IP: Report on Deregulation Talk in DC

[David Farber <farber () cis upenn edu>]

Date: Tue, 11 Mar 1997 15:41:00 -0500
From: Asia Program <wwicsap () pop erols com>




The following is the text from a talk delivered at the Woodrow Wilson Center
(Washington DC) on Friday, 7 Mar 97, by Yasuo Kanzaki, chairman, Nikko
Research Center Ltd.


The talk was entitled, "Deregulation in Japan:  Big Bang or Big Whimper?"
Dr. Edward J. Lincoln, senior fellow at Brookings served as discussant.


For more information on this and other Wilson Center events, please contact
Dr. Mary-Lea Cox, program associate, Asia Program at MLCOX () sivm si edu


***************************************************************


Deregulation in Japan: Big Bang or Big Whimper?
By Yasuo Kanzaki 


Thank you very much, Jim, for your very kind introduction. I'm
honored to be able to speak to you this afternoon in the library of
the famous Smithsonian Castle where great men and women have
spoken, challenging the conventional wisdoms of the day and opening
new frontiers of thought and discourse. 


The subject of my talk today is the impending reform of the
Japanese financial industry. In the next half-hour or so, I hope to
make the case that this reform will amount to a Big Bang, and not
a Big Whimper as Dr. Mary-Lea Cox of the Wilson Center who invited
me to this event suspects, and as many of you here may also
suspect. As you no doubt know, the expression, Big Bang, was first
used to describe the British financial reform of 1986. I am going
to argue that the Japanese version of the Big Bang will be - or at
least has the potential of being - more basic and far-reaching than
the British original. 


I) WHY IT WILL BE A BIG BANG
I realize that there is great skepticism whenever we Japanese
declare we are about to implement reform. I can understand the
skeptics. 


The skeptics say Prime Minister Hashimoto's reforms will be a Big
Whimper because he has only announced his intention to push major
reforms, without presenting road-maps and blueprints; because he
comes from the Liberal Democratic Party which is for the status quo 
and against reform; and because the recent weakening of the yen has
reduced the pressure towards reform. 


The skeptics also point to the poor Japanese record in pushing
reform of their own accord. We often need gaiatsu  to get moving.
The skeptics recall that the proposed Maekawa reforms of the late
1980s were quickly abandoned and forgotten once Japan's current
account surplus as a percentage of GDP started to decline, thanks
to the dramatic increase of luxury imports (which was fueled by the
financial bubble) and to the sharp appreciation of the yen. 


Some skeptics also cite cultural reasons why attempts at
reform in Japan often end up being Big Whimpers. They say that
bureaucratic dominance and opaqueness of the system are difficult
to change because the Japanese, deep down, accept administrative
regulation and don't believe in the virtues of competition. One
consequence of these cultural constraints is that the process of
deregulation is tightly controlled by the current supervisors,
according to the skeptics.


These criticisms are more or less valid. Nevertheless, I am
convinced that this time round, reform is for real. In order for us
Japanese to get serious about reform, we must see it as being in
our own interest and as being feasible. And we now do.


Why?  Because we know that our economic growth has been
blocked and that traditional remedies using fiscal and monetary
policies have proved ineffective. Meanwhile, the US and Britain,
which have pushed deregulation since the early 1980s, have regained
vitality. The slump in Japan, and the boom in the US and Britain,
have prompted us Japanese to think seriously about deregulation and
more generally, structural reform.


In addition, the new electoral system makes it easier to
implement reform. Before electoral reform, politicians often put
the interests of business groups and bureaucrats ahead of public
interests, and campaign promises did not have much meaning. The new
electoral system has weakened the ties between politicians,
bureaucrats and business. The shift to single-seat constituencies,
with each candidate representing a political party and its
policies, means that campaign promises are taken more seriously.
Politicians are now chosen for campaign promises and are expected
to honor them. 


Let me cite some of the problems that we see in our economy
today and believe need fixing. First of all, deterioration of the
national budget has reached crisis proportions. People still think
that Japan manages a healthy budget, but in fact, our accumulated
national debt, including that of local public bodies, will have
grown almost as large as the country's GDP (of Y500tr) by the end
of FY96.


Second, demographic factors, particularly the aging of the
Japanese population, is putting additional pressure on the national
budget. Higher growth would make it easier for our economy to
absorb large budget deficits. But high growth is a thing of the
past, and the Japanese population is rapidly aging, as families
become smaller and the rate of population growth declines.
According to the Economic Planning Agency, 4.2 people of working
age (between 20 and 64) support one elderly person today, but by
2020, there will be only 2.1 people of working to look after each
elderly person.


Third, excessive regulation is hampering economic activity
across the board. Moreover, bureaucratic rules and decisions are
written and administered by rigidly compartmentalized government
agencies: Even decisions made within the same ministry are
sometimes contradictory, as well as cumbersome and stifling. This
compartmentalization is one major reason why fiscal measures to
reflate the economy don't work.


