Keiretsu for a new age

Supported by news that Toyota’s auto arm has finally turned a corner, advocates of the traditional Japanese business model – keiretsu – are singing from the rooftops of Tokyo again. Rita Lobo considers whether they’ll be around for long

 
 

Last year’s earthquake in Japan and floods in Thailand caused massive supply problems for Toyota, Nissan, Honda and other car manufacturing companies. But it has been announced that the Japanese car industry is expecting to make a full recovery in 2012 after a year marred with natural disasters that dampened both production and profits. Toyota and Nissan in particular have reported phenomenal bounce-backs, though both companies have very different corporate governance strategies: Toyota is a persevering keiretsu, while Nissan worked hard to break its keiretsu links over a decade ago.

Toyota’s output in the first quarter of this year reached 2.49 million vehicles, surpassing General Motors and Volkswagen. The Japanese company is on the brink of reclaiming its title as the world’s biggest car manufacturer. The astounding bounce-back can be attributed to Toyota’s stable relationships with its suppliers: the automaker is one of a few surviving keiretsu, a form of corporate governance traditional of post-war Japan. The system is renowned for producing strong corporate links that ensure member companies get mutual assistance in times of difficulty, as well as dependable, working buyer/supplier relationships.

Usually keiretsu are networks revolving around a principal bank that provides capital and loans to a variety of manufacturing and service companies who, in turn, hold stakes in the bank and in each other. Toyota Group is a notable exception: instead of a principal bank, Toyota Auto is in the centre of the keiretsu with a variety of ancillary firms, namely its suppliers and customers, surrounding it. Today, Toyota Group owns stakes in over 200 of its primary part suppliers and 70 of its equipment manufacturers, as well as Toyota Auto, its top-cat company. Toyota Auto is currently the world’s third-largest automaker, after General Motors and Volkswagen.

Toyota Auto is unique in owning majority stakes in three of its weaker affiliates, Daihatsu, Hino and Kanto Auto Works. When Toyota bought these shares in the early 2000s they were concerned about a foreign takeover of their affiliates and suppliers; keiretsu are particularly wary of foreign involvement in their companies and are notoriously insular in their approach to production, preferring to keep everything in-house. By owning controlling shares in some of its weaker affiliates, Toyota Auto ensured that it would have a free hand in turning those companies around without any foreign interference, thus protecting its interests in its suppliers.

Struggling to keep up

Company profile: Mitsubishi

One of the most traditional keiretsu in Japan, Mitsubishi was founded by a 19th-century industrialist of samurai stock. The firm evolved from a powerful family-owned zaibatsu to one of the most successful keiretsu in Japan. At its peak Mitsubishi Group’s powerful keiretsu consisted of over 180 companies, most of which came under the umbrella of 28 main companies, producing everything from automobiles to television sets and photographic equipment. In 1994 Mitsubishi Group firms were responsible for 9.5 percent of Japan’s total corporate profits. Mitsubishi performed extremely well worldwide in what experts called a ‘mitsubishification’ of global markets.

Like most traditional keiretsu, by the late 1990s many of its companies were suffering. In 1999 the keiretsu was facing a combined debt of $132m, from its 13 largest companies. In 2004, Mitsubishi Group had to rescue one of its top players, Mitsubishi Motors Company (MMC) by injecting ¥450bn into the ailing automaker. Despite being forced into an alliance with Daimler-Chrysler in 2000, MMC was still haemorrhaging. Despite the high-profile rescue, Mitsubishi companies have drifted further apart; once one of Japan’s most tight-knit keiretsu, now its clusters are almost unidentifiable. Though the companies are linked by name and enjoy loose affiliations, they are no longer adjacent in the network space.

Mitsubishi companies have managed to emerge successful from the crisis, mainly through clever alliances outside of their keiretsu. Mitsubishi Trading Co. is still the largest in Japan and has forecast a profit of ¥500bn for 2013. Today, its chief companies are no longer manufacturing. Commodities however, have allowed Mitsubishi Group to thrive – there are 11 major automakers in the country and only three energy traders, the biggest of which is Mitsubishi itself.

