Chapter

8 Japan1

Author(s):
International Monetary Fund
Published Date:
August 2003
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Governance Framework

Debt management objectives

Debt management policies in Japan have two primary objectives: first, to ensure smooth and stable funding for fiscal management; second, to curb costs on medium-to long-term financing, thus alleviating the burden on taxpayers.

Smooth funding aims to ensure that Japanese government bond (JGB) issuance will not have a turbulent impact on the market. This can be accomplished by maintaining high levels of transparency, predictability, and considerations to financial market trends. Stable funding means to issue bonds according to the planned amount of government bond issuance.

Improving the secondary market is also an essential element that needs to be taken into account in formulating debt management policies. The government bond market is the market where credit risk–free interest rates are formed. Thus, it serves as the foundation for the broader financial marketplace. JGBs also account for the majority of securities in the domestic bond and debenture market, both in issue amount and trading volume. Consequently, efforts to improve liquidity and increase efficiency in the secondary market, instead of improving the primary market alone, are essential to foster the financial market as a whole. In the end, this will help to increase the Japanese market’s international competitiveness. Another point is that an improved secondary market will also facilitate a smoother, more stable, and low-cost issuance of government bonds.

Coordination with monetary and fiscal policies

The primary objectives of debt management policies are to ensure smooth and stable funding while curbing financing costs to alleviate the fiscal burden. Accordingly, debt management policies must facilitate fiscal management.

Both debt management policies and monetary policies can affect the economy via interest rates. So, unless consistency is secured between these two areas, appropriate economic policies cannot be implemented. Therefore, it is essential for the government and the central bank to maintain adequate levels of consistency and transparency in their own policies while fully taking into account policy interactions during the process of policymaking.

In the relations with monetary policy, it is essential to prohibit the central bank from underwriting government bonds in the primary market and adhere to the principle of issuing government bonds in the market. This is mandatory in the context of maintaining fiscal restraints and the independence of the central bank, and it is legally set forth in Japan’s Finance Law (Article 5). One exception exists. With the approval of the parliament (the Diet), refunding bonds can be issued directly to the Bank of Japan (BoJ) when government bonds held by the BoJ mature. This exception is permitted because such issuance of refunding bonds will not lead to increased money supply.

The government should not be allowed to request the central bank to ease its monetary policy, alleviate the fiscal burden, or purchase government bonds to help absorb JGBs. Requests such as these would be detrimental to debt management policies, because they would undermine investor confidence in government bonds and also could fuel inflationary expectations. Therefore, such requests are never made. Moreover, developing monetary policy is the prerogative of the policy board at the BoJ, and the final decision making concerning the purchase of government bonds lies with the BoJ.

Legal framework of government debt management

Article 85 of the constitution stipulates that no money shall be expended, nor shall the state obligate itself, except as authorized by the Diet. Accordingly, JGBs are, without exception, issued on legal grounds.

Laws that serve as a basis for issuance vary according to the use of funds

In principle, the issue amount of government bonds is determined for each fiscal year, which begins on April 1 and ends on March 31 the following year. At present, four main laws provide the grounds for the issuance of government bonds:

  • Construction bonds under the Public Finance Law: Although the Public Finance Law stipulates that, in principle, government expenditure must be financed by tax revenue (Body, Paragraph 1 of Article 4), it allows for government bond issuance or borrowing only as a means to finance public works (Proviso, Paragraph 1 of Article 4). The maximum issue amount for each fiscal year is specified in the general provisions of the budget and must be approved by the Diet.

  • Special deficit-financing bonds under the special laws: As mentioned, the Public Finance Law permits the issuance of government bonds only to finance public works. However, when there is a budgetary deficit, a special law enacted for each fiscal year based on Article 4 of the Public Finance Law authorizes the government to issue special deficit-financing bonds. Also, with special deficit-financing bonds, the maximum issue amount for each fiscal year is specified in the general provisions of the budget and must be approved by the Diet.

