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Bond Market Development in Japan

2008

Naoyuki Yoshino*

* Professor of Economics, Keio University, Chair person, JGB Investors Meeting, MOF, Member, Debt ManagementCouncil, MOF, [email protected]
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CONTENTS

I. Introduction

II. The History of Bond Market Development in Japan

III. Trends of Japanese Government Bonds Issues

IV. Debt Management Policies

V. The Major Mechanism for Japanese Government Bonds Issuance and Transactions

VI. Policy Recommendations to Asian Countries
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Bond Market Development in Japan

Naoyuki Yoshino*

I. INTRODUCTION

Each country shows different development stages in the bond market. Japanese experience

shows that the government bonds are sold mainly to the banking sector in the early stages of the

development of the bond market. However, in year 2006, all these syndicated sales were abolished.

Currently all the Government bonds are sold through market auctions. There are no forced sales to the

financial institutions. Some Asian countries are in the process of starting the government bond market,

as Japan started in 1965. Many lessons could be learned from the experiences of those overseas. In

Japan, the Government bonds whose maturity was 10 years were the major product issued by the MOF

in the 1970s and 1980s. In the beginning stage of the setting up of the Government bond market, 10 year

Government bonds were mainly sold to the financial institutions.

From 1990s, the MOF started to sell various kinds of government bonds to the market, namely,

short-term, medium-term and long-term. Short-term Government bonds are treasury bills which are

redeemed within one year and they are discounted bonds. Medium-term Government bonds such as 5

years are mainly sold to banks. Commercial banks in Japan prefer to hold 4-5 years Government bonds,

since the average maturity of deposits is less than 5 years.

It is important to focus on the kinds of customers that will purchase Mongolian and Sri Lankan

Government bonds. Who will be the major participants in the government bond market in each country?

Since bank deposits are the major financial means of saving in Mongolia, it is advisable to issueGovernment bonds to match the need of the commercial banking sector. Commercial banks are

borrowing and lending money through the short term money market on a daily basis. The Central Bank

of Mongolia participates into the short term money market either supplying base money or absorbing

base money from the market.

It is also advisable to start to purchase long-term Government bonds as an instrument of the

monetary policy. If the commercial banks prefer 5 years government bonds, it would be better to issue

such a maturity. In addition, it could be an instrument of the open market operations by the Central

Bank. Primary market is easier to set up compared with the secondary market. However, continuous

issue of the government bonds for the primary market is required. Continuous issue of governmentbonds will allow the market participants to be ready to participate in the primary market on a regular

basis.

At first, a certain maturity of Government bond could be issued, one that mainly focuses on the

banking industry. Such Government bonds preferred by the banks will be 3 years to 5 years. The term

of the Government bonds will be matched with the average maturity of the bank deposits in each

country. Before the secondary market is well developed, it will be possible for the government to

* Professor of Economics, Keio University, Chair person, JGB Investors Meeting, MOF, Member, Debt ManagementCouncil, MOF, [email protected]
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purchase its own security before maturity according to the needs of banks and pension funds. As private

insurance companies and other financial institutions grow, a greater variety of Government bonds can be

issued to match the needs of the market. The kinds of Government bonds to be issued should be based

on the needs of the market. Therefore, short term Government bonds will mainly be targeted to banks.

Long term Government bonds will mainly be targeted to pension funds initially. Gradually the kindsof Government bonds will be expanded to much more variety of maturities.

Dialogue with the market participants should be conducted frequently, such as banks, pension

funds, insurance companies etc. who are actively purchasing from the market. Financial Institutions

should communicate with the government. Informing them of the kinds of changes that should be made

to the government bond market, the kinds of terms requiring by Government bonds are in need, and

what kinds of Government bonds (such as new types of government bonds, inflation indexed bonds,

floating interest rate bonds etc.) are in most demand by the market.

The Government bonds can be sold not only to financial institutions but also to privateindividuals as the market develops. Postal savings in Japan played an important role during the

process of economic development. The Government can sell individually targeted Government bonds to

households. The terms of individually targeted Government bonds are 5 years (fixed interest rate) and

10 years (variable interest rate). These Government bonds are sold through private financial institutions

and post offices. There are many lessons to be learned from Japans experiences as is shown below.

II. THE HISTORY OF BOND MARKET DEVELOPMENT IN JAPAN

The development of the bond market in Japan can be seen with the growth of Japansgovernment bond (JGB) market. JGBs, which the Government issues for financing purposes play the

central role in Japan's financial and securities markets as a financial instrument traded on the market

with high levels of credit and liquidity Thus, JGBs yields are regarded as benchmarks of the bond

market in Japan.

The Japanese economy has developed continuously since the 1950s. There have been several

fluctuations with the Japanese economy, affected in particular by two major oil crises in 1974 and 1979.

Despite these crises, the Japanese economy did remarkably well until 1989 when the bubble burst.