The six traditional keiretsu, Mitsui, Sumitomo, Mitsubishi, Daichi-Kangyo, Fuji and Sanwa can be traced back to the end of the Second World War when they replaced ancient family monopolies known as zaibatsu. Toyota Group was originally a part of Mitsui, but it broke away in the 1970s to become a keiretsu in its own right. During the Allied occupation zaibatsu were eliminated by Americans who thought the family enterprises were undemocratic and inconducive to a free-market. Japan, eager to recover from the war, reorganised zaibatsu as keiretsu by replacing family dynasties with independent management. Keiretsu eventually had the opposite effect the Americans had planned, and claimed monopoly to the Japanese domestic market, making it impossible for foreign companies to compete in the country.

Despite this, the keiretsu worked well as a post-war system and economists credit Japanese economic success on this protective business model. The keiretsu structure defused the sometimes antipathetic relationship between supplier and buyer: when both parties own shares in each other, the working relationship is much more likely be one of mutual benefit. “The close, cooperative, and flexible relations typical of these networks facilitate responsiveness, coordination, and learning among the affiliated firms,” explains James Lincoln from the Walter A Haas School of Business at the University of California, Berkeley, “unlike the ‘arms-length’ and adversarial supplier relations typical of the American auto-industry, keiretsu suppliers support one another by assisting in the development of products, parts, processes and people.”

The mutually supportive business networks were the backbone of the Japanese economy for four decades after the War and paved the way for unprecedented and unrivalled growth and prosperity as the country rose to become the world’s second-largest economy.

Keiretsu didn’t only affect cross-shareholdings and buyer/supplier links, they also dominated corporate relationships; affiliated firms benefited from executive transfers and preferential trade and lending, much like a members-only club. Often presidents and senior managers of keiretsu companies sit on each others boards, and meet in ‘president’s councils’ which determines the future development of the keiretsu as a whole, while maintaining individual management in each associated company.

Once employed in a keiretsu company, an individual is often guaranteed lifelong employment within that keiretsu, in any one of the myriad firms associated with it. Lifelong employment and personnel transfers are a tool employed by keiretsu to strengthen corporate links and ensure mutual business interests are being upheld: the downside is that keiretsu are less likely to dismiss unproductive employees or replace poor-performing management. It means that there is very little renovation of business strategies and corporate governance as all employees and management are of the same stock, and this has a very negative impact on a keiretsu’s competitive advantage.

Above: Mitsubishi Motors Corporation President, Osamu Masuko. Mitsubishi was forced to cut its keiretsu structure in the 1990s.

The world in the 1990s
Originally, Keiretsu ensured that Japanese firms dominated the domestic markets and made it almost impossible for foreign companies to compete for a share of Japan’s booming trade. The keiretsu system virtually stays bankruptcy within the network as it encourages main banks and companies to make over-investments in ancillary firms; within the keiretsu structure it is beneficial for the buyer if its long-time supplier stays in business and vice-versa. The system of mutual-investment and cross-shareholdings sacrifices immediate profits in order to cultivate more and better business over a longer period of time. In the long-run however, keiretsu affiliation significantly benefits smaller and poorer performing companies at the expense of their high-performing counterparts, who continually over-invest or bail-out their affiliates.

By the late 1980s Japanese products, from cars to photographic cameras and electronic equipment were powerful competitors in the global markets. A combination of financial deregulation and over-confidence in the Japanese market led to aggressive speculation, with banks in the habit of granting increasingly risky loans. Keiretsu were driving the economy with a high rate of reinvestment and keiretsu companies comprised 75 percent of the value of shares at the Tokyo Stock Exchange.

In the early 1990s global technological advances meant that Japanese manufacturers lost some of their competitive edge, which, combined with keiretsu’s reluctance to accept foreign investment, had disastrous consequences. “The stable shareholding patterns underpinning the keiretsu were threatened by a lengthy economic downturn as firms and banks were left with less financial slack to maintain their group shareholdings,” explains Sandra Dow and Jean McGuire in the European Financial Review.

Japan faced a deep and enduring recession in the 90s, prompting a rethink of the form and function of the traditional business groups. There was widespread criticism of the keiretsu in the press and political arena, which culminated in sweeping regulatory reforms to Japan’s financial system with the specific goal of reducing keiretsu influence. The system simply was not competitive enough in the face-changing global capital markets, forcing the country to move toward financial liberalisation. This had the direct effect of attracting ample foreign investment.

