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• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T00310R000200190003-2
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 31
• Document Creation Date: January 12, 2017
• Document Release Date: September 7, 2010
• Sequence Number: 3
• Publication Date: October 1, 1984
• Content Type: REPORT

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Japanese Financial
Liberalization: Economic and
Political Dimensions
EA 84-10190
October 1984
Copy 3 2 6
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Lill cuwilIIC VI v11-
Intelligence
Political Dimensions
Japanese Financial
Liberalization: Economic and
Northeast Asia Division, OEA
are welcome and may be directed to the Chief,
Office of East Asian Analysis. Comments and queries
This paper was prepared byl
Secret
EA 84-10190
October 1984
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Overview
Information available
as of 2 October 1984
was used in this report.
Political Dimensions
Japanese Financial
Liberalization: Economic and
investment and economic development.
Japanese financial markets have been highly regulated for most of the
postwar period, with the government dictating the scope of activities for
intermediaries and strongly influencing the cost of credit to borrowers and
the extent of capital flows. The tightly controlled financial system was
initially designed to ensure that relatively scarce personal savings were
channeled to business firms at the lowest possible cost to encourage rapid
prices.
An increase in personal savings coupled with a decline in the need for
investment following the 1973-74 oil crisis destroyed much of the system's
rationale and led some Japanese-including the central bank-to press for
financial deregulation. The Finance Ministry's response to these initial
pressures, however, was narrowly focused and piecemeal. Progress was
concentrated in short-term money markets, where interest rates were
decontrolled, and in international transactions. As US financial deregula-
tion picked up speed in the latter half of the 1970s, many analysts began to
focus on the possible economic ramifications of Japan's less ambitious
liberalization program. Some charged that Japanese companies benefited
handsomely from regulations that kept the country's growing pool of
savings at home, keeping interest rates-and thus production costs-low,
and thereby permitting Japanese firms to undercut foreign competitors'
yen transactions can be conducted freely outside of Japan.
The mushrooming of Japan's current account surplus since 1981 has
heightened foreign concern over Tokyo's financial regulations. Some US
observers argue that these controls have kept the yen from appreciating
and hindered the recycling of Japan's huge foreign trade surpluses.
Pressure from Washington, which culminated in last spring's bilateral yen-
dollar working group meetings, has focused Japanese attention on these
problem areas. Tokyo has promised additional movement on financial
market liberalization, including the removal of most restrictions on interest
rates within two to three years. To promote yen internationalization, the
Japanese Government has pledged to create new Euroyen markets, where
We believe domestic factors, as well as international pressure, will compel
Japanese authorities during the remainder of the decade to accelerate the
pace at which they deregulate the financial system although bureaucratic
obstacles will continue to block abrupt liberalization:
? The volume of internal government debt that is maturing will jump
beginning in 1985, straining the financial system as it now exists and
perhaps leading to the removal of remaining interest rate regulations.
iii Secret
EA 84-10190
October 1984
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? Once begun, liberalization in Japan, as in other countries, feeds upon
itself. Losers from past deregulation are already demanding compensa-
tion in the form of liberalization in an area of their choice.
We believe US observers frequently fail to recognize the full extent of past
liberalization. Hence, they tend to overstate the impact removal of
remaining financial regulations will have on Japanese competitiveness. We
doubt that future reform will do much to narrow Japan's global trade
surplus or its surplus with the United States:
? We are skeptical that further financial liberalization will erase the
alleged Japanese competitive advantage derived from low interest rates.
As a result of the deregulation of money markets in 1978-79 and the lib-
eralization of foreign exchange controls in 1980, Japanese real interest
rates are now largely in line with those prevailing elsewhere. Moreover,
we believe it unlikely that borrowing costs for companies will rise further
as decontrol progresses. Future deregulation should heighten competition
among Japanese banks and thus restrain them from passing along higher
funding costs. Additionally, the nonbank financing options of Japanese
corporations will expand.
? We believe analysis forecasting an appreciation of the yen as liberaliza-
tion reaches its maximum has merit but should not be pushed too far. Fi-
nancial markets are expected to deepen and accommodate a greater
volume of transactions as deregulation progresses, making them more
attractive to foreign institutional investors. Unless accompanied by a rise
in Japanese real interest rates relative to those prevailing elsewhere,
however, this development will have only a minor impact on the yen.
Given the current freedom of capital flows, real interest rates in Japan do
not diverge much from those prevailing elsewhere.
? Although we doubt future financial liberalization will do much to alter
corporate financing costs or the value of the yen, we feel reform has
many positive aspects. Chief among them is the ongoing expansion of
foreign access to yen capital markets. This allows foreigners, including
US corporations, to reduce risks by diversifying the currency composition
of their borrowings. Although the cost of yen financing in real terms may
not be especially low, in nominal terms it is. Low nominal interest rates
are expected to continue, as low inflation and high savings seem
entrenched in Japan.
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The Japanese Financial System 1
The Finance Ministry: Wedded to Gradual Liberalization 5
The Domestic Challenges to MOF Conservatism 7
The Dynamics of Liberalization 9
Progress and Remaining Problems 11
Short-Term Money Markets 11
Japanese Securities Markets 13
Capital Flows Into and Out of Japan 15
Implications of Financial Liberalization 19
International Economic Implications of Deregulation 21
Japan: Chronology of Financial Liberalization Measures 25
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Japanese Financial
Liberalization: Economic and
Political Dimensions
After World War II the Japanese Government mold-
ed the country's financial system to foster a high level
of investment and rapid economic growth. The Minis-
try of Finance (MOF) implemented sweeping regula-
tions to ensure that personal savings were channeled
to business firms at the lowest possible cost. The
financial authorities controlled:
? The availability of credit. The government, believ-
ing indirect financing from bank loans (rather than
direct financing through stocks and bonds) was the
most efficient way to fund corporate investment,
made sure large banks got sufficient funding. In the
immediate postwar period, these institutions were in
turn directed to give preference to loan requests
from basic industries-such as steel-viewed as key
to reconstruction efforts.