Fourth, Japan has been slow to adapt to the globalization of
economy and business. With globalization, cross-border movement of
goods and services has increased vastly. The explosion of
cross-border transaction in information - and along with it,
capital - has been particularly astounding. Given the development
of communications technology, we Japanese can never again close off
our borders as we did during the Tokugawa Era. Instead, we in
business will have to adopt global standards and practices, notably
in accounting and taxation. The Japanese Government, too, must
change, making its regulation more transparent and comprehensible
to foreigners.


Fifth, Japanese Government's economic policy has put
manufacturers' and  suppliers' interests first, neglecting
consumers' interests. This, too, must change. After the Meiji
Restoration and in the post-World War II period, we strived to
catch up with the West economically. In doing so, we have tended to
give precedence to producer-supplier interests, at the expense of
the consumers. The "convoy system" of managing the financial
sector, with the convoy navigating at the speed of the
slowest-moving institutions, is an example of a system created for
the suppliers (in this case,  the financial institutions), not for
their customers.


II) REFORM TIMETABLE
I have just cited five reasons why the Japanese feel they must
carry out reform.  


Last summer, Prime Minister Hashimoto announced his intention
to implement reforms in five broad areas. These five areas are the
bureaucracy; the national budget; economic structure; financial
industry; and social welfare. Hashimoto added another area of
reform in December -  the educational system. 


So we now have six major reforms planned. Many committees are
making recommendations to the government, and a great number of
bills are in the pipeline in the Diet. In the area of financial
industry reform alone, there are three bills awaiting enactment in
the next month or so. These bills concern reform of the Bank of
Japan, Ministry of Finance and foreign exchange controls.


A proposal for another crucial reform - the reorganization of
government bureaucracy in Tokyo - will be submitted by the advisory
committee on administrative reform to the cabinet before the end of
November. The precise nature of this proposal is not yet known, but
it will probably reflect the views of the committee deputy
chairman, a former LDP Diet member, Mr. Mizuno. Mizuno's idea is to
define five key roles of government and then decide which
government agency will play these roles, rather than starting out
with the agencies. The five government roles, according to Mizuno,
are: 
1) ensuring the continued existence of the nation;
2) increasing national wealth;
3) providing for the livelihood of citizens;
4) promoting education and culture; and
5) overseeing those who govern. 


In Mizuno's scheme, roles now played by the Ministry of Finance
will be divided by two agencies. The budget function will go to the
new Treasury Ministry while supervision of financial and capital
markets will be taken up by the new Ministry of Economy and
Industry, which will inherit some of the roles of what are now
MITI, the Economic Planning Agency and  the Ministry of Post and
Telecommunications.


III) REFORM OF THE FINANCIAL INDUSTRY, OR THE BIG BANG
Prime Minister Hashimoto has put top priority on financial
reform. He has stated that without a much-improved  financial
system, Japan's economic growth cannot be sustained. He stressed
that since we face an aging society, we need efficient markets
which provide better returns for the 1,200 trillion yen worth of
financial assets held by private Japanese individuals. Hashimoto
has said, further, that he aims to revitalize the Japanese
financial market and make it as advanced as the New York and London
markets by the year 2001.


Why is reform of the financial industry spearheading
Hashimoto's  grand scheme? I can think of several reasons, not very
flattering to the industry. First of all,  the financial industry
is regarded as - indeed is  - one of the most heavily protected and
regulated in Japan. Secondly, due partly to various recent
scandals, the financial industry is among the least popular and
least likely to receive public sympathy. Third, the industry has
fallen far behind foreign competitors and the public is demanding
better service from their bankers and brokers. Fourth, to
revitalize the Japanese economy, restoring confidence in the
financial industry is absolutely crucial. 


Reform of the financial industry has two objectives. One is
system reform and the other is disposition of bad loans. Let me
begin with the bad loans first. The Japanese Government claims that
the worst is over, and I basically agree. According to the Ministry
of Finance,  or MoF, problem loans held by the entire Japanese
banking sector amounted to Y29tr at the end of last September, down
from Y34tr at the end of March, 1996. This drop resulted mainly
from the transfer of banks' bad loans to jusen  (or housing loan
companies) to the Japanese version of Resolution Trust Corporation. 


The total amount of special write-off reserves held by the
banking sector was Y9.9tr in September. If these special reserves
are indeed applied and if in addition, banks can capitalize
collateral (of about Y12tr) against bad loans, Y7tr in bad loans
will remain. On the other side, there are operating profits
(averaging Y6tr over the last five years), reserves excluding those
for special write-off (Y2.6tr),  and unrealized capital gains
(Y23.5tr). The sum of these three items, of Y32tr, can be regarded
as a comfortable buffer against the remaining bad loans.


