FIMA Research Center, University of Hawai'i 1 Post-Big Bang Reforms: The Japanese Government Bond...

FIMA Research Center, University of Hawai'i

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Post-Big Bang Reforms: The Japanese Government Bond Market

S. Ghon RheeS. Ghon Rhee

K. J. Luke Distinguished Professor of K. J. Luke Distinguished Professor of

International Finance and BankingInternational Finance and Banking

University of Hawai’iUniversity of Hawai’i


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Motivation for UK Big Bang in 1986

1.1. London Trading Volume Prior to UK Big BangLondon Trading Volume Prior to UK Big Bang1/131/13thth of New York Volume of New York Volume1/51/5thth of Tokyo Volume of Tokyo Volume

2.2. Reform Measures in UKReform Measures in UKa.a. InternationalizationInternationalization

b.b. Deregulation of Fixed Commission RuleDeregulation of Fixed Commission Rulec.c. Allowance of Proprietary TransactionAllowance of Proprietary Transactiond.d. Opening of Ownership of Stock Exchange Opening of Ownership of Stock Exchange Members to Outsiders Members to Outsiders


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Motivation for Japan’s Big Bang Shrinking MarketShrinking Market

Once the largest in the world, Tokyo market capitalization is now Once the largest in the world, Tokyo market capitalization is now about one-fifth of New York’s about one-fifth of New York’s

$15.1 trillion vs. $3.2 trillion$15.1 trillion vs. $3.2 trillion Less Active MarketLess Active Market

Tokyo Trading Volume is less than one-tenth of New York VolumeTokyo Trading Volume is less than one-tenth of New York Volume $31.9 trillion vs. $2.7 trillion$31.9 trillion vs. $2.7 trillion

Depressed MarketDepressed Market::

Dec 29,’89Dec 29,’89 At PresentAt Present

DJIADJIA 2,753 2,753 10,50010,500

Nikkei 225Nikkei 225 38,91638,916 11,50011,500


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Big Bang Financial Reforms: Japan (I)

1.1. Deregulation of cross-border transactions Deregulation of cross-border transactions and and foreign exchange businessforeign exchange business2.2. Adoption of a competitive auction method to Adoption of a competitive auction method to issue issue financing billsfinancing bills3.3. Abolition of securities transaction tax Abolition of securities transaction tax 4.4. Deregulation of brokerage commissionDeregulation of brokerage commission5.5. Preparation of legal framework for loan/asset Preparation of legal framework for loan/asset securitizationsecuritization6.6. Allowance of off-exchange tradingAllowance of off-exchange trading


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Big Bang Financial Reforms: Japan (II)7.7. Allowance of banks and financial Allowance of banks and financial

institutions institutions to issue bondsto issue bonds

8.8. Entry by banks, securities companies, and Entry by banks, securities companies, and insurance companies into each insurance companies into each

other’s other’s businessbusiness

9.9. Introduction of individual stock optionsIntroduction of individual stock options

10.10. Replacement of merit-based licensing Replacement of merit-based licensing system system with a disclosure-based registration with a disclosure-based registration system system for securities companiesfor securities companies


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Three Major Weaknesses of JGB Market1.1. Fails to Tap the Pool of Global Fails to Tap the Pool of Global

CapitalCapital2.2. Violates the Rule of Separation Violates the Rule of Separation

between Government Liabilities between Government Liabilities and Assets Managementand Assets Management

3.3. Needs to Complete Infrastructures Needs to Complete Infrastructures of the Primary and Secondary of the Primary and Secondary

Markets Markets


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Investment by Foreign Investors in JGBs Foreigners’ Holding of Government DebtForeigners’ Holding of Government Debt

• Japan: Japan: 5% 5% • United States:United States: 37%37%• United Kingdom: United Kingdom: 14%14%

As of April 1999, the withholding tax on As of April 1999, the withholding tax on redemption gains and interest income redemption gains and interest income from JGBs were exempted for foreigners. from JGBs were exempted for foreigners.

