3 Japan: S. Ghon Rhee

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78 Government Bond Market Development in Asia

3
Japan
S. Ghon Rhee

I. Introduction

At the end of 1999, Japanese Government bonds (JGBs) issued by


the central Government reached ¥359 trillion (US$3.30 trillion), exceed-
ing the United States’ outstanding Treasury securities balance of $3.28
trillion. In scal year 2000 alone, Japan’s Ministry of Finance (MOF)
planned to raise ¥85.87 trillion gross through the issuance of JGBs,
while the US Treasury paid $140 billion in debt over the last two years
and plans further payments. As a result, Japan is expected to remain the
largest issuer of government debt in the world in the foreseeable future.
As summarized in Table 1, Japan’s government debt is expected to reach
137 percent of gross domestic product (GDP) in 2000, whereas the United
States and United Kingdom are expected to achieve respective debt levels
of 53 percent and 61 percent relative to GDP.

TABLE 1
Government Debt and Fiscal Decit
(percent)

Japan United States United Kingdom


Government Debt/GDP
1997 101.1 65.9 65.8
1998 117.9 62.1 65.8
1999 127.8 57.7 62.6
2000 137.2 53.2 61.0

Fiscal Decit/GDP
1997 –3.4 0.4 –2.1
1998 –5.3 1.3 0.3
1999 –7.3 1.6 –0.4
2000 –7.1 2.0 –0.6
Source: IMF, World Economic Outlook (October 1999)
Japan 79

This is bad news for Japan’s economy and the future credit rating
of JGBs. Even though it sounds far-fetched at present to discuss the risk
of runaway inŽation given the deŽationary trend of the Japanese economy,
the latent threat of inŽation cannot be overlooked in the presence of
ever-increasing scal decits in the Japanese government budget. Ac-
cording to International Monetary Fund (IMF) predictions, Japan’s scal
decit will reach 7.1 percent of its GDP in 2000, while the United States
will gain a surplus of 2 percent (Panel B of Table 1). Furthermore, inter-
national credit rating agencies such as Moody’s and Du¬ and Phelps
issue warnings about possible down-grading of yen-denominated debt
rating.
The fact that Japan will remain the largest issuer of government
debt securities is important news for further development of the JGB
market because the MOF will be forced to heed the cost minimization of
JGBs.1 Any reform measures necessary to attain this goal will be adopted
more expediently and decisively than ever before.
This paper reviews the key steps for further development of the
JGB market in aligning its infrastructures with those of the US and UK
government securities markets. The remainder of this paper is divided
into three sections. In Section II we assess if Japan’s MOF is able to
minimize the cost of JGBs given the current status of the market, and in
Section III, we identify numerous reform measures to create a more e¬ec-
tive and e¹cient JGB market. The last section touches upon particularly
urgent policy issues on the regional level for the progression of the JGB
market to better serve global and regional constituencies.

II. How to Minimize the Cost of Government Securities

Schinasi and Smith (1998) recommend three courses of action to


minimize the cost of government debt securities: (i) tap the pool of
global capital; (ii) grant greater independence to government debt man-
agement from monetary policy; and (iii) reform primary and secondary
market infrastructures to appeal to institutional investors. When the cost
minimizing e¬ort is assessed against the above three criteria, Japan’s
MOF does not score highly.

1. The ratio of government bond issues to total government expenditure in


the scal year 2000 budget will be 38.4 percent. Refer to a scal policy speech
by Finance Minister Kiichi Miyazawa at the 147th Session of the National Diet in
January 2000.
80 Government Bond Market Development in Asia

A. Tapping the Pool of Global Capital

Inonue (1999) reports that nonresidents hold approximately 10


percent of JGBs, while nonresident holdings of US and UK government
debt amount to 36.9 percent and 14.4 percent, respectively. Schinasi and
Smith (1998), however, report a smaller percentage in the order of 4 to 5
percent for Japan, citing the Bank for International Settlements (BIS)
source. This suggests that further internationalization of the yen is nec-
essary to tap the pool of global capital. Although some concerns have
been expressed regarding the delay of the implementation of reform
measures in areas such as the pension system, bank recapitalization, and
deposit insurance scheme, the MOF should be credited for its Big Bang
reforms in internationalizing the yen. As of April 1999, the withholding
tax on redemption gains and interest income from JGBs was exempted
for nonresidents and foreign corporations.2 The impact of eliminating
withholding taxes in Japan is yet to be assessed, but it is expected to
have a signicant and lasting e¬ect on nonresident holding of JGBs.3

