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Can Japan Put Its Wealth to Work?

Reformers are agitating for a Japanese sovereign wealth fund.

At a time when countries like China, Singapore and South Korea have been building up sovereign wealth funds to maximize returns on their bulging surpluses, Japan stands out as an anomaly in Asia. The country boasts by far the biggest pools of capital in the region, with foreign exchange reserves second only to China’s, at $971 billion, and ¥150 trillion ($1.4 trillion) sitting in the Government Pension Investment Fund. But Japan has largely failed to put those massive resources to work effectively. The Ministry of Finance and the Bank of Japan plow the bulk of the currency reserves into U.S. Treasuries in a bid to prevent a sharp decline in the dollar and maintain the competitiveness of Japan’s exporters, while the government plows most of the pension fund into Japanese government bonds to finance the state’s enormous debt.

Pressure for change is building rapidly, though. In May a study group of legislators from the ruling Liberal Democratic Party proposed that the government take ¥10 trillion from public pension funds to launch a sovereign fund in a bid to juice up returns. Separately, the Council on Economic and Fiscal Policy, a government advisory body, in June issued a report calling for major reforms in managing the GPIF to improve performance after the giant fund disclosed a loss of ¥5.7 trillion — equivalent to 3.8 percent of assets — in its fiscal year ended March 31. It had generated an average annual return of just 3.5 percent during the preceding five years.

Yuji Yamamoto, the former Financial Services minister who headed the LDP study group, says Japan needs to radically change the way it manages its public assets if it is to avoid higher taxes or an increase in the national debt. If the GPIF had been able to match the 9 percent average annual returns of the Canada Pension Plan over the past five years, “Japan could have gained an extra ¥36.7 trillion,” Yamamoto told Institutional Investor in a recent interview at his Tokyo office. “Our goal now is to expose why returns on the GPIF are so small. No one is showing any interest in whether the [fund] produces plus or minus returns. No one takes any responsibility.”

Japanese politics have been in turmoil since the surprise resignation of prime minister Yasuo Fukuda in September. Taro Aso, who had been serving as Foreign minister, was elected by the LDP to succeed Fukuda after he pledged to revive Japan’s economy, which contracted at a steep 3.0 percent annualized rate in the three months ended June 30. He pushed a ¥1.81 trillion supplementary budget through Parliament last month to stimulate the economy. The economic arguments for raising returns on Japan’s giant public pension fund should be persuasive to Aso, advocates of a sovereign fund contend. The new Finance minister, Shoichi Nakagawa, has in the past advocated that Japan use some of the income on its foreign exchange reserves to seed such a fund.

Because of its aging population, Japan is in a bind: The number of people qualifying for pension benefits is increasing rapidly while the number of young people contributing to the funds declines. Successive governments have raised the retirement age and increased pension contributions but haven’t succeeded in averting a funding crunch. The Fukuda government had proposed increasing its contribution from one third to one half of total premiums by next April, but it couldn’t do so without raising the unpopular national sales tax. Aso’s government has indicated that it has no plans to increase the tax, which stands at 5 percent. Higher returns, if they can be achieved, would offer the easiest way out of the funding problem.

“Management of our pension fund reserves must be improved,” says Shijuro Ogata, former deputy governor for international affairs at the Bank of Japan. He bemoans the “very low return on their investment in financial assets and their often worthless investment in athletic stadiums, parks and other buildings.”

The LDP group recommends seeding a sovereign fund with ¥10 trillion from the public pension fund as a first step. If successful, the fund could draw more money from the pension fund and eventually manage some of Japan’s foreign exchange reserves, say backers.

The GPIF is responsible for investing and administering the reserve funds of Japan’s two main public pension pools, the Employees Pension Insurance Scheme and the National Pension Scheme. Everyone over 20 is obliged to join the latter; the employee pension fund covers all private sector workers. The loss in the most recent fiscal year, which reduced cumulative gains on the GPIF since its inception in 2000 to just ¥7.4 trillion, was a result of the downturn in global stock and bond markets, according to GPIF officials, but some analysts found this puzzling, given the composition of the pension fund’s portfolio. It is currently invested 67 percent in Japanese government bonds, 11 percent in domestic stocks, 9 percent in foreign stocks, 8 percent in foreign bonds and 5 percent in short-term assets. The Ministry of Health and Welfare decides asset allocation under a medium-term plan every five years.

