Bond Market Development in Japan

2008

Naoyuki Yoshino*

* Professor of Economics, Keio University, Chair person, JGB Investors Meeting, MOF, Member, Debt Management
Council, MOF, yoshino@econ.keio.ac.jp

CONTENTS

I.

Introduction

II. The History of Bond Market Development in Japan III. Trends of Japanese Government Bonds Issues IV. Debt Management Policies V. The Major Mechanism for Japanese Government Bonds Issuance and Transactions VI. Policy Recommendations to Asian Countries

Bond Market Development in Japan

Naoyuki Yoshino*

I. INTRODUCTION
Each country shows different development stages in the bond market. Japanese experience shows that the government bonds are sold mainly to the banking sector in the early stages of the development of the bond market. However, in year 2006, all these syndicated sales were abolished. Currently all the Government bonds are sold through market auctions. There are no forced sales to the financial institutions. Some Asian countries are in the process of starting the government bond market, as Japan started in 1965. Many lessons could be learned from the experiences of those overseas. In Japan, the Government bonds whose maturity was 10 years were the major product issued by the MOF in the 1970s and 1980s. In the beginning stage of the setting up of the Government bond market, 10 year Government bonds were mainly sold to the financial institutions. From 1990s, the MOF started to sell various kinds of government bonds to the market, namely, short-term, medium-term and long-term. Short-term Government bonds are treasury bills which are redeemed within one year and they are discounted bonds. Medium-term Government bonds such as 5 years are mainly sold to banks. Commercial banks in Japan prefer to hold 4-5 years Government bonds, since the average maturity of deposits is less than 5 years. It is important to focus on the kinds of customers that will purchase Mongolian and Sri Lankan Government bonds. Who will be the major participants in the government bond market in each country? Since bank deposits are the major financial means of saving in Mongolia, it is advisable to issue Government bonds to match the need of the commercial banking sector. Commercial banks are borrowing and lending money through the short term money market on a daily basis. The Central Bank of Mongolia participates into the short term money market either supplying base money or absorbing base money from the market. It is also advisable to start to purchase long-term Government bonds as an instrument of the monetary policy. If the commercial banks prefer 5 years government bonds, it would be better to issue such a maturity. In addition, it could be an instrument of the open market operations by the Central Bank. Primary market is easier to set up compared with the secondary market. However, continuous issue of the government bonds for the primary market is required. Continuous issue of government bonds will allow the market participants to be ready to participate in the primary market on a regular basis. At first, a certain maturity of Government bond could be issued, one that mainly focuses on the banking industry. Such Government bonds preferred by the banks will be 3 years to 5 years. The term of the Government bonds will be matched with the average maturity of the bank deposits in each country. Before the secondary market is well developed, it will be possible for the government to

* Professor of Economics, Keio University, Chair person, JGB Investors Meeting, MOF, Member, Debt Management Council, MOF, yoshino@econ.keio.ac.jp
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purchase its own security before maturity according to the needs of banks and pension funds. As private insurance companies and other financial institutions grow, a greater variety of Government bonds can be issued to match the needs of the market. The kinds of Government bonds to be issued should be based on the needs of the market. Therefore, short term Government bonds will mainly be targeted to banks. Long term Government bonds will mainly be targeted to pension funds initially. Gradually the kinds of Government bonds will be expanded to much more variety of maturities. Dialogue with the market participants should be conducted frequently, such as banks, pension funds, insurance companies etc. who are actively purchasing from the market. Financial Institutions should communicate with the government. Informing them of the kinds of changes that should be made to the government bond market, the kinds of terms requiring by Government bonds are in need, and what kinds of Government bonds (such as new types of government bonds, inflation indexed bonds, floating interest rate bonds etc.) are in most demand by the market. The Government bonds can be sold not only to financial institutions but also to private individuals as the market develops. Postal savings in Japan played an important role during the process of economic development. The Government can sell individually targeted Government bonds to households. The terms of individually targeted Government bonds are 5 years (fixed interest rate) and 10 years (variable interest rate). These Government bonds are sold through private financial institutions and post offices. There are many lessons to be learned from Japans experiences as is shown below.

II. THE HISTORY OF BOND MARKET DEVELOPMENT IN JAPAN

The development of the bond market in Japan can be seen with the growth of Japans government bond (JGB) market. JGBs, which the Government issues for financing purposes play the central role in Japan's financial and securities markets as a financial instrument traded on the market with high levels of credit and liquidity Thus, JGBs yields are regarded as benchmarks of the bond market in Japan. The Japanese economy has developed continuously since the 1950s. There have been several fluctuations with the Japanese economy, affected in particular by two major oil crises in 1974 and 1979. Despite these crises, the Japanese economy did remarkably well until 1989 when the bubble burst. Since the 1990s, the Japanese budget deficit has been increasing rapidly for a number of reasons: (i) long-term recession and the decline of tax revenue; (ii) various tax rate reductions introduced in late 1990s; (iii) failure of the Keynesian Policy which relies on public work to enhance economic recovery immediately after the collapse of the bubbles in 1991; and (iv) an increase in welfare spending such as medical spending due to the aging population. Thus, the budget deficit climbed to higher than 170% of GDP from 70% in 1993, comparable to the level seen in other OECD nations.

Figure 1.

General government dependency for government bonds

Social welfare represents the biggest part of the general government budget, at about 25%. It represented only 7.7% in 1950 and 13.7% in 1955. However, the aging population forced government to spend much more money on medical care etc. Figure 2 compares the aging population (the share of population who are more than 65 years old). Japan is the most rapidly aging society among the OECD countries. There are three major taxes in Japan, namely, (i) income tax, (ii) corporate tax, and (iii) consumption tax. Figure 2. Population aging in Japan in comparison to other countries

Total tax revenue peaked in 1991 when the bubble economy burst. Income tax started to decline rapidly after 1991. The Corporate tax also started to decline due to recession. In 1988, consumption tax increased from 3% to 5%, however the consumption tax revenue has not shown much change since 1999 due to long- term economic recess. Increasing government expenditure together with gradual decline in tax revenue brought high dependency on Government Bonds as shown in Figure 3. In 2003 and 2004, the Government Bonds dependency ratio to total spending went up to 44%.

Figure 3.

