Beyond the Yen
When the Japanese government first announced a Private Finance
Initiative (PFI) program for domestic government projects the news
was met with both excitement and scepticism. Although the market
potential was obvious, observers were concerned that local
governments would be hostile to the idea of private sector
involvement in public services.
In the three years since the first PFI project in Japan, market development has indeed been slow. Only 35 designated PFI projects have been completed. Of those 35, a good number are very small, like the co-generation power project at Tokyo Metropolitan Government's Kanamachi water treatment plant which cost just $10 million.
A year ago, fears about local government intransigence seemed warranted when a Cabinet Office survey revealed that 80% of local governments and municipalities had not even started preparations for bidding projects on a PFI basis. Among the respondents of the survey, which included most of the 3,300 municipal governments in Japan, more than 70% said the introduction of the PFI program has not gone well due to a lack of awareness of the importance of such projects
However, in the intervening 12 months, the number of deals in the pipeline has built up steadily and Japan could eventually eclipse other PFI markets both in terms of the number of PFI projects and the total size of the PFI market.
According to Naoaki Eguchi, lawyer at the Tokyo Aoyama Aoki Law Office/Baker & McKenzie joint enterprise, there are now 19 designated national PFI projects and 70 local government PFI projects in the works. Yuichi Nishigori at Mizuho Corporate Bank says his bank is targeting 20 to 30 major projects, over ¥5 billion ($40 million) in size, this year. And behind the 89 designated local and central government projects, more than 300 additional projects are now earmarked for PFI status.
The majority of projects will involve the construction of buildings (including hospitals, museums, and university facilities), rather than transport or utilities developments, says Yuji Tsujiki, manager in Bank of Tokyo-Mitsubishi (BTM)'s infrastructure project group. Tsujiki says that 14 university projects alone will close this year. The two largest university PFI schemes, for Kyoto and Tokyo Universities, are valued at between ¥5 and ¥10 billion each and will involve the central government as ?offtaker?.
In Japan absolute necessity is the mother of all reform and this high volume of PFI deals is largely because of the credit crunch and financial problems faced by local government.
The fiscal difficulties stem from falling local tax revenues in the dismal economy, tax cuts made necessary to stimulate growth, and rising social obligations, partly thanks to Japan's ageing population. Urban prefectures in particular, whose revenue comes in large part from corporate income taxes and enterprise taxes on corporations, have been hard hit by reduced tax income. Demonstrating the scale of the problem, the government's total budget shortfall came to over ¥14.1 trillion in fiscal 2002.
To make up for that shortfall, and to encourage public works projects to stimulate the local economy, most local governments have issued large numbers of bonds. Local government debt in Japan (including municipalities and prefectures) has risen dramatically as a result. According to one banker, Japan's total outstanding public-sector debt is projected to reach ¥675 trillion by the end of March, equivalent to more than 130% of GDP.
In response, the central government has tried to cap annual government borrowings. Prime Minister Junichiro Koizumi's government previously pledged to limit government bond issuance to below ¥30 trillion. Although it is no longer likely that this target will be met, as the macroeconomic situation necessitates higher government spending, PFI continues to be seen as a key means to secure funding for social projects without exacerbating the debt problem. ?Through PFI, local governments are basically trying to novate the repayment of project expenditure to the private sector,? says a banker.
Funding PFI
But in passing the buck, the government's funding problems become the funding problems of the private sector. According to Nishigori, between ¥200 and ¥300 billion of funding will be required next financial year to cover all the PFI projects.
Market observers argue Japan's banking market alone will not absorb annual deal flow of that magnitude. All the more so because of the mergers that have taken place amongst Japan's top tier banks and the long loan tenor demanded by PFI concessions ? 20 year financings are the norm.
?To meet the demand for capital we will have to turn to a number of different sources of funds?, says Nishigori, ?including Japanese regional and association banks?.
Beyond the banking market, arrangers are actively wooing other financial services firms, including life insurance companies and institutional investors. Nishigori says that insurance companies have already started to participate in syndicated PFI deals but the list of institutional investors involved in the market needs to be expanded.
As early as 1999, Sompo Japan provided ¥500 million for the construction of an elementary school in Chofu, Tokyo, built under a quasi-PFI scheme (the project was set in motion before the Japanese government got round to officially mandating schemes for PFI status). While the size of Sompo's investment and the project itself was small, it was noteworthy as the first investment by a non-life insurance company.
Foreign banks are another potential source of funds. DBJ's Yamashita says, ?A lot of foreign banks with project finance experience have come to our offices to find out more about the development of the PFI market here.?
Helping to spur interest amongst foreign institutions, the average size of deals entering the market has increased steadily over the last three years. According to Eguchi, a rough average for the size of central government projects is more than $100 million.
