No. 25 — June 30, 2000


Weekly Review

--- by Jon Choy

Financial industry executives and regulators in Japan have worked long and hard to make the country's financial markets a center of global activity. Not only was this development seen as a natural consequence of Japan's position as the world's second-largest economy, but such an outcome also was considered vital to the nation's continued industrial strength and future growth. Achieving this goal, however, has been anything but simple. Close ties between government regulators and businesses as well as myriad laws and rules have greatly complicated and retarded the process of internationalizing Japanese financial markets. Recent events show how far the country has come in its quest and the distance that still must be covered.

Equity funds - Tired of the record-low rates of return earned by traditional savings instruments and worried about how to finance such major expenditures as education costs, home purchases and retirement, savers are pouring money as never before into investment trusts (Japanese-style mutual funds). Although this vehicle has been around for several years, recent changes in laws and the tax code have made it more attractive. The market value of investment trusts was a little more than ¥11 trillion ($100 billion at ¥110=$1.00) at the end of 1998, when no single fund had more than ¥200 billion ($1.8 billion) in assets. By the end of 1999, in contrast, the total had jumped to nearly ¥16 trillion ($145.5 billion). Moreover, seven funds topped the ¥200 billion ($1.8 billion) mark and several more were flirting with this amount.

Since the start of this year, savers have accelerated the shift of money into equity investment trusts. In February, for example, it took Nomura Securities Co., Ltd. just three weeks to pull in more than ¥800 billion ($7.3 billion) for a new open-ended fund. Since then, assets have risen to a hair under ¥1 trillion ($9.1 billion), encouraging Japan's top brokerage house to double the marketing goal for the fund to ¥2 trillion ($18.2 billion). With the Ministry of Posts and Telecommunications estimating that the postal savings system will lose as much as ¥49 trillion ($445.5 billion) in long-term deposits by the end of FY 2001 (see JEI Report No. 15A, April 14, 2000), equity fund managers are occupying the catbird seat.

Private equity funds, which invest only in companies that are not publicly traded, also have appeared on the scene. Goldman Sachs Group, Inc., Morgan Stanley Dean Witter & Co., Advantage Partners, Inc. and other investment bankers have tied up with local partners to launch a handful of private equity funds. While institutional investors have made this vehicle very successful in the United States and in Europe, some analysts question whether it will do as well in Japan where information on privately held firms is harder to unearth.

Partly in response to this concern, the Japan Securities Dealers Association recently proposed new disclosure rules for companies that offer their shares on the so-called green-sheet market. Opened in July 1997, this market is analogous to the pink-sheet market in the United States, which handles trades in over-the-counter stocks not included in the daily NASDAQ listing. As of early 2000, the shares of 42 privately held companies were being traded by 17 brokerages on Japan's green-sheet exchange. JASDA wants to raise this number by attracting venture enterprises and venture capital firms. It is touting the green-sheet market's less-demanding listing conditions and new, comprehensive reporting rules.

Fund advisers - Not surprisingly given the huge sums of money up for grabs, domestic and foreign financial firms of every type are setting up investment advisory operations. The Security Analysts Association of Japan reports that the number of certified financial analysts continues to increase every year. From just 2,268 in 1990, the size of this profession reached 8,502 by 1995 and hit 13,541 at the end of last year. Fund management firms — themselves experiencing a population boom — are casting a wide net for skilled employees. Many foreign firms are rushing into the market in the hope of securing even a small slice of the fast-expanding pie.

OTC market - After languishing for several years, the OTC market has become white-hot, thanks to the frenzied interest in venture start-ups — particularly Internet-related ones — and the establishment of three new trading systems. Last November, the Tokyo Stock Exchange opened the Market of High Growth and Emerging Stocks, commonly known as MOTHERS, to great fanfare (see JEI Report No. 42B, November 5, 1999). The Sapporo Stock Exchange launched its "Ambitious" market for high technology start-ups April 7. And June 19, eight local firms offered their shares to investors on NASDAQ Japan, Inc.'s new OTC system. Each of these markets has easier listing requirements than Japan's premier bourse, the TSE. All three hope to attract technology companies with the potential for strong growth.

While the new exchanges are well-timed in terms of the increasing demand for high-return/ high-risk investments and the need for venture business financing, their track records to date have been less than inspiring. MOTHERS, in particular, has highlighted the drawbacks of this type of investment. Initially, things went as hoped: the prices of MOTHERS companies rose far above their initial public offering prices. But since February, the heat has seemed to escape from the market and prices have fallen below IPO levels. When Web site designer Livin' on the EDGE Co., Ltd. became the seventh stock to trade on MOTHERS April 6, its shares closed the first day at ¥4.4 million ($40,000) each, 27 percent below the IPO price of ¥6 million ($54,500). Citing poor prospects, other companies have postponed plans to list on MOTHERS.

