A year ago at this time, market watchers in Japan were still hopeful that momentum from the nearly 60% surge in share prices in 1999 would carry over into 2000. The first few months of 2000 saw the TOPIX index covering Tokyo Stock Exchange first-section companies—some 1,450 stocks—hover around the mid-1600 level, only slightly off the 1999 year-end close of 1722.
But then everything came unglued. In April 2000, the NASDAQ market in the US began its now famous implosion, and at the same time in Japan the Nikkei 225 stock index underwent a major revision, causing market turmoil. The introduction of mark-to-market accounting in Japan in April 2001 also put pressure on investors—mainly banks—to begin dumping shares before they had to realise losses. On the political front, Prime Minister Obuchi passed away, replaced in an opaque back-room deal by the current PM, Yoshiro Mori, who has presided over a series of scandals and other confidence-decimating measures such as backpedalling on economic reform.
For market watchers, the Nikkei episode has been quite a spectacle. As many as 30 names in the Nikkei newspaper’s widely used index were changed in order to make the index more accurately reflect the “new economy”. This actually meant that new economy euphoria provided an excuse to clean house in an index that hadn’t been touched in years. The result was that 30 unattractive, low-priced names left the index, to be replaced by 30 much more expensive stocks. Fund managers of course sold off the 30 names leaving the index, but those sales did not generate nearly enough funds to buy the 30 new names. So broad market selling ensued. Estimates suggest that the change permanently wiped about 2,000 points off the index. Finance Minister Miyazawa berated Nikkei for destroying the continuity of the index, while many media organizations—including the influential national broadcaster NHK—have either dropped Nikkei or are reporting it after showing the movements of TOPIX.
The more lasting impact of the Nikkei reshuffle, however, has been the closer correlation between the new Nikkei and NASDAQ. Some 35% of the stocks in the Nikkei index are technology names, which is almost twice that of the TOPIX universe. Unsurprisingly, there is a growing divergence between TOPIX and Nikkei, even though they both purport to cover the same market. At then end of 2000 TOPIX was ahead of where it was at the close of 1998, though the opposite was true for Nikkei.
So now that we’re almost to the mid-point of 2001, what’s in the cards? The political front remains as opaque as ever, with PM Mori’s political demise imminent and no clear front runner in the wings. The Liberal Democratic Party appears set to hold an election for a new party president in late April, and whoever emerges victorious will inherit the role of prime minister, at least for a while. An Upper House election is slated for July, and it now appears that the Liberal Democratic Party will suffer a sound defeat. So whoever keeps the PM’s chair warm from late April to July could be forced to step down to take responsibility for a drubbing in the election. Whatever the case, the political situation is being identified by analysts as a major source of downside risk.

Resolution of the banking sector’s woes doesn’t offer much comfort, either. Japan’s banks are still burdened with massive nonperforming loans, which the banks have been provisioning against but have not been aggressively writing off for more than a decade. Providing such life support to their customers has cost the banks dearly, and it has tied up capital that could be more effectively deployed elsewhere. At the same time, the unwinding of cross-held shares and falling stock prices leave the banks with diminished capacity to deal with any increases in nonperforming assets.
Into this maelstrom has stepped a no-nonsense mandarin, Hakuo Yanagisawa, head of Japan’s Financial Services Agency. Yanagisawa is charged with regulating the banking sector, and he has been calling for drastic reforms of the troubled sector. One of his ideas is to permit US-style exchange-traded funds (ETFs), in the hope of populating the funds with shares being sold the banks. As part of its latest economic recovery package, the government is proposing the formation of a special fund to buy the stocks being shed by the banks, but Yanagisawa has rightly questioned the wisdom of getting the government into the brokerage business. His concern is that once the government buys the shares, at some point it will need to dispose of them, thereby putting downward pressure on the market. The FSA chief would like to avoid a situation like the one in Hong Kong, where the government came under criticism for directly buying shares, even though the sell-off of those shares, via the Tracker Fund, has been mostly a success.
Yanagisawa’s goal is to place the shares being sold by banks directly in the hands of investors, and he recognizes a convenient tool to achieve this is the ETF structure. For Japanese investors, long burdened by some of the highest fees in the world on fund investments, ETFs could finally represent an inexpensive, efficient means of gaining market exposure. And as in other markets, the active management crowd has performed quite inconsistently versus the overall market. The most recent rage were Japanese small-cap or tech funds concentrating on the stock of one company, cellular phone marketer Hikari Tsushin, whose share price has plunged more than 90% and taken down the funds with it.
But US-style ETFs are not yet permitted in Japan, and a couple of hurdles stand in the way. One is the structure itself, whereby the underwriter (or creator) of the fund makes an in-kind contribution of stocks to the fund instead of buying stocks in the market. The in-kind contribution mechanism keeps the cost of managing the fund low by avoiding taxes on the purchases of stocks in the market. But with tax revenues at an all-time low in Japan in line with the economic downturn, the tax authorities are reluctant to permit a structure that doesn’t bring in revenue. Another hurdle is the tax treatment of funds versus individual stock purchases. Funds are taxed at a rate several percent higher than stocks, which means that unless a fund turns in a stellar performance, the higher tax rate—in addition to the expensive brokerage fees—keeps the net performance of funds at disappointing levels.
Compared to a year ago, when there was still a shade of optimism in Japan, overall sentiment remains in the doldrums. Until the political situation stabilises and economic reform gets on track, any schemes for revitalising the markets will be met with scepticism by investors.
David Collins is vice president Standard & Poor’s in Tokyo

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