Japan was once an entirely closed economy. Foreign traders were, until the middle of the nineteenth century, required to live on Dejima, an artificial island in Nagasaki harbour. Their route to the mainland was across a narrow causeway that was open only during the day, and even then only to those with a special permit. At night, the traders were locked out.
EU Trade Commissioner Peter Mandelson reminded Japanese business and government figures about Dejima when he gave them a speech earlier this year. Dejima was the only opening in an otherwise entirely closed economy, he said. From one perspective, it represented the persistence of trade, even when barriers are erected against it. But it was also a symbol of suspicion of the outside world – suspicion of trade.
Dejima is a thing of the past, said Mr Mandelson. But it served as a useful metaphor for understanding Japan’s position in the world today. Globalisation had transformed the economies of Europe, but in Japan it was still unfinished business. Barriers to investment had kept productive EU investment out of the Japanese economy, despite the fact that Europe had been welcoming such investment for decades.
“As a foreigner looking at Japan from the outside, what I see is a globalisation paradox,” said Mr Mandelson. “For decades Japan has taken advantage of an open global investment climate. Both it and the host economies have benefited from that investment. Yet at home it remains the most closed investment market in the developed world…. Japan went global long ago, but at home it holds back from becoming globalised.”
Especially at a time of global economic uncertainty, “the single greatest threat to the economic openness that underwrites our prosperity in Europe, the US and Japan is a return to the Dejima mindset – The economic nationalism and protectionism that makes us see foreign participation in our economies as a sign of vulnerability,” said Mr Mandelson. “This is an argument that is increasingly powerful in the US and Europe, especially as the global economy and the growth of world trade has slowed.”
Mr Mandelson is right. Europe has benefited in competitiveness terms from welcoming Japanese investment, but Japanese rules are leading EU companies to invest in China and elsewhere in Asia, rather than in Japan. Japan’s limitations on foreign direct investment are costing the country in terms of productivity and competitiveness.
Japan’s net investment outflows rose to more than €30bn in 2006 – a 16-year high. But inflows were paltry. Europe invested a net total of less than half a billion euros in Japan in 2006. That means for every euro Japan invested in the UK and the Netherlands alone, for example, European companies were able to invest a net total of only three cents in Japan. “This is, frankly, hard to understand,” said Mr Mandelson.
Europe is the biggest exporter of FDI in the global economy. It has about three trillion euro invested globally. Yet only €47bn is in Japan – less than three percent. “Nowhere else in the developed world is EU investment so thin on the ground,” he said. “In fact, Japan is the only country in the developed world with which the EU has a negative balance of investment flows.” FDI stocks in most European countries are around 20 percent of GDP. In Japan they are less than three percent of GDP. In fact, Japan is the second largest economy in the world, but Europe trades more with Switzerland.
Why is the situation so one-sided? Partly, there are still too many restrictions on FDI in Japan, far more than Japanese companies face in Europe. European companies cannot participate in the agricultural sector, the forestry sector or maritime transport. There are also disincentives that operate at one remove: European construction companies put off Japanese plans because they are unable to secure public procurement contracts in open tenders.
But the main cause, said Mr Mandelson, is the lack of a developed mergers and acquisitions market, which is an obvious precondition for FDI flows and the basis of most FDI globally. A review last year of Japan’s mergers laws to allow triangular mergers of foreign companies with Japanese companies have widened the possibilities for foreign participation, but the merger between Citibank and Nikko has been the only result so far, and was more an internal realignment than an example of a genuine merger. Many Japanese companies have responded to the prospect of mergers by creating poison pill schemes.
Indeed, Mr Mandelson made his speech just after Tokyo rejected, on national security grounds, a proposal by The Children’s Investment Fund, a UK activist fund, to double its stake in J-Power, an electric power wholesaler, to 20 percent. Japan needed to recognise that investment brought trade, technology and management skills, said Mr Mandelson. “We are not talking about fly-by-night short-term players who are going to earn a quick buck at Japan’s expense and then clear off. And that’s how I think Japan views outside investors too much,” he said.
Mr Mandelson couched his comments with a litany of respectful asides, in the hope that he might avoid giving offence, but were greeted frostily nonetheless. However, his is not the only voice calling for change. The Asian Corporate Governance Association has since told Japanese public companies to improve their corporate governance standards or risk further undermining the confidence of foreign investors. It said improvements were essential for Japan’s economic health.
The ACGA published a white paper on the topic which argued that “the system of governance in most Japanese listed companies fails to meet the needs of stakeholders or the nation.” Its report – Japan White Paper – represented the first time that global institutional investors have worked together to raise concerns about corporate governance issues in Japan. The paper has the support of leading global pension funds and fund mangers, including: Aberdeen Asset Management, from Singapore; the California Public Employees’ Retirement System (CalPERS), from the US; and F&C Asset Management, from the UK.