Government bond dependency ratio

With the budget deficit increasing, issues of JGBs has increased, especially in recent years, JGBs have been issued on a large scale, bringing the outstanding debt to enormous amounts. The Major development process of the government bond markets in Japan since the 1960s can be summarized as the following. The Deficit financing bond was issued for the first time after World War II in 1965. In the 1960s, government bonds were sold to financial institutions (syndicated underwriting). Furthermore, JGBs were purchased by the Bank of Japan one year after issue; the maturity of JGBs was 1 year in 1960s and 1970s in the sense that the JGB could be purchased after being held by the financial institutions for one year if required, despite the face maturity being 10 years. In 1966, JGB underwriting by the Trust Fund Bureau (MOF) had started. The main sources of the Trust Fund Bureau fund came from postal savings, post life insurance and Government pension fund reserves. High household savings were kept mainly in private financial institutions as deposits or government postal savings. Postal savings in Japan offered a unique financial product which private banks were not allowed to issue. Namely, 10 year deposits (Teigaku Deposits) whose interest rates were fixed for 10 years and could be withdrawn any time after 6 months. Since Japanese postal savings were entrusted to the Ministry of Finance for 7 years for fixed interest rates, postal savings could provide a fixed interest product on a long-term basis. At this time Private banks offered only 1 year deposits. Postal savings attracted numerous customers. In 1974, the first oil crisis forced the Japanese government to issue more government bonds. The Japanese economy suffered a lot by sudden rise of oil price by OPEC. Almost all oil in Japan is imported from overseas. The price of oil increased to three times that in 1973. A high dependence on oil from abroad made the Japanese economy quite vulnerable to oil shock. Many industries use oil as their energy source and export oriented Japanese industries were faced with high production costs caused by the sudden increase in oil price. The Japanese real economic growth went negative (-0.5%) for the first time since World War II due to a decline in exports, private investment and consumption. High economic growth stopped. In order to mitigate the sudden oil shock and declining private demands, the Japanese government introduced the Keynesian fiscal policy by stimulating the Japanese economy. Public works were implemented. Negative real economic growth brought a decline in tax revenues so that the Government had to rely on issuing Government bonds. The Governments dependency on Government bonds increased as shown in Figure 1. All these Government bonds were sold to financial institutions. Syndicated groups of financial institutions, which consist of private banks, insurance companies and securities companies, purchased these Government bonds. However, huge issues of JGBs made it difficult for financial institutions to keep holding all the JGBs. In 1977, trading of JGBs, which were held by financial institutions, initiated in the market. 1982 saw the launch of 15 year floating rate JGBs which were offered privately. This was the first time that the JGB was issued not just for 10 year maturity, but maturity. In 1983, banks started to sell Government bonds through their branch offices to individual investors. JGBs were kept at financial institutions, however huge issues of JGBs made it difficult to keep them all at their branch accounts. The Ministry of Finance decided to sell the JGBs to individuals through the branch offices of financial institutions. In 1984, banks were allowed to deal in Government bonds, local Government bonds and Government guaranteed bonds despite the opposition of securities firms in the past. Securities firms were only allowed to deal in Government bonds in the past and they dominated in the bond market. Thus, they were reluctant for private banks to start

dealing in Government bonds. In 1988, the handling of JGB for public offering by post offices started. In 1989, partial competitive auction of 10-year Government bonds was introduced. In 1990, Expansion of the ratio of competitive auction on 10-year Government bonds from 40% to 60% was implemented. In 1991, the same-day publication of auction results of 10-year Government bonds started. 1994 saw the launch of public offering auctions of 6-year JGBs. In 1996, quarterly auction of 20-year JGBs started. 1999 saw the launch of public offering auction of 1-year Treasury bills (TBs) and launch of public offering auctions of 30-year JGBs. In 2000, public offering auction of 15-year floating-rate JGBs were launched. In 2005, increase in the competitive auction of 10-year JGBs (from 85% to 90%). In 2006, the syndicated underwriting was completely abolished and all the JGB issues were traded on the financial market. In contrast to the continuous growth of the Government bond market, the corporate bond market has not been developed. In 1905, issues of non-collateral corporate bonds law were implemented and new issues of corporate bonds were increased. However, huge issues of corporate bonds created defaults of bonds. In 1935, quality enhancing of the bond market started. Regulation of the new issues of corporate bonds, such as proper conditions and collateral based conditions continued until the 1990s. Thus, the corporate bond market was not developed in Japan. Furthermore, Japanese Government banks provided long-term loans to corporations in the past which contributed less dependency on corporate bonds by firms. Table 1 denotes the amount of trade in the bond market in Japan. The majority of the bond market is the Government bond and the share of the corporate bond is relatively small.

Year

1989 (%) 2001 (%) 2004 (%) 2006 (%)

Amount of trade in the bond market, (trillion yen) Japanese Local Government Corporate Government Government Guaranteed Bond Bond Bond Bond 3,411 8 18 7 (92.9) (2.1) (0.5) (1.9) 3,972 44 33 44 (95.7) (1.1) (0.8) (1.1) 6,317 82 74 90 (95.2) (1.2) (1.1) (1.4) 9,566 43 53 59 (97.5) (0.4) (0.5) (0.6)

Table 1.

Total

3,672 (100.0) 4,154 (100.0) 6,637 (100.0) 9,809 (100.0)

III. TRENDS OF JAPANESE GOVERNMENT BONDS ISSUES

A. Huge increase of Japanese Government bonds in recent years The JGB issue numbers have been on the increase in recent years. While the JGB issue amount often refers to that of new financial resource bonds (construction bonds + special deficit financing bonds), securities issued by the central Government also include refunding bonds and fiscal loan bonds.

As we reviewed in the previous section, the total issue amount of these Government bonds was increasing at a dramatic pace particularly in the recent years. Although the issue amount of new financial resource bonds had been hovering between 30 and 40 trillion since FY1998, it reduced to under 30 trillion in FY2006. However the total issue amount of JGBs, including refunding bonds, increased from 70 trillion to over 80 trillion from FY1998 to FY2000. Furthermore, launch of fiscal loan bonds in FY2001 pushed it to over 130 trillion, and since then it has been continuously increasing. In FY2006, however, the total amount was at the same level as in FY 2005, approximately 165 trillion.

B. Variety of Japanese Government bonds to satisfy demand from the market (1) Types of JGBs classified by method of issuance As Table 2 shows, there are many types of JGBs and methods of issuance in Japan. What follows is an overview of types of JGBs and their issuance methods. JGBs are the securities issued by the central Government. The central Government pays the bondholders, interests on the securities and repays the principal amount (i.e., redemption). Interest is payable on a semiannual basis and the principal amount is redeemed at maturity. There are six categories of JGBs currently issued: (i) Short term (6-month and 1-year Treasury Bills); (ii) medium term (2-year and 5-year Bonds); (iii) long term (10-year Bonds); (iv) super long term (15-year floating rate, 20-year, 30-year Bonds and 40-year bonds); (v) JGBs for individual investors (5-year and 10-year); and (vi) inflation-indexed bonds (10-year). As Table 3 shows, the long-term JGBs (10 years or more), the benchmark of the market, account for more than 50% of all JGBs outstanding. Table 2. Various types of JGBs

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Table 3.

Various kinds of JGB and their outstanding amount

a) Discount bonds The short-term JGBs are all discount bonds, meaning that they are issued at the price lower than the face value. No interest payments are made, but at maturity the principal amounts are redeemed at face value. For example, if the maturity of the bond is 100 yen and it were sold at 95 yen, the interest payment at the maturity becomes 5 yen which is equivalent of the interest rate of 5.2% (=5/95).

b) Fixed-rate coupon bonds All medium- (2-year and 5-year bonds), long-(10-year bonds), super-long-term bonds (20-year, and 30-year bonds (except for the 15-year floating-rate bonds)) and JGBs for individual investors (5-year) are the bonds with fixed-rate coupons. Figure 4 shows the fluctuations of 10-year JGB yield in the market. The interest rate on 10-year JGBs is determined by the market when it is issued. With fixed-rate coupon-bearing bonds, the interest calculated by the coupon rate determined at the time of issuance is paid on a semiannual basis until the security matures and the principal is redeemed at face value.

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Figure 4.

