10. Recent Developments and Outlook for Japan’s Capital Flows

Alessandro Zanello, and Daniel Citrin
Published Date:
November 2008
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Shinobu Nakagawa and Christopher Faulkner-MacDonagh 

In recent years, capital flows have picked up sharply, reflecting a more outward-oriented attitude by private Japanese investors (Figure 10.1). Private holdings have been largely concentrated in debt securities, consistent with a widening of interest rate differentials, low market volatilities, and a generally conservative approach to investing. Households are also purchasing an increasing amount of equities in search of higher yield. Meanwhile, Japanese corporations are seeing a sharp increase in income from foreign assets, reflecting past projects that are now turning profitable.

Figure 10.1Net Receipts from Foreign Assets

(US$ billion)

a Income from public debt securities estimated from the international investment position stock data for the previous year.

Source: Bank of Japan.

This chapter examines the challenges posed by structural changes in Japan’s financial flows—particularly from the ongoing reduction in home bias among retail investors. Households could increase external holdings significantly over the next ten years—potentially providing a boost to some emerging market economies (most likely, to those in Asia). These outflows could also act as a headwind to movements in the yen exchange rate (see Chapter 16). At the same time, many may not be fully aware of the risks of investing abroad, and regulators may need to strengthen oversight. Furthermore, as financial flows expand and the types of assets become more complex, policymakers will require better information on cross-border flows. Finally, further deregulation to foreign ownership and reforms to deepen domestic financial markets could catalyze capital inflows to Japan and help offset downward pressure on the yen.

Capital outflows1

In an effort to diversify portfolios and earn higher returns, Japanese investors have increasingly looked overseas. Holdings of foreign assets have almost doubled since 2000, to about US$5¼ trillion in 2006 (120 percent of GDP). While official foreign exchange intervention during 2003–04 contributed to assets accumulation, the more recent trend has been driven by private investors. Holdings have risen across a broad range of privately-held foreign assets (global securities, foreign direct investment (FDI), and bank credits). Outside the banking sector, however, private investments are mostly concentrated in global securities (equities, debt, and money market instruments).2

Global securities investment: investor base and strategies

Banks, insurance companies, and pension funds remain significant foreign investors. Banks continue to account for a large share of foreign investment in securities and credits (Figure 10.2). (The share in the total has changed little since 2000.) However, their investments mostly reflect lending operations, owing to easier provisioning regulations and an extension of relationship banking to the foreign subsidiaries of domestic clients.3 While pension funds and life insurance companies increased holdings of foreign securities from 2000 to 2003, lately they have been net sellers, reflecting internal exposure limits.

Figure 10.2Foreign Assets Held by Japanese Residents

(in US$ trillion (left axis) and % of GDP (right axis))

Sources: Ministry of Finance; Bank of Japan.

Mutual funds have taken on greater foreign exposure, reflecting the preferences of individual investors. Household clients helped drive mutual funds to increase rapidly their purchases of global securities, which now represent nearly half of assets under management (Table 10.1 and Figure 10.3). This allocation is significantly higher than elsewhere in the financial industry, reflecting the willingness of households to diversify and to take greater levels of risks.

Table 10.1Foreign Assets Holdings

By investor, in US$ billiona

Nonfinancial sector400506752
Financial institutions1,8462,3063,189
Life insurance210293320
Pension funds165218244
Mutual funds85134382

Excludes official foreign reserves, trade credits, and FDI; includes external bank credits and global securities.

Sources: Ministry of Finance; Bank of Japan.

Excludes official foreign reserves, trade credits, and FDI; includes external bank credits and global securities.

Sources: Ministry of Finance; Bank of Japan.

Figure 10.3Global Securities Holdings

(as a share of total financial assets, by financial institution)

Source: Bank of Japan.

