The restructuring of the Japanese financial system, initiated in the mid-1970s, has now acquired added international significance. Japan has exported an unprecedented volume of capital in recent years, and is expected to continue doing so. For example, exports of long-term capital from Japan between 1984 and 1986 amounted to almost $250 billion, making Japan the largest creditor nation, with outstanding foreign claims of over $180 billion at the end of 1986. These exports derived in part from Japan’s current account surplus and in part from short-term borrowing from abroad. Purchases of foreign securities constituted over 70 percent of the long-term capital outflows.
Japan’s financial system, which contributed to the country’s earlier economic development by channeling personal savings to the industrial sector, has grown rapidly in recent years. Personal assets within the financial system (such as bank deposits, bonds, and equities), for example, increased from just ¥120 trillion (or about 100 percent of GNP) at end-1973 to over ¥580 trillion (or about 200 percent of GNP) at end-1986; the current volume is estimated to be equivalent to about a third of the personal financial assets in the US system and about three times the size of the system of either the Federal Republic of Germany or the United Kingdom.
The Japanese financial system is also among the most complex, and includes some of the largest institutions (in terms of total assets) in the world. There are several important markets in which these institutions operate; both the markets themselves and the financial instruments traded on them have increased in number and level of sophistication in recent years. Empirical studies suggest that, as a result of recent regulatory changes, different components of the once segmented market have become fully integrated. The interbank market, where banks adjust their short-term reserve positions, provides the Bank of Japan with a primary instrument of monetary policy by means of sales and purchases of commercial bills. Bonds and stocks are traded both in several regional exchanges and over the counter. The government bond market is by far the largest and most active market; the transactions cost, measured by bid-ask spreads on government bonds, is now smaller than that on comparable bonds in the US market. However, the market for short-term public bonds is not yet well developed because issues of Treasury bills have so far been relatively small and infrequent.
System in transition
The Japanese authorities controlled interest rates and thereby influenced credit allocation during most of the first 30 years of the post-World War II era. They also emphasized functional separation as an instrument of financial regulation, for example, between banks and securities companies (along the lines of the US Glass-Steagall Act); between banks that lend to larger corporations and institutions dedicated to small businesses; and between ordinary banks (which could take only short-term deposits) and trust banks and long-term credit banks (which could hold such long-term liabilities as trusts and debentures). Reinforcing the effectiveness of domestic regulation, the Foreign Exchange Law regulated almost all international financial transactions.
The system based on interest controls persisted because of the absence of an efficient bond market and the presence of foreign exchange restrictions. First, the requirement that firms issuing securities register assets as collateral limited the number of eligible firms in the primary market and, along with extensive regulations on issuing conditions, restricted the development of a corporate bond market. Most corporate bonds were purchased by financial institutions that had special long-term relationships with the issuing firms, and thus these bonds were really a form of bank lending. Second, because of the rapidly expanding tax base during the period of high economic growth, the government sector remained either in surplus or in a small deficit through 1975, and the amount of government bonds outstanding was negligible. Most government bonds were directly purchased by a syndicate of banks and securities companies in predetermined fixed proportions, and these banks were not allowed to sell the bonds except to the Bank of Japan, the central bank.
This system began to change in 1975 when the fiscal position of the government deteriorated with a fall in the rate of growth of tax revenue during the recession following the quadrupling of oil prices in 1973; the government has since shown a large deficit. The voluminous repurchases of bonds by the Bank of Japan from the banking sector may have been in conflict with the objectives of its monetary policy. The authorities, therefore, encouraged the development of a large secondary market in government bonds by first allowing the banks to sell these bonds in 1977 and progressively eased the conditions imposed on their secondary sales through 1986. As a result, the private holdings of government bonds increased from ¥1.4 trillion at end-1974 to ¥13.9 trillion at end-1976, and to ¥95.7 trillion at end-1986.
