Japan is saying sayonara to its lost decade. Led by a comprehensive reform program initiated by the Hashimoto Administration in late 1996, serious attempts have been made to revitalize the economy by enhancing competition. The corporate sector has responded by changing business practices, with more emphasis on the market mechanism as the guiding principle. Mergers and acquisitions (M&As) across corporate groups and national borders have become a common tool of restructuring. As the new millennium unfolds, there are early signs that the worst may be over for the Japanese economy, with structural reform finally bearing fruit.
What Went Wrong?
Ten years after the asset-price bubble burst, the Japanese economy is still struggling with its aftermath. At its trough in October 1998, the benchmark Nikkei average index was down to one-third its peak level recorded in late 1989. Prices of land for commercial use and residential use have dropped 70 percent and 45 percent, respectively, since 1991. As a result, most financial institutions were left holding very large volumes of bad debts, forcing them to take a much more cautious stance in extending new loans. A number of major financial institutions actually became insolvent in the second half of the 1990s, pushing the economy to the brink of a crisis. Households and companies also suffered immense capital losses, prompting them to cut spending in an attempt to repair their balance sheets. The currency crisis in neighboring Asian countries that erupted in the summer of 1997 added further deflationary pressures to the Japanese economy. The government has tried to boost the economy by implementing several rounds of fiscal stimulus packages totaling more than ¥100 trillion (about $1,000 billion) since 1992.
At the same time, the Bank of Japan has allowed interest rates to fall to a historically low level. The overall impact on economic growth, however, has been disappointing, with GDP expanding only 1.0 percent a year between 1992 and 1999 (Figure 1).
As efforts to restore economic growth through fiscal and monetary expansion have failed repeatedly, there has been growing recognition that Japan’s stagnation is due not only to cyclical factors by also to structural ones that reduce the potential growth rate. Japan’s economic growth rate has declined in steps since the early 1970s, from 10.4 percent in the 1960s to 5.2 percent in the 1970s, to 3.8 percent in the 1980s, and to 1.7 in the 1990s. Since investment (as measured by gross capital formation) as a percentage of GDP was about the same (at about 30 percent) in both the 1980s and the 1990s, the decline in the growth rate in recent years can be attributed to a decline in investment efficiency, as reflected in a sharp increase in the incremental capital-output ratio (ICOR).
Indeed, the ICOR is now substantially higher, and thus efficiency of investment much lower, in Japan than in the United States (Figure 2). Above all, the potential economic growth rate slowed as a natural result of Japan closing its technology gap with the industrial powers. The rate was further dragged down because both the government and the corporate sector failed to adapt the institutions that had contributed to the economy’s past success to a new environment characterized by globalization, aging population, and the transition to a post-industrial society.
In retrospect, the postwar “Japanese model” played an important role in supporting Japanese industry during its catch-up phase when technology was readily available from abroad and corporate goals were clear and investment risk was small. A spirit of national consensus promoted close cooperation between business and government, helping to concentrate resources in promising areas that needed substantial initial investment. A high savings rate reduced the cost of capital and promoted investment in an era when capital controls prevented domestic interest rates from converging to the overseas levels, while the emergence of new industries ensured that the marginal efficiency of investment stayed high. A cross-shareholding system centered on main banks allowed the pursuance of long-term corporate goals (including a lifetime employment system and market share maximization) instead of short-term profits. Combined with a dedication to the production of high-quality products, Japanese manufacturers quickly established themselves as a major force in international markets.
Now that the catch-up process is over and Japan needs to develop its own economic frontiers, a new system that promotes competition and risk-taking has become all the more important. Furthermore, Japan is facing three new challenges. First, its working population has been shrinking since the mid-1990s, thanks to the aging of population and a declining birthrate. Second, the trend towards globalization implies keener international competition not only in the manufacturing sector but also in the service sector (finance, distribution, telecommunications, etc). Third, rapid developments in information technologies call for more flexible and innovative business practices. Many of the structures and institutions that proved so valuable in helping to develop Japan’s industrial power in the past are thus no longer sufficient to meet the needs of a more mature, service-oriented economy. To revitalize the Japanese economy in this new environment, the following structural problems need be redressed.
