The Problem in the Japanese Bond Market - Essay Example

Japanese bond market Part 1 History of Japanese Bond Market Corporate history of Japan dates back to 1867 when Meiji Revolution brought in western style modernisation. In 1878, Tokyo stock exchange was established. In 1890, Osaka Railway made a first ever bond issuance. 1927-1933 witnessed active issuance of corporate bonds. Due to Word war II from 1941-45 there were no bonds issue during and after the war. In 1963, Japan joined OECD and in 1966 First JGB (Japanese Government Bonds) issuance was made after the war. After the oil shock 1973, JGBs were issued for the first time to finace budget deficts. (Endo 2002) However, Japan is known for its bank dependent economy unlike market-centred economy of the U.S.A. and the U.K. Japanese firms have been reported to have mobilised only 8% of their funds through issue of bonds in the recent 1997-2001 period as against just 1% by German firms. (Allen and Gale 2000) See figure 1 below. Part 2 Japanese Bond Regulations As early as in 1930s, Japanese firms were issuing bonds without the backing of collaterals resulting in disputes between investors and bond issuers due to defaults. Underwriters were also blamed for carelessness though they were forced to purchase the defaulted bonds but at one point of time, they also found it difficult to take over the defaulted bonds. This state of affairs forced compulsory revision of law making it mandatory for providing collaterals for the bonds issued. The rule known as Compulsory collateral made the corporations to provide their land and buildings as collaterals for the bonds issued. Later by the end of World War II, the Japanese Government through its Ministry of Finance and Bank of Japan formulated eligibility criteria for the bond issuers known as Qualification Standard aimed at blocking financially weak bond issuers to gain investor confidence. The criteria for qualification were measured through several financial indicators such as amount of capital stock, net assets and capital ratio. The selected issuers were then ranked by grading them as ‘AA, A, BB, and B which determined the quantum of bond issues for each bond issuers. The ranking method is not similar to that of American type of credit rating which indicated the extent of default risk. For issue of Domestic Bonds, a company should be a listed company with 1 billion yen or more outstanding in par value and its securities must be well diversified among individual and corporate holders. For delisting outstanding in par value must be less than 300 million yen and it is done on the 4th business day prior to maturity date. For issue of Government bonds listing application is not necessary but criteria are the same as for domestic bonds. For delisting outstanding in par value should be less than 300 million yen while schedule is the 6th business day prior to date of maturity. Foreign bonds are of two kinds. They are Samurai Bonds and Shogun Bonds. For both applications for listing is necessary. Samurai bonds are yen-denominated bonds issued in Japan by non-Japanese companies. Shogun bonds foreign currency denominated issued in Japan by non-Japanese companies. Listing criteria for Samurai bonds are that there should be one billion yen or more outstanding in par value evenly spread over amongst individual and corporate owners. Delisting conditions are the same as for domestic bonds. Shogun bonds are listed as per conditions applicable to Samurai bonds. Convertible bonds can be from corporate bonds, bank debentures, municipal bonds and government associated organisation bonds listing and delisting condition for which are the same as for domestic bonds. (TSE) Part 3 What factors affect Japanese Bond Market As bond issuers had no choice of stipulating interest rates in relation to their creditworthiness Japanese corporations found bonds not so attractive. As a result, Japanese corporations during 1970s started resorting to overseas markets in New York, London, and Switzerland by issuing foreign bonds. This made the Bank of Japan and Japan’s Ministry of Commerce to consider how to revive the domestic bond market. (Yamori et al 2006) In spite of deregulation of bond issues, there were bond failures attributed to not so careful credit rating See the table 1 below for the failures. As per the report of Merrill Lynch, Japanese Government Bond market ranked the second largest in the world for the second time in the year 2001. The world bond market for the year 2000 was $ 31.4 trillion equalling world’s total GDP. (Basta 2001). Ozeki (2006) says that Japanese bond market has undergone drastic change in the face of deflation and financial crisis in the last decade and also has been influenced by world events such as Asian currency crisis, burst of the I.T. bubble, and poor credit rating for G.M. and Ford. Figure 2 below would show the linkage between Japanese and Global markets (Figure 2) The three factors of world bond market that have influenced Japanese bond market are direct impact of Samurai bonds, attitude of overseas investors on stocks towards the Japanese bond market, and impact of performance of global bond markets on Japanese investors who compete for domestic bonds. The first one concerns Samurai bonds that are yen-denominated