4. Credit market

Credit spreads have been stable at tight levels on the Chart 37: Corporate spreads whole, and the favorable environment for financing % points remained unchanged as the amount issued and 1.0 originated increased for products such as CPs, Aa A 0.8 Baa Ba corporate bonds, and syndicated . The stable environment in the credit markets in recent years 0.6 remained underpinned by: (1) solid corporate earnings 0.4 and improvement in balance sheet quality, (2) investors’ search for yield behavior, and (3) positive 0.2 lending attitude of banks. 0.0 Jan-04 Jul-04 Jan-05 Jul-05 Credit spreads remain at tight levels on the Notes: 1. Spreads on bonds with 5-year maturity. whole 2. The indicated ratings are those of Moody’s. Source: Securities Dealers Association Looking at the credit spreads in detail, spreads with a rating of single A and higher remained stable at Chart 38: CDS indices (Japan, US, Europe) extremely tight levels while corporate bond spreads bps and CDS premiums for firms with a rating of triple B 80 or double B widened (Charts 37 and 38). The widening 70 of spreads was due largely to idiosyncratic concern 60 over some firms with disappointing performance and 50 did not suggest deterioration in the credit market as a 40 whole. Furthermore, the shape of the credit curve has 30 remained almost the same because the change in 20 spreads observed in this period for ratings of triple B 10 US Europe Japan and others was limited from a relatively long-term 0 perspective (Chart 39). Jan-04 Jul-04 Jan-05 Jul-05 Notes: Japan: iTraxx CJ, US: DJ CDX NA.IG, Europe: iTraxx Europe Source: Markit Group

Chart 39: Corporate bond credit curves (Japan) (Reference) Corporate bond credit curves (US)

% % 4 4 average (01/04/99-12/30/05) average (01/04/99-12/30/05) end-June 2005 3 3 end-June 2005 end-December 2005 end-December 2005 2 2

1 1

0 0 Aa A Baa Ba Aa A Baa Ba

Notes: 1. Spreads on bonds with 4- to 6-year maturity. Note: Spreads on bonds with 3- to 5-year maturity. 2. The indicated ratings are those of Moody’s. Source: Merrill Lynch Source: Japan Securities Dealers Association

16 In the market of yen-denominated bonds issued by Chart 40: Yen-denominated foreign bond non-residents (Samurai bonds), spreads of the spreads bps bps financing-arms of some U.S. automakers widened 900 90 (Chart 40). In the markets of public sector bonds 800 GMAC#3 (Ba1) 80 (government guaranteed bonds, municipal bonds, and 700 FMCC#1 (Baa3) 70 Fiscal and Program Agency bonds), 600 Citi#5 (Aa1, right scale) 60 reflecting the political discussions on privatization and 500 50 consolidation of governmental financial institutions, 400 40 300 30 spreads on some institutions widened (Charts 41 and 200 20 42). However, most of the other issues performed 100 10 solidly in both markets. 0 0 Jan-05 Apr-05 Jul-05 Oct-05

During the second half of 2005, spreads on some Notes: 1. Spreads on bonds with 3-year maturity. firms have widened. But these were for idiosyncratic 2. The indicated ratings are those of Moody’s at reasons with little effect on the credit market as a end-December 2005. Source: Bloomberg whole, leaving overall spreads tight.

Meanwhile, in the U.S. market, spreads for GM and Chart 41: Government guaranteed bond and municipal bond spreads Ford which had been fairly stable during the summer, % 0.20 started to widen again due to the Chapter 11 Tokyo-to Osaka-fu bankruptcy of an auto-parts company that had strong Japan Corporation for Municipal Enterprises 0.15 business relations with GM. Nonetheless, as was the Jointly issued local bonds case in Japan, while the spreads of auto-related firms 0.10 widened, spreads of the overall market remained tight against the background of solid corporate performance. 0.05

0.00 (Reference) CDS spreads on GM/Ford Jan-05 Apr-05 Jul-05 Oct-05 A Note: Spreads on bonds with 10-year maturity. bps B C 1400 Source: Japan Securities Dealers Association GM 1200 Ford 1000 GMAC Chart 42: FILP agency bond and bank 800 FMCC debenture spreads 600 % 0.30 Development Bank of Japan 400 Japan Bank for International Corp. 0.25 Japan Expressway Holding and Debt Repayment Agency 200 Narita International Airport Corp. 0.20 The Shoko Chukin Bank 0 Jan-05 Apr-05 Jul-05 Oct-05 0.15

