Japan ponders sovereign wealth fund

Under a government panel proposal, the fund would use government pension fund assets, rather than foreign exchange reserves, to boost returns.
A panel set up by JapanÆs ruling Liberal Democratic Party has announced plans to employ funds from the government pension investment fund (GPIF) for new investments, using new professional managers. The funds would be invested domestically as well as internationally.

Japan has a huge government-controlled pension system that is mostly invested in low-yielding government bonds and Japanese equities. It also has $1 trillion in foreign exchange reserves. It would be tempting to use one to boost the other, but that is highly unlikely, says Susumu Kato, chief economist at CLSA in Japan.

ôItÆs taboo for the Japanese government to discuss selling off its dollar reserves. Japan is the single biggest holder of US Treasury bonds in the world, and any such talk could have terrible consequences on the exchange rate,ö he says.

In that sense, a Japanese sovereign wealth fund would be different to the model used in the Middle East and China, where the gigantic FX reserves are used. Countries accumulate foreign exchange reserves as a way to prevent their currencies from strengthening.

The idea for the new fund is driven by politiciansÆ concerns about how to fund the pensions of JapanÆs large baby boomer generation, which will be retiring over the next few years as those born in the late 1940s turn 60. Accurate figures are not available but every Japanese has heard rumours that the system in operation now û guaranteed pension payouts for retiring workers financed by new workers û is not likely to last the next few decades.

Western countries have gone through the same experience, with almost all private pension schemes having moved from defined benefits (often a government-guaranteed payout) to defined contributions (the user buys his own portfolio, and lives with the consequences). CLSAÆs Kato points out that the GPIFÆs performance has been poor over the past 10 years due to an under-performing equity market and low yields on government bonds. There has also been criticism over the quality of investment managers at the GPIF, who are actually bureaucrats and behave accordingly.

The demographic weakness (fewer young workers) which afflicts Japan makes a gloomy scenario more likely, especially since productivity is one of the weak spots of the Japanese economy. Fewer workers would need to produce more to support increasing retirees, but this is not happening.

The GPIF has around $1.5 trillion under management. As of March 2007, it had 66% of its assets in domestic bonds, 17% in Japanese stocks, 11% in foreign stocks and the remainder in foreign bonds. Its size makes it one of the largest pension funds in the world, but its returns are not regarded as being adequate to surmount Japan's demographic challenge.

One industry expert in Tokyo downplayed the impact of the proposed sovereign wealth fund, saying that expectations of farming out state pension assets to high-risk, high return managers are "out of touch with reality". He suggests that $100 billion would be carved out of the existing $1.5 trillion and new managers asked to manage the sum ôa bit more actively û which is a lot easier (to get returns on) than managing $1.5 trillion activelyö. GPIF assets are managed passively.

The expert suggests that the managers would be given the same risk/return profile as the rest of the fund, but with a mandate to get "a little more alphaàeven an extra basis point on $100 billion is quite a chunk of moneyö, he says. He worries how much of that would go to pay the managers, however.

Western-style professional managers get paid a fee based on the size of assets under management, as well as the performance. But given the huge size of the fund and the possible returns, the Japanese public might be reluctant to use such a compensation structure. Industry specialists say that would endanger hiring the best managers.

Ultimately, itÆs not a new fund which is going to save JapanÆs pension problem, however skilled its managers. The underlying issue is an economy which has the slowest growth in Asia. Accelerating the economic growth rate and sharing that growth rate with shareholders would be a more reliable way of ensuring the long term safety of JapanÆs greying population than tinkering with the investment structure.

Frank Packard, head of HSBCÆs North Asia alternative investment group says the suggestion of the fund fits in with a broader plan to make Tokyo a more attractive financial centre. ôTokyo is changing its ways. The first step was the privatisation of the post office, as well as the restructurings at the Development Bank of Japan and the Japan Bank of International Cooperation,ö he says. ôAllowing outside access to pension money is one more liberalising step of the restrictions on government-related pots of money.ö
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