  • Refunding bonds under the Special Account Law of the Government Debt Consolidation Fund: The government can issue refunding bonds (except for fiscal loan fund special account bonds) up to the amount required for consolidation or redemption of government bonds during a given fiscal year (Article 5 and 5-2 of the Special Account Law of the Government Debt Consolidation Fund). Because refunding bond issues will not affect the outstanding government debt, their maximum issue amount is not subject to approval from the Diet. The actual issue amount is determined according to the so-called 60-year redemption rule (discussed in another section).

  • Fiscal loan fund special account bonds under the Fiscal Loan Fund Special Account Act: The government can now issue bonds or borrow to finance fiscal loan programs (Article 11 of the Fiscal Loan Fund Special Account Act) as a result of the reform of the Fiscal Investment and Loan Program (FILP) system that took effect in April 2001. (Under the old system, all postal savings and pension reserves were deposited with the trust fund bureau to finance the FILP. Such a scheme with a compulsory deposit no longer exists. Instead, under the new system, each FILP agency must in principle raise funds from the market by issuing FILP agency bonds. Should circumstances necessitate, however, the funds can be raised in part by issuing government bonds.)

The laws define how the proceeds will be used. However, from the investor’s perspective, there is no differentiation between construction bonds, special deficit-financing bonds, refunding bonds, and fiscal loan fund special account bonds.

Law- and ordinance-based handling of government bonds

The minister of finance is granted the authority by the Law Concerning Government Bonds to determine government bond issuance, registration, and other basic procedural matters related to government bonds. Specific procedures are stipulated in the ministry ordinances established by the Law Concerning Government Bonds. The law also specifies the BoJ’s role in handling government bonds.

The government debt consolidation fund

Debt reduction in Japan is built around the government debt consolidation fund (GDCF). Fiscal resources for all interest payments and redemption of government bonds are funneled into the GDCF, accumulated, and disbursed from the GDCF.

Funds are transferred from the general account to the special account for the GDCF. Revenue from issuing refunding bonds is also stored at the GDCF, to be used to redeem bonds at maturity. Independent management of the cash flow regarding interest payments and redemption, as such, aims to contribute to investor confidence in the security of interest payments and redemption.

Sixty-year redemption rule

The so-called 60-year redemption rule—meaning each issue of debt should be redeemed over a span of 60 years—plays a central role in the debt reduction system. The concept is based on the average economic depreciation period of the assets purchased by construction bonds and special deficit-financing bonds being about 60 years, so redemption should be completed during that period.

The rule allows calculation of the net amount to be redeemed out of the gross redemption amount for maturing bonds. In other words, the rule is used to determine the amount of fiscal resources to be financed by issuing refunding bonds (for the purpose of net redemption). The 60-year redemption rule is not applied to fiscal loan fund special account bonds, because the fund collected from the FILP investment will be used for their redemption.

The following is an example to show how the rule actually works. A new ¥60 billion, 10-year funding bond is issued. When the bonds become due, ¥10 billion yen—or one-sixth of the original issue amount—will be put toward cash redemption (in the GDCF) and refunding bonds for the remaining ¥50 billion will be issued. Assume these refunding bonds are in five-year bonds. When the refunding bonds become due in five years, ¥5 billion—or five-sixtieths of the original issue amount—of the redeem and refunding bonds for the remaining ¥45 billion will be issued. Repeating this, the entire issue would be redeemed 60 years after the initial issuance.

Organizational structure

The issue amount in JGBs is determined during the budgetary process for each fiscal year. Within the ministry of finance, the following departments are involved in the work related to government borrowing:

  • Budget bureau: The budget bureau compiles the amount of new issuance of funding bonds that constitute the revenue of the general account.

  • Financial bureau, fiscal investment and loan program division: As the division in charge of the FILP, this section compiles the issue amount of fiscal loan fund special account bonds that constitute the revenue of fiscal loan fund special account.

  • Financial bureau, government debt division: As the name suggests, this division plays the central role in debt management policies, which range from compiling a government bond issuance plan and setting terms for each issue, to designing new schemes and programs, such as the separate trading of registered interest and principal of securities ([STRIPS] that were launched in fiscal year 2002). The government debt division also calculates the issue amount of refunding bonds based on the 60-year redemption rule.

  • Financial bureau, treasury division: This division is responsible for the day-to-day cash-flow management of the general account, based on the circumstances of debt issuance. It also issues financing bills to cover fund shortages in the short term.