Industrial policy and government regulations
As argued convincingly by Katz (1998), the overall thrust of Japan’s industrial policy has switched from market-conforming “accelerationism” to market-defying “preservatism.” The purpose is to preserve already existing industries in order to protect sunk costs, to prevent unemployment, and to maintain wage equality. The recession cartels formed under the initiative of the Ministry of International Trade and Industry (MITI) to protect declining industries have reinforced inefficiency. In the name of egalitarianism, members of a recession cartel are obliged to cut production in proportion to their share of the market or their share of capacity. To help out the weakest, the bigger or stronger firms are sometimes pressured to take an extra-large cut. Under Japan’s “convoy” system, the whole convoy can move no faster than the slowest ship.
At the same time, excessive government regulations and a high corporate tax rate have sustained domestic prices at an artificially high level. The gap with overseas prices is particularly marked for public utilities charges and transportation and distribution costs. Protection of the agricultural sector has also led to higher food prices and land prices. Since services and land are important inputs for the manufacturing sector, their high prices adversely affect the competitiveness of Japanese products in international markets, forcing companies to relocate production offshore. Furthermore, constrained by the notorious “Large-scale Retail Store Law,” the Japanese retail sector has traditionally been composed of small stores and complex distribution networks. The resulting inefficiency and wide mark-ups have made consumer product prices much higher in Japan than overseas.
Banking and finance
Until recently, the convoy system also applied to the financial sector whereby the government ensured that all financial institutions (banks in particular) would not go bankrupt. In the event that a bank had become insolvent, the Ministry of Finance would arrange for it to merge with another bank in order to protect the interest of depositors and borrowers. The presence of this “safety net” created moral hazard problems, prompting banks to take excessive risks, as they did during the late 1980s. This sowed the seeds of the bad-debt problem that emerged with the bursting of the asset-price bubble in the 1990s.
Japan needs to establish a financial system capable of allocating funds based on the market mechanism instead of administrative guidance. Japan’s financial system was originally established to assist the formation of a mass production society by soaking up funds from the public at large and then lending them out to standardized mass production type industries. Uniform interest rates and government protection adopted for this system meant that major corporations could rely on low-cost borrowing from commercial banks. This system, however, encouraged inefficient uses of capital, rewarding marginally profitable firms by penalizing more efficient competitors. It also limited the access of Japanese consumers to a full range of competitive financial products. In addition, under the traditional system venture businesses have difficulty borrowing from banks because they do not have land to offer as collateral. To develop new industries, Japan should take steps to facilitate venture businesses to raise funds through capital markets, including listing on stock markets, to ensure that savings are channeled to industries that may involve high risks.
At the same time, there is an urgent need to reform the postal savings system, which is the largest deposit-taking institution in the world. This state-run system enjoys a competitive advantage over private banks because it does not have to pay any corporate taxes or deposit insurance premiums and it is not subject to reserve requirements. Postal savings are used to finance policy loans (channeled automatically through the Ministry of Finance and then government-related financial institutions) based more on political than on economic considerations. Some of these borrowers are public corporations that are running very large deficits, raising doubt over their ability to repay without additional financial support from the government.
The immense amount of public expenditures, including those incurred in the name of pump-priming fiscal expansion, probably was not used efficiently. At 6.0 percent of GDP in FY1998 public fixed capital formation is significantly higher than in other industrial countries (1.9 percent for the US, for example). The lack of transparency in awarding contracts has provided fertile soil for corruption and collusion among construction companies to raise prices. Public works have also been used as tools to create jobs and transfer income (to the construction sector and to the countryside) rather than as investment to yield a return. Making matters worse, under a very rigid budget system, public expenditures continue to be channeled into declining sectors while such new areas as information infrastructure receive insufficient public funds. This backward-looking public spending strategy has led to a misallocation of social resources and retarded economic growth.
