More Bang For the Yen?

Japan's financial reforms are more cosmetic than real.


As Asian currencies and equities dropped last year, International Monetary Fund analysts and global fund managers discovered yet another important "Asian value": denial. Thai banks "can't imagine what will happen if they tell you the truth," a director of a Hong Kong-based investment management company told Dow Jones News Service in October. "As long as they still say there are no problems, I say stay away."

This failure to face reality is largely the result of an inability to define reality. Lax reporting and disclosure standards make a true accounting of Asia's bad debts extremely difficult. When capital allocation decisions are based on political rather than financial criteria, the incentives are to keep such reporting ambiguous.

But don't ask Indonesia's President Suharto and his Asian colleagues to shoulder all the blame on this point. After all, they had a highly regarded model: Japan.

Japanese government officials and business leaders have been suffering their own extended case of denial since the bursting of an economic bubble in 1991. For nearly the entire past decade, bad loans and stock market losses have been swept under the nation's tatami mats. The reflex to cover up has been aided by vague reporting practices and widespread fears that a public comeuppance would reveal too much about the links between bad loans and government officials. The nation's leaders also simply waited and hoped that the export machine, hero of so many previous domestic crises, would lift Japan's economy again, and that rising equity and real estate markets would make all bad things go away.

Unlike Thailand, Indonesia, and the others, Japan's currency devaluation stretched out over the past three years (rather than about three weeks), from a peak of ¥80 to the dollar in 1995 to nearly ¥135 in January. But Japan shares with its less-developed Asian neighbors the same kind of outdated, autocratic financial sector, leashed closely to politicians and their bureaucratic henchmen.

Modernizing and opening up these institutions are the ostensible goals of Japan's "Big Bang." The namesake of more narrowly focused security-market deregulation in England in the mid-1980s, Japan's Big Bang implies that a thunderous liberalization of the financial sector is taking place. That's what Japanese leaders want everyone to believe, but it's not that at all.

True, the package of official reforms will induce more competition in banking and securities markets and offer attractive opportunities for foreign financial expertise. But critical components of the fossilized structure responsible for a long list of financial market problems remain beyond the reach of reform.

Some of the most significant change is promised by two important measures. Foreign exchange controls will be eliminated April 1. At the same time, brokerage commissions were deregulated on trades greater than ¥50 million (about $400,000). Commissions have been both standardized and steep for decades, one of many factors freezing individuals out of equity markets.

In addition, this spring, banks may once again establish holding companies (a structure banned by the United States during the postwar occupation). Barriers between banks and brokerages will be eliminated sometime in early 2000. And by late 2001, the insurance market may be opened to banks and brokerages as well.

These are all good things. They will almost certainly increase competition and spur some much needed innovation in those two now noticeably state-run industries. The new currency policy, for example, allows any individual or business to swap yen for foreign currency. Official commentators frequently mention that this means McDonald's and L.L. Bean can accept payment in dollars. Though a public boost to continuing "internationalization" rhetoric in Japan, that kind of talk shifts attention from the much bigger benefits that would result from yet freer exchange.

Japanese save a lot–roughly 12 percent of disposable income, or about three times the comparable U.S. rate. Only about 10 percent of total personal financial assets flows into stocks and securities. (Americans place more than 50 percent of their financial assets in stocks and other securities, according to Bank of Japan comparisons.) Sadly, more than half of Japan's considerable savings sits in deposit accounts earning only about 1.5 or 2 percent. Better access to foreign currencies, through retail banking and securities markets, will offer better access to much higher returns available overseas.

Despite all that savings to target, Japanese financial institutions have so far failed to offer the kinds of retail products widely available to investors in the United States. (The type of money management account pioneered years ago by Merrill Lynch, for example, is one of the "innovative" new products several firms now are planning to offer.) There are complex reasons for this, and not all of them are addressed by Big Bang measures.

Still, most observers agree, banks and brokerages can't help but get more dynamic. The big four securities firms get an average of nearly one-third of their income from stock commissions. For second-tier brokerages, commissions total 40 percent of income. Eliminating these standardized income sources should not only reduce investors' expenses but also send securities managers scrambling to develop new products to gain competitive advantage.

Many of those new products will very likely come from foreign firms. Financial industry managers in Japan are woefully inexperienced at chasing higher returns, managing risks, and marketing sophisticated financial products. Even in pre-Big Bang conditions, the hip bank for new ideas was Citibank, whose customers still are the only ones with access to a 24-hour ATM network. As reform unfolds, there is an unusually hospitable environment for foreign expertise. Last fall, Swiss Bank Corp. announced a joint venture with Long-Term Credit Bank of Japan to enter the retail securities market. Smith Barney, Bankers Trust of New York, and Barclays Bank also announced tie-ins with Japanese partners.

The biggest move came from Merrill Lynch. Already an established competitor in institutional accounts, the brokerage announced plans to establish a retail network in Japan. That prospect sent a "chill of fear through the domestic industry," according to Japan's most prominent business newspaper. A big part of that network will be built on the rubble of Yamaichi Securities' bankrupt branches. Yamaichi, Japan's fourth-largest brokerage, failed last November, leaving several thousand unemployed. That not only gives Merrill Lynch a public relations edge, it also helps illustrate for the Japanese that, in competitive systems, something new and better often springs from failure.