Since the 1990s, the Japanese budget deficit has been increasing rapidly for a number of reasons: (i)

long-term recession and the decline of tax revenue; (ii) various tax rate reductions introduced in late1990s; (iii) failure of the Keynesian Policy which relies on public work to enhance economic recovery

immediately after the collapse of the bubbles in 1991; and (iv) an increase in welfare spending such as

medical spending due to the aging population. Thus, the budget deficit climbed to higher than 170% of

GDP from 70% in 1993, comparable to the level seen in other OECD nations.
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Figure 1. General government dependency for government bonds

Social welfare represents the biggest part of the general government budget, at about 25%. It

represented only 7.7% in 1950 and 13.7% in 1955. However, the aging population forced government to

spend much more money on medical care etc. Figure 2 compares the aging population (the share of

population who are more than 65 years old). Japan is the most rapidly aging society among the OECD

countries. There are three major taxes in Japan, namely, (i) income tax, (ii) corporate tax, and (iii)

consumption tax.

Figure 2. Population aging in Japan in comparison to other countries

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Total tax revenue peaked in 1991 when the bubble economy burst. Income tax started to

decline rapidly after 1991. The Corporate tax also started to decline due to recession. In 1988,

consumption tax increased from 3% to 5%, however the consumption tax revenue has not shown much

change since 1999 due to long- term economic recess. Increasing government expenditure together withgradual decline in tax revenue brought high dependency on Government Bonds as shown in Figure 3. In

2003 and 2004, the Government Bonds dependency ratio to total spending went up to 44%.

Figure 3. Government bond dependency ratio

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With the budget deficit increasing, issues of JGBs has increased, especially in recent years,

JGBs have been issued on a large scale, bringing the outstanding debt to enormous amounts. The

Major development process of the government bond markets in Japan since the 1960s can be

summarized as the following.

The Deficit financing bond was issued for the first time after World War II in 1965. In the

1960s, government bonds were sold to financial institutions (syndicated underwriting). Furthermore,

JGBs were purchased by the Bank of Japan one year after issue; the maturity of JGBs was 1 year in

1960s and 1970s in the sense that the JGB could be purchased after being held by the financial

institutions for one year if required, despite the face maturity being 10 years. In 1966, JGB

underwriting by the Trust Fund Bureau (MOF) had started. The main sources of the Trust Fund

Bureau fund came from postal savings, post life insurance and Government pension fund reserves. High

household savings were kept mainly in private financial institutions as deposits or government postal

savings. Postal savings in Japan offered a unique financial product which private banks were not

allowed to issue. Namely, 10 year deposits (Teigaku Deposits) whose interest rates were fixed for 10years and could be withdrawn any time after 6 months. Since Japanese postal savings were entrusted to

the Ministry of Finance for 7 years for fixed interest rates, postal savings could provide a fixed interest

product on a long-term basis. At this time Private banks offered only 1 year deposits. Postal savings

attracted numerous customers.

In 1974, the first oil crisis forced the Japanese government to issue more government bonds.

The Japanese economy suffered a lot by sudden rise of oil price by OPEC. Almost all oil in Japan is

imported from overseas. The price of oil increased to three times that in 1973. A high dependence on

oil from abroad made the Japanese economy quite vulnerable to oil shock. Many industries use oil as

their energy source and export oriented Japanese industries were faced with high production costscaused by the sudden increase in oil price. The Japanese real economic growth went negative (-0.5%)

for the first time since World War II due to a decline in exports, private investment and consumption.

High economic growth stopped. In order to mitigate the sudden oil shock and declining private demands,

the Japanese government introduced the Keynesian fiscal policy by stimulating the Japanese economy.

Public works were implemented. Negative real economic growth brought a decline in tax revenues so

that the Government had to rely on issuing Government bonds. The Governments dependency on

Government bonds increased as shown in Figure 1. All these Government bonds were sold to financial

institutions. Syndicated groups of financial institutions, which consist of private banks, insurance

companies and securities companies, purchased these Government bonds. However, huge issues of

JGBs made it difficult for financial institutions to keep holding all the JGBs. In 1977, trading of JGBs,which were held by financial institutions, initiated in the market. 1982 saw the launch of 15 year

floating rate JGBs which were offered privately. This was the first time that the JGB was issued not

just for 10 year maturity, but maturity.

In 1983, banks started to sell Government bonds through their branch offices to individual

investors. JGBs were kept at financial institutions, however huge issues of JGBs made it difficult to

keep them all at their branch accounts. The Ministry of Finance decided to sell the JGBs to individuals

through the branch offices of financial institutions. In 1984, banks were allowed to deal in

Government bonds, local Government bonds and Government guaranteed bonds despite the opposition

of securities firms in the past. Securities firms were only allowed to deal in Government bonds in the

past and they dominated in the bond market. Thus, they were reluctant for private banks to start
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dealing in Government bonds. In 1988, the handling of JGB for public offering by post offices started.

In 1989, partial competitive auction of 10-year Government bonds was introduced.

In 1990, Expansion of the ratio of competitive auction on 10-year Government bonds from 40%

to 60% was implemented. In 1991, the same-day publication of auction results of 10-year Government

bonds started. 1994 saw the launch of public offering auctions of 6-year JGBs. In 1996, quarterlyauction of 20-year JGBs started. 1999 saw the launch of public offering auction of 1-year Treasury bills

(TBs) and launch of public offering auctions of 30-year JGBs. In 2000, public offering auction of

15-year floating-rate JGBs were launched. In 2005, increase in the competitive auction of 10-year

JGBs (from 85% to 90%). In 2006, the syndicated underwriting was completely abolished and all the

JGB issues were traded on the financial market.

