Annual Report on

The Japanese Economy and Public Finance


- Japanese Economy Heading for New Growth Era

with Conditions for Growth Restored -

Cabinet Office

Government of Japan

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Section 3 Financial Market Recovery

    An outline of the Japanese financial markets since the beginning of 2006 shows movements reflecting recovery of the real economy (Figure 1-3-1). Stock prices increased their upward trend after the economy overcame a temporary slowdown last year. Although the market took a breather in early 2005, it moved steadily on the strength of brisk corporate earnings and the Nikkei Stock Average rose above the 17,500 yen level in early April. The stock average turned lower again in early May and remained at a level of around 15,000 yen level as of late June. Long-term interest rates (10-year government bond yield) posted a moderate rise after the lifting on the quantitative easing policy in March. Meanwhile, on the foreign exchange market (yen's rate vis--vis US dollar), the yen, which was weaker last year due to expanding differentials in interest rates between Japan and other countries, began to appreciate in the beginning of 2006 and hit the 110 yen level at one stage on receding anticipations of higher interest rates in the United States. On the other hand, the yen's real effective exchange rate, which takes into account inflation rates in Japan and abroad and weighted value of trade, is moving at its lowest level since 1985. Private bank lending posted a year-on-year gain in March. According to official land prices announced in March, the margin of decline in land prices is decreasing and in some areas, mainly in metropolitan areas, land prices are rising.
Figure 1-3-1 Trends of Financial Markets (2005~latest)
    Since financial market situations affect the real economy, and vice versa, it is necessary to examine their interactive effects. From this perspective, this Section will analyze characteristic movements in the financial market and outline the impacts on the real economy of a possible rise in interest rates amid the recovery trend of the economy.

1. Variation factors and future prospects of long-term interest rates

(Stable long-term interest rates at low level amid economic recovery)
    While stock prices rose reflecting economic recovery after a temporary slowdown, long-term interest rates (yield on 10-year government bonds) remained stable at relatively low levels throughout fiscal 2005 (end of March 2005: 1.32% ->end of March 2006: 1.77% <year-to-year rise of 0.45%>). The fact behind this is that interest rates remained stable on the expectation that the quantitative easing policy will be maintained for a considerable period of time (so-called "duration effect"). But, as far as long-term interest rates are concerned, it is also due to the fact that long-term interest rates have increasingly correlated with overseas interest rates. In June 2004, the US raised its policy interest rate and other countries moved to adjust their easy monetary policies gradually. However, the real long-term interest rates in Japan and other countries have converged to a historically low level (mostly 2~3%) (Figure 1-3-2 (1)).
Figure 1-3-2 Transition of Real Long-Term Interest Rates in Major Countries and World Savings Rate
    It has been pointed out that behind this phenomenon of global low interest rates is a global savings glut that was created in the last 10 years(21), besides the fact that China's excess supply capacity resulting from the country's increased investment has brought about low inflation worldwide. The global savings glut may have something to do with the fact that emerging economies and oil-producing countries that had been borrowers on the international capital market have become lenders. In other words, these countries have achieved current-account surpluses and their foreign exchange reserves have increased markedly after a series of financial crises in Asia and some other countries. Higher crude oil prices have also helped the emerging economies and oil-producing countries achieve current-account surpluses (Figure 1-3-2 (2)). With these surpluses having been flowing into the international capital market, real long-term interest rates may have been determined independent of the savings-investment balance of each country.

(Mechanism to set real long-term interest rates under the open economic system)
    In what follows, we examined, based on Ishi [1996], if the convergence of real long-term interest rates worldwide can be explained by domestic factors affecting interest rates in each country or by global factors, such as global savings glut (world savings rate).
    In open economy, the gap in the rate of return on financial assets at home and abroad (= real interest-rate differential at home and abroad) is adjusted by international capital movement through the predicted rate of change in real exchange rate (real expected rate of change in the exchange rate) or risk premium on exchange rate fluctuations. Suppose that market participants expected that long-term exchange rates are determined based on purchasing power parity. In that case, since real exchange rates become constant and the risk premium on exchange rate fluctuations diminishes in a theoretical static long-term equilibrium situation, real interest rates would be equalized at home and abroad. And the real long-term interest rate equalized at home and abroad would be determined depending on the savings rate and marginal efficiency of investment worldwide.
    Based on this perspective, we have conducted a panel data analysis of real long-term interest rates in Japan, US, UK., Germany and France to specify the determinants of the interest rates in the respective countries by using real short-term interest rates (a proxy variable for each country's monetary policy stance) and the deviation differential of real effective exchange rates from real exchange rate trends (a proxy variable for the predicted rate of change in real exchange rate). We have excluded from our final estimation equation the accumulative current account ratio, which is another proxy variable for the risk premium on exchange rate fluctuations. Although the ratio could also signify the level of domestic savings rate, we have found that its power of explanation, if included in explaining variables, is weak and that accumulative current account has almost no effect on each country's real long-term interest rates.
    In this estimation, the constant portion (year dummy + constant term) of the estimation results is thought to have extracted the factors common to real long-term interest rates of the five countries. In order to examine "the probability that the global savings glut has a common impact on long-term interest rates of the countries," we have conducted a regression analysis of the constant portion to break it down into the portion explainable by changes in the world savings rate and the portion of other errors.
    Incidentally, with regard to world savings rate, previous work used the average savings rates weighted by real GDP of the advanced countries covered. However, based on our view that the savings surplus of developing countries have been flowing into the capital markets of advanced countries, we used the savings rate of developing countries (IMF estimate) in our estimation for and after 1992. As to estimation period, we covered in and after the 1980s, when the liberalization of international capital movement began to make progress, and in order to examine structural changes, we divided the period into five intervals: 1) 1982~1986, 2) 1987~1991, 3) 1992~1996, 4) 1997~2001, and 5) 2002~2004.

