Where credit's due

Reform of Japan's public sector has been a drawn-out process, and there's still a lot of uncertainty over issues such as the likely risk profile of restructured government bodies. But credit quality is getting more attention

Japan's sovereign rating was upgraded one notch in April for the first time since 2002. But government agencies and municipalities cannot be so sure of their own standing, thanks - ironically - to the very reforms that helped bring the AA country rating from Standard & Poor's. That's because uncertainty remains over how the restructured public sector will function and be financed, and, therefore, over its risk profile.

The most significant issue regards the level of financial risk faced by municipalities - such as towns and prefectures, which will all remain under government control - and government agenices, some of which will remain under government control and some of which will be privatised (see box). The main concerns surround government guarantees of agency and muni finances, including bonds.

"The new fiscal restructuring law (the law for the fiscal stabilisation of regional bodies, submitted on March 9) replaces the current one (the law concerning special measures for promoting the restructuring of local public finance), which was seen to include an implicit guarantee that the government will not let municipalities fail, even if they are no longer financially viable," says Alexander During, head of Asia-Pacific relative value research at Deutsche Securities in Tokyo. "The new law says munis 'should not be hindered' from carrying out a restructuring effort, whereas under the previous law they could actively expect aid. The automatic safety net is getting weaker."

Only a few municipalities have effectively gone bankrupt over the years, including the town of Fukushima City in Fukushima prefecture in 1972; Akaike, a small town in Fukuoka prefecture, in 1992; Ueno, a city in Mie prefecture, in 1997; and the town of Yubari in Hokkaido prefecture, last year. "They suffered a financial crisis where they needed government aid to make their payments," says During. "So support is still very strong. The government certainly cannot let munis go under so that street lights or water supplies fail. It may not guarantee money for bonds or debt, but essential services must be provided."

Meanwhile financial support for agencies varies, just as their functions differ - they range from state corporations responsible for parts of the road infrastructure, such as Japan Expressway Holding and Debt Repayment Agency, to the Defence Facilities Administration Agency. Some are incorporated with an explicit financial government guarantee, while others are 100% government-owed but have no explicit guarantee, although they may have some private financial backing. Accordingly, their financial backing post-reform will also vary on a case-by-case basis.

Government-owned agencies also seem likely to remain well supported. One agency, Tokyo Waterfront City Development, received loan forgiveness last year on Yen200 billion ($1.6 billion) of the debt it owed to financial institutions.

"Agencies will not suffer so much as to fail - the government has given them a lot of support," says Akane Enatsu, a corporate bond analyst at Nikko Citigroup in Tokyo, who has written research on the Japanese public sector. "The government is giving them benign support still, but telling them they must be more efficient in their spending."As a result, she says, the reforms will not have much of an overall effect on agencies' risk management, partly due to the very gradual nature of the transition. "Most entities know that there will not be big sudden impacts in the public sector, so they won't change their risk management attitudes very much," says Enatsu.

Officials at the Japan Finance Corporation for Municipal Enterpises (JFM) - one of the largest government agencies, with assets of $221.4 billion as of March 31, 2006 - appear to agree with this view. "We don't think the reform of policy-based finance will have a big impact on our overall business," says Takashi Endo, manager of JFM's finance division in Tokyo. "Considering that the new JFM will succeed to all of the assets and liabilities of the current JFM and that its borrowers will be limited to local governments, our business model holds virtually unchanged. Therefore, we don't see a radical change in risk management strategy is necessary."

Endo adds: "Under the new law we are not supposed to go bankrupt." But JFM, along with other agencies, is not certain about how the government guarantee will function overall. "It's unclear for now whether the government guarantee will apply to our foreign bonds," says Endo. "However, we would like to look to overseas markets as an option to raise funds irrespective of the government guarantee being given or not."

JFM provides local governments with long-term, low- and fixed-interest financing and has issued a total of 62 government-guaranteed foreign bonds since 1984, totalling Yen1.98 trillion.

Losing support?

Certain agencies - those due to be privatised, for example - will in theory not have the luxury of any government support, so they will need to find other ways to bolster their credit. Take the Development Bank of Japan (DBJ), which extends long-term financial facilities for projects with 'high public-policy content' - such projects might include technology promotion, environmental conservation or regional development. DBJ is, like Shoko Chukin Bank, a state-run bank, and both are due to go private in October next year.

It has been reported that DBJ, for example, is examining the possibility of turning itself into an investment fund, which would give it more flexibility, as investment funds are not bound by tight banking industry regulations. DBJ declined to comment on the likely effect of the reforms on its business model or risk management approach.

"Those (agencies) the government plans to privatise will be the most affected by the reforms," says Takahira Ogawa, director of international public finance ratings at Standard & Poor's (S&P) in Tokyo. But this assumes the government fully cuts its ties with DBJ and Shoko Chukin. And some private-sector banks fear that some state-linked privileges may remain that would distort competition.

Recent bond ratings have demonstrated the credit rating agencies' views on the issue of government support. On March 12, Standard & Poor's assigned a rating of AA- with a negative outlook to DBJ's Yen10 billion 1.93%, series 30 non-guaranteed bonds that are due March 20, 2019. These are so-called 'zaito agency' bonds, issued by government-affiliated financial institutions and other entities since 2001 to finance the Fiscal Investment and Loan Programme. Zaito bonds are unguaranteed, so interest rates on them are directly linked to the issuer's credit standing, which seems less certain than it was, hence the agency's decision to award a below-sovereign rating.