The highly regulated financial system achieved its
primary goal: corporate investment in plant and
equipment grew an average 16 percent annually dur-
ing the 1960s. The system, nonetheless, had its draw-
backs. Banks tended to:
? Form such close ties to individual businesses that
they lent excessive amounts to longtime clients,
resulting in overinvestment in steel, petrochemicals,
and textiles.
? Require borrowers to deposit over 20 percent of
their loan proceeds as compensating balances, un-
dermining in part the government's efforts to keep
interest rates low (see figure 1)
The 1973-74 oil shock, which ended double-digit
GNP growth in Japan, destroyed much of the ration-
ale for the highly regulated system. Many past propo-
nents of the status quo became advocates of a more
market-oriented system:
? The cost of credit. Financial authorities stabilized
nominal interest rates on corporate borrowing from
banks, at times at artificially low levels. To reduce
bank funding costs, interest rates on deposits were
kept below market levels, and households were
offered tax incentives to save.
? The scope of operations of financial institutions. As
in the United States, banks were prohibited from
handling securities transactions. In Japan, more-
over, bank functions were specialized. For example,
regional banks looked after the financing needs of
farms and small businesses, while long-term credit
banks and city banks-commercial banks on a
national scale-filled the needs of large businesses.
? Capital flows into and out of Japan. Such flows
were generally prohibited to prevent balance-of-
payments problems. This restriction also provided
valuable insulation for the nonmarket aspects of the
regulated financial system.
? As growth prospects dimmed for capital-intensive
heavy industry, the private sector's need for low-cost
investment loans declined, and its need for high-
yielding financial assets in which to invest surplus
funds became increasingly important.
? The Bank of Japan found its traditional monetary
policy tools, which had emphasized bank access to
credit, lost much of their relevance as loan demand
slackened relative to the supply of savings (see
figure 2).
The Finance Ministry's response to initial pressures
for a freeing of financial controls was narrowly fo-
cused and piecemeal:
? Short-term money markets were deregulated in a
step-by-step fashion, enabling the Bank of Japan to
deemphasize credit availability and instead to influ-
ence interest rates in the open market.
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Figure 1
Japan: Nominal and Effective Interest Rates, 1970-82'
Percent
12
I.. I 1LilI I ..I
4 1970 71 72 73 74 75 76 77 78 79 80 81 82
" Quarterly data.
b Includes effect of compensating balances.
Figure 2
Japan: Household Savings as a Share of Corporate
Investment, 1970-81
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? Because of the concerted go-slow effort, residual
restrictions remain, limiting both the access to
certain markets and the rate of return available on
some assets.
Foreign critics claim the remaining regulations cause
a variety of economic ills and therefore question the
Finance Ministry's gradual approach to liberalization:
? As the size of Japan's current account surplus has
grown, so have concerns about how financial regula-
tions might retard or distort efforts to invest these
surplus funds abroad.
? The existence of controlled interest rates on deposits
raises questions about the competitive advantage
Japanese firms may enjoy because of lower capital
costs.
? Underdeveloped money markets are a legacy of past
and present regulations and of the dominance of
indirect financing during the high growth era. Crit-
ics claim this underdevelopment, which reduces the
attractiveness of yen assets to institutions whose
large investments could swamp thin markets, is an
obstacle to long-term strengthening of the Japanese
currency.
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Figure 3
Japan: Volume of Secondary Bond Market
Transactions, 1970-82
Trillion yen
350
SUU
250
200
150
100 - - -
Table I
Japan: Ministry of Finance Bureaus
Involved in Liberalization Debates
Underwriters allowed to resell
deficit bonds after holding
them 100 clays
Underwriters allowed to resell
deficit bonds once the bonds
have been listed on the stock
exchange, usually seven to
nine months
Underwriters allowed to resell
deficit bonds after holding
them for one year
Budget Yoshihiko Yoshino Prepares and monitors government Committed to reduction of budget deficit. Op-
budget posed to measures that would raise government
debt service costs, such as market-determined
bond yields.
Financial Yasutaka Miyamoto Administers central government Would like to improve the attractiveness of gov-
borrowing ernment bonds to general public by expanding
diversity and responsiveness to market forces.
Banking Masateru Yoshida Regulates banks and insurance Has key say in major liberalization moves. Gener-
companies ally favors gradual deregulation as long as meas-
ures do not harm weaker institutions.
Securities Toru Sato Regulates securities industry Probably willing to see liberalization proceed
more quickly than Banking Bureau because its
constituency-securities industry-likely to fare
well in freer environment.
International Toyoo Gyoten
finance
Administers financial dealings with Viewed as most pro-deregulation. Has frequently
other countries liberalized Japanese banks' overseas operations
when decontrol at home politically unacceptable.
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The Finance Ministry:
Wedded to Gradual Liberalization
The Ministry of Finance, which has primary responsi-
bility for shaping the Japanese financial system, is
becoming sensitized to foreign concerns about finan-
cial regulations. We believe, nonetheless, that domes-
tic pressures continue to guide MOF decisions on the
pace of financial reform.
In the upper echelons of the Ministry, advocates of
gradual liberalization predominate, with those favor-
ing faster action a vocal minority and with only a few
opposed to any further financial changes:
? Press reporting indicates Finance Minister Take-
shita favors gradual liberalization; so do the Minis-
try's Securities and Banking Bureaus.
? Officials in the International Finance Bureau, the
newest and thus the least powerful of the Ministry's
in the financial arena ' but has not been able to
prevent gradual erosion of its near monopoly on
personal savings. The MOF has begun to approve
new types of financial assets with rates of return
competitive with those offered on postal savings
accounts. In January 1980, for example, the Minis-
try allowed securities houses to offer mutual funds
that invest in medium-term government bonds.