JGB yield curves

c) Floating rate bonds The 15-year floating-rate bonds and the JGBs for individual investors (10-year) feature their coupon rate that varies according to certain rules. The inflation-indexed bonds is a security of which the principal amount is linked to the consumer price index (CPI). Thus, although their coupon-rate is fixed, the interest payment also fluctuates. d) Abolished bonds In the past, there used to be some other types of JGBs. However, after the August 1988 issue of 3-year fixed rate bonds, the September 2000 issue of 5-year discount bonds, the February 2001 issue of 4-year fixed-rate bonds, the March 2001 issue of 6-year fixed-rate bonds, and the November 2002 issue of 3-year discount bonds, these bonds have been stopped being issued due to lack of demand from the market. e) JGB for individual investors . Individual investors, compared with financial institutions, now account for a much smaller share in JGB holdings. However, they tend to be relatively stable and long-term bondholders. Thus, it should make the market stable and enable us to finance more smoothly to diversify the bondholder composition further, with particular emphasis on individuals. For these reasons, the Ministry launched in March 2003 the bonds specifically designed for individual investors. Furthermore, in January 2006, we started to issue a new model of JGBs for individual investors, 5-year fixed-rate bonds. Following is the overview of two types. JGBs for individual investors are issued on a quarterly basis most likely on the 15th day of April, July, October and January and the flotation term starts during the first half of March, June, September and December. It is available at financial institutions, such as security companies,

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banks and post offices. Along with other conventional JGBs, it is issued and in exclusive accounts for JGBs at financial institutions or post offices.

fully managed paperless

Table 4. JGB for individual investors

f) Inflation-indexed bonds Inflation-indexed bonds, introduced in March 2004, are the securities in which principal amounts vary as they are linked to the consumer price index -i.e., CPI excluding fresh food. While this new instrument meets the needs of investors who want to avert inflationary risks, it can also serve as a means of observing the expected inflation rate on the market. In the case of conventional fixed-rate coupon-bearing JGBs, the principal at the time of issuance remains unchanged until redemption, and the interest amount remains the same for biannual interest payment. In contrast, in the case of inflation-indexed bonds, the principal amount varies as it is linked to the CPI. So if the CPI increases after issue, the principal amount also increases according to the rate of inflation, and vice versa, and at maturity these bonds are redeemed at the adjusted principal amount (hereinafter called "inflation-adjusted principal amount"). Interest amount is calculated by multiplying the inflation-adjusted principal amount at the time of interest payment by the pre-fixed coupon rate, so it also changes according to the rate of inflation. The inflation-adjusted principal amount is calculated by multiplying face value by indexation coefficient. Indexation coefficient, which indicates the level of fluctuation from the time of issuance, is calculated by dividing the Ref index for the day by the Ref index at the time of issuance (specifically, the 10th day of the issue month).

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2. Demand side of Japanese Government Bond As is shown in Figure 5 and Table 4, JGBs are mainly held by banks, other financial institutions and insurance companies due to high savings ratios in the past. Holdings by foreigners are quite small compared with other major countries. In June 2007, the ratio of holdings by foreigners was only 5.8%. Households purchases have increased recently (5.1%) due to low interest rate on bank deposits (by zero interest rate policy conducted by BOJ). 18.8% of JGBs are held by financial institutions, 21.7% by postal savings, 9.2% by postal life insurance, 9.3% by private life insurance, 10.3% is held by public pension funds and 4.1% is held by private pension funds.

Figure 5.

Breakdown by JGB holders

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Table 5.

Holdings of JGBs by various investors

IV. DEBT MANAGEMENT POLICIES

As reviewed in section II, in recent years, JGBs have been issued on a large scale, bringing the outstanding debt to enormous amounts. As a result, debt management policies have become increasingly significant in order to secure smooth and stable financing and to minimize medium and long-term financing costs against such a backdrop. This section outlines the debt management policies and gives an overview of each policy. The debt management policies are the collective term that includes various policies in areas that range from Government bond issuance to distribution and redemption. Given the severe fiscal situation, large-scale JGB issuance will continue. It is thus essential that the Ministry of Finance (MOF), as the debt-issuing authority, implements its debt management policies in accordance with the aim of securing stable and low-cost financing which are the foundations for smooth fiscal management. When implementing debt management policies in the future, it is important to address the following points: (i) securing stable financing in the age of large-scale JGB issuance; (ii) maintaining and increasing the JGB market liquidity; and (iii) appropriately managing a large amount of outstanding JGBs. Debt management policies have two major objectives: (i) to secure smooth and stable financing; and (ii) to minimize medium and long-term financing costs. Every year in late December, the issuing authorities announce an issuance plan for the coming fiscal year, covering the issue amount by types of maturity, the total issue amount, etc. In designing these issuance plans, the authorities listen to opinions from market participants and attempt on this basis to maintain an appropriate balance among different maturity zones short-, medium-, long-, and super-long-term while taking into account correlations between financing costs and risks associated with interest rates and refunding, in addition to the future redemption profile. As the fiscal year proceeds, we listen to investors to enable us to respond to market needs and trends, for example, by increasing the issue amount of maturity zones according to investor's demand. In addition, the authorities attempt to ensure the predictability of the market in our day-to-day

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management of the JGBs.

It is important for the debt-issuing authority to make the market more competitive and efficient. In October 2004, the MOF introduced the JGB Market Special Participants Scheme, a new framework to ensure stable JGB issues based more on market principles. With massive issuance Government bonds (JGB) expected to continue in future yearsJGB issuance plans must be formulated with the utmost care to ensure a reliable and smooth issuance process. To achieve thisthe MOF (Ministry of Finance) holds a close dialogue with the market through various meetingsincluding (i) the meeting of JGB market special participantsin order to grasp market needs in a carefulrigorous manner. On the other handthe authorities should not focus solely on current market needs; the authorities should also properly formulate and implement systems and mechanisms that are necessary in building a medium-to-long term JGB management policy. There are several important steps to be taken by the Government so as to inform the market participants of their planned demand.

Figure 6.

Trend of JGB Issuance

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Figure 7.

Change in JGB issue amount

A. Types of JGBs classified by funding purposes The JGB issuance plan of each year is announced based on the different kinds of Government bonds classified by funding purposes, namely: (i) new financial resource bonds (construction bonds); (ii) new financial resource bonds (deficit financing bonds), (iii) refunding bonds; and (iv) FILP bonds. These bonds are not different from each other when it comes to holdings and transactions as financial products. (1) Construction bonds (new financial resource bonds) Article 4(1) of the Public Finance Law prescribes that annual government expenditure has to be covered in principle by annual government revenue generated from other than Government bonds or borrowings. But as an exception, a proviso of the Article allows the Government to raise money through bond issuance or borrowings for the purpose of public works, capital subscription or lending. Bonds governed by this proviso of Article 4(1) are called construction bonds. The Article prescribes that the government can issue construction bonds within the amount approved by the Diet, and the ceiling amount is provided under the general provisions of the general account budget. When intending to get approval for this ceiling amount, the Government is obliged to submit to the Diet a redemption plan that shows the redemption amount, the redemption method and the redemption dates for each fiscal year. (2) Special deficit-financing bonds (special law enacted for each fiscal year) When estimating a shortage of government revenue despite the issuance of construction bonds, the

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Government can issue Government bonds based on a special law to raise money for the purpose of other than public works and the like. Given their nature, these bonds are called "special deficit-financing bonds". As is the case with construction bonds, the Government can issue special deficit-financing bonds within the amount approved by the Diet and the ceiling amount is provided under the general provisions of general account budget. The Government is also required to submit a redemption plan to the Diet for reference. Special deficit-financing bond issuance must be made in exceptional cases. Therefore, the Government has to minimize the issue amount as much as possible within the amount approved by the Diet, while taking into account the state of tax and other revenues. In this context, it is allowed to issue special deficit-financing bonds even during the accounting adjustment term. Specifically, the Government is allowed to issue special deficit-financing bonds until the end of June in the next fiscal year, in order to adjust issue amount of special deficit-financing bonds until the end of May in the next fiscal year; the deadline for collecting the tax revenue for the fiscal year. (3) Refunding bonds (Article 5(1) and 5-2 of the special account law of the Government Debt Consolidation Fund) Pursuant to Articles 5(1) and 5-2 of the Special Account Law of Government Debt Consolidation Fund, the Government is allowed to issue refunding bonds to secure funds for consolidation or redemption of Government bonds. In the issuance of refunding bonds, the Government is not required to seek Diet approval for the maximum issuance amount.