Parallel to the development of the government bond market, a bond repurchase market (called the Gensaki market) expanded in the form of a short-term money market, causing large outflows from regulated bank deposits. This prompted the authorities to allow banks to issue, at market rates, negotiable certificates of deposit in 1979 and money market certificates in 1985 subject to certain restrictions on the amount, denomination, and maturity of issues; the authorities progressively eased these restrictions and, in October 1987, eliminated the ceilings on the amount of issues. The authorities also began to liberalize interest rates on large denomination time deposits in 1985; they decided to eliminate interest controls from April 1988 on time deposits in excess of Y50 million with a maturity of over one month. Deposits in bank accounts with market interest rates now account for close to 20 percent of total yen bank deposits.
The liberalization of the Japanese money market has not greatly benefited individuals, since the minimum denomination of most free market instruments is set at ¥50–100 million; even the denomination of money market certificates (whose return is set at a fixed percentage below CDs) is set at ¥10 million (approximately $70,000). This exclusion of individuals was designed to protect the smaller financial institutions that depend almost entirely on low-cost, fixed-rate deposits by individuals for funding.
The authorities, however, recognize that the liberalization of interest rates on small denomination deposits is inevitable. Some outflows from these deposits have already occurred. For example, the net asset value of mutual funds (called investment trusts in Japan) increased from ¥500 billion at end-1980 to over ¥4 trillion at end-1987. Moreover, with the shortening maturities of long- and medium-term government bonds, there already is a de facto short-term government bond market to which individuals have access; securities companies have also introduced (through investment trust companies) highly liquid mutual funds based on government bonds with deposit-like features.
With the scheduled elimination of the tax exemption on interest income from postal savings and other bank deposits in April 1988, pressure for interest rate liberalization on small denomination deposits is likely to increase. The public debate over interest rate liberalization for small savers has led to the questioning of the status of the Postal Savings System, by far the largest single financial institution in the world in terms of total assets; about ¥110 trillion, one third of total personal deposits, is currently placed in this system. Although the Postal Savings System served a useful role in mobilizing personal financial resources for Japanese economic development in the past, private banks now question the need for such a public savings institution in a highly advanced economy and are apprehensive about competing with an institution that does not necessarily require an optimal return on capital.
Major components of the Japanese financial market
Source: Bank of Japan.
1Of this total, only about ¥3 trillion constitutes the private market.
Greater access to the Euromarket with its range of instruments has weakened the case for maintaining the functional separation of domestic financial institutions. With the globalization of financial market activity, many Japanese institutions operate in foreign markets where there is no separation between investment and commercial banking. The recent decision to allow foreign banks to set up investment banking subsidiaries in Japan will lead to added pressure to further ease the traditional separation of banks and securities companies within Japan. (In December 1987, an advisory committee to the Minister of Finance suggested the possibility of allowing banks to set up investment banking subsidiaries and securities companies to set up commercial banking subsidiaries in the future.) Some change has already taken place. For example, banks have been allowed to act as brokers in the government bond market since 1983, and securities companies have been allowed to make consumer loans with government bonds as collateral since 1985. Banks and securities companies are given equal access to both underwriting and dealing in the new commercial paper market.
The pace of change in the domestic market was accelerated by the increased degree of integration of the Japanese economy with the rest of the world. As more and more Japanese firms began to operate abroad, the authorities took a series of measures to ease restrictions on capital flows throughout the 1970s within the context of the old Foreign Exchange Law. However, the policy of allowing foreign exchange transactions by administrative fiat became increasingly costly to administer, and the need to simplify procedures led to the enactment, in December 1980, of a new Foreign Exchange Law, which permitted all foreign exchange transactions except those that were expressly prohibited. The authorities, however, retained some control in areas that were crucial to the regulation of the domestic market, such as issues of yen-denominated bonds, regulation of authorized foreign exchange banks and residents’ bank accounts abroad. (However, residents were allowed to hold domestic bank accounts denominated in foreign currencies at market rates.)
The authorities continued to ease restrictions on capital flows under the framework of the new law. The measures taken by the Japanese authorities included easing the issuing requirements for both resident and nonresident firms in the Euroyen bond market; abolishing restrictions on the amount of foreign currency (including Euroyen) liabilities that could be converted to yen assets by financial institutions (June 1984); eliminating withholding tax on interest on Euroyen bonds for nonresidents (April 1985); and permitting the introduction of such new types of Euroyen instruments as zero coupon, dual currency, deep discount, and floating rate bonds (June 1985).