Some projects are much larger. One of the largest upcoming PFI designated projects is the Central Government Office Building No 7 project for which bids are due in next month. According to market sources, the total project size will be over ¥100 billion. Project Finance understands that the likely tenor of the financing will be equal to the construction period plus 15 years. Four to five bidding groups, each with their own financial adviser, are thought to be competing for the project. Large local government projects coming up (over $50 million) include Kochi Hospital and Tokyo Youth Plaza.
But it is more likely, concedes Yamashita that foreign banks will target central government projects instead of local government PFI ventures. ?Foreign banks find it difficult to evaluate the credit worthiness of local government in Japan and much more easy to assess the risk of deals where the central government is the off-taker.?
One foreign banker in Tokyo admits, ?taking indirect credit risk of a Japanese local municipality is a major concern, particularly given the normal loan tenor in Japanese PFI deals.?
Foreign banks are especially wary about the local government market because, they say, the financial position of most of the local governments is opaque. ?Most of the local governments we have looked at do not have conventional balance sheets,? says the foreign financier.
Analysts are all the more concerned about local government finances because of growing pressure to amend and even abolish the local allocation tax grant system through which the central government allocates a certain proportion of the five national taxes (income tax, corporate tax, alcohol tax, consumption tax, tobacco tax) to local authorities. ?We don't yet know whether there will be reform, what the exact reforms will be and how this will impact on the financial position of individual local governments,? says one banker.
With the exception of DePfa Bank no foreign bank has participated in a Japanese PFI deal to date. In 2001, the German institution participated in the funding of a health, medical treatment and welfare college in Kanagawa Prefecture near Tokyo. DePfa was the largest lender in a six-strong syndicate amounting to ¥11.1 billion. The loan has one of the longest tenors seen in the PFI market, and relies on phased installments from the Prefecture for repayment.
But DePfa itself is an oddity, a financial institution specializing in loans to local governments. It is also noteworthy that the bank has only been involved in this one Japanese transaction, despite its appetite for government risk and long tenor deals. In contrast, since 1999, DePfa has been involved in 40 other public infrastructure projects in Europe (including the former Eastern Block countries).
Other foreign finance houses will have to analyze local government risk completely from scratch, having no previous track record of financing Japanese local governments.
?It is also easier for us to get involved in the market if a foreign sponsor participates as the project sponsor, but so far, foreign corporate involvement in the PFI market has also been rare,? says the foreign banker.
The one instance of a foreign firm being involved in a Japanese PFI project as sponsor is Singapore port operator PSA Corp's involvement in the construction of the Hibiki container terminal being constructed on 75 hectares of reclaimed land off Kitakyushu.
In December 2001, a 17-firm consortium led by PSA Corp. reached a basic agreement with Kitakyushu to build and operate the port. The municipal government of Kitakyushu will provide the land and berths.
Foreign banks will be encouraged by the fact that few legal concerns now exist in the Japan PFI market. The 1999 PFI law has been bolstered by a further PFI Promotion Law, albeit only comprised of 23 Articles, and several other legal guidelines.
Eguchi says a concrete security package exists for lenders involved in PFI transactions. ?If there is one issue of concern it lies in the enforcement of step in rights in a situation where the project company has gone bankrupt. But it is our opinion that step in rights will be strengthened in the near future, by taking into account UNCTRAL [United Nations Commission on International Trade Law] guidelines,? Eguchi says.
Also encouraging for the banking sector, the length of concession is shortening, allowing a shortening of loan tenor. ?This is happening precisely because of the difficulty of getting longer term loans,? says one banker. A number of the earliest PFI projects had concession periods of 30 years. Now, according to Nishigori, project concession is typically 15 to 20 years.
Back to bonds
Although the market is awash with sovereign and sub-sovereign Japanese bonds, long term, the architects of the country's PFI program hope that the debt capital markets will provide the bulk of the funds for PFI schemes.
Arrangers will play a crucial role in developing a PFI-linked bond market by building the right sort of risk return profiles into PFI transactions.
But Japan's bond market infrastructure is still being refined to encourage more investors to hold bonds of any kind, be they corporate or governmental. The retail segment is particularly underdeveloped. Individual bond holdings are limited, only ¥10 trillion out of ¥410 trillion in outstanding bonds are held by individual investors.
Moreover financiers believe the tenor of PFI linked bonds would be too long to attract enough interest from either institutional or individual investors, in present conditions.
Yet the market is evolving. From March the central government is set to sell long-term bonds exclusively to individual investors, the first time it will have issued such debt in Japan. On 3 February, it started accepting subscriptions at private financial institutions and post offices.
Also, according to one financier, appetite is growing for Japanese municipal governments and government financial institutions bonds issued without a central government guarantee.