bonds issued by non-Japanese corporations. These bonds of Xerox in 2000, Enron in 2001, Worldcom in 2002 and GM/Ford in 2005 purchased by Japanese investors had to be offloaded by them for distress sales due to defaults and downgrades of the said companies. This gave rise to vicious circle in Samurai market by selling leading further selling for investors’ liquidity needs. The second one is foreign investors in Japanese stock market which is volatile also view the Japanese bonds with risk aversion and market sentiment. The third factor that domestic investors will increase or decrease their investment in foreign bond depending on the performance of domestic bonds. That is domestic bond market will respond negatively if the foreign bonds perform poorly and not that when there is lesser demand for foreign bonds, it will result in increase in demand for domestic bonds. The figure 2 above would show two cycles of 1997-2000 and 2001-2005 in the credit spreads. In the first cycle, Japan’s financial crisis started in 1997 due to which capital injection to Banks in Japan was resorted resulting in temporary economic recovery and reduction in risk premiums. At the same time Asian currency crisis in 1997, Russian debt crisis in 1998, IT bubble in 1999-2000 occurred parallel to events in Japanese market. The second cycle of 2001-2006 witnessed bursting of IT bubble, and resurfacing of economic crisis in Japan. Reform project in Japanese financial system that took place in 2003, showed economic recovery in 2005 and shrinkage in risk premiums. To develop bond markets, Japan abolished securities transaction tax in March 1999, passed securitization laws in November 2000 and introduced repurchase (repo) transactions in April 2001.In 2005 Japan took the following measures to attract foreign investments in Japanese bonds. The foreign juridical persons except those charged with income tax on interest, who had been restricted to foreign governments, foreign central banks and international institutions, are now eligible to hold inflation-indexed bonds. Formalities required of foreign investors to receive tax exemptions on Japanese Government bonds have been simplified. In order to promote purchase by foreign investors, seminars on JGBs have been conducted in London, Amsterdam, Frankfurt, and Paris in January 2006. For foreign investors, the following are the main initiatives taken in the last decade. In 1999 through 2002, tax exemption on interest on JGBs has been allowed. Tax emption on profit on Treasury Bills (TBs) redemption was introduce in 1999 and further expanded in 2004. With the advent of STRIPS, tax exemption on loan interest received by certain foreign investors Gensaki transactions (repo transactions) and transactions using JGBs has been permitted. Samurai bonds issued in 2004 amounted to 1.68 trillion yen equivalent to US$ 16.2 billion and this represented an increased by 730 billion yen equivalent to US $ 7.1 billion from last year. Indian Export-Import Bank in Japan issued Samurai bonds for 20 billion yen (USD 194 million) first time in the last fifteen years which evoked considerable interest among many Japanese institutional investors. The book transfer system introduced in 2006 for non-JGB bonds is expected to improve operational convenience in Bond markets. (AFMM) Bond lending known as repo transactions are an important feature of Japanese Bond Market. The two types of repo transactions are cash collateralized bond lending and Gensaki. The bond lending in Japan started in 1989 but without collaterals because of the interest factor on collateralised lending, was liberalized in 1995 by removal of restrictions and this became the main feature of the bond lending in Japan. Gensaki bonds were mainly restricted to Treasury bills and FB as they were exempt from securities transactions tax. When this tax was abolished in 1999, it was decided to replace the cash-collateralized repo system by globally standardized transaction system resulting in new type of Gensaki bonds with inbuilt mechanism being issued for cross border transactions as well as domestic transactions. As there is no restriction on foreigners to own Japanese bonds, investors are free to conduct capital transactions in bonds with foreign individuals and companies. (Asian Development Bank 2005 p108-120) Japan is the world’s largest debt issuer yet it has no published information on segments of investors. Hence it has been decided to keep especially non-resident investors informed. As the funds from non-resident investors are held by custodians who are reluctant to risk on being taxed for their JGB holdings, non-resident investor base still remains limited. If there is a scheme to free the custodians from worrying about tax implications, foreign investor base for JGB will surely expand. (Minutes of Meeting 32nd round 2004) A business week online report of May 2, 2007 says any pull out by Japanese investors from U.S. treasury market will not result in spiralling of interest rates as it happened in 1987 though conditions remain the same. Many people are of the opinion that something that hasn't happened for 20 years is unlikely to happen again. Still, the U.S. current account deficit as a percentage of gross domestic product is already nearly twice