  • Tax bureau: Government bond–related tax systems fall under the jurisdiction of the tax bureau.

The BOJ handles all the government bond–related procedural work, from issuance to redemption. Serving as the central securities depository for government bonds, the BOJ also provides the financial network system, BOJ-NET, which is an online system in which a number of financial institutions participate to settle both government bonds and funds.

Being responsible for supervision of financial markets, the financial services agency takes the initiative in establishing rules and systems for trading as well as supervising the secondary market.

Debt Management Strategy and the Risk Management Framework

Debt management strategy

As mentioned, the objectives of debt management can be summarized in three points:

  • first, to ensure smooth and stable funding for fiscal management;

  • second, to curb costs on medium- to long-term financing, thus alleviating the burden on taxpayers; and

  • third, to develop a debt market that has high levels of efficiency and liquidity.

To accomplish these objectives as a whole, it is essential that debt management policy be based on two different, yet closely related, perspectives—to be market friendly and to promote market development.

This section outlines the debt management strategy with a focus on the implementation of policies that are market friendly. Market development is the focus of the next section.

Strengthened communications with the market

To ensure smooth and stable funding, it is essential to fully take into account the trends and needs in the market so as not to cause turbulence. Therefore, to implement policies that are market friendly, an appropriate understanding of market trends and needs is indispensable. It is equally essential to work on market expectations through two-way communications for any major change in policy.

The government debt division within the ministry of finance, in charge of the issuance and maintenance of government bonds, has several monitoring officials who maintain daily contact with bond market participants. Vital information collected through this channel is reported to higher reaches of government. At the time of issue, a number of market participants are interviewed just before the bidding, so that issue terms can be fine tuned to meet market needs.

Although such day-to-day market monitoring by the officials in charge is instrumental to market-based debt management, it was realized that an advisory group, made up of a wide range of participants, would be helpful for a multilateral exchange of views. Thus, in September 2000, the ministry of finance established the Meeting on the Japanese Government Bond Market, a forum of key market participants, scholars, and experts. Although this meeting is not granted policymaking powers, it promotes an active participation of its members by appropriately reflecting the content of discussion on debt management policies. Moreover, through discussion at the meeting, the debt management authority can indicate its policy stance, either explicitly or implicitly. Thus, the subjects discussed at the meeting are diverse, ranging from short-term agenda, such as maturity structure, to longer-term issues, such as institutional improvement of the government bond market.

Meetings of this group take place more or less monthly. Market participants who take part are elected once every six months, based on their bidding performance. However, it is important that participation in a meeting with the debt management authority does not lead to giving special attention to those who participate. Thus, in the case of the Meeting on the Japanese Government Bond Market, the chair holds a press conference immediately after each meeting to announce the content of the discussion. Furthermore, detailed minutes are published before the market opens the following morning, thus eliminating any information gap between members and nonmembers.

Issuance at par value

Japanese investors tend to prefer issues to take place at or near par value. Accordingly, when determining issue terms, the coupon and maturity must be based on the actual market situation so that the issue price comes close to par value. Consequently, an outstanding issue can be reopened only when the market rate immediately before an auction is close to the coupon rate of the outstanding bond. As a result, whether or not the reopening rule will be applied will not be known until the announcement of the issue terms on the bidding day. One consequence is that it is rather difficult to predict the final outstanding amount for each issue. This is a problem that remains to be addressed, for example, by introducing a regular reopening rule, such as those used in some other countries. A change could make the issue price either substantially over par or under par. Thus, it is crucial to see if the par-driven propensity of Japanese investors will change when current value accounting becomes more prevalent.

Bond issuance via auction

To ensure that government bond issuance is market friendly, it is desirable that the primary and secondary markets be linked. Accordingly, an effective approach to market-based issuance of government bonds is to hold auctions among a number of market participants.

In Japan, 10-year bonds—the main tenor since the beginning of the JGB history—are issued exceptionally through syndicate underwriting. At present, however, 60 percent of the issue is distributed to syndicate members via a competitive-price auction, to reflect the market mechanism as much as possible. The remaining 40 percent are allocated to syndicate members at a fixed price and share. As to the amount offered at a competitive-price auction, when the offered bids amount to less than the scheduled amount, the syndicate members are supposed to undertake the remaining balance according to their fixed shares at a price equivalent to the average contract price in the competitive-price auction.2

All other bonds are issued by use of auctions. As a result, 90 percent of the government bonds issued in the financial market during fiscal year 2001 were offered at auctions.

