Japan’s reputation as a bad investor — earning much less than it should on a vast foreign portfolio — is wrong, according to recent research with big implications for the world’s largest creditor nation.
Despite holding a huge amount of low-yielding bonds, Japan earned an annual average of 4.4 per cent on its foreign assets from 1996 to 2014, while paying only 3.1 per cent to foreigners on their investments in Japan, Kenneth Rogoff of Harvard University and his co-author, Takeshi Tashiro, have found.
The difference adds tens of billions of dollars a year to Japanese living standards, and will become all the more important as the population ages. The big question is whether such returns can continue in a world of low interest rates.
“Our paper can be interpreted as saying Japan has a safe haven effect — it may act as a hedge against extreme events,” says Mr Tashiro, who is based at the Research Institute of Economy, Trade and Industry in Tokyo. “Japan is the second-largest economy in the G7 and has huge net foreign assets.”
In return for Japan’s stability in times of crisis — the yen rose sharply during the Great Recession of 2008-09 — foreigners may be willing to accept lower yields on their holdings. That lets Japan pick up extra return, despite weighting its portfolio towards low-yielding foreign debt, while foreigners own higher-yielding Japanese equities.
Japan has overseas assets of about $8tn and debts of $5tn; the $3tn of net assets is about 75 per cent of gross domestic product. At almost 4 per cent of GDP last year, income from those assets kept Japan’s current account in the black, offsetting trade deficits to pay for more oil after the Fukushima nuclear disaster in 2011.
The scale of Japan’s net assets guarantees an income, but the size of that income depends on their profitability. Crucial to the gap found by Mr Rogoff and Mr Tashiro is debt securities: Japan earned 4.5 per cent on its foreign bonds, while paying just 0.2 per cent. Foreign exchange gains added another percentage point of return.
The period they study covers a historic bull market for bonds, however, and the US Federal Reserve is now heading into a cycle of rate rises. Nor is the big yen weakening triggered by prime minister Shinzo Abe’s election in 2012 likely to recur. That could mean a lower return on Japan’s bond portfolio in the future.
The picture is different for direct investment. Japan’s companies earn net income from their factories and branches abroad, but only because they have invested so much, with $1.2tn of outbound direct investment, compared with $200bn coming the other way.
The profitability of Japan’s foreign direct investment (FDI) is dismal: it earned 4.8 per cent a year between 2001 and 2014, while foreigners earned 11.5 per cent on the capital of their subsidiaries in Japan.
Returns on FDI tend to rise over time as overseas operations pay off acquisition finance or overcome their start-up costs. Toyota shows this trend: in the 1990s, the Japanese parent made almost all the profit. Now, its consolidated operating profit, including foreign subsidiaries, is higher by more than $12bn.
Returns at other Japanese companies, which went abroad more recently, may also rise in the future, but only if they bought at sensible prices.
“Cross-border acquisitions in the competitive US market for corporate control do not get the pick of the litter and are often divested,” argues Robert McCauley of the Bank for International Settlements in a recent paper.
“Non-US multinationals make half of their US acquisitions in manufacturing and their targets’ returns are well below the average for US manufacturers,” he says, arguing that foreign buyers, of which Japanese companies are among the biggest, “are taking themselves to the cleaners”.
That leaves equities. Japan directly owns just $500bn in foreign equities, while foreigners own almost $1,400bn in Japanese shares. Equity returns are usually higher, to compensate for the extra risk, making this the reason Japan is often regarded as a bad international investor, excessively averse to risk.
But Mr Rogoff and Mr Tashiro find Japan has done well on its overseas shares, earning an annual return of 9.6 per cent (or 11.5 per cent including foreign exchange gains), while foreigners have made 7.3 per cent.
That may reflect the bad post-bubble years for Japan’s stock market set against excellent returns in the US and elsewhere. If Mr Abe’s corporate governance reforms boost equities in Japan relative to other countries, this gap could reverse.
On the other hand, Mr Abe has also pushed the country’s $1.1tn Government Pension Investment Fund to buy more foreign equities and Japan Post is following suit, reducing the traditional skew in Japan’s portfolio towards bonds.
As Japan enters a demographic decline, it will increasingly live off the returns made from its investments during the boom years. Boosting the yield from its FDI would help. Mr Rogoff and Mr Tashiro’s work suggests that otherwise Japan is holding its own.