However, tax exemption is not done at However, tax exemption is not done at the source and is applicable only to BOJ the source and is applicable only to BOJ book-entry system.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 Fiscal Investment and Loan Program (FILP) of MOFMOF

FILP Asset Size: FILP Asset Size: $3.38 trillion $3.38 trillion FILP Assets invested in JGBs:FILP Assets invested in JGBs: 17%17% MOF is the largest issuer and buyer of government MOF is the largest issuer and buyer of government

bonds bonds

Government Holding of Its Own securitiesGovernment Holding of Its Own securitiesJapan:Japan: 46% of JGBs Outstanding 46% of JGBs Outstanding US:US: 13%13%


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

MOF’s Dual Role: An explicit MOF’s Dual Role: An explicit violation of the separation ruleviolation of the separation rule

Negative consequences:Negative consequences: Primary Market: Lack of intense competition Primary Market: Lack of intense competition Secondary Market: Increased uncertainty in Secondary Market: Increased uncertainty in

JGB yieldsJGB yields


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

a.a. Introduction of Financial Futures and OptionsIntroduction of Financial Futures and Optionsb.b. Active Trading of Treasury Securities on a Active Trading of Treasury Securities on a

When-Issued BasisWhen-Issued Basisc.c. Expansion of REPO transactionsExpansion of REPO transactionsd.d. Introduction of the Separate Trading of Introduction of the Separate Trading of

Registered Interest and Principal of Registered Interest and Principal of Securities Securities (STRIPS)(STRIPS)


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Sequence of Government Bond Market Reforms: French Experience

a.a. Bond futures market (1986)Bond futures market (1986)b.b. Primary dealer system (1987)Primary dealer system (1987)c.c. Interdealer broker network (1987)Interdealer broker network (1987)d.d. Purely competitive auctions (1987)Purely competitive auctions (1987)e.e. REPOs (1991)REPOs (1991)f.f. STRIPS (1991)STRIPS (1991) Brossard, Philippe, 1998, The French Bond Market: Enhancing Liquidity, A paper Brossard, Philippe, 1998, The French Bond Market: Enhancing Liquidity, A paper

presented at a World Bank Workshop on the Development of Government presented at a World Bank Workshop on the Development of Government Bond Markets, June 11-12, Seoul, Korea.Bond Markets, June 11-12, Seoul, Korea.


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Suggested Post-Big Bang Reform Measures for Japan

Creation of the primary dealer systemCreation of the primary dealer system Adoption of the uniform-price auction methodAdoption of the uniform-price auction method Introduction of when-issued tradingIntroduction of when-issued trading Revamping the REPO marketRevamping the REPO market Introduction of STRIPsIntroduction of STRIPs


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Creation of the Primary Dealer System

Existence of primary dealers does not Existence of primary dealers does not necessarily guarantee intense competition on necessarily guarantee intense competition on the primary market but they are experts in the primary market but they are experts in pricing, market pricing, market making, and distributionmaking, and distribution

No primary dealer system: Japan and GermanyNo primary dealer system: Japan and Germany MOF’s dual role (buyer and seller) to be blamed MOF’s dual role (buyer and seller) to be blamed

for the lack of primary dealer system in Japanfor the lack of primary dealer system in Japan Syndicated underwriting: Past normSyndicated underwriting: Past norm Public auction systems are now used for: Public auction systems are now used for:

2-, 4-, 6-, and 20-year bonds2-, 4-, 6-, and 20-year bonds

Issuing Techniques ofGovernment Bonds

Fixed Price Public SubscriptionsFixed Price Public SubscriptionsUnderwriter consortium utilized Underwriter consortium utilized

Private PlacementsPrivate PlacementsIn the absence of well-functioning secondary marketsIn the absence of well-functioning secondary markets

Tap IssuesTap IssuesSold directly into the secondary market through Sold directly into the secondary market through

branch network of banks or securities companiesbranch network of banks or securities companies

AuctionsAuctionsMultiple price auction vs. Uniform Price AuctionMultiple price auction vs. Uniform Price Auction

Issuing Techniques ofamong OECD Members

Uniform Price AuctionUniform Price AuctionFinland, Italy, Netherlands, Norway, and Finland, Italy, Netherlands, Norway, and Switzerland, UKSwitzerland, UK

Multiple Price AuctionMultiple Price AuctionAustralia, Austria, Canada, Sweden, UKAustralia, Austria, Canada, Sweden, UK

Tap IssueTap IssueUS, UK, Germany, Canada, and most of US, UK, Germany, Canada, and most of

