• With a view to determining the scale of the problems surrounding the operations of the "external organizations" (gaikaku dantai, i.e. public corporations and the third sector organizations) of local governments, the scale of the interest and credit risk involved was estimated on the basis of published statistics.
• The results of the estimates suggest that, in view of the impact of this problem on the management of local government finances and its implications for monetary order, the desirable future directions for policy management are as follows:

Directions for a Response to the Problems Surrounding the Operations of Local Government "External Organizations"

1. Problems Inherent in the "Regional Power Revitalization Corporation" Concept

• Although at the present stage, the concept underlying the proposed "Regional Power Revitalization Corporation of Japan" can be seen as based on the successful experience of the Industrial Revitalization Corporation of Japan (IRCJ), the problems it is intended to address are quite different at a fundamental level from those addressed by the IRCJ. In its present stage of development, it is unlikely that the "Regional Power Revitalization Corporation" concept will function effectively.
• The first problem is that it is not clear what state the operations of an "external organization" with problems must be in to fall within the Corporation's brief, and when the results of the above-mentioned estimates are taken into consideration, it seems unlikely that the allocation of funds to the Corporation and the design of the scheme are adequate or appropriate.

—The scale of funding allocated to the Corporation (¥30 billion) and the scope of the government guarantee applicable to its borrowings (up to ¥1.6 trillion) may well be too small in view of the scale of the problems involved (see page 3).
—It is not envisaged that designated cities (seirei shitei toshi), which may possibly face even greater problems than prefectural governments, will contribute funds to the Corporation.
—Although the scale of the risk relating to "external organizations" varies considerably from one local government to another, all prefectural governments are required to contribute a uniform amount of funds.

• The second problem is that it is not clear whether the problems facing local government "external organizations" are to be addressed solely on an individual case basis or whether some kind of response at national level is being considered.
• If anything, it would appear that the intention is to address problems rather individually, but in practice it is likely to be very difficult to resolve problems on an individual basis. This is because, unlike the problems faced by the IRCJ, the problems in this case, essentially, relate to the fulfillment of obligations where local governments, which in Japan enjoy quasi-sovereign status, have provided credit enhancement (“debt guarantee” to the two kinds of public corporations < i.e. a land corporation or highway corporation > or “compensation for losses” to the third- sector organizations).

—There have already been judicial rulings on this point, including a ruling by the Supreme Court (2nd Petty Bench decision of September 21, 2007).

• If, in future, the response to even a single case is irregular, the repercussions on monetary order in Japan will be grave. In other words, if debt adjustment leads to a situation in which even part of the debt guarantee or compensation for losses relating to the obligations of an "external organization" is not fulfilled, in financial transaction terms, this would be tantamount to a default on the part of a local government, which in Japan is a quasi-sovereign body.

—In this case, it will be very difficult for private banks to maintain the risk weighting of the BIS regulation on loans to local governments (set by the financial supervision authority of the country in question, i.e. the Financial Services Agency in Japan; currently 0%).
—It cannot be denied that raising the level of risk weight could have a serious impact on the operations of private banks, especially regional banks, and on regional monetary order.
—At the same time, it is highly likely that the cost of local governments for procuring funds from the private sector would have to go up.

2. The Limits of Effectiveness of the Measures Being Considered by the Ministry of Internal Affairs and Communications

• When the Ministry of Internal Affairs and Communications "Study Group on Debt Adjustment" reconvened in July this year, it was announced that the Study Group was looking at the possibility of "allowing the issue of regional government bonds, under certain conditions, for the purpose of disposing of the debts of 'external organizations'", and that discussions would continue into the autumn.
• However, this amounts to little more than transferring the obligation, for which the "external organization" itself bears the primarily responsibility, to the local government which is the parent of the "external organization", under certain conditions, and postponing the problem by reassigning the debt. At a time when interest rates are rising, this would have the same kind of impact on the local government itself as it does at present on the "external organization" and would not lead to an essential or fundamental solution.