The paper argues that governance practices are failing for three reasons. They do not provide sufficient supervision of corporate strategy; they “protect management from the discipline of the market” by making takeovers difficult; and they limit the returns on equity investment.
The ACGA says that corporate governance is essential to the creation of a more internationally competitive corporate sector in Japan and to the longer-term growth of the Japanese economy and its capital markets. Some leading companies in Japan have made strides in corporate governance in recent years, but “the system of governance in most listed companies is not meeting the needs of stakeholders or the nation.”
Its paper argues that the corporate governance systems of some leading companies continue to evolve and improve. However, it says the current Japanese model of corporate governance has its roots in the period of rapid reconstruction and growth in the 1950s and 1960s.
This was a time when the population of the country was much younger, when few, if any, Japanese companies had achieved the dominant positions that so many now enjoy, and when investment capital was comparatively scarce. “It was a model that was often driven by a uniquely Japanese pattern of intense, oligopolistic competition and a resolute pursuit of the internal generation of capital,” the paper says. “This served Japan well at that time but it is less appropriate to the needs of the nation in the circumstances prevailing today, in which companies are not starved of capital and a more open model of corporate capitalism is required.”
That’s why the paper calls for a fresh look at the basic tenets of Japan’s corporate culture and, particularly, its system of corporate governance.
The high water mark of confidence in the old Japanese model of corporate strategy was seen in the early 1980s, but public confidence in it declined sharply from 1990 onwards and this has been felt nowhere more strongly than in Japan itself, the paper says.
In March this year, for example, Nihon Keizai Shimbun carried a front-page article reporting that large Japanese corporate pension funds, dissatisfied with returns from the domestic equity market, were increasing their weightings of foreign equities and other asset classes.
A symptom of the longer term decline in domestic investor confidence can also be seen in the fact that the majority of net buying of stocks over the past five years has been by foreign funds. Yet since late 2007 even foreign confidence has fallen sharply, helping to drive the Nikkei Index down by more than 20 percent. “This has significant implications for the Japanese economy as a whole,” the paper says.
Better governance will not fix all the problems afflicting Japan’s stock market and economy, but it will be an essential element in the rebuilding of confidence. Improved investor confidence will bring funds flowing back into Japan, the paper argues. “It will encourage Japanese domestic investors, both retail and institutional, to re-enter the market; and it will assist the development of the financial services sector, an important new area of growth for the Japanese economy and a provider of employment in future.”
That means a move towards global governance standards is in Japan’s national interest, and this will be even more true as the government tries to turn Tokyo into a leading international financial centre.
For the ACGA, fairer treatment of shareholders is an integral part of this process. “It is important to restore shareholders to their rightful, legal place as the owners of companies and to ensure that their interests are protected alongside other stakeholders,” its paper argues. “Shareholders invest their savings in companies because they trust that management will look after these funds and provide a fair return. When managers fail to do so, they effectively break their most fundamental contract with shareholders.”
Moreover, the provision of healthy returns to shareholders requires that capital is utilised efficiently. Inflated balance sheets and undisciplined acquisitions and diversification are signs of management inefficiency and corporate weakness, not strength. Over the medium to long term, the total shareholder returns of Japanese companies that pay higher dividends outperform those that pay lower dividends, according ACGA analysis. “A healthy dividend policy, therefore, reflects a healthy company and does not, as many managers appear to believe, mean that a company is simply ‘giving money away’,” it says.
Better treatment of shareholders is not the only reason why the ACGA wants governance practices to change. There are also long-term demographic and social factors that will require higher investment returns in Japan, namely the ageing of the population and the rapid rise in the number of pensioners.
It is estimated that by 2025, the percentage of Japanese people over the age of 65 years will be approximately 30 percent – one of the highest ratios among developed countries. The pressure on listed companies to generate income for pension funds in Japan, therefore, is likely to increase. “Improved shareholder value will be vital in order to achieve positive social outcomes,” says the ACGA.
The fair treatment of shareholders can and should be aligned with the fair treatment of other stakeholders, it says. Indeed, most of the institutional investor members of the ACGA are “long-term shareowners who seek to invest in well-managed companies that are both profitable and good corporate citizens,” it says. “While the interests of different stakeholders may differ over the short term, they can be aligned over the medium to long term through sound management and good governance. Indeed, this is one of the primary tasks of a board of directors and senior management. Successful companies perform this balancing act well.”
The paper makes recommendations on six issues. These include removing poison pill takeover defences, introducing more fairness and transparency on shareholder votes, and bolstering independent supervision of management. “It is still common for listed companies in Japan to be run as if management, not shareholders, were the owners,” the ACGA says.
Japan is often lauded for its version of “stakeholder capitalism”, where the business balances the interests of shareholders with other groups, such as employees and the wider community. But this view “is outdated and fundamentally inaccurate,” the paper says.
And it is right. Japan and its companies have enjoyed the open door policies of Western nations for decades. Now it is time for them to return the invitation.