The World Today
August/September 1998

Shout Louder for Change

By Christoher Purvis

Japan’s economic success was for many years the object of admiration and envy. This has largely been from the consumer point of view: we have looked to Japan as the producer of so many ‘necessities’: the car, the PC, the mobile phone, the Walkman. Japanese investment in the USA and Europe has been welcome, not only for the jobs it created, but also, in Britain, for the stimulus to changes in the workplace. Japanese management techniques were widely admired. But curiosity is now suddenly transformed into a deep concern that the economic crisis, compounded by the ruling party’s leadership problems, will be a major threat to the stability of the world economy.

The story of the economic regeneration of Japan after the war is remarkable. Per capita Gross National Product (GNP) has risen from $132 in 1950 to nearly $40,000, in a country of 125 million. Such growth was achieved largely through Japanese society’s ability to pull together in a common goal: to rebuild the country after the conflict.

Japanese management systems became the envy of the western world; many was the conference on ‘just in time’ delivery. Even two years ago ‘stakeholder economy’, a phrase briefly fashionable in London, seemed to recall the Japanese approach to corporate governance: the importance of the interests of the employee, the community and the client above those of the shareholder.

There was admiration for the way in which Japan’s leading industries had been nurtured so carefully by the relevant ministries, notably the Ministry for International Trade and Industry (MITI) and the Ministry of Finance (MOF). The cross-shareholding structure created an environment of stability, which allowed companies to make good long term decisions: none of the short-termism that blights those listed on the New York and London stock exchanges. This allowed a very high level of capital spending by firms, much higher than in Europe and the United States.

Even the reaction to crises during the last fifty years has been admired. I remember the stifling heat in Tokyo offices during the second oil crisis when the air conditioning was turned off, or during the first stock market downturn in 1990 the view of the Japanese staff in my office that we should all take an immediate pay cut and pull together in tackling the loss of profitability.

In the late 1980’s a number of commentators began to point out that this blueprint for success in the past 50 years was unlikely to be as useful in the next. The problems were most apparent in those parts of the economy which had been the most protected by their ministries: oils, pharmaceuticals and financials. These companies were heavily governed from Kasumigaseki, the seat of the bureaucracy.

There was precise regulation of what each company could do. The banks, for example, were divided into three types, commercial, long term, and trust, and none was allowed to cross the border into another’s territory. One did try: in the nineteen fifties Daiwa Bank had an enterprising chief executive who was prepared to risk ignoring the guidance from the ministry to be able to carry out both commercial and trust banking business. As late as the eighties Daiwa was still suffering from having stepped out of line.

Such guidance and control happened less in the manufacturing sector. The story goes that Mr Honda was asked by MITI to concentrate on motorbikes, but he ignored the advice. Honda went on to become more successful than some older established automobile manufacturers.

The manufacturing companies have to a degree learnt from competition how to adapt and change. But the financial sector, which was beginning to compete seriously on the global stage in the 1980’s, found that it was fighting with one hand tied behind the back. Radical changes would have to be made.

There has been a gradual process of deregulation in the financial industry over the last fifteen years. There was intense pressure from foreign firms to enter the Japanese market, which resulted in the opening up of some parts of the financial sector. Japanese financial companies themselves needed deregulation in their home market to learn to compete internationally.

The manufacturing sector was held back by an inefficient financial sector. This was particularly the case in the management of pension funds: poor performance had a direct impact on the company profitability. In 1996 Prime Minister Ryutaro Hashimoto, as part of a programme of reform to cover much of the Japanese economy and society, heralded a ‘Big Bang’ in the financial markets, although the bang was to be stretched over several years. The changes may be slow, but it was accepted that the liberalisation must happen.

The effects of the financial sector changes would not be limited to the banks; there would be a far reaching impact on the whole economy and society. The gradual breakdown of the cosy relationship between the ministry, the financial companies and their clients would bring new pressures on company management.

Corporate governance as practised in the West started to become an issue as the interests of shareholders took on a new importance: the Sony board now has 40 per cent non-executive directors. But there has been no fundamental reform of corporate governance as seen in the UK with the Cadbury and Hampel reports.

The financial industry is starting to look more critically at the return on its assets, and companies who were previously able to ignore their shareholders have started thinking in terms of return on equity. They in turn are trying to influence the providers of financial services, notably pension fund managers: the pressure is beginning to rise.

 

Under threat

The management systems so admired only ten years ago are under threat. Lifetime employment cannot survive the pressure from the demanding shareholder. The Japanese company which has become global in scope cannot expect foreign employees alone to be made redundant in downturns. Pressure for performance will also mean a higher proportion of results related pay and a move from the old system of promotion and rewards increasing automatically with age.

The pressure for change has not only come in the financial sector. There is some evidence of a growing general dissatisfaction with the structure and order of society. A large proportion of Japanese now have part of their education abroad and return with high expectations for career and remuneration. Foreign companies have no problems recruiting among those - particular women and the young - who want to do better than would be allowed in a major Japanese corporation.

Dissatisfaction with government control and high taxes is becoming vocal. Prime Minister Hosokawa was brought to power on high hopes for change – although they came to little. There are signs of a voluntary sector beginning to thrive as frustrations with the government’s inability to solve problems increases. In Tokyo 600,000 people are now engaged in voluntary activities of some kind.

 

In dire trouble

This is a major transition in the way Japan is structured and organised and it would have been challenging enough even in calmer times. But the enormity of the transformation has been compounded by the severest economic downturn since the war.

In the nineteen eighties there was huge economic expansion, driven largely by credit growth used for the acquisition of assets by both companies and individuals, whether of property, securities or manufacturing capacity. The banks also expanded geographically most notably into South East Asia. Such growth was not sustainable and this is the eighth year of decline in asset prices.