(4) Fiscal Investment and Loan Program (FILP) bonds The FILP was originally receiving money from postal savings, post life insurance and pension fund reserves. They are loaned to government banks and government corporations so as to implement policies such as low interest rate loans by government banks. This system changed its structure in 2001. The FILP stopped receiving money from postal savings, post life insurance and pension reserves, instead the FILP started to introduce the FILP bonds to the market. Postal savings, post life insurance and pension reserves started their own portfolio investments rather than depositing their money in the FILP system. B. JGB issuance plan: annual basis The issuance breakdown of FY2007 for example shows that a record 4.5 trillion yen cut in construction bonds (new financing resource bonds) and deficit financing bonds (new financing resource bonds) serve as a revenue source for the FY2007 budget. Issuance of refunding bondsthe amounts for which are determined by outstanding bonds that are due to matureis reduced by 8.5 trillion yen. This reduction is largely attributable to JGB management measures taken in FY2006including the buy-back of existing bonds financed by a 12 trillion yen transfer from the Fiscal Loan Fund Special Account. The FILP bond issuance which is determined by not only the scale of new lending under the Fiscal Loan Program but also the financial position of the overall Fiscal Loan Fundis curtailed by 8.6 trillion yen. This cut was due to the slimmed-down scale of new lending for FY2007as well as reduced refunding needs resulting from a substantially reduced outstanding loan balance which was made possible by the reforms to the FILP carried out thus far.

C. JGB market issuance calendar base Recently the authorities have substantially reduced JGB issuance but this reduction does not

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directly result in a similar reduction in actual issuance to the market. The methods of JGB issuance in FY 2007 are divided largely into (i) issuance to the market, (ii) issuance to individual investors, and (iii) issuance to the public sector. The reduction is attributable firstlya decrease in FILP bonds leads to a reduction in the underwriting commitments of Postal Savings Pension Reserves and Postal Life Insurance. Secondly the amount switched to the BOJ Bank of Japandropped sharply because of a decrease in JGBs which are held by the Bank and mature in FY 2007due in part to the buy-back program carried out in FY2006. JGBs issued to individual investors increased slightly.

D. Budget projections in each year The Budget Projections in each year Budget Policy is an estimate of the impact likely to be caused by the FY2007 budget on revenue and expenditure in the years up to FY2010. The estimate uses economic indicatorswhich are tentatively determined based on the statements in The direction and strategy of the Japanese economy a cabinet decision taken in January 2007 as assumptions for FY2008 onwards and then estimates the cost burden likely to be imposed in future years by the systems and policies contemplated in the FY2007 budget. It should be noted that this projection is not binding on the Governments future budget formulationand the figures presented here may vary according to changes in assumptions. In additionon the basis of the above projectionsthe financial state of the Government Debt Cash Flow for the years until FY2020 is explained in the published document Cash Flow Projection of GDCF. This document shows the results of calculations of outstanding amount of general bondsetc. based on certain assumptions. E. Change in outstanding balance of general bonds if the JGB mechanically extended over future years issuance plan is

The balance was calculated by first mechanically extending maturity-specific JGB issues in the JGB issuance plan for example from FY2008 to FY2011and then calculating redemption and issuance for each fiscal year. The outstanding amount of general bonds when the JGB issuance plan for FY2007 is mechanically extended. F. Cost-at-risk analysis Government debt management deals with future interest rate risks. It is important to understand and manage these risks in order to minimize the funding costs in the medium to long term. The Ministry of Finance sees to it that JGB redemptions at maturity and issuance of refunding bonds are not tilted toward any particular year and that bond issuance programs are drawn up in such a manner that the composition of redemption periods is well balanced between short medium long and super-long terms. Furthermorethe Financial Bureau quantitatively analyzes and ascertains interest rate risk using cost-at-risk CaRanalysis for risk management purposes. Using future planned bond issuance issuance amount and maturity structure as given CaR analysis calculates the median interest payment cost and range of its distribution by model based simulations of future interest fluctuation. In CaR analysiswe can analyze various issuance patterns shortening or lengthening the maturity structureand compare the relationship between medium to long-term costs and risks. This would be valuable in designing planned bond issuance. Assuming a normal yield-curve heading upward interest rate increases with maturity shortening the average maturity of issued JGBs reduces interest payment costs. Howeverthe probability of being exposed to interest rate risks rises as the frequency of refunding increases. In this way the trade-off between cost and risk can be quantified by using CaR analysis. When shortening or lengthening the maturity structure in a particular fiscal year the trade-off between the interest payment cost costand the relative CaR riskis shown in general as follows. Howeverit is necessary to keep in mind that results will vary depending on the assumptions and the model used to generate future interest rates. Furthermorenot only future interest rates but also the Governments fiscal

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position will influence debt service costs. Thereforethis quantitative analysis does not directly and ideally show the burden of future interest payment and desirable JGB issuance. It should be used as a reference for designing planned bond issuance and managing outstanding JGBs

V. THE MAJOR MECHANISM FOR JGBS ISSUANCE AND TRANSACTIONS

A. Two methods of issuing JGBs When issuing JGBs, there are basically two methods offering for the market and offering for the public sector. The parenthesized figure after each heading shows the planned issue amount for FY2006 in that category of issuance method. JGBs are principally issued in public offering on market-based issue terms. (1) Price/yield-competitive auction Price/yield-competitive auction is a method in which each auction participant submits a bidding price (or yield) and bidding amount in response to the issue terms (e.g., issue amount, maturity, coupon rate) presented by the MOF, and the issue price and amount will then be determined based on the bids. In this type of auction, the issuing authority starts selling first to the highest price bidder in descending order (or to the lowest yield bidder in ascending order) until the cumulative total reaches the planned issue amount. In Japan, the auction method varies by type of security. One is the conventional method by which each winning bidder purchases the security at his bidding price; and the other is the Dutch-style method by which all winning bidders pay the same lowest price of their biddings regardless of their original bid. In order to increase government bond liquidity, the Ministry also started implementing the immediate reopening rule effective from March 2001 issues. When a new issue is offered by the MOF, both its coupon rate and principal/interest payment dates may occasionally correspond to those of a specific issue outstanding. In such a case, the Ministry of Finance reopens the outstanding issue additionally. And then, as soon as it comes into the market, the reopened issue is immediately dealt as the outstanding issue based on the immediate reopening rule. Also, under the new rule, a reopened issue will generate accrued. Furthermore, in April 2006, auctions for enhanced-liquidity, in which the outstanding issues with scarce liquidity are additionally reopened, were introduced to maintain and enhance the liquidity of the secondary market. Based on the need from market participants, the Ministry had discussed and brought up at the meeting of the JGB Market Special Participant and finally decided to introduce the above auctions after FY2006.