One immediate result of these measures was the rapid increase in the size of the Euroyen bond market relative to the domestic yen-denominated bond market and the Eurobond market denominated in other major currencies. Since 1986, the yen has become the second most widely used currency of denomination (next to the US dollar) in the Eurobond market. In addition, foreign borrowers were given greater access to the Japanese domestic bond market. Despite its many restrictions, the domestic yen bond market for foreign borrowers (sometimes called the Samurai bond market) has been an important source of funding for such international organizations as the World Bank and the Asian Development Bank, and has been larger than the so-called Yankee market in the United States since 1985.
The liberalization of international capital transactions has made Tokyo an important international banking center. In 1986, Tokyo accounted for 15 percent of all claims in international bank lending, second only to London (23 percent). Japanese banks have also become active in international bank lending, accounting for 33 percent of ownership of all claims in 1986; US banks accounted for 18 percent. Tokyo’s international status was enhanced further with the establishment of an offshore banking center in December 1986. Although nonresident banks and the nonresident accounts of resident banks are exempt from reserve requirements and withholding taxes, they are still subject to stamp duty and regulations that are somewhat restrictive by international standards.
Increased ease of access to the more deregulated Euromarket led more and more Japanese firms to conduct their financial transactions outside Japan. This reduced business opportunities for some domestic institutions and created further pressure for domestic market liberalization. In order to revitalize the domestic corporate bond market, the authorities introduced a bond rating system in 1985 and relaxed the eligibility requirements for issuing unsecured bonds (i.e., without collateral requirements) on several occasions; as a result, the number of firms that could issue bonds domestically increased from about 60 before February 1987 to about 180 by the beginning of 1988. The authorities also eased the collateral requirements for unsecured bonds and simplified disclosure procedures for firms issuing secured bonds in 1987. Moreover, firms that do not meet the eligibility requirements for unsecured bonds or the collateral requirement for secured bonds can now issue corporate bonds but with bank guarantees.
The Japanese authorities deregulated the operation of the interbank market progressively through 1987 to ensure the effectiveness of interbank market operations by maintaining the depth of the market and increasing arbitrage opportunities with other markets. The market now offers instruments with a broader range of maturities, as well as unsecured instruments. The authorities also introduced new financial instruments, such as yen bankers’ acceptances in June 1985, Treasury bills in February 1986, and yen commercial paper in November 1987. The market for bankers’ acceptances has remained extremely small, however, because of the availability of other, more attractive, trade-financing methods; the market for Treasury bills and other short-term government bills is also small (less than half the size of the certificates-of-deposit market) and is not yet fully developed.
The greater role of the market mechanism in the presence of remaining regulations on the type and maturity of bank assets and liabilities has increased the exposure of financial institutions to interest rate and other risks. The authorities have, therefore, allowed various types of new financial instruments to be introduced in the market as hedging devices in an increasingly sophisticated financial environment. As a first measure, they authorized the establishment of a futures market in government bonds in October 1985. Subsequently, they allowed resident institutions to use foreign financial futures markets in May 1987 and authorized the Osaka Stock Exchange to introduce trading in stock futures on a limited scale in June 1987. The commencement of trading in stock index futures at the Tokyo Stock Exchange is expected by the end of 1988 and preparations are under way to establish a more comprehensive financial futures market in which both banks and securities companies can participate.
Entry of foreign institutions
With large savings and accumulation of personal wealth, Japan has become increasingly attractive to foreign financial institutions both as a source of finance as well as a market for financial services. Moreover, some institutions see Japan as an important link in the chain of 24-hour global financial trading. As a manifestation of this interest in Japan, the number of foreign banks with full branch operations in Japan increased from 18 in 1970 to 81 in 1987; although their share in the foreign exchange business is high at over 20 percent, their share in bank lending is small at about 2 percent. The number of foreign securities companies, at only six before 1982, is expected to reach 60 in 1988. The number of foreign corporations listed on the Tokyo Stock Exchange, now the largest stock exchange in the world, with a total market value of well over ¥350 trillion, increased from 11 in 1984 to 76 in December 1987. (The New York Stock Exchange lists 59 non-US corporations.)
