68: Let the sun rise
Financial market liberalization in Japan
The problem: weak domestic investment
Japan is the world's second largest economy, but its protectionist policies have often made it difficult for overseas firms to enter a range of its financial markets such as pension fund investments.
The idea: open the market
Eventually, the Japanese parliament decided that such rigid protectionism was no longer sustainable; so it moved to allow foreign companies to provide expert advice and management to pension funds. The entry of new players forces domestic incumbents to improve their efficiency and skills. Meanwhile, pension fund members prosper from enhanced returns and more efficient fund management.
Results: the Japanese experience
The Japanese have a strong propensity to save for their old age, regularly saving between a quarter and a third of GDP.
The trouble is, this torrent of private savings was not directed into worthwhile investments. Strict regulation stifled competition in the pension fund industry. Domestic trust banks and insurance companies enjoyed a statutory monopoly to manage pension fund money. But they squandered this capital through poor investment decisions, often influenced by traditional business or keirestsu relationships. Life assurance companies, for example, were reluctant to sell shares in companies that performed badly because of long-standing traditional business ties.
By the mid 1990s it became abundantly clear that many investments were making meagre or negative returns. In the recession of the late 1990s a large number of Japanese companies were revealed to be insolvent. By 1998 the net liabilities of bankrupt corporations, as a proportion of GDP, was higher than it was in the US in the depression years of the 1930s.
Returns on pension investment were so low that many large company pension schemes were badly underfunded. Indeed, in 1998 the National Bureau of Asian Research estimated that the pensions of publicly listed companies could be under-financed by as much as $400 billion, while the net pension debt of the state pension systems totalled a horrifying $5 trillion - perhaps the largest pension funding overhang in the world.
The deepening economic crisis obliged the Japanese government to overhaul its financial markets. This 'Big Bang' deregulation was accelerated by the 1995 US-Japan Pension Accord, which enabled American firms to compete for the right to manage certain Japanese pension assets. Trust banks and insurance companies lost their monopoly over the management of pension funds.
Domestic fund managers' abysmal track record in handling occupational pension schemes in Japan persuaded a host of Japanese pension plans to begin looking further afield for advice. In autumn 1997 the government permitted foreign fund managers to offer advice to pension funds held in tax-qualified funds, a market worth 15 trillion yen.
Companies such as Fujitsu and Sony were the first to transfer pension fund money away from poorly performing asset managers. Fujitsu, for instance, appointed a clutch of foreign firms including Schroders, J P Morgan and Credit Suisse, to manage 20 per cent of its 500 billion yen fund. Foreign fund managers were able to increase their market share from 8 per cent in 1995 to 22 per cent in 1997.
Further financial deregulation has given much greater discretion to fund managers in terms of the asset categories they are permitted to use. Government regulation made pension funds highly risk averse and curbed their ability to channel money overseas. In the ten-year period 1985 -1995 Japanese trust banks were only able to achieve a cumulative 59 per cent return on the pension assets they managed, equivalent to a compound average annual return of 4.7 per cent. In contrast, company defined benefit schemes in the US returned 249 per cent, equivalent to a compound average annual return of 13.3 per cent.
In 1998 the Japanese government repealed the Foreign Exchange and Foreign Trade Control Act , which had prohibited Japanese investors from holding overseas yen accounts or converting foreign money with any institution other than a 'foreign exchange bank'. This law effectively barred pension funds from investing in foreign mutual funds. Japanese investors are now free to invest abroad, however, and they are able to invest in foreign mutual funds through Japanese banks, whereas previously they could only do so through securities firms. Competition has become much keener
Assessment: deregulation is a boon to savers
Financial liberalization has led Japanese savers to switch from low-yielding bank and post office deposits to investments offering better risk-return profiles. Many foreign asset managers have forged new links with Japanese banks and securities firms in order to gain a firm foothold in the marketplace.
Legislative reforms have placed a greater focus on the need to generate reasonable returns to shareholders. Previously, shareholders had to take a back seat to rival claims from suppliers, customers, employees and (most importantly of all) the managers of the business.
There has been a surge in the amount of cash raised through the market rather than from companies' traditional banking relationships. Two new stock markets were launched on the Tokyo stock exchange, aimed particularly at IT and internet companies.
Japanese companies, so long preoccupied with sales growth and increasing market share, have now refocused on managing capital resources more carefully with a view to maximising returns to shareholders and attracting foreign investors.
There was also a boom in merger and acquisition activity as companies restructure their assets.
The Japanese economy has of course not yet recovered from the major downturn in the region. Other policy errors, and the political unwillingness to liberalize other market regulations, have deepened the crisis.
Unfortunately, the Japanese politicians postponed the much needed reforms of taxation and pensions for far too long and resisted the idea of opening up the banking system to new entrants. They also provided large loans to small and medium-sized enterprises (SMEs) that were effectively bankrupt. The recapitalization of the banking system in early 1999 reduced the pressure on large corporate borrowers to rationalize their bloated costs. Meanwhile, the traditional keiretusu relationships and bureaucratic inertia remain a significant barrier to a robust, free market economic system. But to the extent that Japan has liberalized its financial markets today, it is better placed to survive difficult world economic conditions than it would otherwise have been.
For futher information:
- 'Asian Pension Survey', Global Custodian, Summer 1998;
- OECD Economic Outlook (www.oecd.org).
- Asset Management in the Twenty First Century, (1998) Goldman Sachs Investment Management Industry Group.
- National Bureau of Asian Research (1998) 'The Transformation of the Japanese Pension Market' Executive Insight No 14 (www.nbr.org).
Copyright 2002: Adam Smith Institute
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