? The Ministry's ability to keep yields on primary
issues of government debt low enough to make a
dent in government interest expenses has waned in
recent years as the secondary bond market has
grown (see figure 3). With increasing frequency, the
syndicate of banks and securities houses that under-
writes over one-third of the government debt has
refused to sustain losses by accepting new issues at
below-market rates.
seven bureaus, are less conservative.
MOF support for a go-slow approach stems partly
from a fear that deregulation will cause a decline in
Ministry prestige and power. Concerns about investor
protection reinforce this preference for gradualism.
Japan still lacks many of the policing agencies found
in the United States, such as the Securities and
Exchange Commission
In defending the gradual approach, Ministry officials
also point to the opposition of the politically powerful
postal savings system and to the possibility that
liberalization would boost the cost of servicing govern-
ment debt. We believe the importance of these obsta-
cles has been overstated. During the past five years,
the Ministry has endorsed-or at least acquiesced
in-changes that have eroded some of the traditional
fundraising advantages of the postal savings system
and the central government:
? The postal savings system has sufficient political
backing in the Liberal Democratic Party (LDP) to
stall attempts to abruptly end its privileged position
We believe the most important source of Ministry
conservatism is its close ties to the institutions it
regulates:
? Frequent administrative contact has cemented these
ties. Employees from major banks and securities
houses, moreover, often serve rotational assignments
at the Ministry, and retired Ministry officials fre-
quently become executives at private banks.
? When combined with the MOF's internal division of
responsibilities, these ties have created powerful
advocates for the protection of both weak and strong
institutions (see table 1). Banking Bureau loyalties,
for example, are torn between institutions that are
likely to fare well in a more competitive environ-
ment-such as the city banks-and those that
probably would not-such as mutual savings and
loan banks, which are already suffering from a
secular decline.
' The Ministry of Posts and Telecommunications has not made post
offices curtail abuses of tax-free personal savings accounts, whereas
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Figure 4
Japan: Government Bond Redemptions, 1972-96
Trillion yen
25
1972 75
'' Assumes budget deficit will he reduced I trillion run annually beginning in
AF Y 1986. Also assumes 6.6-percent yields on government bonds.
Figure 5
Japan: Interest Rate Structure
Interest arbitrage
Linked by regulators
Rigid margins
CD and
gettsalsi rates
Long-term
Average interest rate prime rate
/on bank loans I~
e
s
%%. ft.. Official discount rate
(5.0 percent since
October 1983)
Government bond
Expected dividend yields in secondary
rates on 5-year loan market
trusts and bank
debentures
Coupon rates
on l0-year
+0.9 government bonds
Short-term Savings deposit
prime rate rates
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The Domestic Challenges
to MOF Conservatism
Although few in Japan question the wisdom of phased
deregulation, criticism of the Finance Ministry's slow
pace of reform is growing. Some of the opposition has
been relatively easy to defuse-such as that originat-
ing in the press-but economic pressures for change
are building, making it increasingly difficult for the
Ministry to drag its heels on deregulation.
The US-Japanese yen-dollar talks in the first half of
1984 ignited a flurry of press comment in Tokyo on
liberalization issues, much of it critical of the Minis-
try's go-slow strategy:
? After the April meeting of the bilateral working
group, an editorial in the respected Asahi claimed
that, in setting the time frame for liberalization, the
Finance Ministry was placing too much emphasis on
protecting banks and too little on the needs of
business firms and the general public.
? We believe the Finance Ministry, as the most
influential of all ministries in Japan, has sufficient
clout to slough off such press criticism
Strong pressure for speedier liberalization from Prime
Minister Nakasone and other high-ranking LDP poli-
ticians has not materialized:
? Although Nakasone cajoled the Ministry into ensur-
ing progress during the yen-dollar talks, we doubt
he will force the MOF to abandon its gradualism.
? Political leaders in Japan have willingly handed over
responsibility for recommending deregulation strat-
egy and timing to MOF advisory panels.
? If financial issues become more politically charged,
we believe reform is as likely to slow as to acceler-
ate. The LDP has close ties to financial institutions
that cater to farmers and small businessmen; these
institutions are expected to fare poorly in a market-
As in the past, the Ministry of Finance has only
limited latitude to ignore economic forces pushing for
deregulation:
? Massive 10-year government debt issues, made fol-
lowing the first oil crisis to cover revenue shortfalls
and to stimulate the economy, begin maturing in
fiscal year 1985 2 (see figure 4). If refinancing of
these bonds is to proceed smoothly, the government
must introduce new flexibility into funding methods
and issue terms.
? If interest-rate ceilings on deposits are not lifted
soon, the funding capacity of banks may be threat-
ened. As short-term instruments with yields freely
determined in the secondary market, government
securities approaching maturity will be attractive
alternatives to time deposits in banks.
? Wage gains have been moderate in recent years,
increasing the importance of interest as a compo-
nent of personal income. We expect this trend to
lead individuals to demand better access to market-
rate investments, especially if the government cur-
tails abuses of tax-exempt small savings accounts.
Members of the financial community are also chal-
lenging the Ministry's slow pace of reform. According
to the press, most financiers are convinced that sweep-
ing liberalization is inevitable, if not imminent. To
prepare for the deregulated environment of the future,
bankers and brokers are urging that the Ministry
permit them to expand the range of services and
market-rate instruments they offer:
? In May, for example, mutual savings and loan
banks requested MOF permission to become regular
commercial banks. As savings and loan banks, only
20 percent of their loans can go to big companies.
oriented financial system.
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Table 2
Japan: Domestic Funding and Clientele
of Financial Institutions
Individual and corporate de- Large businesses. Individuals get Highly leveraged and funding base
posits, with maximum ma- about 10 percent of loans. narrowing. Underwriting of govern-
turity of two years. Money ment debt squeezing profitability.
markets.
Loan trust certificates, with Historically heavy industry, Future rosy if they, along with life
two- and five-year maturi- but more emphasis on service in- insurance companies, can retain exclu-
ties. dustry. sive rights to manage pension funds.
Long-term credit banks Five-year bank debentures. Capital-intensive industry. Growth prospects have dimmed as cor-
Deposits from corporate cli- porate investment needs have fallen.
ents and government.