Banks start the collapse

Company profile: Nissan

When Renault’s Carlos Ghosn assumed the helm of Nissan in 1999 after the French auto-manufacturer bought a 38.4 percent stake in the Japanese keiretsu, his first order of business was cost cutting. Nissan had previously been known for the quality of its technology and its industrious and disciplined workforce, but over the years it had lost market share. Most of all, Nissan was lacking adequate management. “Its business strategy lacked focus and its resources were scattered over too many product lines and overseas markets. It reflected an awkward and ultimately mistaken strategy of trying to compete on all product lines and markets where Toyota, its much larger rival and market leader, was present,” explains Risaburo Nezu of the Fujitsu Research Institute.

He achieved this by selling off Nissan stakes in 1,390 companies; only four companies deemed critical to business were spared from the cull. The dismantlement of the keiretsu ensured the company reduced its production costs through competitive bidding from suppliers, but it also fed equity back into the company from the sale of shares. The third step of Ghosn’s ‘revival plan’ was a drive to cut 20 percent of its supply costs over three years which he successfully achieved.

Without keiretsu links holding them back, Nissan was free to aggressively change parts suppliers when needs arose, a strategy that proved extremely successful last year, when so many suppliers were affected by the earthquake and floods. By changing parts procurement and maintaining assembly operations outside Japan, Nissan was appropriately insulated against last year’s natural disasters. The company reported a solid profit for last year with a net income of ¥341bn, up seven percent, reaffirming its place as Japan’s most profitable car manufacturer.

The Nissan-Renault alliance effectively dismantled the most traditional of all Japanese keiretsu: “Unlike the independently-minded Toyota, Nissan had traditionally been closed off and more attentive to the Ministry of International Trade and Industry (MITI), the powerhouse of the Japanese economy, which regarded Nissan as the centre-piece of its post-war industrial policy,” says Nezu. The dismantling of a rigid and unproductive keiretsu turned Nissan around and in 2011, despite serious setbacks like the earthquake in Japan, the company posted earnings of ¥341bn, a seven percent increase from 2010, and claimed the lead as a most profitable carmaker in the country that year.

The keiretsu model had created an insular market in Japan. The whole system was so protective against foreign control that it was no longer competitive in the global markets. “Exchange rate fluctuations, labour and transport costs and local content rules drove Japan manufacturers to move production abroad, and in so doing drop domestic keiretsu suppliers for new foreign ones,” explains Lincoln. The keiretsu model was no longer sustainable and foreign ownership in Japanese companies increased from five percent in 1990 to almost 18 percent in 2002, according to the Association of Japanese Stock Exchanges. Foreign shareholders pressured Japanese companies to sell shareholdings in affiliate companies. “Reciprocal shareholdings among Japanese firms declined from 18 percent of total outstanding shares in Japan to 7.4 percent, and ‘stable’ ownership declined from 45.6 percent to 27.1 percent during the same period,” according to research by Dow and McGuire.

New foreign investors and owners began to systematically hack away at the foundations of keiretsu. The keiretsu business model was designed to cultivate solid business over years, however, in the face of an evolving market, this proved to be hiding a deeply ingrained conservatism which was damaging affiliated companies in both the domestic market and abroad. This collegiate mentality was behind Mitsubishi’s decision to continue using their own computer software programmes when other companies were moving on to Microsoft Corp and other universally compatible technology, as well as many other examples of backward corporate decision-making that plagued all keiretsu.

Other technological advances and ever-rising global economic competition forced Japanese keiretsu to reconsider their long-standing business strategies and companies began seeking business opportunities outside and in spite of keiretsu. The corporate links that had once protected businesses were now holding them back in terms of ability to compete, and most companies were revising their company development strategies.

Not even the banks that had once been the backbone of the keiretsu operation were immune; massive non-performing loans extended to keiretsu companies were dragging them down. Banks eventually became the first keiretsu companies to merge outside their networks in a wave of mass-mergers that dominated the financial landscape in the late 1990s. Mitsui Bank merged with Tayo-Kobe Bank to form Sakura, which subsequently merged with Sumitomo Bank in 2000. In 1998, Fuji, Dai-Chi Kangyo and the Industrial Bank of Japan, merged into Mizhuo Bank – two of the three banks had been central in keiretsu. “The implications for Japan’s post-war business structures were huge: together these two mergers reduced from six to four the commercial ‘city’ banks, long the institutional leadership and public face of the keiretsu,” says Lincoln.