In contrast to the continuous growth of the Government bond market, the corporate bond

market has not been developed. In 1905, issues of non-collateral corporate bonds law were implemented

and new issues of corporate bonds were increased. However, huge issues of corporate bonds created

defaults of bonds. In 1935, quality enhancing of the bond market started. Regulation of the new issuesof corporate bonds, such as proper conditions and collateral based conditions continued until the 1990s.

Thus, the corporate bond market was not developed in Japan. Furthermore, Japanese Government banks

provided long-term loans to corporations in the past which contributed less dependency on corporate

bonds by firms. Table 1 denotes the amount of trade in the bond market in Japan. The majority of the

bond market is the Government bond and the share of the corporate bond is relatively small.

Table 1. Amount of trade in the bond market,

(trillion yen)

Year JapaneseGovernment

Bond

LocalGovernment

Bond

GovernmentGuaranteed

Bond

CorporateBond

Total

1989 3,411 8 18 7 3,672

(%) (92.9) (2.1) (0.5) (1.9) (100.0)

2001 3,972 44 33 44 4,154

(%) (95.7) (1.1) (0.8) (1.1) (100.0)

2004 6,317 82 74 90 6,637

(%) (95.2) (1.2) (1.1) (1.4) (100.0)

2006 9,566 43 53 59 9,809

(%) (97.5) (0.4) (0.5) (0.6) (100.0)

III. TRENDS OF JAPANESE GOVERNMENT BONDS ISSUES

A. Huge increase of Japanese Government bonds in recent years

The JGB issue numbers have been on the increase in recent years. While the JGB issue amount

often refers to that of new financial resource bonds (construction bonds + special deficit financing

bonds), securities issued by the central Government also include refunding bonds and fiscal loan bonds.
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As we reviewed in the previous section, the total issue amount of these Government bonds was

increasing at a dramatic pace particularly in the recent years. Although the issue amount of new

financial resource bonds had been hovering between 30 and 40 trillion since FY1998, it reduced to

under 30 trillion in FY2006. However the total issue amount of JGBs, including refunding bonds,

increased from 70 trillion to over 80 trillion from FY1998 to FY2000. Furthermore, launch of fiscal

loan bonds in FY2001 pushed it to over 130 trillion, and since then it has been continuously increasing.In FY2006, however, the total amount was at the same level as in FY 2005, approximately 165 trillion.

B. Variety of Japanese Government bonds to satisfy demand from the market

(1) Types of JGBs classified by method of issuance

As Table 2 shows, there are many types of JGBs and methods of issuance in Japan. What

follows is an overview of types of JGBs and their issuance methods. JGBs are the securities issued bythe central Government. The central Government pays the bondholders, interests on the securities and

repays the principal amount (i.e., redemption). Interest is payable on a semiannual basis and the

principal amount is redeemed at maturity. There are six categories of JGBs currently issued: (i) Short

term (6-month and 1-year Treasury Bills); (ii) medium term (2-year and 5-year Bonds); (iii) long term

(10-year Bonds); (iv) super long term (15-year floating rate, 20-year, 30-year Bonds and 40-year bonds);

(v) JGBs for individual investors (5-year and 10-year); and (vi) inflation-indexed bonds (10-year). As

Table 3 shows, the long-term JGBs (10 years or more), the benchmark of the market, account for more

than 50% of all JGBs outstanding.

Table 2. Various types of JGBs
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Table 3. Various kinds of JGB and their outstanding amount

a) Discount bonds

The short-term JGBs are all discount bonds, meaning that they are issued at the price lower than theface value. No interest payments are made, but at maturity the principal amounts are redeemed at face

value. For example, if the maturity of the bond is 100 yen and it were sold at 95 yen, the interest

payment at the maturity becomes 5 yen which is equivalent of the interest rate of 5.2% (=5/95).

b) Fixed-rate coupon bonds

All medium- (2-year and 5-year bonds), long-(10-year bonds), super-long-term bonds (20-year, and

30-year bonds (except for the 15-year floating-rate bonds)) and JGBs for individual investors (5-year)

are the bonds with fixed-rate coupons. Figure 4 shows the fluctuations of 10-year JGB yield in the

market. The interest rate on 10-year JGBs is determined by the market when it is issued. With fixed-ratecoupon-bearing bonds, the interest calculated by the coupon rate determined at the time of issuance is

paid on a semiannual basis until the security matures and the principal is redeemed at face value.

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Figure 4. JGB yield curves

c) Floating rate bonds

The 15-year floating-rate bonds and the JGBs for individual investors (10-year) feature their couponrate that varies according to certain rules. The inflation-indexed bonds is a security of which the

principal amount is linked to the consumer price index (CPI). Thus, although their coupon-rate is fixed,

the interest payment also fluctuates.

d) Abolished bonds

In the past, there used to be some other types of JGBs. However, after the August 1988 issue of

3-year fixed rate bonds, the September 2000 issue of 5-year discount bonds, the February 2001 issue of

4-year fixed-rate bonds, the March 2001 issue of 6-year fixed-rate bonds, and the November 2002 issue

of 3-year discount bonds, these bonds have been stopped being issued due to lack of demand from the

market.

e) JGB for individual investors

. Individual investors, compared with financial institutions, now account for a much smaller share in

JGB holdings. However, they tend to be relatively stable and long-term bondholders. Thus, it should

make the market stable and enable us to finance more smoothly to diversify the bondholder composition

further, with particular emphasis on individuals. For these reasons, the Ministry launched in March 2003

the bonds specifically designed for individual investors. Furthermore, in January 2006, we started to

issue a new model of JGBs for individual investors, 5-year fixed-rate bonds. Following is the overview

of two types. JGBs for individual investors are issued on a quarterly basis most likely on the 15th day

of April, July, October and January and the flotation term starts during the first half of March,

June, September and December. It is available at financial institutions, such as security companies,

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banks and post offices. Along with other conventional JGBs, it is issued and fully managed paperless

in exclusive accounts for JGBs at financial institutions or post offices.