(2) Non-competitive auction Besides competitive auction, 2-year, 5-year and 10-year bonds are also issued through non-competitive auction. This approach is to take into account small and medium market participants who tend to submit a smaller bid than their larger counterparts. Biddings for non-competitive auction are offered at the same time as for the price-competitive auction, and the price offered equals the weighted average accepted price of the price-competitive auction. One can bid for either the price-competitive auction or for the non-price competitive auction. The maximum issue amount is 10% of the planned issue amount. Each participant, excluding the Shinkin (Credit Cooperatives) Central Bank, the Shinkumi (Credit Association) Federation Bank, the Rokinren Bank (Labor Bank) and the Norinchukin Bank

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(Central Bank for Agricultural Banks), is permitted to bid up to 1 billion. (3) Non-price competitive auction Non-price competitive auction is an auction in which biddings are offered at the same time as for the price-competitive auction. The maximum issuance amount is set at 10% of the total planned issue amount and the price offered is equal to the weighted average accepted price of the price-competitive auction. Only the JGB market special participants are eligible to bid in this auction. Each participant is allowed to bid up to the amount set based on the result of its successful bids during the preceding two quarters. A non-price competitive auction is an auction carried out after the competitive auction is finished. The price offered is equal to the weighted average accepted price in the price-competitive auction or lowest accepted price in Dutch-style yield-competitive auction. Only the JGB market special participants are eligible to bid in this auction. Each participant is allowed to bid up to the 10% of its total successful biddings in the competitive auction and non-price competitive auction. B. The secondary bond market The secondary bond market can be divided by transactions that take place on exchange and transactions that are made over the counter (OTC), for example, at security companies. OTC is a predominant transaction method for bonds, because bonds have so many issues that their transactions and procedures tend to be cumbersome and bond transactions per se are complex. Currently, 2-year, 5-year, 10-year, 20-year, and 30-year fixed-rate JGBs are listed on the Stock Exchange in Tokyo, Osaka, and Nagoya, and their daily transaction volume is published. In the OTC market, in principle, a price is concluded through a negotiation between the parties concerned. However, in order to ensure fair and smooth OTC bond transactions, the Fair Business Practice Regulations by the Japan Securities Dealers Association require each securities company to maintain the fairness of the transaction by acting at a proper price according to a set of internal rules. Furthermore, to improve the price discovery function of the OTC market, the Association publishes reference prices for OTC bond transactions on every business day, based on the reports from its member security companies and other financial institutions. (1) Case of Tokyo Stock Exchange Since 1997 the period between a given transaction of JGBs and its settlement has been "T+3", meaning the settlement is made on the third business day from the day on which the transaction is made. Efforts are being made by market participants to shorten the settlement period. In January 2003, a new transfer settlement system was launched, and the Japan Government Bond Clearing Corporation, which was established in October 2003, commenced operation on May 2nd, 2005. For delivery of JGBs and settlement of the funds, the Bank of Japan Financial Network System (here-in-after the BOJ-NET6) is used. Under the BOJ-NET, the Delivery versus Payment (DVP) settlement has been introduced to minimize settlement risks. Further, in January 2001, the Bank of Japan made a changeover from the designated-time settlement system to the new real-time gross settlement system. The RTGS system is the only mode for its settlement system, in order to reduce the systemic risk inherent in designated-time net settlement. The when-issued (WI) transaction is a transaction made during a period between an auction announcement (in principle, a week before the auction) and the day of issuance. Besides a transaction during a period between an auction and the day of issuance, one prior to the auction is made since

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February 2004. This will make it easier for market participants to keep up with the market trends, while adding to smoother pricing for new JGB issues and hence smoother financing. The 2001 launch of the RTGS system prompted the introduction of a number of trade practices that were already in place in major securities markets abroad. Ranging from cutoff time and reversal time11 to fail rule and bilateral netting, these trade practices contributed to transaction/settlement efficiency or facilitation. With the fail rule, a failure to deliver securities on the scheduled settlement date is referred to as a "fail," and not as a default, and therefore, in principle, the exercise of right of cancellation or receive/payment of delinquency charges is avoided. To avert a prolonged fail, however, the Japan Securities Dealers Association sets forth three means from which to choose: a) delivery and receipt of securities equivalent to the original securities as a substitute; b) execution of reversing trade; and c) execution of a buy. Government bond futures represent a contract to trade a bond-either buying or selling-at a set point in the future for an agreed price. The contract is standardized, as Government bond futures are traded exclusively on exchange on the assumption that an unspecified number of investors take part. In Government bond futures, JGBs actually issued are not traded. Trading is made, instead, on fictitious JGBs on which interest rates and maturities are "standardized" by the Stock Exchange. All futures contracts may be settled either by offsetting or by delivery. For example, during a certain period trading participants can always make an offsetting order for net settlement. Or, you can opt for delivering JGBs on the delivery date of the contract month. Given the fictitious nature, however, JGBs in deliverable grade will be delivered. C. Government bond futures Bond lending transactions or the so-called repo transactions are the transactions in which Government bonds are borrowed with cash as collateral, and after a certain period of time, the lender receives the delivery of the equivalent amount of equivalent securities and repays the cash collateral to the borrower. For several years after the 1989 launch of bond lending, however, a major part of bond lending in Japan used to be unsecured lending, as there were restrictions on interest on collateral. Once these restrictions were removed in 1995, due to concerns over credit risk and also to prepare for the launch of a rolling settlement method, secured lending with cash collateral took over as the mainstream of bond lending. On the other hand, bond gensaki transactions (i.e., bond transactions with repurchase or resale agreements), that emerged as the bond issuing market reopened after World War II, used to be the principal means of fund raising. However, as gensaki transactions were made subject to Securities Transaction Tax since 1953, and also as a number of new short-term financial products entered the stage one after another in the late 1970s and 80s e.g., certificates of deposit, commercial paper, and large-sum time deposits the focus of fund raising shifted to other means, such as repo transactions. The arena for bond gensaki transactions was thus scaled back primarily to TBs and FBs that are exempted from Securities Transaction Tax. Although Securities Transaction Tax was abolished in 1999 to help revitalize the security market, bond gensaki transactions remained flagging because unlike repo transactions, gensaki transactions were ill equipped with risk management methods. However, the same year, the Subcouncil on the Internationalization of Yen at the Council on Foreign Exchange and Other Transactions recommended that Japan's repo market, based on a unique system for cash-collateralized lending and borrowing, should be replaced by a globally standardized type of transaction. In response to this recommendation, a

