Wednesday, February 23, 2011

GPIF Worried About Japan's Public Debt?

Chikafumi Hodo and Hiroyasu Hoshi of Reuters report, Japan's giant pension fund warns on nation's debt:

Japan's $1.4 trillion Government Pension Investment Fund (GPIF), the world's largest pension fund, warned the country needs to resolve its debt problems, although, for now, it is sticking to its basic investment strategy.

GPIF Chairman Takahiro Mitani said in an interview with Reuters that Japan's bulging public debt -- the largest among developed countries at double the size of its $5 trillion economy -- would reach a crucial point in five to 10 years if the problem is not resolved.

The GPIF, whose asset size is larger than both the Canadian and Indian economies, is a major force in the Japanese government bonds (JGB) market, where it parks two-thirds of its assets.

The GPIF plans to diversify its portfolio, however, by investing in emerging markets, where its hopes to start channeling funds in the financial year that starts in April.

"We are not thinking of changing our basic portfolio as a result of ratings changes by credit rating companies," Mitani said on Wednesday.

Moody's Investors Service changed the outlook on Japan's Aa2 sovereign rating to negative from stable on Tuesday, warning that government policies may be insufficient to rein in the country's huge public debt.

That warning followed Standard & Poor's downgrade of its rating on JGBs last month, its first such cut in nine years.


Bond markets showed a muted reaction to Moody's action on the view that high domestic savings will provide ample funding for the government for now.

"I don't think investors are making investment decisions based on credit rating companies' actions. Rather, they are watching overall fund flows into JGBs to make their decisions," Mitani said.

Still, it is important for the Japanese government to resolve its fiscal problems, Mitani said, adding that he shared the credit rating firms' views that the country cannot leave the debt situation as it is. He did not elaborate.

The GPIF, which invests the reserves of national and corporate pension plans, held total assets of 117.6 trillion yen as of September.

Its performance in the six-month period to September was a negative 1.5 percent, compared with a positive 7.91 percent for the whole financial year that ended last March.

The fund's performance up until September lagged other major overseas counterparts, such as California Public Employees' Retirement System (Calpers) which posted a positive return of 3 percent, while the Canada Pension Plan Investment Board produced a bigger return of plus 5.2 percent.

Besides Japanese government bonds, the fund also has exposure to domestic shares, foreign bonds and foreign equities.


Mitani said the GPIF was in no hurry to move into emerging equity markets, which have recently lost steam.

A tender to pick fund managers for GPIF's emerging market equities investments closed in December and it has completed its first round of screening, he said.

He expected the entire selection process could take about one year as the fund received a large volume of applications.

The fund decided to take on exposure to emerging markets as they are growing rapidly and offered great potential for future growth, he added.

"We don't have to rush in now as emerging market (equities prices) are in a corrective phase," he said.

"We want to take more time and we want to be more selective in choosing managers."

Mitani said the fund's investments in emerging markets would be gradual and the initial amount would be small.

The GPIF will use the MSCI main emerging market stock index .MSCIEF as its benchmark.

As of September, about more than 9 percent of the GPIF's total assets were in foreign equities.

Maybe Mr. Mitani is looking for a serious correction before plowing billions of dollars in emerging markets (EM). I don't know but I can introduce GPIF to a very experienced emerging markets manager I know here in Montreal who will be glad to consult them for a fraction of the cost they're going to be paying these EM managers they're currently reviewing.

Back to the topic in the article. Kip McDaniel of aiCIO reports, Japan's GPIF Calls on Gov't to Rein in Mounting Public Debt:

Chairman Takahiro Mitani of Japan's $1.4 trillion Government Pension Investment Fund (GPIF), the world’s largest and thus first on aiGlobal 500 listing of the world's largest asset owners, has called on the government to help rescue the nation from its growing debt before it reaches a critical point.

"We are not thinking of changing our basic portfolio as a result of ratings changes by credit rating companies," Mitani told Reuters, noting that the fund aims to diversify its portfolio by increasingly investing in emerging markets. In the six month period to September, the performance of GPIF, which has an asset size larger than both the Canadian and Indian economies, was negative 1.5%, compared with a positive 7.91% for the entire financial year that ended last March.

The statements by Mitani over Japan's burgeoning public debt, amounting to double the size of its $5 trillion economy, follows the decision by Moody's Investors Service to change the outlook on Japan's Aa2 sovereign rating to negative from stable. It also comes about a month after Standard & Poor’s downgraded the government’s sovereign debt rating, with both Moody's and the S&P asserting long-term fiscal unsustainability of the country's debt.

Late last year, the fund came under fire from an Organization for Economic Co-operation and Development (OECD) report. The report, focusing on both governance and investment strategy issues at the GPIF, followed a set of 2006 reforms at the fund. “While much improved,” the report states, referring to previous reforms, “the new governance structure still falls short of international best practices and in some aspects does not meet some of the basic criteria contained in OECD recommendations.”

