Nomura Chairman Ujiie Charts Roadmap for Japan’s Fiscal Recovery

November 2, 2007

Speaker
Junichi Ujiie, Chairman, Nomura Holdings, Inc.

Presider
John Thain, Chief Executive Officer, NYSE Euronext

On November 2, 2007, Nomura chairman Junichi Ujiie shared with Japan Society his thoughts on next steps for fiscal reform and economic stability in Japan.

“Once upon a time Japan was the best student in the classroom of fiscal prudence,” Dr. Ujiie said. In the early 1990s, Japan’s budget deficit represented just 1 percent of GDP, the lowest of any G-7 nation, and public sector debt was 65 percent of GDP. Today, public sector debt outstanding is almost 180 percent of GDP. “If any company borrowed one point eight times its annual sales, rating agencies would want to run for cover,” he declared.

With economic recovery and more restrained public spending, the budget deficit has shrunk, but “Japan should not be complacent with this progress,” he said. Half of all public spending in Japan goes “not for investment into the future,” but for transfer payments and debt service--“and on the revenue side, the recovery in tax receipts is largely dependent on the current business cycle, and one cannot take this for granted.”

With long-term structural challenges of this sort, “the roadmap for Japan’s fiscal recovery is simple: primary balance first and primary surplus next,” Dr. Ujiie stated.

Japan must put an end to increases in public debt; beyond this, he said, many people advocate a mix of spending cuts and tax increases, but “however viable these proposals may look, I believe that many of them miss one important point. They run the risk of cutting the existing pie into too many thin slices while not attempting to grow the pie.”

Furthermore, he said, “the general electorate does not find that the right balance is struck between what they pay the government and what they receive.” Government scandals, including the mismanagement of pension recordkeeping “on a gigantic scale,” have compounded this mistrust. “When people are angry, you do not ask for tax increases.”

“I am not going so far to argue that any tax increase is not possible,” Dr. Ujiie said. “However, I do think the first priority now should be for the government to repair the broken trust before they can ask for higher taxes.”

Economic growth in Japan depends on two engines, not one, in his view: manufacturing, which has been and continues to be Japan’s great strength, and services, where “slowly but steadily, deregulation is at work.”

“Japan is moving in the right direction, with or without government knowing it,” he remarked. Restrictions on retail-store opening hours have been lifted. Private competition is succeeding in parcel delivery. And in the healthcare sector, there are small but significant improvements. For-profit companies are still barred from running hospitals, but cities are partnering with private enterprise to build and operate new medical institutions, and “certain private sector companies are quietly getting ready by running hospitals under the guise of their captive employee health insurance benefit programs, to accumulate experience to run a hospital business profitably.”

In financial services, Dr. Ujiie’s own industry, he finds multiple reasons for optimism on growth. Commercial banks have rid themselves of excess NPLs, nonperforming loans, and will soon begin paying taxes again, and new regulations will improve the environment for wholesale and institutional banking.

“You might think that I am saying something strange, because many Japanese newspapers are busy writing on the negative impact of the new financial service legislation on retail distribution of financial products. Well, do not listen to Japanese newspaper reporters too much,” he said with a smile.

“They love writing about troubles. But they completely overlook the current progress toward a business-friendly regulatory framework for the institutional side of the banking business. I am convinced that this initiative will be the catalyst to greatly change the shape of the Japanese financial market for the better.”

Japan’s huge pool of financial assets, some 20 percent of financial holdings worldwide, must be liberated from unnecessary constraints, Dr. Ujiie continued.

Household savings represents some $13 trillion, over half in low-yielding deposit accounts; meanwhile, “Australia, with only 20 million population, boasts a mutual fund market that has been larger than Japan since 2001,” he observed. “This demands attention.”

Public pension funds of about $2.7 trillion are run “almost on autopilot,” with a target investment return of only 1.1 percent net after inflation; in his view, Japan should create a mix of internal and external teams that compete with one another to manage these assets better, including appropriate exposure to alternative investments.

Finally, there are roughly $1 trillion in foreign exchange reserves--about 15 months’ worth of imports, far more than Japan needs, he said.

To finance these reserves, the government buys short-term government bonds and invests in U.S. Treasurys and other foreign-government debt--“in other words, the government of Japan borrows in yen to buy U.S. dollars and other currencies. This reminds you of a hedge fund doing a carry trade,” he remarked dryly, “except that short-term U.S. Treasury bills are not the greatest source of yield pickup.”

“The basic question that we should ask is how much of Japan’s foreign currency reserve should be directed to Japan’s version of the so-called sovereign wealth fund,” said Dr. Ujiie, and “my recommendation is to start small,” by investing in a well-balanced portfolio the roughly $45 billion in spread that the government earns annually through its foreign-reserve-account “carry trade,” and using the fund to help pay for pensions for current and future workers.

Dr. Ujiie ended his talk with reflections on Japan Society’s 100th anniversary and the inspiration for the Society’s founding.