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new type of bond gensaki transactions, with a built-in mechanism for risk management, was launched in April 2001. In the future, bond gensaki transactions are expected to play a pivotal role in the short-term money market, and to enjoy greater presence not only in cross-border transactions with nonresidents but also in domestic transactions. D. STRIPS In Japan, Government bonds of which principal and interest components can be separated are called the "strippable book-entry securities." All coupon-bearing bonds issued in January 2003 and thereafter except for 15-year floating-rate bonds, JGBs for Individual Investors, and inflation-indexed bonds are "strippable book entry securities." Only corporations (including trustees of certain trusts) can hold stripped book-entry securities. Only the JGB Market Special Participants can apply for stripping and reconstruction of STRIPS. E. Interest rate swap transactions An interest rate swap transaction is a transaction in which different types of interest payments (for example floating-rate and fixed-rate)are exchanged for a specific period of time. Interest rate swap transactions for the purpose of debt management operations became possible under the Law for the Special Account of the Government Debt Consolidation Fundas amended in 2002. 1n the new promotion of debt management policythe Government will seek to align the number of years remaining until maturity from the perspective of managing interest rate risk by utilizing swap transactions (starting in 2005). In consideration of the abovethe MOF has worked to upgrade the relevant systems entered into a basic agreement with 23 transaction counterparties most of which are JGB and Market Special Participantspursuant to the guidelines issued by the International Swaps and Derivatives AssociationInc. (ISDA). Since January 2006we have carried out swap transactions when market trends have been found to be stable. To carry out a transaction we make an offer to several transaction counterparties according to a rotation scheduleand enter into a contract with the counterparty that presents the most favorable terms. Transaction results are published on a semi-annual basis on the MOF website (in April and October).

F. Buy-back program The buy-back program is a scheme for the Government to retire debt by buying back outstanding immature bonds. The buy-back program is similar to advance redemption in that both are meant to retire debt before maturity. Butthere is a difference. With advance redemptionthe debt is repaid in principle at face value in complete disregard of the will of bondholders. With the buy-back program the debt is bought back only from the bondholders willing to take part in the deal. In the past buy-back program used to be implemented on very limited occasions such as when the an heir pays government bonds as the tax in kind pursuant to the inheritance Tax Law or when the deposit a candidate set aside pursuant to the Public Office Election Law has to be confiscated upon losing an election. To level out JGB redemptions with maturities heavily concentrated on FY2008 we improved the existing system in June 2002 by revising the Law on Buy-backs and Retirement of Government Bondsand by taking other actions. In February 2003we began to buy back bonds maturing in FY2008. At this point in time are buying back bonds covering a wide range of years to we maturity in order to maintain or enhance liquidity in the JGB market. We are buying back bonds held by private financial institutions through auctions. We also bought back and retired bonds held by the Bank of Japan and the Fiscal Loan Special Account.

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G. Government bond administration (the Law concerning Government Bonds) The Law concerning Government Bonds stipulates basic matters that range from Government bond issuance to administrative procedures regarding the outstanding issues. Provisions in the law can be classified into the following five categories: (i) The MOF decides the terms of issuance and other Government bond issuance-related matters; and matters necessary for principal and interest payments and certificates and their registration. (ii) The BOJ is entrusted with JGB-related administrative tasks. (iii) Registration of government bonds (iv) Relief measures for damaged or lost bearer Government bonds (v) Extinctive prescription of Government bonds Where there is no stipulation in this law, the civil law, the commercial law, or general principles, such as trade practices, will apply. Specific procedures regarding issuance and redemption of Government bonds are prescribed in the Regulations on Government Bonds, the Ordinance on Government Bond Issuance, the Bank of Japan Regulations on the Administrative Treatment of Government Bonds, and the Ordinance on Special Treatment Procedures at the Bank of Japan for Principal and Interest Payments on Government Bonds. H. Recent measures taken to improve the market 1. Improvement of JGB market liquidity and efficient debt management We have attempted to expand the composition of the bondholder base by diversifying JGB instruments, to help us ensure stable issuance. It is particularly important for us to encourage individual investors and foreign investors to purchase JGBs, given that the ratio of bondholding among these groups is currently lower in Japan compared to other countries. We will periodically have a meeting with the JGB Market Special Participants and a meeting with Japanese Government Bond Investors to allow dialogue between market participants. We shall also continue to publish the Debt Management Report to provide a comprehensive overview of the status of the public debt and our debt management policies, thus enabling greater policy transparency. The JGB underwriting syndicate group, made up of main financial institutions (numbering 1,201 as of March 2006), was formed to underwrite the total value of 10-year bonds. Since the Ministry resumed JGB issues in January 1966, the syndicate has played a major role in ensuring stable JGB issues. As the JGB market has developed, however, some market participants have more recently pointed out that the system hampers market efficiency. Based in part on this consideration, from April 1988, the Ministry began revising the system and steadily increased the percentage of JGBs offered by competitive auction, in order to make the market more competitive and efficient. Additionally, in October 2004, the Ministry introduced the JGB Market Special Participants Scheme, a new framework to ensure stable JGB issues based more on market principles. And an auction to provide liquidity is designed to reopen existing issues that suffer from structural or long-term liquidity problemseither because a majority of the issue is held by investors to maturityor becomes temporarily liquid because of transient rising demand. In this way the auction seeks to maintain or enhance liquidity in the JGB market. We proceeded with discussions with JGB Market Special Participants and other meetings on the implementation of such auctions in

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consideration of the needs of market playersand decided to initiate auctions in April 2006. 2. Diversification of JGB instruments and of JGB holders The web site of the MOF shows the latest debt-related information that ranges from auction announcements and results to FAQ and statistics. The MOF publishes a newsletter on JGBs on a quarterly basis. In addition, the MOF will carry out a buy-back program with 12 trillion transferred from Fiscal Loan Fund to reduce outstanding JGBs1 trillion from the market, 5.5 trillion from the BOJs holdings and 5.5 trillion Fiscal Loan Funds holdings. Buy-back will be expanded to include all types of JGBs starting January, 2006. 30-year, inflation-indexed and 15-year floating bonds will be included pending the computer systems revision.

3. Dialogue with the market participants Dialogue with the market continues in meetings of JGB Market Special Participants and the JGB investors. In order to secure stable financing and to implement appropriate policies to enhance market liquidity of JGBs. The MOF aims to promote the dialogue with the market. a) The Advisory Council on Government Debt Management

Since November 2004, the Ministry has held the Advisory Council on Government Debt Management. This council enables us to benefit from the opinions and advice of market experts and academics in the private sector with a high degree of insight into the market, and its discussions concern public debt management with a focus on government debt management policy from a medium- to long-term perspective.

b) The meeting of JGB market special participants Since the introduction of the JGB Market Special Participants scheme in October 2004

the Ministry have also held a meeting of JGB Market Special Participants to exchange opinions between members and the Ministry concerning important topics relating to the bond market. The so-called "primary dealer" system had been in place in major Western countries as a scheme to promote stable financing as well as to maintain and improve debt market liquidity. Given that large-scale JGB issuance is expected to continue, a new scheme based on the primary dealer system was also introduced in Japan in October 2004. Under the scheme the "JGB Market Special Participants" Scheme - the Ministry grants special entitlements to certain auction participants when they carry out responsibilities essential to debt management policies. The following is an outline of the scheme: Basic Outline of the JGB Market Special Participants Scheme. (i) Purpose In order to promote stable financing and to maintain and improve liquidity on the JGB market, the MOF make a corporation with "JGB Market Special Participants" who are key role players in the JGB market and participate in planning and operating JGB