Though clearly good, these reforms by themselves are not good enough. Certainly, they are not worthy of the "Big Bang" label and do not constitute the kind of wholesale reform needed to modernize the financial industry. They consist of a gradual and "organic" reform process, according to Alicia Ogawa, managing director and head of equity research at Salomon Brothers Asia Ltd. At a forum in Tokyo last summer, Ogawa noted the drawn-out pace of the reforms and suggested that the phrase "Long Bang" is more accurate. Akio Mikuni, president of an independent bond rating agency in Tokyo, called the reforms "mostly cosmetic policy changes dished up largely for the purpose of mollifying Japan's trading partners."

How is eliminating fixed commissions and removing barriers between industries just "cosmetic"? Because critical, older game rules, responsible for shaping the current system, haven't been touched.

Taxes, for instance. Japanese haven't accumulated large savings merely because of cultural preferences. The tax system encourages savings and discourages participation by individuals in stock and bond markets. (Dividends are double-taxed, while interest income is taxed at a flat 20 percent.) Tax treatment for corporate ownership of stock encourages stock holding. Companies can use unrealized gains or losses to their advantage on balance sheets, while capital gains on sale of stock are taxed at an effective corporate income tax rate of almost 50 percent.

The tax structure, however, remains untouched by reform. So do accounting practices designed primarily for Ministry of Finance controls and not for public disclosure. In fact, most firms don't even regularly issue detailed reports to the public. The MOF gets the details and releases its own reports weeks later. Firms issue summarized versions to shareholders and prospective investors.

Without a tax system which at least treats savings and investment more evenly, and without meaningful public financial reporting, even aggressive companies like Merrill Lynch may find it difficult to either attract new customers or adequately evaluate the health of the firms in which those customers might invest.

But these are small matters compared to the impact on the financial industry of ¥230 trillion ($1.8 trillion) held in postal savings accounts run by the government and untouched by any deregulation. One-third of Japan's total savings is thus under government control. These funds, together with an additional ¥100 trillion ($800 billion) from postal insurance contracts, are managed by the Ministry of Finance. Special tax treatment–it's the government post office, so there are no taxes paid on those revenues–give postal savings accounts higher interest rates and a clear advantage compared to banks.

Then there is the finance ministry itself. MOF officials establish financial policy, license financial institutions, and supervise their performance. Until recently, the ministry ran the Bank of Japan too (and many believe it still will, though more indirectly, under a revised law). As the financial reporting practices illustrate, institutional management systems are designed with MOF control in mind. Revealing serious problems with banks, brokerages, or insurance firms is, in practice, the same as revealing bad news about the MOF itself. No wonder that, as the end of the decade approaches, there is still little accounting of the bad loans stemming from the crash of the bubble economy in 1991.

While the supervision of institutions will later be folded into a new agency reporting directly to the prime minister's office, no one believes the MOF has given up its control of financial markets. Staffers at the new agency, for example, will come from the MOF. Critical decisions will be a collaborative effort between the finance minister and the head of the agency. But the MOF controls the agency's budget.

None of this is especially surprising. The Big Bang is a political initiative. Prime Minister Ryutaro Hashimoto announced it in late 1996 as one of six areas of reform to which his administration had dedicated itself. Reform proved a popular theme in that year's national campaign.

A year and a half later, the final shape of the Big Bang proposals reflects their political roots. The reforms opening up banks and securities markets to greater competition targeted two industries politically weakened by scandals and a massive public bailout of failed housing loan corporations. But as the proposals targeted areas with more political clout, they were either delayed or dismissed altogether. Threatened with having their well-protected industry opened to bankers and stock brokers, insurance industry leaders pressed their case to ruling Liberal Democratic Party members receiving considerable financial support from the industry. Any significant move to spur more competition in insurance was delayed until fiscal 2001.

Postal services employ 300,000 people eager to work for LDP candidates during elections and fund-raising events. Their objections to privatizing postal operations gained support from several party members. Thus, there's not even a tiny bang for postal savings and postal insurance. These funds are scheduled to be transferred to a special government corporation in 2003. But that's just shifting them around the bureaucratic table.

Political influence may even yield some unexpected benefits. Evolving scandals, which led to the recent arrests of MOF officials and the subsequent resignation of the finance minister, are eroding the ministry's ability to shape details of the reforms to suit its purposes.

It's still common for observers of Japan to speak of a unique governing system, one that rather mysteriously lacks input from its large, free electorate. Of course Japan is different, as all countries have unique characteristics. But the financial reform process suggests Japan's system is not unrecognizable. Special interests, including middle-class savers (who wanted hands kept off their privileged postal savings accounts), applied as much pressure as they could to preserve their protections and handouts. Japan's government responded in essentially the same way other modern democracies would.

Think of the half dozen or so "reforms" of the American Social Security system in the past 20 years. Think of the Contract with America. You'll see Japan's Big Bang picture clearly enough.

Michael J. Oakes (mjojpn@gol.com) is a writer and teacher living in Japan.