Evaluating Japan's "Big Bang" Financial Deregulation

Edward J. Lincoln

Prepared for the Trilateral Forum on U.S.-Japan-China Cooperation

in the Asia Pacific Region

Berkeley, November 11-12, 1997

In November 1996, Prime Minister Ryutaro Hashimoto called for a Japanese "Big Bang" deregulation of financial markets, borrowing his rhetoric from the deregulation of London financial markets in the 1980s. Deregulation of many aspects of the Japanese economy has been under discussion since 1993, with tepid results to date. But Prime Minister Hashimoto has given the impression that the financial sector changes will be pursued more vigorously and could be more significant than in other sectors by the announced completion date of 2001.

What should we make of the proposed agenda of changes? Japan's problems with its financial system have already had important implications for Japan's economic partners, including China and the United States. The proposed changes, should they occur as planned, raise new questions about the international impact of Japan's financial markets. Some of the lessons of Japan may be particularly important for China, now struggling with reform of state enterprises and the banking sector.

Unfortunately, the conclusion of this paper is that Japan is not changing as much as the rhetoric suggests. The deregulation initiative is real, and a number of changes will occur, but some of the current weaknesses of the system may well continue despite these deregulation efforts. Thus, Japan's financial system may experience continued inefficiency and remain susceptible to moral hazard problems, with other nations facing the prospect of coping with the international ramifications of those problems.

Background

Until the late 1970s, the Japanese economy operated with highly regulated financial markets. The overall financial system intentionally favored intermediation through banks; the banking sector was finely segmented; banking and securities firms were strictly separated; virtually all interest rates were controlled by the government; foreign exchange was tightly controlled (along with a fixed exchange rate until 1973 and a heavily managed floating rate for the rest of the 1970s); and the variety of financial instruments of all kinds was very limited and subject to approval by the Ministry of Finance. Monetary policy operated primarily through quantitative measures (varying the supply of central bank credit to the commercial banking system) rather than interest rate manipulation, and with interest rates set below market clearing rates, the government was also in a position to influence commercial banks' allocation of credit to industry.

Although Japan never ran an explicitly socialist economic system, the hand of government was heavy in influencing choices made by private sector firms. Perhaps nowhere was this more evident than in the controls over the financial sector. Government-owned banks (particularly the Japan Development Bank) acted as signaling devices in this era, providing an indication to the commercial banking sector as to which industries and firms were favored by the government (and therefore deserving of commercial loans as well). Controls over deposit and loan rates, regulatory authority over the opening of new branches, and control over bank audits (a function entrusted to both the Ministry of Finance and the Bank of Japan) all placed the Ministry of Finance in a position to virtually dictate the profitability of Japanese banks. Under such circumstances, the prudent banker listened carefully to advice and guidance from the government, and watched carefully for signals concerning appropriate lending behavior. Meanwhile, the stock market and securities firms were reduced to playing a peripheral and highly speculative game since the market had no impact on either corporate control or behavior. Finally, insurance companies were given a comfortable, profitable, licensed oligopoly and reduced to the position of being suppliers of long-term loans to the same favored industries to which the banks directed their loans.

In a broad sense, the function of the financial system is to provide the connection between savers and those engaged in real investment (that is, those building factories and other productive assets), mediating among differing combinations of risk and return. The rather controlled Japanese financial system appears to have performed this function well in the 1950s and 1960s. Households put their savings primarily in bank deposits (and insurance policies), and the banks lent to industry. The economy grew quickly (suggesting that the financial system did not misdirect funds unduly to unproductive uses), bad loans were minimal, and financial institutions were profitable.

All good things come to an end eventually. For Japan, the natural consequence of prolonged economic success was a slowdown of the economy from the 1970s when it had largely caught up with advanced industrial nations. Ten percent growth and higher is the privilege of successful developing countries, not mature industrial economies. The initial response to slower growth in the 1970s was a rapid increase in government deficits (more accidental than a deliberate Keynsian response to the oil price induced recession of 1974). Rising issues of government bonds to cover the deficits led to resistance from the financial community concerning the low fixed interest rates at which government debt was issued. The ensuing government-industry bargaining process produced a gradual decontrol of interest rates, including, eventually, bank deposit and loan rates. Shifts in profitability among different kinds of banks led to pressures for a gradual lowering of barriers among the various segments of banking. A new foreign exchange control law came into effect in 1980, and under it, controls over foreign exchange were gradually eased.