what it was in 1987, while Japan's current account surplus has reached levels comparable to those of 1987. These two factors could contribute to dollar selling and yen strength, respectively. While another March, 1987-style collapse in the dollar may not happen anytime soon, the fact that countries are beginning to worry about inflation and mini-bubbles is indeed reminiscent of conditions in 1987 and we need to tread carefully. (Richard 2007) Part 4 Factors of Japanese bonds that would affect world bond market The three ways of funds mobilisation by corporations are equity instruments, bonds and bank borrowing. Of late there has been much discussion about optimal debt-equity ratio ever since Modiglini and Miller in 1958 propounded the theorem on firm value emphasising on cash flows over leverage. A firm can maximise its value through an optimal debt financing rather than 100 % equity financing due to the short term nature of commitments. Bonds financing stands at a higher plane than bank borrowing due to likely interference by Banks in day to day management and compulsory payment of interest at the Bank determined rate and rests. In case of Bonds, once bonds are issued, the firms can concentrate on their core activities to be able to redeem the bonds on the appointed time where as Bank borrowing is continuing one having to submit reports to the controlling authorities more often than in the case of bonds. Bond markets have become important for a country’s economy because investors are better placed than bankers to identify investment-worthy firms. United States is the only country with a well-developed corporate bond market as evidenced by the percentage of GDP’s of other countries being just a fraction of the U.S. percentage in bond market financing. (Rajan and Zingales 1995) In contrast, Bank financing was three times that of U.S. in 1995.for other countries like Japan, Malaysia and Thailand. (Sapsford 1997) A well-developed bond market will be featuring a well-functioning derivatives market with interest rates and currency risks properly hedged. If a bond market is free from Governmental interference, the economy of a country will be less likely to face crisis due to non performing loans advanced by the banking system due to its inherent inferior risk assessment capacity. As per the estimates banks hold 60% of savings in Japan as against 20 % in the U.S. (Sapsford 1997) The heavily bank financed economy will have fewer decision makers than in the case of bonds backed economy. For example in Thailand maximum lending was done by just four banks. Banks will tend to hide non-performing loans with the tacit approval the Governments to portray a well managed economy, whereas Bond issuers have to be vigilant right from the start. Bond investors have better risk assessment record than Banks since bond investors have direct stake in the outcome than the Banks in their lending outcomes. Besides, Banks tend to give more loans only when their deposits are bulging and they also dump loans on unwilling borrowers to show results which is not a healthy functioning. Moreover, in case of inadequate deposits with banks, corporations will be at peril without timely financing if they have no access to bonds market. (Hakansson H 1999) Factors affecting World bond market Calling it Tsunami in the bond market, Fekete (2005) says that U.S. Federal Government and Bank of Japan are doing check-kitting in high secrecy as the former had been and still doing with U.S treasury. It is done by exchange of non-interest bearing yen balances for interest bearing Treasury debt in more than required volume just to finance American huge trade deficit with Japan. As early as in 1999, Business week reported under the caption “The Bond market that shook the world.” The Government of Japan announced that his ministry would close $ 3.4 billion worth of Government Bonds of Japan but it ended up buying its own bonds as the buyer of the last resort. Instead of bond market collapsing, it triggered soaring of the bond prices with lesser yields from 2.4% to 1.9 %. Yen came down by 118 to dollar. Wall street also followed suit resulting in coming from a high of 5.43% prevailing for over six months. Japan had already promised $ 700 million in tax cuts having no scope for funds coming in. Hence at the behest of the U.S. to kick start its economy my making buy its own bonds. “In effect, the ministry is taking money out of one pocket--the vast trust funds that it manages, such as the $2 trillion in the postal savings system--and putting it in another. What's needed now is for the Bank of Japan to buy bonds, effectively monetizing the debt and juicing Japan with new cash. ‘‘[Rubin and others] want the Bank of Japan to step in,'' says one international monetary official.”