(Increasing downward pressure on real long-term interest rates caused by rising world savings rate)
    Figure 1-3-3 shows results of the panel data analysis and a factor analysis of real long-term interest rates in three countries (Japan, US, Germany) based on the estimation results to understand real long-term interest determining factors in each period. The outline of the results is as follow.
Figure 1-3-3 Result of Panel estimation on Real Long-Term Interest Rates in Japan, US and Germany and Factor Analysis of 3 Countries' Real Long-Term Interest Rates based on Estimation Results
    1) Throughout the estimation period, each country's real short-term interest rate (a proxy variable for monetary policy) has a significant effect on real long-term interest rate movement. The coefficient is relatively high in 1) 1982~1986 with 0.58 and 2) 1987~1991 with 0.44. However, in 5) 2002~2004, the influence of real short-term interest rates on real long-term interest rates decreased relatively and its significance is not as clear as in the preceding periods.
    2) It is hard to say that the predicted rate of change in real exchange rate (a proxy variable is the deviation differential of real effective exchange rates from real exchange rate trends) has significant impact on a stable basis. But, it contributed to a rise in real long-term interest rate during the period when exchange rate misalignment (deviation of real effective exchange rate from medium-term purchasing power parity) was said to be observed (for instance, the first half of the 1980s <1982~1986> when the dollar depreciated sharply under a high interest-rate policy by the US and when market participants' expectations of further depreciation of the dollar were believed to have been strong).
    3) Finally, as to the impact of the world savings rate on each country's real long-term interest rates, it, as expected, has a negative correlation, with a rise (fall) in world savings rate causing a decline (rise) in real long-term interest rates. For instance, during 1987~1991 and most recently (2002~2004), there was a global decline in real long-term interest rates in line with a rise in savings rate. The recent rise in world savings rate means a rise in savings rate in emerging countries and oil-producing countries and it is highly likely that has been putting downward pressure on interest rates worldwide. The explicit employment in our estimation of the savings rate of developing countries, the supply source of funds to advanced countries in the global fund cycle, has produced an intriguing result in that we have got world savings rate to better account for downward pressure on long-term interest rates.

(Risk of a global rise in interest rates in the future)
    Points to keep in mind regarding the future trends of long-term interest rates in Japan and other countries, as suggested by the estimation results above, are outlined below.
    1) The impact of real short-term interest rates on real long-term interest rates has decreased recently and real long-term interest rates have come to be less influenced by monetary policy. In the 1990s, amid expanding international capital transactions, the impact of accumulative current accounts on real long-term interest rates and the premiums on exchange risks have decreased. As a result, the portion of the long-term interest rates in Japan and other advanced countries that can be explained by the world savings rate has increased and it is likely that international interest rate differences have narrowed and have been converging to a certain level.
    2) However, in the first half of the 1980s, advanced countries simultaneously implemented tighter monetary policies focusing on controlling inflation, and real long-term interest rates rose along with real short-term interest rates. In recent years, Japan, the US and European countries have again shifted their monetary policy vector toward tightening. Although the tightening is of progressive nature stemming from the countries' precautionary monetary policies, it is necessary to pay close attention to the possible impact of a surge in crude oil prices in the short term and any change in the current global inflationary trend in the medium and long term relative to future inflationary trends.
    3) Furthermore, regarding the trends of global savings-investment balance and international capital flow, developing countries' excessive savings have been continuously financing the huge current-account deficits of the United States (Figure 1-3-4, Appended Figure 1-12). With interest rates expected to follow an upward trend, it is also necessary to monitor the risk that an economic recession in the US and destabilization of the financial situation of developing countries may have adverse impacts on international capital flows.
Figure 1-3-4 Capital Exporters and Capital Importers in the World (2005)

2. Evaluation of potential impact of a rise in interest rates on real economy

    A rise in interest rates would impact the real economy through various routes. For instance, it would have adverse impacts on economic recovery through an increase in interest payment burden of corporations and households; it would expand fiscal deficits through an increase in interest payments on government bonds; and it would cause financial institutions to have a huge amount of appraisal losses through a decline in bond prices. If a rise in long-term interest rates is in line with economic recovery and is moderate, the impact of the increase in interest payment burden on corporate earnings can be absorbed by an increase in sales and a rise in asset prices. In a similar way, financial institutions' appraisal losses on their bond holdings can be offset with increases in profits generated by higher lending interest rates and appraisal gains on their stock holdings. Since the household sector has more personal deposits than its borrowings, a rise in interest rates would lead to an increase in interest income. However, when it comes to the impact on individual households, a rise in interest rates would increase the interest payment burdens of households using housing loans with floating interest rates. In what follows, the impacts of a rise in interest rates are outlined sector by sector.

(1) Income transfer from households to corporations took place due to lower interest rates so far.
    Regarding income redistribution through changes in interest income, in general, a decline in interest rate is expected to increase the expenditure propensity of the macro economy, as income is generally transferred from the household sector to the corporate sector with the higher propensity to expend. However, with corporations' investment behavior becoming increasingly cautious due partly to the balance sheet adjustment after the collapse of the bubble economy and with interest rates staying at extremely low levels, it has been pointed out that the redistribution of income from the household sector to the corporate sector is problematic from the perspective of social fairness.
    A study of the trends of sector-by-sector net profit in and after fiscal 1995, when the household sector's receipt and payment of interest income reversed, shows that, when interest rates were on a downward trend, both interest income of households and the interest payments by corporations (non-financial corporations) decreased conspicuously (Figure 1-3-5). It can be said that the direct effect of lower interest rates was income transfer from households to corporations. Incidentally, the accumulated interest income of financial institutions since fiscal 1995 has been decreasing slightly, indicating that the lower interest rates are not having a positive impact on financial institutions at least in terms of interest income. In terms of intermediary of funds, financial institutions are neutral in the income aspect.
Figure 1-3-5 Trends of Sector-by-Sector Net Interest Income

