Post-Big Bang Reforms: The Japanese Government Bond Market

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Post-Big Bang Reforms The Japanese Government
Bond Market

• S. Ghon Rhee
• K. J. Luke Distinguished Professor of
• International Finance and Banking
• University of Hawaii

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Motivation for UK Big Bang in 1986

• 1. London Trading Volume Prior to UK Big Bang
• 1/13th of New York Volume
• 1/5th of Tokyo Volume
• 2. Reform Measures in UK
• a. Internationalization
• b. Deregulation of Fixed Commission Rule
• c. Allowance of Proprietary Transaction
• d. Opening of Ownership of Stock Exchange
  Members to Outsiders

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Motivation for Japans Big Bang

• Shrinking Market
• Once the largest in the world, Tokyo market
  capitalization is now about one-fifth of New
  Yorks
• 15.1 trillion vs. 3.2 trillion
• Less Active Market
• Tokyo Trading Volume is less than one-tenth of
  New York Volume
• 31.9 trillion vs. 2.7 trillion
• Depressed Market
• Dec 29,89 At
  Present
• DJIA 2,753 10,500
• Nikkei 225 38,916 11,500
  

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Big Bang Financial Reforms Japan (I)

• 1. Deregulation of cross-border transactions
  and foreign exchange business
• 2. Adoption of a competitive auction method to
  issue financing bills
• 3. Abolition of securities transaction tax
• 4. Deregulation of brokerage commission
• 5. Preparation of legal framework for loan/asset
  securitization
• 6.    Allowance of off-exchange trading

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Big Bang Financial Reforms Japan (II)

• 7.   Allowance of banks and financial
  institutions to issue bonds
• 8.   Entry by banks, securities companies, and
  insurance companies into each others
  business
• 9. Introduction of individual stock options
• 10.  Replacement of merit-based licensing system
  with a disclosure-based registration system for
  securities companies

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Three Major Weaknesses of JGB Market

• 1. Fails to Tap the Pool of Global Capital
• 2. Violates the Rule of Separation between
  Government Liabilities and Assets Management
• 3. Needs to Complete Infrastructures of the
  Primary and Secondary Markets

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Investment by Foreign Investors in JGBs

• Foreigners Holding of Government Debt
• Japan 5
• United States 37
• United Kingdom 14
• As of April 1999, the withholding tax on
  redemption gains and interest income from JGBs
  were exempted for foreigners.
• However, tax exemption is not done at the
  source and is applicable only to BOJ book-entry
  system.

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Violation of the Separation Rule between
Government Liabilities and Assets Management
(I) 

• Fiscal Investment and Loan Program (FILP) of MOF
• FILP Asset Size 3.38 trillion
• FILP Assets invested in JGBs 17
• MOF is the largest issuer and buyer of government
  bonds
• Government Holding of Its Own securities
• Japan 46 of JGBs Outstanding
• US 13

9
Violation of the Separation Rulebetween
Government Liabilities and Assets Management
(II) 

• MOFs Dual Role An explicit violation of the
  separation rule
• Negative consequences
• Primary Market Lack of intense competition
• Secondary Market Increased uncertainty in JGB
  yields

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Underlying Forces for the US Government Bond
Market Expansion in 1980s

• a. Introduction of Financial Futures and Options
• b. Active Trading of Treasury Securities on a
  When-Issued Basis
• c. Expansion of REPO transactions
• d. Introduction of the Separate Trading of
  Registered Interest and Principal of Securities
  (STRIPS)

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Sequence of Government Bond Market Reforms
French Experience

• a. Bond futures market (1986)
• b. Primary dealer system (1987)
• c. Interdealer broker network (1987)
• d. Purely competitive auctions (1987)
• e. REPOs (1991)
• f. STRIPS (1991)
•  
• Brossard, Philippe, 1998, The French Bond Market
  Enhancing Liquidity, A paper presented at a World
  Bank Workshop on the Development of Government
  Bond Markets, June 11-12, Seoul, Korea.

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Suggested Post-Big Bang Reform Measures for
Japan  

• Creation of the primary dealer system
• Adoption of the uniform-price auction method
• Introduction of when-issued trading
• Revamping the REPO market
• Introduction of STRIPs

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Creation of the Primary Dealer System

• Existence of primary dealers does not necessarily
  guarantee intense competition on the primary
  market but they are experts in pricing, market
  making, and distribution
• No primary dealer system Japan and Germany
• MOFs dual role (buyer and seller) to be blamed
  for the lack of primary dealer system in Japan
• Syndicated underwriting Past norm
• Public auction systems are now used for
• 2-, 4-, 6-, and 20-year bonds

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Issuing Techniques ofGovernment Bonds

• Fixed Price Public Subscriptions
• Underwriter consortium utilized
• Private Placements
• In the absence of well-functioning secondary
  markets
• Tap Issues
• Sold directly into the secondary market through
  branch network of banks or securities companies
• Auctions
• Multiple price auction vs. Uniform Price Auction

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Issuing Techniques ofamong OECD Members

• Uniform Price Auction
• Finland, Italy, Netherlands, Norway, and
  Switzerland, UK
• Multiple Price Auction
• Australia, Austria, Canada, Sweden, UK
• Tap Issue
• US, UK, Germany, Canada, and most of OECD
  members, but not Japan

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Two Major Auction Methods

• Multiple-price auction method
• a. Successful bidders pay the prices they bid.
  ..winners curse
• b. Bidders tend to shade their bids below the
  maximum that they are actually willing to pay
• Uniform-price auction method
• a. All successful bidders pay the same price for
  a given security
• b. Hence, some successful bidders may pay a lower
  price than they actually bid.

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Adoption of Uniform-Price Auction Method (II)

• Empirical Evidence
• a. The uniform-price auction method generates
  higher revenue for the government
• b. US Treasury has been utilizing the
  uniform-price auction method for all Treasury
  securities since 1997
• c. Japan never adopted the uniform-price auction
  method

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Introduction of When-Issued Trading

• Most advanced markets allow trading during the
  period between the time a new issue is announced
  and the time it is actually issued.
• Ranging from one week to two-weeks (US market)
• As short as two days (France)
• When-issued trading functions like trading in a
  forward market.
• Major Benefits
• Minimize price and quantity uncertainties.
• Lower underwriting risk
• Increase revenue from the new issue
• By not allowing when-issued trading in Japan, the
  MOF foregoes these benefits.

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Revamping of the REPO Market (I)

• Major Functions of REPO Market
• a. allows primary dealers to cover their short
  positions
• b. allows institutional investors to maximize
  investment income by lending their securities
• c. allows foreign investors to reduce currency
  risk through money market hedging
• d. facilitates clearing and settlement
  transactions

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Revamping of the REPO Market (II)

• Traditional Gensaki Market
• European-style REPO (sell-and-buy-back)
• Ownership to the security is transferred to the
  buyer
• No marking-to-market
• Major instruments Short-term Treasury and
  Financing Bills
• American-Style REPO market
• Borrow and Lend
• No transfer of security ownership
• Marking-to-market
• Major instruments All Treasury and corporate
  securities

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Introduce STRIPS

• By introducing STRIPS, the MOF can provide the
  market with highly liquid zero-coupon bonds and
  notes.
• As a result, STRIPS will
• a. expand the investor base
• b. improve tracking of effective yield curve
• c. allow institutional investors to reduce
  reinvestment risk.

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Thank You!