Deregulation seems to have helped in fostering a change in the risk appetite of Japanese households. Banks (in 1998) and Japan Post (in 2005) were allowed to sell mutual fund products at bank branches. Sales have been brisk and currently bank originations account for more than half of total assets under management. Banks have proved a popular sales channel because at one location clients can conduct multiple transactions and search for products that match their investment strategies.

However, Japanese households have approached foreign investment cautiously. In general, they prefer sovereign bonds in mature markets and selected emerging economies with liquid debt markets. Bonds have been popular, because the principal has largely been protected, while households have received regular income, similar to interest on bank deposits. More recently, these funds have lost their appeal somewhat, since yields have declined (especially relative to other investment classes) and investors have been more attuned to the benefits from portfolio diversification. This has prompted some funds to begin offering more “exotic” strategies, including equity index funds in emerging countries (such as in Brazil, Russia, India, and China) and to a lesser extent, foreign-domiciled hedge funds.

Global securities investment: outlook

Currently, individuals still hold a very large share of financial assets in currency and deposits. Bank savings and cash represent around half of households’ US$13 trillion in financial assets, a share that is twice as high as the average in other G7 countries. Conversely, the share of Japanese holdings of securities is much lower (Figure 10.4). This aggregate, however, masks a recent rebalancing of households’ portfolios, away from currency and deposits (whose share has declined by 5 percentage points since 2001) to securities—including mutual funds.

Figure 10.4Household Financial Asset Allocationa

a As of December 2006 except for Italy (2005).

Source: National Authorities.

Population aging is likely to add momentum to global securities investment. Those above the age of 60 hold the bulk of household financial assets and have the highest proportion of assets in securities (Figure 10.5). This age group holds a larger share of riskier assets than younger cohorts partly because its life expectancy is higher—and investment income lower—than anticipated. In addition, with some uncertainty regarding the benefits under the public pension system, some investors are also seeking to reduce reliance on it for retirement income. If current investment patterns continue, there could be larger holdings of riskier assets, including foreign ones, as the baby-boom generation enters this cohort.

Figure 10.5Household Holdings of Securities by Age Group

(% of total household financial assets)

Source: Ministry of Internal Affairs and Communications.

These trends suggest that the large capital outflow from the household sector is likely to continue for some time, barring a significant deterioration of the economic environment. If households continue to rebalance portfolios at a similar pace as in the recent past, there would be an annual shift of around 1 percent of total assets (over US$120 billion) from deposits to securities (foreign and domestic). At this pace, the process would take around 10–15 years before the portfolio allocation becomes similar to the other G7 countries (but still with higher shares in currency and deposits). Assuming that mutual funds continue to comprise around one-quarter of securities holdings, and that external investments account for around half of mutual fund assets, the annual outflow could be around US$15 billion per year.4 The cumulative outflow would be about US$225 billion (in current prices and exchange rates), lifting household’s external exposure to around 5 percent of assets (Figure 10.6).

Figure 10.6Outflows by Destination, 2005–07

(cumulative flows to April 2007, in US$ billion)

a Includes eastern Europe, Middle East, and Oceania.

Source: Ministry of Finance.

Asian economies could receive much of these flows. While foreign investment is largely concentrated in U.S. and European assets, Asia’s share is steadily rising. In response, Japanese asset management companies have entered into alliances across the region, and banks have sold a greater number of Asia-focused funds.

Nevertheless, several factors could delay these developments. The bulk of these outflows are being driven by strong returns abroad, relative to Japanese markets. At the same time, mutual fund fees remain high—at around 3 percent of assets. If the current, benign global environment ends, and markets sour, these fees would cut into returns, possibly wiping out the incentive to invest externally. Alternatively, a strong rebound in the Japanese economy could lift domestic markets and yields. Financial deregulation and innovation could spark the introduction of new products and encourage investors to keep their money in Japan. Over the longer term, the structural outflows are likely to diminish, as retirees begin to draw down assets.

