Sometimes a financial market may present not just a win-win opportunity for participants, but can even be a case of win-win-win. While that might seem a wildly optimistic view to take of the public debt market in one of the Organisation for Economic Co-operation and Development’s (OECD) most heavily indebted members, deregulation of municipal borrowing in Japan could be good for almost everyone, including the central government, the regions themselves and, last but not least, an important group of foreign investors.
The process is not entirely new. In the past 12 years, the share of local government funding undertaken directly by Japan’s central government has shrunk from 44% to 38%, while public bond issues have tripled from 8% to 25% (see chart). That, however, could be just the start.
HOW THE JAPANESE GOVERNMENT'S SHARE OF MUNICIPAL FUNDING HAS SHRUNK
In the next five-to-10 years, Japan’s 2000 or so municipalities will be largely released from heavy-handed state financial and administrative control through a process known as the Trinity Reforms, which includes allowing local authorities to raise more taxes while the ministry of finance in Tokyo reduces the amounts of national taxes it passes on to the regions and the subsidies it provides for individual projects.
While these changes are taking place, the municipal debt market is rapidly being freed from official apron strings. Until mid-2006 public bonds issued by all but two municipalities were identically priced through negotiations between the ministry of internal affairs and communications (MIC) and a Japanese megabank or securities firm representing investors. Only the Metropolis of Tokyo and the City of Yokohama were allowed to negotiate directly with the market.
This situation ended abruptly last August when the fair trade commission, prompted by MIC minister Heizo Takenaka, the spearhead of financial reform under former Prime Minister Junichiro Koizumi, ruled that identical pricing was a breach of the competitive principle. The result: since September, municipal bond issuers have begun to set prices through bidding or book-building, using big securities firms as underwriters. The underwriters include foreign houses such as Goldman Sachs Japan and Morgan Stanley Japan, which had previously co-ordinated issues for Tokyo and Nagoya.
Yasuro Ken Koizumi, a managing director in Goldman’s financing group, which claims a 25% share of underwriting for the top 10 municipalities, describes the shift of funding from the public to the private sector as a way to launch “a new more proactive stage” for municipality financing.
System shift
The shift to a market system ended an anomaly between the identical pricing of issues in the primary market and large differences in spreads in the secondary market, where bonds issued by the Metropolis of Tokyo command a spread of 12-15 basis points (bp) over the 10-year Japan Government Bond (JGB) yield, while smaller or heavily indebted prefectures pay up to 30bp over JGBs. Although that made for a more rational market, competitive pricing of newly issued bonds may have set off a chain reaction of other marketed-oriented measures.
Two issues in particular that came alive under the reforming Takenaka administration were the introduction of requested credit ratings for municipal bonds by international rating agencies and the introduction of a legal bankruptcy system.
Ratings battles
Until early 2006, the MIC opposed credit ratings for municipalities on the grounds that municipal debts were implicitly guaranteed by the central government – although no legal guarantee existed. What existed instead were ratings based on public information published by domestic Japanese rating agencies that show a narrow range of difference between large municipalities with ample financial resources and smaller, poorer municipalities.
By mid-year, the ministry had relented to the extent of allowing the heavily indebted City of Yokohama to request a rating from Standard and Poor’s (S&P). Its consent was based on Yokohama’s case that it had devised a medium-term financial revival programme (without help from the central government) and needed to have its efforts understood by investors. The four-year-old programme calls for an 8% annual reduction in the value of bond issues, cuts in public works spending and an improvement in local tax collection rates from 96.2% in 2002 to 97.6% by 2010. (Yokohama was awarded an AA- rating in October, which the city boasts is identical to S&P’s rating for Japanese government bonds.)
Bankruptcy safety net
Within the next six months, the Metropolis of Tokyo and at least two other important municipalities are expected to follow suit by obtaining ratings from S&P or Moody’s. The head of the municipal bond issue division in the MIC now says the ministry is “neutral” on the ratings issue, although it still thinks ratings are a luxury beyond the means of many smaller local governments. On the bankruptcy issue, the ministry is adamant that Japan “does not want or need” a bankruptcy law for municipalities because their budgets are included in the national budget. However, it is prepared to admit that the government needs to organise a safety net to help troubled local governments, as well as more efficient ways to monitor local finances.
These two matters came to the fore last summer when the former coal town of Yubari declared insolvency and had to seek emergency help from Hokkaido, the big northern island prefecture with publicly issued bonds trading on the secondary market. Hokkaido, and eventually the central government, came to Yubari’s rescue but not before the spread on Hokkaido’s bonds had shot up from 30bp to 100bp over the JGB benchmark on the secondary market.
The Yubari troubles raised another question that could provide an opportunity for foreign banks that are interested in Japan’s municipal finance market: that of private placements.
The private placement problem
Out of Japan’s 2000 nominally independent municipalities (soon to be reduced through mergers to about 1000 entities), only the country’s 15 largest cities and 24 out of 47 prefectures are allowed to issue public bonds directly to the market. The remainder depend on private placements that can take the form of loans, bonds or tradable loan certificates purchased by groups that are restricted by law to a maximum of up to 49 investors. This system has a long history, with private placements accounting for 36% of municipal funding in 1994 and an almost unchanged 37% in the current fiscal year.
Despite that apparent stability, private placements, like the public bond market, may be due for some important changes. A feature of the current system is that most funds flowing through it come from the 60 or so regional banks that dominate local financial transactions. Regional banks have a local stranglehold deriving from a tradition whereby most prefectures appoint a designated bank to handle their finances. But there are signs that this may change, not because regional banks are being squeezed out of the market, but because even the largest regional banks are not well placed to handle the often very long terms of 30 years or more being requested by prefectural governments.
