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FRBSF Ul)€€KLV U ttcr May 10,1985 Japan's Financial Reform The financial reform process referred to as "de regulation" in the United States is also occurring in Japan, where it is called "financial liberaliza tion." Both processes share certain catalysts and objectives, but the cultural, institutional, and economic environments of the two countries ensure significant differences in their respective approaches to financial reform. This Letter outlines the liberalization process in Japan and discusses the importance of liberalization from the U.S. perspective. Japanese financial liberalization Financial liberalization in Japan is focused on re structuring the domestic and international flow of funds between lenders and borrowers to satisfy better the new requirements of economic growth in the 1980s. Specific reforms, which officially started in 1976, have been designed to increase the role of market forces by relaxing interest rate constraints and broadening portfolio opportunities for market participants; expanding existing secur ities markets and developing new securities markets for both private and public debt; increas ing capital flows in and out of Japan; widening access by foreign financial institutions to Japan's financial system; and "internationalizing" the yen with the objective of increasing Japan's role in the international financial system. Japan's financial system prior to liberalization was highly constrained by regulation and administra tive guidance from the Ministry of Finance (MOF) and the Bank of Japan (BOJ). Banks and other financial institutions were subject to portfolio restrictions, interest rate constraints on deposit and lending activity, and restrictions on inter national transactions. Securities markets were undeveloped since government deficits were small and corporate borrowers relied almost exclusively on large banks for short- and long-term funding. The domestic financial system was internationally isolated via a complex set of capital controls, restrictions on Euro-yen activity, and limited access by foreign financial institutions. The objectives of this highly structured, seg mented, and regulated system were to support export-led economic growth, industrialization, and high personal savings, and to provide a simple conduit for transferring the large surplus of funds in the personal sector to the large deficit in the corporate sector. The objectives were well-served by the regulatory system until the first oil-price shock of 1973-74, which marked the end of rapid economic growth in Japan. Real GNP growth declined from a 10 percent level to the present range of 3 to 5 percent. The impact of reduced economic growth on the flow of funds must be judged the most important catalyst for financial liberalization for three reasons. First, the slowdown increased the size of the public sector deficit significantly. Public sector deficits had averaged about 2 percent of GNP prior to 1973, but had quickly increased to over 7 percent of GNP by 1975. Rather than sell the increasing volume of government debt on the open market, the MOF placed the debtdirectly with a "captive" syndicate of banks and other institutions that were required to purchase the debt at below-market rates and to hold it for as long as one year. Syndi cate members did not resist the procedure prior to 1975 largely because the amount of debt was small. Also, the BOJ was willing to repurchase the debt from banks at prices that guaranteed no cap ital loss, and the MOF allowed securities com panies to use the debt to support a repurchase, or "gensaki," market as it is called in Japan. After 1975, when the size of the debt rose, the MOF met with increasing market resistance and was forced to make a number of concessions to market forces, which officially started the liberalization process. Second, slower economic growth with concom itant reductions in profit opportunities and in the need to expand plant and equipment meant that the corporate sector deficit declined significantly. Corporate sector deficits have averaged about 6 percent of GNP prior to 1973; they declined to less than 4 percent of GNP after 1975. The banking system's market share dropped as a result of re duced corporate demand for credit. And corpora tions became more aware of alternative sources of funding, particularly the management of financial assets as a new source of profit. Banks thus became advocates of increased flexibility as a means of FRBSF re-establishing and increasing their market share, and corporations became advocates of more fund ing sources and more market-sensitive financial assets. Third, the household sector also brought pressure to liberalize the financial system. Prior to 1974, households' alternatives for investing their savings were restricted to a narrow set of regulated finan cial assets. For a variety of reasons, they did not use the financial system as a major source of bor rowing. Slower economic growth, however, in creased