As to the other objective of system reform, Hashimoto
enunciated three principles that the Tokyo market should become
"Free," "Fair" and "Global"  to achieve, in his words, (and I
quote) "a dynamic renaissance as an advanced international
financial market" (end quote). "Free" means that the Tokyo market
will be open to new players, it will expand the line of business
for various types of financial institutions, it will deregulate
brokerage commissions, it will liberalize cross-boarder
transactions, and that it will improve the system of managing
assets such as pension and mutual funds.


"Fair" means improving the transparency of rules, promoting
greater  disclosure and strengthening policing and enforcement
against wrong- doing.


"Global" means changing laws, regulations and practices to
match accepted international norms, and coordinating further with
supervising agencies of other countries, such as members of the G7.


How will this system reform proceed? We will not have a clear
picture  until summer, when various committees are expected to come
up with specific proposals for revising the current, relevant laws,
including the banking law and securities exchange law. 


But revision of one law relating to the financial system is
imminent. The bill amending the  Foreign Exchange Control Act is to
be presented in the Diet within this month. I shall focus on this
piece of legislation because it comes before the others and will
have truly far-reaching consequences.


IV) REVISION OF THE FOREIGN EXCHANGE LAW  
A while ago, Mr. Sakakibara, the eminent director general of
MoF's International Finance Bureau,  told me of his determination
to revise the foreign exchange law.  After the law is revised, MoF,
or Ministry of Finance, will no longer have the power to say "Yes"
or "No" when private institutions ask for its permission to engage
in various offshore transactions, Sakakibara said. This is because,
under the new law, no MoF permission will be required for such
transactions except in cases involving countries subject to
economic sanctions, and in cases in which internationally
agreements are violated.      


What surprised me was that Sakakibara, the cream of the most
powerful government agency in Japan, intended to surrender its
privilege and reduce its size. 


Under the current foreign exchange law, only designated banks
have the right to deal in foreign currencies. Revision will change
this. Under current law, private Japanese interests are not
permitted to hold a bank account or a brokerage account outside of
Japan. Under the new law, any Japanese person can open such an
account. He added that if the foreign exchange law is revised,
other laws - including one which governs foreign securities
companies - will have to be revised also. This last law restricts
Japanese entities, other than financial institutions, from opening
accounts with securities companies outside of Japan. After
relaxation, private Japanese investors will be able to subscribe to
American mutual funds. Sakakibara predicted that at least two
sections within MoF's International Finance Bureau will cease
operation.


V)  IMPLICATIONS OF THE NEW FOREIGN EXCHANGE LAW 
Amendment of the foreign exchange law will have far-reaching
consequences which add up to a Big Bang, not a Big Whimper. I will
just mention five of these. First, change in the foreign exchange
law will remove some of the firewalls dividing various types of
financial business, and will give more discretion to the managers
of financial institutions. Division of labor among financial
institutions has been more clear-cut in Japan than in the United
States. For example, the banking sector is divided into ordinary
commercial banks, long-term credit banks and trust banks.
Institutions in each sector are licensed and controlled under
separate laws. The privilege of dealing in foreign exchange is in
the hands of banks licensed under the Foreign Exchange Control Act.
The revised foreign exchange law will revoke various special rights
given to institutions.


Second, intensified competition from foreign financial
institutions  following relaxation of foreign exchange controls
will put extra pressure on inefficient domestic institutions. Until
now, the "convoy system"  under which fast and efficient ships
traveled at the speed of the slowest and most inefficient ships,
has protected the weaker institutions. The "convoy" is also a
splendid system for efficient institutions, because they can keep
excess profits accruing to them without appearing to be
anti-social. But just as Japanese resort hotels face serious
competition from hotels in Hawaii and Guam as a result of freer
foreign travel,  relaxation of exchange controls will bring more
foreign competition to the Japanese financial industry. Unless
domestic institutions produce good results, individual investors
will take their money to foreign institutions. Under the
circumstance, the more efficient domestic financial institutions
will no longer want to travel with the slowest ships in the
"convoy," for fear that they will lose business to foreign
competitors. Thus, new competition should bring an end to the
"convoy system."


Third, the system of fixed brokerage will be deregulated so
that Japanese markets can compete with overseas markets. Japanese
securities houses depend heavily on fixed commission revenue, which
accounts for as much as 50% of total revenue even among the Big
Four firms. In exchange for the liberalization of commissions,
securities companies are asking MoF to give them freedom to trade
in a greater variety of financial products. Under the current
Securities Exchange Law, Japanese securities companies are only
allowed to deal in "negotiable securities" as defined and listed in
that law, and are prohibited from dealing in other financial
instruments. 


