Euroweek Japan report: Sumi Interview

Euroweek – Japan capital markets report, October 2011

Euroweek: Japan occupies a curious position in terms of the way world investors see it. It has faced a year of great challenges: the terrible earthquake, political uncertainty, sovereign downgrades, and very high debt. Yet the strength of the yen shows the world sees it as a safe haven. Where do you see Japan in world markets today?

Sumi-san: In Japan, we have gone through adjustments in the real estate market about a decade earlier than what is currently going on in Europe and America. Japan as a market is considered already to have been beaten; the remaining downside risk seems to be minimal, whereas for Europe and North America, people are still hoping that the real estate market doesn’t fall as badly as it did in Japan’s case. In Japan we had a full adjustment with the price of land going back to pre-bubble levels entirely. The US and UK don’t want to go down as far as Japan did, but investors fear the risk of further decline.

I would like to say that people are crazy about Japanese prospects and are therefore investing in Japan. But unfortunately, many would agree that investors see Japan has already taken the hit, has limited further downside risk compared to other economies, and hence is seen as a safe haven.

EW: Given that environment, what is the effect on Japan’s bond markets, and in particular JGBs?

In terms of the ownership of Japan’s JGBs, only 5% are held by foreigners. That said, the foreigners tend to trade more actively compared to Japanese institutional investors; they account for about 20% of the trading volume. If you consider Goldman Sachs Japan or Merrill Lynch Japan, they are very active participants and qualify as Japanese.

The JGB market is reasonably linked to the entire global market, but it is a yen denominated market, and its characteristics are very different from the dollar or euro denominated world. Nominally speaking we have very low yield, although in the rest of the world the yield curve has come down quite a lot too; with the American and German 10-years closing to 2%, and Japan now at 1%, the nominal difference between the Japanese and other interest rate environments has somewhat closed down.

Japan is a nation of net savings, and will continue to be so for a while at least. Nobody knows for sure how this ageing population impact will play out, and intuitively it should mean we will have lower net savings down the road, but for the moment we have plenty of savings – both household and corporate sector savings.

EW: You mention the 5% ownership level today. Would you like that 5% level to be higher, and is this the sort of environment in which it’s likely to happen?

I would like to have a very diversified investor base for Japanese government bonds. 45% of JGBs are in the hands of Japanese commercial banks, all of whom have similar business models. As a result of this similar way of thinking, they tend to act similarly to certain news; hence there is a chance of herding, with money moving together in one direction and then the next. So we would like to welcome more foreign ownership of JGBs, but at the same time we do not have a target number per se.

Sometimes people argue that Japan is different to Greece, in that in Japan 95% of JGBs are held by domestic investors. If you look at the Japanese net savings position, we could of course go to 100%. We have no difficulty in funding our own debt with our own savings. So 95% doesn’t mean much in itself, as long as we keep our net saver position and continue to be a creditor to the rest of the world. By the same token, if foreigners take on 10% of JGBs but the Japanese have a whole bunch of other foreign assets, that’s fine with us.

There are arguments that foreigners make the markets more unstable, which I personally don’t buy. Look at the last few disturbances of the JGB market. In 1998 the Trust Fund Bureau of the Japanese Ministry of Finance announced it wouldn’t be buying as much JGBs as it used to. The way we conveyed the news was not sophisticated enough; we inadvertently surprised the market, in a bad way. That was purely domestic, but we did have a shock. Then there was the VAR shock, which happens when banks are equipped with similar value at risk, risk hedges or risk management software. Therefore a certain movement of the JGB market triggered a sell order to most of the commercial banks. That effect fed into another program, and it escalated.

There is of course a chance that some news that may not surprise the Japanese may surprise foreigners, but we would rather have small tremors than calm and then boom. That’s my personal view, but I think it’s shared by many of my colleagues: we do welcome people who think and act differently from Japanese commercial bankers, including foreigners, households, pension funds, and foreign reserve banks. Some people may not want hedge funds to be active in the market, but I personally think somewhat differently. The arbitrage is important in demonstrating our yield curve is well managed, and that the integrity of our yield curve is strong. We don’t want to exclude any type of investors. But we don’t want malicious kinds of people; we understand Europeans may have different views on the shorting of government securities.