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management policies with special entitlements and responsibilities. (ii) Responsibilities of Special Participants a) Bidding responsibility: in every auction, the Special Participants shall bid for an adequate amount (at least 3% of the planned issue amount) at reasonable prices. b) Purchasing responsibility: the Special Participants shall purchase and underwrite at least a specified share of the planned total issue amount (1% in principle) in each of the super-long-term, long-term, medium-term and short-term zones in auctions for the preceding two quarters. c) Responsibility on the secondary market: the Special Participants shall provide sufficient liquidity to the JGB secondary market. d) Supply of information: the Special Participants shall provide information on JGB markets and related transactions to the MOF. (iii) Entitlements of Special Participants i) Participation in the meeting of JBG Market Special Participants: the Special Participants can take part in the meeting, held as a rule on a quarterly basis, in order to exchange opinions with the Ministry on debt management policies. ii) Participation in buy-back auctions: the Special Participants can take part in buy-back auctions. iii) Separation and integration of STRIPS bonds: The Special Participants can apply for the separation and integration of STRIPS. iv) Participation in Non-price competitive auctions: the Special Participants can take part in non-price competitive auction (held concurrently with normal competitive auctions) and Non-price Competitive Auction (held after normal competitive auctions). These auctions enable Special Participants to obtain bonds at the weighed average accepted price at a competitive price auction, up to a purchasing limit preset for each Participant on the basis of past accepted price (non-price competitive auction ) and past subscriptions (non-price competitive auction). v) Participation in liquidity supply auctions: the Special Participants can take part in liquidity supply auctions that are designed to maintain and improve liquidity on the JGB market. vi) Preferential participation in interest rate swap transactions: the Special Participants can be preferential counterparties for the interest rate swap transactions implemented by the Ministry. (iv) History of introduction of systems i) October 2004, the JGB Market Special Participants system was introduced (Special Participants were designated. Meetings of Special Participants started. The non-price competitive auction was launched.). ii) April 200, the non-price competitive auction was launched.

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iii) January 2006, interest rate swap transactions started. iv) April 2006, auctions for enhanced-liquidity were launched. Figure 8. Various Improvement Measures taken

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3) The Meeting of JGB Investors The Ministry has hosted the Meeting of JGB Investors since April 2002to directly and continually share ideas with JGB investors on a continuous basis. This meetingheld about four times a year consists of academic experts and major institutional investors such as banks and life insurance companies. 4) The Meeting with JGB Top Retailers From the perspective of promoting bond ownership by individual investorsin June 2007 we began to hold meetings with top JGB retail brokers to express our appreciation of the performance achieved and efforts made by financial institutions that aggressively make offerings to and solicit subscriptions from individual investors. The meetings also allow for a mutual exchange of views and opinions between JGB selling agencies and the MOF on the further promotion of JGB sales to individual investors. 5) The Debt Management Report and IR for overseas investors Since 2004, The Ministry published "the Debt Management Report" to increase the transparency of our management on the government debt. In the report, we clarify the basic concepts of our debt management and introduces the activities of the Financial Bureau. It makes it easier to understand broadly the whole debt of the public sector. (i.e., the "public debt"). We are holding 'Ministry of Finance Seminars on the Japanese Economy and Japanese Government Bonds' to urge foreign investors to purchase JGBs. The main targets of the seminars are large investors, market participants and economists. These seminars give us chances to explain the current status and future direction of the Japanese economy, fiscal structural reforms and debt management policies (issuance plans, tax reforms, etc.) directly to foreign investors. Our aim is to encourage them to understand these topics and to increase reliance on JGBs, thus promoting JGB holding by them.

VI. POLICY RECOMMENDATIONS TO ASIAN COUNTRIES

(1) Stage of Bond Market Development Each country shows different development stages in the bond market. Japanese experience shows that the government bonds are sold mainly to the banking sector in the early stages of the development of the bond market. It was sold to postal savings, postal life insurance and pension funds through the Fiscal Investment and Loan Program (FILP program) of MOF (Ministry of Finance). They were also sold to various private financial institutions such as commercial banks, insurance companies, and security companies. Private financial institutions set up syndicated group to purchase Government bonds. However, in year 2006, all these syndicated sales were abolished. Currently all the Government bonds are sold through market auctions. There are no forced sales to the financial institutions. In Japan, the Government bonds whose maturity was 10 years were the major product issued by the MOF in the 1970s and 1980s. In the beginning stage of the setting up of the Government bond market, 10 year Government bonds were mainly sold to the financial institutions. From 1990s, the MOF started to sell various kinds of government bonds to the market, namely, short-term, medium-term and

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long-term. Short-term Government bonds are treasury bills which are redeemed within one year and they are discounted bonds. Medium-term Government bonds such as 5 years are mainly sold to banks. Commercial banks in Japan prefer to hold 4-5 years Government bonds, since the average maturity of deposits is less than 5 years. 10 year Government bonds are also purchased by commercial banks, postal savings etc. 15 year government bond in Japan is the floating bonds. The MOF also issues long-term Government bonds such as 20 years and 30 years. The MOF is also thinking of issuing 40 year Government bonds. These long term Government bonds are mainly targeted to pension funds and insurance companies. Foreign institutional investors can also purchase long-term Japanese Government bonds. (2) Major participants in the government bond market It is important to focus on the kinds of customers that will purchase Mongolian and Sri Lankan Government bonds. Who will be the major participants in the government bond market in each country? Since bank deposits are the major financial means of saving in Mongolia, it is advisable to issue Government bonds to match the need of the commercial banking sector. In Japan, the government bonds of medium term such as 5 years are major financial instruments of commercial banks. It would be advisable to examine the average liabilities of the commercial banks in Mongolia and Sri Lanka. The asset side of the commercial banks would ideally be matched with the liabilities of the commercial banks. In Mongolia, while the interest rate of government debt is determined by competitive market force, the Central Bank financing was extended at much below market interest rates. However, the easy purchase of the government debt by the Central Bank will lose fiscal discipline and at the same time the autonomy of the monetary policy will be lost. When the Central bank operates its open market operations, it has to purchase Government bonds through the market just like other market participants. The Central Bank can supply high powered money into the economy through lending to the commercial banks through the discount window. The open market operation is not the only way to supply base money into the market. The primary target of the monetary policy is to attain the stability of the price level and the stable economic growth rather than to serves as a financing body for the government debt. Many examples in Latin American countries show the strong independence of the Central Bank is the key to control inflation and the domestic economy. (3) Short term money market and the Government bond market Commercial banks are borrowing and lending money through the short term money market on a daily basis. The Central Bank of Mongolia participates into the short term money market either supplying base money or absorbing base money from the market. As the short term money market develops, the Treasury bills can be traded just like the money market instruments which can develop the secondary market for the short term Treasury bills. It is also advisable to start to purchase long-term Government bonds as an instrument of the monetary policy. If the commercial banks prefer 5 years government bonds, it would be better to issue such a maturity. In addition, it could be an instrument of the open market operations by the Central Bank. (4) How to set up interest rates on the Government bonds In Japan, all the interest rates of the Government bonds are currently determined by the market.