Regional financial institutions Deposits of up to three Cash-short city banks. Small and Ample funding but poor growth
years' maturity. medium-size businesses. prospects.
Securities houses Brokerage fees chief source Industry. Good growth prospects, but many
of income. smaller firms troubled.
Insurance companies Sales of insurance. Industry, concentrating on long- Aging of population will improve
term, fixed-rate loans. growth prospects.
a Approximately 80 percent of bank funding comes from deposits
whose interest rates are regulated.
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The strength of the challenge to the existing Japanese
financial system varies by issue. Like the various
bureaus in the MOF, specific financial institutions
may support liberalization in one area only to oppose
it in another. Differences in funding bases and clien-
tele account for this inconsistency (see table 2). For
example, city banks would like to expand their fund-
raising options, specificially by gaining permission to
issue five-year bank debentures. They oppose t'he
introduction of commercial paper, however, fearing it
would allow securities companies to lure away their
loan customers.
Intraministerial and intraindustry differences fre-
quently immobilize the policymaking process. When
severe financial strains develop within the economy,
however, the importance of these differences is re-
duced, allowing liberalization to proceed:
? Rising interest rates tend to highlight strains within
the financial system and to jar loose the policymak-
ing process, permitting partial liberalization to
occur.
Once begun, liberalization in Japan, as in other
countries, has fed upon itself. Losers from deregula-
tion in one area have sought compensation in the form
of liberalization in another area. In the United States,
for instance, when the advent of money market funds
threatened the funding base of savings and loan
institutions, savings and loan groups lobbied for the
removal of interest-rate ceilings on savings accounts.
competitive rates. In October 1983 city banks got into
the act by offering new high-yielding instruments,
which combined a 10-year government bond fund
with a 10-year time deposit.
This natural unraveling process helps explain why the
pace of financial liberalization in Japan is accelerat-
ing despite bureaucratic obstacles:
? Feedback from past deregulation is creating pres-
sure for further reform. Furthermore, the expanded
freedom the MOF has given Japanese financial
institutions in international dealings in recent years
is now generating pressure for similar leeway at
home.
? We believe the method in which the regulated
system unravels will be shaped by the vested inter-
ests of bureaucrats and politicians. Feedback from
past liberalization will be allowed to proceed unhin-
dered in areas-such as deregulation of interest
rates on large deposits-that do not harm key LDP
or MOF constituencies. On the other hand, we
believe fundamental reform of the corporate bond
market-which could lead to a large-scale shift of
business from banks to securities houses-will be
slow in coming.
? The MOF probably will be allowed to pursue
phased deregulation in the future, but the pace at
which liberalization measures are introduced no
doubt will be stepped up.
In Japan the events following the advent of medium-
term government investment (chukoku) funds in 1980
show a similar pattern of liberalization begetting
further liberalization. These chukoku funds, intro-
duced to relieve some of the burden placed on finan-
cial institutions underwriting government debt issues,
became the highest yielding assets within reach of
individual investors. The fundraising capacity of the
leading securities firms, with exclusive right to handle
these funds, increased as a result of their attractive-
ness. On the other hand, the funding base of other
syndicate members declined. To redress this situation,
trust banks and long-term credit banks obtained
MOF permission in 1981 to offer accounts with
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Figure 6
Selected OECD Countries: Capital and Money Market
Balances as a Share of GNP, Yearend 1983
Japan West Germany United United States
Kingdom
Table 3
Japan: Money Market Instruments
Instrument
Maturity
Minimum Denomi-
nation (million yen)
Balance (as of 30 April
1984) (trillion yen)
Gensaki
One to 364 days
100
Certificate of deposit
Three to six months
300
Half day to one
month
1, by custom
5.1
One to four months
(latter by custom)
10
Short-term government
securities a
Usually 60 days
1
a Includes treasury bills, food bills, and foreign exchange bills.
Most bills are held by the Bank of Japan and various government
trusts.
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Liberalization issues vary from one type of financial
market in Japan to another, as do the prospects for
significant deregulation in the near future
Short-term money markets in Japan, as elsewhere,
allow corporations and financial institutions to dispose
of-or acquire-temporary liquidity to adjust for
seasonal and geographic funding needs. Instruments
with competitive rates of return must be offered in a
wide variety of maturities and denominations to meet
participants' differing needs (see table 3). By defini-
tion, money markets only handle assets with maturi-
ties of less than one year.
As the focus of the government's first efforts to
deregulate interest rates, Japanese short-term credit
markets generally offer competitive yields:
? Until the late 1970s only yields in the gensaki
market-where long-term bonds with attached re-
purchase agreements are traded-were freely deter-
mined. Gensaki yields are still considered the most
representative short-term rates in Japan.
? Rates in the call and bill discount markets, where
Japanese banks receive and extend each other short-
term financing, were deregulated step by step from
1977 through 1979. Central bank open-market op-
erations, however, continue to influence rates avail-
able in these markets.
Although interest rates move flexibly in existing
money markets, problems regarding terms of issue
and access remain:
? Only financial institutions are allowed to participate
in call and bill discount markets. Direct deals by
firms and individuals would increase the market
competitiveness.
? Certificates of deposit (CDs) are not considered
negotiable securities in Japan, and a secondary
market was not permitted to develop until April
1982.
? We believe the lack of a viable market in short-term
government debt instruments (in particular, trea-
sury bills) is the most serious shortcoming. Unlike
their US counterparts, Japanese treasury bills are
sold only for stopgap funding. The Finance Minis-
try, moreover, fixes yields on these securities below
market levels. The Bank of Japan thus incurs a loss
when it sells them to call market brokers.
? Business firms in Japan are not permitted to issue
commercial paper. As short-term unsecured promis-
sory notes, commercial paper is considered incom-
patible with traditional Japanese reliance on collat-
eralized financing.