3. Directions for a Future Response

• In future, the problems and issues relating to the "Regional Power Revitalization Corporation" concept must be debated at a national level and the concept must be redrawn to make it more effective with a view to finding essential solutions to the problems it needs to address.
• First, it should be clearly recognized that the problems in question cannot be resolved on an individual basis, but should be addressed at a national level.
• The deliberations should then be continued, and should include the following directions: (i) The central government should draw up uniform, objective and egalitarian criteria by which to evaluate the sustainability and necessity of the operations of each "external organization" at national level; (ii) on the basis of these criteria, all "external organizations" should be scrutinized with a view to identifying those requiring a radical response, and, at the same time, an organization should be established, in which the government has a degree of involvement, and responsibility for addressing the issues in question should be transferred to this organization.

Estimates of Risk Relating to "External Organizations" Borne by Local Governments

1. Heavy Use of Finance

• A feature of the support provided by local governments to their "external organizations" (public corporations and third-sector organizations) is that, in addition to non-repayable funding such as grants and subsidies, heavy use is made of financial methods which assume that the money loaned will be repaid in the future, i.e. (iii) loans (*1), (iv) credit guarantees (*2), and (v) compensation for losses (*3).
  *1: The local government lends funds directly to the "external organization".
  *2: A private bank or other financial institution lends funds to a land corporation or highway corporation and the local government guarantees the obligation.
  *3: A private bank or other financial institution lends funds, usually to a third-sector organization, and the local government provides compensation in respect of the losses incurred in the event that part or all of the funds cannot be repaid.

2. The Risk Borne by All Prefectural Governments and Designated Cities

• The results of our estimates of the scale of interest and credit risk relating to "external organizations" (public corporations and third-sector organizations) that all prefectural governments and designated cities bear as a result of these financial methods are as follows.

—The total latent interest and credit risk is approximately ¥10 trillion (Fig. 1).
—Of this total, the interest and credit risk relating to "external organizations" whose financial position has deteriorated "to a significant degree", amounts to approximately ¥650 billion (Fig. 2).
—Similarly, the interest and credit risk relating to "external organizations" whose financial position has deteriorated "to some degree" amounts to approximately ¥5.4 trillion (Fig. 3).

3. Evaluation of Results of Estimates of Risks Borne by Individual Local Governments

• The gap between local governments that bear a large risk and those that bear a small risk is extremely large.

—While for some local governments the ratio of latent risk to the “standard financial needs” is more than 130% for others it is virtually 0% (Fig. 1).

• In many cases, the problem is greater among designated cities than among prefectural governments. The risks associated with land corporations and highway corporations, and with transportation-related third-sector organizations tend to be greater.
• There is also a tendency for local governments which should theoretically be in a stronger financial position to bear a greater risk, e.g. local governments which are not receiving local allocation tax.
• In a few cases, the risk borne by prefectures which include a designated city increases coincidently with the risk borne by the designated city itself.
• The local governments bearing high latent risk are not necessarily the local governments with "external organizations" whose operations have actually deteriorated to a significant degree.
• This is not so simply a "provincial" problem. It is also to a great extend a problem of "major conurbations".

In the current climate of low interest rates, even "external organizations" which are still "going concerns" may still see their position deteriorate in the event of a future rise in interest rates if they are burdened with large debts. In this case, it is undeniably possible that multiple cases in which it is not possible to resolve the problems surrounding the operations of "external organizations" even at the "parent" local government level, may arise simultaneously among local governments with a high level of financial exposure.

4. Relationship to the "Future Burden Ratio"

• It is possible that the lineup of local governments with a relatively high "future burden ratio" on the basis of the Law on the Fiscal Consolidation of the Local Governments due to be published shortly (at the end of September 2008) will differ from the lineup based on the results of the estimates.
• This law is intended only to "impose legal discipline by the public jurisprudence with regard to the operation of local government finance systems". Therefore, for management purposes, the use of methods for the evaluation of the operational status of "external organizations" that do not rely on financial statements is also permitted (Appendix Fig. 5) and, even if the method used relies on financial statements, a number of exemptions are granted in connection with the burden relating to "external organizations" (Appendix Fig. 7).
• It is therefore to be feared that, even among local governments whose future burden ratio is not, at present, particularly high in relative terms, if the assumed conditions, e.g. interest rates, change, deterioration in the position of an "external organization" may even trigger an impact on the finances of the "parent" local government.

For more information on the content of this report, please contact Sayuri Kawamura, the Japan Research Institute, Limited.

Tel: 03-3288-4148
E-mail：kawamura.sayuri@jri.co.jp

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