Notes: 1. (A) Mar. 16: GM lowered its first-quarter and 0.10 full-year 2005 earnings guidance. (B) Oct. 8: Delphi filed for Chapter 11 bankruptcy. 0.05 (C) Oct. 27: GM and GMAC received subpoenas from SEC. 0.00 2. Spreads on bonds with 5-year maturity. Jan-05 Apr-05 Jul-05 Oct-05 Source: Bloomberg Notes: 1. Spreads on bonds with 5-year maturity for Development Bank of Japan and the Shoko Chukin Bank, while those with 10-year maturity for the others. 2. Japan Expressway Holding and Debt Repayment Agency took over Japan Highway Public Corporation on 1st October 2005. Source: Japan Securities Dealers Association

17 Favorable financing environment Chart 43: Year-on-year change in Bank lending, corporate bonds and CP issuance

Looking at the primary market, outstanding of CPs % % increased, reflecting the financing needs of 5 20 4 Corporate Bonds 18 corporations for larger winter bonus payments and so 3 Bank Lending 16 forth. Issues of corporate bonds (SBs) increased as well 2 CP (right scale) 14 1 12 (Charts 43 and 44). The amount issued by electric 10 0 power companies, which had been declining for the 8 -1 6 last several years, started to increase due to expanded -2 4 plans for business fixed investment. The amount of -3 2 subordinated debt issued by major and regional banks -4 0 -5 -2 rose as well. Looking at the amount issued by rating Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 grades, there was a notable increase in issuance by triple B-rated firms (Chart 45). Notes: 1. The bank lending amount is adjusted to exclude factors such as the liquidation of loans. 2. The corporate bonds and CP are figures as of end of month. During the second half of 2005, there was a notable 3. The latest figure of corporate bonds is as of Nov., 2005. increase in the number of firms that issued SBs for the Sources: Bank of Japan, Japan Securities Dealers Association, I-N Information Systems first time. In 2005, the number of companies that issued their first bonds reached to 37, the highest since 1998, when firms increased their bond issuance as a Chart 44: Domestic corporate bond (SB) issuance by sectors substitute for bank loans against the background of constraints on banks’ lending capacity amidst the trillion yen 3 financial system problems (Chart 46 and 47). Among Banks these 37 firms, about half were regional banks and Electricity and gas bank holding companies issuing subordinated debts. At 2 Others the same time, issuance by real estate investment trusts (REIT) and IT related companies increased. 1

Chart 45: Domestic straight corporate bond 0 issuance by ratings 02/1Q 02/3Q 03/1Q 03/3Q 04/1Q 04/3Q 05/1Q 05/3Q trillion yen Note: Banks include bank holding companies. 3 Source: I-N Information Systems

AAA AA A BBB 2 Chart 46: Numbers of new issuers

70 1 60 50

0 40 02/1Q 02/3Q 03/1Q 03/3Q 04/1Q 04/3Q 05/1Q 05/3Q 30

Notes: Issuers are classified by the highest rating among S&P, 20 Moody’s, R&I and JCR. Source: I-N Information Systems 10 0 FY92 93 94 95 96 97 98 99 00 01 02 03 04 05

Source: I-N Information Systems

18 The number of Japanese REIT has increased and its Chart 47: New issuers by sector market capitalization has reached around 3 trillion yen (Chart 48 and Box 3). In 2005, these funds started CY 2004 CY 2005 issuing REIT bonds as a means of diversifying their Issuers Amount Issuers Amount financing sources. For the corporate sector, triple B- New issuers 15 6,335 37 10,800 rated firms, many of which are IT related firms having Banks 6 3,550 19 5,450 a strong need for financing to expand their business, Local Banks 2 350 15 2,250 increased the amount issued. REIT 0 0 7 1,750 Others 9 2,785 11 3,600 BBB rated 6 1,085 7 2,120 In the Samurai , issuance amounts increased mainly for the financial related sector (Chart Notes: 1. Issuers are classified by the highest rating among S&P, 49). The low issuance costs in Japan seemed to have Moody’s, R&I and JCR. 2. Volume unit: 100 million yen attracted the issuers. Source: I-N Information Systems

