Annual Report on

The Japanese Economy and Public Finance

2005

- No Gains Without Reforms V -

Cabinet Office

Government of Japan


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Section 2 From Public Sector to Private Sector - Various Methods

    As the birthrate continues to decline and the population continues to age, there is a possibility that Japan will have a "big government" in the future. In order to maintain the vitality of the economy and keep the public sector to a sustainable size, however, reforms aiming to develop a "small government" must be undertaken immediately. To that end, budget system reform, reform of social security systems, reform of the relationship between central and local governments are important, but in addition to those, it is important to thoroughly implement the policy of "from public sector to private sector" in order to leave to the private sector what it can do, and have the public sector carry out operations that are truly necessary for it to carry out. This section comprehensively studies this "from public sector to private sector" reform.

1. The New Boundary between the Private and the Public Sector

 Changes to the concept of public goods
    The classical bases for the supply of a public service by the public sector are (i) that it is a public good for which the market cannot determine the price (consumption of the good is non-rivalrous and non-excludable), (ii) that if the good is traded on a market, a natural monopoly will result, and (iii) that it involves provision of goods which have positive or negative externalities. In addition, due to considerations of income distribution and social welfare, there are many public goods for which the provision of a universal service (that can be accessed nationwide for the same charge) is compulsory. However, in the present day these points do not necessarily guarantee that it is most appropriate for the supplier to be the public sector.
    First, there has been technological progress and competition has become possible in sectors that were thought of as natural monopolies until now, by allowing the entry of new companies. Even in sectors for which huge facilities are necessary, such as telecommunications and electricity, it is possible to enable the entry of new companies and advance competition by taking such measures as liberalizing access to the facilities, which were the bottleneck preventing entry. Japan has already privatized NTT and in the electricity market, government regulations have been eased and competition among private businesses has been introduced.
    Second, concerning judgment of whether a good has external economy and the pros and cons of providing a universal service, it is necessary to take into consideration the possibility that social necessity is changing in accordance with changing times. In particular, in the present day when alternative methods have been developed as a result of technological progress and per capita income has reached high levels due to economic growth, it is necessary to constantly review what the aim of policies should be. Furthermore, even if a universal service is to be maintained, it is possible to combine it with the advance of competition through the entry of the private sector by having the public sector support the expenses of the service with funding, rather than having it directly supply the service.
    Third, even for pure public goods which cannot be charged for in the market and public services for which it is concluded that continuing involvement of the public sector is necessary, it is possible to increase efficiency and the satisfaction level of the citizens by introducing competition with the private sector and utilizing its experience and know-how. The opening up of public services to the private sector through the Public Private Partnership (PPP) developed in Europe and North America in the 1990s is based on exactly this idea. The PPP concept varies from country to country but specifically it is an attempt to introduce the competition principle and the management know-how of the private sector to the supply of public services in sectors where the involvement of the public sector is necessary, by methods such as commissioning to the private sector, PFI, corporatization, etc. This does not mean, however, that it is fine to leave everything to the private sector. The aim of the PPP is to maximize the value of output for each tax money input regardless of whether the supplier is the public sector or the private sector. Therefore, there is no reason why the public sector cannot continue to provide public services if opportunities for potential entry of the private sector are increased and there is competition between the public sector and the private sector and as a result, public sector efficiency increases to about the same level as that of the private sector.

 The significance of market tests
    The drawing of the line between the private sector and the public sector is not necessarily as clear as it used to be. Market tests directly compare efficiency based on competitive tendering between the public and private sectors and so provide a new view of the division of roles between the private and public sectors. Specifically, market tests involve implementation of competitive tendering between the public and private sectors under transparent, neutral and fair competitive conditions for the provision of a public service, and the service provider which offers the better price and quality wins the contract and provides the service in question. One of the major characteristics of market tests is that while formerly it was basically the public sector that judged which operations would be privatized or commissioned, under the market test system it is necessary for the public sector to show that it is better in terms of price and quality through competitive tendering between the public and private sectors in order to be given the operation.
    It has been pointed out that even though in many cases in the past in Japan standard public sector operations such as cleaning of facilities and security have been partially commissioned to the private sector, the opening up of the core public services sector, including planning and policy-making, to the private sector has not advanced much. For this reason, the First Report on Promoting Regulatory Reform and Opening Up to the Private Sector (December 2004 meeting of the Council for Regulatory Reform and Opening up to the Private Sector) proposed that it was necessary to appropriately introduce market tests, to continue to introduce them on a trial basis in FY2005, and to carry out full-scale implementation in FY2006. It said that market tests were needed as a cross-sectional method to surpass the previous partial commissioning to the private sector and to accelerate the transfer of business activities from the public sector to the private sector through privatization and transfer to the public sector of comprehensive public services. Market tests are discussed in detail in Section 4.

 "From public sector to private sector" policy methods and their selection
    Once the sectors that should be transferred "from public sector to private sector" have been decided, the issue at the next stage is by what method they will actually be transferred to the private sector. Specifically, "from public sector to private sector" methods include privatization (transfer of ownership), commissioning of operations, the Designated Management Entity System, PFI, social investment funds, etc. (Table 2-2-1).(15)
Table 2-2-1 Major approaches to "from public to private sector"
    Summarizing these methods in terms of the involvement of the public sector, in the case of social investment funds, in principle, the role of the public sector is no more than to provide indirect support for business proposals which are recognized as having a certain level of profitability, while management of business proposals and funds itself is left to the private sector. In the case of privatization (transfer of ownership) the role of the public sector is large in the initial stage when it is being decided which business activities to privatize and what kind of systems design to implement, but once privatization has been accomplished the involvement of the public sector becomes small. In the case of PFI, the Designated Management Entity System and commissioning of operations, in principle, the private sector carries out the operation and management of facilities within the scope of contracts, agreements with the public sector, but under the Designated Management Entity System managers are given some discretion.
    In general, from the perspective of sufficiently taking advantage of the ideas and experience of the private sector, lesser involvement of the public sector is preferred. On the other hand, if there is a strong requirement to achieve certain policy targets, a certain level of public sector involvement is necessary. For example, in cases where socially preferred levels of services are not provided if ownership is completely transferred to the private sector (when the safety or quality of services declines due to insufficient investment or excessive cost reductions), rather than transfer all ownership to the private sector through privatization, it is surely appropriate to use methods that give facility management rights to the private sector while maintaining partial ownership in the public sector (the Designated Management Entity System, etc.) to ensure that public services are provided to the required levels through the involvement of the public sector. Furthermore, for public services that are in a monopoly situation so that even after the move "from public sector to private sector" there will be no competition with other private companies, rather than transfer ownership to the private sector through privatization, it is possible that services can be supplied more efficiently in the form of public establishment, private management, in which the management of facilities is left to private companies through competitive tendering and competition is effective at the time businesses are selected. Furthermore, if this tendering is carried out at regular intervals, it will give companies an incentive to continuously improve efficiency.
    However, even in the case of public establishment, private management of Designated Management Entities it is of course necessary to keep the involvement of the public sector to the minimum necessary level, and transparent, neutral and fair procedures in the processes of selection of companies and evaluation of business activities are extremely important prerequisites for the efficient supply of high-quality services. Furthermore, from the perspective of sufficiently taking advantage of the ideas and experience of the private sector, it is important to reflect the proposals of the private sector when deciding what kinds of administrative and business activities should be transferred "from public sector to private sector" or selected in future.

2. "From Public Sector to Private Sector" - Commissioning of Administrative and Business Activities and PFI

 The current state of outsourcing and PFI
    The "from public sector to private sector" method that is most generally adopted is commissioning of the provision of public services and the construction of facilities to private sector businesses. Of these methods, the outsourcing of public services is being widely carried out in Japan, primarily for standard public sector operations. According to a Ministry of Internal Affairs and Communications survey (Ministry of Internal Affairs and Communications (2004a)), a major share of general office work and facility administrative services of local governments has been outsourced, and between 1998 and 2003 the proportion of commissioning has increased in nearly all operations. (Figure 2-2-2).
Figure 2-2-2 State of outsourcing by municipalities
    PFI is a method of using private funds, management capacity and technological capabilities to design, build, maintain, operate and manage public-related facilities The PFI Law was established in 1999 and implementation guidelines had been announced for 197 PFI projects as of the end of May 2005 (Table 2-2-3). Looking at these projects by sector, PFI projects were most often implemented for educational and cultural facilities such as school buildings and cultural halls, medical facilities, waste disposal facilities, and public -related facilities such as government offices, but they were also implemented for parks, prisons, etc. Concerning the economic effects due to the introduction of the PFI method, looking at value for money (the difference between expenditure during the entire project period when the public sector implements the project and expenditure when a PFI project is implemented) for projects for which tendering has been implemented to date, on average a cost of reduction of around 30% can be seen (Figure 2-2-4).
Table 2-2-3 Number of PFI projects for which implementation guidelines have been established and announced
Figure 2-2-4 Effect of PFI looking at Value for Money (VFM)

 Overview of the Designated Management Entity System
    In addition to the commissioning of standard operations already described above, there is also the Designated Management Entity System in local governments, a system for more comprehensively transferring the management of public-related facilities to external organizations. The Designated Management Entity System is a system that was introduced through a 2003 amendment to the Local Autonomy Law. Compared to former management commissioning systems, restrictions on the range of agents who can have management transferred have been removed and discretion concerning management has been greatly expanded. Specifically, under former systems management and operation of public-related facilities was limited to public bodies (land improvement districts, etc.), public organizations (agricultural cooperatives, chambers of commerce and industry, residents' associations, etc.), and corporations at least half owned by local governments (the so-called auxiliary organizations of the third sector, etc.), but under the Designated Management Entity System such restrictions are not established; rather specific management entities are to be designated through a vote in the local assembly. For this reason, it has become possible to transfer the management of public-related facilities to commercial companies and specified noncommercial activities corporations (NPO corporations), regional organizations, etc., but not to individuals. Furthermore, under the former management commissioning systems, the local government, as the organization that set up the facility, possessed the right to manage it and could not delegate the right to give permission to use the facilities. However, under the Designated Management Entity System, the local government can delegate the right to manage a facility to a Designated Management Entity and get them to exercise that right. In this way, through the introduction of the Designated Management Entity System, full advantage is taken of the management know-how of the private sector and an environment is created in which the services for residents can be improved and administration costs reduced.