(Business week 1999) These kinds of market interventions artificially make the bubble burst ultimately affecting not only Japanese bond market but also world bond markets. Part 5 What's the advantage and disadvantage or problem in Japanese Bond Market Both advantages and disadvantages seem to come from rating agencies. The need of the hour is therefore the rating agencies of American orientation should take local conditions and culture in Japan in proper perspective and play a realistic role while they announce their ratings as the bond market is easily influenced both ways by credit ratings. The JGBs are only used to tide over crisis situations and to give tacit support to U.S. Government to tide over their trade deficit side effects. The JGBs are not backed by assets. This will only add to the bubble and in order to avoid bubble bursting, Japan has fallen into the vicious circle of endless infusion of JGBs into the system. The fact that Japan is well entrenched in capital goods production which renders the rest of the world dependent on it, is the only silver lining for Japan’s economic crisis. The official version of through the Minutes of Meeting by Finance Ministry in 2005 5th round says that the Japanese economy is still in a state of instability as to which direction it will take and that stock prices have yet to reach 12,000 yen level which does not appear to happen in the near future says that any occurrence of rise in stock price will have a bearing on the Bond market. Since investors in the U.S. have shifted to treasury bills due to sluggish functioning of securities, it has affected Japanese bond market favourable resulting net buying for the year 2005 to be substantial. (Minutes of Meeting 5th round 2005) Due to non-performing loans after the bubble period, banking sector of Japan has been severely crippled and causing stains of the banks’ capital structure. The bank dependant corporate sector was starved of funds resulting poor performance of Japan’s economy for a prolonged period. This could have been avoided had there been a wider capital market accessible to corporate sector. Developing a domestic bond market with access to foreign borrowers will result in better allocation of surplus liquidity and overall improvement of Japanese economy. Though the bank-oriented economy of Japan has been evidently turning into a market based economy, allocation of domestic savings still is dependent on banks’ intermediated lending. Therefore financial reforms must aim at identifying alternative ways of redirecting savings to productive assets keeping in view the broad-based market system. Ddevelopment of Japan’s bond market can be achieved by “ (i) removing regulation which limits access to the underwriting and trading process; (ii) reducing the concentration of market power in the hands of banks; (iii) encouraging a broader investment choice by Japanese investors including households and institutional investors; (iii) improving infrastructure for the issuing and trading of securities; and (iv) promoting the issuance of debt securities among potential domestic borrowers; (v) encouraging non-resident borrowers to tap the pool of Japan’s excess domestic savings through domestic bond issues; and finally (vi) encouraging further internationalization of the yen, since there is a lack of yen funding requirements by foreign firms.( Batten and Szilagyi 2002) References AFMM+3, Hyderabd, India May 3-4, 2006 Asian Development Bank 2005 “Bond Market Settlement and Emerging Linkages in Selected ASEAN +3 countries June 2005 p 108-120 Allen, F., and D. Gale, 2000, Comparing Financial Systems, Cambridge, Mass.; MIT Press. Basta Karim 2001 “World Bond Market Analysis” Merrill Lynch April 30, 2001 Batten Jonathan and Szilagyi Peter 2002 Disintermediation and Bond Market Development in Japan Business Week March 1999 ‘The Bond Market That Shook the World’ accessed December 8, 2007 < http://www.businessweek.com/1999/99_09/b3618101.htm> Endo Tadashi March 7, 2002 “Interactions between Government and Corporate Bond Markets “International Finance corporation Fekete E Natal March 7 2005 “Tsunami in the bond market” Financial Sense Editorials accessed December 9, 2007 < http://www.financialsense.com/index.html> Ferri, G., Lui, G., Stiglitz, J.E., 1999. The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis. Economic Notes by Banca Monte dei Paschi di Siena SpA 28(3), 335--55. Hakansson H.Nills “The Role of a Corporate Bond Market in an Economy- in Avoiding Crisis” 1999 Haas School of Business, University of California, Berkely. Kurosawa, Y., 1999. Economics of Rating (in Japanese). PHP Research Institute Inc. Minutes of Meeting 32nd Round “Minute of Meeting on the Japanese Government Bond Market (32nd round) February 12, 2004 Minutes of Meeting 5th Round “Minute of Meeting on the Japanese Government Bond Market (5th round) 2005 Ozeki Koya 2006 Japan Credit Perspectives: Global Bond Market and Japan September 2006 PIMCO Bonds, accessed December 18, 2007 < http://www.pimco.com> Rajan, Raghuram G. and Luigi Zingales, “What Do We Know about Capital Structure? Some Evidence from International Data,” The Journal of Finance, December 1995, 1421-1460. Richard, Koo 2007 “What If Foreign Money Shunned the U.S.? The likely result of a Japanese and Chinese retreat from the Treasury market would be skyrocketing interest rates stateside. (INSIGHT)” Business week online May 2, 2007 Sapsford, Jathon, “Japanese Growth Model Hits a Wall in Asia,” The Wall Street Journal, October 16, 1997. TSE accessed December 8, 2007 < http://www.tse.or.jp/english/index.html> Yamori Nobuyoshi, Nishigaki Narunto, and Asai Yoshihiro 2006 Credit Ratings in the Japanese Bond Market, The Institute of Social and Economic Research, Osaka University. Read More