Table 4. JGB for individual investors

f) Inflation-indexed bonds

Inflation-indexed bonds, introduced in March 2004, are the securities in which principal amounts

vary as they are linked to the consumer price index -i.e., CPI excluding fresh food. While this new

instrument meets the needs of investors who want to avert inflationary risks, it can also serve as a means

of observing the expected inflation rate on the market. In the case of conventional fixed-rate

coupon-bearing JGBs, the principal at the time of issuance remains unchanged until redemption, and the

interest amount remains the same for biannual interest payment. In contrast, in the case ofinflation-indexed bonds, the principal amount varies as it is linked to the CPI. So if the CPI increases

after issue, the principal amount also increases according to the rate of inflation, and vice versa, and at

maturity these bonds are redeemed at the adjusted principal amount (hereinafter called

"inflation-adjusted principal amount"). Interest amount is calculated by multiplying the

inflation-adjusted principal amount at the time of interest payment by the pre-fixed coupon rate, so it

also changes according to the rate of inflation. The inflation-adjusted principal amount is calculated by

multiplying face value by indexation coefficient. Indexation coefficient, which indicates the level of

fluctuation from the time of issuance, is calculated by dividing the Ref index for the day by the Ref

index at the time of issuance (specifically, the 10th day of the issue month).

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2. Demand side of Japanese Government Bond

As is shown in Figure 5 and Table 4, JGBs are mainly held by banks, other financial institutions

and insurance companies due to high savings ratios in the past. Holdings by foreigners are quite small

compared with other major countries. In June 2007, the ratio of holdings by foreigners was only 5.8%.

Households purchases have increased recently (5.1%) due to low interest rate on bank deposits (by zerointerest rate policy conducted by BOJ). 18.8% of JGBs are held by financial institutions, 21.7% by

postal savings, 9.2% by postal life insurance, 9.3% by private life insurance, 10.3% is held by public

pension funds and 4.1% is held by private pension funds.

Figure 5. Breakdown by JGB holders

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Table 5. Holdings of JGBs by various investors

IV. DEBT MANAGEMENT POLICIES

As reviewed in section II, in recent years, JGBs have been issued on a large scale, bringing theoutstanding debt to enormous amounts. As a result, debt management policies have becomeincreasingly significant in order to secure smooth and stable financing and to minimize medium andlong-term financing costs against such a backdrop. This section outlines the debt management policiesand gives an overview of each policy. The debt management policies are the collective term thatincludes various policies in areas that range from Government bond issuance to distribution andredemption. Given the severe fiscal situation, large-scale JGB issuance will continue. It is thus essentialthat the Ministry of Finance (MOF), as the debt-issuing authority, implements its debt managementpolicies in accordance with the aim of securing stable and low-cost financing which are the foundations

for smooth fiscal management.

When implementing debt management policies in the future, it is important to address the followingpoints: (i) securing stable financing in the age of large-scale JGB issuance; (ii) maintaining andincreasing the JGB market liquidity; and (iii) appropriately managing a large amount of outstandingJGBs. Debt management policies have two major objectives: (i) to secure smooth and stable financing;and (ii) to minimize medium and long-term financing costs. Every year in late December, the issuingauthorities announce an issuance plan for the coming fiscal year, covering the issue amount by types ofmaturity, the total issue amount, etc. In designing these issuance plans, the authorities listen to opinionsfrom market participants and attempt on this basis to maintain an appropriate balance among differentmaturity zones short-, medium-, long-, and super-long-term while taking into account correlationsbetween financing costs and risks associated with interest rates and refunding, in addition to the future

redemption profile. As the fiscal year proceeds, we listen to investors to enable us to respond to marketneeds and trends, for example, by increasing the issue amount of maturity zones according to investor'sdemand. In addition, the authorities attempt to ensure the predictability of the market in our day-to-day

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management of the JGBs.

It is important for the debt-issuing authority to make the market more competitive and efficient. InOctober 2004, the MOF introduced the JGB Market Special Participants Scheme, a new framework to

ensure stable JGB issues based more on market principles. With massive issuance Government bonds(JGB) expected to continue in future yearsJGB issuance plans must be formulated with the utmostcare to ensure a reliable and smooth issuance process. To achieve thisthe MOF (Ministry of Finance)holds a close dialogue with the market through various meetingsincluding (i) the meeting of JGBmarket special participantsin order to grasp market needs in a carefulrigorous manner. On the otherhandthe authorities should not focus solely on current market needs; the authorities should alsoproperly formulate and implement systems and mechanisms that are necessary in building amedium-to-long term JGB management policy. There are several important steps to be taken by theGovernment so as to inform the market participants of their planned demand.

