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

Issue No. 15
Friday, February 14, 2003

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The Bottom Line:

o The asset allocation practices of Japan's public pension funds
have come under renewed scrutiny. While the major complaint
historically had been government-mandated asset allocation
(i.e., the infamous 50-30-30-20 rule), liberalization has
resulted in increased exposure to domestic equities just at
the wrong time. As a result, the public pension funds ・
particularly the Government Pension Investment Fund (GPIF) --
continue to rack up substantial investment losses.

o It is also disturbing to see that the pool of financial assets
in Japan is peaking and beginning to decline. Moreover,
continued stock-market losses by the nation's pension funds ・
traditionally buyers of last resort for the stock market --
are driving them and individual investors to offshore
investments in record amounts, meaning that the favorable
impact from increased exposure to equities by these pension
funds is being mitigated by incremental flows into overseas,
not domestic, equities. Indeed, these offshore investment
flows now exceed the inflow of investments in Japanese
equities by foreign investors.

o Thus the structural supply-demand picture for Japanese
equities remains bleak despite the Bank of Japan's decision to
directly purchase 2 trillion yen in equities from the nation's
banks and a possible effort by the LDP to delay imposition of
the rule requiring banks to reduce the value of their
stockholdings to within their regulated capital by the first
half of fiscal 2004. Moreover, the government and poorly
managed Japanese companies are making a serious mistake if
they believe they can continue to count on Japan's traditional
"buyers of last resort" to save them from much-needed reforms
and competition for capital.

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Japan's Government Pension Investment Fund (GPIF) may be on the verge
of dramatic reform. It only came into being in April 2001 after
merging the infamous Nenpuku (Pension Welfare Association) and is
gradually wresting control of the nation's public welfare pension
funds from the Finance Ministry's Trust Fund Bureau. As of September
2002, the GPIF had assets under management of just under 29 trillion
yen. But over the next several years (to 2008), this is expected to
rise to 150 trillion yen as it gradually assumes control of all the
nation's pension funds.

There is already debate about whether the GPIF needs to be dissolved
or its investment approach radically reformed. Prime minister
Junichiro Koizumi has stated that "serious thought" should be given to
the thought of dissolving the GPIF; the idea was first raised in 2001
as part of wider debate over the reform of public-sector corporations.
Sell-side analysts are suggesting there is an "emerging possibility"
that the GPIF could be eliminated. They take their cues from the prime
minister's remarks, but also from a heated debate under way in the
Social Security Council, a key subcommittee of the Ministry of Health,
Labor and Welfare. The subcommittee is focusing on the issue of how
public pension assets should be invested, raising the fundamental
question of whether public pensions should continue to use a
diversified investment approach that allocates a certain percentage of
assets to the stock market or pull out of the stock market altogether
and put all assets into "ultra-safe" government bonds.

The debate is intensifying as the investment losses at the GPIF
continue to mount. The fund had a cumulative deficit of 1.7 trillion
yen in fiscal 2000 and reported another deficit of 1.3 trillion yen in
fiscal 2001. That 3.0 trillion yen in cumulative deficits is
equivalent to 11.5 percent of the 26 trillion yen the fund had
invested in domestic and foreign stocks and bonds. Total welfare
pension reserves in fiscal 2001 were 147 trillion yen, of which 40
trillion yen was managed by the GPIF.

To be fair, most of the losses so far are the result of problems
inherited from Nenpuku. The GPIF inherited 1.7 trillion yen in
capital losses on the 23 trillion yen in funds inherited from Nenpuku
and in fiscal 2001 had to pay interest of 690 billion yen on these
funds that were "borrowed" from the Finance Ministry's old Trust Fund
Bureau, meaning that actual losses on investments were more like 610
billion yen in fiscal 2001. It also inherited a lot of structural
problems with these losses. For one, the GPIF manages only some 3
trillion yen in-house. The rest is outsourced to domestic and foreign
asset managers. Nenpuku had been dealing with a hodgepodge of
investment managers in a very unsystematic fashion. When Noboru
Terada, formerly of Nomura Securities, took over as head of the GPIF,
he began to review the contracts the GPIF had with outside fund

What he found by using the Sharpe ratio and other analytical
techniques was that the portfolios of all but one of the fund managers
in no way resembled the investment style the managers professed to be
pursuing. In other words, they all changed their investment styles to
suit their perception of trends in the stock market. In the end, they
all were chasing the same kind of stocks and producing the same
mediocre-to-horrible investment returns.

