Japan’s $3+ Trillion Postal Privatization to Have Significant Impact on Financial Markets

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Late 1990s “Big Bang” Forecast to Change Investment Behavior in Japan

Financial reforms were a central tenet of the “Action Plan for Economic and Structural Reform” adopted by the Japanese Government in the fall of 1996. As a result,a dramatic "Big Bang" liberalization of Japanese financial markets was enacted on April 1, 1998. This included a revised foreign-exchange law. Regulations concerning brokerage commissions were also relaxed.

To promote financial sector consolidation, steps were also taken to ease the regulatory barriers that kept insurance, banking, and other firms from competing with each other. Foreign financial institutions seeking a larger share of the $9+ trillion in estimated assets held by Japanese investors had long been seeking to enter Japan’s investment trust market. Roughly equivalent to U.S. style mutual funds, the sale of these instruments had formerly been restricted to Japanese financial institutions. In December 1997, however, foreign firms were granted the right to form sales alliances and in December 1998, to market them directly.

Believing Japanese investors would be eager to achieve higher returns through exposure to products like those offered in the U.S. and other markets, foreign financial firms moved to expand their presence in Japan. Merrill Lynch, for example, acquired the failed Yamaichi Securities Co., Japan’s fourth largest brokerage company, for about $300 million. With a national network of branch offices and over 2,000 salespeople, Merrill sought to gain retail market share.

Despite a major commitment and introduction of U.S. investment products, training and business techniques, as well as a concerted effort to localize themselves to better interact with Japanese consumers, Merrill ultimately was not able to achieve the success they were looking for. Therefore, by the end of the first year of this operation, Merrill had less than half the Japanese assets under management than could be found within the ¥625 billion held by Goldman Sachs, which catered to corporate and institutional clients..

Japanese Preferred Security of Bank Deposits to the Risk of Equity Investment

While the introduction of discount brokers and online Internet trading has begun to change the nature of investing in Japan, the typical Japanese retail investor, more than 50 years old, remains conservative in their outlook. Many live in rural areas and equate the stock market with a casino. Exhibiting a distinct preference for earned over unearned income, they have found it hard to distinguish between investment and speculation. These perceptions were only reinforced when the nation’s “bubble economy” burst in the early 1990s. Furthermore, unlike the U.S., Japanese culture precludes many investors from revealing personal information until they have established a close relationship with the requestor.

Most Japanese were also unfamiliar with the long-term, buy-and-hold, index-style investing that led to the dramatic growth of retail investing and mutual fund assets seen in the U.S., and the U.K. Customers were also used to brokers making house calls, and providing a very high level of service, especially to high-income households.

Their apprehensive and conservative attitude made it difficult for them to consider alternatives, especially from foreign companies. As a result, they preferred the security of guaranteed bank deposits and especially that of the PSS, even though this resulted in annual interest rate returns of less than 1%.

Part of the reason so much money was placed in the PSS was that there were advantageous tax benefits. For example, in the past interest on postal savings was tax exempt. This has now been changed to a limit of ¥3.5 million, after which interest is taxed at an incremental rate of 20%. Since the PSS also receives subsidies from the Japanese government, however, it has been able to offer higher interest rates and fewer restrictions on accounts than private banks. Furthermore, in uncertain economic times, the PSS was also seen as being more secure and less risky than private banks..

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Financial Reforms Helping to Strengthen Japanese Banking Institutions

At the same time, Big Bang reforms are bringing about heightened competition. New financial policy tools geared to initiate "prompt corrective action" are helping to gauge the soundness of individual firms and banking institutions. As a result, financial institutions with low capital adequacy levels have been required to improve their condition, lest a new administrative organization known as the Financial Supervisory Agency (FSA), moves to issue directives designed to improve, or even to close, their operations. Foreign private equity investors including Ripplewood, Cerberus, Lone Star and WL Ross also entered the sector. They introduced western banking practices, including better use of technology and decision-making based on credit analysis rather than collateral and personal relationships. This has helped to raise banking standards and performance in domestically-owned institutions as well.

Over time these measures helped to initiate significant change. As a result, in FY 2003, after ten consecutive years of operating losses, the industry has begun to again achieve profitability. The latest data provides further evidence and this year three of Japan’s top four banking groups, Mitsubishi Tokyo , Mizuho and Sumitomo Mitsui , announced they had been profitable for the first six months of FY2004 and expect to meet the government’s March 2005 deadline to reduce their non-performing loans by 50%. A fourth group, UFJ Holdings, reported a loss, and rather than take the risk of violating Bank for International Settlement (BIS) requirements, is now in the process of being acquired by Mitsubishi Tokyo. This is likely to further reduce excess capacity in this sector.