The process of deregulation, however, proceeded with considerable caution and in a piecemeal fashion, with somewhat mixed results. Slower economic growth implied slower growth in demand for loans to finance plant and equipment investments by large manufacturers. Eager for new areas of business, large commercial banks moved into real estate lending in the 1980s with the explicit encouragement and guidance of the Ministry of Finance. This move was pregnant with moral hazard; for the first time in several decades, the banks were faced with unfamiliar loan clients, combined with the continued assumption of an implicit guarantee (of bank viability) from the Ministry of Finance. Their resulting lack of discretion helped feed the real estate and stock market speculation in the late 1980s, and the collapse of those speculative bubbles has left the banking sector saddled with enormous amounts of non-performing loans and badly tarnished reputations. Estimates of the amount of non-performing loans by 1995 ranged from $200 billion to $800 billion (some of which has subsequently been written off by the banks). Securities firms, meanwhile, have faced exposure of some of their shady practices, including guaranteed returns for favored clients (with Nomura's "VIP" list including bureaucrats and politicians) and payoffs to sokaiya racketeers. The press has been full of a seemingly never-ending stream of new revelations of scandals and bad debts since the early 1990s, involving banks, non-bank real estate institutions, and securities firms. The latest round of revelations (payoffs to a particularly greedy sokaiya) has now unseated the top management of the top four securities firms and a major bank, some of whom have also been indicted.

Japanese financial institutions also used their new freedom to expand rapidly in international markets in the 1980s, only to discover that their highly protected history left them poorly equipped to compete in a highly competitive international arena. They could gain market share through aggressive pricing of loans and other financial services, but lacked the ability or desire to adequately evaluate risk, and they have been retreating from many of those markets in the 1990s. Some of the transactions fueling their move overseas, were, in fact, hardly international. Japanese corporations proceeded to issue bonds overseas because transactions costs were lower and qualifications more lenient than at home, but virtually all of the bonds were purchased by Japanese financial institutions. In the reverse direction, foreign financial institutions rushed into liberalized Japanese markets during the 1980s, only to be disappointed with the plethora of remaining regulations which held transactions costs high and denied them the ability to use many of their competitive advantages in the market.

The New Deregulation Agenda

This accumulation of problems and losses has now prompted consideration of further deregulation. Japanese government officials had been very satisfied with the structure and controlled nature of the financial system as it existed from the 1950s through the 1970s, a satisfaction stemming from both fond recollection of rapid economic growth and their inherent distrust of letting freely operating markets allocate credit in the economy. But the deregulation moves of the past 20 years were largely inevitable and irreversible, and now some officials argue that further deregulation is necessary to yield a new regime that is stable and efficient. This thinking led to Prime Minister Hashimoto's decision to give the deregulation process higher visibility by raising the political rhetoric.

The agenda for deregulation includes a variety of proposed measures affecting virtually all aspects of finance. In June 1997, an advisory council to the Ministry of Finance released a report on deregulation, providing the basic agenda for the "big bang." The primary changes under consideration are:

· Further deregulation of foreign exchange rules (ending the limitation of foreign exchange business to certain commercial banks; easing rules on non-financial firms netting out their exchange positions internally; and easing limitations on individuals engaging in investment overseas).

· Decontrol of brokerage commissions, easing rules concerning trading shares off-exchange, and relaxation of rules concerning the over-the-counter market, all designed to increase competition and lower transactions prices in equity markets.

· Elimination of the securities transaction tax (a proposal not included in the commission's report, but discussed recently as a means to invigorate equities markets).

· Legalization of holding companies, with some restrictions on size and scope (reversing a prohibition in effect since 1947, imposed as part of the effort to eliminate the zaibatsu).

· Legalization of asset backed securities.

· Easing restrictions on derivatives.

· Deregulation of the insurance sector (permitting price competition, allowing greater flexibility in product design, and removing the strict separation of life and non-life insurance companies).

· A general lowering of the barriers separating banking and securities, as well as lowering or eliminating the segmentation among kinds of banks.

The list is actually considerably longer, but many of the other items proposed are either quite minor or rather vague at the present time. Changes in regulations concerning foreign exchange transactions, removal of the holding company ban, and decontrol of brokerage commissions will all begin in 1998, with other moves hopefully occurring over the following three years.