Outward FDI: characteristics and outlook

FDI from Japan has also increased steadily during the last decade (Table 10.2). Globalization pressures have encouraged firms to locate distribution centers closer to customers or to seek cheaper production bases. This process has continued largely unabated, except in 1998–99, when the Asian financial crisis caused a temporary, large-scale withdrawal. Japanese FDI reached a record US$450 billion at year-end 2006 (about 10½ percent of GDP).

Table 10.2Outward FDI Position by Region
North America1385016336
United States1324715635
ex. China51189120
Latin Am.218399
Cayman Is.9325
Source: Bank of Japan.
Source: Bank of Japan.

The largest stock of FDI remains in North America, but Asia and the European Union (EU) are increasingly serving as important bases of operations (Table 10.3). North America’s share of FDI has fallen sharply since 2000, offset by gains in Asia and the EU. Unsurprisingly, China serves as the largest host of Japanese FDI in Asia, accounting for around one-quarter of the regional total. Investments in Australia, Hong Kong SAR, Singapore, and Thailand account for most of the remainder. In general, Asian and North American investments are in industrial sectors. European FDI appears to be somewhat more concentrated, with most firms located in financial centers (the Netherlands and United Kingdom) and in the financial industry.

Table 10.3Outward FDI Position by Major industry, 2006(US$ billion)


Chemicals &


and Retail



North America1634322192220
Source: Bank of Japan.
Source: Bank of Japan.

FDI outflows are likely to continue growing. In its annual survey of foreign operations, the Japan Bank for International Cooperation (JBIC, 2006) reports that 83 percent of manufacturers plan to expand overseas. Respondents note that higher growth opportunities abroad serve to offset limited possibilities in domestic markets. As Japanese corporations expand, they are likely to encourage further investment in overseas financial subsidiaries that would support the offshore operations.

Yen carry trades and associated financial flows

Some recent capital outflows have also involved yen carry trades, the practice of borrowing in yen at low cost to invest in higher-yielding non-yen instruments. A widening of interest rate differentials, coupled with low volatility, has raised incentives for such trading. To the extent that these positions are leveraged, there is a risk of a disorderly unwinding. Such was the case in October 1998, when the U.S. dollar fell by almost 15 percent against the yen. While the effects on the real sector were minimal, the unwinding of short positions by hedge funds and large financial institutions led to a rapid drying up of liquidity. This resulted in unprecedented price disconnects and market seizures.

While there are no data on the outstanding stock of carry trade positions, the indirect evidence from the possible sources of funding suggests that carry trades have been limited to date. In particular:

  • Bank lending to foreign institutions.5 Although large, most bank credit is extended to U.S.- and EU-based affiliates of Japanese firms. Also, lending to financial centers (where many hedge funds are domiciled) has risen only modestly, suggesting a small role for either hedge funds or banks in financing carry positions from this channel.

  • Foreign banks’ borrowing in short-term money markets. Foreign banks are active borrowers (Figure 10.7), but market commentators reckon much of this funding is for yen-yen transactions (such as yield curve arbitrage) that have no impact on the exchange rate. The short-term nature of this financing also limits the impact on the yen.

  • Derivatives-based lending in yen.6 The notional stock of contracts in the yen swap markets is smaller than U.S. and euro positions, so the size—of itself—does not indicate risk. (There are many reasons for purchasing swaps, including for financial trading and international trade.) In addition, the amount outstanding has changed little since 2004 (Figure 10.8), suggesting these markets have played only a small role in carry trades. Finally, borrowers may not be able to pay off loans quickly, or may be worried about the impact on their credit ratings from a default—so it is not clear that trouble with these loans would spark a rapid or disorderly unwinding. Instead, adjustment would likely be protracted, thus imparting inertia to the process.

  • Foreign exchange margin trading (Figure 10.9).7 The recent, sharp rise in margin trading may actually reflect structural factors. (Transaction fees are lower on margin deposits than foreign currency deposits at banks.) Furthermore, the average account sizes are small (reportedly around US$6,000), and losses could easily be absorbed by most investors. Finally, conventional foreign currency deposits have fallen (creating a capital inflow) faster than the rise in margin accounts, potentially offsetting any affect of margin trading on the yen.