EW: Can you outline your plans for JGB issuance?

We formulate our issuance plan every Christmas time for the next fiscal year which starts in April. Our policy is to make it as predictable and transparent as possible. Our issuance plan goes from bills for two, three and six months, to 40 years, as well as inflation linked and floating or constant maturity types. We consult with the investor community and broker-dealers before coming up with these final numbers, and usually when they are finalized and published, they come as no surprise to the market.

One characteristic is that we have more issuance in the long end, 30 to 40 years, responding to the market’s need, especially the insurance industry: its regulator is increasingly aware of the need to match the duration of their assets and liabilities. Long-dated securities are in high demand.

On these longer-dated securities, the government has a comparative advantage over private issuers; it is a very long period of time for a corporation. But people are tending to live very long these days, and therefore need some certainty, some longer-term commitment on a nominal fixed term basis. So in these areas, and on the other very short term side, at either end of the yield curve the need for the government is stronger. And we are willing to respond to this increased demand. That translates to lower costs to tax payers who pay the interest rates.

EW: I notice a lot of municipalities in Japan have started to do more flexible term issuance, in order to issue opportunistically. Is that something you can do with JGBs?

If you are issuing 145 trillion yen of JGBs, there’s very limited room for being opportunistic. You can take an opportunistic position and may gain one time, but you have to go back to the market every year for large scale issuance. Instead of being seen as taking advantage of situations, we believe that being seen as predictable and transparent will pay off more in the longer run. We issue to finance government operations, and of course government funding needs may change; a good example is disaster relief, and in such cases we may need to change in mid-year, and we do. But in such cases when people know about disaster relief, they can think in terms of what the government, or our office, would be likely to think. We try to float the idea, and once it’s finalized it usually comes as very little surprise. Investors are not a homogenous bunch: some like this way, others like that way, and we can’t fulfill everybody’s requests at the same time.  But usually we are within expectations. Our aim is to try to convey bad news as early as possible, to keep the surprise element to a minimum. If anything, the surprise element should be a good one.

EW: Japanese domestic investors are tremendously loyal to JGBs: as you said, you could cover them 100% domestically. But will that remain the case in the long term? Are there circumstances in which domestic investors could look elsewhere for greater yield?

Theoretically we could go to 100% – my point was that Japan has national savings sufficient to cover the entire issuance of the government at the moment. Would it stay that way indefinitely? I’m not sure. We will be facing the ageing of the population; the baby boomers will become 65 this year and next year, the people born in 1946 and 1947. They will start collecting their pensions. And the retirement age is 60 for many Japanese firms, so of course as people retire they live out of their savings and therefore the savings ratio, intuitively, will be declining. That is exactly why we have a fiscal consolidation plan of shrinking the primary deficit with the national and local government, to try to achieve a primary balance by 2020. We may have net declining savings but at the same time are trying to shrink government dissaving. That’s our plan.

EW: I know you don’t want to talk about currency direction, but does the current strength of the yen have an impact on your borrowing program?

It is reflected only on the very short end. We see demand pretty much across the entire spectrum of the yield curve. Perhaps you should ask foreign investors how much of their decisions are currency motivated. In my experience, many investors distinguish between the currency play and the rates play. There may be some investors who think in terms of their own currency, but among most major players there is a division: currency people are currency people and rates people are pretty much rates people.

EW: When you communicate with foreign investors, do you coordinate your marketing with JBIC and DBJ

We have a somewhat coordinated appearance. Today [at a Euromoney conference in Singapore] I had a keynote speech, Shizuoka Prefecture was presenting, and so was the Japan Housing Finance Agency. This sort of opportunity is beneficial for ourselves and issuers, so it is natural we congregate.