This has been extremely constricting and stifling, given that
modern financial markets are creating an unending stream of new
financial products. Incredibly, Japanese securities companies had
to spend more than three years before they were able to obtain
permission from MoF to handle asset-backed securities.  This was
not only because of the long-standing rivalry between the
securities companies and banks, but also because of the fact that
non-banks come under the jurisdiction of a different ministry. In
other words, power struggle between MoF and MITI contributed to the
delay. 


Fourth, revision of the foreign exchange law will put pressure
on the Japanese to harmonize their tax rules with prevailing
international practice. The Japanese transaction tax, assessed at
0.21%  for stocks and 0.03% for bonds, will raise a total Y380
billion for MoF in the FY97 budget. This tax burden is certainly a
handicap for the Tokyo market and is very likely to be abolished,
although this will come only after the austere MoF finds a way to
make up for the revenue loss of yen 380 billion - whether by
reforming the overall assets-related tax system or by raising the 
withholding tax rate. 


So changes in the tax system will become necessary. But the
broader point here is that liberalization of foreign exchange
controls will have to be followed by other changes, including in
the tax system. 


Fifth,  deregulation in foreign exchange dealing as well as
other areas will give the private sector greater responsibility. In
the past, regulations introduced by the authorities gave a sort of
excuse for the private sector not to take hard decisions by itself.
But as deregulation advances, companies and individuals have
greater freedom - and responsibility - to act. In the new
environment, companies and individuals will have to make up their
own minds, weighing the rewards against the risks.  


VI) CHALLENGE FOR THE PRIVATE SECTOR 
Will the Japanese Big Bang succeed? Success will depend on
both the government and the private sector playing their parts. 
As for the government, I believe that Hashimoto has leadership and
will deliver on his promises. I have already told you that Mr.
Sakakibara at the Ministry of Finance is determined to strip the
powerful ministry of its powers to implement reform. 


So the Hashimoto government is serious, both at political and
bureaucratic levels. But change of law and bureaucratic system is
not enough to make a success of financial industry reform. Reform
must also be executed by the private sector, within each financial
institution. Will the banks and securities houses rise to the
challenge? That is the big question for us practitioners in the
Japanese market. 


Before closing my presentation, I would like to tell you about
my conversation with Dr. Michael von Krem, who was Chairman of
CSFB, or Credit Suisse First Boston, in London back in the
mid-1980s.


Michael told me then that CSFB had won the competition against
British merchant banks and was now targeting Japanese institutions.
He said that as an American house, CSFB had four major assets -
capital, human resources, computer technology and open-space
offices. On capital, he pointed out that Japanese firms also were
well-capitalized. "CSFB and the Japanese are even on this point,"
he said.  


On human resources,  von Krem said that while British merchant
banks had well-educated Oxford or Cambridge University graduates,
an American firm like his utilized broader-based talent than the
British. Von Krem's number-one sales person was a Filipino woman
and the number-two was a Chinese; A European came only in third
place. Von Krem felt that the Japanese are similar to the British
in recruiting and mobilizing human resources and that CSFB would
therefore win a point in this area. 


Von Krem boasted that Americans were the pioneers in applying
computer technology to finance and that he would thus gain another
point at our expense. 


Finally, he pointed out that CSFB took full advantage of
open-space offices in the most modern building in the City. Offices
of the old British merchant banks had more pillars and walls that
separated one office from another.  In von Krem's open-space
offices, his currency traders, for example, could easily follow
movements of bond traders, equity traders and commodities traders,
and help each other. This was unthinkable at British merchant
banks. 


Interestingly, von Krem opined that although the Japanese have
open-space offices like some American houses, the Japanese office
is not able to take advantage of such offices because of
restrictive laws and regulations. He thus thought he will take
another point from the Japanese institutions. "In all, we will win
three points and have one even. You will loose," he said. 


Unfortunately von Krem was right. We lost. 


This is the reason why I support Hashimoto's drastic reform
agenda. Fortunately, we still have huge financial assets held by
Japanese individuals, which are not properly being managed on their
behalf; almost 60% of these funds are still held in the form of
bank and postal deposits. Japan not only has world-class
manufacturing giants such as Sony and Toyota but also a great
number of small and medium-sized enterprises which provide jobs to
more than 60% of the nation's work force. Unlike the Sonies and the
Toyotas, these smaller companies have lacked access to world
financial markets and relied on inefficient Japanese markets for
financial needs. If those of us who work in Japanese financial
industry succeed in our reform, introducing better products and
raising the return on investment for our clients, we can help
revitalize the great many smaller-scale Japanese companies and
enrich their employees. This makes financial reform all the more
necessary and worthwhile.  


As I suggested to you earlier, it is now up to each financial
institution to respond to Hashimoto's call for a renaissance. 
Those institutions which dare to reinvent themselves will thrive;
those which fail to meet the challenge will be weeded out.  


Time is limited. We must finish our reform before we all get
old.








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