  • Short-yen trading positions (Figure 10.10).8 Even though the short-yen positions of noncommercial traders have tracked movements in the yen-U.S. dollar exchange rate well, it is not clear if this market is representative. First, traders must self-report whether they are “noncommercial”—and not all of these traders are speculators. Recent data suggest these positions could be used to hedge currency risk in Japanese stock trades. Second, only a small amount of foreign exchange trading goes through these markets.

Figure 10.7Borrowing in the Uncollateralized Call Market

(average amount outstanding each month in ¥ trillion)

Source: Bank of Japan.

Figure 10.8Japanese Banks’ External Creditsa

(average annual growth in 2002–06)

a Figures in parentheses are the regional shares at end 2006.

b Offshore centers include Hong Kong SAR and Singapore.

Source: Bank of Japan.

Figure 10.9Foreign Exchange Deposits (In margin accounts (for trading) and in bank currency deposits)

(¥ billion)

Sources: JP Morgan; Bank of Japan.

Figure 10.10CME Yen Trading Position

(against Japanese equity investment by foreign investors and ¥-US$ exchange rate)

Source: Bloomberg.

In light of the considerable uncertainties surrounding the size of the carry trade, it is difficult to draw conclusions about its significance. The wide range of estimates on the carry trade reflects a diversity of views regarding which market is the “best” indicator, and market sizes differ greatly—from around US$100 billion to nearly US$2 trillion. Since there is limited evidence of a yen carry trade in any one funding market, it is likely that the stock of leveraged trades is closer to the lower end of most estimates. In addition, even estimates at the upper end would still be smaller than holdings of securities by longer-term investors.

Furthermore, the maturation of markets over the past decade gives additional comfort regarding the adjustment process.9 First, interest rate differentials are expected to narrow gradually, so market participants have ample opportunity to unwind positions. Second, the long-side of the carry trade appears to be spread across a number of currencies (while in 1998, it was narrowly concentrated on the U.S. dollar), suggesting that any adjustment may involve less movement in the dollar-yen rate. Third, global macro hedge funds are less important at present, and hedge funds have shown flexibility in unwinding their positions, thanks to better risk management techniques. Fourth, the investor base in Japan is more diversified—and holdings remain heavily concentrated in yen assets—adding stability to the financial landscape. Finally, financial markets are in general deeper than a decade ago and better able to absorb asset price volatility. That said, there is still a possibility that an unwinding of carry trades could have a harmful effect in shallower or less liquid markets.

Capital inflows and developments in capital markets

Capital inflows are also growing. Overseas investors hold about US$2¾ trillion in Japanese assets at the end of 2006 (Figure 10.11), only about half of the outward stock. Furthermore, foreign investment registered only a small increase over 2000–04. More recently, foreign holdings of Japanese assets have picked up in tandem with the improvement in the economy.

Figure 10.11Japanese Assets Held by Nonresidents

(US$ trillion and % of GDP)

Sources: Ministry of Finance; Bank of Japan.

Traditionally, foreigners have participated in Japan’s capital markets primarily through lending. Until 2002, loans represented nearly half of foreign investments in Japan and were focused exclusively on corporate clients and households. However, the scope of lending is now broader, with securities lending accounting for around 15 percent of overall lending. At the same time, traditional operations have slowed and the value of loans outstanding has fallen.

Much of the recent rise in foreign ownership of Japanese assets reflects investments in the stock market. Foreigners have been net purchasers of Japanese equities since late 2003, with monthly net inflows averaging around US$8V½ billion. As a result, foreign participation in the stock exchanges has jumped sharply and, in 2006, accounts for nearly one-quarter of the trades—and almost half of the daily turnover (Table 10.4). The rise of Asian investors has been particularly striking, as their participation in the Tokyo market rivals that of North American investors.