Evaluation

On the surface, the list of proposed changes is quite ambitious and deals with a number of the objections which foreign financial institutions have raised in the past concerning specific obstacles to their own business operations in Japan. But will this deregulation agenda bring about major changes in the operation, efficiency, openness, and stability of Japanese financial markets? Will financial markets more closely resemble those of the United States within a few years? There are actually two interrelated questions here, because what is at stake is not just alteration of financial sector rules, but changes in corporate governance in the non-financial sector as well. Will non-financial corporate behavior also change in a manner consistent with the needs of deregulated financial markets? While the proposed changes are a useful step forward, there are substantial reasons to be cautious or skeptical in evaluating the potential outcome.

Political Will. Is Prime Minister Hashimoto, the Liberal Democratic Party (LDP), or the Ministry of Finance truly committed to a major reformulation of financial markets and institutions? The Prime Minister and the LDP have an overriding concern with restoring the numerical majority of the party in the Diet. One could argue that the appearance of change, action, and progress is sufficient for that purpose--or at least that Hashimoto and the leadership of the party believe it is sufficient. To that end, a variety of regulatory changes in the piecemeal tradition of the past 20 years, partially emasculated in implementation by administrative rulings, could be sufficient to provide the appearance of aggressive leadership. Similarly, administrative reform characterized by a reshuffling of the ministries without altering the fundamental relationship of the state to the people may be sufficient to give the appearance of bold leadership. Such cynicism may be over done, but Japanese politics of the past 50 years is littered with far more examples of such posturing than of real change.

Optimists note that Hashimoto has been quite outspoken on both deregulation and administrative reform, a contrast with most prime ministers in the past decade. Nevertheless, one wonders whether a politician who has been associated throughout his career with the most conservative wing of this political party can truly transform himself into a champion of progressive changes.

Similar reservations apply to the bureaucracy. The Ministry of Finance has endorsed a gradual deregulation process in the past 20 years, but shows few signs of truly endorsing an American-style framework for finance.⁽¹⁾ For reasons explored below, such a system would require further changes beyond what is contemplated in the current round of reform.

Rhetoric and Reality. Related to the above point, Japan often presents a dilemma in sorting out the reality from the rhetoric. One should always be cautious about accepting changes at face value. The current case in point is the deregulation of foreign exchange control slated to go into effect next April. This change is being touted by the Japanese government as a major development, one which will decontrol a variety of international transactions. Optimists envision more competitive markets driving down the cost of foreign exchange transactions, as well as a possible large capital outflow as it becomes easier for individuals to invest overseas.

Current rhetoric is rather reminiscent of 1980, when Japan passed a major new foreign exchange control law, which reversed the underlying principle of "controlled unless explicitly permitted" (included in the 1949 Foreign Exchange Control Law) to "permitted unless explicitly controlled" (a change which a few misinformed journalists are now attributing to the changes coming into effect next year). Changes at that time did lead to a surge in capital outflow, especially since controls over investment abroad were eased more rapidly than those on investment into Japan. By the mid-1980s, though, most significant official constraints on capital flow in either direction were gone.

If Japan undertook major foreign exchange decontrol 17 years ago, what is left? Actually the process has been a more gradual one; the 1980 law ratified a series of administrative changes which had already been made in the 1970s and paved the way for other deregulation measures in the early to mid-1980s. But the reality is that most foreign exchange transactions are no longer regulated in any meaningful sense, so the new law and rules coming in to effect next year will make relatively little difference.

Restriction of foreign exchange business to authorized commercial banks will be dropped, so that any company--financial or non-financial--can engage in foreign exchange. But over 160 banks are currently authorized to engage in this business; it is unclear that expanding the number will really inject much more competition into the market. Proponents note that convenience stores (Seven Eleven, Family Mart, etc.) could enter the exchange business, but one wonders what difference this would really make (and their daily transaction volume of is unlikely to be sufficiently large to make them a driver of more competitive commission fees).