B. Granting the Government Debt Management Program Greater


Independence from Monetary Policy

As far as the management of government assets and liabilities is


concerned, Central Banks are responsible for asset management while
Ministries of Finance maintain operational authority over liabilities man-
agement. According to Cassard and Folkerts-Landau (1997), such separation
of responsibilities is necessary considering the potential conŽicts of in-
terest between monetary policy and debt management. In Japan, however,
MOF violates the simple rule of separating assets and liabilities manage-
ment because of the activities of its Trust Fund Bureau (TFB). The TFB
is the largest fund manager in the world, managing a total of ¥440
trillion in assets, which is known as the Fiscal Investment and Loan

2. Campbell (1997) forcefully illustrates how the counterparty risk was


unnecessarily created by the lack of ownership registration to avoid withholding
taxes, and how unnecessary “churning” prior to coupon payment dates added
costly transaction costs as nonresident investors switched out of their JGB hold-
ings before the Big Bang nancial reforms were implemented.
3. Germany eliminated withholding taxes on interest income from domestic
government bonds held by nonresidents in October 1984. As a result, the per-
centage of German government bonds held by foreign investors jumped from 10
percent in 1984 to 38 percent in 1988. This information is drawn from the
Tokyo-Mitsubishi Securities Company’s web site.
4. This amount is equivalent to approximately 80 percent of Japan’s GDP.
Japan 81

TABLE 2
Fiscal Investment and Loan Program (February 2000)
(billion yen)

Amount Percent
Assets
Long-Term Government Bonds ¥ 83,302 18.8
Treasury and Financial Bills 999 0.2
General Account and Special Accounts 102,145 23.0
Government-Owned Organizations 117,850 26.5
Local Government 66,042 14.9
Special Companies 69,821 15.7
Bank Debentures 1,278 0.3
Others 1,533 0.3
Cash/Deposits 1,100 0.3
Total ¥ 444,069 100.0
Liabilities
Postal Savings and Postal Transfer Deposits ¥ 256,268 57.5
Postal Life Insurance Deposits 4,587 1.0
Employee’s Pension Deposits 130,942 29.5
National Pension Deposits 10,772 2.4
Other Deposits 36,238 8.2
Others 5,262 1.2
Total ¥ 444,069 100.0
Source: Ministry of Finance, http://www.mof.go.jp/english/mr-tfb/e1014ao.htm

Program (FILP).4 As shown in Table 2, the primary sources of the FILP


fund are comprised of postal savings (58 percent) and employees’ and
national pension deposits (32 percent). On the asset side of the balance
sheet, the fund is invested in government-owned organizations (27 per-
cent), general and special accounts (23 percent), JGBs (19 percent),
municipal governments (15 percent), etc.
Although MOF considers FILP an extension of its scal policy, its
purchasing of JGBs is perceived as critically important by market par-
ticipants in predicting the direction of long-term interest rate movement.
For example, the TFB announced in the latter part of 1999 that it would
suspend ¥200 billion ($1.91 billion) bond purchases in the open market
each month. This triggered a sharp decline in the prices of JGBs, raising
their yields to as high as 2.7 percent. After the resumption of purchasing

5. Refer to “Bond Plan Key to Halting Rise in Japan Interest,” Asian Wall
Street Journal (30 November 1999).
82 Government Bond Market Development in Asia

activities by TFB, however, the yield level stabilized to the current level
of around 1.8 percent (10-year JGBs).5 With FILP’s holdings accounting
for over one third of JGBs outstanding, the MOF is e¬ectively the larg-
est seller and buyer of JGBs. This dual role executed by MOF is in
explicit violation of the rule of separation between government debt
management and monetary policy. Comingled management of assets and
liabilities, especially FILP’s inadvertent inŽuence over monetary policy,
not only causes the cost of government-issued debt to increase but also
creates serious impediments to the development of the JGB markets, as
discussed below.