What method of auction to choose—price or yield auction, or whether to issue bonds at a uniform price or each at a bidding price—is another point to be considered. In Japan, a price auction method has been adopted for all government bonds, except for 30-year bonds and 15-year floating-rate bonds,3 and issues each of them at a contract price.

With 30-year bonds, the current market yield—the basis for determining the coupon rate—is not readily available, because the secondary market for 30-year bonds is not yet fully functioning. These bonds are therefore offered by a yield auction, and the coupon rate is determined afterward based on auction results, a method that ensures the bonds are issued at or near par. All winning bidders can purchase the bonds at the maximum contract yield (i.e., single-price method). This method is regarded as effective for issuing bonds with a long maturity.

Risk management

The largest risks the debt issuing authority can face are interest rate fluctuation risks and refinancing risk. For example, concentrating issues on a specific maturity when determining maturity structure could increase the risk of raising yields, or concentrating redemption on a specific timing could increase refunding risks in the future. Therefore, a priority is to maintain an appropriate balance among different maturity zones in the debt portfolio. This is achieved by assessing the market latitude for each zone, such as short-term, medium-term, long-term, and super-long-term.

In recent years, JGBs with maturity other than 10 years have quickly established themselves as new benchmark bonds with increasing liquidity, which has facilitated risk management. However, as a result, the appropriate balance among different maturity zones has also been in a state of flux. Thus, at present, no fixed standard exists for either maturity-wise ratios or average maturity.

It is also essential to smooth the redemption structure in the debt portfolio as much as possible. In fiscal year 2002, a buyback program with the aim of adjusting the maturity structure in the debt portfolio is expected to be implemented.

When the distribution of debt issuance among maturity zones is subject to change, it could lead to increasing interest rate fluctuation risks. Similarly, a change in debt-related systems (i.e., systems governing debt market activities such as legal systems or settlement systems) could increase interest rate fluctuation risks if it is not expected by the market. Therefore, when making a policy change, it is desirable to create a soft landing by sending signals to the market via various channels to ensure that the change will be a factor already considered in the market expectations. For example, in a government bond issuance plan for each fiscal year, the market is particularly interested in knowing the issue amount for each maturity zone. This is where the Meeting on the Japanese Government Bond Market can prove its worth. An opportunity to have discussions with market participants, which will help us better understand the market needs, together with prompt disclosure of the content of discussions, should help increase the predictability of the yet-to-be-announced maturity structure.

Developing the Government Securities Market

Diversification of government bond maturity and product appeal

To develop an efficient market for government bonds, it is essential to achieve a smooth yield curve by developing a benchmark bond for each maturity zone, thus increasing liquidity across the entire yield curve. In the past, the maturity structure focused on 10-year bonds, making it virtually the only benchmark bond in Japan. In recent years, however, introducing new types of government bonds with maturities of other than 10 years has diversified maturity zones.4 Also, in compiling the issuance plan for each fiscal year, issues have increased in 2-year, 5-year,5 10-year, and 20-year bonds to develop them into benchmarks while taking into account the balance among them. When determining the terms of issue based on the market situation, whether or not the reopening rule can be applied depends on the circumstances at the time of issue, as described. But when the reopening rule is applied, it is aimed and expected to increase liquidity of that particular issue.

However, an excessive diversification of maturity zones will be incompatible with the effort to develop benchmarks. At present, it would be inappropriate to add yet other benchmarks by establishing new maturity bonds in addition to 2-year, 5-year, 10-year, and 20-year bonds.

To provide investors with varied investment opportunities focused just on maturities, it is also necessary to consider diversification from the standpoint of implementation of suitable, needs-oriented instruments and from the angle of product appeal. For example, today, 15-year floating-rate bonds, with the semiannual coupon pegged to the interest rate of 10-year bonds, are offered in public auctions, a response to the growing investor needs for products that can allow them to hedge against interest rate fluctuation risks.