 State of Introduction of the Designated Management Entity System
    With the introduction of the Designated Management Entity System, the former management commissioning systems were abolished, so except in cases where local governments directly manage a facility, it is necessary for public-related facilities that are currently commissioning management to switch to the Designated Management Entity System within three years of the enforcement of the amended law (by September 1, 2006). (However, commissioning contracts with the private sector are possible for individual standard operations such as cleaning, maintenance and repair of facilities, just as before.) So introduction of the Designated Management Entity System in local governments is proceeding.
    According to a June 2004 Ministry of Internal Affairs and Communications survey (Ministry of Internal Affairs and Communications (2004b)), the number of organizations that have introduced the Designated Management Entity System is 10 prefectures (21.3% of prefectures), 9 designated cities (69.2% of designated cities), and 374 municipalities (12.0% of municipalities) (Figure 2-2-5). The system has been introduced for a total of 1,550 facilities and the breakdown of these facilities by type is as follows: medical and social welfare facilities (35.4%), educational facilities (24.5%), recreational and sports facilities (22.7%), foundation facilities (8.8%), and industrial promotion facilities (8.6%). Looking at the types of project managers taking over management of facilities as Designated Management Entities, public organizations (57.2%) account for the majority and incorporated foundations (14.4%) are the second most common type. On the other hand, there are also a number of joint-stock companies (10.7%), limited liability companies (2.7%) and NPO organizations (5.2%) and enough of them can be seen to suggest that the introduction of the Designated Management Entity System has had the effect of broadening the range of organizations to which the management of public-related facilities is delegated. Concerning the procedures for selecting a Designated Management Entity, although multiple answers were allowed so the organizations were counted more than once, more than 50% of organizations replied that they made a selection without a public tendering process.
Figure 2-2-5 State of introduction of Designated Management Entity System

 Economic effects due to utilization of the private sector - Analysis using the Designated Management Entity Questionnaire Survey
    With the introduction of the Designated Management Entity System and increase in PFI projects, opportunities for private businesses to comprehensively manage public-related facilities have increased but the question is whether utilizing the private sector in this way has actually improved the efficiency of operations and the quality of the services provided. To answer this question the Cabinet Office commissioned a questionnaire survey of 1,461 businesses participating in the management and operation of public-related facilities as Designated Management Entities (responses were received from 435 of these businesses (a response rate of 29.8%)). The survey was implemented in March 2005 and based on the survey results a statistical analysis was carried out concerning where there was any change in the efficiency of operations and the quality of services after the introduction of the new system and furthermore whether there was any difference between different types of private and public sector entities.(16) Examples of this kind of policy analysis using micro-level data include analyses of at-home long-term care businesses, analyses of child-care services. Although it is becoming a generally used method, this was the first time it had been used to carry out an analysis of the Designated Management Entity System.(17)
    The survey was conducted with reference to the Ministry of Internal Affairs and Communications survey concerning the Designated Management Entity System mentioned above and covered businesses already designated as Designated Management Entities (hereafter, abbreviated to "current businesses") and, for comparison, businesses that were managing the same facility before the Designated Management Entity System was introduced (hereafter, abbreviated to "previous businesses") (in the case that the same business continued to manage the facility after the introduction of the new system the business is classified as a previous business before the introduction of the system and a current business after the introduction of the system).
    Since it is difficult to directly observe the quality of the management and operation services of facilities, a points rating evaluation approach was adopted in which a number of questions were established for the evaluation of services. Points were awarded for the answers to these questions and the points were added together to get a total score. The specific evaluation items were as follows: response to customers, service times, partnership with users, management and maintenance of service content, response at times of accident or emergency, management of private information, maintenance and management of facilities, staff management, training systems, how well-planned and transparent the business activities are, and the implementation of self-evaluation, and for each of these items four more-specific evaluation items were established. (Appended Note 2-3.)(18) In addition, just as in the prior research, the survey looked at whether there was a statistically significant difference between previous businesses and current businesses and between the private and public sectors with respect to the score for the services evaluation calculated for each type of business entity. In addition, an analysis was carried out to determine if there was any difference in the quality of services between previous businesses and current businesses and between the private and public sectors after making adjustments for various attributes by estimating the quality function of services. Based on financial data for which there was a response in the questionnaire survey, the survey estimated the expenditure function and examined whether or not there were any disparities between previous businesses and current businesses and between the private and public sectors after adjustments had been made for differences in the quality of services.

 Major results of the questionnaire survey
    First of all, looking at the attributes of the businesses that responded, approximately half of current businesses were public businesses while private commercial enterprises and private noncommercial businesses such as NPOs accounted for about one-quarter each. Approximately 80% of previous businesses were public businesses and approximately 20% were private noncommercial businesses. Looking at the type of facilities medical and welfare facilities, educational and cultural facilities, and recreational facilities each accounted for around 20% to 30% of the total. (Appended Note 2-3 mentioned above.)
    When current businesses were asked to conduct a self-evaluation of how their performance had changed as a result of the introduction of the Designated Management Entity System, more than 40% responded that users' level of satisfaction with services had improved, and more than 30% said the efficiency of management had improved (Figure 2-2-6). Furthermore, 20% of current businesses responded that their number of users and income from usage charges had both increased and just over 10% responded that their revenue was flat but that their number of users had increased. Looking at this by type of business entity, the percentage that responded that the satisfaction level of users had increased was approximately 77% for private commercial enterprises and approximately 52% for private noncommercial businesses, much higher levels than the approximately 43% for public businesses. Concerning management efficiency, just over 60% of private commercial enterprises and just under 50% of private noncommercial businesses responded that it had improved whereas only just under 30% of public businesses responded that it had improved. Concerning trends in the number of users and revenue from usage charges, just over 40% of private commercial enterprises and private noncommercial businesses responded that they had increased, higher than the approximately 26% of public businesses who said so.
Figure 2-2-6 Self-evaluation of situation after introduction of Designated Management Entity System

 The difference in the quality of services provided by the public sector and the private sector
    Above we looked at the self-evaluation of businesses as revealed in their responses to the survey. Here we use statistical methods to determine if there is a disparity in the quality and efficiency of services depending on the differences between business entities, namely previous businesses and current businesses, and public businesses, private noncommercial businesses (NPOs, etc.) and private commercial enterprises. In order to evaluate the quality of services, questions were asked concerning the evaluation items already described above, points were awarded up to maximum of four for each item based on the response results and the points were totaled to calculate an overall score concerning the quality of services for each type of entity (Figure 2-2-7, Appended Note 2-3 mentioned above). Looking at the results in order to compare previous businesses and current businesses, the quality of services has improved since the introduction of the Designated Management Entity System for both public businesses and private noncommercial businesses and the disparity is statistically significant.
Figure 2-2-7 Service quality evaluation by entity
    Next, concerning current businesses that are managing and operating facilities after the introduction of the system, paying close attention to the differences among business entities, private commercial enterprises scored the highest, followed by public businesses and private noncommercial enterprises, in that order, and when the difference was statistically verified, the result was that there was a significant difference at the 5% level. Therefore, looking only at the evaluation items presented in the survey, the possibility is suggested that the quality of services of private commercial enterprises is the highest. Looking at individual evaluation items, the score of private commercial enterprises is higher than that of public businesses and private noncommercial businesses for most of the items, but in particular the score of private commercial enterprises was relatively high for items contributing to improvements in the convenience of users and increases in the number of users, namely, "response to users," "service times," "efforts to find new users," and for personnel management aspects, namely "staff management," and "training systems." On the other hand, private noncommercial businesses scored the highest for the evaluation item concerning "partnership with users" followed by private commercial enterprises and public businesses in that order. It is thought that this suggests that NPOs have certain advantages concerning participation in facilities management.
    Next, the quality of services function was estimated setting the overall score calculated concerning the quality of services as the dependent variable, and after adjusting for attributes such as type of facilities, specifics of users, number of users, number of staff and the site environment (city dummy), the survey looked at whether or not statistical disparities could be seen between types of businesses entities. According to the estimate result, the coefficient of the public businesses and private noncommercial businesses dummy variable is significantly negative and the fact that compared to private commercial enterprises the quality of services of public businesses and private noncommercial businesses is relatively low is also shown statistically. (Because the private commercial enterprises dummy variable was excluded from the estimate as a reference variable, the coefficient of public businesses and private noncommercial businesses is relatively different compared to that of private commercial enterprises.) (Table 2-2-8.) Furthermore, the current businesses dummy variable is significantly positive, showing that the quality of services compared to previous businesses is becoming high.
Table 2-2-8 Result of quality of services function estimation