household awareness of the burdens of being limited to investing wealth in regulated, relatively low-yielding investments. In addition, the changing age distribution of the population toward older individuals increased the need to manage financial assets for retirement. Other forces also were important in bringing pressure for liberalizing Japan's financial struc ture. The shift from a fixed to a floating exchange rate system after 1973 brought pressure to end restrictions on short- and long-term capital movements in and out of Japan. In addition, deposit rate ceilings became seriously binding on the occasions when secondary market rates ex ceeded regulated rates. As well, advances in com puter technology increased the ability of financial institutions to innovate and introduce new services (such as cash dispensers and credit cards) and new financial assets (such as combined demand/time deposit accounts and government bond mutual fund accounts). Pressure from outside Japan recently has become an important impetus to further liberalization. Japan has been encouraged to open its markets to international competition, including its financial system to access by foreign financial institutions, and to take steps that will make the yen an inter national currency like the dollar—one widely used to make international payments and which is attractive as an investment vehicle for foreigners. What has been accomplished The financial reforms in Japan have been directed toward four areas: intermediation finance, the government bond market, the short-term money market, and international finance. In intermediation finance, banks have been authorized to issue large CDs paying interest rates that are responsive to market rates, to offer new deposit accounts that earn higher regulated rates of return, and to increase consumer lending. Securities companies have been authorized to issue bond fund accounts with limited transaction features. Deposits, with the exception of large CDs, are still subject to interest rate ceilings. However, the regulators have been willing to adjust ceilings more frequently to minimize the spread between market and regulated interest rates. Most of the controls over lending rates previously enforced by the regulators have been removed. In the government bond market, the MOF has permitted syndicate members to sell government debt 100 days after purchase, offered medium-term government bonds publicly (at market rates), al lowed banks to make over-the-counter sales of new government issues, and narrowed the spread between the market and issue rate on securities sold to syndicate members. Overall, the new issue market for government bonds has become sensi tive to market forces. In short-term securities markets, transactions in the government bond repurchase market, or gensaki trade, have expanded greatly since the market was officially recognized in 1976. The volume of CDs has grown quickly since their authorization in 1979. Despite the lack of a new-issue Treasury bill market, the shortened maturity of existing long-term debt has de facto established a short term government securities market. Finally, reg ulators have expanded participation in the inter bank money market and largely freed it of interest rate restrictions. In international finance, liberalization has in creased access by foreign financial institutions and relaxed or eliminated most of the restrictions over capital flows. The 1980 amendments to the Foreign Exchange and Foreign Trade Control Law officially established the principle that capital flows in and out of Japan are not to be regulated, and that controls will only be used in an emergency to prevent disruptive exchange rate fluctuations. In addition, the environment for an expanded Euro-yen market has been improved by allowing nonresidents to issue Euro yen bonds, by removing the withholding tax on non-residents holding Euro-yen bonds issued by Japanese residents, and by allowing Japanese banks and foreign banks to issue Euro-yen CDs. Ten years have passed since the initial efforts at financial reform in Japan, and considerable prog ress has been made. Additional reforms, such as establishing a bankers' acceptance market and a bond futures market, and removing interest rate ceilings on large deposits, are planned for the near future. Importance from the U.S. perspective Financial reform in Japan has recently become an issue in discussions between the U.S. and Japan over international trade issues. In the May 1984 policy discussions between the U.S. Treasury and the MOF, the U.S. encouraged Japan to increase the pace of financial liberalization, especially with regard to increasing access for foreign finan cial institutions to Japan's domestic markets, and to take steps to increase the use of the yen in international trade and finance. The U.S. expected a faster pace of liberalization to increase the world demand for the yen, and thus contribute to a lower yen/dollar exchange rate as well as an increase in U.S. exports of financial