Figure 6. Trend of JGB Issuance

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Figure 7. Change in JGB issue amount

A. Types of JGBs classified by funding purposes

The JGB issuance plan of each year is announced based on the different kinds of Government bonds

classified by funding purposes, namely: (i) new financial resource bonds (construction bonds); (ii) new

financial resource bonds (deficit financing bonds), (iii) refunding bonds; and (iv) FILP bonds. These

bonds are not different from each other when it comes to holdings and transactions as financial products.

(1) Construction bonds (new financial resource bonds)

Article 4(1) of the Public Finance Law prescribes that annual government expenditure has to be

covered in principle by annual government revenue generated from other than Government bonds orborrowings. But as an exception, a proviso of the Article allows the Government to raise money through

bond issuance or borrowings for the purpose of public works, capital subscription or lending. Bonds

governed by this proviso of Article 4(1) are called construction bonds. The Article prescribes that the

government can issue construction bonds within the amount approved by the Diet, and the ceiling

amount is provided under the general provisions of the general account budget. When intending to get

approval for this ceiling amount, the Government is obliged to submit to the Diet a redemption plan that

shows the redemption amount, the redemption method and the redemption dates for each fiscal year.

(2) Special deficit-financing bonds (special law enacted for each fiscal year)

When estimating a shortage of government revenue despite the issuance of construction bonds, the

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Government can issue Government bonds based on aspecial law to raise money for the purpose of other

than public works and the like. Given their nature, these bonds are called "special deficit-financing

bonds". As is the case with construction bonds, the Government can issue special deficit-financing

bonds within the amount approved by the Diet and the ceiling amount is provided under the general

provisions of general account budget. The Government is also required to submit a redemption plan to

the Diet for reference. Special deficit-financing bond issuance must be made in exceptional cases.Therefore, the Government has to minimize the issue amount as much as possible within the amount

approved by the Diet, while taking into account the state of tax and other revenues. In this context, it is

allowed to issue special deficit-financing bonds even during the accounting adjustment term.

Specifically, the Government is allowed to issue special deficit-financing bonds until the end of June in

the next fiscal year, in order to adjust issue amount of special deficit-financing bonds until the end of

May in the next fiscal year; the deadline for collecting the tax revenue for the fiscal year.

(3) Refunding bonds (Article 5(1) and 5-2 of the special account law of the Government Debt

Consolidation Fund)

Pursuant to Articles 5(1) and 5-2 of the Special Account Law of Government Debt Consolidation

Fund, the Government is allowed to issue refunding bonds to secure funds for consolidation or

redemption of Government bonds. In the issuance of refunding bonds, the Government is not required to

seek Diet approval for the maximum issuance amount.

(4) Fiscal Investment and Loan Program (FILP) bonds

The FILP was originally receiving money from postal savings, post life insurance and pension fund

reserves. They are loaned to government banks and government corporations so as to implement policiessuch as low interest rate loans by government banks. This system changed its structure in 2001. The

FILP stopped receiving money from postal savings, post life insurance and pension reserves, instead the

FILP started to introducethe FILP bonds to the market. Postal savings, post life insurance and pension

reserves started their own portfolio investments rather than depositing their money in the FILP system.

B. JGB issuance plan: annual basis

The issuance breakdown of FY2007 for example shows that a record 4.5 trillion yen cut inconstruction bonds (new financing resource bonds) and deficit financing bonds (new financing resourcebonds) serve as a revenue source for the FY2007 budget. Issuance of refunding bondsthe amounts for

which are determined by outstanding bonds that are due to matureis reduced by 8.5trillion yen. This reduction is largely attributable to JGB management measures taken inFY2006including the buy-back of existing bonds financed by a 12 trillion yen transfer from the FiscalLoan Fund Special Account. The FILP bond issuance which is determined by not only the scale ofnew lending under the Fiscal Loan Program but also the financial position of the overall Fiscal LoanFundis curtailed by 8.6 trillion yen. This cut was due to the slimmed-down scale of new lending forFY2007as well as reduced refunding needs resulting from a substantially reduced outstanding loanbalance which was made possible by the reforms to the FILP carried out thus far.

C. JGB market issuance calendar baseRecently the authorities have substantially reduced JGB issuance but this reduction does not
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directly result in a similar reduction in actual issuance to the market. The methods of JGB issuance inFY 2007 are divided largely into (i) issuance to the market, (ii) issuance toindividual investors, and (iii) issuance to the public sector. The reduction is attributablefirstlya decrease in FILP bonds leads to a reduction in the underwriting commitments ofPostal SavingsPension Reserves and Postal Life Insurance. Secondlythe amount switched to the BOJBank of Japandropped sharply because of a decrease in JGBs which are held by the Bank and

mature in FY 2007due in part to the buy-back program carried out in FY2006. JGBs issued toindividual investors increased slightly.

D. Budget projections in each year

The Budget Projections in each year Budget Policy is an estimate of the impact likely to becaused by the FY2007 budget on revenue and expenditure in the years up to FY2010. The estimateuses economic indicatorswhich are tentatively determined based on the statements in The directionand strategy of the Japanese economy a cabinet decision taken in January 2007as assumptions forFY2008 onwards and then estimates the cost burden likely to be imposed in future years by thesystems and policies contemplated in the FY2007 budget. It should be noted that this projection is notbinding on the Governments future budget formulationand the figures presented here may varyaccording to changes in assumptions. In additionon the basis of the above projectionsthe financialstate of the Government Debt Cash Flow for the years until FY2020 is explained in the publisheddocument Cash Flow Projection of GDCF. This document shows the results of calculationsof outstanding amount of general bondsetc. based on certain assumptions.

