The BOJ and the Koizumi Administration--More Mixed Signals


The Koizumi Administration was first caught off-guard by the Bank of Japan's unprecedented step of buying shares from banks, announced on September 18. BOJ Governor challenged the Koizumi Administration to show some initiative in dealing with the country's dismal financial situation. The Prime Minister's response was to appoint bank reform hawk Heizo Takenaka to the FSA, who promptly set to work trying to put together a comprehensive "anti-inflation" package, and appointing more hawks to an advisory panel for the FSA's NPL clean-up effort. The sudden zeal to clean up the banking mess by the Koizumi Administration set the stock market in a tizzy, as investors feared a sudden rush of new bankruptcies if Japan were to really push the banks to clean up their loan books. According to Teikoku Data Bank, there are about 200,000 financial strapped companies with a total of JPY135 tillion in bad loans. The bulk of these could fail in the next two years, pushing up total bankruptcies to 5X the current failure rate. Some economists claim that if Japan pushes to clean up the banking sector, they will need JPY30 trillion to offset the deflationary pressure on the economy.


This is where Mr. Takenaka caught the Bank of Japan off-guard, by requesting that the BOJ adopt inflation targets to stave off the inevitable deflationary pressures. The Bank has reacted with caution to what they perceive to be a challenge to their independence. Since PM Koizumi has given Takenaka a free hand, the BOJ thinks they know what this means--constant government pressure to ease money supply to achieve an annual inflation target of 2%~3%. They Bank has already tried to go in this direction, with little success. In 1999, the BOJ introduced a monetary policy aimed at bringing interest rates to near zero percent. Last year, this was followed by efforts to lossen up the money supply by aggressively increasing the balance of deposit reserves held at the Bank. Inside the Bank and among other observers, the view is that it is impossible for monetary policy alone to bring about inflation. This is because the globalization of the economy itself is bringing down prices due to technological innovation and global competition.


It is high time that the BOJ, MOF and the Koizumi Administration stopped positioning against each other and got with the program--i.e., the Bank of Japan has succeeded in pushing the Koizumi Administration to action, and they should have been prepared to respond to any initiatives coming out of the Koizumi Administration. To avoid killing the economic patient with a strong dose of bad loan liquidations, the government and the BOJ and the MOF will have to come up with a coordinated, integrated package of inflation-inducing measures, tax cut incentives and fiscal stimulus as the move to clear the decks of some 200,000 financially weak firms gathers momentum.

Direct of Japan's Welfare Pension Association Sees Little Hope for Japanese Stocks


In FY2001, the Association saw JPY1 trillion in underfunded pension liabilities. Mr. Yano, Managing Director of the Association, said that this is partially the result of the rapid aging of Japan's population which is not matched by new funding sources. In other words, as Japan's pension system matures, fund flows have shifted from excess contributions to excess payouts. This of course places additional pressure to produce investment returns in excess of the fund's hurdle rate. However, investment returns for the past two years have been minus, and these minus returns have accounted for half of the funding shortage.


Last year, the fund began disclosing the institutions with which it had contracted fund management. Part of the funds' evaluation of asset managers selected includs how proactive they are in exercising their proxy voting rights. Heretofore, the organization had reviewed its asset manager contracts every three years, but henceforth will review them constantly. The foreign asset managers currently under contract to the Welfare Pension Association are; Morgan Stanley Asset Management and State Street Investment Trust (foreign equities), UBS Global Asset Management (foreign bonds). In addition, among the contracted asset managers for domestic stocks is Merril Lynch Asset Managers.


The Association determines asset allocation by long-term returns for each asset class, and expected returns. The problem however is domestic stocks, where the long-term returns are 4.5%, but these sorts of returns have not been seen during the current era of ultra-low interest rates. As a result of lowering expected returns on domestic bonds to more realistic levels, they have reduced their exposure to JGBs by 5% points and increased their weight in foreign securities by a similar amount. Another factor in their increasing weight of overseas securities is the coming decline in Japan's population and Japan's depressed expected GDP growth. The end result is continued low domestic interest rates, which is pushing even the domestic public pension funds into foreign securities.


They have also allocated funds for alternative investments of JPY15 billion, to begin investing in private equity overseas.


Revised Portfolio Allocations (Previous Allocations)


Foreign Equities 23% (18%)


Foreign bonds 7% (7%)


Domestic Equities 33% (33%)


Domestic Bonds 37% (42%)


The reason they have begun to contract funds management out to foreign managers is their long history of fund management and their global network. Japanese fund management companies's histories go back only about 10 years, and many of them continue to subcontract out management of foreign equities. Over the next 10 years, Mr. Yano foresees a consolidation within the the Japanese fund management companies. While these firms are growing youner fund managers, their management consists of many hand-me-downs from banks, insurance companies and brokerages, while the president usually has a sales background, with no actual fund management experience. Moreover, they sell pension fund services like they were selling mutual funds, often change fund managers, and change their investment methodologies.