? Japan also lacks yen-denominated bankers accept-
ances, which are negotiable instruments involving
bank drafts to pay trade-related financing at matu-
rity. However, Japan's bill discount market is a
close substitute, with tacit bank guarantees on
payment replacing the formal ones involved in bank-
er acceptances.
We believe the prospects for filling the gaps in Japan's
money markets are good:
? In the final report of the US-Japanese yen-dollar
working group in mid-1984, the MOF pledged to
inaugurate a yen-denominated bankers acceptance
market by 1985. Although many Japanese were
initially skeptical that the new market would prove
an attractive way to finance foreign trade, by early
October almost all financiers there were enthusias-
tic about its potential, according to US Embassy
reporting.
? To enhance monetary policy effectiveness, the cen-
tral bank is pushing for a US-style treasury bill
market where securities can be freely traded. The
Finance Ministry is cool to the idea, claiming the
present system is more appropriate. As soaring
refinancing needs force the government to diversify
its fundraising methods, many Japanese believe
25X1
MOF opposition will subside
25X1
The major defect of Japanese money markets, accord-
ing to most experts, is the narrow range of instru-
ments available, which has kept the market small by
international standards (see figure 6):
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Figure 7
Selected OECD Countries: Share of Funds That Nonfinancial
Sectors Raise Directly in Capital Markets
Percent
55
Japan
United States
Figure 8
Japan: Comparison of Government Bond Yields in
Primary and Secondary Markets, 1973-84a
Percentage points
2.0
I-J
-1.0 1973 74 75 76 77 78 79 80 81 82 83 84
Yields on secondary market of bonds with longest maturity minus yields on new
10-year bond issues. Quarterly data.
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The government's postwar decision to encourage firms
to rely on indirect financing dealt Japanese bond and
equity markets a heavy blow. Leery of antagonizing
their bankers, companies shied away from investigat-
ing nonbank funding sources. As economic momen-
tum slowed in the mid-1970s, the power balance
between banks and companies became more equal.
Firms felt freer to explore direct financing options
namely, stock and bond issues.
What potential borrowers in Japan's equity and cor-
porate bond market found in the mid-1970s, however,
was not particularly appealing (see figure 7):
? Industrial bonds had to be secured by collateral, an
especially onerous requirement for leasing and trad-
ing companies that possessed only limited amounts
of land, factories, and machinery. Japanese compa-
nies that floated unsecured bonds overseas, more-
over, had difficulty issuing secured bonds domesti-
cally without violating provisions of agreements
with overseas trustee companies.
? The tradition of giving existing stockholders the
right to buy new issues at par value raised the cost
of raising funds via equity markets for established
companies.
For investors, flaws in Japanese securities markets
were equally obvious:
? Yields on primary issues of bonds, especially gov-
ernment ones, frequently carried below-market cou-
pon rates.
? Primary and secondary bond markets were small
until the mid-1970s, when the government began
using deficit financing. As a result, investors'
choices were limited.
? Over two-thirds of the stock listed on the Tokyo
Stock Exchange were and still are held by institu-
tional investors, including companies in industrial
groups such as Mitsui; these stocks were rarely
traded. The shares held elsewhere were viewed as
fair game for speculators, and price movements
were quite volatile, discouraging individuals from
entering the market.
In the past decade, some of these defects have been
rectified:
? As indicated earlier, the underwriting syndicate for
central government bonds is forcing the Finance
Ministry to set yields on new issues close to those
prevailing on the secondary market (see figure 8).
This development has ripple effects throughout the
financial system, as regulators tend to link interest
rates.
? In 1979 Sears Roebuck became the first private
company to issue totally unsecured bonds in Japan.
The eligibility requirements drafted at that time
were so stiff, however, that only I 1 Japanese compa-
nies qualified.
? In FY 1980 par issues accounted for only 8 percent
of the new domestic equity issues.
We believe the power balance between banks and
securities companies will determine if remaining defi-
ciencies-particularly those in the corporate bond
market-are corrected:
? Banks, especially long-term credit banks, oppose
further erosion of the principle of collateralization.
Eligibility requirements for unsecured corporate
bond issues have been relaxed twice in the 1980s,
but banks have used their clout to ensure conces-
sions were minor.
? Securities houses are growing faster than other
types of financial institutions in Japan. We believe
at least a decade will pass, however, before this
trend erodes the banks' political and economic
supremacy.
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Figure 9
Japan: International Capital Flows, 1972-83
Figure 10
Japan: Yen Bond Issues by Nonresidents, 1970-83a
Billion veil
1,000
400
200
800
600
" 1970 71 72 73" 74b 75" 76 77 78 79" 80' 81 82 83
Includes private placements as well as public offerings.
b Years when Japan's current account was in deficit.
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Capital Flows Into and Out of Japan
In its 1949 foreign exchange law, Japan forbade all
capital transactions between residents and foreigners
without Cabinet approval. The prohibition on capital
flows was intended to help control balance-of-pay-
ments problems but also provided valuable insulation
for the highly regulated financial system. As the
economy matured and other industrialized nations
began to open their capital markets, Tokyo gradually
softened this stricture:
? As a condition for entry into the OECD in 1964,
Japan removed bars that had limited the free
exchange of yen for other currencies and gold.
? In the 1970s, balance-of-payments considerations
periodically inspired the Finance Ministry to liber-
alize foreign exchange transactions. For example, to
attract overseas funds to cover a $9 billion current
account deficit, Tokyo in 1979 allowed nonresidents
to participate in the gensaki market and in the
newly created CD market.
In 1980 Tokyo formalized its more progressive atti-
tude toward capital movements by enacting a new
foreign exchange law. It made restrictions on external
transactions the exception rather than the rule. As a
result, capital flows in both directions mounted rapid-
ly (see figure 9):
? Capital inflows quadrupled and outflows doubled
from 1979 to 1983. Because outflows started from a
much larger base, however, they still exceeded
inflows by $18 billion last year.
? Much of the increase in outflows reflects the desire
of institutional investors in Japan to reduce risks by
diversifying the currency denomination of their
portfolios.