Meanwhile, the issuance of public sector bonds excluding the residential mortgage backed securities (RMBS) issued by the Government Housing Loan Chart 48: J-REIT Markets trillion yen Corporation (GHLC), decreased compared with a year 3.0 30 ago (Chart 50). This was mainly due to the decrease in 2.7 27 government guaranteed bonds issued by the Depositary 2.4 Market Capitalization (left scale) 24 Insurance Corporation of Japan. 2.1 Number of Funds (right scale) 21 1.8 18 1.5 15 Chart 49: Amount issued of yen-denominated 1.2 12 foreign bonds 0.9 9 0.6 6 0.3 3 0.7 trillion yen 0.0 0 Others 0.6 Sep-01 Jun-02 Mar-03 Dec-03 Sep-04 Jun-05 0.5 Financial related firms Note: Figures are as of month-end. 0.4 Source: QUICK 0.3 0.2 Chart 50: Amount issued of government 0.1 guaranteed bonds, FILP agency 0.0 bonds and municipal bonds 02/1Q 02/3Q 03/1Q 03/3Q 04/1Q 04/3Q 05/1Q 05/3Q trillion yen Source: I-N Information Systems 5 Municipal bonds FILP agency bonds 4 Chart 51: Amount originated of syndicated loans Government-guaranteed bonds trillion yen % 12 60 3 Others 10 50 Listed companies 2 8 Ratio of others 40 1 6 30 0 4 20 02/1Q 02/3Q 03/1Q 03/3Q 04/1Q 04/3Q 05/1Q 05/3Q

2 10 Notes: 1. RMBS issued by the Government Housing Loan 0 0 Corporation are excluded from FILP agency bonds. 2. The amount issued in 05/4Q is the figure of Oct. and 03/2Q 03/4Q 04/2Q 04/4Q 05/2Q Nov. only. Source: I-N Information Systems Source: Bank of Japan

19 Steady development of a broad range of Chart 52: Amount issued of securitized products financing channels trillion yen 3.0 Others 2.5 Credit receivables and consumer loans Syndicated loans can be characterized as an CDO intermediate financing means between traditional over- 2.0 Equipment lease CMBS the-counter bank loans and financing 1.5 RMBS instrument such as corporate bonds. The loan market has grown steadily by about 30 percent year-on-year 1.0 (Chart 51). Loans to non-listed entities accounted for 0.5 more than 50 percent of the total outstanding and, as 0.0 was the case with the corporate bond market, the 04/2Q 04/3Q 04/4Q 05/1Q 05/2Q 05/3Q 05/4Q borrower base was expanding. Source: Bank of Japan

The issuance of securitized products has also increased (Chart 52). Looking at the type of underlying assets, issuance of products backed by real-estate related property such as RMBS and commercial mortgage backed securities were notable. This increase was mainly due to the fact that the GHLC started to issue large block of RMBS backed by mortgage loans originated in the past, following the partial amendment of the law governing GHLC in June.

Investors’ demand for yield

Investors’ search for yield behavior has helped maintain a favorable financing environment such as expansion of the borrower base and stable tight spreads. The overall low long-term rates seemed to be a background to such behavior (Box 4). Investors’ search for yield behavior could be observed not only in the credit markets but also in other markets. Individual investors have increased their trading in the stock markets. Furthermore, the amount outstanding of mutual funds investing in foreign assets and equity mutual funds that pool corporate and individuals’ into risk assets has been on the rise (Box 5).

While the U.S. and European long-term interest rates remain low, investors searched for yield in global financial markets as well. Investments in emerging markets were increasing once again, as well as in the equity and corporate bond markets in major countries. Especially, bank loans to emerging countries, mainly to Eastern Europe and Asia by Euro-area banks, were at an historical high. Japanese bank loans to Asia were recovering albeit at low levels (Box 6). Investments in hedge funds continued as well (Box 7). Although the performance of hedge funds has declined in recent years, institutional investors’ demand for hedge funds has Chart 53: Commodity Index Prices been still strong in order to May 31, 1985 = 100 May 31, 1985 = 100 gain absolute returns and to 210 1,000 diversify their portfolio. At Reuters-CRB Index Reuters-CRB Industrial Sub-index 800 the same time, investments in 170 Reuters-CRB Precious Metals Sub-index Reuters-CRB Energy Sub-index (right scale) commodity markets were 600 expanding (Chart 53). Search 130 for yield behavior has 400 90 increased the interaction 200 between domestic and foreign markets through expansion of 50 0 arbitrage trading and May-85 May-87 May-89 May-91 May-93 May-95 May-97 May-99 May-01 May-03 May-05 diversification of investments. Note: Energy Sub-index is consisted of crude oil, heating oil and natural gas. Industrial Sub-index is consisted of copper and cotton, Precious Metals Sub-index is consisted of gold, platinum and silver. Source: CRB