The Japanese banks have come under huge pressure: Hokkaido Takushoku Bank, one of the twenty major commercial banks which the government had indicated would be secure, has failed, as have, so far, two major securities companies.

The Japanese now have to deal with a banking system which is in dire trouble and an economy which is teetering on the brink of depression. Wholesale prices are declining by 2.3 per cent and unemployment at 4.1 per cent is at its highest level since the war. The declining yen makes it impossible for Japan to play its part in the recovery of Asia, and all this when the whole economy and society are embarking on a major structural change.

The debate on the right course of action is at its fiercest for many years. There are broadly speaking three camps: the reactionaries, the ‘do nothing’ brigade and the radicals.

There is a strong school of thought that the present predicament has been largely caused by the steps already taken to open up the economy. It has been suggested that the liberalisation of foreign exchange, which was only introduced on 1 April, should be reversed.

There has been a proposal that all foreign banks in Japan should help bail out failed Japanese financial institutions. A MOF official is quoted as saying that you ‘cannot get something for nothing’ - a firm endorsement of the old convoy system by which all moved forward at the pace of the slowest ship. There is a hint of fierce nationalism in this camp.

Almost more worrying because it is so widespread is the group which does nothing. Many in senior positions in Japanese companies, continue to enjoy the trappings of corporate life. Other than a small number in the financial sector, companies are still not suffering enough pain to make action necessary. It is too easy for them to rationalise their inactivity saying that they have survived similar crises and once again hard work and team spirit will pull them through. Unfortunately this is not the required medicine and indeed it prevents the cure: companies have to restructure, cut out whole lines of business, merge, cut costs, sack employees.

There is a strong desire among politicians to do nothing. The Liberal Democratic Party (LDP) has not responded to the shock of finding itself briefly out of power by embracing radical policies and has reverted to internal faction fighting. The campaign for the upper house election of 12 July was not notable for the substance of the debate. Following the party’s disastrous result, there will be a period of uncertainty even once a new leader is found.

Inactivity is rationalised: the LDP put forward a high sounding reform strategy two years ago. A key proposal was to bring local and national government debt down to 3 per cent of GDP and it is the prospect of a U-turn on this fiscal policy which is frightening the party. It is argued that the economic packages already passed, the most recent in April amounting to an injection into the economy of $110 billion, must be sufficient.

There is now a focus on the ageing problem in Japan and the resulting strains on social security. It is feared that an increase in unemployment would aggravate matters. Such concerns are surely overdone; it may be true that the social security and pension schemes are inadequate, but it is this that has led the Japanese to accumulate their $9 trillion of personal savings.

The greatest proponents of the ‘do nothing’ philosophy are the bureaucrats. The semi-controlled economy has served the country well. Their rationalisation for inactivity is that in times of crisis it cannot be right to liberalise the economy further. There would be a danger of a complete loss of control leading to a major financial crisis.

But perhaps a more powerful motivation for such inactivity is the fact that those bureaucrats have spent thirty years working extremely hard for little personal reward in the expectation that at the end they would be given a comfortable senior position in one of Japan’s leading companies. Why should change come with this generation?

There is, however, an increasing number of people who are willing to think the unthinkable. Full scale liberalisation of markets, particularly the financial markets, but also services, distribution and above all labour, will help to pull the economy out of its crisis, as well as curing the medium term problems of Japan’s competitiveness globally.

The banking crisis remains: the $200 billion of the Financial System Stabilisation Fund provided by the government in March has not cured the problem; indeed by failing to differentiate between good and bad banks it has aggravated it. Further action is required.

Thus deregulation and a belief in the market place’s ability to sort out the crisis is as important as ever. But liberalisation is not a sufficient cure: the fiscal U-turn is essential, indeed wholesale fiscal reform, with a permanent cut in corporation tax and at the top end of personal income tax; continuing monetary expansion - and a weak Yen - remain important until some recovery is seen.

There is a risk that the weak Yen might revive trade frictions, particularly with the United States. Of more immediate concern is the knock-on effect on the Chinese Remninbi and other Asian economies. But the weak Yen is the only way for corporate Japan to restore itself to health.

There was such excessive capital investment in the nineteen eighties that return on capital employed is now woefully small. Such a high level of capacity has in turn led to high levels of stocks, which companies must reduce. A continuing weak Yen is an essential ingredient in the cure. There is a risk to the rest of Asia; but this is preferable to the risk to the world economy of a Japanese depression.

 

The crunch is coming

The Japanese structure offers few levers for those wanting to make radical changes. This is a crunch which can be compared to the other turning points in Japanese history in the last two hundred years; the revolutions of 1868 and 1945 were both brought about by a new approach within Japan combined with pressure from outside. This led to a new leadership. There are similar calls for change today from both inside and outside Japan, but they are not yet loud enough.

There is a danger that markets will be just buoyant enough to allow government and companies to muddle through. While further market turbulence brings with it risks of a domino effect on the rest of Asia, it must be desirable for Japan to be forced to make structural changes.

There is therefore a narrow path to be trod: a worsening of the situation is desirable to the extent that it forces the Japanese government to grasp the nettle, companies to embrace a deregulated market in goods, services and labour and society to see the attractions of a transition to individualism; at the same time Japan must avoid being the catalyst for disaster in the rest of Asia. Japan has been able in the past to provide leadership to face such challenges and, with help and encouragement from outside, it can do so again.

It is critical that Japan not only tackles the short term crisis, but also uses it to transform its systems so that it can play its proper role in the world in the next fifty years. The possible repercussions of a withdrawal of assets from United States and European markets, a collapse in imports to Japan, a decline in aid and an increasingly nationalistic Japan are very significant. The western world does indeed have an interest in Japan’s economic success.