Deposit-Guarantee Limits Marks a Major Additional Reform Measure

Japanese citizens have enjoyed unlimited government guarantees on banking deposits since 1996. This was intended to build confidence in the banking system, yet has had the unfortunate side effect of allowing the Japanese public to ignore the underlying stability and health of the institutions to which they entrusted their funds. As a result, banks could engage in unsound and unprofitable practices and face little scrutiny from depositors who remained sure their funds would be repaid through the existence of unlimited government guarantees, regardless of the amount or circumstances.

Realizing this only resulted in irresponsible behavior, in April 2002, the Japanese government imposed guarantee limits of ¥10 million (about $100,000) on time and installment savings deposits. Next year, in April 2005, guarantees on all interest-bearing demand deposits in private banks—money that can be withdrawn at any time— will become subject to the same limit as well.

This move is likely to have important structural consequences as Japanese banking customers will no longer be able to ignore the health of the institutions to which they entrust their funds. The banks themselves will also have to demonstrate their underlying health if they are to retain their depositor base. Finally, Japanese investors will no longer be able to simply deposit all their funds into a bank under the assumption they are 100% guaranteed by the government.

Combined with a general need to seek higher returns as more Japanese citizens advance into retirement age, as well as creative marketing by stronger institutions, this is likely to increase general awareness, and the perceived attractiveness of different financial instruments and products. Government institutions are also moving to encourage this transition and are considering tax reforms and other measures to encourage investment into equities, trusts and other financial securities. For example, dividends are currently taxed at a 20% rate, the same as interest from bank deposits or fixed income securities. Capital gains, however, had been taxed at a higher 26% rate. This is now recognized as being discriminatory toward equity investments and steps are being taken to lower this rate to the same 20%.This will all help to deliver some of the changes in investor behavior that had been forecast when the Big Bang reforms were first initiated.

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Privatizing Japan’s Postal Savings System is the Next Reform Challenge

Junichiro Koizumi was elected Prime Minister of Japan in 2001, winning a popular mandate to lead the country out of a decade of economic stagnation. Perhaps his most ambitious goal has been to privatize Japanese postal services, which includes Japan's PSS. The PSS deposit base currently totals approximately ¥350 trillion or $3.3 trillion ( ¥230 trillion in savings and ¥120 trilliion in insurance). This accounts for over one third of Japanese household deposits and makes it the largest financial institution in the world. It is about 2.5 times the size of Citigroup, and about 20 times that of Postbank, the banking subsidiary of Deutsche Post. It also holds about a 30% share of the Japanese life insurance market.

Postal deposits, life insurance premiums, and other sources of funds support an extensive system of government programs funded through the Fiscal Investment and Loan Program (FILP). The ¥400 trillion in assets currently held by the FILP is more than the total of Japan's four largest private banks. The FILP was created a half century ago, gathering funds from asset-rich sources such as the PSS and pension reserves via internal sales of Japanese Government Bonds to finance necessary public projects, While these initiatives helped to develop the infrastructure that enabled Japan to become the world’s second largest economy, over the past decade or two they often could not be justified as efficient uses of capital. Many projects were approved, which while perhaps serving as short term measures to stimulate domestic activity during periods of economic recession, also introduced longer term distortions to the Japanese economy and rising public sector debt that ultimately must be repaid.

In the past, the PSS also received preferential treatment. From the consumer perspective, Japanese savers were not charged any tax on interest gained from PSS holdings. In addition, unlike private banks, this institution is exempt from corporate taxes and pays no risk premium to the deposit insurance fund. Furthermore, only private banks are scheduled to lose the unlimited government guarantee on demand deposits next year. As a result of these advantages, the PSS attracts a huge amount of household assets. Given that public confidence in private banks is only now being restored, postal savings assets have steadily increased for over a decade.

The current effort to privatize the PSS stems from a growing recognition that the current system represents a major structural barrier to developing a more efficient financial system in Japan. Change is essential to allow the private sector to stand on its own feet and to develop a banking and business culture that can efficiently allocate capital according to market mechanisms and the basic tenets of modern credit analysis.

To begin rectifying these imbalances, FILP assets have fallen over the past ten years -- from about ¥40 trillion in 1995 to ¥20 trillion in 2004. Additionally, in July 2002, the government opened up postal services to competition for the first time in 132 years. Even more importantly, steps were taken in April, 2003 to form a new entity, Japan Post, which will act as a holding company. Until that time, the PSS was operated as a governmental agency. Under the new system, a state-run business enterprise provides the four core postal services. This includes mail delivery, management of individual branches, postal savings, and postal life insurance. It marks a definitive shift from an approach that relied upon allocated government funding to an autonomous and flexible system based on market principles, as used by a private business.