Among the report’s complaints relating to governance, the GPIF still is not required to put its investment policy in writing, and there remains uncertainty surrounding the issue of whether the fund’s Board sets – or simply recommends – the investment policy. Also concerning to the OECD was the fact that the responsibilities of Chairman of the Board, Chief Executive Officer, and Chief Investment Officer all coalesce in one man – currently Takahiro Mitani. “The lack of a clear separation between operational and oversight roles within the fund is a major problem that goes against OECD recommendations,” the report stated before recommending that the roles be distinct. Furthermore, the report asserted, a more robust staff should be hired.

I'm a stickler for pension governance and believe in transparency, so I don't understand why GPIF's investment policy isn't made public. But when you're the biggest fund in the world, you don't want to start telegraphing your moves in advance. In fact, you can argue that GPIF is too big and needs to be cut into several large funds (Mr. Mitani rejects such proposals). A senior pension fund manager told me that ABP, the large Dutch pension fund, is struggling with economies of scale due to its size. It's not easy for these mega-funds to deliver returns once they cross a certain asset threshold (I've seen this with hedge funds).

As for Mr. Mitani's influence, I believe that it's crucial to segregate senior functions. The President & CEO of a pension fund doesn't have time to be the Chief Investment Officer. I've seen it firsthand and think it's too much responsibility for one person to handle. You want your CIO to be dedicated full-time to investments. Presidents & CEOs have to handle the board and stakeholders on top of heading the fund, leaving them little time to follow markets closely and make tactical investment decisions.

There is little doubt that Mr. Mitani is one of Japan's most powerful men. If he's expressing concern over Japan's mounting public debt, it's because he's worried about what the future holds. There are legions of hedge fund managers salivating at the thought of making a fortune shorting JGBs. Most of them have been slaughtered over the years and will continue getting slaughtered betting against JGBs.

In November 2009, Richard Katz, editor of the Oriental Economist Alert, wrote an op-ed in the WSJ, Now Is Not the Time to Fret About Tokyo's Debts. I quote the following:

Deficit hawks assert that the Bank of Japan will soon lose its ability to keep rates low, arguing that the struggle between the government and private borrowers for limited funds will send interest rates skyward.

The evidence says the opposite: There is no crowding out. The government has not even borrowed enough to offset the decline in private borrowing. Corporate net debt peaked at 117% of GDP in 1990. By 2007, corporations seeking to shed nonperforming loans had reduced their debt to 70% of GDP. Household gross debt, meanwhile, fell to 70% of GDP in 2007 from 82% of GDP in 1999. As a result, the total combined private and government debt peaked in 2000 at 276% of GDP, and has since declined to 244% as of 2007, the latest data available.

Nor is there any lack of buyers for new government bonds, 95% of which are held by domestic investors. The banks need to buy this paper to offset the decline in their core lending business. From 1998 through 2009, outstanding bank deposits rose 17% but bank loans fell 13%. How could the banks pay interest to their depositors unless they bought bonds to earn interest?

The real danger from Japan's debt buildup is not a potential crisis in the government-bond market but corrosion in the real economy. The Bank of Japan will retain both the need and the ability to keep long-term rates very low for the foreseeable future. But this method of avoiding fiscal crisis causes enormous collateral damage.

By lowering the hurdle rate for investment, this action leads firms to pour capital into wasteful projects that temporarily boost demand but end up hurting long-term growth. Consider this decade's binge in new supermarkets, even though total supermarket sales have been flat for years. Then there are all the "zombie" firms kept in business by very low interest rates; 20% of bank loans charge less than 1% interest while 5% charge less than 0.5%.

Japan has been here before. In 1997, a similar debt scare led Prime Minster Ryutaro Hashimoto to raise consumption taxes, plunging the country into deep recession. In 2003, similar panicky storylines spooked the markets. It's easy to see why investors are having déjà vu; Tokyo today is headed toward a budget deficit that's 10% of GDP, and the ratio of outstanding government debt to GDP has hit a record high.

Japan is certainly a deficit addict. Ever since the mid-1970s, a structural shortfall in private domestic demand has compelled the government to sustain decade after decade of deficit spending to make up for that shortfall. Japan's new government says it wants to solve that problem by using government money to raise household disposable income. Yet, fearing today's deficits, policy makers are waffling on that program. Virtually every day various ministers come out with a new and conflicting message on fiscal policy.

Japan's top fiscal priority today should be to use large budget deficits—spent on the right things, such as child care allowances, free high school tuition, connecting suburban houses to sewage lines and consumer-oriented tax cuts—to ensure recovery. With many economists anticipating economic softness in the first half of 2010, perhaps even a quarter of negative growth, this is hardly the time for premature withdrawal. Once recovery is in place, that's the time to address the deficit and, more importantly, its underlying causes.

Even though that article was written over a year ago, it's worth keeping in mind that Japan's net debt profile isn't as bad as doomsayers portray it to be. More recently, Lindsay Whipp of the FT reports, Japan’s debt gives investors unlikely opening:

The distant chimes of alarm bells are going off about Japan again.