Toyota Group is one of the only keiretsu to persevere with the business model, albeit with some adaptations, but it has refused to eradicate its cross-shareholding practices and insists on cultivating solid working relationships with its suppliers and affiliates, despite the potential for disaster. Conversely, Nissan formed a business alliance with Renault and in 2000, newly-appointed Nissan President Carlos Ghosn was accused of ‘un-Japanese’ moves as he moved to systematically eradicate all traces of keiretsu from the company in order to cut costs and make Nissan competitive again.

Keiretsu redux?
The earthquake, tsunami and nuclear scare in 2011 were damaging to all manufacturing companies in Japan, but Toyota and Nissan in particular endured the adversities and still turned a profit in the financial year to March 31, 2012. Toyota and Nissan were two of the most powerful keiretsu in Japan, but have taken opposite business development paths. Nissan, after the successful alliance with Renault, purged itself of any keiretsu links through the sale of all of its stock held in cross-shareholdings. Without keiretsu affiliations holding it back, Nissan procured new suppliers and emerged as the most profitable Japanese car manufacturer in 2011.

Toyota, on the other hand, confirmed its recovery by announcing net profit forecasts for 2012 of ¥760bn, the highest in five years. It is quickly moving to reclaim its position as the world’s biggest automaker, after slipping to third in 2011. It has firmly held its structure as a keiretsu while other companies rushed to break corporate links. “With the rise in foreign investment and general liberalisation of mergers and acquisitions rules in Japan, companies are returning to the cross-shareholding defense,” claims Lincoln. Indeed, Toyota Group companies described their continued interest in cross-shareholding as an indispensable strategy for survival in a fiercely competitive global market.

Last year, Nissan reported profits 20 percent higher than Toyota’s despite producing half as many cars. This brings into question Toyota’s keiretsu traditions; by maintaining solid relationships with its suppliers and refusing to shift positions during a crisis, Toyota suffered heavy losses. Nissan on the other hand, with no strong corporate links, dumped struggling suppliers, and managed to ensure commercial success in a troublesome climate.

Conversely, past the recovery period, Toyota is re-establishing itself as the worlds leading automaker, producing twice as many vehicles as Nissan, and earning double the profit, too.

Toyota Group, though confident in its keiretsu network, have developed and adjusted their corporate governance by applying well-practiced business strategies of cultivating high-trust and long-term partnerships with foreign and Japanese suppliers. Toyota is succeeding to take the best of the old model, its strong mutually beneficial corporate links, while at the same time leaving behind its conservative protectionism, emerging a global keiretsu network fit for 21st-century competition.

Company profile: Sumitomo Mitsui Financial Group

Mitsui Bank was the epicentre of Mitsui, a large and traditional keiretsu trading mainly in chemicals and heavy industry. Like most keiretsu banks it was laden with non-performing loans taken out by other keiretsu affiliates. In 1990 it was forced to merge with Tayo-Kobe Bank to form Sakura, then the world’s second-largest bank in terms of deposits.

In 1992, Sakura merged with Sumitomo Bank, the central bank in another traditional keiretsu. The merger was revolutionary because it was the first time the keiretsu central banks merged outside of their networks. The result was Sumitomo Mitsui Banking Corp (SMBC), now Sumitomo Mitsui Financial Group (SMFG), the third largest bank in the world at the time of its formation. These successive mergers were a direct result of Japan’s enduring economic downturn.

SMFG is one of three ‘megabanks’ that operate in Japan today. In 2010, it turned a net profit of over ¥500bn. In 2000 SMFG debuted in the New York Stock Exchange and though successful, the bank still lags behind its American and European competitors.

Some critics suggest that the deep-rooted keiretsu culture is to blame for this; managers maintain a typically insular approach to business, foreign operations are often run by Japanese executives rather then talented foreigners, and they tend to promote their senior executives from its former keiretsu affiliate companies.