 Analysis of the efficiency of services
    Using the financial data obtained from responses to the questionnaire survey, the expenditure function of facilities management businesses was estimated. The dependent variable was total expenditure and factor price indicators (labor costs, general management expenses, etc.) and output indicators (service times, number of users) were used as the independent variables. After adjusting for quality of services (services evaluation total score) and attributes of facilities (type of facilities, specifics of users, site environment), the survey looked at whether there was a difference in efficiency depending on the type of businesses entity (Table 2-2-9). According to the estimate result, the coefficient of the current businesses dummy variable is significantly negative, showing that current businesses are more efficient compared to previous businesses. On the other hand, the public businesses and private noncommercial businesses dummy variables are not statistically significant, so the result is that there has been no difference with respect to efficiency compared to private commercial enterprises. Furthermore, concerning quality of services, the coefficient is significantly positive and this shows that the costs of providing high-quality services are high. The fact that in this way the efficiency of current businesses is increasing across the board regardless of the differences between types of business entities shows that the introduction of the new system has resulted in a certain degree of competition among businesses.
Table 2-2-9 Results of estimation of expenditure function

 The effects of the introduction of the Designated Management Entity System as revealed in the survey results
    Looking at the above results, it is thought that both the quality and efficiency of services can be improved with respect to the operation and management of facilities by opening up the management of facilities to private businesses through the Designated Management Entity System. In particular, the advantages of private commercial enterprises over public businesses made clear in the current survey are, (i) with respect to improving the convenience of users, they are making efforts to extend service times, take into account the opinions and complaints of users, and homogenize the content of services, and (ii) they are implementing thorough staff management, namely, by adopting personnel evaluations and performance-based pay systems and providing staff education with a high training participation rate both internally and externally. On the other hand, it is thought that private noncommercial businesses such as NPOs. are making a contribution that public businesses and private commercial enterprises do not make with respect to increasing the participation of residents and users in the management and operation of facilities and promoting partnership with users.
    It is thought that the above disparity in the performances of the private and public sectors basically arises from the fact that private businesses are more strongly customer-orientated, due to their character as commercial businesses, than the "head-in-the-sand" public sector. Furthermore, it is thought that private noncommercial organizations also have an awareness of taking the viewpoint of residents to effectively manage commissioned operations. In addition to this, it is thought that differences in how strongly the competition principle works on the management businesses and differences in the extent of discretion with respect to contracts are also reflected in the performances of the public sector and the private sector. Specifically, in the process of selection of businesses, over 60% of private commercial enterprises are selected in a process of proposal competition through a public tender, whereas over 60% of public businesses and nearly half of private noncommercial businesses are selected through arbitral contracts (a contract for which a specific business is arbitrarily selected) and there is a concern that in the latter case there is not sufficient competitive pressure (Figure 2-2-10). Furthermore, private commercial enterprises have greater discretion over all aspects of running the business, including improvement of services, revision of usage charges, personnel deployment and employment, appointment of the heads of facilities, facilities repair and additional investment, and funds procurement, than public businesses and private noncommercial businesses. It is thought that this could be because in many cases public businesses are continuing as management entities from before the introduction of the Designated Management Entity System and in such cases, even if they switch to the new system, the content of their contracts remains little changed from before.
Figure 2-2-10 Differences in contractual content, etc., by entity

 Challenges in the operation of the Designated Management Entity System
    The Designated Management Entity has only just been introduced and partly for this reason challenges remain in the operation of the system. The challenges with respect to the new system indicated by private corporations that have become Designated Management Entities in the current survey can be broadly divided into challenges concerning the selection of Designated Management Entities, challenges concerning the content of contracts and general challenges related to the system (Table 2-2-11).
Table 2-2-11 Challenges for the Designated Management Entity System indicated by the questionnaire survey
    First, concerning the selection of Designated Management Entities, it was pointed out that traditionally in most cases entities were designated without going through a public tendering process, and in addition even if public tender was carried out, existing companies were in an advantageous position anyway as a result of the fact that the selection process lacked transparency and the public tender period was extremely short. Furthermore, it was pointed out that there is a concern that if too much priority is given to price in the selection criteria and the local government making the selection does not have sufficient knowledge, the result will be that companies that do not have sufficient capacity to provide the services get the contract.
    Concerning the content of agreements, many of the businesses pointed out that the degree of discretion of Designated Management Entities, including the setting of charges, is still small. Concerning the agreement period, some were of the opinion that 5 years would be sufficient while, on the other hand, some pointed out that if the period was too short it would be difficult to ensure high-quality staff. Furthermore, it was also pointed out that there was ambiguity concerning whether the local government or the Designated Management Entity would bear the burden for expenditure related to the repair of facilities, etc.
    Concerning general challenges related to the system, many expressed opinions concerning employment including the opinion that the deployment of staff was insufficient due to cost reductions and as a result the provision of high-quality services was difficult, and the opinion that in the process of cost reduction staff employment issues were arising.
    As a request item from businesses that have become Designated Management Entities to their public sector partner, it was pointed out that it was necessary for the public sector partner to not merely formally introduce the new system but reaffirm its awareness of the original aim of the system to realize efficient provision of high-quality services through the commissioning of facilities. Furthermore, some respondents called for greater objectivity and transparency in the selection process, including clarification of the screening criteria in the selection process and carrying out of wider public tender.

3. "From Public Sector to Private Sector" - Privatization (Transfer of Ownership Type)

 Advantages due to changing organizations from public sector to private sector
    The transfer of ownership type of privatization is when the public sector sells the companies and business activities it owns to the private sector and delegates the responsibility for supplying services to the private sector. In Japan examples of this type of privatization include Nippon Telegraph and Telephone Corporation (NTT), Japan Railways (JR) and Japan Tobacco Inc. (JT), as will be described later. Methods of transferring ownership include a public offering of stock in which the asset is widely sold to general investors, selling the asset to specified investors or companies, selling the asset to the management or employees of the company to be privatized, etc. In Japan, however, the first method - public offering of stock - is the one that is generally used. Unlike with outsourcing the transfer of ownership type of privatization entails changes to the organizational configurations of the entities supplying public services, and its success or failure depends on how efficiently the organization functions as a private company compared to how efficiently it functioned as a part of the public sector, and on how appropriately the principle of competition with other private companies operates as a result of privatization.
    In general, in private companies it is thought that mechanisms operate that discipline and motivate managers through the exercise of shareholders rights including their voting rights and the dispatch of board members and market discipline, which is the sale of stocks, and as a result, efficient results are achieved. If motivational mechanisms of the same kind as in private companies are applied to the public sector, efficiency improvements are possible. However, even if public sector efficiency actually increases as a result of management efforts and monetary profit gets bigger, there is a strong possibility that if that profit is only widely and thinly distributed to the government or the citizens in general, the motivational impact on managers will not be strong. Furthermore, if privatization of the public sector results in the competition principle taking effect in that goods market, consumers will have a wider range of choices available to them and companies will be strongly motivated to innovate.(19) Therefore, as long as the evil of excessive expenditure reductions bringing about a socially negative impact as a result of privatization is small, privatization has the advantage of fostering innovation and improving the efficiency of the overall economy.

(1) Results of privatization in other countries

 State of privatization in OECD countries
    Privatization of public companies has been widely carried out throughout the world since the 1980s. The specific advantages of privatization are not only benefits for public finances such as income from the sale of the asset and increased tax revenues; they also include increased productivity and profitability as a result of governance by the private sector, an increased consumer surplus as a result of decreased charges and improvements in the quality of services resulting from increased competition, and deepening of the capital market.
    According to an OECD survey, approximately 650 billion US dollars (approximately 68 trillion yen) was obtained from the privatization of public companies in OECD countries between 1990 and 2001, but privatization peaked in the second half of the 1990s and has been in a declining trend since (Figure 2-2-12 (a)).(20) It is thought that this is because in most countries the large-scale privatization projects, such as telecommunications, electricity and gas have basically been completed. Looking at privatization by sector, the largest amount is in telecommunications, which accounts for around 40% of all privatization, followed by the energy sector, including electricity and gas with 14%, the finance sector with 13%, the manufacturing industry with 11%, and the transportation sector with 10% (Figure 2-2-12 (b)).
Figure 2-2-12 (a) Value of privatization of state-owned enterprises
Figure 2-2-12 (b) Privatization by sector (1980-2001)

 Economic effects of privatization in other countries
    Concerning the impact of privatization on company profitability, productivity, investment, according to existing studies, in most cases a trend can be seen in which all of these aspects improve post-privatization. For example, according to a study which surveyed more than 200 companies in 41 countries, comparing average performance in the three years after privatization with average performance in the three years before privatization, it was seen that nearly 70% of companies increased their profitability (profit of sales), 80% of companies increased their productivity measured as sales per employee, and 60% of companies increased their investment rate (Figure 2-2-13)).(21) Furthermore, although the number of employees declined at around half of the companies, there was not a statistically significant disparity between the period before privatization and after privatization and the increase in real sales is statistically significant at the 1% level, so it is thought that the increase in sales made a big contribution to the post-privatization increase in productivity.
Figure 2-2-13 Proportion of companies that had improved business conditions after privatization
    Comparing the value of listed stocks of major individual privatized companies in major countries and the total size of the capital market in that country in order to see the impact of the listing of public companies on capital markets, large-scale privatization projects such as state-run telecommunications companies accounts for between 5% and 10% of the capital market in major developed countries. In developing countries and middle-income countries, they accounts for more than 15% of the capital market (Appended Table 2-4). Based on these facts, it is thought that the privatization of state-run companies has had the effect of deepening the capital markets.