E. Change in outstanding balance of general bonds if the JGB issuance plan ismechanically extended over future years

The balance was calculated by first mechanically extending maturity-specific JGB issues in theJGB issuance plan for example from FY2008 to FY2011and then calculating redemption andissuance for each fiscal year. The outstanding amount of general bonds when the JGB issuanceplan for FY2007 is mechanically extended.

F. Cost-at-risk analysis

Government debt management deals with future interest rate risks. It is important to understand andmanage these risks in order to minimize the funding costs in the medium to long term. The Ministry ofFinance sees to it that JGB redemptions at maturity and issuance of refunding bonds are not tiltedtoward any particular year and that bond issuance programs are drawn up in such a manner thatthe composition of redemption periods is well balanced between shortmediumlong andsuper-long terms. Furthermorethe Financial Bureau quantitatively analyzes and ascertains interest

rate risk using cost-at-risk CaRanalysis for risk management purposes.

Using future planned bond issuanceissuance amount and maturity structureas givenCaR analysis calculates the median interest payment cost and range of its distribution by model basedsimulations of future interest fluctuation. In CaR analysiswe can analyze various issuancepatterns shortening or lengthening the maturity structureand compare the relationship betweenmedium to long-term costs and risks. This would be valuable in designing planned bond issuance.Assuming a normal yield-curve heading upward interest rate increases with maturityshortening theaverage maturity of issued JGBs reduces interest payment costs. Howeverthe probability of beingexposed to interest rate risks rises as the frequency of refunding increases. In this way thetrade-off between cost and risk can be quantified by using CaR analysis. When shortening orlengthening the maturity structure in a particular fiscal year the trade-off between the interest paymentcost costand the relative CaR riskis shown in general as follows. Howeverit is necessary tokeep in mind that results will vary depending on the assumptions and the model used to generatefuture interest rates. Furthermorenot only future interest rates but also the Governments fiscal
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position will influence debt service costs. Thereforethis quantitative analysis does not directly andideally show the burden of future interest payment and desirable JGB issuance. It should be usedas a reference for designing planned bond issuance and managing outstanding JGBs

V. THE MAJOR MECHANISM FOR JGBS ISSUANCE AND TRANSACTIONS

A. Two methods of issuing JGBs

When issuing JGBs, there are basically two methods offering for the market and offering for the

public sector. The parenthesized figure after each heading shows the planned issue amount for FY2006

in that category of issuance method. JGBs are principally issued in public offering on market-based

issue terms.

(1) Price/yield-competitive auction

Price/yield-competitive auction is a method in which each auction participant submits a bidding

price (or yield) and bidding amount in response to the issue terms (e.g., issue amount, maturity, coupon

rate) presented by the MOF, and the issue price and amount will then be determined based on the bids.

In this type of auction, the issuing authority starts selling first to the highest price bidder in descending

order (or to the lowest yield bidder in ascending order) until the cumulative total reaches the planned

issue amount. In Japan, the auction method varies by type of security. One is the conventional method

by which each winning bidder purchases the security at his bidding price; and the other is the

Dutch-style method by which all winning bidders pay the same lowest price of their biddings regardless

of their original bid. In order to increase government bond liquidity, the Ministry also started

implementing the immediate reopening rule effective from March 2001 issues. When a new issue isoffered by the MOF, both its coupon rate and principal/interest payment dates may occasionally

correspond to those of a specific issue outstanding. In such a case, the Ministry of Finance reopens the

outstanding issue additionally. And then, as soon as it comes into the market, the reopened issue is

immediately dealt as the outstanding issue based on the immediate reopening rule. Also, under the new

rule, a reopened issue will generate accrued. Furthermore, in April 2006, auctions for enhanced-liquidity,

in which the outstanding issues with scarce liquidity are additionally reopened, were introduced to

maintain and enhance the liquidity of the secondary market. Based on the need from market participants,

the Ministry had discussed and brought up at the meeting of the JGB Market Special Participant and

finally decided to introduce the above auctions after FY2006.

(2) Non-competitive auction

Besides competitive auction, 2-year, 5-year and 10-year bonds are also issued through

non-competitive auction. This approach is to take into account small and medium market participants

who tend to submit a smaller bid than their larger counterparts. Biddings for non-competitive auction are

offered at the same time as for the price-competitive auction, and the price offered equals the weighted

average accepted price of the price-competitive auction. One can bid for either the price-competitive

auction or for the non-price competitive auction. The maximum issue amount is 10% of the planned

issue amount. Each participant, excluding the Shinkin (Credit Cooperatives) Central Bank, the Shinkumi(Credit Association) Federation Bank, the Rokinren Bank (Labor Bank) and the Norinchukin Bank
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(Central Bank for Agricultural Banks), is permitted to bid up to 1 billion.