Firms will be allowed to make domestic transactions in foreign currencies, rather than being required to convert prices into yen as soon as products are imported. A trading company, for example, could buy and import foreign oil and then sell it to domestic power companies in dollars rather than yen. But this involves no clear efficiency gain; all that occurs is a transfer of exchange risk and transaction cost from importers to other companies, which may or may not be a useful change. If the trend were for strong companies to use their market power to push the exchange risk on to smaller domestic firms, then the change could conceivably be detrimental.

Firms will also be allowed to more easily net out foreign exchange internally. This change is particularly puzzling, as many firms have been doing this already. Apparently permission to engage in this internal netting is discretionary on the part of the Ministry of Finance and will now become universal. One presumes, however, that most firms which have been heavily engaged in external transactions have been doing this for years.

Finally, individuals will be allowed to hold foreign financial accounts. Here is another puzzling development, since some Japanese do exactly this already. Pessimists argue that this permission will lead to a rush of capital abroad, as individuals shift their financial portfolios to include more foreign assets in order to take advantage of higher interest rates. Since overseas investments involve exchange risk, which individuals are not in a position to hedge, this prediction is extremely doubtful. At least this change makes it easier for American and other foreign financial institutions to offer foreign mutual funds and money market funds to Japanese investors (although some of this is already permitted). But even this small change is being undermined; the Ministry of Finance has announced new and onerous reporting requirements for any individual moving more than ¥2 million (currently the equivalent of $16,000) into or out of the country. This reporting requirement would require, for example, families of all Japanese students matriculating at Berkeley (and any other U.S. university) to report their tuition payments! These rules are likely to have a chilling effect on individual portfolio behavior.

Thus, a deregulation measure touted as a significant piece of the "big bang" will turn out to be relatively minor in significance despite considerable effort by the Ministry of Finance and the press to convince the public otherwise. One worries that many of the other proposed changes be characterized by a similar disparity between the public relations claims and reality.

Financial Institution Personnel Practices. Whether Japanese financial institutions can or will shift their internal human resource management practices successfully to meet the new challenges of deregulated markets is entirely unclear. Japanese corporations--both financial and non-financial--have strongly favored management personnel systems in which individuals rotate broadly through the organization rather than becoming specialists. But complex financial markets require high levels of specialized expertise at odds with this practice. Furthermore, understanding the complexities of financial markets requires strong mathematical skills not emphasized in Japanese financial institutions. Decisions have been based to a large extent on personal relationships with clients (and internally with colleagues) rather than on careful quantitative analysis, as is the case throughout the Japanese economy. These kinds of entrenched personnel practices and management behavior patterns are not easy to change, especially since they are at the core of what many Japanese believe is the essence of their brand of capitalism.

Current practices lead to moral hazard. Specialists are supervised by managers who do not understand what the specialists are doing. As in the case of Daiwa Bank's $2 billion losses in New York, inability to understand what employees are doing opens the door for egregious problems.

The other side to this problem is the pattern of positive and negative incentives for employees. As a crude generalization, Japanese financial institutions appear to be excessively biased toward negative incentives. Managers are afraid of making mistakes, leading them to be overly cautious. If their caution yields poor business results, they can escape blame by demonstrating that they behaved in a standardized behavior, such as lending to long-term clients. Traders, meanwhile, are generally not rewarded (or not very much) for their actual market performance. For them the fear of showing a loss predominates (leading to the increasingly desperate behavior of the individual who eventually lost the $2 billion for Daiwa bank). Traders need a monetary incentive to encourage positive performance and they need the leeway to make short-term mistakes without punishment or fear. In markets with risk, traders will not win all the time, but the Japanese incentive structure appears to insert too much concern about admitting losses.

Optimists believe new competitive will cause financial institutions to remedy both their personnel rotation policies and employee compensation policies. Nevertheless, these behavior patterns are deeply embedded in Japanese corporate behavior and could prove to be very difficult to change.

Disclosure. If financial markets are to operate on the basis of dispassionate risk analysis rather than personal relationships, markets and financial institutions need access to accurate and relevant corporate information. The general lack of detailed financial or other information concerning Japanese corporations is infamous, and little is happening to change this problem of non-transparency. As with personnel practices, this problem is very deeply imbedded in the fabric of Japanese society and corporate behavior. Information does not flow as freely as in the United States, and it tends to run in specialized channels characterized by close personal or corporate ties. Corporate annual reports in Japan convey relatively little useful information, and official financial filings are little better.

