Japan Fails to Gain Traction as an International Financial Center

Note: This is an edited version of an analysis I wrote as a Council Member with Gerson Lehrman Group (http://www.glgroup.com) and posted to GLG members on December 10, 2007.

A recent article in Bloomberg correctly captures the sentiment of hedge funds, private equity funds and other buy-side investors when it comes to Japan: Despite government statements attempting to support Tokyo as a major financial center, actions speak louder than words.

The new Financial Instruments and Exchange Law, that came into full effect from September 2007, was passed in June 2006 following a series of accounting fraud and insider-trading cases. The laudable intent is to boost protection for general investors, which would accelerate a shift from savings to investments. In theory this should be good for capital markets in Japan, given that nearly half of the $12 trillion in assets are cash savings.

However, the same law adds regulations for on-shore hedge funds and similar investment vehicles. At a recent hedge fund compliance seminar I attended last month, a Japanese lawyer pointed out that "the rules on sales and solicitation remain very broad, ambiguous, unclear, and controversial." If that's the opinion of an expert in the financial laws and regulations in Japan, what is the average hedge fund manager to do?

Clearly it is attractive to go offshore, particularly to a location that is actively recruiting hedge funds. Singapore is currently among the most popular due to a regime that exempts funds with 30 or fewer investors from nearly all regulatory requirements. Japanese laws similarly provided relaxed rules for off-shore funds that meet certain requirements in particular if there is no solicitation of Japanese investors.

Other factors also contribute to this trend. In addition to vague, unclear, and potentially more burdensome regulations, taxes in Japan remain high. Why pay 37% on profits, when offshoring via Singapore, Dubai, or any one of a number of other locations offers much lower taxation rates?

Furthermore, the costs of operation in Japan remain relatively high. Prime office rents continue to skyrocket - exceeding 50,000 yen per tsubo per month (1 tsubo = 3.3 square meters). Despite a decade of deflation, staff costs and cost of living overall remain higher than most other Asian locations, and the rising value of the yen doesn't help.

But perhaps most important of all, the government as a whole does not really appear interested in promoting Tokyo as a financial center. Instead foreign investors often run into resistance. Examples include the failed attempts by Steel Partners to gain control over local firms. Carlyle group has similarly closed only a few deals in Japan. Prospect Asset Management has also run afoul of tax authorities. To be sure, I've written before that alternative approaches to investment in Japan can offer excellent returns (for example the high office rents mentioned above have also lead to lucrative opportunities for many firms), nevertheless the sense is that Japan, Inc. is not there to support the foreign investor.

Singapore is an amazing contrast. Government and regulatory authorities in Singapore are known for actively promoting the island as a financial center. Officials will make time to meet serious foreign investors to present options and look for ways to encourage coming to Singapore. Even tax breaks and grants have been available for capital investment from time to time. It's almost paradise in comparison.

This is not to say that Singapore is not without issues or that Japan should never be considered. Singapore's regulatory regime is not necessarily more transparent than elsewhere in Asia. Also, the small size of the population limits the pool of available local talent, which can be a constraint for certain firms.

Japan remains a rich source of capital, and the sheer size of the economy does allow for a wide range of investment activities. Indeed, the relative paucity of new hedge funds registering in Japan could be an opportunity for a clever fund targeted at Japanese investors. In addition, Japan focused funds will likely need some form of research capability on the ground to stay current on fast-moving trends in the market place.

Many articles have been written that discount Japan, so I'll close with the caveat that Japan may still figure out how to improve its standing as a financial center. But in the short run, the consensus view of any one I've talked to recently, is that new funds are better off setting up off-shore, with Singapore a prime candidate.

Update: It appears Japanese authorities are taking note of the situation, and further simplification of regulatory reporting requirements appears to be in the works. This is just part of the issue, but it would seem to be a step in the right direction!