? The growth in the external bond issues of Japanese
firms, predominantly in the form of low-interest
Swiss franc paper, accounts for much of the rise in
inflows.
Even after the promulgation of the 1980 law, the
Ministry of Finance continued to restrain many types
of capital flows through administrative guidance:
? During April-September 1983 the MOF set a $11
billion cap on medium- and long-term lending by
private Japanese banks to overseas borrowers. We
believe this inhibited the efficiency with which the
Japanese current account surplus was recycled.
? Japan's current account balance weighs heavily in
MOF decisions on the permissible volume of yen-
denominated bond issues by foreigners (see figure
10).
Although freedom of capital movements is incom-
plete, we believe the liberalization that has taken
place has effectively integrated Japanese money mar-
kets with those abroad. Tokyo, moreover, has shown a
willingness to remove some of the remaining barriers
to the free flow of funds into and out of Japan:
? Euroyen and gensaki interest rates usually move in
tandem, indicative of the integration that now
exists.
? In March 1984, the Finance Ministry ended its
case-by-case screening of banks' offshore medium-
and long-term yen loans. Some Japanese journalists
doubt this will boost offshore yen lending because
they consider the new requirements that the MOF
imposed at that time as equally restrictive; these
requirements were designed to prevent banks from
extending excessive amounts to troubled LDC debt-
ors. In our view, this is a valid concern, but the ease
with which Indonesia and New Zealand borrowed
record sums of yen over the summer provides some
evidence of a genuine liberalization.
? In our judgment, the principle of free capital flows
is well enough entrenched that backsliding will be
minimal when Japan encounters balance-of-pay-
25X1
25X1
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Figure 11
Use of Mark, Pound, and Yen as Official Foreign
Exchange Reserves, 1975-82
Table 4
Situation in Euroyen Markets
Euroyen bond issues by nonresi- Only supranational agencies or Aaa-rated
dents of Japan governments that have previously floated
three samurai bonds are eligible to float
bonds.
were given permission to issue convertible
Euroyen bonds; 30 became eligible to issue
straight Euroyen bonds.
Euroyen certificates of deposit Currently prohibited because financial au-
(CDs) thorities fear Euroyen CDs will compete
head-on with domestic CDs in Japan and
proceeds might be used to fund long-term
Euroyen lending.
Short-term Euroyen lending to nonresidents
liberalized in June 1983 and to residents in
June 1984. Medium- and long-term lending
still prohibited.
The MOF is expected to allow governments with
lower credit ratings and fewer samurai issues to tap
the Euroyen bond market later this year. Foreign
companies with similar qualifications-a pool of four
at present- are also likely to gain access.
Future relaxation probably will be tied to improve-
ments in the domestic corporate bond market, such
as an easing of heavy collateral requirements and
enhanced rewards for being a good credit risk.
This prohibition is slated to be lifted by I December
1984. Unlike domestic CDs, ceilings on issues will
not be imposed. Proceeds, however, will not be
allowed to flow back into Japan. This restriction is
designed to minimize negative fallout on the domes-
tic market.
The Ministry of Finance is unlikely to grant banks
permission to make medium- and long-term Euroyen
loans this year, according to press reports. MOF
officials fear decontrol would undermine the regulat-
ed interest-rate system in Japan.
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As Tokyo has become more openminded about capital
flows, prospects for yen internationalization have
brightened. Even so, the potential for wide interna-
tional use of the yen as a currency for trade transac-
tions and as a medium for investment remains largely
unrealized. Some US observers view internationaliza-
tion as key to sustained strengthening of the yen.
The share of Japanese trade denominated in yen is
rising, although still below the corresponding ratio in
other industrial powers:
? Currently 40 percent of Japanese exports are in-
voiced in yen, up from 33 percent in 1981; this is
less than half as high as the share of West German
exports priced in marks. The import side of the
picture is even more striking: only 3 percent of
Japanese imports are yen denominated.
? Financial analysts frequently cite the lack of yen-
denominated bankers' acceptances as the cause of
the low level of trade conducted in yen. In our view,
this argument should not be pushed too far given the
existence of a close substitute, namely, the bill
discount market.
? We believe the biggest obstacle to enlarging the
volume of yen-based trade is the international tradi-
tion of pricing raw materials in dollars. These items
accounted for over two-thirds of Japanese imports in
1983.
In our opinion, use of yen as a reserve currency is also
limited, reflecting in part past Japanese attempts to
discourage this form of internationalization:
? Tokyo reversed that policy in 1978, however, and in
March 1980 exempted yen deposits of foreign gov-
ernments from interest-rate ceilings. The Japanese
hoped that, by making such deposits more attrac-
tive, they would be able to attract the funds of oil
exporters to cover the $11 billion current account
deficit (see figure 11).
We believe relaxation of capital controls has had its
most profound effect on the yen's use as an investment
medium:
? In 1983 the yen replaced the British pound as the
second most popular currency in international lend-
ing. The yen's 6-percent share paled, however, next
to the dollar's 74-percent share. Five percent of
foreign bond and Eurobond issues were denominat-
ed in yen last year, putting the yen in fourth place-
behind the dollar, the deutsche mark, and the
pound.
Further expansion of the yen's role in international
finance hinges partly on the creation of free Euroyen
markets, where yen transactions can be conducted
outside of Japan. Financial authorities in Tokyo so far
have been reluctant to allow these markets to develop.
They fear uncontrolled growth of Euroyen markets
may erode monetary policy control and lead to unreg-
ulated risk taking by banks:
? Despite their apprehension, Japanese officials
agreed at the yen-dollar talks to improve residents'
and nonresidents' access to Euroyen markets (see
table 4). In July the Japanese press speculated that
some of these measures would be implemented
ahead of schedule to reduce economic tensions with
West European countries and the United States.
? The rules governing Euroyen markets have been
carefully crafted, however, to limit the markets'
attractiveness. For example, Tokyo will not let
proceeds from Euroyen CD issues flow back into
Japan.