Unnished Primary and Secondary Markets Infrastructures

Recognizing the growing importance of capital market-based -


nancing, the Big Bang program implemented numerous reform measures
to improve the infrastructure of the primary and secondary markets from
November 1996 onwards. These measures include: (i) the deregulation
of cross-border transactions and foreign exchange business; (ii) the adoption
of competitive auctions to issue nancial bills;6 (iii) the abolition of the
securities transaction tax; (iv) the deregulation of brokerage commis-
sions; (v) the preparation of legal framework for loan/asset securitization;
(vi) the deregulation of o¬-exchange trading; (vii) the entry by banks,
securities companies, and insurance companies into each other’s busi-
ness; (viii) the introduction of individual stock options, and (ix) the
replacement of a merit-based licensing system with a disclosure-based
registration system for securities companies. As shown in Table 3, the
scope and complexity of the reform programs were unprecedented, and
the coordinated e¬orts of various government agencies were exemplary.
To identify the unnished reform areas for the JGB market, Japan
may want to consider the US government securities market as a role
model. In retrospect, four major developments signify the underlying
forces that rapidly expanded the US government securities markets in
the 1980s. These are: (i) the active trading of Treasury securities on a
when-issued (WI) basis, which assisted in minimizing the underwriting
risk by reducing price and quantity uncertainties; (ii) the introduction

6. Financing bills are issued on a document basis like Treasury bills. Be-
cause the discount rate remained below prevailing short-term market interest rates,
virtually all issues had to be subscribed by the Bank of Japan. Under the Big
Bang reform programs, Treasury nancing bills, food nancing bills, and foreign
exchange fund bills are all integrated into single nancing bills and they are
issued under a competitive auction system.
Japan 83

TABLE 3
Financial System Reforma
Expansion in means of asset investment

Fiscal 1997 Fiscal 1998

Enhancement to investment
trusts
Introduction of general Necessary deregulation Further improvements in
securities accounts carried out and introduced product attractiveness
(CMA) on 1 October. (amendment concerning
salaries e¬ected 10
September)
Introduction of company- Establish the general
type investment trusts institutional framework
(Investment Trust Law)
(law took e¬ect on
1 December)
Introduction of privately Stipulate privately placed
placed investment trusts investment trusts in law
(Investment Trust Law)
(law took e¬ect on
1 December)
Introduction of over-the- Store space lent for “direct Sales by banks themselves
counter (OTC) sales of sales by investment trust (Securities & Exchange
investment trusts by companies” (introduced on Law)
banks and other nancial 1 December after sales (law took e¬ect on
institutions rules were nalized) 1 December)
Full liberalization of Tokyo Stock Exchange and Introducing OTC securities
securities derivatives Osaka Stock Exchange derivatives (Securities and
introduced options on Exchange Law) (Law on
individual stocks (on 18 July) Foreign Securities Law
Enhance attractiveness of Expanding use of stock Firms) (law took e¬ect on
stocks options (law took e¬ect on 1 December)
1 June)
Promoting share buy-backs
as a means of writing
down prots
(law took e¬ect on 1 June)
Smaller minimum Have already articulated
investment lots for stocks how the Commercial Code
is to be interpreted
regarding conditional
changes in the Articles of
Incorporation (31 July)
Streamlining of foreign Introduced DR-based Designate DRs as securities.
equity listing by using trading in listed foreign (Securities and Exchange
depository receipts (DRs) equities (1 June) Law) (law took e¬ect on 1
December)
Revision of listing standards
(1 December)
(Tokyo Stock Exchange)
Improve access to trading Eliminated the system that Tokyo Stock Exchange
and quotation gives access to real-time Enhancement of market
information information only to information (30 November)
branches near the market
(1 October)
a
– This schedule was released by MOF in June 1999. It contains major reform
programs even though some updating of correct progress is needed. Please refer to
http://www.mof.go.jp/english/system/system.htm.
84 Government Bond Market Development in Asia