services to Japan (by making Japanese financial markets more access ible to U.S. institutions). Some economists argue it is not certain how the yen/dollar exchange rate will be influenced by the liberalization process in Japan. One study, for example, concluded that some of the proposals advanced for opening up the Japanese financial system, if enacted, would increase the exchange value of the yen while others would decrease it. Other studies have reached a similar conclusion. It is by no means clear, therefore, that the dollar's rise against the yen and other currencies would be offset significantly by a faster pace of Japanese liberalization. Instead, the effects of high U.S. inter est rates and federal deficits will continue to dom inate in determining the yen/dollar exchange rate. Neither is it clear that giving U.S. financial institu tions greater access to Japanese markets will mean a greater export of U.S. financial services to Japan. Japan has changed its Banking Law to incorporate the principle that domestic and foreign banks are to be treated equally. FJowever, this has meant that foreign banks now face competition in some areas for which they previously held a privileged posi tion. The case of impact loans is a good example. An impact loan is a loan to a Japanese resident denominated in a foreign currency, which, until recently, only foreign banks could make. As a result of liberalization, Japanese banks now com pete aggressively and may have an advantage in being more familiar with the needs of Japanese customers. Despite these reservations, it is still true that there are significant benefits to the U.S. from Japan's liberalization process. The increased use of the yen in international trade and finance will increase Japan's role to a level commensurate with its economic size. It also will make it more likely that the U.S. and Japan will play a joint role in providing a financial infrastructure for the Pacific Basin region, a region that shows signs of being the world's major growth center in coming decades. Conclusion There are important benefits to the Japanese from a more liberalized financial system. The pre-liberalized financial system served Japan's needs for the three decades after World War II. It was struc turally simple and provided an excellent conduit for the transfer of sizeable household savings to large corporations in support of export-led eco nomic growth and industrialization. Since then, Japan has become a major industrialized economy that must face oil-price shocks, slower economic growth, changing flows of funds, and increased financial integration with the rest of the industrial ized world. Japanese regulators have recognized the incompatibility of the previously constrained financial system with the new economic environ ment, and have made progress toward creating a freer, more competitive, and open financial system. Despite the uncertainty over the beneficial effects of Japanese liberalization on the yen/dollar ex change rate and the U.S. balance on goods and services, there is no question that the U.S. ulti mately stands to gain from a continuation of the liberalization process. Thomas F. Cargill Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor (Gregory Tong) or to the author____ Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246. uo}6u!qsonn oijopi qcqf) nomoH ojujojuo^ uo6 o jo ouozuy opoAay ovjsoiy ODSpUDJJ UOS jo ^uog 0 A J0 S 0 y |DJ0p0-) qusuuqjodacj ipjoesey BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions)___________________________________________________ Change from 04/25/84 Amount Change Selected Assets and Liabilities Outstanding from Dollar Percent7 Large Commercial Banks 04/17/85 04/24/85 Loans, Leases and Investments1 2 Loans and Leases1 6 Commercial and Industrial Real estate Loans to Individuals Leases U.S. Treasury and Agency Securities1 2 Other Securities2 Total Deposits Demand Deposits Demand Deposits Adjusted3 Other Transaction Balances4 Total Non-Transaction Balances6 Money Market Deposit Accounts—Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed Money5 Two Week Averages of Daily Figures Reserve Position, All Reporting Banks Excess Reserves (+)/Deficiency (-) Borrowings Net free reserves (+)/Net borrowed(-) 1 2 3 4 5 6 189,617 171,694 51,982 62,815 33,767 5,350 11,005 6,918 193,273 44,103 30,149 13,583 135,587 43,310 38,699 22,954 Period ended 04/22/85 88 24 64 11,140 12,664 3,888 2,849 6,115 356 1,067 456 8,677 954 1,297 1,456 6,267 6.2 7.9 8.0 4.7 22.1 7.1 8.8 6.1 4.7 2.2 4.4 12.0 4.8 281 3,693 9.3 69 2,157 714 1,717 1.8 8.0 13 265 259 16 186 3 261 9 -4,423 -3,244 -1,118 - 949 - 230 - - - Period ended 04/08/85 - 32 123 155 Includes loss reserves, unearned income, excludes interbank loans Excludes trading account securities Excludes U.S. government and depository institution deposits and cash items ATS, NOW, Super NOW and savings accounts with telephone transfers Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources Includes items not shown separately 1 ^ pe'Cent cha" 8e