20 5. Chart 54: USD, JPY, EUR and Asian currencies exchange rates The yen fell against major currencies such as the U.S. dollar (USD) and the Euro (EUR), and against against USD Asian currencies (Chart 54). On the contrary, the Jan. 1, 2004=100 110 USD continued to strengthen against major 108 appreciation of USD currencies following the trend in the first half of 106 104 2005. 102 100 As for the developments in the foreign exchange 98 96 markets, the yen had fallen against the USD to 121 94 JPY yen by the beginning of December, from around 111 92 EUR 90 Asian Currency Index yen at the end of June 2005. The fall was due to the 88 widening of the short-term differential Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- between Japan and the U.S., and the increase in 04 04 04 04 05 05 05 05 foreign asset investments from domestic investors. This was the first time that the yen had fallen to 121 against JPY yen since March 2003. Jan. 1, 2004=100 117 115 The EUR had fallen to around 1.17 USD/EUR by 113 USD 111 EUR Asian Currency Index the beginning of December, from around 1.21 109 USD/EUR at the end of June 2005, due to the 107 appreciation of JPY 105 widening short-term interest rate differential and 103 repatriation by U.S. corporations from overseas 101 99 bases under the American Job Creation Act of 2004. 97 Both the yen and EUR weakened against the USD, 95 but since the yen fell basically against all major 93 Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- currencies, the euro-yen rate rose to 143 yen by 04 04 04 04 05 05 05 05 mid-December from around 134 yen at the end of Source: Bloomberg June. The yen hit its lowest level against the EUR since its introduction in 1999. Chart 55: Major Asian currencies/ However, from mid-December 2005 to the USD exchange rates beginning of 2006, USD fell somewhat against Jan. 1, 2004=100 major currencies, as dollar selling related to position 130 unwinding dominated the market. 120 appreciation of USD

110 Meanwhile, major Asian currencies held steady against the USD throughout the second half of 2005 100 (Chart 55). Asian currencies fell in October over 90 concerns about economic disturbance caused by the 80 rise in crude oil price, and the selling of Asian stocks by some investors to realize profits before 70 Jan-04 Jul-04 Jan-05 Jul-05 their financial year end. However, by the year end, Korean won Taiwan dollar the solid performance of Asian economies, increase Singapore dollar Thailand baht Indonesia rupiah Philippines peso in policy rates, and the rise in stock prices contributed to the appreciation of their currencies. Source: Bloomberg Meanwhile, since the revaluation of the Chinese Yuan (CNY) on July 21, the CNY remained flat on the whole, and the percentage rise against the USD

21 was limited to 0.5 percent by the year end from 8.11 Chart 56: CNY spot and NDF exchange rates CNY/USD CNY/USD, the rate after the revaluation (Chart 56). 7.7 During the second half of 2005, the yen fell against 7.8 major Asian currencies. In 2006, reflecting Asian 7.9 stock purchases by overseas investors, Asian 8.0 currency rates remain solid against the USD. 8.1 8.2 Factors behind the decline of the yen 8.3 Jan-05 Apr-05 Jul-05 Oct-05 Spot NDF(1Y) As discussed above, in the second half of 2005, NDF(6M) NDF(1M) the yen continued to follow its downward trend Note: NDF (Non-Deliverable Forward) is one of the forward from the first half of 2005 while Japan’s economy transactions which trade the difference in amount between recovered and stock prices outperformed overseas the contracted rate and the spot rate at a maturity date without a spot exchange transaction. market. Three factors lie behind this trend. Source: Bloomberg