Table 10.4Tokyo Stock Exchange Tradinga(monthly averages (in billions), by region)
Volume traded


North America1.

Includes first section (blue chip), second section (smaller firms), and Mothers market (growth and emerging industries).

Purchases of shares.

Source: Haver Analytics.

Includes first section (blue chip), second section (smaller firms), and Mothers market (growth and emerging industries).

Purchases of shares.

Source: Haver Analytics.

Other portfolio investments by nonresidents remain small, particularly in the bond market. Private bonds and other structured instruments represent less than 5 percent of foreigners’ investments in Japan, reflecting the generally small size of these financial markets. Holdings of public sector bonds—particularly central government bonds (JGBs)—is more significant, accounting for around 10–15 percent of foreigners’ portfolios. Nevertheless, the share of JGBs held by overseas investors is low—at just under 6 percent in 2006—compared with those in other advanced countries. (Overseas investors hold around 29 percent of government bonds in France; 47 percent in Germany; 27 percent in the United Kingdom; and 46 percent in the United States.)

The Japanese authorities recognize the importance of developing domestic capital markets further. Thanks to deregulation and promotion efforts by the Ministry of Finance, the ratio of foreigners holding JGBs has nearly doubled since the beginning of the decade. By other measures, the capital markets—including the stock markets—remain smaller than their international counterparts (Figure 10.12). To reinvigorate domestic markets, the Council of Economic and Fiscal Policy has released an interim report outlining some strategies for promoting Tokyo as an international financial center (Box 10.1).

Figure 10.12Major Stock Exchanges: Market Capitalization

Source: Haver Analytics.

The attraction of FDI has received particular attention, because foreign ownership of firms remains limited. Since 2000, foreigners have bought up Japanese companies at a rate of around US$30 billion per year, with gross purchases in 2006 reaching a record level (Figure 10.13). But gross sales have also been large, and net inflows have been only marginally positive over this period. Furthermore, the FDI stock is low by international standards; the average stock of FDI liabilities in the euro area, United States, and United Kingdom is around ten times higher (just above 25 percent of GDP). Recognizing the need for additional action, the government has set a target to lift foreign ownership to 5 percent of GDP over the medium term. Recent steps to facilitate greater foreign ownership include permitting “triangular mergers” for subsidiaries of foreign institutions (used by private equity funds in merger and acquisition strategies), which became effective in May 2007.

Figure 10.13Foreign Direct Investment in Japan

(stock outstanding and annual gross inflows (purchases and sales))

Sources: Ministry of Finance; Bank of Japan.

Box 10.1Promoting Tokyo as an International Financial Center

In mid-April 2007, the Council of Economic and Fiscal Policy (CEFP) published its interim report titled, “Toward Creating Financial and Capital Markets with True Competitiveness.” The report focuses on three areas—enhancing market infrastructure, promoting financial innovation, and upgrading the regulatory system—for promoting Tokyo as an international financial center.a It makes only broad recommendations, but does raise the possibility of more sweeping changes. Measures in the report include:

Enhancing infrastructure to make more accessible the Tokyo market

  • Create a comprehensive exchange covering securities, financial futures, commodities, and crops.

  • Expand assets allowed in mutual funds, such as foreign real estate funds.

  • Improve the market for securitized products and syndicated loans.

  • Adopt the International Financial Reporting Standards and encourage greater use of English.

Promoting financial deregulation and innovation

  • Review rules separating banking and securities sectors, while introducing proper firewalls to prevent possible conflict of interests.

  • Consider adopting a comprehensive tax on all financial income.

  • Promote greater financial literacy and more professionals (especially lawyers and accountants).

Enhancing the transparency and predictability of the regulators

  • Introduce cost-benefit analysis when evaluating regulations.

  • Adopt a principle-based regulatory approach and safe-harbor rules.

  • Enhance the function of self-regulatory organization, including for the stock exchange.