(2) Sector-by-sector effects of higher interest rates

(1% point rise in interest rates increases net interest income of households by about 6 trillion yen)
    As described above, a decline in interest rates reduces the interest income of households. So, we have estimated the effects of a 1% point rise in interest rates on the assumption that there will be no changes in the contents of assets and debts. The results of the estimation show that households' payment of interest increases by 2.5 trillion yen and their receipt of interest increases by 8.8 trillion yen, leaving a net increase of 6.3 trillion yen in interest income. Based on this, we estimated the increase in consumption expenditure by applying a simple consumption function. The result comes to about 1.2 trillion yen (0.4%: relative to consumption expenditure in 2005)(22). This estimation, however, does not take into account the negative effect of the higher interest rate on households' compensation of employment via the corporation route. The estimation should be interpreted with some caution because it also fails to take into account the spending-restraining route (substitution effect of consumption and savings), such as purchase of durable goods.
    Moreover, households' actual consumption behavior varies depending on the status of their deposits and borrowings outstanding. We have studied household-by-household differences in savings/borrowings structure per household 1) by age group of household head, 2) by type of tenure of dwelling, and 3) by yearly income group. The study has found that in 1) by age group of household head, the older the household head is, the larger is the deposits (deposits outstanding - borrowings outstanding) the household has, and that, in 2) by type of tenure of dwelling, the net borrowings of households repaying housing loans are large, while the net deposits of worker's households living in rented houses or company-owned houses are relatively large. Furthermore, in 3) by yearly income group, the net deposits of households with an yearly income of less than 5 million yen and those with yearly income of 10 million yen or more are relatively high (Figure 1-3-6). These findings suggest that an increase in consumption expenditure induced by an increase in interest income will be relatively large among elderly people and those in higher income brackets.
Figure 1-3-6 Households' Deposits Outstanding and Borrowings Outstanding

(Housing loans with higher ratios of variable rates are exposed to the risk of higher interest rates)
    When interest rates are rising, but compensation of employment is not expected to increase, households having mortgage loans, etc. need to be careful. In other words, variable-rate housing loans and the type of loans in which borrowers can decide the period for payment at a fixed rate (for instance: 2 years at a fixed rate) inherently have the risk of a rise in interest rates. Here, in order to do a trial calculation of the impact on housing loans of a rise in interest rates, we assumed borrowing conditions for a model case by using data (FY2004) of the Government Housing Loan Corp. (Table 1-3-7, Appended Note 1-4). In this model case, since the variable-rate portion is slightly below 30% of the total loan (the remaining 70% of the loans are from the Government Housing Loan Corp., etc. and have fixed interest rates), if the interest rate rises 0.5% annually and the repayment plan is revised five years later, the amount of annual payment relative to annual income will increase by about 2% from the initial 18.6% (an increase of about 110,000 yen for a household with an annual income of 6.14 million yen). The calculation is simply based on the borrowing conditions we assumed by using the average data on the users of Government Housing Loan Corp. loans. The actual figure of course varies depending on not only annual income but also the total amount of loan and the type of interest rates. At present, of the outstanding housing loans to individuals, 25% are accounted for by the Government Housing Loan Corp. and the remaining 75% by private housing loans (Figure 1-3-8). Of the outstanding housing loans to individuals provided by the private sector, about 30% are accounted for by variable-rate loans. If the type of loans in which borrowers can decide the fixed-rate period for up to 3 years are included, the ratio comes to about 70% of the total. This shows that the borrowing period of private housing loans with fixed interest rates is relatively short.
Table 1-3-7 Mortgage Payments Simulation by Variable Rate Ratio
Figure 1-3-8 Ratio of Loan from Government Housing Loan Corp., Ratios of Housing Loan from Private Financial Institutions by Type of Interest Rate
    Therefore, we calculated figures in case where the variable rate portion of the loan is increased to 50% by using the model case above, but without changing the total amount of loan. The calculation results show that if the interest rate rises 1.0% annually, the amount of annual payment relative to annual income increases to 24.4% five years later (an increase of about 400,000 yen for a household with annual income of 6.14 million yen). Furthermore, if the whole loan is of variable-rate type, the ratio rises to 29.4% five years later (an increase of about 800,000 yen).
    For households with large borrowings relative to their annual income and high ratios of loans with variable rate which moves in line with market interest rates, it is necessary to pay attention to interest-rate movement.

(1% point rise in interest rates increases corporate sector's interest payment burden by about 3 trillion yen)
    During the current economic recovery phase, corporations and financial institutions promoted restructuring and increasing profitability. A study of the relationship between all banks' average contractual interest rates and corporate earnings shows that a sharp decline in lending rate in the mid-1990s contributed a great deal to the improvement of the ordinary profit to sales ratio by decreasing non-operating expenses. Since then, low interest rates, coupled with corporations' loan repayment efforts, has continued to make a positive contribution to corporate earnings.
    At present, with the economy continuing its moderate recovery, corporate earnings are increasing sharply. If the lending rates increase in the future, however, it may have a negative impact on corporate earnings. If the average contractual interest rate on outstanding loans rises by 1 percentage point, it would increase interest expenses by 3.1 trillion yen (Figure 1-3-9). The amount is within the range that can be absorbed by the increase in corporate earnings in 2005. Thanks to the corporations' efforts to reduce interest-bearing debts, the impact of a rise in interest rates has become smaller. However, in view of the fact that small and medium-sized corporations and some non-manufacturing industries, such as real estate, still have lots of interest-bearing debts, it is necessary to keep in mind that the impact of the increase in interest expenses caused by a rise in interest rates varies depending on the size and types of industry. We did a trial calculation of changes in sales and expenditure that are necessary to make up for the 3.1 trillion yen increase in interest expense from the perspective of marginal profit (sales - variable costs). It shows that if the extra interest expense is to be made up for by increasing sales, it is necessary to increase sales prices or sales volume by 1.2% and that if it is to be made up for by decreasing fixed costs, it is necessary to reduce fixed costs by 1.2% (Appended Figure 1-13). These calculation results suggest that a rise in interest rates would result in putting upward pressure on prices or holding down corporate earnings. It is also necessary to take into account that a rise in domestic interest rates relative to overseas interest rates would trigger an appreciation of the yen and this in turn would affect corporate earnings by reducing the price competitiveness of exporting companies or by reducing import costs.
Figure 1-3-9 Impact of Rising Interest Rates on Corporate Earnings (estimate)

(A rise in interest rates is a factor pushing up banks' profits)
    From the perspective of bank's profits a change in interest rates affects both funding costs and lending returns. The profits depend not only on banks' investment and fund-raising balance (loan and deposit balance by types of interest rate (fixed or floating) and term) but also on their loan/deposit interest rate setting behavior. Furthermore, if a rise in interest rates is due to an economic fluctuation, it will help improve the qualities of loan credits and reduce credit-related costs and this in turn would have favorable impacts on banks' profits.
    Here, we calculated the impact of a rise in lending interest rates on banks' return on funds (Appended Note 1-5). Regarding interest income from loans, since the ratio of short-term loans to total loans is about 30%, banks can expect an increase in earnings by taking into account a rise in market interest rates early. On the other hand, regarding interest payment on deposits, since slightly less than 60% of bank deposits are accounted for by liquid deposits, such as ordinary deposits with less sensitivity to changes in market interest rates, deposit interest rates on the whole do not rise as much as lending interest rates. To sum it up, banks can expect improvement in the spread between deposit and lending rates. Our calculation results shows an increase of 0.7 trillion yen in return on funds(23).