(2) Case study on examples of privatization in Japan

 Aims and background of privatization
    The cases of Nippon Telegraph and Telephone Corporation (NTT), Japan Railways (JR), and Japan Tobacco Inc. (JT) are presented below as representative examples of state-owned companies that were privatized and the background to their privatization and the state of their management post-privatization are considered in detail.
    First, looking at the series of developments that led to these companies being considered for privatization and the aims of privatization, the privatization of all three companies was planned in the 1980s but the circumstances were very different in each case (Table 2-2-14).
Table 2-2-14 Outline of privatization of NTT, JR and JT
    Concerning NTT, against a background in which innovations in telecommunications technology were resulting in private businesses entering the telecommunications sector in other developed countries, the major premise was that competition should also be introduced into the Japanese telecommunications market, monopolized until that time by the Nippon Telegraph and Telephone Public Corporation. If competition with private businesses was introduced, in the form of a public corporation NTT would be faced with various restrictions such as control of the budget, restrictions on investment, and restrictions on funds management, lacking the freedom needed to manage itself to compete with the private sector. It was necessary to give NTT that discretion through privatization.
    For JR, the biggest challenges were its unprofitable structure and resolving the enormous accumulated debt issue caused by it. At that time, even though JR was being paid subsidies amounting to approximately 600 billion yen a year, it was recording a deficit of around 1 trillion yen a year and as of 1987, the year it was privatized, its accumulated debt had reached 37 trillion yen, including borrowing for financial deficit and capital investment, Japan Railway Construction Public Corporation debt and the pension burden. The Ad Hoc Commission on Administrative Reform and the Supervisory Committee for JNR Reconstruction of the time pointed out that this inefficiency was due to excessive involvement of the central government under the public corporation system, a delayed response to changes in the structure of transportation, the harm of a regional-dependent structure and uniform management based on a nationwide one-dimensional organization, etc., and they aimed to establish independent management through division and privatization in order to eliminate these problems.
    In the case of JT, demands from foreign countries to open up the market provided the impetus for privatization. Formerly, there was a monopolistic system for tobacco and the Japan Monopoly Sales Corporation was the sole seller of tobacco domestically. However, in order to appropriately respond to demands from foreign countries to open up the market, it was decided to abolish the monopolistic system and carry out privatization with a view to creating competitive conditions in the domestic market and further improving the efficiency of management.

 Economic impact post-privatization
    The backgrounds that led to privatization of NTT, JR and JT differ, but large improvements in the efficiency and profitability of the three companies after the privatization have been seen.
    First, looking at changes in per capita ordinary profits and productivity post-privatization, all three companies have shown marked improvement compared to before privatization (Figure 2-2-15). Comparing the level of per-employee ordinary profits in the first fiscal year of privatization and currently, NTT (consolidated basis) has increased by approximately 8 times (FY2004), JT has increased by approximately 5.5 times (FY2004), and JR has increased by approximately 3 times (FY2002). And during the same period productivity has increased from around 1.5 to 3 times compared to its level at the time of privatization. These changes in per capita profitability and productivity were partly due to the economies of scale brought about by increased sales and partly due to adjustments to more appropriate personnel levels (Figure 2-2-16). Sales for both JR and JT have been flat or slightly increasing compared to the time of privatization, whereas NTT's sales have increased by more than 2 times as the historical technology shift from fixed-line telephones to mobile communications has occured, and this has made a big contribution to improvement in profits and productivity for the entire NTT Group. On the other hand, the number of employees has declined around 30% for both NTT and JR compared to the time of privatization; furthermore, at JT the number of employees has declined to fewer than half the number at the time of privatization and the effects of this restructuring have contributed to the improvement in per capita profit and productivity.
Figure 2-2-15 Changes in per capita profitability and productivity after privatization of NTT, JR and JT
Figure 2-2-16 Changes in sales and personnel for NTT, JR and JT
    The privatization of the three former public corporations has had a big impact on the capital markets. Under law, the government has an obligation to hold at least one-third of NTT's stocks. Concerning JT, the government is obliged to hold stocks that are at least one-half of the total number of JT stocks freely transferred to the government at the time JT was established and more than one-third of the total number of JT issued stocks. Up until this point in time, the aggregate value of stocks sold on the market for NTT, JR (the three JR companies on Honshu) and JT has risen to approximately 4 trillion yen each for NTT and JR, and approximately 4 trillion yen and approximately 1 trillion yen for JT. As of the current point in time, the total value of stocks of NTT, JR (the three JR companies on Honshu) and JT, excluding the portion held by the government accounts for 1.1%, 1.2% and 0.3% of the capital market respectively and so the three companies are contributing to expanding the base of the capital market. (Figure 2-2-17).(22) Furthermore, in the case of NTT stocks and JT stocks, sales income is allocated to fiscal resources for government bond redemption and in the case of JR stocks to the payment of pensions for former Japan National Railways staff. Looking at trends in the stock prices of these five companies since they were listed in terms of their degree of divergence from the Nikkei average, except for NTT which was listed in the bubble period, they are generally higher than the Nikkei average. This suggests that it is thought that profitability got stronger as a result of privatization. (Figure 2-2-18).
Figure 2-2-17 Market value of stocks and share held by government for NTT, JR and JT
Figure 2-2-18 Trends in the degree of divergence from the Nikkei average for NTT, JR and JT

 Design of organizations and systems post-privatization
    As already described above, whether or not privatization leads to improved productivity and increased profits as expected largely depends on how efficient the privatized organization is and on the extent to which the market competition principle is effective. In the cases of NTT, JR and JT, there were major differences in the design of organizations and systems post-privatization (in the case of NTT, division into subscriber line network-based NTT East and NTT West and other group companies (NTT DoCoMo, NTT Communications, NTT Data); in the case of JR, division into a freight company and passenger companies for each region; and in the case of JT, the organization was not divided up at all). However, taking into account the state of competition with other private companies that each of the three companies was placed in and the level of cross-subsidies from high-profit sectors to low-profit sectors, etc., it is thought that appropriate judgments were made tailored to the conditions of each company.
    In the case of NTT, the separation of the monopolistic subscriber line network from the companies providing other services was carried out in order to eliminate unfair competition that arises from the characteristics of telecommunications business activities, namely the concern that it is difficult for other private businesses carrying out business activities such as long-distance communications to run their businesses without depending on the telephone line network owned by NTT East and NTT West, meaning that if NTT East and NTT West, existing monopoly businesses, discriminate against other businesses in providing access to the network (for example requiring expensive usage charges, etc.), the entry of new companies into growth sectors will be obstructed. However, this does not mean that this organizational separation was carried out at the time of the 1985 privatization of NTT. NTT was finally separated into regional communications and long-distance communications organizations in 1999 through the process of introducing new systems, including the establishment of the connection rule based on the principles of "impartial, fair, and no discrimination domestically or internationally" (Appended Figure 2-5). Due to the recent progress of telecommunications technologies, broadband networks (IP networks) that do not depend on existing telephone line networks have been developed and as a result the 2003 amended Telecommunications Business Law abolished the former classification of telecommunications businesses into "Type 1" and "Type 2" based on such factors as whether or not they owned bottleneck facilities like telephone line networks.
    Regional division was carried out in the case of JR in order to correct the problem that incentives to improve the efficiency of loss-making routes were obstructed by cross-subsidies from profitable routes to loss-making routes and to advance improvements in efficiency by making it possible to set wages commensurate to actual conditions in each region. For example, before privatization in 1985, although the local transport routes (142 routes) accounted for no more than 4% of total transportation volume, their losses had reached more than 600 billion yen even after the provision of 69.8 billion yen in special grants and accounted for one-third of the total losses of Japan National Railways (Table 2-2-19). Post-privatization, 45 of these loss-making routes had been switched to bus transportation and 38 had been switched to railway transportation in the third sector by 1990. On the other hand, due to the regional division, disparities in profitability between each company appeared but this issue was dealt with for the three JR companies on Honshu by setting different lease charges for the Shinkansen Holding Corporation (for example, setting more expensive lease charges for the highly profitable JR Tokai). Furthermore, debt inherited from the former Japan National Railways was set to zero for JR Hokkaido, JR Shikoku and JR Kyushu and their losses were covered by the management profit of the management stability fund established due to the burden of Japan National Railways. Of the 37 trillion yen of long-term debt accumulated by Japan National Railways, the 25.5 trillion yen not inherited by the successor corporations was disposed of by the Japanese National Railways Settlement Corporation (JNRSC), and at the time the JNRSC was dissolved, 24.1 trillion yen of the debt balance of 28.3 trillion yen had been borne by the central government and the remaining debt related to pensions for former Japan National Railways staff was inherited by the Japan Railway Construction Public Corporation (current name: Japan Railway Construction, Transport and Technology Agency) and JR (Appended Figure 2-6).
Table 2-2-19 Business conditions of local transport routes
    JT was given monopoly rights regarding the manufacture of "manufactured tobacco" in order to ensure its international competitiveness as it grappled with the domestic leaf tobacco issue. Due to the entry into the market of foreign tobacco companies, JT's share of the domestic tobacco market has been consistently declining for the most part (it declined from 97.6% in FY1985 to 72.9% in FY2003 (Figure 2-2-20)), but due to rationalizations such as a large reduction in the number of employees and measures to improve the efficiency of the organization such as consolidation of factories, ordinary profits are in an increasing trend. Furthermore, JT has actively developed its business activities overseas and domestically it has actively advanced into sectors other than the tobacco business. The JT Group's share of the world tobacco market increased from 6.9% in 1985 to 8.2% in 2002 due to factors such as its acquisition of RJR (excluding the United States), etc.
Figure 2-2-20 Trends in JT's share