of nancial futures and options written on Treasury securities, which


provided necessary vehicles for hedging of interest rate risk; (iii) the
expansion of repurchase (repo) and reverse repo (RRP) transactions which
supported the increase of market liquidity and short-term investment
activities, and (iv) the introduction of the Separate Trading of Regis-
tered Interest and Principal of Securities (STRIPS) which facilitated hedging
of reinvestment risk through coupon stripping.
Currently, WI trading is illegal in Japan, and STRIPS is yet to be
introduced. Although localized variations of repo markets such as the
Gensaki market and the Kashisai market emerged in Japan, their devel-
opments were inhibited by tax-related impediments (Gensaki) and the
interest rate ceiling on cash collateral (Kashisai). For example, as Gensaki
is recognized as a form of bond trading, trading was subject to securities
transaction tax. Therefore, the majority of Gensaki transactions were
implemented using Treasury bills and nancing bills that were exempted
from securities transaction tax. However, stamp duties on bills could not
be avoided. In contrast, transactions on the Kashisai market have not
been subject to securities transaction taxes. Legal and operational mo-
dalities of the two market reŽected a hybrid form of American-style classic
repos and European-style sale-and-buyback contracts. As a result the two
markets could not fully develop. The Japanese futures market (with equity
index and long-term bond as underlying assets) has earned the unfortu-
nate reputation of being overregulated because of stringent regulatory
policies, including margin requirements and circuit breakers.

III. Post-Big Bang Reform Measures

In terms of GDP, Japan’s economy is about one half the size of the
US economy and about four times as large as that of the UK. As Japan’s
capital market development emulates the past experiences of its US coun-
terpart, the above four areas should be an interesting point of departure
in assessing further reforms for the JGB market. Since the JGB market
has matured in its own historical, macroeconomic, and institutional frame-
work, it faces a unique blend of capital market policy issues. Therefore,
this section will examine some capital market policy issues that are
unique to the JGB market and in light of US market experiences.

A. Lack of Primary Dealer System

One idiosyncratic feature of the JGB market is the lack of the


primary dealer (PD) system. This may be largely attributed to the role
played by TFB as a de facto underwriter in the primary market. With
Japan 85

TFB serving as an active buyer of newly issued JGBs (usually under a


buy-and-hold investment strategy), purely competitive public auctions
must have been di¹cult to implement. Naturally, underwriting by a syn-
dicate has been the standard in the JGB primary market, especially for
the benchmark 10-year bonds, with the specic goal of absorbing the
full amount of new issues. Although competitive auction features were
built into the current syndicate underwriting, their utilization has been
limited. Public auction systems (based on multiple-price auctions) were
introduced later for bonds with maturities of 2, 4, 6, and 20 years, but
syndicate underwriting and noncompetitive auctions remain the major
vehicle for absorbing new issues of JGBs. Thus, a PD system providing
competitive bidding at primary auctions did not nd a position in the
JGB market.
With respect to international investors’ primary concerns regarding
low liquidity and large spread between bid and ask prices on the JGB
market, the introduction of a PD system is denitely a viable alternative
worthy of serious consideration (Table 4). PD systems are designed to
attain at least three goals in the government securities market: rst, e¹cient
price discovery through intense competition among participating deal-
ers; second, provision of liquidity through market-making, and third,
distribution of government-issued securities. In addition, PDs serve as
the counterparts to Central Banks in open market operations (OMO).
Most advanced economies have adopted the primary system with the
exceptions of Japan and Germany, which are both historically known for
their bank-based nancial systems, rather than the US- and UK-style
capital market-based nancial systems.
The major impediment to the adoption of the PD system in Japan
is MOF’s role as a buyer of JGBs. Therefore, it is a blessing in disguise
that the MOF expects a large shortfall in FILP funds, amounting to
approximately ¥35 trillion, when xed 10-year deposits in the National
Postal Savings System mature in 2000 and 2001.7 This will force MOF
to review structural reforms in the funding method and management of
FILP agencies, with an implementation target of 2001. Given the sheer
magnitude and scope of FILP activities, the complexity of FILP reforms
is beyond comprehension. 8 However, the overall direction of FILP re-
form is not di¹cult to dene, no matter how complicated the process.
First, FILP agencies should be corporatized to gain complete autonomy,
while the MOF should adopt a hands-o¬ policy to facilitate the separate

7. “Japanese turn to ‘zaito’ to boost nances”, Financial Times, 13 March 2000.