In addition, the STRIPS system is expected to be introduced shortly. This introduction should not only increase the number of options available to investors, but also it will help achieve a more precise zero-coupon yield curve, thus increasing the efficiency of the debt market.

Information regarding bond issuance

Issuance plan for each fiscal year

To make debt issuance transparent and predictable, the ministry of finance formulates and announces a government bond issuance plan for the coming fiscal year at the same time as the announcement of the budget. The issuance plan consists of two parts: classification by funding purpose and classification by issuance methods and maturity.

The latter classification is divided into two: the total amount to be distributed in the private sector and the total amount to those in the public sector. The amount to be distributed in the private sector is further broken down by maturity, and the amount to be distributed in the public sector is further classified by public entity.

Because the ministry of finance makes it a rule to level each issue amount for a given maturity, market participants should be able to predict the approximate amount per issue based on the total issue amount by maturity.

Auction calendar

In March 1999, in an effort to make debt issuance more transparent and predictable, the ministry of finance began to publish the auction calendar and offering amount prior to auctions. Previously, the auction calendar for the coming three months was announced quarterly. The shortcoming of this method, however, was that investors had to wait until the last minute to be informed of the first auction in the coming quarter. Thus, in October 2001, the announcing method was changed to a monthly announcement of the auction calendar scheduled for the three months ahead. This has added to the predictability of debt issuance.

Issue terms

The total offering amount for each issue is published approximately one week before each auction. The coupon rate and the date of redemption, however, are announced on each auction date, because these two are determined by referring to the market situation up to the last minute before the auction starts.

Publication of this information is made to market participants at predetermined times via the Internet and news agencies.

Auction results

To minimize the risks on the part of market participants, it is desirable to announce the auction results as promptly as possible. Since May 2001, auction results have been produced within one and one-half hours. However, results used to take as long as two and one-half hours to appear, but by April 2000, the time had been shortened to two hours.

Government bond–related taxation

A 20 percent withholding tax is levied on the interest on coupon-bearing bonds. Those held by designated financial institutions (e.g., banks and securities firms), however, are exempted from withholding tax.

Furthermore, in September 1999, a withholding tax exemption system for interest on government bonds held by nonresident investors was introduced. In April 2001, the tax benefit was expanded even further. Under the expanded scheme, withholding tax exemption is also granted to interest on government bonds deposited by nonresident investors in the BOJ book-entry systems through foreign financial institutions (including so-called global custodians).

Profits on redemption of discount bonds are subject to an 18 percent withholding tax automatically at the time of purchase. However, profits on treasury bills and financing bills are exempted from withholding tax, because they are now held via the transfer settlement system.

Diversified market participants

To develop a debt market with high levels of liquidity, it is essential to diversify market participants as much as possible, thus increasing the depth of the market.

One of the characteristics of the Japanese debt market is that the government sector (including the public financial sector, such as postal savings), together with the private banking and insurance sector, hold a large share of the outstanding JGBs, whereas the share of JGBs held by individual investors and nonresident investors remains at a low level compared with other countries.6 Perhaps one underlying factor is Japan’s indirect finance–oriented structure. Even today, a large amount of household financial assets (totaling ¥1,400 trillion) is invested indirectly in government bonds via bank deposits and postal savings. One of the reasons that have added to this trend has been the deteriorating demand for funds in the private sector because of stagnation in the economy in recent years.

As such, the structure of debt holders in any given country is so deeply rooted in the financial system as a whole that it is impossible to categorically argue how it should take shape. However, when a limited number of institutional investors hold the majority of outstanding JGBs, the debt market is more likely to move more dramatically if there is a shock. Thus, to increase the stability of the debt market, it is far better to diversify debt holders as much as possible.

Also, the introduction of the payoff system in April 2002 (meaning a deposit insurance system that guaranteed term deposits up to ¥10 million, compared with an unlimited amount in the past) is expected to heighten the public awareness of credit risks. As a result, macroeconomic flows of capital may become more risk conscious. If that happens, there should be greater needs for government bonds, because they are credit risk–free financial assets.

In diversifying market participants, the current policy priorities are to promote further participation by individual investors, nonresident investors, and nonfinancial corporations.

