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Japan: Closed for Remodeling

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Japan is amazing. Its economy stagnated for nearly two decades even as the rest of the world experienced dynamic economic growth, a technology revolution and a considerable increase in prosperity. The extraordinary thing is that even now Japan remains the world’s second largest economy, its largest supplier of investment capital and one of the wealthiest societies, with some $15 trillion in accumulated savings.

Nevertheless, something had to give. In the early 1990s, Japan had the highest per capita GDP among the Group of Seven leading industrial nations. It now has the lowest — thanks to lukewarm growth rates averaging around 1.5 percent a year since 1992.

Bad System, Good CompaniesThe reason why Japan endures as a global economic power is its top-notch manufacturing companies. They are no longer feared around the world the way they once were. They have lost their aggressive edge which drove them in the 1970s and 1980s, when they kept prices low in order to grab market share from local producers. In the old days, they used their protected domestic market to subsidize low prices abroad. Now, domestic demand in Japan remains sluggish, whereas price competition from China and other parts of Asia, as well as from Eastern Europe and Latin America, makes this strategy unworkable.

Nor are Japanese companies particularly innovative. Two decades ago, they introduced what then was dizzying product innovation, improving technology and creating cool design. Gadgets like the Sony Walkman revolutionized consumer electronics. Now, you get this kind of innovation from the likes of Apple and Research in Motion, not from the Japanese.

Nevertheless, Japanese companies continue to capitalize on their established brand names and are holding their own in a highly competitive environment. They still manage to provide quality products at competitive prices. Largely because of its ability to compete in international markets, Japan continues to run up large current account surpluses, which measured 4.3 percent of its GDP in the latest 12 months. This is an impressive achievement, considering that Japan depends entirely on imported oil. Exports have increased to nearly 18 percent of GDP currently from around 9 percent in the mid-1990s, compensating for the fact that imports rocketed to 16 percent of GDP from 7 percent during the same time period.

Foreign Interest|In recent years, corporate profits have been rising, driven by strong demand around the world, a soft yen and successful cost-cutting introduced by Japanese manufacturers. Japanese stock prices have also increased, with the Nikkei 225 average peaking above 18,000 in mid-2007. Still, it was nowhere near its levels of the early 1990s. As a result, the price-to-earnings ratio in the Tokyo bourse is down to a moderate 15, vs. 50 or higher in the early years of the decade.

This should make Japanese shares very attractive. However, domestic investors are still in no mood to buy. Conventional wisdom maintains that retail investors in Japan were so badly burned by the stock market collapse during the 1990s and the early 2000s that they are not interested in taking risks with their money. But this explanation doesn’t hold water. Other Asian investors, in China, Hong Kong, Singapore and Korea, have gone through boom/bust cycles in their domestic markets for years. Whenever there is carnage, they lose money hand over fist, but as soon as the dust settles and the losses are sorted out, they are back in the market working on the next bubble.

Japanese investors did the same thing throughout the 1980s. The problem is that Japanese society has now lost faith in the country’s ability to prosper. Japanese savers are less and less willing to take any risk, at home or abroad, and they are keeping their savings in safe Japanese government bonds, which yield around 1.5 percent.

This is the main reason why the global economic recovery in the first half of this decade failed to spread into Japan. The domestic side of the equation never fully kicked in. Businesses did begin investing, but consumers refused to loosen their purse strings. Growth remained reliant on the export sector, as well as on make-work public spending programs run by the government.

Much of the stock market rally in recent years was buoyed by portfolio fund inflows from abroad. With restrictions on non-resident share ownership loosening up, foreign investors were attracted to Japanese exporters and further encouraged by the weakness of the yen. The share of foreign ownership of Japanese equities, which measured less than 5 percent in the late 1980s, rose to 28 percent by 2006.

The current environment has also spurred foreign interest in purchasing Japanese companies, despite the fact that M&A activity in Japan is limited and foreign bidders face special obstacles. During the 1990s, Japan did open up its economy, and earlier in this decade, under the long-serving Prime Minister Junichiro Koizumi, foreign companies were permitted to use their shares when they took over Japanese firms. Even private equity firms have set up shop in Japan. On paper at least, a number of Japanese companies look like they could be ripe for an LBO, especially with interest rates still effectively near zero.

The world economy remains awash in liquidity. Corporations are carrying unprecedented amounts of cash on their balance sheets and, despite the threat of a credit crunch in early 2008, there is still plenty of money available to borrow. Moreover, the U.S. Federal Reserve has slashed its interest rates in recent months, further reducing the cost of borrowing. Add to this a cheap yen, and worries by Japanese authorities that foreign investors will snap up bargains among the country’s manufacturing jewels for next to nothing become understandable.

Different MeasuresSome economists argue that opening up Japanese companies to foreign investors, both financial and strategic, will be beneficial for the economy and shake up its cozy business establishment. They frown at measures adopted by the government to discourage bids from foreign companies and to impede hostile takeovers, especially by international private equity firms. Japanese companies have been similarly castigated when they cling to the country’s cross-shareholding system, whereby friendly investors hold large stakes in one another, shielding domestic companies from a takeover.

It is true that corporate raiders, hedge funds and private equity firms, as well as activist institutional investors, have done much to streamline U.S. companies and to make them more efficient. However, the involvement of these players in Japan may not work the same magic, if only because Japanese companies have already become efficient in the face of relentless global competition.

Toyota, for example, has long been the world’s largest automaker in terms of market capitalization, roughly 20 times the size of GM. Moreover, it recently beat out GM in the race for the top spot in terms of unit sales as well. It remains highly profitable despite a very difficult market environment.

Prescriptions to fix Japan’s economic woes have not changed since the early 1990s. Despite continued stagnation, they have never been tried. Japan suffers from a dearth of consumer demand and excess savings. This not only damages Japan’s economic prospects over the longer term, but harms the world economy as well, since the world is experiencing substantial overinvestment and risks facing an overhang of supply over demand. As a first step, the government needs to change restrictive land-use laws and spur home ownership, and to encourage the construction of larger single family homes. Other measures to spur domestic demand will need to follow.

Otherwise, without such steps, Japanese companies will endure as bright lights in an increasingly bleak domestic economic landscape.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected]. His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.


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