"The negative outlook on the issuer credit rating on DBJ reflects the government's decision in November 2005 to privatise the bank and the resulting possibility of diminishing government support to DBJ," says Standard & Poor's in a statement. "While the credit ratings on DBJ will be more dependent on its stand-alone credit strengths following the privatisation, the government's level of support for DBJ is still unclear."

This decision contrasts strongly with Moody's rating and comments in early May on bonds issued by Japan Expressway Holding and Debt Repayment Agency (Jehdra), which will remain government-run. The Yen30 billion 1.78% series 21 senior secured bonds, due 2017, were rated Aaa, with a stable rating outlook. "The rating reflects Jehdra's intrinsic strength - including Moody's expectation the favourable legal and regulatory framework will continue, contributing to its low operating and refinancing risks - and the credit support which Moody's believes the government would provide in a stressful situation," said the rating agency in a statement in May.

Deutsche Bank's During feels investors should take careful consideration of ratings of municipal bonds. "This is not a very good time to be rating," he says. "The income structure of the municipal governments is being redesigned - so if you rate 10-year bond you don't know how things are going to change in the next few years."

But S&P's Ogawa says: "S&P is very experienced at rating Japanese government agencies and has been doing so since 2001 on a stand-alone credit basis. This is not an area we have just entered. And since they have been issuing government-guaranteed bonds for a long time, we have been rating those bonds since the mid-1990s."

Despite the concerns, the market seems fairly positive on Japanese agency and muni bonds in general - including those issued by agencies due to be privatised and otherwise. The spread on JFM bonds has been tight and the movement of spreads has been reasonably consistent, says S&P's Ogawa.

Increasing transparency

Ultimately, it should be easier for all concerned to examine the financial standing of agencies, although that will not come overnight. "Generally credit analysis will become a lot more important in Japan now," says Duering. "But improved analysis is not possible unless you have transparency, which is not good in Japan. The new law is the first step to greater transparency, but disclosure won't be perfect even then."

It has been difficult in the past to get agencies to reveal their total debt amounts, says Duering. "Regional bonds are easy to get information on, but less available are the amounts of loans outstanding," he says. "A lot is not being disclosed that would be very important for outside investors."

A major stumbling block to greater disclosure is cash accounting, says Duering. "Everyone in Japan uses it, and a law requiring accrual accounting probably won't come in until 2011. The problem with balance sheets is how you treat long-life assets. For example, how do you value sidewalks or other parts of the infrastructure for which you don't have potential buyers?"

Research authored by Duering published in April, Draft law for fiscal stabilisation of municipalities, sums up the overall uncertainties. He points out the consensus seems to be that municipalities will still be able to rely on government support and that ratings from rating agencies reflect this.

"There is therefore no regulation that we are aware of defining the rights of creditors in such a default situation, such as seizure of assets, or bankruptcy protection measures," says the report. "There have been discussions reported in the press that would point to the possibility of such regulations and it would certainly be helpful for the market to have the question of municipal defaults clearly answered in one way or another." The Ministry of Finance did not respond to requests for comment.

RESTRUCTURING RATIONALE

The main rationale behind the overhaul of Japan's public sector is to improve the efficiency of its spending, says Akane Enatsu, corporate bond research analyst at Nikko Citigroup in Tokyo. At its peak in fiscal-year 2000, the size of the Fiscal Investment and Loan Programme (Filp) - Japan's so-called 'second budget' - available for special agencies and municipalities was around Yen400 trillion ($3 trillion). The funds came from postal savings and pension reserves, and were controlled by the Ministry of Finance, which felt too much money was flowing automatically to special agencies and the like and that they were not spending it efficiently enough, says Enatsu.

So the government decided to overhaul the system through the Filp reform in April 2001.The first, and main, step of the reform was to stop the automatic flow of funds to the agencies, says Enatsu. There were several parts to the reform, including the launch of 'zaito agency' bonds - these are not explicitly guaranteed by the government. As a result, zaito bond issuers have an incentive to show efficiency improvements, and if they do not, they must pay funding costs themselves back to investors, she says.

In addition to the Filp reform, there were other reforms in the Japanese public sector, such as special agency reform and public finance reform, adds Enatsu. Through the public finance reform, two banks are to be privatised, the Development Bank of Japan and Shoko Chukin Bank.

Moreover, five public financial institutions are to be merged into a single public finance corporation: the National Life Finance Corporation; the Agriculture, Forestry and Fisheries Finance Corporation; the Japan Finance Corporation for Small and Medium Enterprises; the Japan Bank for International Cooperation; and Okinawa Development Finance Corporation.

And thirdly, the Japan Finance Corporation for Municipal Enterprises will pass from being under central government control to local government control. All organisational changes are scheduled for October 2008, with one exception: the Okinawa Development Finance Corporation is to be merged with the others in 2012.

Another major issue of public-sector reform is that of tax allocation. The central government is debating how to correct growing disparities in tax revenues among local government bodies. For example, municipalities with high revenues (due to dense populations and high concentrations of industry and corporates), such as those in Tokyo, actually require less financial help from the government than those with low populations and less industry. Low-revenue munis include former mining towns such as Yubari in Hokkaido prefecture, whose population had been around 120,000 at its peak in 1960s, but has now fallen to less than 13,000. Hence tax revenue is far too low to support the infrastructure there, such as the hospitals.