As part of current deregulation changes, corporations are supposed to change their accounting practices from registering assets at purchase cost to current market value, but this is only one of many changes that would be needed to provide markets with adequate information to evaluate risk and potential returns.

The existing system has relied upon corporate oversight by two groups presumed to have detailed and accurate insight in to corporate behavior: government and the "main" banks. Government, with its intrusive daily interaction with corporations is often assumed to possess sufficient information and expert understanding to provide administrative guidance. The whole structure of postwar Japanese development presumed that government is capable of playing such a role (diminishing the need for a private sector information market to supply details to financial market participants). The "main" bank for a corporation (the bank from which the corporation borrows the most, a privileged long-term relationship) is also supposed to know more about the inner workings of the corporation than other creditors. In times of trouble, the main bank takes the lead in restructuring the corporation, including dispatch of its own officers to take over management.

Such a system has fundamentally different information flows than a market-based system. Confinement of much of the relevant information to government and main banks yields a very non-transparent system and the Japanese system has been entrenched for so long that the market for information on Japanese corporations is very poorly developed. One of the few independent risk analysis voices in Japan, Mikuni and Company (the only truly independent Japanese bond rating agency), for example, has been harassed by the Ministry of Finance for the past decade. The other source of information of corporate behavior has been the sokaiya, albeit motivated by bribery more than efficiency, and the current attack on the sokaiya actually holds the ironic possibility that less information on corporate behavior will become known to market participants.

Will a vigorous market for corporate information spring into existence as a result of the "big bang?" There are few signs that it will. Consider, for example, proposed changes in bank inspection, a function currently held by both the Bank of Japan and Ministry of Finance. Administrative reform may yield an "independent" bank inspection agency separate from the Ministry of Finance. But neither the MOF nor the Bank of Japan is comfortable with this notion because of a fear that much of the truly important information resulting from an inspection is held personally by the inspector rather than available in the resulting report. Sharing of information, even across agencies of the government, is a problem. Therefore, either the MOF will vigorously block creation of the new agency, or dominate the new organization to ensure that it can obtain relevant information.

Corporate Governance. If financial deregulation is to have real meaning, it would be necessary for non-financial corporate governance and behavior to shift significantly. Behind the existing system lies the practice of "stable stockholding," wherein some 70 percent of corporate equity is held by other corporations for the purpose of cementing long-term business relationships and preventing hostile takeovers. In addition, corporate boards of directors are composed almost entirely of managers in the firm, depriving the board of any function as an external voice representing the interests of share holders.

As long as this pronounced pattern of stock holding and corporate board composition continues, the stock market plays little real role, as corporate behavior does not respond to fluctuations in share prices. Companies in the United States performing poorly experience falling share prices on the stock exchange leading to either pressure from the board of directors and/or the possibility of a takeover. None of this occurs in Japan.

Optimists believe that banks, permitted to own up to five percent of the equity of other corporations (most of it held as long-term stable holdings), will be forced to sell off these large holdings of shares because deregulation implies a more competitive market (creating an environment in which they cannot afford to hold shares for essentially uneconomic reasons). However, it is far more likely that those shares, if actually sold, would be placed with other friendly corporations, with little change in the overall pattern. If some 70 percent of all corporate equity remains locked up in such holdings, the stock market's role in the economy will not become more significant.

Absent a role in influencing corporate behavior or shifting corporate ownership, and relegated to trading a minority of issued shares, the market will remain susceptible to stock "ramping" and other scandals which have characterized past behavior. While the proposed changes in the stock market (such as decontrol of brokerage commissions) might make the market more attractive, the fundamental nature of the game will not change.

Holding companies. One of the principal changes in the "big bang" is the legalization of holding companies, with some limitations on size and scope. Ideally, they will provide a mechanism to inject greater flexibility into corporate structure and performance. However, expectations that the legalization of holding companies will lead to a more active repackaging of corporations for the sake of efficiency are overblown.

In the financial sector, the new holding company format will provide the vehicle for institutions to enter new fields of business previously denied them, such as banks entering insurance. Although the holding company structure for owning and managing such subsidiaries may be new, the notion of entering new lines of business through subsidiaries is not. The jusen were subsidiaries of the large commercial banks, and provide a cogent example of the potential for mismanagement (or deliberate malfeasance) by parent firms.