From April of this year, the fund began to manage index funds in-house, starting with JPY50 billion and expanding this to JPY100 billion. As a result, they have created a position for their own in-house proxy voting. From July, of 150 shareholder proposals reviewed for 30 companies, they voted negative on 15. Mr. Yano also said that the Association would like to create a specific set of proxy voting criteria in time for next year's shareholder proposals. Using these criteria, they would like to be able to screen the proposals to flag certain issues, such as too many directors, too low dividend, continued deficits and other trigger issues. While the Association alone cannot dramatically change Japan's corporate governance practices, by publishing their proxy voting criteria, releasing lists of those companies which they believe are not appropriate for investment, they can increase their corporate governance influence in the market place.


The Welfare Pension Association's Proxy Voting Guidelines


1) The association believes that voting proxies will service to maximize returns for our beneficiaries.


2) The boards of directors to which we entrust funds for management are expected to require management of their organizations to place primary focus on shareholder returns.


3) Asset managers to which we entrust funds are required to have a clear proxy voting review and implementation methodology for voting proxies, and are expected to have an ability to evaluate whether the companies in which they invest have sufficient information disclosure.


4) Asset managers to which we entrust funds are expected to utilize the following criteria and vote proxies in accordance with their evaluation of these criteria; a) the composition and size of the board, b) how profits are distributed, c) changes in financial strategy and the business mix, d) corporate accounting responsibility.


5) Asset managers to which we entrust funds are expected to report on how they voted on the proxies.


6) Proxy voting status will be considered as one quantitative factor in evaluations.

Stock Buybacks One of the Few Sources of Stock Demand


Aside from public pension funds, the listed companies themselves are one of the few sources of stock demand in the Japanese market. Non-financial corporations were net sellers during the April~June period by JPY37.4 billion, but were net buyers by JPY399.2 billion during the July~September period. While non-financial corporations are also selling bank stocks in response to cross-holding unwinding by the banks, but their repurchases of stock exceed this selling. According to a compilation of buyback programs already approved by shareholders, total approved stock buybacks are around JPY9.72 trillion for some 980 companies. However, the actual amount of repurchases has been much lower. Since the commercial code was changed to allow repurchases as treasury stock, a total of 371 companies have bought back only JPY1.9 trillion worth of stock--in other words, only slightly higher than the JPY1.45 trillion in FY2001.

Japan's Structural Net Sellers


Even assuming that the government's new "tough love" attitude toward cleaning up the non-performing loan mess works, Japan's stock market will still be hobbled by net selling from financial institutions every time the market tries to rally--irregardless of economic conditions or "fundamentals". Between 1997 and 2002, Japan's banks (excluding trust banks) were net sellers of a total of JPY8.8 trillion worth of stock. By September 2004, they have to sell all holdings in excess of the value of their core capital. As of March 2002, the 12 major banks had total core capital of JPY17.3 trillion, while the market value of their stock holdings was JPY25.6 trillion, implying they still needed to sell JPY8.3 trillion more stock before the 2004 cutoff.


As most of their strategic holdings in weaker companies are hopelessly under water, the stock that have been punished the most by this structural net selling have been Japan's bluechips. For example, the major four banks' holdings of Toyota as of March 2002 were JPY1.6 trillion, and they also have large holdings of Honda, Nintendo and Tokyo Electric Power. The situation is the same for life and non-life insurers, who were net sellers of stock by JPY1.1 trillion last fiscal year, compared to net selling by the major banks of JPY1.7 trillion. While life insurers were net buyers of stock by JPY1.1 trillion for their investment portfolios, they at the same time reduced their strategic holdings of stock by JPY3.1 trillion.


In addition, the financial institutions now have a new tool with which to sell their stock holdings, i.e., the ETF (exchange traded fund). Tokyo Mitsubishi Bank, Tokio Marine and Fire and others have already unloaded JPY1.4 trillion of stock through this method. Since there is no minimum unit price for these ETFs, the market expectation is that they will be effective in drawing individual savings.


Given the recent plunge in stock prices, however, financial institutions are sitting on unrealized losses on their stock portfolios, and thus find it difficult to unload stock. In FY2002, the major banks were expecting to sell JPY4.9 trillion worth of stock, but by September had actually sold only JPY1.5~JPY1.6 trillion.

Market Capitalization of Global Stock Markets Shrinks JPY1,500 Trillion


Market capitalization for the major European, US and Asian markets is now down over US$12 trillion (JPY1,500 trillion) from the peak two and a half years ago. This represents some 40% of world GDP, which in 2001 was US$31 trillion. In addition, the implosion of market values was larger than the US GDP (at US$10.2 trillion), or Japan's personal financial assets of (US$11.5 trillion). Lead by the implosion of the TMT bubble, the shrinkage of global equity market capitalization continues.


In addition to the global shrinkage of market values, Japan has its own indigenous problems as well. Prime Minister Koizumi will go down in history as the Prime Minister that was most damaging to the Japanese equity market. Since he became Prime Minister, the Japanese equity market has lost JPY131 trillion in value (US$1.1 trillion), or almost two times as much market value as was lost during the second-worst Mori Administration, and the carnage continues. The Japanese stock market is presently trying to discount the possible bankruptcy of some of the largest listed deadbeat borrowers, as the Koizumi Administration implements new, tough policies to accelerate non-performing loan liquidation. If the real dead wood still listed on Japanese stock markets were allowed to go bankrupt, the Nikkei 225 could well be below 7,000 in two years time.