(Expansion of the loss on JGBs held by regional banks)
    On the other hand, from the perspective of bank's balance sheets, a rise in long-term interest rates affects the loss of bonds held by the banking sector. For instance, assuming a 1.0% rise in long-term interest rates and that the yield curves of government bonds shift upward in parallel throughout their life, we calculated the loss of three major banks (government bonds outstanding as of the end of 2004: 65.0 trillion yen) due to decline in the prices of the government bonds the banks hold. Our estimate shows that the loss of the three banks totals about 2.2 trillion yen (Appended Note 1-6). Since the three major bank's bond portfolios focus on short- and medium-term bonds with the average remaining life of about 3.5 years, compared with about 5 years in the average remaining life of the government bonds in circulation, they are relatively resistant to increases in interest rates.
    On the other hand, the average remaining life of government bonds held by 64 regional banks (25.8 trillion yen as of the end of fiscal 2004) is relatively long at about 6.3 years, with many of their holdings being medium- and long-term bonds. Our estimate of the regional banks' loss caused by declines in government bond prices comes to total about 1.6 trillion yen.
    Generally speaking, even when interest rates rise, if stock prices also rise, the loss on bonds could be offset by gains on stock holdings. Furthermore, even if there is an loss on bonds, it has no direct impact on the periodic income as the loss is simply reported in the balance sheet after the tax effect is taken into account. It is, therefore, highly likely that the impact on the bank's profit is not as large as the impact of direct losses caused by decline in government bond prices.
    But, for the banks whose resistance to a rise in interest rates is relatively low in view of their government bond holdings structure and whose capital base is weak and unable to expect appraisal gains on stock holdings and improvement in the spread on bank lending, it is necessary to be mindful of a sharp rise in interest rates.

(1% rise in interest rates increases debt-servicing cost by 2~4 trillion yen by FY2009)
    Should interest rates rise sharply in line with economic recovery as government bond outstanding is increasing enormously every year, the increase in debt servicing cost would exceed the increase in tax revenues generated by the economic recovery, worsening Japanese fiscal conditions.
    The central and local governments' long-term debt outstanding is expected to reach approximately 775 trillion yen at the end of FY2006. Of this amount, about 542 trillion yen are accounted for by general government bonds. In fiscal 2006, the central government plans to issue JGBs worth a total of 138 trillion yen (excluding fiscal loan bonds), about 30 trillion yen in new financial resource bonds and about 108 trillion yen in refunding bonds. Should interest rates rise under these circumstances, it would have a major impact on the fiscal conditions, because a rise in interest rates not only has a direct impact on an increase in debt-servicing costs for the newly issued bonds but also increases refunding costs for the already-issued bonds. According to the "Budget Projections in FY2006 Budget Policy" (Ministry of Finance), if interest rates rise by 1% point from the standard case (interest rate: 2%), the debt-servicing cost increases by 1.6 trillion yen in fiscal 2007 and by about 4.0 trillion yen in fiscal 2009 (Figure 1-3-10).
Figure 1-3-10 Changes in JGB Issue Amount and Impact of a Rise in Interest Rates

3. Stock Market Continuing Recovery Reflecting Economic Recovery

(Stock prices on upward trend and aggregate market value recovering to level of bubble years)
    Stock prices (Nikkei Stock Average), after falling below 11,000 yen in May 2005, gained upward momentum on expectations that the economy got out of its adjustment phase. Stock prices rose above 16,000 yen in late 2005, backed by forecast of strong corporate performance and active buying by foreign investors. In early 2006, stock prices fell below 15,500 yen on reports that the prosecutor's office searched the houses of some company officials. Still later, stock prices rose again reflecting overall stable movement of financial markets following the lifting of the quantitative monetary easing policy, rising above the 17,000 yen level in the end of fiscal 2005 in March, the level last seen in August 2000. As a result, stock prices (Nikkei Stock Average) posted a gain of 46.2% in fiscal 2005, the biggest gain among major countries (compared with a 5.8% gain of the Dow Jones Industrial Average in New York and a 37.3% rise in Germany's DAX). Among the biggest percentage gainers by type of industry were domestic demand- and raw material-related stocks, while among the smaller gainers were electric and gas utility stocks (Figure 1-3-11).
Figure 1-3-11 Stock Prices on Rising Trend
    Meanwhile, the aggregate market value of the stocks listed on the TSE First Section increased to 548 trillion yen, approaching close to the all-time high of 591 trillion yen posted at the end of 1989, during the bubble years. Both trading volume and trading value on the TSE First Section posted record highs in fiscal 2005 (trading volume 536.4 billion shares, trading value 554 trillion yen), reflecting the expansion of stock investors, such as increased stock trading by individual investors via the Internet and by foreign investors, and increases in corporations' M&A activities and stock buy-backs.