Stocks Will Bring More Losses
From the fiscal year beginning April 2002, the GPIF had planned to
pump about 9 trillion yen in fresh funds into financial markets, with
1.7 trillion yen going into domestic stocks. The increase in financial
market investments is tied directly to a drop in investments in
so-called *zaito* bonds, or debt securities issued to finance the
government's fiscal investment and loan program (FILP). As part of a
sweeping reform of public-sector entities, issuance of zaito bonds was
to be reduced in fiscal 2002, as the government encouraged
public-sector entities to raise money in the bond market on their own.
As a result, the GPIF was expected to spend only 6.7 trillion yen on
zaito bonds in fiscal 2002, less than 60 percent of the amount
purchased the previous fiscal year. The planned 1.7 trillion yen
investment is about equivalent to the JPY1.64 trillion yen of shares
that banks sold off last year as they unwound cross-shareholdings.

Moreover, fiscal 2002 was only the first year of a substantial
multi-year bet on stocks. The GPIF's market investments are expected
to expand to some 150 trillion yen by the end of fiscal 2008, with
their allocation to stocks expected to rise to somewhere in the 4-12
percent range, or a maximum of 11 trillion yen, making the fund the
largest single stock-market investor in the world. What the Japanese
government is already beginning to realize, however, is that given the
sheer size of the GPIF, the danger is that sudden market declines
could generate massive capital losses. Thus strengthening the entity's
risk-management capabilities takes on increasing urgency, and the
increased equity allocation is therefore generating intense debate in
the Social Security Council.

The GPIF already surprised observers in fiscal 2002 by allocating 33
percent of the 9 trillion yen in new funds more or less equally (i.e.,
1.5 trillion yen each) to foreign bonds and stocks. This was roughly
double the 15 percent allocation market participants had expected. The
19 percent allocation for Japanese stocks was also above the
12-percent long-term target but a far cry from the 50-percent
allocation demanded by some politicians as a means of propping up an
ailing domestic stock market.

R&I estimates that the average return on 170 corporate pension funds
for the first nine months of fiscal 2002 was -10.4 percent, meaning
that pension-fund capital losses are not only a GPIF problem. A change
in Welfare Pension rules now allows companies to return the so-called
"future" substitute component of their employee pension plans that
they had been administrating on behalf of the government. In an
October 2002 survey, the Employee Pension Fund Association found that
35.5 percent of Japan's 1,700 pension funds wanted to return the proxy
portion, and as many as 54.3 percent are seriously considering doing
so. Two-hundred fifty-three companies have already received approval.
From the fall of 2003, companies will also have the option of
returning the "past" portion. In principle, companies are currently
required to return the "past" portion in the form of cash. Daiwa
Institute of Research estimates that the potential selling pressure on
stock prices, if these funds were returned in cash, could reach 10
trillion yen, necessitating the sale of some 3 trillion yen in

If companies could return the "for-government" managed portion in the
form of shares, the potential selling pressure on the stock market
would be greatly reduced. This fact has not been lost on the Ministry
of Health, Labor and Welfare, which has drafted new rules that would
allow companies to return the "past" portion pension-fund assets to
the government in the form of shares, with certain conditions. Under
the draft rules, if a pension fund wishes to return assets in the form
of domestic stocks, the shares would have to be packaged so as to move
in tandem with the Topix, with a "tracking error" of 0.2 percent or

Specialists at trust banks and other pension-fund managers believe it
is possible to create an index-linked fund that satisfies those
requirements if a pension fund holds domestic stock assets worth
3-5 billion yen. This means that a pension fund will be able to return
the portion in kind if it holds 20-30 billion yen worth of assets,
under the assumption that half of the assets belongs to the proxy
portion and that domestic stocks make up around 30 percent of its
overall investment portfolio. Given these conditions, roughly 25
percent of the country's 1,700 pension funds would satisfy the
requirements. Moreover, people involved in pension management believe
that this degree of tracking error is actually more than fair. The
ministry would like to set the rules by April, begin accepting
applications from July and begin approving share transfers from
October 2003.