(3) Non-price competitive auction

Non-price competitive auction is an auction in which biddings are offered at the same time as for

the price-competitive auction. The maximum issuance amount is set at 10% of the total planned issueamount and the price offered is equal to the weighted average accepted price of the price-competitive

auction. Only the JGB market special participants are eligible to bid in this auction. Each participant is

allowed to bid up to the amount set based on the result of its successful bids during the preceding two

quarters. A non-price competitive auction is an auction carried out after the competitive auction is

finished. The price offered is equal to the weighted average accepted price in the price-competitive

auction or lowest accepted price in Dutch-style yield-competitive auction. Only the JGB market special

participants are eligible to bid in this auction. Each participant is allowed to bid up to the 10% of its

total successful biddings in the competitive auction and non-price competitive auction.

B. The secondary bond market

The secondary bond market can be divided by transactions that take place on exchange and

transactions that are made over the counter (OTC), for example, at security companies. OTC is a

predominant transaction method for bonds, because bonds have so many issues that their transactions

and procedures tend to be cumbersome and bond transactions per se are complex. Currently, 2-year,

5-year, 10-year, 20-year, and 30-year fixed-rate JGBs are listed on the Stock Exchange in Tokyo, Osaka,

and Nagoya, and their daily transaction volume is published. In the OTC market, in principle, a price is

concluded through a negotiation between the parties concerned. However, in order to ensure fair and

smooth OTC bond transactions, the Fair Business Practice Regulations by the Japan Securities Dealers

Association require each securities company to maintain the fairness of the transaction by acting at aproper price according to a set of internal rules. Furthermore, to improve the price discovery function of

the OTC market, the Association publishes reference prices for OTC bond transactions on every

business day, based on the reports from its member security companies and other financial institutions.

(1) Case of Tokyo Stock Exchange

Since 1997 the period between a given transaction of JGBs and its settlement has been "T+3",

meaning the settlement is made on the third business day from the day on which the transaction is made.

Efforts are being made by market participants to shorten the settlement period. In January 2003, a new

transfer settlement system was launched, and the Japan Government Bond Clearing Corporation, whichwas established in October 2003, commenced operation on May 2nd, 2005. For delivery of JGBs and

settlement of the funds, the Bank of Japan Financial Network System (here-in-after the BOJ-NET6) is

used. Under the BOJ-NET, the Delivery versus Payment (DVP) settlement has been introduced to

minimize settlement risks. Further, in January 2001, the Bank of Japan made a changeover from the

designated-time settlement system to the new real-time gross settlement system. The RTGS system is

the only mode for its settlement system, in order to reduce the systemic risk inherent in designated-time

net settlement.

The when-issued (WI) transaction is a transaction made during a period between an auction

announcement (in principle, a week before the auction) and the day of issuance. Besides a transaction

during a period between an auction and the day of issuance, one prior to the auction is made since
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February 2004. This will make it easier for market participants to keep up with the market trends, while

adding to smoother pricing for new JGB issues and hence smoother financing. The 2001 launch of the

RTGS system prompted the introduction of a number of trade practices that were already in place in

major securities markets abroad. Ranging from cutoff time and reversal time11 to fail rule and bilateral

netting, these trade practices contributed to transaction/settlement efficiency or facilitation. With the fail

rule, a failure to deliver securities on the scheduled settlement date is referred to as a "fail," and not as adefault, and therefore, in principle, the exercise of right of cancellation or receive/payment of

delinquency charges is avoided. To avert a prolonged fail, however, the Japan Securities Dealers

Association sets forth three means from which to choose: a) delivery and receipt of securities equivalent

to the original securities as a substitute; b) execution of reversing trade; and c) execution of a buy.

Government bond futures represent a contract to trade a bond-either buying or selling-at a set point

in the future for an agreed price. The contract is standardized, as Government bond futures are traded

exclusively on exchange on the assumption that an unspecified number of investors take part. In

Government bond futures, JGBs actually issued are not traded. Trading is made, instead, on fictitious

JGBs on which interest rates and maturities are "standardized" by the Stock Exchange. All futurescontracts may be settled either by offsetting or by delivery. For example, during a certain period

trading participants can always make an offsetting order for net settlement. Or, you can opt for

delivering JGBs on the delivery date of the contract month. Given the fictitious nature, however, JGBs

in deliverable grade will be delivered.

C. Government bond futures

Bond lending transactions or the so-called repo transactions are the transactions in which

Government bonds are borrowed with cash as collateral, and after a certain period of time, the lender

receives the delivery of the equivalent amount of equivalent securities and repays the cash collateral tothe borrower. For several years after the 1989 launch of bond lending, however, a major part of bond

lending in Japan used to be unsecured lending, as there were restrictions on interest on collateral. Once

these restrictions were removed in 1995, due to concerns over credit risk and also to prepare for the

launch of a rolling settlement method, secured lending with cash collateral took over as the mainstream

of bond lending.

On the other hand, bond gensaki transactions (i.e., bond transactions with repurchase or resale

agreements), that emerged as the bond issuing market reopened after World War II, used to be the

principal means of fund raising. However, as gensaki transactions were made subject to Securities

Transaction Tax since 1953, and also as a number of new short-term financial products entered the stageone after another in the late 1970s and 80s e.g., certificates of deposit, commercial paper, and

large-sum time deposits the focus of fund raising shifted to other means, such as repo transactions.

The arena for bond gensaki transactions was thus scaled back primarily to TBs and FBs that are

exempted from Securities Transaction Tax.