(Factors behind rising stock prices: strong corporate performance and shrinking risk premiums)
    One of the factors behind the rising stock prices since 2005 is a continuing strong earnings momentum mainly in large enterprises (a profit increase for three consecutive years up to March 2005 and a double-digit increase for two consecutive years). Meanwhile, stock prices declined from an April 2000 high (Nikkei Stock Average: 20,833 yen) to an April 2003 low (Nikkei Stock Average: 7,607 yen) and then remained weak until the early spring of 2005. As a result, stock prices, as measured by forward price-earnings ratio (PER, TOPIX base), a stock price variation indicator, corrected their overvalued level in the past one year or two compared with stock prices in foreign markets (Figure 1-3-12). Most recently, however, the P-E ratio began to rise again, reflecting rising stock prices.
Figure 1-3-12 International Comparison of Forward PER
    Second, the expansion of stock investors is having a favorable impact on stock supply-demand situations. In the past, the "structural selling pressure" from domestic investors, such as the unwinding of cross shareholdings between financial institutions and their corporate customers and the daiko henjo return of pension funds' assets to the state in the process of restructuring of financial institutions and corporations, increased risk premiums on stockholdings and was putting downward pressure on stock prices. However, the risk tolerance of domestic investors, such as individual investors, investment trusts, and business corporations, has increased since 2005, apparently buoyed by heavy net purchases of stocks by foreign investors. As a result, the structural selling pressure stemming from supply-demand situations has eased and instead the anticipation of higher stock prices ahead increased.
    In order to verify these movements, we made a factor analysis of forward PER fluctuations (Figure 1-3-13). Specifically, based on a discounted dividend model, we broke down PER into 1) expected growth rate of corporate earnings (g), 2) return on equity (ROE), and 3) stock capital cost (k). In addition, we assumed that 3) stock capital cost (k) is a sum of risk-free interest rates like interest rates on JGBs with extremely low default risk, and risk premiums on stockholdings. By doing so, PER fluctuations can be divided into (i) stock capital cost factor (with profits being constant, PER will rise if risk-free interest rates decline and risk premiums decrease) and (ii) residual earnings factor (if ROE and the expected growth rate of corporate earnings are high, PER will rise as they generate excess earnings).
Figure 1-3-13 Factor Analysis of Forward PER (changes from previous quarter)
    An analysis of recent (2003~most recent period) PER fluctuating factor (quarterly) based on the above idea shows that since the third quarter of last year, when stock prices began to rise in their full swing, declines in stock capital cost and increases in corporate residual earnings (excess earnings) have helped forward PER to rise higher. The declines in stock capital cost, in particular, indicates that the risk premiums on stockholdings have decreased sharply since the latter half of 2005 amid a downward trend of long-term interest rates.

(Increasing presence of individual investors in stock market)
    Stock investors, such as foreign investors, individual investors and business corporations, are expanding on the stock market and this may have led to the shrinking risk premiums on stockholdings.
    First, although foreign investors, who have been the largest buyers of stocks, tended to sell more stocks than they buy when stock prices were on a downward trend from 2000 to 2002, their net stock purchases have increased drastically since the latter half of 2003 (See Figure 1-3-11 (4)). While banks and business corporations have been promoting unwinding of their cross shareholdings in the medium and long terms, foreign ownership of shares has risen to 26.7% (as of the end of FY2005) (Figure 1-3-14).
Figure 1-3-14 Changes in Stock Ownership Ratio by Type of Shareholder
    Meanwhile, individual investors expanded their stock trading via the Internet and on margin and actively traded stocks on the TSE second section and emerging markets, such as JASDAQ and Mothers (Figure 1-3-15). However, despite their increased trading volume, individual investors' stock ownership ratio remains unchanged.
Figure 1-3-15 Changes in TOPIX and Emerging Markets, Status of Margin Trading
    The following is the recent trend of individual investors in terms of 1) factors behind the increasing number of individual investors, 2) stock ownership ratio by age and annual income of household head, and 3) stocks held by individual investors.
    1) According to the TSE, the number of individual investors (total of shareholding individuals(24)) came to 38.08 million (as of the end of FY2005), a sharp increase of 2.5 million from the previous fiscal year. The increase is mainly due to the fact that the revised commercial law, which went into force in October 2001, has made it possible for stock-issuing corporations to set the minimum stock trading unit freely, resulting in a reduction of the purchase price per unit of transaction (Figure 1-3-16). Incidentally, about 30% of the increase in the number of individual investors is accounted for by increases in trading on the TSE second section and Mothers, etc.
Figure 1-3-16 Factor Analysis of Changes in the Number of Individual Shareholders (total of shareholding individuals)
    2) As for stock ownership ratio by age of household head, persons aged 60~69 years old have 9.3% of their financial assets in stocks and stock investment trusts and the comparable ratio for persons aged 70 or more comes to 10.6%. By annual income of household head, persons in higher income brackets have higher stock ownership ratio. But, even for such persons in higher income brackets, their stock ownership is only at the 10% level. It is difficult to make a simple comparison with the case in the United States since US data includes indirect holdings of stocks through pension funds. But, for reference's sake, Americans in their 40s and 50s have the highest stock ownership ratio, with stocks accounting for more than 50% of their financial assets, although the ratio begins to decrease sharply at 65 years old or over. The characteristic of Japanese household in terms of stock ownership is that it is biased toward elderly people aged 65 years old or over and in higher income brackets (Figure 1-3-17).
Figure 1-3-17 Stock Ownership Ratio by Age Group/Annual Income of Household Head
    3) Stocks held by individual shareholders are mostly those of non-manufacturers, such as electricity and gas companies whose stocks yield high dividends and airborne transportation or trucking companies that have adopted a shareholder special benefit plan. The ownership ratio of stocks in the service industry is also high, but this may be because individual shareholders have increased their trading on the emerging markets where most of the listed stocks are those of non-manufacturing companies. Individual investors' ownership ratio of high-priced stocks of financial, precision machine and transportation equipment companies may have something to do with the minimum unit of trading. Incidentally, foreign investors' ownership ratio is high in high-priced international blue chips, such as those of medical supplies, electric equipment and precision machine manufacturers, while their ratio of stocks popular with Japanese individual investors is low (Figure 1-3-18).
Figure 1-3-18 Individual/Foreign Investors' Ownership of Stocks by Type of Industry
    The above three points can be summarized as follows. (i) Although individual investors have increased their stock trading via the Internet, etc., their stock ownership ratio has not increased compared with foreign investors who have increased their ratio in the medium term. (ii) Major factors behind the increase in the number of individual investors are the reduction in minimum transaction unit through stock splits, etc. and an increase in IPOs mostly on the emerging markets. (iii) Meanwhile, many of the conventional individual shareholders are persons aged 60 years old or over and in higher income brackets and they have higher ownership ratios in high dividend-yielding stocks of electricity and gas companies and domestic demand-related stocks.
    As to relations between the stock trading expansion by individual investors and the real economy, in the short term, a rise in stock prices will have a wealth effect. Recently, besides elderly people and persons in higher income brackets, whose stock ownership ratio is high, people in their 30s and 40s have increased stock trading via the Internet(25). However, when stock prices fall, it will have a negative wealth effect. In the emerging stock markets, where individual shareholders have increased, some of the stocks plunged in early 2006 triggered by the revelation of window-dressing settlements, and the stocks still remain below the price level seen at the end of 2005. As we have seen in the factor analysis of forward PER (changes from previous quarter), stock prices will be affected by corporate earnings for FY2006 and the trend of long-term interest rates. It is necessary to keep in mind that if the economic environment surrounding stock investment deteriorates and uncertainty about the future increases, it would reduce investors' risk tolerance and expand risk premiums.
    "From savings to investment" is often mentioned from the perspective of looking toward structural changes in the Japanese financial system. The expansion of individual investors' presence in the stock market could be seen as a positive movement. However, some investors are "trading stocks but not holding them," preoccupied with short-term trading aimed at capital gains. It is hoped that individual shareholders committed to corporations' business growth in the medium and long terms will increase.