However, aside from realizing capital losses when stocks are sold to
transfer the funds, these pension assets do not simply disappear, but
are transferred to the Pension Fund Association (PFA), whose job it is
to manage pension assets of employees of companies that have failed,
and of employees of companies who have returned the pension assets to
the government. This fund now has some 58 trillion yen in assets. But
the PFA has the same problems as other pension funds -- negative
returns. In fiscal 2000, the fund lost 9.8 percent, and in fiscal 2001
it lost 4.2 percent; it also recorded negative returns in fiscal 2002.

Assets Have Peaked
The disturbing trend regarding structural supply-demand for Japanese
equities is that the pool of financial assets in Japan has begun to
shrink. Despite massive capital losses in the stock market, a major
secular bull market in bonds helped to support continued growth
in pension and personal financial assets throughout most of the Heisei
Malaise. However, the growth of Japan's pension assets and personal
financial assets appears to have peaked out sometime in the second
quarter of 2001 and is now down several percentage points from this
peak. Moreover, fund payouts can only increase with the rapid aging of
the Japanese population.

A major reversal in the trend toward higher equity asset allocations
for the GPIF would have a substantial impact on the stock market
because public pension funds have been shouldering a significant
amount of the selling pressure in the stock market, typically acting
as a "buyer of last resort." Public pensions have become a huge
presence in the Tokyo stock market -- their holdings of total listed
shares have surpassed that of the banks and the insurers (life and
nonlife). In 2002 for example, the trust banks (representing mainly
pension funds) were net buyers by 2.446 trillion, compared to net
selling of 1.656 billion by the banks and insurers, making the trust
banks the largest net buyers of equity in the market.

No Recourse
After enduring substantial criticism about the wastefulness of the
Finance Ministry's Trust Fund Bureau and the Fiscal Investment and
Loan Program (FILP), the Japanese government moved to dismantle the
Trust Fund Bureau and is transferring the nation's pool of pension
funds to a dedicated management organization, the GPIF. In doing so,
the government subjects "pork barrel" government-sponsored
corporations to market forces that will determine if these
organizations are really economically viable or not, and imposes
fiduciary responsibility on the GPIF to work to enhance the economic
value of the pension assets it has been entrusted with.

The sad fact of life, however, is that increased exposure to equity
markets for the nation's pension funds has so far only exacerbated the
problem -- the value of the funds continue to shrink due to
stock-market losses, while the future benefit liabilities continue to
accumulate as the funds are nowhere near producing the returns they
need to provide for future pension obligations.

What to do? The corporate pension funds are lowering projected
returns; returning the proxy portion (government welfare pension
fund portion) of their funds to the government; more actively
voting their proxies on domestic companies; increasing their
exposure to overseas stocks and bonds; and simply closing down the
funds. The government pension funds are becoming much more
demanding of the asset managers they subcontract funds to; firing
domestic fund managers while hiring foreign fund managers; more
actively voting their proxies on domestic companies; and increasing
their exposure to overseas stocks and bonds.

Given their size and influence on Japan's stock market, the nation's
pension funds cannot just "vote with their feet" en masse, as can
foreign investors, individuals and banks. They are being forced
into becoming the sentinels for Japanese corporate governance because
they are becoming major stakeholders whose fortunes are intricately
entwined with those of the companies in which they invest. Put in this
context, the growing activism of corporate and public pension funds is
very much a defensive, as opposed to an offensive, effort to try and
abate the ongoing destruction of capital arising from the structural
bear market in Japanese equities. In fiscal 2001, the GPIF saw 28 of
its asset managers vote the proxies on their holdings, and they voted
against 570 of some 42,800 shareholder proposals. The PFA voted
against 15 of 150 shareholder proposals. In fact, the fund now uses
two basic screens for picking companies: earnings and corporate

