March 23, 2011 / 10:45 AM / 7 years ago

Analysis: For Japan, a SWF may suit its reconstruction needs

TOKYO (Reuters) - In the past, Japan has shied away from putting some of its $1 trillion-plus foreign reserves into a sovereign wealth fund. Its devastating earthquake and tsunami may prove a turning point in the debate as such a fund would help meet huge reconstruction costs.

Japan will need multiple approaches to fund reconstruction, which might cost as much as $300 billion. Having a sovereign wealth fund (SWF) that makes long-term investments in the country’s battered northeast coast would give Japan another tool for the job.

A Japanese reconstruction fund could draw on the experience of an agency Germany used to integrate East Germany’s economy, which needed massive restructuring.

A fund could allow Tokyo to better mobilize its reserves -- the world’s second largest -- that are set to rise even further after last week’s foreign-exchange intervention.

The projects undertaken by such a fund in Japan could attract SWFs from other countries, which globally control assets of almost $4 trillion, as partner investors. They are increasingly keen on infrastructure as large-scale investments that also provide a good hedge against inflation.

The ruling Democratic Party’s proposal last year to set up a Singapore-style SWF failed to take off, largely due to doubts Japan should treat its reserves as a pure asset given public debt twice the size of its $5 trillion economy.

However, estimates of a huge cost to rebuild Japan’s northeastern region of Tohoku are rekindling the debate about better deploying otherwise idle reserves, mostly invested in U.S. Treasuries.

It would take time to set up an SWF, as several laws would have to be changed. But reconstruction will be a long-term project, and a fund could help with costs beyond what an emergency budget or short-term measures would help cover.

“If Japan had a SWF, then earthquake reconstruction and nuclear cleanup would be appropriate spending priorities for such a fund. It’s entirely doable now and it would have greater public buy-in,” said Andrew Ang, associate at the U.S. National Bureau of Economic Research.

“It would be terrific for both capital in and outside Japan. The primary attraction of infrastructure is that it can provide a set of long-term cash flows. It has a large inflation hedge as it gives you large exposure to economic activity.”

The economic cost of rebuilding the quake-hit region could be about 6 percent of gross domestic product, or up to 25 trillion yen ($308 billon) -- surpassing that of a 1995 Kobe earthquake to become the world’s costliest natural disaster.

Japan’s chief cabinet secretary Yukio Edano said last week the government will begin considering setting up a Ministry of Reconstruction to deal with the earthquake aftermath.

The Nikkei newspaper has said the government was discussing creating a recovery fund that would provide mid- to long-term lending for firms directly hit by the disaster.

Other countries have similar funds. New Zealand’s earthquake fund, before the February 22 quake, had nearly $6 billion in assets, invested both at home and overseas.


Reconstruction and economic re-integration of a large area such as the Tohoku region -- with the severely affected coastline stretching to 500 kilometers -- are unprecedented in developed economies like Japan after the end of World War Two.

The closest it may get, at least in principle, is “Treuhandanstalt” -- the agency Germany set up in 1990 that took over the ownership of East German enterprises.

The value of the property taken over by Treuhand was estimated to be 200-600 billion West German marks, according to a paper by University of Munster professor Hans-Jürgen Krysmanski. This translates to around $123-370 billion at the 1990 exchange rate of the deutschmark to the U.S. dollar.

“Efforts that lie behind may be comparable. It’s about reconstructing the area that is significantly, in economic terms, behind the rest of the country. There’s a parallel between Germany and Japan,” said Steffen Kern, economist at Deutsche Bank in Frankfurt and an expert on SWFs.

He said, however, the mechanics between a potential Japan fund and Treuhand would be different.

“In Japan, you have to construct from scratch. In Germany, they took over all the assets of German Democratic Republic and sold them off,” Kern said. “Japan is looking for a fund equipped with initial endowments which satisfy future investment for reconstruction.”

Treuhand-style home investment is often seen by sovereign funds as something of a taboo, because domestic recycling of surpluses risks fanning inflation and discouraging competitiveness.

Those taboos, however, don’t necessarily apply to Japan. Because Japan is a big importer of natural resources, it is not swimming in petrodollars or other windfall revenues.

If anything, the mostly agricultural Tohoku region could use sustained investment.

And Japan has been trapped in deflation almost constantly for much of the past 16 years. Deploying its foreign reserves in a reconstruction fund that makes hefty domestic investments may help it beat deflation by generating greater demand.


Infrastructure investment in the Tohoku region can open the way for other sovereign investment funds to participate as they are hungry for large-scale infrastructure investments.

A report published by the Massachusetts Institute of Technology last year showed sovereign wealth funds could invest up to almost $290 billion a year in real estate, or nearly a tenth of their assets, in the next five years as they seek to hedge their often-volatile source of wealth.

A separate report from data provider Preqin showed the proportion of SWFs investing in infrastructure rose to 61 percent this year from 47 percent in 2010, while those with real estate investment rose to 56 percent from 51.

Norway’s $500 billion SWF is building its real estate portfolio into a targeted 5 percent of overall investments in the next 4-5 years.

There is a shortage of markets with significant depth for SWFs -- such as ones in China and Abu Dhabi -- to invest without taking substantial stakes or causing volatile moves. Infrastructure is a rare asset that meets their criteria.

“The project size (of Tohoku rebuilding) itself is enormous -- hundreds of billions of dollars. SWFs have that money. They want investments that are scalable,” Ang said.

Infrastructure may also attract investors beyond SWFs, especially private equity firms which have struggled to find attractive investments in Japan.

Private equity firm Advent has wound up its Japan focused fund due to a lack of sufficient opportunities, while CITIC Capital Partners -- owned by China’s SWF -- closed its Japan buyout fund without raising the full amount it targeted.

Editing by Richard Borsuk

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