4. Bank Lending Begins Increasing

(Lending by private banks, mainly housing loans and to SMEs, recovering)
    Lending by private banks, which had been decreasing for a long time, has begun to increase. Although lending to large enterprises is decreasing, lending to small and medium-sized enterprises and housing loans to individuals continue their recovery (Figure 1-3-19 (1)).
Figure 1-3-19 Trend in Bank Lending
    Behind the increase in housing loans to individuals are the facts that the housing market is shifting to private banks as the Government Housing Loan Corp. is scheduled to abolish direct investment in housing loans as a rule (Figure 1-3-19 (2)) and that banks are actively providing housing loans as they are more profitable than lending to corporations and bond investment.
    As to lending to corporations, lending to small and medium-sized enterprises has been recovering. SMEs had generally remained in a severe financing environment in terms of cash flow since the financial crisis in late 1997. The recent recovery in lending reflects that banks have eased their lending attitude, as the excessive debts of SMEs have decreased and the problem of non-performing loans has been resolved.
    On the other hand, lending to large enterprises is not increasing despite the fact that large enterprises have posted high growth in their business investment (in 2005, manufacturers' business investment posted a double-digit increase for the second consecutive year). A study of the growth rate in lending by type of industry shows that while lending to manufacturers remains about 10% below a year-before level, lending to non-manufacturers has been recovering and in particular lending to the money-lending and real estate industries has posted year-to-year increases (Figure 1-3-19 (3)).
    Meanwhile, domestic lending rates on new loans have been on a downward trend. A study of changes in loans outstanding by interest rate shows that loans carrying an interest rate of less than 1% have increased drastically since 2000 and accounted for 30% of the total outstanding loans at the end of 2005 (Figure 1-3-20). Housing loans to individuals, whose lending rate level is seen as relatively high, have been increasing, and yet at the same time, loans carrying an interest rate of less than 1% have also been increasing. This suggests that supply and demand conditions for corporate lending have eased. In what follows, we will analyze the supply and demand conditions of the lending market by using a model reflecting banks' lending activities and corporations' borrowing activities.
Figure 1-3-20 Changes in the Share of Loans Outstanding by Interest Rate

(Changes in banks' lending activities)
    When financial institutions provide loans, it is reasonable to suppose that the amount of profit they can make from the loan (level of lending interest rate) and the degree of risk they can take, in other words, the soundness of the financial institutions themselves (non-performing loans ratio, capital adequacy ratio) have an impact. Then, we have conducted a regression analysis setting these factors as the explaining variables and the growth rate of the outstanding lending as the explained variables. The estimate of the lending supply curve of financial institutions based on the analysis shows that the curve is gradually shifting to the right. This indicates that even if the lending rate is the same, the outstanding lending tends to increase more than before and that banks' lending capacity is steadily recovering (Figure 1-3-21).
Figure 1-3-21 Estimation of Financial Institutions' Lending Supply Curve

(Big corporations are shifting away from bank borrowings to direct financing market)
    At the same time, changes can be observed also in corporate borrowing activities. Despite the recovery in the lending capacity of financial institutions, their lending to corporations has yet to show a positive year-on-year increase as described above, and lending rates are falling. It has been pointed out that this may be because corporations are holding down business investment within the limit of their internal resources and spending surplus funds on repaying interest-bearing debts, or because corporations, mainly big corporations, are increasing fund procurement on the direct financing market.
    In order to study the impact of fund constraints on loan demand, we have estimated loan demand functions by size of corporations (Figure 1-3-22). As explaining variables of corporate loan demand (borrowings from financial institutions / tangible fixed assets), we used 1) loan rate, 2) operating profit ratio (operating profit / tangible fixed assets), 3) mark-to-market assets ratio (market value of stocks + market value of assets / tangible fixed assets), 4) business investment to cash flow ratio (amount of business investment / cash flow) and 5) outstanding balance of corporate bonds, or alternative funding source (corporate bonds outstanding / tangible fixed assets). Of them, 3) mark-to-market assets ratio was used to see the impact of corporate balance sheet adjustments on loan demand, and 4) business investment to cash flow ratio was used to see the impact of fund constraints on loan demand. They are both thought to be positively correlated with loan demand.
Figure 1-3-22 Estimation of Loan Demand Functions by Size of Corporations
    The results showed that, in the case of large and medium-sized manufacturers, corporate bonds had a significant negative correlation with loan demand, indicating that the alternative funding source has eliminated the need for bank borrowing. The mark-to-market assets ratio and the business investment to cash flow ratio also had a significant negative correlation with loan demand, indicating that since many of the large and medium-sized manufacturers are financially sound, the amount of mark-to-market assets have no impact on loan demand and that they have shifted to direct financing. On the other hand, in the case of large and medium-sized non-manufacturers and SMEs, the mark-to-market assets ratio had a significant positive correlation. This indicates that if business investment increases beyond the limit of cash flow (in other words, when there are fund constraints), loan demand is likely to increase in line with banks' active lending posture (restoration of lending capacity).
    With the economy continuing its recovery, attention is being focused on whether or not bank lending will pick up its increasing trend. Looking toward the future based on the estimation of the loan demand functions above, we could say that, in the case of SMEs, if their financial positions improve and if they increase business investment beyond the limit of their cash flows, they are likely to increase borrowings from banks. On the other hand, in the case of big corporations (especially large manufacturers), the incentives for them to use direct financing are increasing in view of structural changes in the relations between banks and corporations, such as the main bank system. In the circumstances, we should carefully watch if an increase in business investment beyond the limit of cash flows would lead to an increase in borrowings from banks.

