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The OECD Observer
January 1999, No. 215
Reinvigorating Business Dynamism in Japan
By Yutaka Imai
After two years of contraction, the Japanese economy is projected to start growing slowly again. The recovery is expected to be weak, in part because of low private-sector confidence and a notable lack of business dynamism. What has become of that dynamism and what is being done to restore it?
There have been worrying signs that Japanese business has lost some of the dynamism it was noted for in earlier decades. The rate of new company formation is now as low as 4%, well below that in other OECD countries and trailing behind the rate of company closure. Meanwhile, the trend in corporate profitability continues to point downwards across a broad range of sectors. There are three main causes behind this weaker dynamism. The first is the lag in fully adjusting to the end of the catch-up process in the manufacturing sector, the second is over-regulation in the non-manufacturing sector and the third cause is the slowness of the corporate system in responding to new business opportunities.
The Lag in Adjustment
As one of the world’s largest economies with a level of productivity similar to that of other high-income countries, Japan can no longer look to its traditional industries to generate new growth. Japanese companies have relocated production heavily abroad, resulting in a ‘hollowing out’ of the domestic manufacturing base. There has been a lag in dealing with this, and it is now clear that new activities and innovations will be needed on a larger scale than hitherto to compensate. The ‘hollowing out’ process not only has led to the closure of large factories in Japan, but has also sparked a massive restructuring of clusters of related suppliers and sub-contractors. Some manufacturing clusters have got through the process successfully, by reorganising their networks and making them more flexible. The most conspicuous example of these dynamic clusters can be found in the so-called high-tech corridor of Tama, which encompasses parts of Tokyo and the two adjacent prefectures of Saitama and Kanagawa. Rather in the vein of Silicon Valley or Italy’s Emilia-Romagna, the Tama corridor is a hotbed of development and growth. Unlike in the rather clubby, traditional system, Tama thrives on open networks of large electrical machinery makers and their research laboratories, some 20-odd universities with science and engineering departments, middle-sized companies with strong product innovation capability—many of them with a dominant position in niche markets—and smaller companies with specialised metalwork capabilities based on the most advanced technologies. However, this new type of industrial development has not been of sufficient magnitude to fill the gap left by the large, relocated industries.
Regulations in the Non-manufacturing Sector
Another important reason for the lack of dynamism in business is over-regulation in non-manufacturing industries. True, there has been some deregulation, but its speed and extent vary from one industry to another. In telecommunications, for example, a substantial easing of restrictions has led to large price cuts and stimulated expansion in both the range and amount of services provided. The easing of the Large-Scale Retail Store Law in 1990, 1992 and 1994 has given rise to larger, more efficient retail outlets and is estimated by the Economic Planning Agency to have increased annual demand by about 0.8% of GDP in the first half of the 1990s. However, in most other sectors deregulation has been slow and partial. The result has been the persistence of inefficiencies and bottlenecks.
The Burden of Tradition
While the legal features of Japan’s corporate system are similar to those in other OECD countries, direct incentives for managers to enhance shareholder value are fewer, and this has not helped business dynamism. In many large companies, board members are promoted from inside, having made a career in the company, and disciplining sanctions through the market for corporate control are therefore limited. Management therefore feels insulated from the pressure to achieve short-term profit, instead favouring decision-making based on long-term perspectives. However, in times of difficulty and uncertainty, what it appears to lack is innovation and the drive to find dynamic solutions. The system of appointments also means that the board of directors cannot function as an impartial monitor of the performance of senior corporate executives, who themselves are board members and appoint other directors. And as board directorships are considered as a reward for company loyalty, the average size of boards is around 25 members for large companies and often as many as 40 directors for the very large ones. Either way, they are far larger than company boards in the United States or Europe. Under these conditions it is extremely hard for a board to be an effective body for making strategic decisions.
Another complication is the key institutional shareholder which exerts primary control over managers in large Japanese companies. This is the so-called main bank, which is also a principal lender. The main bank is commonly believed to monitor managerial performance, thereby reducing the burden on other shareholders, and, if necessary, to act on behalf of the market as a disciplining force on managers. Another often-cited advantage of having main banks is that it involves lower costs in the event of financial distress compared with going through formal, and often protracted, bankruptcy procedures. However, these corporate governance arrangements are likely to have fuelled managerial aversion to large risks, in particular since directors promoted from within tend to favour continuity over change.
Policy Initiatives
To reinvigorate business dynamism, further deregulation and the enhancement of the capacity to innovate and take calculated risks are needed. The government has taken several initiatives to enhance Japan’s innovative capacity. First, the hitherto compartmentalised R&D system is to be improved by increasing the flows of information and researchers between the government research laboratories, universities and businesses. Second, the efficiency of public funding is to be raised by introducing competitive considerations in budgetary allocation and making third-party evaluation of publicly-funded projects obligatory. And third, the protection of intellectual property rights has been strengthened, and universities are to be encouraged to have their innovative work patented and sold. To underpin these improvements to the R&D system in the long term and to help develop more flexible and adaptable human capital, the government plans to carry out some difficult educational reforms. The broad objective of the changes to R&D is mainly to provide greater autonomy to all the players in research in financing and managing their affairs and to encourage interaction and creativity. The changes are therefore to be welcomed and should be pursued further, as long as adequate governance mechanisms are put in place that are commensurate with the degree of autonomy granted.
But for innovation to be of any use in the market, a climate for taking up business ventures is needed. The government has prepared the legal and institutional infrastructure for a potentially huge increase in the supply of risk capital, including the easing of restrictions on investment in unlisted shares by pension funds and the creation of a special over-the-counter (OTC) market for innovative companies. There are a couple of problems though. For a start, the price formation function in the OTC market may have to be strengthened. Moreover, given that the financial market is dominated by inherently risk-averse banks the government will need both perseverance and patience, as well as further measures, before venture capital plays a significant role in financing innovative ventures in Japan.
Measures have also been taken to help traditional business arrangements and corporate governance practices to move forward. But change has been generally slow. In fact, surveys indicate that, while company executives accept that shifts are likely to occur, they do not see much need for change as far as their own companies are concerned (chart). An exception is the seniority wage system and there now seems to be a consensus among firms that this system will have to give way to merit-based pay.
Other reforms are required for businesses to rediscover their old dynamism. One example is in the labour market and the measures the government has adopted or plans to take in this area, such as deregulating labour placement and dispatch services, are commendable. But they should be reinforced by action to do away with obstacles to job switching, notably by improving the transferability of corporate pensions.
Still, the priority should be to restore balance between different corporate stakeholders. The traditional Japanese corporate governance approach gives too much power to insiders. It is high time to redress that balance. The recent initiatives of some leading companies to reduce the size of their boards and to increase the participation of outside directors should therefore be encouraged by the stock exchange. More frequent shareholders’ derivative suits against corporate directors are a welcome move, but it would, nevertheless, be useful to introduce the so-called ‘business judgement rule’ so as to prevent excessive risk aversion by corporate directors. The revised tax treatment of stock options should help to bring managers’ interests more closely into line with those of their shareholders.
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