For non-financial firms, optimists believe that holding companies will provide corporations with a mechanism to acquire or expel individual business divisions in response to pressures to restructure in a more efficient manner. In the past, Japanese corporations have had a tendency to maintain poorly performing divisions for years, on the excuse that they were valuable as part of a long-term business strategy. A holding company format would theoretically provide Japanese firms with a means to behave more like American corporations. But underlying the lack of acquisitions and divestitures in Japan has been strong a social constraint on personnel practices. A firm that acquires another has virtually no ability to downsize the workforce or greatly alter upper management, and there is no sign that this situation is changing. Therefore, it is unlikely that the new holding company format will lead to any burst of effective corporate restructuring.

Real Estate. Little is being done to alter the inflexible nature of real estate markets. Banks have been writing off some of their bad loans, but little of the property securing those loans has actually been sold. Real estate markets continue to be burdened with inefficient zoning rules, heavy transactions taxes combined with very light property taxation, inadequate ability to remove tenants, and other problems. Absent changes to truly unleash real estate transactions, innovations such as asset-backed securities will probably have little impact in improving efficiency or reducing the underlying risk involved in real estate financing.

Bilateral negotiations. All of the talk concerning deregulation remains at odds with Japanese government behavior at the bilateral bargaining table. Insurance industry deregulation is being touted as a major part of the financial "big bang." But the changes to be implemented in the insurance sector required long and often bitter negotiations between Japan and the United States over a long three-year period. Without heavy American pressure, the internally generated "big bang" would have fallen far short on allowing price competition, product innovation, and new marketing techniques.

The resulting agreement at the end of 1996 in insurance was actually a rather positive development, and may lead to real changes in one of the most regulated parts of Japanese financial markets, and as such, should be welcomed as a significant part of financial deregulation. Nevertheless, this example should be a sobering lesson in the distinction between what Americans think constitutes deregulation and what Japanese government and private-sector interests believe. Thus, even if Prime Minister Hashimoto were being sincere in the drive for deregulation, the boundary of feasible changes in the absence of specific foreign pressures is likely to be far narrower than what Americans feel is desirable or necessary to produce efficiency and stability.

Risk Aversion. Financial deregulation presupposes a population willing to take advantage of the changes--individuals willing to acquire the new financial instruments that should become available. But the Japanese public remains distinctively risk averse in its investment decisions, keeping a high share of its savings in the form of bank account. In 1995, Japanese households held a very large 62 percent of their total financial assets in the form of cash and bank deposits (compared to only 19 percent in the case of American households).⁽²⁾ Furthermore, one third of bank deposits were deposits in the government's Postal Savings system (the lowest risk of all possible investments). It is not at all clear that households will jump at the opportunity to broaden their savings portfolios to include asset-backed securities, foreign mutual funds, derivatives, and other innovations.

In the absence of an eager household sector, financial deregulation could leave Japan still characterized with a high degree of intermediation, in which the holders of the new financial instruments appearing in the market are mainly the banks. Expansion of the corporate bond market in the 1980s followed precisely this pattern; as the corporate bond market was gradually decontrolled, the primary purchasers of corporate bonds were banks, resulting in little alteration in the real flow of funds, the way institutions evaluated risk, or the criteria for investment decisions. In Japan, 77 percent of corporate bonds are held by the banking sector (47 percent by commercial banks and 30 percent by government-owned financial institutions) and only 10 percent by households. In the United States, banks hold only 5 percent of corporate bonds, households 4 percent, and non-bank financial institutions 80 percent (representing investment banks, providing indirect ownership for households through money market and mutual funds).⁽³⁾

At the very least, alteration of household investment patterns will require increased public confidence in the stability of the new financial instruments. But many of the new innovations imply a higher expected return at higher levels of risk, and it remains entirely unclear whether the public understands the trade off between risk and expected return or is willing to accept it. Availability of a wider range of financial instruments with varied risk/return attributes is certainly an obvious and welcome step in the right direction on the supply side. Demand for them, though, is equally crucial for the reforms to have much meaning.

The International Perspective

What does the "big bang" imply for the United States, China, and Japan's international financial activities? At this point in time, there are few answers, but plenty of questions.