In the 1870s, Kentaro Kaneko, a samurai born in Fukuoka province, came to study in the U.S.; “although he did not speak English, he wisely decided to attend a grade school first and then go to Harvard, where he met Theodore Roosevelt,” Dr. Ujiie recounted. In 1904, Japan’s war with Russia got under way, and shortly after the war began, “Hirohumi Ito, the Japanese political leader, recognized that his small island nation would have trouble sustaining a war with a gigantic neighbor.”

“Ito had the foresight to ask of Kaneko to sail to the United States to invite the then President of the United States, his former classmate, to act as a mediator between the two warring countries,” Dr. Ujiie said. “Kaneko helped the Japanese envoy, Jutarō Komura, to conclude the U.S.-brokered Portsmouth Peace Treaty with imperial Russia,” representing the first international mediation conducted by the U.S.; and “as a result of America’s heightened interest in Japan following the Russo-Japanese war, groups such as the Japan Society emerged to further strengthen relations between the two countries.”

“My speech today concerned the road to Japan’s fiscal recovery, and I was optimistic about Japan’s ability to achieve fiscal prudence, but only if Japan comes to its senses with respect to enhancing private sector dynamism and promoting free capital market principles,” ideas that “have something in common with America’s way of running a free market economy,” Dr. Ujiie concluded. “And being a self-appointed friend of the U.S. and Japan, I want to sincerely congratulate the Japan Society upon its great achievement over the past century and I look forward to the contributions it will make in the next 100 years. I, for one, will be very happy to help you to help us.”

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Mutual funds and exchange-traded funds are perfect assets for households to invest in—why have they not been attractive and grown in Japan, and what can we do about that?

For one thing, the Japanese household sector invests quite a lot in one particular asset that’s very volatile, namely houses, replied Dr. Ujiie. The secondary market in housing is thin, transaction costs are high--it’s a volatile market. This limits investors’ tolerance for risk in other areas.

“So I think that one important thing is to try to develop the type of houses which can be put on the secondary market, and then the liquidity of the houses is going to increase, and thereby the household sector can accommodate investment in equity.”

Additionally, he said, Japan needs to offer better versions of its 401(k) and IRA programs. “In my case, my 401(k), my company is going to provide about $2,000 per year, and I cannot match it. And $2,000 per year in a 401(k)--well, should I really worry about that?”

Given the weakness of the U.S. dollar, how concerned are you on the ability of the manufacturing sector to continue to be one of the engines driving the Japanese economy?

Both the yen and the dollar “are very, very weak” among the major currencies, so even though Japan’s manufacturing sector is indeed heavily export driven, “there is not much direct impact right now,” Dr. Ujiie responded. Corporate profits are starting to get distributed out more to the labor force, “which will in turn I think push domestic demand--not in the distant future, and we can see some sign of it right now. So, you need a little bit more patience.”

Would you comment on the quality of financial managers in Japan, and how managers’ education can be improved?

“Let’s not underestimate the Japanese fund manager’s ability to catch up,” responded Dr. Ujiie. “To attract good talent you have to open up our economy--then I think a good cycle will start.”

Is there a possibility that other Asian markets will move ahead faster on hedge funds, trading, market reforms, in a way that makes it difficult for Japanese markets?

“I would think yes. But I think that that’s not bad,” Dr. Ujiie replied. Singapore, Hong Kong, Tokyo are in the same time zone, and as each tries to be innovative, that’s “incentive for the Tokyo market to become more competitive.”

Japanese managements tell me that they see investment offshore as a rational strategy, because Japan’s demographics are compounding what appears to be a structurally depressed return on equity. How would you reconcile that with an effort to drive more household financial assets into the domestic capital markets?

“This is a really difficult question to answer,” Dr. Ujiie commented. Under new legislation, the retirement age is being raised, from 60 to 65, which will add to the workforce, and immigration laws are going to be relaxed to invite more workers from China and the ASEAN countries, he said; and “in my mind we should really open up our economy to import foreign capital more freely into Japan,” to make up for any shortfall in capital that’s available from domestic sources.

How do you see the current credit crisis here in the U.S. affecting Japan?

“In Japan there is not much credit shortage at all,” with big M&A transactions still taking place; and major Japanese financial institutions haven’t recorded sizable losses on subprime investments, replied Dr. Ujiie. “So, Japan is a little far away from the current problem of credit or liquidity, or subprime, or securitization.”

“When you look at the last 15 years,” he added, Japanese banks made limited use of securitization, and “therefore those NPLs sit on the bank’s balance sheet, and therefore the whole banking system” was in trouble, and “they dragged down the economy for 15 years. So, I would think that securitization itself may not be that bad.”

What is your view on the prospects for Japanese capital to be more highly allocated in general to equity investment?

It will take some time, given the long period since the bubble burst where people did not see better earnings from equities than from fixed-income products, Dr. Ujiie said. “As I said before, we need some kind of institutional scheme to push the people to the capital market, especially the equity side."