Regarding individual investors, various public relations activities have started to communicate the benefits of investing in government bonds. Toward the end of 2001, for example, a public relations media campaign was designed to reach individual investors, using television, radio, newspapers, magazines, and posters. In addition, plans have been set in fiscal year 2002 to introduce nonmarketable government bonds specifically designed for individual investors.

As for nonresident investors, the tax exemption measures have already facilitated their entry into the JGB market, and there are plans to further promote their understanding of Japan’s tax system and other related regulatory frameworks. For the overseas audience, the Internet, in particular, is regarded as an effective vehicle to deliver information.

Improved settlement system

The BoJ serves as the central securities depository for government bonds and provides settlement services for JGBs. The platform for settlement of book-entry securities is the BOJ-NET system. Bidding-related procedures in the issuance of these securities are also processed online via the BOJ-NET system.7

Book-entry securities are settled on-line on the BOJ-NET Japanese Government Securities Transfer System, a part of the BOJ-NET system. Another part of the BOJ-NET system is the BOJ-NET Funds Transfer System, an on-line system for the electronic transfer of funds across the current accounts at the BoJ. These separate services were linked in April 1999 to allow for the delivery-versus-payment (DVP) method of settlement. To maintain security of the settlement system, the DVP method of settlement is essential, thus avoiding the risks arising from the different timing of settling funds and securities.

Furthermore, in January 2001, a shift in the method of settling government bonds and the current accounts at the BoJ took place––from designated-time net settlement to real-time gross settlement (RTGS). Such a system involves a settlement mode that limits the direct effect of a financial institution’s inability to pay (e.g., in the event the institution is unable to transfer funds or government bonds for any reason) to the counter-parties in a transaction. In other words, the changeover to the RTGS system was aimed at reducing the systemic risk inherent in designated-time net settlement.8

Introduction of the RTGS system has also solved another problem of the former designated-time net settlement. Under the old settlement system, each payment was interrelated with other payments settled at the same settlement time through the netting process, whereas with RTGS, each payment is settled individually.

In addition, under the RTGS method, settlement of most transactions at the BoJ is now completed early in the day. The earlier timing of settlement has also contributed to the reduction of systemic risk by substantially reducing the amount outstanding of transactions remaining unsettled on the settlement day. However, RTGS is not totally free from delays in settlement and an increase in loop transactions (a situation where, for example, three counter-parties short-sell a security among each other, which will start a loop because no one has the security to transfer) deriving from an increase in settlement work or a chain of transactions. Therefore, the occurrence of fails,9 up to a certain degree, needs to be permitted.

Previously, designated-time net settlement was the norm for the Japanese bond market. Thus, to avoid the systemic risk inherent in this settlement method, failed transactions were generally not permitted. Accordingly, the so-called good-fail rule (unified business practice for treatment of fails) was not in demand then. However, introduction of the RTGS system has changed the circumstances, prompting the Japan Securities Dealers Association to study and introduce a good-fail rule similar to the ones established in key overseas markets (for explanation, see the Appendix).

Development of related markets

Increased convenience of the futures market and the repo market should facilitate hedged or arbitrated transactions among three markets, including the cash market (i.e., underlying assets market), thus adding to the liquidity of the government bond market as a whole.

Japan’s futures market for government bonds opened in 1985 at the Tokyo Stock Exchange. Trading of long-term (10-year) JGB futures, which account for the majority of JGB futures transactions, in the contract month traded most actively has extremely high levels of liquidity.10 This is due, in part, to the fact that many market participants take part for a variety of purposes, such as arbitrage between contract months or spot versus futures, hedging, and speculations.

The repo market in Japan used to have two types of transactions––old-type repurchase agreement and repo transactions of JGBs using cash as collateral (known as the “JGB repo”). Both types had some problems to be addressed. Previously, repo transactions of JGBs using cash as collateral were employed for coupon-bearing government bonds, and the former repurchase agreement was the norm for short-term government bonds. In other words, Japan’s repo market used to be divided by these two different types of transactions.

