Prime Minister Abe of the Liberal Democratic Party (LDP) came to power for the second time at the end of 2012 promising to end years of deflation and has continued to enjoy very high popularity because of this, the sense of optimism he conveys and his firm stance on the Senkaku islands with China. He has also initiated further large fiscal expenditure to restore the transport infrastructure, much of which dates back to the 1960s. All this culminated in another victory for the LDP, this time in the Upper House elections on July 21, so the party now enjoys a majority in both houses of the Diet, with three clear years until more elections are required.
There is a real chance this time that this is not just another attempt to reflate an indebted mature economy with a shrinking population. The problem is serious and the debt-to-GDP ratio, after many years of large budget deficits, while not yet critical, may well become so in five-six years’ time if economic growth and nominal GDP growth cannot be reignited. To do this, reform is necessary. Many difficult issues which have been shelved for up to 30 years or more must be addressed, plans drawn up and change driven through against inevitable resistance from entrenched vested interests.
Japan has long embraced a mercantilist approach to economic management, preferring market share over return on equity, low returns to savers to finance high levels of capex, the maximisation of employment for social reasons as welfare provision was partially outsourced to the private sector, tacit discouragement of FDI and large current account surpluses. This model largely ceased to work as interest rates were deregulated in the 1980s resulting in a remarkable property boom and bust.
However many aspects remain and return on equity in Japan is half US levels – for multiple reasons including overemployment, excessive capex, misallocated capital and capital inefficiency. The last is partly a function of companies’ willingness to accumulate cash on their balance sheets and avoid being in hock to banks with whom they lost trust some time ago.Japanese corporations have been protected from market pressures which might correct these trends because aggressive M&A has been nigh on impossible; there have been long term reciprocal shareholding relationships; and domestic institutional as well as mutual fund investors have assiduously avoided putting any pressure on management through either voting or engagement. Executives have only been held to account by their bankers (who are more concerned with creditworthiness than RoE) and to a lesser extent by the press and foreign investors (who have been relatively powerless).
If the proposed structural reforms prove significant and are actually delivered, many of the old assumptions about Japan will change. There could be material tax reform, both corporate and personal. The latter would help limit the decline in the savings ratio and shift the balance towards expenditure taxes away from income taxes, while a Japanese-style ISA will also be introduced.
Corporate tax reform, in the form of reduced depreciation rates and lower headline rates of tax, could help with misallocation of capital and promote higher dividend payout ratios.
A Trans Pacific trade agreement, even if it contains some special exception clauses, could begin to erode agricultural protectionism and shake up Japan’s inefficient farming sector as well as act as a trigger to reform restrictive wholesaling practices. Labour market reform could make it easier to “hire and fire” and together with other changes, could increase the rate of female participation in the workforce, currently the lowest in the OECD, thereby easing any labour shortage arising from the ageing population. Constitutional change is also mooted and the clear intention is to restart as many nuclear power stations that pass safety tests as soon as possible to reduce oil and gas imports, and to prevent Japan’s current account deficit widening further.
There is also recognition that the private sector must lead any return to growth. Part of this process must be to enable entrepreneurs by removing regulations which have limited competition and shut out not just foreign competitors but also small new entrants in many sectors. The other part is reinvigorating the large corporate sector. Many major Japanese companies have disappointed, as the protection that the system provided in the past (which allowed longer term thinking and lifetime employment, etc.) also perhaps allowed for pedestrian or lacklustre decision-making. For instance Korean electronics companies have often trounced their Japanese counterparts and proven better at getting into and out of business segments. That bastion of the corporate establishment, the Nikkei newspaper, not only now has a section covering companies described as “Diminished Giants” but on the first day of the current new fiscal year remarkably called for Japanese companies “to listen to their shareholders”.
Shareholder rights have improved slowly in Japan over the last ten years and are now probably much greater than exist under Delaware law but the practice of corporate governance still lags many OECD countries in terms of independent directors, accountability of auditors, and so on. The LDP has sadly stepped back from its manifesto promise to insist on multiple independent directors and now simply endorses the idea that companies should have at least one independent director on a “comply or explain” basis. But it clearly recognises that if economic success requires better corporate decision-making (including discussion of strategy and risk management) then better governance is at least a good first step.
Although foreign ownership of stocks has reached around 30% in Japan and the share of trading by foreigners has at times exceeded 65%, this is still not quite enough to drive change. Some companies have got the message and like Hitachi are engaged in multi-year reform and restructuring programmes or have unilaterally appointed independent directors like Toyota, while others have slowly but surely become more willing to enter into constructive dialogue with foreign shareholders like ourselves. However, this has been a slow process.So now the LDP has launched study groups to introduce a Stewardship Code (as in the UK and elsewhere) to persuade domestic institutions to recognise their responsibilities as long-term owners of these companies, to vote actively and to engage, and then to be transparent to their ultimate beneficiaries about these activities. Resistance has already been encountered from both life insurance companies and trust banks who are either unwilling to resource this activity or afraid of offending their corporate clients. The public sector pension funds, which it might be hoped would lead the way, are being encouraged to increase their equity holdings but, under pressure from both corporates and the Ministry of Health & Welfare (to which most are beholden), they are reluctant to “interfere” by actively engaging. Much education will be necessary to explain that engagement can often be both constructive and win-win.
Prime Minister Abe has established in his office the Headquarters for Japan’s Economic Revitalization. We should not doubt his serious intent, nor easily dismiss the idea that this may just be a real paradigm shift, despite the difficulties involved in implementation. Japan has also launched through METI (Ministry of Economy Trade and Industry) its own version of the Kay Review to consider how capital markets and investors should best function to help create sustainable long term value. The Tokyo Stock Exchange is launching a new index of companies with good governance, accounting standards and higher RoE.
So there are many initiatives under way but it will all take time. And changing ways of thinking and behaviour that have been in place for over 50 years will be slow. As Karel van Wolferen explained in his 1989 book the Enigma of Japanese Power, there is a lot of inertia inherent in the very plural Japanese system of government, so it will not be easy for Abe to accelerate the process. However there is a shared sense of crisis in Japan, which should assist him and it looks like investors will be invited to help.
Stephen Cohen is CEO of Governance for Owners