5. Trends of Land Prices and Real Estate-Related Markets

(1) Land prices showing signs of picking up

(Land prices declining on the national average, but rising in commercial districts of 3 metropolitan areas)
    According to the Land Price Publication (January 2006 survey), the national average land price continued to decline for 15 consecutive years. Land prices are now almost half the level of the time of peak (1991) (national average: an overall decline of 52.1%, decline in residential districts of 47.2%, decline in commercial districts of 70.2%). However, land prices show signs of picking up, with the rate of decline decreasing for residential districts for three consecutive years and for commercial districts for four consecutive years, and the commercial districts of the three metropolitan areas of Tokyo, Osaka, and Nagoya all posting a year-to-year rise for the first time in 15 years (Figure 1-3-23).
Figure 1-3-23 Trends in Official Land Prices (Residential and Commercial districts)
    Even in local areas, the rate of decline decreased for two consecutive years in residential districts and for three consecutive years in commercial districts. Besides, Sapporo City posted a year-to-year rise in land prices on average for the first time in 15 years. There are also areas where land prices posted a year-to-year rise in other regional cities, such as Sendai, Hiroshima and Okayama. On the other hand, in some other regional cities, there are many areas where land prices still continue to decline sharply due partly to a decrease in population and partly to low customer-gathering potential in commercial districts. In this manner, there are regional differentials in land price movements depending on the convenience and other conditions of each area.

(In some regional cities, land prices show signs of picking up)
    A comparison of land price trends in the commercial districts of major cities (central zones) in 2003, the year the national average rate of decline of commercial districts began to decrease, and 2006, the most recent year, reveals the following characteristics (Figure 1-3-24, Appended Figure1-14).
Figure 1-3-24 Land Prices in Central Zones (commercial districts)
1) As can be seen in Tokyo (Chiyoda Ward, Chuo Ward, Minato Ward), Nagoya City (Nakamura Ward) and Osaka City (Chuo Ward), the land prices in the inner-city districts of the three metropolitan areas all have posted a year-to-year rise or remained flat. In the major cities like Fukuoka City (Chuo Ward), Sapporo City (Chuo Ward) and Yokohama City (Nishi Ward), land prices have picked up markedly, with the number of areas posting a year-to-year decline decreasing. There is a trend for land prices to increase more in high-price areas, apparently reflecting the fact that these areas are highly convenient and profitable. In particular, land prices in some areas in Tokyo and Nagoya posted a year-to-year rise of more than 30% in 2006. In other government-designated cities, such as Sendai City (Aoba Ward) and Kobe City (Chuo Ward), land prices in some areas have also posted a year-to-year rise.
2) Other than government-designated cities, there are many regional cities in which the rate of decline in land prices is continuing to decrease. In some areas in Kagoshima City and Okayama City, etc., land prices have stopped declining and have begun to remain flat or rise because of the measures to increase the convenience and profitability of these areas.
3) On the other hand, in some other regional cities, such as Akita City and Asahikawa City, the decline in land prices has been continuing, with some areas posting a year-to-year decline of more than 10%.

(Land price rises expanding into wider areas in Tokyo metropolitan area)
    Incidentally, a study of the growth rate of land prices in residential districts in the Tokyo metropolitan area shows that land prices posted a year-to-year rise in the areas up to about 5km from Tokyo Station in last year's survey (Figure 1-3-25). But, according to this year's survey, year-to-year rise in residential land prices were observed in the areas up to 15-20km from the station, indicating that land prices are picking up in wider areas. In the Osaka and Nagoya metropolitan areas, land prices remained flat or began to rise in some areas, but such areas have yet to expand geographically.
Figure 1-3-25 Land Price Trends in Major Cities
    Meanwhile, as to land price levels in the Tokyo wards, residential land prices decline 62.6% and commercial land prices decline 80.1% to the level of the time of peak, or almost the same level as those before the bubble period. So, it's wrong to say that the asset-inflated bubble economy has been rekindled. However, in view of the fact that land prices posted a rise of about 30% in some areas, it is necessary to closely monitor such a sharp rise in the future and to examine if it is due to the enhanced convenience and profitability of the area or not.

(Vacancy rate of commercial buildings declining moderately, but rents still in weak tone)
    From these perspectives, let's take a look at the real estate market, centering on office buildings. With the economy recovering moderately, demand for office buildings has been increasing in highly convenient areas mainly in inner cities. A study of the office rental market in the Tokyo wards, where land prices posted the first year-to-year rise in 15 years, shows that the vacancy rate of office buildings has dropped to 3.2% (as of the end of March 2006) (Figure 1-3-26).
Figure 1-3-26 Office Vacancy Rate, Average Rent, and Land Prices
    On the other hand, office rents are still continuing to decline, though they show signs of stopping declining. Although demand is on an improving trend (vacancy rate is on a declining trend) as land prices began to rise in line with the economic recovery, office rents have yet to establish a definite trend of recovery. Therefore, it can be said that the sharp rise in land prices seen in some commercial districts are isolated phenomena and that the improvement in demand for office space has yet to generate an upward pressure on land prices.
    In other major cities where land prices clearly show signs of stopping declining, such as Osaka, Nagoya, Sapporo, Sendai, and Fukuoka, the vacancy rate of office buildings has been on a declining trend like in the Tokyo wards (the vacancy rate is slightly higher than in the Tokyo wards, standing at 6.5~9%), but office rents have yet to recover.