The Japanese corporate system, characterized by long-term relations, has led to inefficiency as companies come to be plagued by excess capacity, over-employment and debt overhang. The lifetime employment system and corporate groupings (keiretsu) centered on main banks played important roles in the development of Japan’s manufacturing industry, which requires on-the-job training, technology transfer to subcontractors, and a stable supply of low-cost funds. However, flexibility in combining various factors of production is more important in new areas such as information and finance. To facilitate industrial restructuring, the government should eliminate obstacles to the mobility of labor, mergers and acquisitions, and development of venture capital.
In recent years, the supervisory function of the main banks has greatly weakened. There is an urgent need to rebuild corporate governance based on market principles. As part of that process, it is necessary to form a mobile market of senior executives to replace the present practice of promoting managers from within the corporate hierarchy. In addition, managers ought to be monitored using objective market indicators, and one way to achieve that is to link their compensation to company share prices by granting them stock options.
Recent Attempts at Reform
While the structural problems facing the Japanese economy are well known, attempts at reform have always met with resistance from vested interests. In a sharp break from its traditional gradual and piecemeal approach, in December 1996 the Japanese government under Prime Minister Ryutaro Hashimoto adopted a comprehensive reform program that covers six key areas including economic structure, finance and banking, public finance, health and welfare, public administration, and education. The aim of this reform program is to revitalize the economy and to create a free and fair socio-economic system that is fully opened to the international community and based on the rules of accountability and market principles. This is to be achieved by eliminating or relaxing regulations and transferring the responsibilities of the government to the private sector. The regulatory role of the government will be shifted from ex ante approval to ex post monitoring of compliance with general rules in this process.
Among the six key areas, “reform of economic structure” will have the largest direct impact on productivity growth. This is to be achieved by shifting resources to growth areas that will underpin domestic employment over the long term. On the one hand, Japanese companies in traditional sectors must work to cut back their payrolls, to streamline their supply structure in line with market needs, and to improve profitability. On the other hand, emerging industries and venture businesses have difficulty securing the funds, human resources, and technology needed for start-up and expansion. The government aims to facilitate corporate restructuring by reducing restrictions that hinder mergers and acquisitions, cross-border investments, alliances and financial transactions both within and across national borders. Specifically, ongoing reform and deregulation initiatives include the following measures (JETRO, 1999).
Changes in corporate taxation
The government implemented a permanent tax cut in FY1999, reducing the corporate tax rate from 46 percent to 40 percent, making it competitive with tax rates in the U.S. and Germany.
Promotion of new industries
The government is supporting the creation of new industries and business start-ups by private entrepreneurs. To this end, it is implementing deregulation, technological development, and human resource development to create a business environment conducive to the growth of 15 industries selected for their high growth potential in the next generation.
Changes in anti-monopoly regulations
Japan’s anti-monopoly law has been revised to facilitate mergers and acquisitions. The ban on pure holding companies (companies with more than half of their assets being shares of other companies) was lifted (effective December 1997 for non-financial firms and March 1998 for financial institutions). In addition, while previously all mergers and acquisitions were required to be reported to the Fair Trade Commission, now only those transactions larger than a certain amount need to be registered.
Changes in commercial law
Corporate acquisitions by stock transfer rather than cash purchases have been approved. Regulations concerning the legal structure of Japanese companies, including rules governing corporate spin-offs and divestitures, are now being reviewed and altered.
Changes in corporate pension systems
A new pension contribution system modeled after the 401(k) plan in the United States will be introduced in 2001. This allows employees to contribute a portion of their compensation, before income taxes, to a company-sponsored retirement plan. Under the new scheme, the employees decide how the contributions are to be invested, and continuity is guaranteed when they change jobs.