8. MOF web site, http://www.mof.go.jp/english/zaito/zae054a.htm, “Funda-
mental Reform to the Fiscal Investment and Loan Program (FILP).”
86 Government Bond Market Development in Asia

TABLE 4
Government Securities Markets

Japan United United


States Kingdom
Turnover Ratio 6.9 22.0 7.0
Bid-Ask Spread
10-Year On-the-Run Issues 7.0 3.1 4.0
10-Year O¬-the-Run Issues 7.0 6.3 4.0
Maturity Distribution (percent)
⬍ 1 Year 5 21 7
1–5 Year 8 62 29
5–10 Year 78 0 34
⬎ 10 Year 9 17 30
Average Issue Size (US$ billion) 8.2 13.9 5.6
Government/Central Bank Holding (percent) 46.3 13.1 3.6
Nonresident Holding (percent) 10.0 36.9 14.4
Settlement T⫹3 T⫹1 T⫹1
DVP-Basis Settlement (percent) * 67.6 percent 100 100
of registered
JGBs and 42.7
percent of book-
entry JGBs
* All JGBs
through BOJ-
NET
Number of Primary None 37 16
Number of Dealers 501 1,700 16
Source: Inoue (1999)

management of government assets and liabilities. Second, the MOF should


not meddle with the JGB market as an active buyer. The MOF’s direct
involvement should be limited to issuer’s function in the capacity of the
manager of government debt.

B. Introduction of the Uniform-Price Auction Method

In a MOF publication Guide to Japanese Government Bond 1998,


the uniform-price auction method is introduced as a noncompetitive bidding
method executed auction undertaken concurrently. This is not a generic
denition of the uniform-price auction but a Japanese-specic interpreta-
tion. Under the conventional uniform-price auction (also known as the
Dutch auction), all bidders whose tenders are accepted pay the same
price for a given security. This is either the lowest of the accepted prices
or the highest of the accepted yields. Therefore, some of the successful
Japan 87

bidders may pay a lower price than they actually bid. In contrast, under
the multiple-price auctions (also known as the discriminatory auction),
participants submit sealed bids and pay the prices they bid. The Govern-
ment accepts the bids at gradually lower prices until the price at which
the auction is fully subscribed. 9 As a result, successful bidders for a
security may pay di¬erent prices for that security. These multiple-price
awards result in the winner’s curse, which means that the highest bidder
wins the auction by paying the highest price, only to nd that another
bidder pays a lower price. Bidders therefore tend to shade their bids
below the maximum that they are actually willing to pay.10 Since Salomon’s
short squeeze scandal was uncovered in mid-1991, the multiple-price
method has been criticized for failing to minimize nancing costs to the
US Treasury, and for encouraging manipulative behavior in the market-
place. The uniform-price, sealed-bid auction is advocated as an alternative.11
Australia, France, and New Zealand now utilize multiple-price (or
multiple-yield) auctions to sell marketable securities, while Canada, Bel-
gium, Italy, and the Netherlands use them for some portions of marketable
securities. Uniform-price, sealed-bid auctions are employed in Denmark,
Switzerland, and the United Kingdom. Beginning in 1992, the US Trea-
sury experimented with uniform-price auctions for two-year and ve-year
notes. Malvey, Archibald, and Flynn (1995) and Malvey and Archibald
(1998) indicated that these auctions produced marginally greater rev-
enue on average for the US Government. Nyborg and Sundaresan (1996)
report that WI market volume is higher under uniform-price than mul-
tiple-price auctions, which indicates a higher information release. The
information release, in turn, reduces preauction uncertainty, the winner’s
curse, and the probability of short squeeze. Feldman and Mehra (1993)
stated that uniform-price auctions become readily accepted because of
their administrative simplicity, economic e¹ciency, and revenue-enhancing