  • Relax professional regulations, while enhancing general investor protection.

  • Strengthen the function of the Securities and Exchange Surveillance Commission (for example, by reviewing the inspection and lawmaking functions and the use of surcharges).

a The report is modeled after the November 2006 “Interim Report of the Committee on Capital Market Regulations” that outlined a range of recommendations for improving the competitiveness of U.S. capital markets.

Summary and policy considerations

Given the possibility that a structural rebalancing in Japanese balance sheets is underway, there is significant potential for continued capital outflows. Japanese households will likely increase their purchases of foreign securities, particularly in Asia. Rapid population aging will also add to the momentum for holding global securities, not only by households through mutual funds, but also by public pension funds, whose portfolios are still relatively home biased.10 As for outward FDI, Japanese corporations are showing a continuing appetite for further investment in manufacturing and financial activities. Emerging Asia is often cited as a region where further expansion could occur. Yen carry trades may also play a role in fueling outflows, but to a lesser extent than these longer-term factors.

Against this backdrop, possible concerns for policymakers include:

  • Retail investor protection. As global exposure increases, investors should be aware of the risks—particularly from exchange rates. The Financial Services Agency plans to require financial institutions to provide full disclosure of the inherent risks, including the maximum amount at risk.

  • Better risk management at financial institutions. Japanese financial institutions may need to adopt more sophisticated risk management, by considering the effects of a broader range of risks in emerging markets—such as regulatory uncertainty and liquidity difficulties.

  • Further development of domestic capital markets. Deeper and broader markets could help promote capital inflows and work toward reducing global imbalances. Current plans to bolster Tokyo’s role on international capital markets could play an important role, as would further financial deregulation.

  • Greater information sharing on cross-border capital flows. The increase in financial flows between countries has made surveillance more challenging. Greater information sharing could help in this regard.


    Japan Bank for International Cooperation (JBIC)2006Survey Report On Overseas Business Operations by Japanese Manufacturing Companies—Results of JBIC FY 2006 Survey: Outlook for Japanese Foreign Direct Investment (18th Annual Survey). November (Tokyo: JBIC Institute).

Data on the stocks of foreign assets are from several sources: primarily, from the flow of funds. However, international investment position data are used for foreign direct investment. The flow data have similar trends, but are noisier.

While valuation changes (including from the yen’s depreciation) helped lift the value of securities holdings from 2000 to 2006, net purchases of securities accounted for around two-thirds of the increase in the stock.

Chapter 12 of this volume discusses recent trends in Japanese bank operations abroad.

Balance of payments data suggest a somewhat faster pace is possible. Net outflows coming from Japanese mutual funds have averaged around US$75 billion, annually, over the past two years.

Low cost, yen-linked loans have reportedly become more common in some markets. For example, in Korea, yen-denominated loans are estimated to have increased by around US$5 billion in 2006, much reportedly to small and medium-size enterprise (SME) importers. This is small relative to the won-denominated loan portfolio of banks, which stood at around US$750 billion at end 2006.

It is possible to take advantage of Japanese interest rates without borrowing in yen. Banks serve as an intermediary between counterparties in the yen swap market (who are long in yen) and borrowers (who take on currency risk in exchange for low interest rates). Reportedly, these transactions have risen in Europe and Asia, but there are no data. However, some have pointed to the large stock of yen currency swaps as a risk.

Margin trading allows investors to leverage deposits in margin trading accounts (up to 10–20 times) to take currency positions in the foreign exchange market. The actual leverage is unknown, but appears to be smaller.

Noncommercial short-yen positions at the Chicago Mercantile Exchange (CME) are cited by some as an indicator of speculative yen carry trades. Market commentary suggests that the global short-yen position is around ten times that in the CME.

Yen carry trades reportedly unwound in the context of the global financial turbulence started in mid-2007, but the process has so far been orderly.

Chapter 9 of this volume looks into the home bias of Japanese retail and institutional investors.

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