 Design of universal service
    The universal service obligation (USO) is considered to be the provision of goods and services for which the involvement of the government is generally indispensable, to all users nationwide and at an affordable price. Generally, this kind of universal service is implemented by governments when the consumption of public goods has external effects (for example, development of water supply and sewerage systems has the effect of improving hygiene and so increasing the welfare of society as a whole), when public goods are considered to be merit goods (meaning that it is thought to be a socially-accepted idea that all people have the right to consume the public good in question), when consideration of the income distribution of users is necessary. However, there is some ambiguity about what specific goods should be subject to universal service.(23) The universal service obligation need not necessarily be provided by public entities only; in fact privatized NTT is obligated to provide universal service even post-privatization. Although JR does not have a universal service obligation, in practice it is retaining some loss-making routes due to factors such as demands from regional communities.
    However, a major issue is how to compensate private companies, which are commercial corporations, for the additional expenditure that arises when they have a universal service obligation. Generally, methods for covering the cost of the expenditure for universal services include (i) the cross-subsidy method (monopolistic businesses cover the cost of expenditure in unprofitable regions with profits from regions with high demand), (ii) the access charge method (monopolistic businesses providing services in unprofitable regions seek to cover their costs in the form of connection fees charged to new companies entering the market), (iii) the universal service fund method (a method in which in principle a fund is established with contributions from all businesses and the fund is used to subsidize the expenditure of businesses providing services to unprofitable regions), and (iv) the direct subsidy method (a method for providing direct subsidies to residents in unprofitable regions in the form of vouchers, etc.). Generally, the cross-subsidy method and the access charge method lack competitive neutrality, on the other hand, the fund method and (in particular) the direct subsidy method require a large amount of expenditure to implement.(24)
    In the case of NTT, post-privatization a large number of new companies entered the market for long-distance telephone services and market competition advanced. As a result, telecommunications charges have become cheaper. In addition, the number of new companies entering the local telephone services market is increasing, primarily in highly-profitable urban areas, and as a result it has become difficult to maintain the universal service covered by internal cross-subsidization by the former NTT. Against this background, in 2002 a mechanism was put in place to cover the expenses that could not be covered by cross-subsidies within NTT East and NTT West using the newly established universal service fund. This universal service fund is funded by contributions from all telecommunications businesses and it is used for basic telecommunications services consisting of subscription telephones, public telephones and emergency notification. Worldwide, the number of countries adopting the fund method for telecommunications-related universal services is increasing (Table 2-2-21).
Table 2-2-21 Mechanisms to ensure universal service in major countries

(3) Outlook for the privatization of postal services

 Background to the privatization of postal services
    After NTT, JR and JT were privatized in the 1980s, privatization efforts were muted in the 1990s but in the 2000s, privatization efforts once again became vigorous. Specifically, in addition to the privatization of Narita Airport, the privatization of special corporations including the highway-related public corporations, and currently a debate concerning the privatization of postal services is under way.
    In particular, the privatization of postal services is considered the most important challenge in order to effectively advance reconstruction of the economy and realize efficient government through the "from public sector to private sector" reform. Specifically, the privatization of postal services is important for building mechanisms so that funds accumulated through post offices as postal savings and postal life insurance are efficiently spent in the private sector through the management judgment of that sector. At the same time privatization would contribute to small government as approximately 30% of national public servants would become private sector employees, the hidden public burden (absence of obligation to pay corporate tax, and deposit insurance premiums) would be reduced and in addition, if the stocks held by the government were sold and the proceeds were paid to the state, it would lead to fiscal reconstruction.
    Furthermore, considering the management environment surrounding the postal services, there is a concern that if this reform is not carried out the following situations will arise. First, with the ongoing development of new methods of communication, such as the spread of the Internet and e-mail, etc., there is a concern that if the freedom of management of the current Japan Post remains constricted, its profitability will worsen and in the future it will become difficult for it to continue to exist and support itself independently. Second, as the private finance sector continues to regain its strength, there is a concern that if postal savings and postal life insurance, which do not necessarily face competitive conditions equal to those of the private sector, continue to be major presences, the flow of funds may go to the public sector more than necessary and obstruct economic revitalization. Third, under the public corporation system there are large restrictions imposed by laws on entry into new markets and international markets that are expected to expand and the management discretion to make quick judgments is limited.
    In relation to the first point, looking at the current state of Japan Post's three businesses, in addition to the fact that the volume of mail is declining by 2% to 3% a year due to the spread of e-mail and income of the postal business is declining, the balance of postal savings and the number of postal life insurance contracts is also declining (Figure 2-2-22 (a)). Furthermore, it is anticipated that the loss of the deposit interest income (deposit interest rates are topped up to 0.2% higher than government bond interest rates) from fiscal loan funds, which currently accounts for just over 60% of income from the postal savings business, will have a big impact on profits when the transitional period after the abolition of the deposit system ends in FY2007 (Figure 2-2-22 (b)).(25) In this difficult environment for existing businesses, there is a possibility that within a framework retaining the restrictions of a public corporation, it will be impossible to quickly launch new businesses, etc.
Figure 2-2-22 (a) Postal business income, postal savings balance, and number of postal life insurance holders
Figure 2-2-22 (b) Profit structure of Japan Post
    Concerning the second point regarding funds circulation, as private financial institutions curtailed risky loans and their operations in the 1990s due to the decline in demand for funds resulting from the sluggishness of the economy and the disposal of non-performing loans, the flow of public funds for both funds management and procurement became relatively large. With respect to funds management, the ratio of loans of public finance institutions relative to total loans of private financial institutions and public finance institutions was approximately 14% in 1990, but the risk-handling capacity of private financial institutions has subsequently declined and in 2003, the ratio was approximately 20% partly due to the fact that public finance has taken on a supplementary role. Furthermore, with respect to funds procurement, the ratio of funds flowing to the public sector in the form of the postal savings and government bonds which account for the financial assets of the household sector increased from 14% in 1990 (postal savings: 13.1%) to a peak of 19.4% in 1998 (postal savings: 18.7%) and in 2003 was 16.8% (postal savings: 15.3%). In this way, public funds gathered in the form of postal savings have occupied a major position in the finances of Japan. It is thought that enabling funds procured through postal savings and postal life insurance to be utilized based on the market principle through the privatization of postal services will contribute to revitalization of the economy.
    Furthermore, from the perspective of competitive conditions with private financial institutions, it has often been pointed out that postal savings have been given an advantage over private financial institutions, namely that they do not pay deposit insurance premiums, corporate tax, etc., but post-privatization, naturally each company will pay deposit insurance premiums and taxes. As an example of the estimate of the amount that would be paid by the postal savings company if it paid the same deposit insurance premiums as private financial institutions during this period, is multiplying the postal savings balance at the end of FY2003 of 227.4 trillion yen by the deposit insurance premium of 0.083% gives the total of approximately 190 billion yen.