Basic Principles to Commence Postal Privatization Adopted in September

In September, the Japanese cabinet adopted the basic principles needed to privatize Japanese postal services over a ten-year time frame. This initiative will be led by the Japanese Prime Minister’s office under the direction of Economic and Fiscal Policy Minister Heizo Takenaka, who successfully led efforts to cut nonperforming loans in major Japanese banking institutions. Takenaka's ability to overcome the intense opposition needed to require the banks to reduce their nonperforming loans by 50% makes him perhaps the most suitable person to take on this challenging task.

Under this plan, Japan Post's four areas of service - mail delivery, management of some 25,000 post offices, savings deposits and life insurance - will become separate businesses in April 2007, each operating within a single holding company. At that time, employees would lose their status as civil servants and branches would be tasked with seeking the best returns rather than supporting the subsidization of public works projects. Privatization will then occur in progressive stages over the following decade.

Privatization of Japan’s PSS can be expected to lead to the development of more sophisticated and efficient financial and capital markets in Japan. This is true because the large amount of funds that were previously directed into the public sector through FILP or JGB’s will then be channeled directly or indirectly into the private sector. That will make Japan’s national savings a precious resource, which can be used to revitalize existing firms and to help support emerging companies as well.


These changes are also likely to impact pricing in Japan’s large government bond (JGB) market. Investor sentiment over these instruments has led to the unusual situation where a Moody’s credit rating upgrade of Japan’s four major banks last month by as many as two notches to single-A-1, pierced Japan’s single-A-2 sovereign rating as a whole. A recent Dow Jones newswire article quoted Moody’s Senior Vice President Mutsuo Suzuki on this situation, who commented, (Japan’s) sovereign rating reflects “some risks associated with the maturity restructuring” of JGB’s in the years ahead. But “the…rating doesn’t necessarily mean that the Japanese Government doesn’t have the financial resources at hand to support these institutions if they need to”.

The realization that the fundamental credit strength of the Japanese government and profitability of major Japanese corporations will allow the nation to resolve any problems that arise is also reflected in another comment in this piece by Goldman Sachs Credit Analyst Takashi Miura, who notes “Market attention will now focus on…an upgrade for Japan sovereign debt”. Furthermore, Moody’s Japan office highlights improvements in the financial structure of private companies in the statement that “We are observing recovering fundamental creditworthiness of many Japanese corporations, which has led to and may continue to lead to upgrades”.

Contemplating the many difficulties at hand, however, has led some analysts to criticize the Koizumi plan for offering too many compromises. As a result, they doubt the government’s resolve. The American Chamber of Commerce in Japan, for example, recently issued a report that states the government’s effort risks enacting privatization in name only, while maintaining real or implied government subsidies and privileges for these new companies.

Others, however, suggest this misses the point. A recent Newsweek account for example, quotes Tokyo analyst Stephen Church who states “… So the outlook is that (the PSS) will actually disappear”. Once that's gone, (Church) says, the government is betting that the privatized bank will simply ‘melt in the sun like a snowman’ as consumers shift their deposits to a new retail private-banking sector that will begin to emerge in the spring of next year as the result of another set of Koizumi reforms.”

The bottom line, however, is the Prime Minister and his team, including Minister Takenaka, understand that Japan ultimately has no choice but to take on this critical challenge. This is based on the clear realization that there cannot be irreversible reform and change in Japan without the privatization of the PSS. As a result they must remain steadfast, determined and dedicated to expending the political will and effort needed to overcome any barriers that stand in the way. That is the reason they consider it to be the “Centerpiece of Reform by the Koizumi Administration” and perhaps the primary policy priority over the remainder of their administration.

While many remain skeptical, in the words of a recent Far Eastern Economic Review article covering the PSS privatization initiative: “In the past, it would have been reasonable to expect little from such a Japanese attempt at big change. But under Koizumi, (this) reform looks to have a chance.”

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The Impact of Postal Savings Privatization is Potentially Enormous

Placing limits on demand deposit guarantees, first within private banks and over time postal savings funds as well, should make Japanese investors far more receptive to a wider range of investment instruments than they have been in the past. These trends are already in motion, as noted by Michio Matsui, President & CEO of Matsui Securities Co. who recently commented that “Last year, equity trading value (in Japan) increased tremendously, reinforcing the presence of retail investors and their importance in the market. This trend was led no doubt by online investors, and last year their real presence was recognized for the first time (ratio of online trading to total retail trading in 1st half of 2003 was 71% in terms of trading value).” Furthermore, Japanese investors accounted for ¥143 trillion of trading in FY 2003, up from ¥103 trillion the prior year, driving the biggest gain in the Topix Index since 1973. In addition, the Tokyo Stock Exchange has reported that Nomura Holdings, Japan's largest securities and investment banking firm, Daiwa Securities Group and Nikko Cordial were among 83 Japanese brokerages that posted a profit for FY2003, against seven that had losses. A year earlier, only 14 Japanese securities firms were profitable.

