while the rest of the market
was rallying, hitting a low of 3.3 percent in January 2004. With rosy
forecasts for both global economic growth and trade, as well as
rebounding consumer and business confidence, capital expenditures are
again being ramped up and could well surprise on the upside. Thus the
stage is being set for a full-fledged recovery in IT and telecom
services in 2004.
Financial Institutions Warm to M&A Game
As we pointed out last week, the Heisei Malaise has produced growing
numbers of companies with shrinking market capitalization that have
heretofore been ignored by the sell-side and most of the buy-side
companies that are often in "gold economy" sectors like textiles, food
and real estate, where the myth of growth has long since evaporated.
But there are now new pools of money whose investment strategy is to
find companies with under-used assets that can be better deployed with
better management or a change in business model.
For Japanese banks and other financial institutions, this is
potentially a lucrative source of new loan growth, along with new
syndicated loan formats for larger projects. A recent example is
Unizon Capital's bid for Kanebo's cosmetics operation. As of September
2003, Kanebo had net negative equity and interest-bearing debts of 520
billion yen. Kanebo had been in talks with Kao to sell its cash-cow
cosmetics business, but the two firms were having difficulty coming to
terms on price. Unizon Capital proposed that it and Kanebo set up a
new company 51 percent owned by Unizon and 49 percent owned by Kanebo
that would represent Kanebo's cosmetics business. Unizon would fund
this purchase with 50 billion yen of its own capital and 250 billion
yen borrowed from Japanese and foreign banks in the form of a
syndicated loan. The sale of its stake in the cosmetics business would
ostensibly allow Kanebo to avoid bankruptcy and pay off its debts,
while providing nice capital gains when the new venture was listed --
both for Unizon and Kanebo.
During the 1980s M&A boom in the US, financial institutions were
active participants in terms of supply funds for such takeovers.
As the boom gained momentum, even the pension funds like CalPERs
joined in. As takeover specialists find they can obtain virtually
unlimited amounts of capital for the right deal, this activity in
Japan could swell to levels heretofore inconceivable in Japan, but
nevertheless more in line with Japan's OECD peers.
-- Darrel Whitten
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