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Figure 12
Selected OECD Countries: Short-Term
Interest Rates, 1975-84a
,
L Iw, ii L_L_,_i i_wi_I Li
Figure 13
Selected OECD Countries: Short-Term Interest Rates
Adjusted for Inflation, 1975-83a
-4
6
I i L I l L -t iL w LPL I IL-w-LI I
1975 76 77 78 79 80 81 82 83
Quarterly data. Adjusted using a nine-month moving average of the consumer price index.
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Analysts differ over how much future deregulation
will impinge on Japanese interest rates and
competitiveness:
? We disagree with this scenario, however, because
most of the postulated increase in credit demand
involves the refinancing of government debt that
begins to mature next year. Tokyo's requirements
for new money are actually declining.
? Some observers believe existing regulations insulate
the Japanese financial system from international
economic forces, permitting authorities to keep in-
terest rates at artificially low levels. These analysts
believe future deregulation will wipe out this artifi-
ciality, reducing Japanese competitiveness in the
process.
? In our view, these arguments underestimate the
effectiveness of past liberalization measures, partic-
ularly the deregulation of money market interest
rates and the freeing of capital flows, at integrating
Japanese financial markets with those abroad. Yen
interest rates now generally move in tandem with
those in other countries, especially during periods
when Tokyo is trying to stabilize the value of the
yen see figures 12 and 13). We believe future
increases in arbitrage involving Japan will be mar-
ginal compared with that which has already taken
place.
Others point to increased funding costs for banks,
resulting from deregulation of deposit rates, as anoth-
er potential route to higher Japanese interest rates:
? Although we believe this argument has some merit,
we also feel banks will be unable to pass along all
their higher funding costs to corporate borrowers as
deregulation spurs financial competition. Bank prof-
itability is as likely to decline as corporate borrow-
ing costs are to rise.
Data Resources, Incorporated (DRI) analysts contend
a credit crunch is likely to strike Japan in 1985,
magnifying the significance of any liberalization-
induced rise in interest rates:
? These analysts see the combination of freer capital
flows and a projected doubling of government bond
issues beginning next year as leading to a 3-percent-
age-point rise in government yields between 1984
and 1987.
Even if liberalization raises the cost of capital to some
extent, we believe this development will alter Japa- 25X1
nese competitiveness only slightly:
? As the share of Japanese corporate investment
financed out of retained earnings has grown from 63
percent in 1968-73 to 75 percent in 1980-83, the
potential competitive advantage conferred by low
nominal interest rates has declined. Moreover, in
real terms, interest rates in Japan are at unprece-
dentedly high levels and yet export competitiveness
remains strong.
? The yen's current weakness against the dollar 3
along with the country's skilled and diligent labor
force are, in our view, more important than capital
costs in explaining Japanese export competitiveness.
? If the analysts who believe a major interest-rate
increase is in the offing are correct, the loss of
Japanese export competitiveness would result main-
ly from the associated upward pressure on the value
of the yen rather than from the increased financing
costs of firms. The pressure on the currency, howev-
er, would have to be great enough to counteract the
short-run negative effects past liberalization is ex-
erting on the yen; these effects are described in the
next section.
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Figure 14
Japan: Medium- and Long-Term Loan Commitments to
Offshore Borrowers, 1982'
International organizations
Indonesia)-
Asia-----
Latin America -
a Yen and foreign currency lending by private financial
institutions totaled $22.4 billion.
Figure 15
Japan: Basic Balance and the Exchange Rate, 1972-83
Billion US $
15
1972
Yen/dollar
exchange rate
Yuen appreciating 200
re atinn to the dollar
1"cn depreciating 305
relative to tilt dollar
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International Economic Implications
of Deregulation
Financial liberalization in Japan has proved a boon to
some foreigners and a headache to others. On the
positive side, foreign access to Japanese capital mar-
kets-and thus to plentiful savings-has improved
during the last five years, at least for many official
borrowers:
? Eligibility requirements for foreign yen bond issues
and loans have been eased repeatedly since 1981,
when Japan's current account surplus began to
mushroom.
? Yen markets in Japan cater primarily to sovereign
borrowers. Not all foreign governments, however,
enjoy equal access. We believe MOF decisions on
which countries get priority in tapping yen markets
are shaped largely by foreign policy concerns. At
present, international organizations and ASEAN
and West European countries appear the most
welcome; troubled LDC debtors and Soviet Bloc
countries appear the least welcome (see figure 14).
? Interest-rate differentials between yen and dollar
assets play a much more important role in the size
of capital flows, in our view, than specific liberaliza-
tion measures do. These differentials stem primarily
from dissimilarities between Japanese and US mac-
roeconomic policy mixes and from dissimilarities in
savings rates. Additionally, swings in the current
account balance can swamp changes in the capital
account balance.
? Over the longer term, liberalization is likely to help
deepen Japanese financial markets; this should
make them more attractive to foreign institutional
investors, boost capital inflows, and perhaps raise
the value of the yen.
Continued liberalization of Japanese markets poses a
potential challenge for Asian countries now serving as
international financial centers, namely, Singapore and
Hong Kong. Japan, with its high-savings rate and
large economy, is in many ways a natural location for
an international financial center:
? Sovereign borrowers also obtain a large share of the
syndicated offshore foreign currency lending done
by the Japanese.
The downward pressure long-term outflows put on the
yen is the negative side of the enhanced openness of
the Japanese financial system. We do not, however,
see a 1-to-1 correlation between liberalization and yen
depreciation:
? Admittedly, annual changes in Japan's basic bal-
ance-the sum of the current account balance and
the long-term capital account balance-and the
yen-dollar exchange rate appear connected (see fig-
ure 15).
? We believe that much of the recent outflow facili-
tated by liberalization-and traceable to Japanese
institutional investors-is a transitory phenomenon.
Once the desired currency diversification of portfo-
lios is attained, outflows should abate, reducing the
downward pressure on the yen.