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Demand and supply of the Government bonds determine the daily interest rates. However in the early stages in the progress of the development of the financial market of the 1960s and 1970s, the interest rates were set by the Government. Deposit rate of interest, prime lending rate of interest and government bond rates were all set by the Government. In those days, Japanese financial markets were isolated from the international financial markets and the economy was dominated by the bank financing. As the financial market develops, as the amount of the Government bonds grows, and as the access to the international financial market become easier, it is no longer possible to regulate interest rate no matter what the market conditions would be. Mongolia is also facing globalization of the financial market. If the capital inflows and outflows are gradually de-regulated and the private sector can easily access the international market, it will not be able to keep on controlling the various interest rates. It would be better instead if it were determined by the market. However, gradual liberalization is required. At the same time, foreign participation into the Mongolian capital market might gradually be deregulated, otherwise the market would be faced with big fluctuations resulting from swings in overseas capital flow. It would be advisable to open the market gradually at a gradual pace or with the liberalization of exchange rates. 1) Suggestions to Asian countries (i) Step one The exchange rate of togrog will be based on the basket of currencies which consist of the currencies of Mongolias major trade partners, such as the Dollar, Euro, Yen etc. The weight of the basket currency can be set to the trade weight at the beginning and gradually change its weight by taking into account the capital flows together with the trade weights. (ii) Capital Liberalization As the foreign trade grows, private companies will have easier access to the overseas capital market. The outflow of capital and inflow of capital will increase. At the same time, foreign pressure to liberalize the capital market will become eminent. Lessons from various Asian countries show that the sudden liberalization hurts the economy since it may not be ready for liberalization. Gradual steps should be taken. First step will be the liberalization of the long term capital flows. Then, it should gradually reduce the maturity of the terms of the capital inflow and outflows. (5) Development of the primary market and the secondary market Primary market is easier to set up compared with the secondary market. However, continuous issue of the government bonds for the primary market is required. Continuous issue of government bonds will allow the market participants to be ready to participate in the primary market on a regular basis. At first, a certain maturity of Government bond could be issued, one that mainly focuses on the banking industry. Such Government bonds preferred by the banks will be 3 years to 5 years. The term of the Government bonds will be matched with the average maturity of the bank deposits in Mongolia. The second type of the government bonds will be targeted to pension funds which have just started in Mongolia. Pension funds are long term oriented by nature, preferring longer term Government bonds such as 10 years and longer. The Government bonds can be purchased mainly for the purpose of buy and hold until maturity. As the bond market becomes more saturated, it will be possible to trade those government bonds on a secondary market. Before the secondary market is well developed, it will be possible for the government to purchase its own security before maturity according to the needs of banks and pension funds. However the rules to

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sell Government bonds before maturity have to be set up until the secondary market is well established. A penalty fee has to be paid to the Government to sell the bonds before maturity, otherwise these transactions will become only the benefit the banks and pension funds, at the same time resulting in loss to the government. As private insurance companies and other financial institutions grow, a greater variety of Government bonds can be issued to match the needs of the market. The kinds of Government bonds to be issued should be based on the needs of the market. Therefore, short term Government bonds will mainly be targeted to banks. Long term Government bonds will mainly be targeted to pension funds initially. Gradually the kinds of Government bonds will be expanded to much more variety of maturities. (6) The bench mark of the bond market Yields curves of the government bonds will be the bench mark for the Mongolian capital market. Issues of short-term Government bonds (mainly targeted to commercial banks) and long-term Government bonds (mainly targeted to the pension funds) will become a benchmark of the interest rates for various securities. The interest rates of government bonds should be announced on a timely basis so that market participants know the fluctuations of the financial market well. (7) Debt Management Office requires dialogue with the market participants Supply of the Government bond has to be matched with the market demand. At the same time, the Debt management office requires to minimize the cost of borrowing from issuing Government bonds. Dialogue with the market participants should be conducted frequently, such as banks, pension funds, insurance companies etc. who are actively purchasing from the market. Financial Institutions should communicate with the government. Informing them of the kinds of changes that should be made to the government bond market, the kinds of terms requiring by Government bonds are in need, and what kinds of Government bonds (such as new types of government bonds, inflation indexed bonds, floating interest rate bonds etc.) are in most demand by the market. The Government should listen to the voice from the market and at the same time, the Government has to minimize the cost of borrowing from the market to minimize the future burden of the interest payments by the Government. (8) Government Bonds for individual investors The Government bonds can be sold not only to financial institutions but also to private individuals as the market develops. Postal savings in Japan played an important role during the process of economic development. It absorbed small individuals savings and it was used through the MOF (as is called the Fiscal Investment and Loan Program) to finance infrastructure investment, regional development, and for providing finance to small businesses through Government banks. The Government can sell individually targeted Government bonds to households. The terms of individually targeted Government bonds are 5 years (fixed interest rate) and 10 years (variable interest rate). These Government bonds are sold through private financial institutions and post offices. The Mongolian government has to understand the needs of private individuals. (9) Infrastructure bonds In order to achieve economic development, basic infrastructures such as roads, highways, and water

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supply are required. The issue of Government bonds and tax revenues are the ways to collect money for infrastructure investments. During the early stage of economic development, effective infrastructures were constructed. Effective infrastructure means that the rate of return for the infrastructure is high. When roads are economically effective, lots of cars use them and the economic benefits from the infrastructure services are large. However, less efficient infrastructures were gradually constructed for political reasons. Rural regions in Japan depended on support from the central government, for example to construct infrastructure in the region. Basic infrastructures are necessary, however, excessive construction of infrastructures continued in rural regions to support the economy. Whatever the expected rates of future return, many highways and bridges were constructed all over Japan. Infrastructure investments are regarded as the future profit making machinery for the region. However, inefficient infrastructures become the future burden for the nation. The maintenance costs are higher than the benefits. A number of cars which use the highways are much less than expected. Unfortunately economic growth in the region is not related to the construction of the infrastructure. In order to avoid the construction in-efficient infrastructures, the revenue bond will be one of the ways for the market to examine the performance of the infrastructures. The rate of return for investors is based on the revenues coming from the infrastructure. If the utilization of the infrastructure is high, the revenue for the highway becomes high. These revenues after deducting various costs to maintain infrastructure will be returned to investors as dividends. If the infrastructure turns to deficits, the investors will suffer lower rates of return. This could help avoid inefficient infrastructure investment. The market will automatically stop the construction of new infrastructures if they are expected to be in efficient. Of course, the basic needs such as water supply and sewage have to be built despite efficiencies. The basic needs should be provided by the tax revenue of the country. However, revenue for infrastructure which is beyond the basic needs should be collected from the private sector based on the expected future revenues. These revenue bonds are issued in the US, Australia and will be issued in Thailand. (10) Final Remarks The development of the Government bond market is important as a benchmark for various kinds of bonds. If its yield curve is traced, large corporations can start to issue their own corporate bond by comparing its yields with the Government bonds. The Government agencies can issue their bonds. Even the infrastructure bonds can be issued. It is an important step for Asian countries to have a short-term and long-term Government bond market so as to develop various kinds of instruments in the financial market. There are many lessons to be learned from various experiences such as these of Japan and Korea.

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Regulatory Framework for Government Bonds REFERENCES (i) JGB Newsletter by Ministry of Finance (MOF, Various issues) (ii) Guide to Japanese Government Bonds (MOF, 2007) (iii) Financial and Economic Statistics Monthly (Bank Of Japan, various issues) (iv) Historical Statistics of Japan (New Edition, 2007, Ministry of Home Affairs) (v) Debt Management Report (MOF, Japan, 2007) (vi) Japanese Securities Market 2007 (Economic Research Institute for Japanese Security)

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