9. In some countries, minimum cut-o¬ prices are imposed by Ministries of


Finance or the scal agents conducting auctions. This may prevent a truly com-
petitive bidding process because: (i) the bidders try to second-guess cut-o¬ prices
rather then assessing the demand and supply of the securities to be issued, or (ii)
the cut-o¬ prices may set the yields higher than market conditions warrant. At
the time of writing, it is not known to the author whether this practice is used in
multiple-price auctions in Japan.
10. For details, refer to the Joint Report on the Government Securities
Market (1992) prepared by the Department of the Treasury, the Securities and
Exchange Commission, and the Board of Governors of the Federal Reserve System.
11. Friedman (1991 and 1960), Chari and Weber (1992), and Umlauf (1993).
12. Umlauf (1993), Nyborg and Sundaresan (1996), and Heller and Lengwiler
(1998).
88 Government Bond Market Development in Asia

potential. A plethora of academic research papers provide empirical evi-


dence in support of this perception.12
As shown in Table 5, Japan’s MOF never adopted uniform-price
auctions, whereas the US and UK employ these auctions for index-linked
bonds and some bonds with specic maturities (two- and ve-year bonds
in the United States).13 The US Treasury is considering expanding the
use of uniform-price auctions for all Treasury issues in the near future.

C. Lack of When-Issued Trading

Among developed government securities markets, Japan is the only


one that considers WI trading illegal. In most advanced markets, including
the United States, trading between the time a new issue is announced
and the time it is actually issued (ranging from one to two weeks) is
allowed, and the issue is said to trade “when, as, and if issued.”14 WI
trading functions like trading in a futures market, in which long and
short positions are taken prior to the settlement date, which is the issue
day of the security traded. Prior to auctions, WI securities are quoted for
trading on a yield basis, because a coupon is not determined until after
an auction is completed. Subsequent to auctions, they are quoted on a
price basis. The most important benet of WI trading is the minimization
of price and quantity uncertainties. The risk of underwriting becomes
smaller, and potential revenue from the new issue increases for the govern-
ment as trading on a WI basis facilitates price discovery and distribution.
By not allowing WI trading, the MOF foregoes these benets.

D. Repo Market

A repo represents the sale of securities by the borrower to the


lender (investor) with an agreement to repurchase the securities at a
specied date and price. It is a combination of spot sale and forward
purchase of the securities. The di¬erence between the selling and repur-

13. Because the uniform-price auction is a legitimate competitive mecha-


nism, the Japanese version of a noncompetitive uniform-price auction is a misnomer.
Noncompetitive bids specify quantity only, while competitive bids specify both
price (or yield) and quantity. In Japan, the price used for settlement for a non-
competitive bid is the weighted average price from the competitive auction conducted
concurrently. By design, this noncompetitive method should be restricted to small
transactions intended for small investors and should remain as an insignicant
supplement to multiple-price auctions.
14. Appendix A “Background on the Treasury Securities Market,” Joint
Report on the Government Securities Market (1992), A1-A19.
Japan 89

TABLE 5
Auction Methods for Government-Issued Securities

Japan United States United Kingdom

Uniform-Price None •2- and 5-year notes •Index-linked Bonds


Auction
•10- and 30-year index-
•linked bonds
Multiplice All JGBs •10- and 30-year bonds •All Securities other
•than index-linked
•bonds
•20-year bonds: •3-, 6-, and 12-month
•Competitive auction •bills
•Only
•2-, 4-, and 6-year
•bonds: both
•competitive and
•non-competitive auction
•5- and 10-year
•bonds: syndicated
•underwriting

Source: Asia-Pacic Financial Markets Research Center, University of Hawaii.

chasing prices represents the interest on the transaction. The borrower’s


repo is the lender’s RRP. The repo market serves numerous purposes. It
allows PDs to cover their short positions, institutional investors to maxi-
mize their investment income by lending their securities, and foreign
investors to reduce currency risk through money market hedging.15 It
also facilitates clearing and settlement transactions and enhances market
liquidity. Without an active repo market, the primary and secondary markets
cannot develop their full potential.
The Kashisai market (now patterned after the US-style repo mar-
ket) is basically a cash-backed bond lending market with the same e¬ect
as that of the Gensaki market. However, Kashisai transactions di¬er from
Gensaki transactions in that they are marked-to-market on a daily basis
like the US-style repos. Kashisai transactions steadily increased since
the shift to rolling settlement in October 1996.16 The Kashisai market