 System design for the privatization of postal services
    The scheme of the bill on the privatization of the postal services recently adopted by a Cabinet decision has the following characteristics compared to examples of past privatization and examples of privatization in foreign countries (Table 2-2-23).
Table 2-2-23 Postal business systems around the world
    The post-privatization organizational configuration will not be regional division as for JR; rather it will be vertical separation as for NTT (division of the network part from the businesses that use it). It will be divided into four companies under a holding company, namely the over-the-counter services network company possessing a network of post offices (the post office joint-stock company) and three companies that use the network: the postal services company, the postal savings company, and the postal life insurance company. The advantages of this kind of vertical separation are that from the perspective of competition policies, the independence of the three businesses - the postal services company, postal savings company, and postal life insurance company - using the same over-the-counter services network is guaranteed, which contributes to creating equal competitive conditions with other private companies by increasing the transparency of transactions among each company, and at the same time, it has the value of making it possible for other private businesses to access the over-the-counter services network.(26) Furthermore, from the perspective of financial supervision, it has the aim of warding off risk between the postal savings business, for which the strict risk management entailed by discretionary operations is required, and other businesses. Internationally, examples of this kind in which post office networks have been made independent can be seen in the United Kingdom and the Netherlands.
    Looking at how each operation will be conducted post-privatization, there will be no major change to the scope of domestic postal operations but the operational freedom of postal savings and postal life insurance is to be incrementally increased through privatization. Postal savings and postal life insurance have reached approximately 340 trillion yen, an enormous scale by international standards, but the post-privatization aim is that these funds contribute to the achievement of efficient resource allocation by flowing through diverse channels in a form that is in line with market mechanisms.(27) Currently, postal savings and postal life insurance funds are operated in a autonomous manner by public corporations, but if they remain public corporations taking into account avoidance of public burden and their relationship to private sector businesses, the scope of their operations will be restricted. For this reason, when embarking on privatization, the fixed amount postal savings and postal life insurance deposited before privatization (this portion is called public corporation accounts, and the plan is for them to include approximately 150 trillion yen in fixed term deposits and approximately 110 trillion yen in postal life insurance funds) will be inherited by an incorporated administrative agency (the Postal Savings and Postal Life Insurance Management Corporation), and they will continue to be operated as safe assets but for funds other than public corporation accounts (approximately 50 trillion yen including ordinary deposits) and new accounts, new asset operations such as loans will be incrementally allowed in order to adapt to the advance of privatization.
    Furthermore, concerning the postal services, a universal service will continue to be required and the post office companies will be obliged to establish post offices so that they can be used nationwide. Concerning financial services, by law, post office companies can provide them as operations that contribute to increasing the convenience of regional residents. During the transitional period, deposit and insurance services will be provided in post offices by designing a system to guarantee the commissioning of operations from postal banks and postal life insurance companies to post office companies. Furthermore, funds from the social and regional contribution fund reserved from a part of the profits of Japan postal services joint-stock companies are to be issued to operations carried out by the postal services company and post office companies that contribute to society and the regions (third and fourth postal operations by postal services joint-stock companies that meet certain conditions, operations increasing the convenience of regional residents by post office joint-stock companies that meet certain conditions). Looking at examples from other countries, in the majority of cases a universal service for postal services is ensured by imposing an obligation on the central government or a monopolistic business while leaving a monopoly retained sector to letter delivery under a certain weight and value (the EU, etc.) and cases can also be seen in which fiscal support is provided to the universal service (including the establishment of a fund). Furthermore, cases can be seen in which a post office network is maintained in sparsely-populated regions through a fund that reserves past profits.(28)

4. "From Public Sector to Private Sector" - Changes in the Flow of Funds and Policy-based Finance

(1) Reform of the public sector and the outlook for the flow of funds in the future

 Funds procurement in the public sector
    How will the flow of funds, including private sector funds, change in future as a result of the large change in funds procurement methods in the public sector incurred by the reform of fiscal investment and loan program (FILP), privatization of postal services, and the reform of special public institutions? First, in the case of funds procurement in the public sector there are broadly two sectors of funds procurement. The first is funds procurement by the central government and the local governments in which funds procurement is carried out by issuing government bonds and local bonds. And the other is funds procurement by special public institutions, including policy-based finance which is the outlet for FILP. Currently, it is being covered by investment-and-loan institution bonds individually issued by each organization and investment and loan bonds issued by the FILP as a whole.
    Concerning the state of funds procurement in these two sectors, looking at the flow of funds accounts, the public funds procurement amount (debts) in a broad sense including government bonds, local bonds, FILP bonds, FILP agency bonds and deposits in fiscal loan funds was approximately 996 trillion yen as of December 2004; of this postal savings accounted for 23.8% (237 trillion yen) and postal life insurance accounted for 7.9% (79 trillion yen). In this sense postal savings have a role as the most important source of public sector funds procurement. On the other hand, it is also a fact that there has been criticism that the existence of postal savings puts pressure on private sector business from the viewpoint of private financial institutions. The advantage of postal savings over private banks, as already described above, is that postal savings do not pay deposit insurance premiums and corporate tax. However, if the postal service is privatized, it will lose the special privileges it has by virtue of being a public sector operation and postal savings will have to compete under the same conditions as private financial institutions. Furthermore, with respect to asset operations, it is expected that funds excluding those from former accounts will be managed in such a way as to revitalize private economic activities through the management judgment of the private sector.

 Changes in the flow of funds after the Reform of Fiscal Investment and Loan Reform
    Through the reform of FILP enforced in FY2001, the obligation to make full deposits in postal savings was abolished and it was decided that deposits would basically be fully reimbursed by FY2007. In this context, the fact that the role of postal savings will undergo large changes due to privatization in future will change the excessive and distorted flow of funds to the public sector and contribute to revitalization of the economy. Furthermore, the fact that the inlets for funds to the public sector will undergo large changes due to the 2001 FILP reform and the current privatization of postal services will have a big impact on the form of special public institutions including policy-based finance, which is a funds outlet. Actually, changes have already been seen in the flow of funds in the public sector since the 2001 FILP reform. Based on the flow of funds account, looking at the changes in the flow of funds by comparing balances as of the end of FY2000 (the end of March 2001), before the FILP reform, and as of the end of December 2004, the following characteristics can be seen (Figure 2-2-24).(29)
Figure 2-2-24 Changes in the flow of funds after Reform of Fiscal Investment and Loan Program (FILP)
(i) With respect to the asset allocation of households, the balance of postal savings and postal life insurance held declined by 33 trillion yen (a 9% decline) partly due to the fact that the fixed amount postal savings deposited in the high interest rate period in the beginning of the 1990s reached maturity.
(ii) Deposits from postal savings and postal life insurance to fiscal loan funds declined by 126 trillion yen (a 50% decline) and deposits from social security funds also declined by 66 trillion yen (a 42% decline). As a result the balance of deposits in fiscal loan funds declined by 191 trillion yen (a 45% decline). On the other hand, procurement through FILP bonds of fiscal loan funds increased by 114 trillion yen. In this context, concerning policy-based finance,(30) borrowing from fiscal loan funds declined by 29 trillion yen (a 26% decline) and procurement through government institution bonds, including FILP agency bonds increased by 5 trillion yen.
(iii) Looking at the funds procurement of households, private non-financial corporations, and central and local governments which are the final borrowers of funds, borrowing by households from public financial institutions(31) for housing declined by 23 trillion yen while borrowing from the private sector increased by 22 trillion yen. As a result of the decrease in the operations of the Government Housing Loan Corporation, capital is being redirected from the public sector to the private sector. Concerning private non-financial corporations, borrowing from both public financial institutions and private financial institutions has declined but the decline in borrowing from public financial institutions has remained relatively small. On the other hand, concerning the central government, borrowing from both the public sector and the private sector (underwriting of government bonds) has increased, but relatively speaking the increase in underwriting for government bonds by public institutions, namely postal savings, postal life insurance and social security funds, has been larger than that by the private sector.
    As stated above, the decrease in the scale of some parts of public finance as a result of the series of FILP reforms and reform of special public institutions is clear, while on the other hand, as in the case of housing loans there are sectors in which redirection of funds from the public sector to the private sector can be clearly seen and it can be discerned that the flow of funds related to public finance has changed. However, as the public debt of the central and local governments increases, postal savings and postal life insurance continue to play a big role in their finances.

 Funds procurement of the central government
    Concerning the funds procurement of the central government, first of all it is essential to strongly promote fiscal structural reforms and dampen the amount of outstanding government bonds. However, as long as the fiscal deficit persists, the public sector will absorb market funds in some form. It is anticipated that when postal savings and postal life insurance, a stable destination for the underwriting of government bonds, diversify its operations involved in new accounts due to privatization in the future, the role of households as the underwriters of government bonds will become bigger than it is currently. Concerning the government bonds for individuals introduced in 2003, compared to former government bonds they are easier for individuals to purchase, and the amount of these bonds being issued is rapidly expanding, going from 2 trillion yen in 2003 to 6.5 trillion yen in 2004 (Appended Figure 2-7).(32) Partly due to the fact that Japan's households have a stronger tendency to hold safe assets compared to foreign countries (the proportion of safe assets is around 60% in Japan, around 30% in the United Kingdom and around 20% in the United States), it is thought that there is a strong possibility that the proportion of government bonds held by individuals will increase (Appended Figure 2-8).

