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Post-Big Bang Reforms: The Japanese Government Bond Market

Post-Big Bang Reforms: The Japanese Government Bond Market. S. Ghon Rhee K. J. Luke Distinguished Professor of International Finance and Banking University of Hawai’i. Motivation for UK Big Bang in 1986. 1. London Trading Volume Prior to UK Big Bang 1/13 th of New York Volume

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Post-Big Bang Reforms: The Japanese Government Bond Market

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  1. Post-Big Bang Reforms: The Japanese Government Bond Market S. Ghon Rhee K. J. Luke Distinguished Professor of International Finance and Banking University of Hawai’i

  2. Motivation for UK Big Bang in 1986 1. London Trading Volume Prior to UK Big Bang 1/13th of New York Volume 1/5th of Tokyo Volume 2. Reform Measures in UK a. Internationalization b. Deregulation of Fixed Commission Rule c. Allowance of Proprietary Transaction d. Opening of Ownership of Stock Exchange Members to Outsiders

  3. Motivation for Japan’s Big Bang • Shrinking Market Once the largest in the world, Tokyo market capitalization is now about one-fifth of New York’s $15.1 trillion vs. $3.2 trillion • Less Active Market Tokyo Trading Volume is less than one-tenth of New York Volume $31.9 trillion vs. $2.7 trillion • Depressed Market: Dec 29,’89At Present DJIA 2,753 10,500 Nikkei 225 38,916 11,500

  4. Big Bang Financial Reforms: Japan (I) 1. Deregulation of cross-border transactions and foreign exchange business 2. Adoption of a competitive auction method to issue financing bills 3. Abolition of securities transaction tax 4. Deregulation of brokerage commission 5.Preparation of legal framework for loan/asset securitization 6.Allowance of off-exchange trading

  5. Big Bang Financial Reforms: Japan (II) 7.Allowance of banks and financial institutions to issue bonds 8.Entry by banks, securities companies, and insurance companies into each other’s business 9. Introduction of individual stock options 10.Replacement of merit-based licensing system with a disclosure-based registration system for securities companies

  6. Three Major Weaknesses of JGB Market 1. Fails to Tap the Pool of Global Capital 2. Violates the Rule of Separation between Government Liabilities and Assets Management 3. Needs to Complete Infrastructures of the Primary and Secondary Markets

  7. Investment by Foreign Investors in JGBs • Foreigners’ Holding of Government Debt • Japan: 5% • United States: 37% • United Kingdom: 14% • As of April 1999, the withholding tax on redemption gains and interest income from JGBs were exempted for foreigners. However, tax exemption is not done at the source and is applicable only to BOJ book-entry system.

  8. Violation of the Separation Rule between Government Liabilities and Assets Management (I)  • Fiscal Investment and Loan Program (FILP) of MOF • FILP Asset Size: $3.38 trillion • FILP Assets invested in JGBs: 17% • MOF is the largest issuer and buyer of government bonds • Government Holding of Its Own securities Japan: 46% of JGBs Outstanding US: 13%

  9. Violation of the Separation Rulebetween Government Liabilities and Assets Management (II)  • MOF’s Dual Role: An explicit violation of the separation rule • Negative consequences: • Primary Market: Lack of intense competition • Secondary Market: Increased uncertainty in JGB yields

  10. Underlying Forces for the US Government Bond Market Expansion in 1980s a. Introduction of Financial Futures and Options b. Active Trading of Treasury Securities on a When-Issued Basis c. Expansion of REPO transactions d. Introduction of the Separate Trading of Registered Interest and Principal of Securities (STRIPS)

  11. Sequence of Government Bond Market Reforms: French Experience a. Bond futures market (1986) b. Primary dealer system (1987) c. Interdealer broker network (1987) d. Purely competitive auctions (1987) e. REPOs (1991) f. STRIPS (1991) Brossard, Philippe, 1998, The French Bond Market: Enhancing Liquidity, A paper presented at a World Bank Workshop on the Development of Government Bond Markets, June 11-12, Seoul, Korea.

  12. Suggested Post-Big Bang Reform Measures for Japan • Creation of the primary dealer system • Adoption of the uniform-price auction method • Introduction of when-issued trading • Revamping the REPO market • Introduction of STRIPs

  13. Creation of the Primary Dealer System • Existence of primary dealers does not necessarily guarantee intense competition on the primary market but they are experts in pricing, market making, and distribution • No primary dealer system: Japan and Germany • MOF’s dual role (buyer and seller) to be blamed for the lack of primary dealer system in Japan • Syndicated underwriting: Past norm • Public auction systems are now used for: 2-, 4-, 6-, and 20-year bonds

  14. Issuing Techniques ofGovernment Bonds • Fixed Price Public Subscriptions Underwriter consortium utilized • Private Placements In the absence of well-functioning secondary markets • Tap Issues Sold directly into the secondary market through branch network of banks or securities companies • Auctions Multiple price auction vs. Uniform Price Auction

  15. Issuing Techniques ofamong OECD Members • Uniform Price Auction Finland, Italy, Netherlands, Norway, and Switzerland, UK • Multiple Price Auction Australia, Austria, Canada, Sweden, UK • Tap Issue US, UK, Germany, Canada, and most of OECD members, but not Japan

  16. Two Major Auction Methods Multiple-price auction method a. Successful bidders pay the prices they bid…. …..“winner’s curse” b. Bidders tend to shade their bids below the maximum that they are actually willing to pay Uniform-price auction method a. All successful bidders pay the same price for a given security b. Hence, some successful bidders may pay a lower price than they actually bid.

  17. Adoption of Uniform-Price Auction Method (II) Empirical Evidence a. The uniform-price auction method generates higher revenue for the government b. US Treasury has been utilizing the uniform-price auction method for all Treasury securities since 1997 c. Japan never adopted the uniform-price auction method

  18. Introduction of When-Issued Trading • Most advanced markets allow trading during the period between the time a new issue is announced and the time it is actually issued. • Ranging from one week to two-weeks (US market) • As short as two days (France) • When-issued trading functions like trading in a forward market. • Major Benefits • Minimize price and quantity uncertainties. • Lower underwriting risk • Increase revenue from the new issue • By not allowing when-issued trading in Japan, the MOF foregoes these benefits.

  19. Revamping of the REPO Market (I) • Major Functions of REPO Market a. allows primary dealers to cover their short positions b. allows institutional investors to maximize investment income by lending their securities c. allows foreign investors to reduce currency risk through money market hedging d. facilitates clearing and settlement transactions

  20. Revamping of the REPO Market (II) Traditional Gensaki Market • European-style REPO (sell-and-buy-back) • Ownership to the security is transferred to the buyer • No marking-to-market • Major instruments: Short-term Treasury and Financing Bills American-Style REPO market • Borrow and Lend • No transfer of security ownership • Marking-to-market • Major instruments: All Treasury and corporate securities

  21. Introduce STRIPS • By introducing STRIPS, the MOF can provide the market with highly liquid zero-coupon bonds and notes. • As a result, STRIPS will: a.expand the investor base b. improve tracking of effective yield curve c. allow institutional investors to reduce reinvestment risk.

  22. Thank You!

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