OECD OECD members, but not Japan members, but not Japan

Two Major Auction Methods

Multiple-price auction methodMultiple-price auction method

a.a. Successful bidders pay the prices they bid…. Successful bidders pay the prices they bid…. …..“…..“winner’s cursewinner’s curse” ”

b.b. Bidders tend to shade their bids below the Bidders tend to shade their bids below the maximum that they are actually willing to paymaximum that they are actually willing to pay

Uniform-price auction methodUniform-price auction methoda.a. All successful bidders pay the same price for a All successful bidders pay the same price for a

given securitygiven securityb.b. Hence, some successful bidders may pay a lower Hence, some successful bidders may pay a lower

price than they actually bid. price than they actually bid.


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Auction Methods: Government-Issued Securities

Japan United States United Kingdom

Uniform-Price Auction

None All Treasury Securities

Index-linked

Bonds

Multiple-Price Auction

All JGBs 20-Year Bond:

Competitive Auction Only

2-, 4- and 6-Year Bond: Both Competitive and Non-competitive Auction

5- and 10-Year Bond: Syndicated Underwriting

None All Securities other than Index-linked Bonds

Adoption of Uniform-Price Auction Method (II)

Empirical EvidenceEmpirical Evidence

a.a. The uniform-price auction method generates The uniform-price auction method generates higher revenue for the government higher revenue for the government

b.b. US Treasury has been utilizing the uniform-price US Treasury has been utilizing the uniform-price auction method for all Treasury securities since auction method for all Treasury securities since 19971997

c.c. Japan never adopted the uniform-price auction Japan never adopted the uniform-price auction methodmethod

Introduction of When-Issued Trading Most advanced markets allow trading during the period Most advanced markets allow trading during the period

between the time a new issue is announced and the time it between the time a new issue is announced and the time it is actually issued.is actually issued. Ranging from one week to two-weeks (US market) Ranging from one week to two-weeks (US market) As short as two days (France)As short as two days (France)

When-issued trading functions like trading in a forward When-issued trading functions like trading in a forward market.market.

Major BenefitsMajor Benefits Minimize price and quantity uncertainties. Minimize price and quantity uncertainties. Lower underwriting riskLower underwriting risk Increase revenue from the new issue Increase revenue from the new issue

By not allowing when-issued trading in Japan, the MOF By not allowing when-issued trading in Japan, the MOF foregoes these benefits.foregoes these benefits.


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Revamping of the REPO Market (I) Major Functions of REPO MarketMajor Functions of REPO Market

a.a. allows primary dealers to cover their short allows primary dealers to cover their short positionspositions

b.b. allows institutional investors to maximize allows institutional investors to maximize investment income by lending their securitiesinvestment income by lending their securities

c.c. allows foreign investors to reduce currency risk allows foreign investors to reduce currency risk through money market hedgingthrough money market hedging

d.d. facilitates clearing and settlement transactionsfacilitates clearing and settlement transactions


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Revamping of the REPO Market (II)

Traditional Gensaki MarketTraditional Gensaki Market European-style REPO (sell-and-buy-back)European-style REPO (sell-and-buy-back) Ownership to the security is transferred to the buyerOwnership to the security is transferred to the buyer No marking-to-marketNo marking-to-market Major instruments: Short-term Treasury and Financing Major instruments: Short-term Treasury and Financing

Bills Bills

American-Style REPO marketAmerican-Style REPO market Borrow and LendBorrow and Lend No transfer of security ownershipNo transfer of security ownership Marking-to-market Marking-to-market Major instruments: All Treasury and corporate Major instruments: All Treasury and corporate

securities securities


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Introduce STRIPS

By introducing STRIPS, the MOF can By introducing STRIPS, the MOF can provide the market with highly liquid zero-provide the market with highly liquid zero-coupon bonds and notes. coupon bonds and notes.

As a result, STRIPS will:As a result, STRIPS will:a.a. expand the investor baseexpand the investor baseb.b. improve tracking of effective yield improve tracking of effective yield

curvecurvec.c. allow institutional investors to allow institutional investors to reduce reduce reinvestment risk. reinvestment risk.

Thank You!

FIMA Research Center, University of Hawai'i 1 Post-Big Bang Reforms: The Japanese Government Bond...

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