Changes in accounting regulations
To improve transparency and disclosure, beginning in FY2000, Japanese companies have been required to report market-value-based consolidated financial statements that cover subsidiaries. Under the new rules, the Japanese accounting system has become consistent with international standards.
In addition to the reform of economic structure, another pillar of Japan’s comprehensive reform program is the financial Big Bang, whose aim is to transform Tokyo into an international financial center on par with New York and London by the year 2001. The three underlying principles are 1) free-toward a free market where the market mechanism prevails, 2) fair-toward a transparent and reliable market, and 3) global-toward an international market ahead of its time. The Big Bang covers all major areas of the financial sector, including banking, securities, and insurance. It drastically removes restrictions on products, services, and organizational structures on one hand, and plans to improve fair trading rules for customer protection and the framework for dealing with failures on the other.
The financial Big Bang was initiated in November 1996 and formulated into a formal agenda in June 1997. As the first step, the Foreign Exchange Law was revised to liberalize cross-border transactions completely in April 1998. Then, the Financial System Reform Law, a package of revisions of laws including the Banking Law, the Securities and Exchange Law, and the Insurance Business Law, came into effect in December 1998. Almost all measures have been subsequently implemented as planned, bringing drastic changes to the financial sector (MOF, 2000).
First, efforts were made to provide attractive services by enhancing competition. Major measures include promoting entry of banks, securities companies and insurance companies into each other’s business, switching from the licensing system to a registration system for securities companies, liberalizing cross-border capital transactions and foreign exchange business, and liberalizing brokerage commissions and insurance premium rates. Many new securities companies, including foreign ones, have been established since switching to a registration system. Furthermore, the liberalization of brokerage commissions has led to an expansion of securities trading through the Internet (online trading). Financial institutions have also taken advantage of deregulation to increase the range of financial instruments and services available to investors, including financial derivatives and new investment trusts and over-the-counter sales of investment trusts by banks and other financial institutions.
Second, new markets and channels for fund raising have been created by abolishing the requirements to trade equities only through stock exchanges, and by introducing electronic trading systems. The Tokyo Stock Exchange opened a new market for promising start-ups, the so-called “MOTHERS” (Market of High Growth and Emerging Stocks), in November 1999. This was followed by the establishment of the NASDAQ-Japan market at the Osaka Stock Exchange in May 2000.
Finally, a framework for prudential surveillance was established by improving the disclosure system, setting up fair trading rules, such as stricter insider trading control, and protecting customers in times of failure of financial institutions. Since the accounting period ending March 1999, financial institutions have been required by law to disclose information on their non-performing assets on a consolidated basis according to standards equivalent to the ones set by the Securities and Exchange Commission of the United States.
It goes without saying that the success of the Big Bang hinges on restoring the stability of Japan’s financial system. Fortunately, much progress has been made since October 1998 when major laws were enacted to allow the government to put failing banks under public control temporarily, and to use public funds to recapitalize banks that are considered viable. A total of ¥60 trillion, equivalent to 12 percent of Japan’s GDP, has been earmarked for these schemes. The troubled Long-term Credit Bank and Nippon Credit Bank were soon nationalized under the new framework. In addition, 15 banks received capital injections from the government amounting to ¥7.5 trillion in March 1999, allowing them to write off bad debts at a faster pace. This financial stabilizing program has succeeded in restoring public confidence in the soundness of the financial system, as reflected in the subsequent elimination of the “Japan premium” (interest rate premium Japanese banks paid when borrowing in international markets) as well as the recovery in the stock prices of Japanese banks.
Early Signs of Change
Thanks to the ongoing reform efforts, the Japanese economy has shown positive signs of change. Corporations are responding to keener competition resulting from globalization and deregulation, and consumers have benefited in this process in terms of lower prices and better services.
Japanese corporations are undergoing a restructuring process that involves not only downsizing but also drastically changing their traditional business practices. Greater emphasis is given to profitability than to market share. Labor mobility is increasing, and merit is gradually replacing seniority as the basis of remuneration. The main bank and keiretsu systems are also losing their influence, and mergers and acquisitions among companies belonging to different corporate groups have increased sharply.