In July 1998, market participants began studying new guidelines for repurchase agreements. This resulted eventually in the Master Repurchase Agreement11 compiled by the Japan Securities Dealers Association, paving the way to the April 2001 introduction of a global standard–oriented method (i.e., new-type repurchase agreement), which is safer and more convenient than the previous method of transactions. The main characteristics of the new-type repurchase agreement are

  • a nonresident-friendly method based on international standards and legally positioned as a “buy-and-sell” transaction,

  • higher levels of safety due to strengthened methods for risk management (including haircut and margin call, also existing in the JGB repo) and incorporated measures for handling the default of a counter-party, and

  • a newly incorporated substitution right (the right to substitute a security with another security during the course of the repo transaction) to facilitate term loan and deposit.

From now on, it is expected that all transactions will be consolidated into the new-type repurchase agreement. The new consolidated method of transactions should also help the efficient formulation of short-term benchmark interest rates that are risk free.

Appendix

The Good-Fail Rule

Under the good-fail rule, a party who fails to honor a transaction on a timely basis is subject to neither punishment nor delinquency charges. This is because the rule is based on the understanding that a fail accompanies the economic effect that as such serves as a deterrent to the occurrence of a fail and, should it occur, as an incentive to address it.

The rule can be illustrated by this example. Suppose X (deliverer) failed to deliver the JGBs to Y (receiver) on the contract date. Then, certainly X cannot receive the money for those JGBs. Thus, X may have to bear the extra cost of raising funds needed to keep holding the securities, or X has to abandon the opportunity to invest the money that was supposed to be paid by Y on the contract date. Besides, X will only be entitled to receive the interest payment for the period that ends on the contract date, no matter how long X is going to hold those JGBs. So, simply put, for X, a fail is nothing but bad news. However, Y will be entitled to receive the interest payment for the period from the contract date to the date of actual delivery, even though the JGBs are not yet in Y’s possession. Also, Y can keep investing the money Y was supposed to pay on the contract date until the actual receipt of the securities. Thus, Y will gain from a fail on the part of X.

However, under the current situation of prolonged low interest rates, the mentioned economic rationality is less effective in serving as deterrent. Thus, to put an extra drag on fails, a temporary measure has been introduced that allows Y, for the time being, to demand that X pay for the cost Y would need to obtain the equivalent amount of securities by borrowing JGBs against cash collateral.

The case study was prepared by Kunimasa Antoku from the Government Debt Division, the Financial Bureau of the Ministry of Finance.

To implement public offering auctions, it is essential that the secondary market be relatively mature and sizable. Thus, when the market is at a relatively early stage of development, introducing a mechanism that ensures stable funding, such as the syndicate underwriting system in Japan, could be a valid policy option.

With 15-year floating-rate bonds, auctions are held on the spread from the reference rate (i.e., the yield on 10-year bonds at the most recent bidding).

Public offering auctions have begun in recent years for the following government bonds: 1-year treasury bills (in April 1999), 30-year coupon-bearing bonds (in September 1999), 5-year coupon-bearing bonds (in February 2000), 15-year floating-rate bonds (in June 2000), and 3-year discount bonds (in November 2000).

Although bonds with maturities of four and six years used to be issued, these bonds were discontinued in fiscal year 2001/02, and five-year bonds were positioned as the benchmark for the medium-term zone. This occurred in response to the increased liquidity of the five-year coupon-bearing bonds introduced in February 2000.

At March 31, 2000, individuals held 2.5 percent and non-resident investors 5.2 percent of outstanding JGBs.

The BoJ was the first to introduce such an on-line bidding system for government bonds. The system dramatically reduced the time needed for bidding procedural work, enabling the same-day publication of auction results.

This risk involves the systemic disruptions posed to financial institutions, and ultimately to the entire financial system, through a chain of settlement failures or delays in settlement.

A fail is a situation in which a recipient of government bonds in a transaction does not receive the bonds from the delivering party on the scheduled settlement date.

Super-long-term (20-year) JGB futures and medium-term (5-year) JGB futures are also traded, but the actual trading volume is negligible at present.

The Master Repurchase Agreement is based on the Global Master Repurchase Agreement, a standard agreement for repurchase agreement used in Europe and the United States that was compiled by the Bond Market Association and the International Securities Market Association.

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