Perhaps most the fundamental question is international financial stability. International systemic stability can be a highly technical issue. But at a simplistic level, one can argue that Japanese financial institutions affected international markets adversely in the 1980s. Because they failed to evaluate risk adequately, they damaged their own financial health and caused inappropriate pricing of international financial assets. As noted by one market participant of the 1980s: "no matter which [overseas] market the Japanese entered, they distorted realistic relationships and accepted low returns."⁽⁴⁾ Eager Japanese banks ended up holding a huge 50 percent of short-term Mexican international debt in 1982 (and thereby were the ones capable of driving Mexico into default because of the short due dates). In the United States, Japanese financial institutions lost as much as $800 billion in the decade from 1985 to 1995 from exchange losses, real estate losses and other mistakes. Now Japanese banks may be over exposed in Southeast Asian markets.

Financial markets provide sophisticated and complex arrays of risk and return. To function properly, it is necessary that markets clear in a realistic manner. When one set of players, such as Japanese financial institutions, distort the pricing of these markets, then the signals provided by the market are incorrect and potentially damaging (attracting too much capital to some investments and too little to others). Japanese financial institutions appear to have done exactly this during the 1980s.

The question now is whether the "big bang" reforms will correct this problem. In some sense, the problem may be resolved even without the reforms. Japanese institutions were so badly damaged in their foray into international markets, that they have retrenched and are proceeding more cautiously. However, in the longer run, problems may remain. Few executives have been punished for the serious lapses of the recent past. At Daiwa Bank, the individual trader responsible for losing $2 billion has gone to jail, but the bank and the Ministry of Finance joined ranks to ensure that responsibility would be confined solely to him. The managers who should have known (or did know) what was happening have not been punished. Furthermore, as noted above, the underlying personnel practices yielding inadequate oversight are not changing.

This question matters because of the size of continuing net and gross capital flows from Japan to the rest of the world. In 1997, Japan's current-account surplus is likely to be approximately $100 billion, and even larger in 1998. In balance-of-payments accounts, net capital flow is equal in size to the current account, so that the net flow of capital from Japan to the rest of the world in 1997 will be roughly $100 billion. Gross flows are even larger. In 1996, when Japan's current account surplus was ¥7.2 trillion (approximately $64 billion at 1996 exchange rates), the gross outflow of private capital was ¥14.6 trillion ($135 billion) and the gross inflow was ¥11.6 billion ($105 billion).⁽⁵⁾ Most of this investment is portfolio investment (bank loans, bond purchases, and portfolio equity investments) rather than direct investment. If Japanese financial institutions do not improve risk analysis, then they possess the potential of continuing to interject inappropriate financial asset pricing into international markets. Is the possibility of continued inefficient Japanese financial behavior sufficient to undermine international financial stability? No answer is offered here, but the question is worth asking.

Risk would be reduced if a higher proportion of Japanese international capital flow moved through foreign financial institutions with stronger analytic capabilities. Presumably some of the changes included in the "big bang" will provide foreign institutions with greater opportunities to handle portions of this flow. For example, changes resulting from the 1995 financial services agreement between the United States and Japan permits foreign institutions to participate in the investment of social security funds. Currently, American investment banks are quickly developing financial products for individuals to enable them to invest overseas. However, how much of the international flow of Japanese money will move through foreign institutions remains entirely unclear, and the Ministry of Finance does not appear to be very eager to use deregulation as a means to enhance the role of foreign financial institutions. The extent to which foreign financial institutions can penetrate Japanese financial markets and participate in the international flow of capital of Japan, therefore, remains a question with no clear answer.

Newly cautious Japanese banks could end up relying more heavily on servicing non-financial Japanese firms abroad. This phenomenon is common; firms providing corporate services (accounting, advertising, finance, logistical support) tend to follow manufacturing firms of their country abroad. One of the possible implications in the case of Japan, however, is the continued construction of strong keiretsu ties abroad. Finance has been one of the mechanisms for Japanese firms to enforce group loyalty or preference. Japanese banks following Japanese manufacturers to China and other Asian markets are likely to continue this practice (and stories already exist of Asian firms threatened with the loss of their Japanese financing if they shift to non-Japanese or non-keiretsu parts suppliers or sales outlets). In some ways, keiretsu structures enhance economic efficiency, but often the reliance of these long-term relationships becomes simply an excuse to avoid adequate project appraisal. Continued reliance of Japanese banks on their traditional domestic clients as they lend abroad would, in fact, suggest that they have not responded to deregulation by enhancing their risk analysis capabilities. But little information is available on Japanese lending to Southeast Asia, so bank lending patterns remain a question.