? Although Japan has natural advantages, the limited
English-speaking skills of its middle managers is a 25X1
distinct handicap.
? Tokyo has not yet embraced the idea of becoming
an international financial center, although Prime
Minister Nakasone has voiced support for such a
move. Concerns about the potentially harmful ef-
fects on neighboring financial centers partly explain
the lack of enthusiasm among many government
officials. Fears about the impact on domestic mone-
tary policy formulation also play a role.
? Some Western analysts argue that the development
of a successful Tokyo financial center would create
more financial business for all of Asia rather than
merely divert existing business to Japan.
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Figure 16
Japan: Corporate Financial Assets, 1975 and 1982
Assets with regulated
interest rates
Table 5
Japan: Banks Among Top 50 Syndicated
Loan Managers, Globally
Assets with regulated
interest rates
Bank of Tokyo
14
Bank of Tokyo
4
Bank of Tokyo
6
Industrial Bank of Japan
19
Industrial Bank of
Japan
13
Industrial Bank of Japan
12
Sumitomo Bank a
27
Fuji a
16
Fuji a
14
Fuji a
34
Sumitomo Bank a
20
Mitsubishi Bank a
17
Long-Term
Credit Bank
39
Dai-ichi Kangyo a
25
Long-Term
Credit Bank
24
Sanwa a
45
Mitsubishi Bank a
26
Sumitomo Bank a
25
Dai-ichi Kangyo a
49
Long-Term
Credit Bank
27
Dai-ichi Kangyo a
26
Nippon Credit
Bank
45
Nippon Credit
Bank
37
Sumitomo Trust
40
Mitsubishi Trust
47
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Appendix
Japan: Chronology of Financial
Liberalization Measures
January
December
April
Underwriters allowed to sell government
bonds after one year.
Eurobond flotation by Japanese companies
decontrolled.
Medium-term government bonds issued on
auction basis.
Increased link between interest rates in primary
and secondary markets.
Added to pressures on banks to look overseas for
growth.
Heightened market influence on terms of bond
issues.
Nonresidents allowed to participate in gensaki Effectively linked Japanese money market with
market. foreign money markets.
Rates on two-month bills allowed to move
freely.
Investment trust funds in medium-term gov-
ernment bonds introduced.
New Foreign Exchange and Trade Control
Law implemented.
Tokyo Stock Exchange amends charter to
permit foreign security companies to become
members.
Annual queuing system for issuance of yen
bonds by foreigners replaced by quarterly
system.
Banks allowed to sell newly issued long-term
government bonds to public.
Minimum-size CD reduced to 300 million
yen.
Spurred growth of underdeveloped money
market.
Ostensibly completed deregulation of money
market.
Formalized new policy of permitting international
capital flows.
Of limited practical significance since there are
only 83 seats on exchange.
Embodied principle that foreign banks are to be
accorded like treatment with domestic banks.
Facilitated recycling of growing current account
surpluses.
Heightened link between primary and secondary
government bond markets.
Boosted growth potential of money market by
putting CDs within reach of more investors.
Select Japanese companies allowed to issue
Euroyen bonds.
Ended case-by-case screening of medium- and
long-term yen lending abroad.
Select banks allowed to deal in government
bonds with maturity of less than two years.
Ceiling for conversion of foreign currency into
yen by banks abolished.
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Expected to increase volume of such loans, even
though prudential net worth ratios imposed.
Further blurred lines between securities and
banking activities.
Simplified operations and widened financial base
of banks, especially foreign ones.
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The Political Dimensions
of Liberalization
We believe the political fallout from the liberalization
of Japanese financial controls is likely to be as
important as the economic fallout. Existing power
relationships between the government and financial
institutions, between financial and nonfinancial insti-
tutions, and among financial institutions are all likely
to change.
Although we expect the Finance Ministry to retain
greater control of financial transactions than its coun-
terparts in other countries-if only by monitoring
activities closely-the MOF's leverage over financial
institutions will decline:
? Financial institutions still have an incentive to heed
Ministry guidance, namely, to ensure themselves a
voice in decisions concerning specific liberalization
measures.
? As liberalization approaches its maximum level,
however, we believe the Finance Ministry will find
itself in the same position with respect to relatively
sound financial institutions that the Ministry of
International Trade and Industry finds itself in with
respect to healthy nonfinancial corporations. Minis-
try advice will be respected only when it appeals to
the self-interest of the institutions.
The supremacy of financial institutions over corpora-
tions is also likely to continue weakening, although
less dramatically, in our view:
? A 1974 law, which prohibited banks from lending
more than 20 percent of their capital and reserves to
a single client, has already reduced the role played
by main banks. These banks, usually city banks, act
as advisers as well as bankers and spearhead finan-
cial rescue packages when necessary.
? Subsequently, Japanese companies made use of
their new freedom in financial dealings to decrease
further dependence on their main banks. Many
firms now regularly tap nonbank and overseas fund-
ing sources and participate actively in Japanese
money markets.
? The emphasis on trust and personal ties in business
dealings in Japan has muted the impact of past
liberalization measures. We suspect it will continue
to do so in the future, preventing foreign financial
intermediaries and the most competitive Japanese
ones from quickly expanding their market shares.
The power balance among financial institutions is also
likely to shift, although the bottom line will depend
heavily on the scope of liberalization:
? If product deregulation occurs in tandem with inter-
est-rate deregulation, those institutions that now
enjoy monopoly privileges in growth areas will be
the losers. Examples are trust banks and insurance
companies, which have exclusive rights to manage
pension funds.
? On the other hand, if a high degree of specialization
is maintained in the financial arena, the profitabili-
ty and soundness of individual institutions will
probably be jeopardized. Smaller banks are most
vulnerable, and mergers may prove imperative.
? We believe the current heavyweights in Japanese
finance (the large city banks and the four big
securities houses) will fare well, regardless of the
type of liberalization embraced. These institutions
have aggressively internationalized their operations
in the last five years and by so doing have learned
how to compete in a market environment (see table
5).
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