The biggest impediment to change is the use of the public pension funds as a captive source of financing for the government’s massive bond debt, which stands at nearly ¥800 trillion, or 150 percent of GDP. The problem is endemic in the Japanese financial system. The country’s vast postal savings and insurance network, which is undergoing a decadelong privatization, has more than a third of its ¥200 trillion of assets in government bonds. A large part of Japan’s colossal ¥1,500 trillion in household savings is also invested in government bonds, either directly or through banks and pension plans.

“We should never forget that Japan has had one of the very biggest sovereign wealth funds in the world. What else should we call the postal savings and insurance system?” says Jesper Koll, president and CEO of Tantallon Research Japan, an arm of Singapore-based hedge fund manager Tantallon Capital Advisors. “The problem is that Japan’s SWF was focused on buying domestic assets, Japanese government bonds and building infrastructure. It reflects how entrenched the old way of doing business and managing national savings still is.”

Advocates of a sovereign fund acknowledge that any large-scale shift out of government bonds could put upward pressure on interest rates — a major reason officials at the Ministry of Finance are cool on the proposal. But LDP study group head Yamamoto argues that Japan can avoid the risk of higher rates by diverting only a modest portion of the public pension funds into a sovereign fund initially. “If we make changes gradually, it should be fine,” he insists. Yamamoto predicts that legislation to create a sovereign wealth fund will likely be presented to Parliament late this year or early next.

Other advocates of pension reform believe the government could boost returns without resorting to a sovereign wealth fund. “There is a lot of room to improve the performance of GPIF even with the current share of government bonds held by the fund,” says Takatoshi Ito, a former senior Finance Ministry official who sits on the Council for Economic and Fiscal Policy, an advisory body established in 2001 by then–prime minister Junichiro Koizumi. “The first thing to do is to reform the GPIF and make it into a more professional and independent organization. We should set up a responsible investment committee and let them decide what to do.”

The GPIF is what is known as an incorporated administrative agency, and as such it faces a variety of institutional constraints, the council says in its report. “Strict restrictions are imposed on its management activities, [and] this obscures responsibility regarding management of public pension fund reserves. Asset managers responsible for investing reserves are supposed to [do so] in a prudent manner, but it is not clear where fiduciary responsibility lies.”

The council proposes overhauling the pension fund by creating an independent agency to make decisions on asset allocation and the selection of external asset managers; the government would confine itself to setting a target for returns. The report also recommends splitting the huge GPIF into several smaller funds, “the size of which is optimal for efficient management in the future.” It suggests starting by launching two funds of ¥10 trillion to ¥20 trillion each to compete with each other transparently. Over time the government could launch more funds, each with its own management committee.

Some restructuring of the funds managed by the GPIF is essential, says Shigemitsu Sugisaki, another former senior Finance Ministry official who is currently a vice chairman at Goldman Sachs Japan. “These funds are too large to be more active,” he says. “They have to have a passive investment policy to buy index funds. Otherwise if they buy a particular stock, they can move it alone.”

In response to growing pressure for better returns, officials at the GPIF said in early July that they may consider investing in alternative assets — including hedge funds and real estate — in the future. “We may consider alternative investments based on whether our risk-return improves by expanding investments to various products,” says Takahiro Kawase, president of the GPIF.

Some industry experts argue that Japan would be better off using its foreign exchange reserves rather than pension fund assets to seed a sovereign wealth fund. The public pension reserves are invested mainly in yen securities and are intended to meet yen-based liabilities, notes John Vail, chief global strategist at Nikko Asset Management in Tokyo. Any effort to diversify pension assets internationally would expose the fund to foreign exchange risk. But foreign exchange reserves are denominated in foreign currencies and could easily be redeployed overseas, he contends.