It is worth noting that municipal bonds issued to fund municipal public works have recently proved popular in the retail market. A case in point is the bond program launched by Gunma Prefecture last March to finance a hospital project.
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In the three years since the first PFI project in Japan, market development has indeed been slow. Only 35 designated PFI projects have been completed. Of those 35, a good number are very small, like the co-generation power project at Tokyo Metropolitan Government's Kanamachi water treatment plant which cost just $10 million.
A year ago, fears about local government intransigence seemed warranted when a Cabinet Office survey revealed that 80% of local governments and municipalities had not even started preparations for bidding projects on a PFI basis. Among the respondents of the survey, which included most of the 3,300 municipal governments in Japan, more than 70% said the introduction of the PFI program has not gone well due to a lack of awareness of the importance of such projects
However, in the intervening 12 months, the number of deals in the pipeline has built up steadily and Japan could eventually eclipse other PFI markets both in terms of the number of PFI projects and the total size of the PFI market.
According to Naoaki Eguchi, lawyer at the Tokyo Aoyama Aoki Law Office/Baker & McKenzie joint enterprise, there are now 19 designated national PFI projects and 70 local government PFI projects in the works. Yuichi Nishigori at Mizuho Corporate Bank says his bank is targeting 20 to 30 major projects, over ¥5 billion ($40 million) in size, this year. And behind the 89 designated local and central government projects, more than 300 additional projects are now earmarked for PFI status.
The majority of projects will involve the construction of buildings (including hospitals, museums, and university facilities), rather than transport or utilities developments, says Yuji Tsujiki, manager in Bank of Tokyo-Mitsubishi (BTM)'s infrastructure project group. Tsujiki says that 14 university projects alone will close this year. The two largest university PFI schemes, for Kyoto and Tokyo Universities, are valued at between ¥5 and ¥10 billion each and will involve the central government as ?offtaker?.
In Japan absolute necessity is the mother of all reform and this high volume of PFI deals is largely because of the credit crunch and financial problems faced by local government.
The fiscal difficulties stem from falling local tax revenues in the dismal economy, tax cuts made necessary to stimulate growth, and rising social obligations, partly thanks to Japan's ageing population. Urban prefectures in particular, whose revenue comes in large part from corporate income taxes and enterprise taxes on corporations, have been hard hit by reduced tax income. Demonstrating the scale of the problem, the government's total budget shortfall came to over ¥14.1 trillion in fiscal 2002.
To make up for that shortfall, and to encourage public works projects to stimulate the local economy, most local governments have issued large numbers of bonds. Local government debt in Japan (including municipalities and prefectures) has risen dramatically as a result. According to one banker, Japan's total outstanding public-sector debt is projected to reach ¥675 trillion by the end of March, equivalent to more than 130% of GDP.
In response, the central government has tried to cap annual government borrowings. Prime Minister Junichiro Koizumi's government previously pledged to limit government bond issuance to below ¥30 trillion. Although it is no longer likely that this target will be met, as the macroeconomic situation necessitates higher government spending, PFI continues to be seen as a key means to secure funding for social projects without exacerbating the debt problem. ?Through PFI, local governments are basically trying to novate the repayment of project expenditure to the private sector,? says a banker.
Funding PFI
But in passing the buck, the government's funding problems become the funding problems of the private sector. According to Nishigori, between ¥200 and ¥300 billion of funding will be required next financial year to cover all the PFI projects.
Market observers argue Japan's banking market alone will not absorb annual deal flow of that magnitude. All the more so because of the mergers that have taken place amongst Japan's top tier banks and the long loan tenor demanded by PFI concessions ? 20 year financings are the norm.
?To meet the demand for capital we will have to turn to a number of different sources of funds?, says Nishigori, ?including Japanese regional and association banks?.
Beyond the banking market, arrangers are actively wooing other financial services firms, including life insurance companies and institutional investors. Nishigori says that insurance companies have already started to participate in syndicated PFI deals but the list of institutional investors involved in the market needs to be expanded.
As early as 1999, Sompo Japan provided ¥500 million for the construction of an elementary school in Chofu, Tokyo, built under a quasi-PFI scheme (the project was set in motion before the Japanese government got round to officially mandating schemes for PFI status). While the size of Sompo's investment and the project itself was small, it was noteworthy as the first investment by a non-life insurance company.
Foreign banks are another potential source of funds. DBJ's Yamashita says, ?A lot of foreign banks with project finance experience have come to our offices to find out more about the development of the PFI market here.?
Helping to spur interest amongst foreign institutions, the average size of deals entering the market has increased steadily over the last three years. According to Eguchi, a rough average for the size of central government projects is more than $100 million.