Firstly, the short-term interest rate differential Chart 57: Short-term interest rates differentials between Japan and the U.S. has widened as the U.S. between Japan and the U.S., and has continued to increase its policy rate (Chart 57). between the U.S. and Europe Japan and the U.S. This widening of short-term interest rate differential yen % points 122 5.0 influenced investors’ strategy toward investment 120 USD/JPY (left scale) and hedging activities through the change in funding 118 4.5 116 difference in 6-month LIBOR between and hedge costs. As discussed, the amount of 114 Japan and the U.S. (right scale) 4.0 112 domestic stocks purchased by overseas investors has 110 exceeded one trillion yen every month since July. 108 3.5 106 Overseas investors seem to have financed their 104 3.0 Japanese stock purchases directly by yen, a low 102 100 2.5 yield currency, or by hedging the foreign exchange Jan-05 Apr-05 Jul-05 Oct-05 risk. Furthermore, while the return on foreign bond the U.S. and Europe (10-year) investments combined with transactions to US dollar % points 1.40 0.0 hedge foreign exchange risks declined nearly to zero EUR/USD (left scale) percent, domestic investors such as life insurance 1.35 -0.5 difference in 6-month LIBOR between companies have unwound some of their hedge 1.30 the U.S. and Europe (right scale) -1.0 transactions or sold hedged foreign bonds to purchase JGBs due to the relatively higher return on 1.25 -1.5 JGBs. While the impact of these transactions on 1.20 -2.0 exchange rates is hard to quantify, the widening of 1.15 -2.5 the short-term interest rate differential seems to Jan-05 Apr-05 Jul-05 Oct-05 have put downward pressure on the yen through the Source: Bloomberg above transactions. Chart 58: Japan’s trade balance trillion yen Secondly, Japan’s trade surplus has declined 4.0 sharply (Chart 58). With the rise in crude oil price and solid domestic demand, imports have risen and 3.5 the trade surplus (balance of payment basis) from 3.0 July to November 2005 was around 4.0 trillion yen, a decline of almost 30 percent, or 1.5 trillion yen, 2.5 from a year ago. The reduction in the trade surplus 2.0 has influenced the behavior of commercial operators 04/1Q 04/3Q 05/1Q 05/3Q such as export and import companies and reduced Notes: 1. The figure for 2005Q4 is 1 1/2 times the sum of the the yen purchasing pressure. figures for Oct and Nov. 2. The figures for Oct and Nov are preliminary. Sources: Ministry of Finance, Bank of Japan

22 Thirdly, outward investments in securities by Chart 59: Portfolio investment trillion yen domestic investors increased sharply (Chart 59). 6 While inward investments in securities (sum of previous 4 methodology stock and bond investments) from July to December accounted for a net inflow of 10.9 trillion yen, net 2 outward investments totaled 13 trillion yen, 0 exceeding inward flows. This suggests that the -2 supply and demand of funds for foreign exchange -4 was net yen selling related to portfolio investment -6 flows. Jan-04 Jul-04 Jan-05 Jul-05 portfolio investment in Japan portfolio investment abroad By investor, banks (banking account), securities net portfolio investment houses and Japanese mutual funds were each a net Note: There is a break in data due to a revision in methodology seller of 5.6 trillion yen, 4.3 trillion yen and 4.6 from Jan 2005. Data before 2005 are based on trades settled, data after 2005 are based on trades contracted. The figures for Oct and trillion yen, respectively. The outflow through Nov 2005 are preliminary. The figure for Dec 2005 is based on securities houses and mutual fund management reports from designated major investors. companies included the foreign currency Sources: Ministry of Finance, Bank of Japan denominated bonds issued by non-residents to Chart 60: Net assets amount of monthly- individual investors, and mutual funds that invest in distribution-type mutual fund “Global foreign bonds. These funds include investments by Sovereign Open” individual investors for which the associated foreign trillion yen exchange risk seem to be not hedged in most cases 5.5 (Chart 60). Those individual investors who were 5.0 willing to take foreign exchange risks for the sake of gaining returns from mainly the interest rate 4.5 differential were increasingly using foreign 4.0 exchange margin trading, which has lower 3.5 transaction costs compared with other foreign currency denominated products such as foreign 3.0 currency deposits. Backed by mainly domestic Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 economic expansion and the rise in stock prices, Source: Bloomberg individual investors seemed to have gained a greater Chart 61: Historical and implied volatility appetite for risk and increased their investments in of USD/JPY foreign assets. Also, the low volatility in the foreign annual rate, % points exchange market has had effects on investors’ 20 18 historical volatility (1-month) decisions considering the risk reward on implied volatility (1-month) investments, thus fueling foreign asset investments 16 14 (Chart 61). 12 10 8 6 4 Jan-02 Jan-03 Jan-04 Jan-05 Source: Bloomberg

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