Just a month after Standard & Poor’s downgraded the government’s sovereign debt rating, Moody’s on Tuesday warned that it might follow suit, both agencies citing long-term fiscal unsustainability of its growing debt pile.

The political deadlock that could delay the passing of budget-related bills and progress on comprehensive tax reform to pay for rising welfare costs is certainly not helping confidence.

Tom Byrne, Moody’s senior vice-president, said that his view “takes into account intensifying political challenges facing the [Naoto] Kan government, which may heighten policy formulation and execution risks”.

Domestic investors, which make up 95 per cent of the Japanese government bond market, are watching developments closely.

While they do not envisage a worst-case scenario, whereby the government will be unable to issue a huge mountain of refinancing bonds, and they certainly do not expect a bond and currency crisis in the medium term, the opacity of the current political turmoil is creating confusion.

“Risk seems to be more skewed towards the downside on domestic investors’ confidence on the political will for fiscal austerity,” says Tomoya Masanao, a Tokyo-based portfolio manager for Pimco.

“This means I should remain cautious about the JGB market. But we are not in the camp that JGBs are going to blow up because of the fiscal situation.”

The long-term sustainability of Japan’s growing debt pile is a touchy subject that has oftendivided domestic and overseas investors. Mistiming a JGB bond and yen crisis or expectations for a spike in yields have caused numerous foreign investors pain. But that has not stopped some placing a small chunk of their assets on a bet that, as Tokyo’s fiscal stability deteriorates in the future, there are huge gains to be made.

And Kyle Bass of Hayman Capital Management, a well-known JGB bear, this month reminded his investors of a looming bond market crisis in Japan.

Investors are well versed in the numbers and they are not pretty. To name a couple, Japan’s gross debt is set to grow to more than twice the size of the economy this year. Its debt burden is estimated to reach Y997,700bn by the end of March 2012. In addition, new bond issuance is set to exceed tax revenues for the third year running in the fiscal year 2011.

But Tokyo can rely on the huge pool of domestic funds to buy up JGBs for now, particularly as there are few other options for investors in yen. Public and private institutions’ capacity for soaking up JGBs minimises the government’s funding costs.

Benchmark 10-year yields may have risen nearly 50 per cent since the beginning of October to 1.27 per cent, in line with gains in US Treasury yields, but they still remain the world’s lowest.

Nevertheless, there have been signs of movement out of JGBs from the public sector. Japan Post Bank’s outstanding JGB holdings dropped Y6,167bn to Y149,724bn between March and December, amid an increase of just over Y2,000bn in its holdings of dollar- and euro-denominated assets. There is a chance this is just an asset allocation adjustment but the buying fits with a call from Shizuka Kamei, a former minister in charge of the post office, to diversify funds.

Japan’s public pension funds were also net sellers of bonds for the first time in almost a decade last year amid deteriorating demographics, and that trend is only likely to continue. But for now, the bond market has shrugged its shoulders at the shift, partly because it remains incremental.

The most important investors last year were commercial banks, as corporate savings have made up for a slowdown in household savings rates. Signs of an improving economy have raised expectations for increased investment by companies using those savings, but one official at a Japanese megabank says that this is not happening.

“Even if Japanese companies’ profits have been good, it does not mean that the domestic economy is improving, because the growth is coming from external demand,” the official said. “I am not seeing a trend of yen-denominated corporate deposits being withdrawn or loan volume picking up,” he says.

Investors agree. Pimco’s Mr Masanao adds that corporate savings are not a temporary phenomenon because the slower growth and deteriorating demographics suggests that companies need to invest less.

“There may be some capital leakage overseas by large corporations, but it’s still a micro story more than a macro one,” he said.

This theme of falling investment is important when estimating the point at which Japan’s current account surplus could shift into deficit, a key moment for the JGB market, according to Société Générale.

Estimates for when that might happen vary widely, but SocGen says that it is possible that Japan could maintain its surplus for “decades to come”. It points out that despite the drop in the household savings rate the current account surplus appears to be on a rising trend over the past two decades, apart from the sharp drop during the financial crisis.

The alarm bells of Japan’s fiscal sustainability may still be distant but that does not mean domestic investors are happy with Japan’s fiscal situation. Ultimately, in the event of a debt and currency crisis, policymakers may be forced to step in and support the market.

“Japan continuing to enjoy a current account surplus does not necessarily mean the government can keep its high debt forever,” says Takuji Okubo, an economist at SocGen. “The more relevant concern . . . is whether the current strong home-bias of Japanese households would subside.”

“The Bank of Japan and Ministry of Finance need to have a sense of crisis,” says the official at the large Japanese bank.

Interestingly, Japan's trade balance swung into a deficit for the first time in almost two years as shipments to China lost steam, but economists say the central bank's forecast for an export-led recovery remains intact. We'll see how geopolitical events and rising crude prices impact their economy in the second half of the year.

Longer-term, demographic trends will put pressure on Japan's public debt. But Japanese policymakers have ample time to start thinking about how they're going to tackle this issue. Mr. Mitani has sounded the alarm, but I'm not sure anyone is paying attention, at least not yet.

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