(2) Expanding J-REIT market

(Establishment of J-REIT market and capital inflow)
    The expansion of the J-REIT (Japanese-version of real estate investment trust) market is sometimes mentioned as one of the factors behind the recent rise in land prices in inner cities. J-REIT came into being following the enforcement of the "Law Concerning Investment Trusts and Investment Corporations" in November 2000. The law stipulates the composition of corporations whose objectives are investment in and management, etc. of real estate. Since two REITs were listed on the Tokyo Stock Exchange in September 2001, the number of listed REITs increased to 33 as of the end of May 2006 (31 on the TSE (one of them is also listed on the Fukuoka Stock Exchange), 1 on the Osaka Securities Exchange, and 1 on the JASDAQ market) and their aggregate market value increased to over 3 trillion yen(26) (Figure 1-3-27).
Figure 1-3-27 Expanding J-REIT Market
    REITs are investment corporations that use funds collected by selling securities to investors and borrowings from financial institutions as capital to purchase real estate properties, such as office buildings, housings, and commercial complexes, and return rental income or the profit from sale of the properties to investors. Since REITs are listed on the stock exchange, they can be traded by general investors. Besides, since REITs invite investment by issuing securities, they can be traded in a small unit, far different from conventional real estate transactions that are usually made on a one-to-one basis. In 2005, about 80% of J-REITs were purchased and sold by financial institutions (25%), individual investors (28%), and foreigners (32%).

(J-REIT market expanding to local areas)
    While land prices in commercial districts posted year-to-year rise in the three metropolitan areas, the J-REIT market has been expanding (Figure 1-3-27). As described earlier, the number of areas where commercial land prices posted a year-to-year rise has increased in the Tokyo wards and their neighboring areas and the number of areas where commercial land prices posted a year-to-year rise or remained flat has also increased in other areas, such as Osaka and Fukuoka. In such areas, J-REITs' investment is also active, suggesting that the inflow of real estate investment funds is one of the factors behind the bottoming out of land prices.
    There were 499 properties held by REITs at the end of June 2005. Nearly half of the properties were located in five wards in central Tokyo (Chiyoda Ward, Chuo Ward, Minato Ward, Shinjuku Ward, Shibuya Ward), more than 60% were in one of Tokyo's 23 wards, and nearly 80% were concentrated in the Kanto region. REITs also held properties in inner cities other than in the Kanto region, including 5.6% in Osaka Prefecture (28 properties) and 4.2% in Fukuoka Prefecture (21 properties) (Figure 1-3-27). A breakdown of these investments by asset size shows that offices accounted for 62.2% of the total investment, followed by commercial complexes with 24.4%, housing with 9.7% and hotels with 2.5%, indicating that the investments have been diversified since the end of March 2002, when offices accounted for 87.2% of the total.

(Trends in Price Formation of Real Estate Funds)
    The calculation method for real estate prices based on the profit return method that is used in pricing REITs is different from the conventional transaction by cases comparison method. If rent income (income gain) and yield are properly disclosed as trading standards and prices are estimated based on the standards, the supply-demand adjustment mechanism would work easily. The Cabinet Office estimated price levels for commercial-use real estate in the central commercial zones of major cities (total of land and buildings) assuming a simple model based on the profit return method and using data for rents and expected rate of return (Figure 1-3-28, Appended Note 1-7). According to the estimation, in cities like Tokyo, Osaka and Fukuoka, if rents remain almost unchanged, the expected rate of return declines. In these cities, real estate prices as measured by the profit return method are rising, suggesting there is a strong expectation of a rise in rents ahead.
Figure 1-3-28 Profit Return Price Index of Commercial Real Estate in the Central Commercial Zones

(Points to Keep in Mind Regarding Future J-REIT Market)
    In view of the price formation of REITs, the following points need to be kept in mind.
    First, land price trends. It is highly likely that the acquisition of properties by J-REITs has been a factor pushing up land prices primarily in urban areas. Recently, some people are concerned that the active acquisition of properties by J-REITs may overheat the market and that it may lead to a sharp rise in property prices. A rise in property acquisition price would be a negative aspect, since it decreases J-REITs' rate of return if rents remain constant.
    Second, trends in office building rents. As we have already described, most of the properties held by J-REITs are in Tokyo wards. Although the vacancy rate of office buildings in inner cities are declining, rents have not yet stopped declining. If it becomes difficult to acquire good properties with high rents, it will decrease REITs' rate of return. But, the profit price of real estate based on the profit return method is influenced not only by the current level of rents but also by expectations on the future direction of rents. In other words, if expectations on the future direction of rents shift from "decline" to "rise," the return on investment may decrease as profit price (acquisition price) rises.
    Incidentally, the yield spread (J-REIT dividend yield - 10-year JGB yield) showing REIT's relative advantage over government bonds, or fungible assets, has narrowed to less than 2% in recent years from more than 4% in 2002 (Figure 1-3-29). This can be viewed as the result of a decline in REITs' profitability. At the same time, it may be because REIT's dividend yield has declined due to a shift from "decline" to "rise" in expectations on the future direction of rents.
Figure 1-3-29 Trends in J-REIT Market
    Third, the impact of a rise in capital-raising cost resulting from a rise in interest rates. Since J-REITs are required to pay dividends to investors in excess of 90% of their distributable income, their accumulation of retained earnings is limited. Therefore, when they acquire new properties, they have to raise funds from external sources. For highly leveraged J-REITs dependent on borrowings from financial institutions, if interest rates rise, their liability cost will increase, and if they are unable to earn enough rent income to cover the rising cost, it would erode their profitability. J-REIT's debt ratio and its profit-earning ratio have a negative correlation with each other.
    In view of the above, if J-REITs' investments in real estate expand from the perspective of rejuvenation and effective medium- and long-term use of that real estate, it would continue to have favorable impacts on the pickup in land prices and the real estate market. From the standpoint of general investors, it is necessary to ensure proper market evaluation and stable price formation of J-REITs as financial assets. The stability of J-REITs is ensured to some extent in that real estate prices are determined not by capital gain but by profit and expected yield. In reality, however, the asset valuation of real estate varies depending on the method for setting profit and expected yield. In order to ensure sound development of the J-REIT market, it is essential to publish reliable rent/price information and yield indicators.

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