EW: What impression do you have from international investors today about how they see sovereign debt?

I have had a four year interval [at the FSA] so this is my return to this scene. I would like to observe the market a bit longer; my knowledge is four years old. In the FSA I have been in touch with the other regulators, and we have been observing the market from that perspective; but the world from the eyes of a regulator is a bit different from the eyes of an issuer or investor.

EW: Having returned to the Ministry of Finance, what experience will you bring from the FSA to your new role?

When you perform duties, you do so with your entire personality; it is very difficult to say this part is relevant and this part is not. To me, it was good to be able to look at interest rate swap regulations worldwide. Interest rate swaps are a parallel world: for example for the Japanese yen yield curve, there is a risk free yield curve – the JGB yield curve – and a swap yield curve. And these fortify each other. If you have a 20 year JGB as a backstop, you can enter into a 20 year swap market knowing you are not too exposed. They are a reality check with each other, and in that sense fortify the integrity of each yield curve. Having a chance to look at this, and knowing the interest rate swap people and the other regulators around the world, is beneficial and allows you to look at JGBs from a different perspective.

EW: There is a Ministry of Finance man in charge of the country now. Is it good for Japan to have someone in charge who has gone through this financial discipline?

I wouldn’t describe Prime Minister Noda as a Ministry of Finance person, but you are right that he has been deputy minister of finance, then minister, and now prime minister. Let me refrain from making any comments on the parliamentary choice. But the parliament has nominated Mr Noda as Prime Minister and in his inaugural press conference speech he made it very clear that regaining fiscal health is something you cannot delay. So we have a very strong mandate from the Prime Minister and we – not only in the Ministry of Finance but the entire government – are trying to work with his new direction.

EW: Can you share a view on what you would like him to do in terms of improving Japan’s fiscal position?

Last year in June the cabinet launched the medium term fiscal framework, and more recently we have tax and social security reform. We have had a temporary departure from this approach after the Lehman crisis: we used to have a goal of achieving primary balance by the mid 2010s, that was decided under the LDP government a few years ago, but in 2008 we had to stimulate the economy so departed from it. Then in June 2010 there was a cabinet decision to put back this primary balance target again. Pretty much every year, except for the big shock in 2008, we have been on target, and that has been the basis of investor confidence in JGBs. We would like to keep that basis. Fiscal health is the basis for debt management.

I like to liken it to a building which is reasonably tolerant to earthquakes, but if the earth itself shudders underneath it… so fiscal health is the base. Under this policy target for the primary balance, we can have a solid basis to debt management policy. For our part, we would like to continue to talk with the market, and come up with no surprises. It may not be too sexy, but it will be no-surprise debt management.

EW: You sound positive. Are the right things being done in Japan?

I certainly believe that.

EW: When the third supplementary budget is passed, is there likely to be a knock on effect in your funding process from that?

We haven’t decided on the magnitude of the third supplementary budget, but the finance minister has said recently that his current thinking is around the 10 trillion yen. That, I think, comes as no surprise to many investors. They are foreseeing a rather large amount of the JGB issuance. But we have some room for maneuver: we have some reserves we have built up by issuing bonds a little earlier than they actually mature. Adjustments can be made – not in the magnitude of tens of billions, but at the margin, we have some room.

EW: Are there any tax issues coming that investors should be aware of?

I think we now have a reasonably broad and easy to follow withholding tax exemption. To me, that should solve many of the issues, but once again that kind of issue is easier to see from the side of the investor. If you have any issue please bring it to our attention. Our recent experience with the tax bureau on this issue has been quite positive. We have been expanding exemptions and lowering procedural barriers.

EW: Do you have any concluding message to international investors?

The JGB is a very liquid instrument and comes in various forms that are easy to fit investors’ needs. We are willing to make it even more investor friendly. For those investors who may want to seek some diversification, the JGB comes in very handy. We welcome the new entrants to the market.