15. Bossard (1998) reports that the newly developed repo market in 1991 to
1993 was essential to foreign participation in the French government securities
market. At present, one third of French government securities are held by non-
residents.
16. “Executives Meeting of East Asia and Pacic Central Banks and Monetary
Authorities,” Financial Markets and Payment Systems in EMEAP Economies (1997).
90 Government Bond Market Development in Asia

witnessed the elimination of a major impediment when the upper limit


on interest rates charged on the cash collateral was lifted in 1996. In
addition, market participants in the Gensaki repo market have been ex-
empted from payment of securities transaction tax since 1999. With these
positive developments, one would expect the Kashisai and the Gensaki
markets to take o¬. Puzzlingly, no drastic changes in market activities
have been reported so far, and this warrants a careful review.

E. Introduction of STRIPS

At present, Japan does not allow coupon stripping, which splits


bond income streams into coupon interest and principal repayment. Cou-
pon stripping was devised in 1982 by Merrill Lynch and Salomon Brothers
to serve bond investors who were concerned about reinvestment risks.
Beginning in 1985, the Treasury introduced the STRIPS program to for-
malize the stripping of designated Treasury securities. The main appeal
of STRIPS is to provide the market with highly liquid zero-coupon Treasury
bonds and notes, thereby expanding the bond investor base. The strip
market also generates arbitrage activities. PDs continuously check the
price of strippable bonds against the sum of the stripped parts (the “whole”
versus the sum of “parts”). The existence of a zero-coupon yield curve
allows a better pricing of traditional coupon bonds. In developing a
very active government securities market from an insignicant and illiq-
uid market, the French authorities, for example, introduced a set of
well-sequenced reform measures. As shown below, the introduction of
STRIPS and the creation of a legal and institutional framework for the
repo market were the latest set of reform measures implemented in France:

• Bond futures market (1986)


• Primary dealer system (1987)
• Interdealer broker network (1987)
• Purely competitive auctions (1987)
• Repos (1991)
• STRIPS (1991)

Given the US experience with STRIPS, and more recent experi-


ences in the French government securities market, the MOF should expedite
the introduction of STRIPS.
Japan 91

Internationalization of the Yen: Implications for the Creation of a


Regional Bond Market

Under the new Miyazawa Initiative, a total of US$30 billion was


pledged by Japan, with half being made available for the medium- to
long-term nancing needs of Asian economies a¬ected by the nancial
crisis. At least two measures under the initiative are directly related to
regional bond market activities. These are: (i) the acquisition of sover-
eign bonds issued to Asian countries by the Export-Import Bank of Japan,
and (ii) support for Asian countries in raising funds from international
nancial markets through the use of guarantee mechanisms. These are
important vehicles to promote the global and regional role of the Tokyo
market by expanding the Gaisai market. Gaisai is a general term as-
signed to all foreign and yen-denominated bonds issued in Japan by
nonresidents. Yen-denominated bonds are called samurai bonds, while
foreign-currency denominated bonds are known as shogun bonds. The
capital market-related funding programs of the new Miyazawa Initiative
were expected to provide the Tokyo nancial markets (both on- and o¬-
shore) with a critical momentum to rea¹rm itself as a global and regional
nancial center. Unfortunately, no details have been available from the
MOF regarding the implementation of the above two measures, and the
underlying reasons for this are not clear. As shown in Table 6, the amount
of Gaisai bonds issued does not exhibit any substantial increases over
the ve-year period from 1995 to 1999.
As an international nancial center, the Tokyo market must compete
with other nancial markets, including the Eurobond market. As shown
in Table 7, the di¬erence in all-in-cost to a sovereign borrower of ¥20
billion between samurai bonds and Euro-yen bonds amounts to seven
basis points or ¥14 million. The time di¬erence required for bond issuance
in both markets di¬ers substantially (from six to seven weeks to a few
days). With a recording system still in place, the clearing and settlement
processes in the samurai bond market are far more cumbersome than the
Eurobond market, where Euroclear and Cedel are readily available and
utilized. Concerted e¬orts must be made for the Tokyo market to serve
both global and regional customers more e¹ciently, and at less cost.
Numerous reform measures have been undertaken to international-
ize the yen and promote foreign investments in the Tokyo nancial markets.
A legal framework for the promotion of cross-border transactions has
been put in place with the revision of the Foreign Exchange Law in
April 1998, but much more has to be done to facilitate actual transac-
tions. For example, clearing and settlement have to be revamped to
introduce delivery versus payment (DvP). At present, 67.6 percent of
92 Government Bond Market Development in Asia