In recent years, Japan has allowed foreign firms into areas hitherto restricted to local institutions, such as trust business. In April 1984, the first foreign institutions were admitted to the government bond syndicate, which underwrites 10-year government bonds and is, by far, the most important source of funding for the government. In responding to the desire of foreign institutions to participate more fully in the market and earn lucrative commissions in underwriting and dealing, the Japanese authorities have increased the shares allocated to these institutions, relaxed (subsequently abolishing) the eligibility requirements for membership in this syndicate, and placed 20 percent of each bond issue under the auction system subject to some restrictions on the maximum amount of underwriting for each firm. About 30 foreign banks and over 20 securities companies were members of the syndicate at the beginning of 1988. The authorities have placed bonds of other maturities almost entirely under competitive auction in order to ensure equal access for foreign institutions.
The continuing process of financial market liberalization will have implications both for Japan and for the rest of the world. In Japan, individual investors will continue to benefit from higher rates of return and more efficient allocation of credit. The greater role of the market mechanism in the system will require further redirection of regulation away from credit allocation to investor protection. The authorities have already implemented a series of measures to protect investors, for example, through a more comprehensive deposit insurance system (ceiling increased from Y3 to ¥10 million in July 1986), and stricter capital adequacy requirements for banks (May 1986). In line with the recent Bank for International Settlements proposal for uniform capital/asset ratios for banks, the authorities will further tighten the capital requirements in the summer of 1988.
Despite higher rates of return on financial assets for small savers, however, it is uncertain whether net private savings in Japan will increase because of the elimination of the tax exemption on interest income from April 1988. If the tax effect dominates the interest rate effect, net savings may well decrease and consumption demand may increase. This is what the authorities hoped for in proposing the taxation of interest income as one way of redressing the savings-investment imbalance, and hence reducing Japan’s large current account surplus.
Greater access to the Japanese financial market by foreign institutions would not only benefit the rest of the world through increased imports of financial services by Japan but also mean a more efficient flow of long-term capital from Japan. In 1986, nearly 85 percent of net long-term capital outflows from Japan went to other member countries of the Organization for Economic Cooperation and Development; of this, over 60 percent went to the United States. Greater participation by foreign institutions of different nationalities in the Japanese market could improve the efficiency of capital flows by increasing direct capital flows to areas with higher rates of return. At the same time, greater holdings of yen-denominated assets and liabilities abroad may increase the need for a more developed market in short-term government securities, so that foreign residents could manage their Japanese government securities portfolio with greater ease.
In the area of monetary policy, the increased availability of market instruments to the corporate sector has necessitated a shift of emphasis from direct controls on bank credit (e.g., window guidance) to money market operations. In addition to traditional interbank market operations, the Bank of Japan has introduced limited operations in the markets for CDs and government refinancing bills. However, the monetary authorities see a need to introduce operations in the Treasury bill market as a more appropriate tool of monetary policy in the future, once such a market is fully developed.
As to monetary targeting, recent financial innovations have not yet significantly diminished the ability of the Bank of Japan to exercise fairly accurate control over monetary aggregates. However, the accelerated pace of technological innovations in financial transactions—such as electronic funds transfers and other settlement procedures that do not rely on the use of central bank credit—may in future weaken the ability of the Bank of Japan to maintain monetary control. In Japan, as elsewhere, there is active discussion among policymakers on how to manage money supply in the face of future technical innovations and to minimize the potential risk (sometimes referred to as “systemic risk”) inherent in such a new financial environment. As specific areas within the financial system come in for review, more changes are likely to occur during the coming years. Although the change has so far been predictable enough to allow the Bank of Japan to retain control over these aggregates, it remains to be seen if the current level of monetary targeting can be maintained with the progress of further financial innovation.
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International Capital Markets: Developments and Prospects
by Maxwell Watson, Donald Mathieson, Russell Kincaid, David Folkerts-Landau, Klaus Regling, and Caroline Atkinson The 1987 update of an annual series, this study reviews recent trends in financial markets from the perspective of the industrial and developing countries. Separate sections review innovations and institutional changes in the major markets over the past decade and developments in the debt situation. Price: $15 (special rate to students, faculty, and libraries $11); 107 pages; ISBN 1-55775-007-6
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