First, Japanese companies are paying more attention to the rate of return on their investment, with return on equity (ROE) and return on assets (ROA) followed closely by both managers and investors. During the bubble period, fuelled by very low cost of capital, Japanese corporations actively increased their asset portfolios with little regard to profitability. The resulting negative economic growth, rising debt and bankruptcies, and inefficient use of management resources have further reduced corporate profits and prompted a change in corporate strategy. A survey by the Economic Planning Agency (EPA, 1999) confirms that an increasing share of Japanese corporations is focusing on the rate of return rather than the absolute levels of sales and profits in their corporate strategy (Figure 3). The same survey shows that many corporate managers see both the cross-shareholding system and the main bank system weakening. From now on, their investment decisions will be closely monitored by shareholders and creditors, who are demanding a rate of return commensurate with the risk on their investment. At the same time, more and more corporate managers have been granted stock options in recent years, so that they now have a stronger incentive to maximize profit.
Second, the lifetime employment system is giving way to a more flexible one. During the recent recession many companies have conducted restructuring through layoffs, introduction of early retirement schemes, and limiting their hiring of new employees. As a result, the unemployment rate has reached a historically high level, and the government has responded by launching diverse initiatives to create employment. In the past, the government’s employment policy was designed to maintain workers at their present jobs, but the emphasis has shifted to promoting the transfer of human resources to new growth areas. Higher labor mobility in turn has made it difficult for Japanese companies to sustain a remuneration system based on seniority, prompting them to shift to a new system based more on merit. This is particularly true for financial institutions, which are losing some of their brightest professionals to foreign competitors expanding their operations in Tokyo.
Finally, mergers and acquisitions have become widely used in corporate reorganization and restructuring to achieve economies of scale and economies of scope. M&A activity is increasing not only in the service sector, which is responding to deregulation, but also in the manufacturing sector, which is facing keen competition in the global market.
The increase in M&As has been led by the banking sector. Following the merger between Mitsubishi Bank and Tokyo Bank in 1996, Dai-ichi Kangyo Bank (DKB), Fuji Bank, and Industrial Bank of Japan (IBJ) have announced a merger plan to form the Mizuho Financial Group in the autumn of 2000, while Sakura Bank and Sumitomo Bank have agreed to merge in 2002. With the latest announcement of a merger plan among Sanwa Bank and Tokai Bank in the spring of 2001, Japan’s major banks will effectively be consolidated into four major groups.
In many cases, recent M&As in the financial sector have involved foreign partners that are eager to cash on the Big Bang. When Yamaichi Securities was liquidated in 1998, Merrill Lynch took over its branch network. GE Capital has acquired Toho Life Insurance Company and Japan Lease Corporation (Japan’s fifth-largest consumer finance company). In 1998 Traveler’s Group invested in Nikko Securities, one of the Big Three in Japan’s securities industry, by purchasing 25 percent of its stock. More recently, Ripplewood, a U.S.-led investment group that includes General Electric and Mellon Bank as major partners, acquired the temporarily nationalized Long-term Credit Bank from the government.
Japan is also part of the global wave of M&As in the automobile industry. Renault of France invested $5.3 billion in Nissan in 1998, giving it a 36.8 percent ownership share of Japan’s second-largest automaker. This was followed by GM’s investment in Fuji Heavy Industry in 1999 and DaimlerChrysler’s acquisition of 33.4 percent stake in Mitsubishi in 2000. As a result, seven out of Japan’s eleven major automakers have come under the control of foreign companies. Of the remaining four, Toyota now has majority holding of Daihatsu and Hino, and only Honda has decided to go it alone.