TABLE 6
Volume of Gaisai Bond Issuance
(trillion yen)

1995 1996 1997 1998 1999 b


Samurai Bonds 1.6 3.9 2.1 0.3 0.5
Shogun Bondsa 0 0 0 0 0
a
Last shogun bonds were issued in 1994; b Including the rst 10 months only.
Source: Industrial Bank of Japan Securities Company (http://www.ibjs.co.jp/e/reports)

TABLE 7
Cost Di¬erential between Samurai and Euroyen Bonds
Assumptions:
Issuer: Sovereign Borrower
Issue Amount: ¥20 billion
Term: Five years

Samurai Bonds Euro-Yen Bonds

Underwriting Fee 40 bp (upfront) 25 bp (upfront)


Commissioned Bank
Fee/Recording Fee 3 bp (upfront) not applicable
Interest Payment Commission 20 bp (of each payment) nil
Principal Payment Commission 10 bp (at maturity) nil
Out-of-Pocket Expenses ¥15 million (upfront) ¥ 8 million (upfront)
All-in-Cost to Issuer (percent) 2.03 (s.a.) 1.961 (s.a.)
Time-Length of Launch 6 to 7 weeks A few days
Clearing and Settlement Recording System Euroclear and Cedel

Note: bp = basis point; s.a. = semi-annual basis


Source: Industrial Bank of Japan Securities Co. (1998)

registered JGBs and 42.7 percent of book-entry JGBs are settled on the
DvP basis, whereas all JGBs processed through the Bank of Japan Finan-
cial Network System (BOJ-Net) rely on the DVP settlement. In contrast,
US and UK government securities are all settled on a DvP basis. Addi-
tionally, JGBs are not eligible for clearing through international clearing
houses such as Euroclear and Cedel, whereas all US and UK government
securities are. Furthermore, no regional clearing network has been cre-
ated to link the Tokyo clearing system with the region’s nancial centers
such as Hong Kong, Singapore, and Sydney. A T+3 settlement period for
JGBs is longer than the T+1 cycle for US and UK securities. Real-Time
Gross Settlement must also be completed to bring Japan’s practices in
Japan 93

line with US and UK systems.17 No publicly accepted practice exists for


failure of deliveries in Japan, unlike in the US and UK markets.18
A great deal of work has yet to be done for the harmonization
of cross-border listing, trading, clearing and settlements, securities bor-
rowing and lending, repo markets, etc, and a study of inter and intraregion
portfolio capital Žows must precede the implementation of the above
cross-border infrastructures. In his own assessment of the Japanese debt
market serving the Asian and Pacic region’s nancing needs, Sakakibara
(1999) noted that the JGB market still lagged substantially behind those
of London and New York in terms of market infrastructure. Therefore, in
addition to building domestic market infrastructures, Japan should in-
tensify its e¬orts to assume a leadership role in creating regional bond
market infrastructures in Tokyo and other nancial centers in the region.
One of the key projects in the development of such infrastructures should
focus on the creation of a single regional central securities depository to
perform the safekeeping, clearance, and settlement functions for all se-
curities available in the Asian and Pacic region.19

17. The target date of adopting RTGS for JGBs is the latter part of 2000.
18. Refer to Appendix “Table of Questionnaire Results” of Bank for Inter-
national Settlements, 1999, Market Liquidity: Research Findings and Selected
Policy Issues (May).
19. For the regional and global level clearing and settlement, refer to Rhee
(2000) and Morgan Guaranty Trust Company (1993).

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