Other notable online and discount brokers that cater to Japanese retail investors include Monex, Rakuten Securities, E*Trade and Kabu.com. Furthermore, a recent Nihon Keizai newspaper survey of 114 Japanese brokerages and related firms found that 20 plan to offer online trading services while 33 others are considering this option. This is in addition to the 31 that already have Internet trading platforms. The potential growth is enormous. Monex CEO Oki Matsumoto recently contemplated these developments in an interview on U.S. public television stating “In the States I think about 50% of the population own stocks and 36% trade stocks. In Japan only like 10% of people own stocks and just 3% trade stocks. It`s … a big space for us to grow into.”

If the Japanese public abandons the caution fostered by unlimited government guarantees and preferential tax treatment, and over time begins to invest their PSS savings in private banks and other investment vehicles -- the country's economy will never be the same. Huge amounts of pent-up household capital would be moved into private financial markets. This would help to bolster not only Japan's incipient economic recovery but, over time, financial markets around the world. Both Japanese and foreign firms are moving to structure themselves to meet this need. One example includes an alliance formed in 2000 between Monex and the U.S. Vanguard Group, to market Vanguard’s mutual funds and investment products to Japanese retail and institutional investors.

PSS privatization will push Japan to more efficiently allocate capital and account for risk. As postal service privileges are removed, the government will be forced to become more fiscally prudent. Since the postal service would no longer be required to purchase government securities, however, JGB’s would have to be sold to individual Japanese investors and foreigners. At present, foreigners only own approximately 3.7% of Japanese government debt. This low proportion has helped to shield Japan from international market pressures. Individual households own even less at 2.6% of the total.

If private investors and foreigners sharply increase their direct JGB holdings, they are less likely to be forgiving about chronic budget deficits. They will also need to perceive a risk-reward ratio that effectively balances the ability of JGB’s to provide stability, liquidity, diversification and Yen exposure with the interest rate that is provided. This transition will be difficult and the resulting upward pressure on interest rates does hold the potential to slow down economic recovery in Japan. Some analysts believe this could result in serious problems, yet others that it will be effectively managed. Bloomberg correspondent, William Pesek, Jr., for example, reported several months ago on a study by Christian Broda of the New York Federal Reserve Bank and David Weinstein of Columbia University. Pesek notes “Its basic argument - that concerns about a Japanese public debt crisis are way overdone - is filling in some of the blanks on how bond yields can stay so low” and “the conclusion of Broda and Weinstein is this: Don't panic. Japan's debt trends, they say, aren't unsustainable. They further argue that (Japanese) government officials have ample time and latitude to meet their obligations via higher taxes or reduced benefits and services.” Pesek concludes the piece with his own comment, that “Maybe investors accepting sub-2 percent yields on Japanese bonds aren't so crazy after all.”

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The Resulting Funds Flows Have the Potential to Raise Global Equity Investments

Irreversible reform of Japan’s PSS, the world's largest financial institution, will mark a major milestone toward completing the economic reforms and restructuring needed to restore Japan’s underlying economic competitiveness.

Despite increased activity by retail and other Japanese investors, the dramatic rise in Japanese equities that has occurred over the past year has to a large extent been driven by foreign inflows. To cite one indicator, inflows through November into Japan-related mutual funds are now three times greater than inflows for all of 2003.

While there are many reasons for optimism over Japan’s future prospects, the potential for a $3 trillion+ inflow into Japanese and other global securities over a decade of postal savings privatization cannot help but exert an additional positive influence. At the same time, it is true that greater private foreign and domestic participation in the JGB market will require a gradual transition away from the “zero interest rate policy” which has existed in Japan since 1999.

For this reason Japan’s Ministry of Finance is presently planning road shows for foreign investors in New York and London next month. These events will be designed to familiarize U.S. and Europe investors with the government’s plans to privatize the PSS, the investment potential of JGB’s, as well as other recent trends and developments that have made Japan one of the best performing and most attractive investment opportunities in the world over the past year.

Data, statistics and the reference materials presented within this newsletter have been compiled by JETRO from publicly-released media and research accounts. Although these statements are believed to be reliable, JETRO does not guarantee their accuracy, and any such information should be checked independently by the reader before they are used to make any business or investment decision.

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