The rise in cross-border M&A activity has been reflected in a sharp increase in foreign direct investment into Japan. According to the Ministry of Finance, inward foreign direct investment almost doubled in FY1999 to reach ¥2.4 trillion in the FY1999. The current pace of investment in Japan by foreign companies is more than five times as high as that five years ago.
Meanwhile, Japan’s deregulation program is moving steadily ahead according to the original schedule. In addition to the changes in the financial sector noted earlier, the positive effects of deregulation have been most apparent in the retail and telecommunications sectors.
Following two major amendments implemented in 1992 and 1994, the Large-scale Retail Store Law was finally abolished in June 2000. As a result of the sharp reduction in entry barriers, the number of large-scale retail stores increased by 41.1 percent between 1991 and 1997 compared with only 16.7 percent in the previous six years, despite a sharp slowdown in economic growth. Keener competition is raising the efficiency of the retail sector, presenting Japanese consumers with lower prices and a greater array of choices than before. The Large-scale Retail Store Law has been replaced by a new Large-scale Retail Store Location Law, which stipulates that regulation of large stores will no longer be based on supply/demand considerations but on the degree to which a large store opening or expansion affects the local environment.
In the telecommunications sector, deregulation has allowed businesses and consumers to access a far wider range of services at reduced prices. For example, long-distance telephone rates have now fallen by more than 75 percent since 1985. Cellular telephone subscriptions have also increased rapidly from 2.13 million in 1993 to the 55.53 million in February 2000 since reform efforts allowed the introduction of a new sales system in 1994.
The expanding scope and size of the market have not only lowered telecommunication costs drastically, but also provided opportunities to a number of foreign firms such as Nokia and Motorola to enter the Japanese market. Investors also recognize the emerging opportunities, as reflected in the highly successful public offering of NTT Mobile Communications Network (DoCoMo) in October 1998.
Progress in structural reform has set the stage for a new phase of self-sustaining growth. Indeed, led by new business opportunities in information-technology-related sectors, the Japanese economy has shown clear signs of recovery, with GDP expanding at a robust annual rate of 10% in the first quarter of 2000. Stock prices have bottomed out, thanks to rising corporate profits and growing recognition of the potential of the “new economy.” Exports have also regained strength on the back of the recovery in Asia. The improvement in the business environment has been accompanied by more active investment and more new jobs offered by Japanese companies.
The Unfinished Agenda
Although there are early signs of change, Japan’s “transition to a market economy” is far from complete, and many barriers hindering reform remain to be overcome.
Trade off between short-term and long-term growth
Reform in some areas has been delayed because of the need to maintain employment and financial stability. In addition to building roads leading to nowhere using taxpayers’ money, there are more implicit forms of serious resource misallocation. Subsidizing money-losing banks and companies has the adverse effect of locking resources in stagnant sectors instead of shifting them to more dynamic ones. Guaranteeing bank loans to small- and medium-sized companies and bailing out troubled financial institutions, in particular, have led to immense moral hazard problems.
Moreover, the current level of fiscal deficit is certainly too high to be sustainable. The Fiscal Structural Reform Act frozen since December 1998 to make room for fiscal stimulation should be revived once private demand is back to the driver’s seat. It is necessary not only to increase tax revenues and to reduce expenditures, but also to improve the fiscal structure itself. This requires redefining the division of labor between the public and the private sectors as well as between the national and local governments based on cost-benefit calculations.
Resistance from vested interest groups
Resistance from vested interest groups has remained a major barrier to reform. Administrative reform, for example, has so far achieved no more than a nominal reshuffling of the ministries. In addition to allowing the private sector and local governments to play a more important role in providing public services, a lot more needs to be done in improving administrative transparency, accountability and adaptability. As pointed out by OECD (1999), Japan suffers from a deeply conservative policy process that slows decision making, discourages open debate, encourages “clientelism,” and allows special interests to block needed changes. New incentives, participants, and controls in the regulatory processes are needed to re-orient old relationships with producer groups, to break up information monopolies in the bureaucracy, and to narrow administrative discretion to re