But these funds cannot simply wait for Japanese companies to improve
their returns. Director Tomomi Yano of the PFA has effectively given
Japanese fund managers and Japanese companies an ultimatum: Improve
shareholder value or watch the fund take more of its assets offshore.
In its latest review of benchmark asset allocations in September of
last year, the fund raised its benchmark allocation of foreign stocks
from 17 to 23 percent, compared with a 33 percent allocation for
domestic stocks. To MoneyWatch, this ultimatum is relevant to both the
companies in which the PFA invests and the government, and the message
is clear: "Work to improve shareholder value, or we will be forced to
invest our money offshore."

Flowing Overseas
It is ironic that the massive amounts of liquidity being provided by
the Bank of Japan has not stimulated Japan's stock market. Indeed,
most of this liquidity has found its way into "safe haven" government
bonds. However, allocations to foreign-currency deposits and overseas
securities (stocks and bonds)・ already growing steadily in the first
half of the 1990s -- have begun to rapidly accelerate. According to
the Bank of Japan's flow-of-funds statements, overseas investment
exposure (stocks and bonds) for all of Japan's pension funds has risen
from just over 6 percent in 1998 to around 11 percent of late, i.e.,
it has nearly doubled. Overseas exposure for smaller public pension
funds has also doubled from around 3 percent to nearly 6 percent. For
example, the PFA's foreign-equity exposure has increased nearly
fivefold from 5 percent in 1995 to nearly 25 percent. The same
trend can be seen in personal financial assets, where the exposure in
1999 was 0.3 percent but has since increased 2.7-fold to 0.8 percent.

In fact, Finance Ministry data indicate that portfolio investment
funds are leaving Japan for greener pastures in record amounts. Net
fund outflows for portfolio investments set an all-time high in fiscal
2002, hitting 16.1 trillion yen during the April-December period,
compared to a previous high of 14.9 trillion yen covering a period
back to 1989, when the government started tracking the data.
Securities investment outflows during the period equaled 18.1 trillion
yen. These outflows have noticeable accelerated during the latter half
of the 1990s.

If the overall "pie" of financial assets in Japan were growing, the
threat from an incremental increase in overseas investments would not
be so noticeable. Now, as the pie is shrinking, the negative impact on
the domestic equity market's supply-demand will be much greater, as
assets are being siphoned from domestic investments to increase
overseas investments.

Other Supply Problems
Amidst all the efforts to reform the banking system, the Liberal
Democratic Party (LDP) keeps trying to turn the clock back. Fearing
another "March crisis," the LDP plans to propose that the September
2004 time limit for the banks to get the value of their stockholdings
to within their regulated capital be delayed to after 2006, when the
Bank of International Settlements plans to introduce new capital
requirement guidelines. In the same proposal, they would like to
remove the provision that requires the banks to put up 8 percent of
the value of stocks sold to make it easier for them to sell their
holdings to the largely ineffective Stock Purchasing Corp.

Yet removing the immediate threat of supply because of this
requirement would not completely solve the supply-demand problem for
Japanese stocks, even given the Bank of Japan's decision to directly
purchase 2 trillion yen in equities from the nation's banks. For one,
any bank that seriously attempts to clean up its balance sheet and
improve its asset efficiency will continue to unwind unproductive
stockholdings. In addition, the continued stock market losses by the
nation's pension funds -- traditionally buyers of last resort for the
stock market -- are driving them and individual investors to offshore
investments, meaning that they can no longer be counted on to bail
out the government buy supporting Japan's stock market, even if the
GPIF's current equity-oriented asset allocations are not reversed by
government intervention.

Throughout most of the Heisei Malaise, large portfolio investment
inflows from foreign investors have acted as a balance for the
structural selling of equities by domestic investors. This is no
longer the case. Portfolio investment outflows from individuals and
domestic investors are now much larger than the inflows from foreign
investors. Thus Japan's government and poorly managed companies are
making a serious mistake if they are counting on Japan's traditional
"buyers of last resort" to save them from much-needed reforms and
competition for capital.

-- Darrel Whitten

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Written by Darrel Whitten

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