Companies Rush to Return Welfare Pension Administration Back to the Government


A typical corporate pension plan in Japan consists of two components. The first is the standard national welfare pension plan, while the second is a supplemental plan specific to each company. Companies administer the national welfare pension plan for their employees on behalf of the government. However, since April of this year, companies now have the option to return the administration of the national welfare pension plan back to the government, and companies are rushing to do just that. So far nearly 140 companies have chosen this option, and in the process have reported some JPY700 billion in extraordinary profits as a result. The extraordinary profits result from the difference in the current value of the pension assets returned to government administration, and the amount that the company had funded for, including future pension liabilities. Thus if the pension is fully funded (i.e., including future pension liabilities), the company actually reports an extraordinary profit. If the pension however is underfunded, the transfer back to government administration creates an extraordinary loss. For a large company like Toyota, for example, the extraordinary profit can be upwards of JPY100 billion.

Calls Increasing for a Japanese Version of an Independent SEC


While Japan has a Securities and Exchange Commission, but it is adjunct to the Financial Services Agency. There are however increasing calls to make Japan's SEC an independent entity tasked with monitoring market trading and corporate compliance. The Liberal Democratic Party's Financial Research Council supports the concept of an independent SEC as a means of reassuring individual investors, who have been buffeted by plunging stock prices and manipulative brokers. The motivation for an independent SEC is that Japan's bureaucracy has not kept pace with the disintermediation of financial markets and the shift from direct financing (loans) to indirect financing (capital markets). As long as the SEC is under the wing of the FSA, it cannot adequately perform its supposed mission of protecting shareholders. As a part of the FSA--which is an organization designed to administer the financial services industry--there is an inherent conflict of interest.

Underfunded Liabilities of the Welfare Pension Association Surpass JPY1 Trillion


The Welfare Pension Association is a special purpose corporation set up by 1,700 nationwide welfare pension programs. The organization manages pension funds for individuals who have since left a company, and they also support those corporate pension funds that have run into financial difficulties by providing payment guarantees, and they also manage facilities for participants in the welfare pension program. In FY2001, however, the organization had underfunded pension liablities of over JPY1 trillion, an amount equal to 18% of their total pension assets. The organization has no parent corporation to provide additional funds to cover the funding liabilities. Like other pension fund organizations, the Welfare Pension Association is suffering from poor investment returns.


Under the current nationwide corporate welfare pension system, if salaried workers lose or change their job and drop out the company-specific welfare pension programs, the pension fund benefits heretofore accrued are turned over to the Welfare Pension Association for management. In addition, if the corporation goes bankrupt or the company's welfare pension fund is disbanded due to financial difficulties, the WPA also assumes these assets for management. Like other Japanese pension funds, the fund's hurdle rate for investment returns is 5.5%, whereas actual returns in FY2000 & FY2001 were minus 2%~5%. At the end of FY2001, assets under management were JPY5.6119 trillion, versus required funds of JPY6.6205 trillion, meaning underfunded pension liabilities were JPY1.86 trillion.

Tokyo Stock Exchange Tightens Listing Requirements


The TSE has been going through a general review of listing requirements from October. Since a new civil restructuring law came into effect early last year, more and more companies are choosing to declare bankruptcy. This includes some of Japan's oldest companies. For example, Hitachi Seiki was established in 1936 and was listed on the TSE first section. On the 19th of August it was trading at 72 yen, which itself was a sign of trouble because any stock trading on the Japanese exchanges that trades under 100 yen is effectively on the short list for bankruptcy. On the 20th, it filed for bankruptcy under the civil restructuring law, and by the 21st, the stock was trading at a mere JPY1. From the onset of 2002, there has been a growing number of companies declaring bankruptcy, or some 20 to date, which represents a four-fold jump from the previous year and the largest number in the past 10 years. With a more aggressive policy by the Koizumi Administration to accelerate bad loan write-offs, we could very well see another surge in such bankruptcies.


The most important of the new TSE listing maintenance rules is the introduction of minimum market capitalization standards, and the exchange authorities drew the line at JPY1.0 billion. If a company's market cap falls under this line on average during any month, or at the end of any month, they are subject to monitoring. If over the next 9 months the company's market capitalization continues to trend under this level, they are subject to delisting. Currently, there are around 20 companies who do not satisfy the new listing maintenance rules.


The second hurdle is positive net equity. If the firm reports net negative equity for two consecutive years, they are also subject to delisting, as compared to a previous standard of three consecutive years, and the company had to be reporting net negative equity on both a consolidated and a parent-only basis.


At the same time, the TSE relaxed new listing requirements. They have dropped the requirement for market capitalization of over JPY100 billion, and earnings over the most recent reporting period of over JPY400 million. "Blue chip" companies that have temporarily fallen into deficit because of restructuring or other extenuating circumstances can still be listed.


The Japan Association of Securities Dealers is also studying the introduction of minimum market capitalization requirements for listing over the counter.