Regional banks have another problem. Under Bank for International Settlements guidelines they must diversify their borrowing base, reducing the extent to which they depend on prefectural governments as dominant customers.
The need for prefectures to raise very long-term finance partly explains why Dexia, a French-Belgian bank specialising in municipal finance, opened a branch in Tokyo in November. Robert Verdier, CEO of Dexia Credit Local’s Tokyo branch, forecasts that by 2016 what he calls “new money”, consisting of long-term and specialised finance including project loans and loans for public private finance projects, may account for 15% of municipal financing, in addition to the 25% that will continue to flow through existing private placement channels. To win a share of this market, Dexia launched a Japan Tour last September, which involves visiting every Japanese prefecture and all of the nation’s 64 regional banks. The tour is due to be completed by next month.
Mr Verdier is insistent that he wants to work with the regional banks, not compete against them, and says that so far he has not had a single request for a regional bank appointment turned down. Dexia’s strategy will be to start by targeting the 300 cities and towns in Japan with populations of more than 80,000. Later, the bank will offer loans to 450 smaller entities with populations of between 20,000 and 80,000. Dexia gained its licence in November and was eligible to start full operations from December 4.
Long-term perspective
Mr Verdier believes there are fundamental reasons why Japan must diversify and lengthen the maturity periods of municipal finance. One is that long-term interest rates are currently below the expected rate of gross domestic product (GDP) growth. If that stays unchanged, Japan could be heading for another asset bubble, similar to that of the late 1980s. But to raise long-term rates, the economy needs an expanded flow of long-term money.
Dexia is not the only European bank that sees opportunities in the private placement sector. Depfa Bank of Germany already has a Tokyo branch and is channelling funds to some of Japan’s biggest municipalities, including Osaka prefecture where it claims it has a 7% share of outstanding debt. Depfa often lends to municipalities using the three Japanese mega banks, Tokyo Mitsubishi UFJ Bank, Mizuho Corporate Bank and Sumitomo Mitsui Banking Corp, as intermediaries.
The unwillingness of municipalities to borrow from foreign lenders is changing fast, says Ulrich Vollmer, general manager at Depfa’s Tokyo branch. “Six to seven years ago, every local issuer had a three-to-four-page list of ‘house banks’; they wouldn’t look at us. Now the MIC encourages municipalities to deal with foreign institutions.”
Although the situation has improved, Mr Vollmer believes that the private placement system for financing municipalities is outdated and will gradually be replaced by syndicated lending. On the other hand, he believes there are “huge groups of investors” in Europe that could become involved in Japanese municipal financing, either through lending or as investors in publicly issued bonds, as the central government’s role shrinks and the municipal market is liberalised.
Tax incentives
A key assumption is that Japan abolishes its 15% withholding tax on dividend payments to foreign investors on bonds traded through the Japan Depositary Centre book entry system, which at the time of going to press was imminent. A senior official at the MIC, which campaigned unsuccessfully in 2005 for the tax to be withdrawn, says that the tax bureau of the ministry of finance has agreed to lift the tax this year provided the MIC can devise a system that prevents domestic investors from posing as foreign investors to enjoy the tax rebate.
The MIC’s analysis of the situation in Europe is that European banks issuing yen-denominated covered bonds will want to buy Japanese municipal paper to diversify the assets that they can place against the bonds. At the moment, the only Japanese asset available for this purpose is the JGB.
Yasunobu Katsuki, chief credit analyst in the fixed income division of Mizuho Securities, agrees. He says recent visits to London have convinced him that European investors are becoming very interested in Japanese municipal bonds. He thinks there will be “huge changes” in foreign activity in market if the withholding tax on bonds is withdrawn.
If that is correct, how big is “huge”? In gross terms, the Japan municipal finance market is one of the world’s largest with about ¥200,000bn ($1740bn) of outstanding liabilities. That is about the same size as the US municipal market, notes Akane Enatsu, senior credit analyst in the fixed income department at Nikko Citigroup. However, the bulk of outstanding issues are still held by the central government or by public institutions, such as
the post office. The ¥60,000bn worth of municipal paper that is held by private sector investors and lenders makes Japan’s market about one quarter the size of the US market and 60% of the size of the European pfandbrief market.
Shrinking state influence
Most important, says Mr Enatsu, is the rate at which the government-held portion of the municipal market will shrink over the coming years as part of Japan’s efforts to cut its huge central government public debt (currently more than 160% of GDP). Developments in this direction will include withdrawal of Japan Post from the purchase of municipal paper in 2007 as a result of the privatisation of the postal system.
A second important change is the planned reorganisation of the Japan Financial Corporation for Municipal Enterprises (JFM), a state-owned bank that finances projects in the regions. JFM will account for 10% of municipal financing flows in the fiscal year 2006 (which ends in March 2007). But the bank is due to be reorganised in two years’ time as a regional entity, owned and managed by prefectures. This will mean that JFM funds will disappear from the central government side of the municipal account. JFM’s successor organisation will continue to provide project finance, but its loans will no longer enjoy an implicit guarantee by virtue of being included in the national budget for municipal financing.
No long-term target exists for central government’s exit from municipal financing; and a total exit seems improbable given the government’s insistence that it acts as a de facto guarantor of regional creditworthiness. Another caveat: rationalisation programmes in the regions and cost saving resulting from mergers of local authorities will mean that the amount of new funds required by municipalities should fall gradually (total funding by the regions for the fiscal year 2006 is estimated at ¥13,900bn by Nikko Citigroup, down 10.2% from fiscal 2005.)
Rationalisation means that the actual value of (non-governmental) publicly issued bonds and private placements may also shrink over the next few years. But the private share of total financing is certain to increase, and rigid official rules on how municipalities fund themselves will give way to transparency. That is why the new era in Japanese regional finance should be good for just about everybody.