Some projects are much larger. One of the largest upcoming PFI designated projects is the Central Government Office Building No 7 project for which bids are due in next month. According to market sources, the total project size will be over ¥100 billion. Project Finance understands that the likely tenor of the financing will be equal to the construction period plus 15 years. Four to five bidding groups, each with their own financial adviser, are thought to be competing for the project. Large local government projects coming up (over $50 million) include Kochi Hospital and Tokyo Youth Plaza.
But it is more likely, concedes Yamashita that foreign banks will target central government projects instead of local government PFI ventures. ?Foreign banks find it difficult to evaluate the credit worthiness of local government in Japan and much more easy to assess the risk of deals where the central government is the off-taker.?
One foreign banker in Tokyo admits, ?taking indirect credit risk of a Japanese local municipality is a major concern, particularly given the normal loan tenor in Japanese PFI deals.?
Foreign banks are especially wary about the local government market because, they say, the financial position of most of the local governments is opaque. ?Most of the local governments we have looked at do not have conventional balance sheets,? says the foreign financier.
Analysts are all the more concerned about local government finances because of growing pressure to amend and even abolish the local allocation tax grant system through which the central government allocates a certain proportion of the five national taxes (income tax, corporate tax, alcohol tax, consumption tax, tobacco tax) to local authorities. ?We don't yet know whether there will be reform, what the exact reforms will be and how this will impact on the financial position of individual local governments,? says one banker.
With the exception of DePfa Bank no foreign bank has participated in a Japanese PFI deal to date. In 2001, the German institution participated in the funding of a health, medical treatment and welfare college in Kanagawa Prefecture near Tokyo. DePfa was the largest lender in a six-strong syndicate amounting to ¥11.1 billion. The loan has one of the longest tenors seen in the PFI market, and relies on phased installments from the Prefecture for repayment.
But DePfa itself is an oddity, a financial institution specializing in loans to local governments. It is also noteworthy that the bank has only been involved in this one Japanese transaction, despite its appetite for government risk and long tenor deals. In contrast, since 1999, DePfa has been involved in 40 other public infrastructure projects in Europe (including the former Eastern Block countries).
Other foreign finance houses will have to analyze local government risk completely from scratch, having no previous track record of financing Japanese local governments.
?It is also easier for us to get involved in the market if a foreign sponsor participates as the project sponsor, but so far, foreign corporate involvement in the PFI market has also been rare,? says the foreign banker.
The one instance of a foreign firm being involved in a Japanese PFI project as sponsor is Singapore port operator PSA Corp's involvement in the construction of the Hibiki container terminal being constructed on 75 hectares of reclaimed land off Kitakyushu.
In December 2001, a 17-firm consortium led by PSA Corp. reached a basic agreement with Kitakyushu to build and operate the port. The municipal government of Kitakyushu will provide the land and berths.
Foreign banks will be encouraged by the fact that few legal concerns now exist in the Japan PFI market. The 1999 PFI law has been bolstered by a further PFI Promotion Law, albeit only comprised of 23 Articles, and several other legal guidelines.
Eguchi says a concrete security package exists for lenders involved in PFI transactions. ?If there is one issue of concern it lies in the enforcement of step in rights in a situation where the project company has gone bankrupt. But it is our opinion that step in rights will be strengthened in the near future, by taking into account UNCTRAL [United Nations Commission on International Trade Law] guidelines,? Eguchi says.
Also encouraging for the banking sector, the length of concession is shortening, allowing a shortening of loan tenor. ?This is happening precisely because of the difficulty of getting longer term loans,? says one banker. A number of the earliest PFI projects had concession periods of 30 years. Now, according to Nishigori, project concession is typically 15 to 20 years.
Back to bonds
Although the market is awash with sovereign and sub-sovereign Japanese bonds, long term, the architects of the country's PFI program hope that the debt capital markets will provide the bulk of the funds for PFI schemes.
Arrangers will play a crucial role in developing a PFI-linked bond market by building the right sort of risk return profiles into PFI transactions.
But Japan's bond market infrastructure is still being refined to encourage more investors to hold bonds of any kind, be they corporate or governmental. The retail segment is particularly underdeveloped. Individual bond holdings are limited, only ¥10 trillion out of ¥410 trillion in outstanding bonds are held by individual investors.
Moreover financiers believe the tenor of PFI linked bonds would be too long to attract enough interest from either institutional or individual investors, in present conditions.
Yet the market is evolving. From March the central government is set to sell long-term bonds exclusively to individual investors, the first time it will have issued such debt in Japan. On 3 February, it started accepting subscriptions at private financial institutions and post offices.
Also, according to one financier, appetite is growing for Japanese municipal governments and government financial institutions bonds issued without a central government guarantee.
It is worth noting that municipal bonds issued to fund municipal public works have recently proved popular in the retail market. A case in point is the bond program launched by Gunma Prefecture last March to finance a hospital project.
Back to contents
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