Although Securities Transaction Tax was abolished in 1999 to help revitalize the security market,

bond gensaki transactions remained flagging because unlike repo transactions, gensaki transactions were

ill equipped with risk management methods. However, the same year, the Subcouncil on the

Internationalization of Yen at the Council on Foreign Exchange and Other Transactions recommended

that Japan's repo market, based on a unique system for cash-collateralized lending and borrowing,

should be replaced by a globally standardized type of transaction. In response to this recommendation, a
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new type of bond gensaki transactions, with a built-in mechanism for risk management, was launched in

April 2001. In the future, bond gensaki transactions are expected to play a pivotal role in the short-term

money market, and to enjoy greater presence not only in cross-border transactions with nonresidents but

also in domestic transactions.

D. STRIPS

In Japan, Government bonds of which principal and interest components can be separated are called

the "strippable book-entry securities." All coupon-bearing bonds issued in January 2003 and thereafter

except for 15-year floating-rate bonds, JGBs for Individual Investors, and inflation-indexed bonds are

"strippable book entry securities." Only corporations (including trustees of certain trusts) can hold

stripped book-entry securities. Only the JGB Market Special Participants can apply for stripping and

reconstruction of STRIPS.

E. Interest rate swap transactions

An interest rate swap transaction is a transaction in which different types of interest payments(for examplefloating-rate and fixed-rate)are exchanged for a specific period of time. Interest rate swaptransactions for the purpose of debt management operations became possible under the Law for theSpecial Account of the Government Debt Consolidation Fundas amended in 2002. 1n the newpromotion of debt management policythe Government will seek to align the number of yearsremaining until maturity from the perspective of managing interest rate risk by utilizingswap transactions (starting in 2005).

In consideration of the abovethe MOF has worked to upgrade the relevantsystemsand entered into a basic agreement with 23 transaction counterpartiesmost of which are JGBMarket Special Participantspursuant to the guidelines issued by the International Swaps

and Derivatives AssociationInc. (ISDA). Since January 2006we have carried out swaptransactions when market trends have been found to be stable. To carry out a transactionwe make an offer to several transaction counterparties according to a rotation scheduleand enterinto a contract with the counterparty that presents the most favorable terms. Transaction resultsare published on a semi-annual basis on the MOF website (in April and October).

F. Buy-back program

The buy-back program is a scheme for the Government to retire debt by buying back outstandingimmature bonds. The buy-back program is similar to advance redemption in that both are meant toretire debt before maturity. Butthere is a difference. With advance redemptionthe debt is repaid in

principle at face value in complete disregard of the will of bondholders. With the buy-back programthedebt is bought back only from the bondholders willing to take part in the deal.

In the pastthe buy-back program used to be implemented on very limited occasions such as whenan heir pays government bonds as the tax in kind pursuant to the inheritance Tax Law or when thedeposit a candidate set aside pursuant to the Public Office Election Law has to be confiscated uponlosing an election. To level out JGB redemptions with maturities heavily concentrated on FY2008we improved the existing system in June 2002 by revising the Law on Buy-backs and Retirement ofGovernment Bondsand by taking other actions. In February 2003we began to buy back bondsmaturing in FY2008. At this point in timewe are buying back bonds covering a wide range of years tomaturity in order to maintain or enhance liquidity in the JGB market. We are buying back bonds held byprivate financial institutions through auctions. We also bought back and retired bonds held by the Bank

of Japan and the Fiscal Loan Special Account.
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G. Government bond administration (the Law concerning Government Bonds)

The Law concerning Government Bonds stipulates basic matters that range from Government bond

issuance to administrative procedures regarding the outstanding issues. Provisions in the law can be

classified into the following five categories:

(i) The MOF decides the terms of issuance and other Government bond issuance-related matters;

and matters necessary for principal and interest payments and certificates and their registration.

(ii) The BOJ is entrusted with JGB-related administrative tasks.

(iii) Registration of government bonds

(iv) Relief measures for damaged or lost bearer Government bonds

(v) Extinctive prescription of Government bonds

Where there is no stipulation in this law, the civil law, the commercial law, or general principles, such as

trade practices, will apply. Specific procedures regarding issuance and redemption of Government bondsare prescribed in the Regulations on Government Bonds, the Ordinance on Government Bond Issuance,

the Bank of Japan Regulations on the Administrative Treatment of Government Bonds, and the

Ordinance on Special Treatment Procedures at the Bank of Japan for Principal and Interest Payments on

Government Bonds.

H. Recent measures taken to improve the market

1. Improvement of JGB market liquidity and efficient debt management

We have attempted to expand the composition of the bondholder base by diversifying JGBinstruments, to help us ensure stable issuance. It is particularly important for us to encourage individual

investors and foreign investors to purchase JGBs, given that the ratio of bondholding among these

groups is currently lower in Japan compared to other countries. We will periodically have a meeting

with the JGB Market Special Participants and a meeting with Japanese Government Bond Investors to

allow dialogue between market participants. We shall also continue to publish the Debt Management

Report to provide a comprehensive overview of the status of the public debt and our debt management

policies, thus enabling greater policy transparency. The JGB underwriting syndicate group, made up of

main financial institutions (numbering 1,201 as of March 2006), was formed to underwrite the total

value of 10-year bonds. Since the Ministry resumed JGB issues in January 1966, the syndicate has

played a major role in ensuring stable JGB issues. As the JGB market has developed, however, somemarket participants have more recently pointed out that the system hampers market efficiency.

Based in part on this consideration, from April 1988, the Ministry began revising the system and