Finally, it is worth noting that Japan's efforts at financial reform provide some lessons for China, as that nation grapples with privatization of state enterprises and reform of the financial sector. In recent years, the "Japanese model" has been a popular concept for economic development. Among the primary elements of this model is the use of government guidance over the financial sector. As argued earlier in this paper, Japan appears to have managed a heavily controlled financial sector rather well from the 1950s through the 1970s. Nevertheless, the problems Japan has faced in the past decade and the difficulty in implementing reform of the earlier system provide sobering evidence of the problems endemic to such systems. In providing the institutional framework for nascent equity markets in China or reforming the banking sector, careful consideration of rules matters greatly. The consequence of poorly designed systems is speculative bubbles and collapses, a draining cycle that damages economic growth. Perhaps the lesson of Japan is one of financial policies to avoid.

Conclusion

Japan's "big bang" financial deregulation is a real phenomenon. Some changes are already slated for implementation next year, and much of the rest of the proposed agenda should be in place by 2001. These changes respond to an extraordinary decade in which Japanese financial institutions first created a heady and speculative asset bubble in the economy, and then wallowed in bad debt and scandalous revelations during the 1990s when the bubble collapsed. The United States also experienced a series of financial scandals in the 1980s (the savings and loan bad loan problem, international bad loan problems, and insider trading scandals in the junk bond and other markets). However, the scale of the problems and scandalous revelations in Japan has been truly breath taking.

Meanwhile, a quiet time bomb keeps ticking: the retirement financing for Japan's baby boom generation--due to begin retiring in another 15 years. With unusually low rates of return in post-bubble Japan, the future financial security of this generation is now in jeopardy, as rates of return on their pension funds are well below necessary levels to finance their retirement income. True deregulation of financial markets, coupled with shifts in behavior of both financial institutions and non-financial corporations ought to improve real rates of return by reducing inefficiency and misdirected allocation of capital. This would be beneficial for both future retirees and the overall efficiency and growth of the economy.

But the conclusion of this paper is that the present set of reforms in the financial sector may not be sufficient to remedy the problems in the system. The reforms are certainly a step in the right direction. Competition will be increased, some of the excessive fees and commissions will disappear, new financial instruments will appear, and foreign financial institutions will gain some additional business. Nevertheless, other problems are likely to remain or change only slowly. Internal personnel practices, reliance on personal contacts and long-standing relationships rather than dispassionate financial analysis, and corporate governance patterns will probably change only slowly.

Japanese investment funds matter to China, the United States, and the rest of the world. We are all better off if Japanese savings are invested efficiently at home and abroad. The "big bang" includes a variety of steps which represent useful changes in the correct direction, even if some of them are far more minor that the government claims. But increased rationality and efficiency in Japanese financial behavior as a result of the "big bang" is by no means assured.

Endnotes

1. Consider, for example, that one of the supposed czars of (international) financial deregulation is Eisuke Sakakibara, Director General of International Finance at the Ministry of Finance. His book, Beyond Capitalism: The Japanese Model of Market Economics (University Press of America, 1993), is a paean to the structures of the past.

2. These data are from the flow of funds accounts for Japan and the United states, available in Bank of Japan, Economic Statistics Annual, 1997 edition, pp. 266-267; and Department of Commerce, Statistical Abstract of the United States, 1994 edition, p. 511. Japanese data are for the end of fiscal year 1996; U.S. data for end of calendar 1993.

3. Ibid.

4. Eugene R. Dattel, The Sun That Never Rose (Probus Publishing Company, 1994), p. 90.

5. Bank of Japan, Balance of Payments Monthly, April 1997, pp. 1,33, 49. Note that beginning in 1996, the government of Japan ceased publishing its balance of payments data in dollars, and does not even include a table of exchange rates in its balance of payments publication. This has made international comparison more cumbersome. The figures for capital flow presented here do not yield a net capital flow equal to the current account surplus. The difference comes from the movement in official foreign exchange reserves (which increased by ¥3.9 trillion--$35 billion--a very large amount) in 1996 and "errors and omissions" which showed an inflow to Japan of ¥131 billion ($1 billion).