Japan’s banks to cash in on saving habit

by Levi Folk | February 12, 2007

Japanese equities, especially banking stocks, present a good opportunity for long-term growth. Japanese savers are highly underinvested in the local stock market, and as interest rates normalize over the next few years, banks will capture mutual fund assets.

The Japanese banking sector collapsed in the 1990s under the weight of non-performing loans tied to declining property prices, but was restored to health in 2003 after undergoing a formal restructuring in the late 1990s. Investors that spotted this deep value opportunity in the early 1990s were well rewarded for their bravery.

Private-equity firm Ripplewood Holdings LLC earned a cool billion for their troubles when they took the de-listed Long-Term Credit Bank (now Shinsei Bank) through restructuring to an initial public offering in 2004. The Nikkei 500 banking index earned a 250% return in the three-year period beginning in 2003.

Restructuring may be priced in, but the prospect remains for Japanese banks to create a mutual fund industry out of the cinders of the equity-market collapse dating back to the early 1990s. The opportunity exists because the Japanese are prodigious savers, holding more half their savings in bank deposits. The challenge is to pry those savings out of low-yielding bank deposits into high-margin investment trusts (mutual funds).

The culture of hoarding cash in Japan has its roots in the collapse of the country’s stock market in the 1990s, in falling prices that have been a characteristic of the landscape since 1998 until last year, and in forced savings through the postal system.

With a healthy dose of skepticism toward the equity market, Japanese investors have been content to hold bank deposits in a declining price environment. Currently, 51.3% of “household financial assets” remain in bank deposits and cash, “compared with only 4% in investment trusts,” reports Christopher Wood in CLSA’s Greed & Fear.

The trigger for creating an exodus from cash into the stock market is inflation, and on that front, we are not out of the woods. The core index of consumer prices has been rising ever so slightly in 2006, but is still negative when energy and food prices are stripped out. A return to an era of inflation remains an important part of the thesis because bank deposits are lock-safe in a period of declining prices.

Early signs of a portfolio shift into investment trusts are evident. Household deposits and cash holdings declined by 4.4% in the middle quarters of 2006, compared with the same period in 2005, reports the Financial Times. Perhaps not coincidentally, investment trust assets “surged” for four straight months to November, 2006. Early days, no doubt, but cause for consideration.

Japan’s Baby Boomers will begin retiring en masse in 2007, and that could lead to a general fall in the savings rate, according to Lombard Research. A decrease in bank deposit holdings and a subsequent rise in equity market investments is another likely outcome if the retiring Boomers hope to meet their income goals in their golden years.

This trend will be all the more pronounced given the 2005 privatization of the country’s postal system, which had trapped over US$3-trillion of domestic savings in low-yielding deposits.

The iShares S&P/Topix 150 Index Fund (ITF/AMEX) is an exchange- traded fund offering broad-based exposure to Japan’s equity market with roughly 23% exposure to financial stocks in contrast to the iShares MSCI Japan Index Fund (EWJ/AMEX), with 11% exposure to commercial banks.

Adding to the opportunity, depending on your perspective, is the absolutely low level of the Japanese yen, which has been falling in inflation-adjusted terms since 2000. In other words, the currency is cheap, offering better value than at any time since 1986, according to the Bank of Japan’s measure of the real effective exchange rate.

The risk is that the yen may continue its decline, a 17% fall in the trade-weighted exchange rate since February, 2005 (the yen is down 30% against the Canadian dollar since November, 1999). Yen deposits, yielding only a quarter percent annually, are only interesting to foreign investors as a source of liquidity for funding investments outside Japan—Brazilian real deposits, commodity futures, you name it.

This suggests that when the yen turns, it could turn hard as all those short-term foreign deposits are repatriated.

The 23% gain in the yen against the U.S. dollar between July and October, 1998 (it moved 12% in 72 hours), in the course of the Russian debt crisis and the demise of Long Term Capital hedge fund, may be more than an interesting historical footnote. History may be destined to repeat itself, making the low-yielding Japanese deposits a haven in the event of a global financial market upheaval.