(2) Reform of policy-based finance

 The current state of policy-based finance
    When the debate on the reform of special public institutions was held in 2001, concerning policy-based finance, it was decided to conduct a review of the target sectors, scale and organization of public finance in the Council on Economic and Fiscal Policy and as a result consideration of these issues was commenced in the Council on Economic and Fiscal Policy in 2002.(33) In a report on the Reform of Policy-based Finance compiled in December 2002 by the Council on Economic and Fiscal Policy, taking into consideration the difficult financial and economic conditions at that time, it was decided to carry out reform of policy-based finance incrementally. Specifically, during the first stage, the non-performing loans concentration disposal period up until the end of FY2004, it was decided to utilize policy-based finance for finance facilitation, in particular it was decided to expend all possible safety net measures to ensure a smooth funds supply when facing rapid changes in the financial environment and the danger of chain reaction bankruptcies. Subsequently, as the disposal of non-performing loans proceeded smoothly, primarily at the major banks and private financial institutions began to recover their functions with the increase in company profits, especially in large companies continuing and their cash position improving in 2005, the Council on Economic and Fiscal Policy resumed deliberations on policy-based finance reform as its second stage. It was decided in the Basic Policies 2005 (June 2005) that the Council on Economic and Fiscal Policy would hold discussions to be completed in fall this year, based on the above policy document (On the Reform of Policy-based Finance, December 2002), and compile the basic policies concerning realization of the ideal form of policy-based finance.
    Essentially finance is different from pure public goods. As many private financial institutions exist and are carrying out business activities, the public sector uses the policy-based finance approach only when there is a high level of public needs in which the social benefits of policy support are much higher than the expenditure required for the policy or when there is a high level of uncertainty and danger, so that evaluation of financial risk is difficult (On the Reform of Policy-based Finance mentioned above). Therefore, it is necessary to stop policy intervention in cases where the policy value has already been lost and in cases for which it is recognized that they still have a public nature, to select the most appropriate methods compared to financial measures other than direct loans and other policy measures.
    Concerning the current state of policy-based finance, the ratio of policy-based finance to total loans by financial institutions has increased from 14% in 1990 to approximately 20% in 2003, partly due to the decline in loans by private institutions (Figure 2-2-25). Concerning the ratio of policy-based finance by sector, comparing 1990, 2000 and 2003, the biggest changes can be seen in the housing sector. In 2000, policy-based finance had a more than 40% share of that sector but by 2003, it had shown a big decline to around 30% (Figure 2-2-26). Furthermore, in the agriculture, forestry and fisheries sector, the share of policy-based finance declined from 21.3% in 1990 to 13.5% in 2003. On the other hand, the share of policy-based finance increased in the large and medium enterprises sector,(34) and the small and medium enterprises sector. However, the expansion of the share of policy-based finance in loans for enterprises partly reflects the fact that the overall loans market got smaller due to the decline in private sector loans, and it can be concluded that policy-based finance simply supplemented the amount of decline in private sector loans. In addition, policy-based finance has maintained a high share of the specified region sector (Okinawa).
Figure 2-2-25 Share of policy-based finance
Figure 2-2-26 Shares of gross lending in policy-based finance (share by sector)

 Characteristics of policy-based finance
    The characteristics of policy-based finance are that long-term loans are most common and interest rate levels tend to be lower compared to those in the private sector. With reference to the Ministry of Internal Affairs and Communications (2003), a graph is made to show the state of banking institutions, with the average loan period on the horizontal axis and the average loan interest rate on the vertical axis. According to this, for policy-based finance the loan period is relatively long compared to that for private banks, such as cities banks, and the level of loan interest rates generally tends to be lower compared to private banks (Figure 2-2-27). Furthermore, because policy-based finance involves accepting loans in sectors for which the evaluation of risk is difficult in order to achieve policy aims with a view to supplementing private sector businesses, in some sectors the non-performing loans ratio is high. Calculating the proportion of remaining debts based on the Financial Reconstruction Law ("bankrupt or de facto bankrupt" loans, "doubtful" loans, "special attention" loans) against the total credit balance (the disclosed non-performing loans ratio) based on documents disclosed by policy-based finance institutions, for all the policy-based finance institutions (excluding the Government Housing Loan Corporation), the ratio has been stable at around 5% for the last few years and as of FY2003 it was lower than the non-performing loans ratio of the major banks (major commercial banks, long-term credit banks, trust banks). However, although the non-performing loans ratio of the major banks declined from 8.4% in FY2001 to 5.2% in FY2003 (Figure 2-2-28) and the write-off of non-performing loans has made great progress at the major banks, in policy-based finance institutions the non-performing loans ratio has not changed much at all. Furthermore, although the write-offs of loans at policy-based finance institutions has rapidly increased recently, the disposal rate (the ratio of the value of loans written off to the total loans balance) is between around 0.1% and 0.8% and is substantially lower than the rate of write-offs of commercial banks (Appended Figure 2-9).
Figure 2-2-27 Comparison of public and private average loan periods and average loan interest rates (FY2001)
Figure 2-2-28 Trends in non-performing loans ratios for government-affiliated financial institutions and private financial institutions

 The efficiency of policy-based finance
    As was already described above, even for policy-based finance serving for the public it is necessary to sufficiency consider what methods are appropriate in order to achieve the aims of policy. In doing so, essentially comprehensive studies of the social benefits and expenditure arising from the supply of public funds should be carried out and at this point the value of subsidy with respect to expenditure was calculated using the same method as the Ministry of Internal Affairs and Communications (2003), as a simplified estimate in order to see the convenience and efficiency of funds supply methods.(35) Specifically, as one measure for showing the value of subsidy of policy-based finance, the amount equivalent to the reduction in interest compared to a hypothetical scenario in which borrowers of funds accept loans from private financial institutions was used (Appended Note 2-4). On the other hand, for expenditure the value of the public financial burden of the government in each fiscal year was used and the ratio of these two values was taken to be the value of subsidy with respect to expenditure (if the ratio is higher than one it means that the value of subsidy is bigger than expenditure). Looking at the trends in this value, since the middle of the 1990s improvement has been seen in many institutions, but in the last few years it has been flat on average (Figure 2-2-29). Furthermore, looking at the net value of subsidy (the value of subsidy minus expenditure) per unit of loans, in the last few years it has been generally flat. This reflects the fact that although fiscal expenditure is in a declining trend, the value of subsidy per unit of loans is also in a generally declining trend. Factors behind the decline in the value of subsidy include the advancement of finance liberalization and the impact of improvements in finance technology, and it is thought that as the loan interest rates of private financial institutions declined substantially in the phase of declining interest rates, the loan interest rates of policy-based finance relatively bottomed out in the phase of declining interest rates. Summarizing the above, concerning the supply of public funds directly through loans, against the background of recent financial conditions and economic conditions, the value of subsidy with respect to expenditure indicator shows that, despite efficiency improvement seen in some policy-based finance institutions their advantage as a whole system is declining even though a certain level of efficiency is being ensured (Ministry of Internal Affairs and Communications (2003)).
Figure 2-2-29 Expenditure to value of subsidy ratio and its content
    Concerning methods of fund supply through policy-based finance, with a view to contributing to the development and revitalization of the finance capital market, it is also important to not only use direct loans but also to increase indirect funds supply methods such as providing support for securitization and debt guarantees, utilizing market functions and private financial institutions. Furthermore, when taking indirect methods, it is also necessary to ensure that efficiency increases at the same time through methods to prevent moral hazard such as risk sharing with the private sector. For example, under the representative loans guarantee system of the Small Business Administration (SBA) in the United States, in order to prevent the moral hazard of private financial institutions, an upper limit is established for the guarantee ratio, and a fixed part of the credit risk is imposed on private financial institutions (for loans of 150,000 dollars or less, it is 85%, and for loans is excess of that amount it is 75%). Taking into account deliberations in the Small and Medium Enterprise Policy Making Council in the Small and Medium Enterprise Agency, measures toward the comprehensive review of Japan's credit guarantee system are also currently underway. These measures include the introduction of partial guarantees and strengthening of functions providing support for management and reconstruction of businesses, the strengthening of management discipline through the establishment of a supervisory framework.