Similarly, NASDAQ Japan — a joint venture of the National Association of Securities Dealers, Inc. and Softbank Corp. that has the backing of the Osaka Stock Exchange — enjoyed an initial burst of interest when trading began. Without "star" companies on its board, however, subsequent activity has been muted. Analysts expect this to change as Softbank's many affiliates list their shares on the new OTC market and as NASDAQ Japan integrates its trading operations with the American NASDAQ market and the impending European NASDAQ market. NASDAQ officials not only plan to computerize many market functions now conducted by brokers — such as limit orders — but they also hope to offer round-the-clock trading by linking the American, Japanese and European OTC exchanges.

Japan's entrenched OTC market, JASDAQ, is fighting back. The securities dealers group has decided that JASDAQ's management must be given a freer hand to innovate and boost efficiency. To achieve this, JASDA will transfer control of JASDAQ to affiliate Jasdaq Market Services Inc., which will seek outside investors to provide up to two-thirds of its equity. However, JASDA will continue to monitor the market after the switch occurs to guard against unfair or illegal trading. The new JASDAQ is scheduled for launch in January 2001.

ECNs - Electronic communications networks, or private systems for the direct trading of stocks, have enjoyed spectacular growth in the United States. ECNs cut out the middlemen — in this case, brokerage houses — by linking buyers and sellers directly. New York-based electronic broker, Inc. and its largest investor, Softbank, hope to launch Japan's first ECN as early as this summer. A competing group of 11 brokerage firms plus Mitsui & Co., Ltd. aims to open a rival ECN this fall that will focus on after-hours trading.

Fixed exchanges - Japan's traditional fixed exchanges are revamping their operations to respond to the competition from the new or planned OTC and ECN exchanges. As noted, the TSE already has opened MOTHERS to compete with the local version of NASDAQ. To counter the threat posed by 24-hour trading, TSE officials are holding meetings with representatives of more than 10 counterparts around the globe, including the New York Stock Exchange and top European bourses, to discuss plans to link their activities for continuous trading.

The recent decision by Nihon Keizai Shimbun, Inc., which controls the Nikkei 225 average of stocks listed on the TSE's first section, to shuffle the composition of this benchmark (see JEI Report No. 17B, April 25, 2000) has caused unforeseen problems. On relatively short notice, Nikkei said that 30 companies included in the Nikkei 225 would be shifted April 24. The idea was to replace these representatives of traditional, slow-growth industries with an equal number of high technology companies.

The announcement sent brokerages and investors scrambling to reconfigure their portfolios to match the new index components. The problem was that the shares of the replacements were less numerous and more expensive than those of the companies being dropped. Analysts calculated that the new Nikkei 225 firms had a combined market value of ¥80 trillion ($727.3 billion) while that for the old ones was just ¥900 billion ($8.2 billion). In order to buy shares of the firms new to the index, investors had to come up with cash or credit, causing a sell-off of other shares to raise money and a sudden jump in margin trading.

Not only did the adjustment process disrupt the market, but the change also detracted from the Nikkei 225's worth as a gauge of the TSE's historical performance. Analysts still are working on ways to compare the post-April 24 market with its predecessor. Some observers are urging that the Topix index, which is based on the value of all shares listed on the TSE, be used as the bellwether indicator.

Of even greater concern is the fact that the compositional change made the TSE more vulnerable to the vagaries of high technology stocks. The TSE began experiencing bigger swings based on the performance of the NASDAQ, which influences technology stocks around the world. Shares of firms in the information and related technology fields generally are more volatile than those of "old economy" companies because their fortunes can turn solely on the success of a new product or service or the introduction of a competing one.

Analysts say that the change in the index components and the enhanced impact of volatile high technology shares are two factors behind the Nikkei 225's disappointing performance since the end of March (see Figure). Because the NASDAQ market is in the midst of a correction, the Nikkei 225 has followed suit, experiencing large one-day losses (or gains). Government and TSE officials have put on a brave face, arguing that the Nikkei 225's slide does not reflect the economy's improving fundamentals.

Besides all the new options for making money, individual investors are saving money as a result of lower brokerage and trading fees. The price-cutting war between traditional brokerage houses and firms that conduct business by telephone or on-line is particularly furious. Nonetheless, Japan's securities industry reported strong profits for FY 1999 and released an upbeat forecast for the current fiscal year.

Recent events highlight the fairly rapid evolution of Japan's capital markets. Without question, though, a regulatory framework that is far out of step with current needs hampers an ongoing transformation. The Commercial Code has been identified in particular as the source of key obstacles. The code sets hard rules for such things as the minimum face value of shares (¥50,000 or $450), the minimum number of shares that can be issued, the minimum capitalization of firms hoping to list their shares and a multitude of other details. Analysts say that these conditions prevent small companies and start-ups that cannot meet the minimums from tapping capital markets. Documents supporting an IPO also must be submitted in Japanese, a demand that foreign firms say makes listing in Japan relatively less attractive.

Current rules also have more subtle effects. Regulations barring the offering of shares at less than face value and the trading of shares before they are issued make stock splits problematic. Moreover, even though the rules recently were liberalized, companies that want to offer stock options as part of their compensation packages still must complete a convoluted process and then face many limits on the distribution of these rewards/inducements. Both Japanese and foreign firms are interested in a rewrite of the relevant sections of the Commercial Code — a mammoth yet critical task that has just begun.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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