Boosting the return on those foreign exchange reserves by a percentage point would be worth nearly ¥1 trillion, or $10 billion, a year, Vail points out. Returns on the reserves have been running at a rate of about 4 percent, according to the CEFP’s Ito. If Japan had formed a sovereign wealth fund from its official reserves several years ago, it would not need to consider raising taxes now, he says. “At the political levels, it seems like an incredible vote winner if you can say, ‘There’s no need to raise taxes. We’re going to get a better return on your money.’ It is the people’s money after all.”

Despite the potential for improved returns, the idea of using foreign exchange reserves to seed a sovereign fund, as China and South Korea have done, remains highly controversial in Japan.

Senior financial officials say privately that any attempt to diversify reserve holdings away from U.S. Treasuries and other dollar-denominated securities could destabilize the Treasury market and undermine the dollar, harming Japanese interests as well as those of the U.S. “The minister of Finance is worried about taking any initiative on the foreign exchange reserves,” says Yamamoto.

Authorities have never disclosed the composition of Japan’s reserves, but they are widely believed to be held mostly in dollars; Yamamoto estimates that 95 percent are invested in U.S. Treasuries. Some 50 percent of the annual earnings on the reserves are used to finance the government’s general budget.

Yamamoto says the government should reach some kind of an agreement with the U.S. before attempting to divert any foreign exchange reserves into a sovereign wealth fund. “I would like to make sure that any action would not influence the foreign exchange market in both currencies,” he explains.

But other analysts reject the idea that putting the currency reserves into a sovereign fund might jeopardize relations with Washington. China’s relations with the U.S. didn’t suffer when the country launched China Investment Corp. a year ago with $200 billion effectively drawn from its reserves.

Japan can boost returns on its reserves “without damaging the relationship with the U.S., especially if it diversifies dollar fixed income into dollar equity or into strategic stakes in U.S. banks,” says Nikko Asset Management’s Vail. Ito suggests that Japan could avoid destabilizing the dollar or the U.S. Treasury market by diverting the annual interest on the reserves, estimated at about ¥4 trillion, into a sovereign wealth fund.

Japan’s currency reserves are the product of decades of official intervention in the foreign exchange market aimed at slowing the rise of the yen, efforts that stretch back to 1971, when the Nixon administration ended the Bretton Woods system of fixed exchange rates and devalued the dollar. Japanese intervention accelerated after the yen soared following the 1985 Plaza Accord, under which the Group of Seven nations agreed to bring down the value of the dollar. Dollar purchases continued until 2004 as Japan sought to offset the deflationary impact of a stronger yen. The government has ceased intervening for the past four years, but the reserves have continued to grow by virtue of the interest earned on them.

Unlike the reserves of oil-exporting countries, Japan’s are not a free asset for the Finance Ministry because they are matched dollar for dollar by yen liabilities. The ministry has financed its interventions with short-term yen borrowings that must be rolled over continuously. Even today the government makes fresh borrowings to match the dollar interest received on the reserves, keeping assets and liabilities balanced. For a government with a debt exceeding 150 percent of GDP, such borrowings are “a time bomb,” says Ito.

Complicating any effort to change the management of Japan’s reserves is the fact that they are overseen by two often competing bureaucracies, the Ministry of Finance and the Bank of Japan. The central bank owns and manages reserves that date from before 1971. Today it simply acts as an agent for the Finance Ministry in conducting any currency intervention.

The ministry “has only a small number of people involved in management of the foreign exchange reserves,” one senior Bank of Japan official tells II, “whereas we have a relatively large number by comparison with the small size of assets under control.”

Stung by criticism of its management of the reserves and increasing calls for the creation of a sovereign wealth fund, the Finance Ministry announced in July that it would open a new section within its foreign exchange markets division to focus on managing its foreign exchange reserves. The section will add only two new staff to the 16 who now deal with the reserves at the ministry, though.

“There is no change in our policy of prioritizing liquidity and safety in managing reserves before pursuing profitability,” a Finance official tells II. In July the ministry for the first time published guidelines identifying eligible assets for investing the reserves as including central government bonds, agency bonds, supranational bonds and securitized bonds that offer high liquidity, as well as deposits in foreign central banks and financial institutions at home and abroad.

If Japan is going to launch a sovereign fund, the impetus will have to come from outside the government’s powerful bureaucracy.