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OECD Working Papers on Finance, Insurance and Private Pensions No. 6 - page 25 / 33

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The other key question is whether the target investment portfolio as it stands provides sufficient diversification given the high level of exposure to Japanese government bonds. This issue is beyond the scope of this paper and should be considered carefully in the light of the growing debt burden of the Japanese government and the general risk apprehension of the Japanese population. Given the size of the fund, the financial market effects of possible changes in the GPIF‘s investment strategy should also be carefully evaluated.

Where the GPIF clearly falls short is in terms of risk control. Investment returns may be targeted but there is no mention of within what risk parameter. The derivation of the Basic Portfolio seems to define how much investment risk GPIF should undertake (active / passive split less than 30:70). Its more sophisticated peers (e.g. the CPPIB in Canada) work to maximize the operation‘s risk budget. The GPIF does not seem to have any mechanism for even trying to generate additional returns (i.e. is not using its scale and long-term nature). Given that risk control is not considered, it may be assumed that the GPIF believes it is a low risk fund and consequently may not be examining its risks adequately. Is the GPIF really considering the risk which its huge holding of JGBs represents (which the OECD considers real given the rising level of public sector debt – even with the country‘s strong ‗home bias‘ and domestic funding ability),20 or is it just assuming that this is a low risk portfolio?

When weighing the pros and cons of different investment strategies, the GPIF could look at the experience of some of the older reserve funds which started operations with conservative portfolios, invested mainly or solely in fixed income securities or loans to public entities (e.g. Canada, Korea and Norway), but have gradually moved to more aggressive investment policies. The more recent funds (France, Ireland, New Zealand and Sweden) have all started with diversified portfolios that included at least a sizeable allocation to equities.

Though some of these funds were hit by the financial crisis in 2008, most recovered almost all of the losses in 2009 (see Figure 11 and Table 321), and none was forced to carry out a major change in its investment strategy (with the exception of the Irish fund which has changed it investments in order to help recapitalize two Irish banks). Their experience shows that it is possible to obtain public approval of a higher risk return investment strategy as long as it is adequately explained and justified.

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From 2009 Economic Survey Japan: looking ahead, the normalisation of financial conditions and a recovery in loan demand are likely to involve a general increase in long-term interest rates. Assuming a rise in Japan‘s long- term interest rate to 2.2% by the end of 2010, the OECD projects that gross public debt will reach 200% of GDP (100% for net debt, which would also be the highest in the OECD area). The rising level of debt increases the risk of a more significant increase in interest rates in coming years. In Japan, the outlook also depends in part on whether the factors that have reduced rates and kept them at a relatively low level in recent years will remain in place. A weakening home bias and a decline in financial institutions‘ purchases of government bonds could contribute to a rise in interest rates. The risk of increasing interest rates going forward lends urgency to Japan‘s efforts to overcome its budget deficit problem.

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For countries that have longer data series, performance figures look somewhat brighter. For instance, over the last 10 years, the IMSS reserve in Mexico had an average nominal return of 8.8% annually; the Polish Demographic Reserve Fund‘s return was 8.5%; and the Government pension fund in Norway‘s was 6.8%.

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