 Example of the Government Housing Loan Corporation which has already been reformed
    Under the Reorganization and Rationalization Plan for Special Public Corporations adopted by Cabinet decision in December 2001, the Government Housing Loan Corporation was to be abolished by FY2006 and a new incorporated administrative agency was to be established to carry out securitization support operations after the abolition. Furthermore, the loans operations of the corporation were to be incrementally reduced up until the time of abolition and a system introduced that is not predicated on interest subsidies, and final consideration given to whether or not loans operations should be continued made at the time of the establishment of the incorporated administrative agency taking into account whether or not the operations of private financial institutions were being implemented smoothly.
    Concerning the reduction of loans operations, a review of the upper limit of the ratio of loans to acquisition expenditure for housing from FY2002 (specifically, a reduction from 100% of expenditure to 80% or 50% depending on annual income) and reduction of special additions (reduction from 8 million yen to 2 million yen) was implemented. Partly as a result of this, the proportion of new housing loans for individuals accounted for by the Government Housing Loan Corporation greatly declined from approximately 34% in FY2000 to approximately 9% in FY2003 and the principle of "leave to the private sector what it can do" is being realized (Figure 2-2-30).
Figure 2-2-30 Share of housing loans held by the Housing Loan Corporation and private-sector financial institutions
    On the other hand, concerning securitization support operations, which will be the major operations of the Government Housing Loan Corporation in future, partly due to the fact that these business activities have only just been commenced, at the current point in time they are still only on a small scale but recently high growth trends have been seen. Concerning purchasing-type securitization support operations where the corporation buys housing loans lent by private financial institutions, puts them in trust and then issues bonds and sells them to investors, even though the FY2004 budget was 1.4 trillion yen, the value purchased between October 2003 when securitization support business activities commenced and the end of March 2005 was, in aggregate, 206.7 billion yen. Guarantee-type securitization support operations where the corporation debt guarantees housing loans lent by private financial institutions commenced from October 2004 and business activities on the scale of 200 billion yen a year are planned. The securitization support operations of the corporation have only just been commenced, but against a background in which the purchased amount is much lower than the planned scale of business activities, it is thought that incentives for private financial institutions to sell housing loans have been small due to the fact that the support operations have not been sufficiently publicized, that consumers are not sufficiently aware of the risk of interest rate changes in future and that essentially housing loans debt is given favorable treatment in the calculation of the capital adequacy ratio with the risk weight under BIS regulations at 50% (from the end of 2006, 35%). However, since fall 2004, against a background of expectations of further rises in interest rates, attention has begun to be focused on fixed interest rate products and in addition, the corporation has improved its products by expanding the range of properties subject to securitization loans and measures have been taken to lower interest rates. These factors increase the number of financial institutions including the major banks which handle the securitization loans of the corporation and the number of purchases by the corporation is rapidly increasing, reaching around 3,000-4,000 per month since February 2005 (Figure 2-2-31). It is worth noting that in the United States the issued balance of mortgage-backed securities (MBS) had reached approximately 4.8 trillion dollars at the end of September 2004 (approximately 536 trillion yen ), a much deeper market compared to Japan's approximately 1.6 trillion yen (as of February 2005). These securities are a source of supply of long-term fixed loans. In order to provide support for this supply of long-term fixed loans, it is expected that the Government Housing Loan Corporation will continue play a pioneering market creation role.
Figure 2-2-31 Number of applications for purchases of securitized loans has increased sharply since the end of 2004
    Looking at the financial state of the Government Housing Loan Corporation, as the value of new loans decreases, partly due to the fact that a large amount of voluntary advanced repayments related to past high interest rate loans are occurring, the value of transfers from the government's general account increased from 375.9 billion yen in FY2002 to 387.2 billion yen in FY2005. Furthermore, looking at the state of the profit margin as of FY2003, on a flow basis, procurement costs due to investment-and-loan institution bond issues were approximately 1.1% whereas loan interest rates were approximately 2.3%, so the profit margin was positive. However, on a balance basis, average interest rates for borrowing (interest payments divided by the balance of borrowing) were approximately 4%, which is higher than 3.4% of the average loan interest rate (loan interest receipts divided by the loans balance), resulting in a negative spread appearing in the operations balance of payments (Appended Figure 2-10).
    The new incorporated administrative agencies are to promote the new operations such as securitization support without relying on subsidies and it is planned to quickly dispose of the future fiscal burden related to prior debt in a transparent manner and without delay, abolish subsidies by FY2011, and move to independent management.(36)

5. Special Public Institutions, Incorporated Administrative Agencies, Local Public Corporations

 Issues related to the organization of the public sector
    It is thought that supply of public services by the "public sector" generally has a tendency to be inefficient primarily due to issues related to the organization of the "public sector." It is not only the central government and local governments (including local public enterprises which carry out water supply and sewerage system business activities, etc.) that are actually supplying public services; the supply of many public services is undertaken by special public institutions, incorporated administrative agencies, local public corporations, and public bodies such as third sector. These public bodies other than the central government or local governments currently consist of 37 special public institutions, 109 incorporated administrative agencies, 1,590 local public corporations of three types (the three public corporations for housing, roads and land established under the special law), and 8,357 third sector bodies (commercial and civil corporations in which local governments invest). Staff working at these public bodies number approximately 800,000 which is equal to around 20% of the total number of staff including central government and local government public servants (approximately 4 million people including postal services, incorporated administrative agencies, and local public enterprises). Looking at trends in the number of staff working at public bodies, after a rapid increase in the 1990s it flattened out in the 2000s or declined slightly (Figure 2-2-32). Furthermore, looking at the National Accounts, in 2003 the total value of financial and non-financial assets held by public companies had risen to approximately 27% of the total assets in the financial and non-financial corporation and around 5% of total fixed capital formation (approximately 23% of public fixed capital formation) was being undertaken by public companies.
Figure 2-2-32 Changes in the number of public businesses and number of employees
    It is not necessary for special public institutions, local public corporations, and public bodies such as the third sector to produce high profits because their aims are non-commercial, but on the other hand it should go without saying that it is necessary for them to minimize the fiscal burden of achieving the public interest. However, the actual situation is that the state of management of some public bodies is getting much worse and there is a concern that the public financial burden will increase. For example, concerning the local public corporations of three types (housing, roads, land) and the third sector bodies, as of FY2003 approximately 50% of the former and approximately 34% of the latter had a deficit (the total deficit for both together came to approximately 160 billion yen) and furthermore subsidies issued to local public corporations of three types and third sector bodies had a total value of approximately 460 billion yen and the balance of guaranteed debt was approximately 10.4 trillion yen (Table 2-2-33).
Table 2-2-33 Financial conditions of local public corporations and the third sector
    Generally, in the case that the planning and policy-making sector and the government enterprises sector that implements policy are united and managed within the same organization and in the case that multiple different businesses are managed in an integrated manner, the proportional distribution of "expenditure" is not carried out appropriately. As a result there is insufficient cost awareness and it is possible that the policy will be inefficient. Hence it is thought there are certain advantages to separating certain specified business activities from others and managing them independently. However, making an organization independent means that the central government and the local governments become unable to completely supervise the actions of the public companies they have jurisdiction over and there is a possibility that this asymmetry of information will lead to inefficiency (agency cost). Furthermore, in the case that even though the fiscal state is worsening, compensation by public bodies can be carried out relatively simply (soft budget constraints), and the incentive to improve efficiency does not have much effect. For this reason, in order to ensure that efficiency, it is necessary to quantitatively measure performance and manage carefully based on that assessment. The introduction of the incorporated administrative agencies system, described next, is one of these improvement policies.

 The introduction of incorporated administrative agencies and the review of organizations and operations
    The incorporated administrative agencies system is a measure that separates certain administrative and business activities in the policy implementation sector from the administrative activities of the offices and ministries, gives independent corporation status to the institutions responsible for those activities and aims for the improvement and revitalization of the quality of operations, improvement of efficiency, autonomous management, and improvement in transparency. The specific business activities subject to the new system are science museums, art museums and training facilities, research institutions, national hospitals, etc., and 109 such corporations existed as of April 2005.(37)
    Looking at the trends of the budget concerning the financial and accounting state of the incorporated administrative agencies, the total value of management subsidies issued from the central government, which are allocated as fiscal resources for the operations and management of the incorporated administrative agencies, increased as a result of the growth in the number of agencies from 349.3 billion yen (57 agencies) in FY2001 to 1.5257 trillion yen (105 agencies) in FY2004 (Table 2-2-34). However, looking at the 53 agencies for which year-to-year comparisons can be made, the management subsidies amount declined, albeit slightly, for the same period, from 262.8 billion yen to 255.7 billion yen. On the other hand, looking at all of the agencies, their income from contracts and self-income increased from 102.6 billion yen (57 corporations) in FY2001 to 5.5337 trillion yen (105 corporations) in FY2004. Of these, the agencies for which year-to-year comparisons can be made increased from 85.5 billion yen to 97.5 billion yen in the same period. Furthermore, according to the Statements of Administrative Services Implementation Cost Calculation, drawn up in order to make clear what expenditure for the operations and management of incorporated administrative agencies is attributable to the public burden, costs for the 59 agencies established by FY2002 incurred a public burden of a total of 429.8 billion yen.
Table 2-2-34 Subsidies for the operating cost of independent administrative agencies
    In the introduction of incorporated administrative agencies, taking into consideration the issues of agency costs and soft budget constraints already described above, ex-ante targets were set and systems for the implementation of strict ex-post checks based on those targets were adopted. Specifically, (i) the responsible state minister determines the mid-term targets ex-ante and the incorporated administrative agencies draw up the mid-term plan and fiscal year plan to achieve those targets, (ii) ex-post, each fiscal year, the operating performance of incorporated administrative agencies is double-checked by the Evaluation Committee for the Incorporated Administrative Agency established in either the Cabinet Office or Ministry in charge and by the Commission on Policy Evaluation and Evaluation of Incorporated Administrative Agencies established in the Ministry of Internal Affairs and Communications. These committees are composed of third parties who have expert knowledge, and (iii) at the completion of the period of the mid-term targets, the responsible state minister considers whether it is necessary to continue the operations of the incorporated administrative agency, the form of the organization and all other aspects of the organization and operations and takes the necessary measures. The Commission on Policy Evaluation and Evaluation of Incorporated Administrative Agencies is required to make recommendations to the responsible state minister concerning whether to reform or abolish the major administrative and business activities of the incorporated administrative agencies.
    In FY2004, in response to the Basic Policies 2004, it was decided to bring forward the evaluation of agencies whose mid-term targets period was due to be completed the following fiscal year. Accordingly a review of the organization and operations of 32 agencies was carried out. As a result, after obtaining the approval of the government's Administrative Reform Promotion Headquarters, 32 agencies were abolished or combined and reorganized as 22 agencies,(38) and the top executives of research and development and education related agencies were given a new status as not public servants but members of the private sector while the abolition or prioritization of administrative and business activities and commissioning to the private sector were promoted.


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