The Return of the Sun

So what went wrong? Burdened by excessive debt and over-investment Japan's "bubble" economy blew up in the early 1990s. When the smoke cleared it became obvious that many traditional Japanese virtues had become vices.

While companies like Sony, Toyota and Toshiba are some of the world’s most successful exporters, Japan's domestic economy is clogged by inefficiencies that other developed economies have eliminated. As an example, Japan's electricity costs are the highest in the OECD. Its transport costs are five times those in the US.

Kochuko means rigidity
Japan's rigid labour market discouraged mobility, enshrined outmoded work practices and rewarded loyalty but not creativity. The kereitsu system reduced competition and created sprawling, inefficient conglomerates.

Now the damage wrought by the long recession is finally forcing change in the structures of the economy, in how it is regulated and in how Japanese companies do business. How is this change is unfolding?

A bang under the banks
The banking sector has always been at the heart of Japanese business, with major banks sitting at the centre of the kereitsu. Consequently banking reform has a profound impact on the economy.

In 1996, the government's "Big Bang" reform package deregulated the banking sector and removed many barriers to competition. These measures improved the range and availability of financial products but failed to change bank’s lending practices.

It took the threat of an overall banking collapse to stimulate real reform. In 1998 the government nationalised two major banks that were effectively insolvent and provided the equivalent of US$71 billion dollars to ease pressure on the banking system.

Most importantly, the government took bank regulation away from the Ministry of Finance (MoF) and appointed independent regulators to enact reform.

Until these changes occurred the MoF was in charge of economic policy, taxation, fiscal policy and bank regulation. These multiple roles made it difficult to enact real reform as changes to the banking system could be delayed or diluted by competing power blocs within the MoF. Close links between senior kereitsu figures and their counterparts in the MoF also slowed the pace of change as they had a strong vested interest in maintaining the status quo.

However, the long recession weakened the MoF's credibility and the government's bank rescue gave it sufficient clout to break down bureaucratic resistance. Once it split the MoF's roles the government was able to enact reforms across the financial system.

Of capital importance
By the 1990s Japan's kereitsu system was an economic liability as it was entrenching poor capital management practices. Lending decisions reflected kereitsu relationships, not economic rationale, so Japanese banks had little experience in credit allocation. Companies within the keiretsu had easy access to "artificially" cheap capital and that led to poor business decisions and over-investment. Poor regulation exacerbated the problem.

Historically, Japan’s high corporate tax rate and its many legislative loopholes encouraged companies to under-report earnings and accumulate assets. Now, a lower tax rate and further tightening of the regulatory code are increasing the pressure on companies to use capital more efficiently, either by reinvesting in the core business or returning capital to shareholders.

Risotura and restructure
A long recession and government pressure is changing the way Japanese banks do business. While interest rates are very low, pressure on the banks to rebuild their balance sheets has led to credit rationing. Banks are now pricing their loans to reflect risk and return rather than to retain relationships.

Credit rationing has a massive effect on Japanese companies. While they have always been adept at cost control they have rarely focused on capital management. Now they must deal with the higher cost of their capital and improve the returns they generate.

Consequently Japanese firms are restructuring - merging, selling underperforming businesses and improving management. Data from Thomson Financial Services confirms the scale of this corporate activity - aggregate deals over 1999 were worth US$150 billion, compared to US$17.5 billion in 1998.

These changes, though painful in the short-term, mirror the restructuring we've seen in the West. This is already creating a more flexible economy, more efficient companies and generating higher corporate profits. Ultimately investors will benefit from this change as higher returns flow to shareholders.

While the long recession has led to regulatory change and better business practices, the Government's macro-economic policy is also starting to work. Over the past seven years the government has spent trillions of yen trying to pump-prime the economy. This loose monetary policy has seen ten-year interest rates fall to just 1.9 per cent.

For years, the reaction to this stimulus was strangely sluggish. Now, after years of trying, the government's expansionary economic measures are starting to take effect. Economic growth is expected to reach 1% in 2000.

More Good News for Nippon
Happily, the rest of the world economy is now enjoying a rare period of synchronized economic growth and that is also helping the Japanese.

This positive economic story is unfolding as major structural changes (especially merger and acquisition activity) are creating a more profitable corporate sector. This combination mirrors that recently enjoyed by investors in Europe. The result could well be the same - good returns for investors.

Japan mirrors Europe in another area. Next year its working population starts to shrink. By 2014 it will be declining by more than one percent a year.

Older and (a bit) bolder
A rapidly ageing population creates a massive demand for retirement funding. With the decline of the sarariman system, individuals are taking more responsibility for their own retirement.

The government now plans to introduce a defined contribution scheme. This will allow individuals to make tax-exempt contributions and to choose how they invest those contributions.

Japanese investors are traditionally risk averse - more than 70 per cent of household savings are still tied up in cash. However, the low yield on other assets and improving consumer confidence means demand for domestic shares is increasing. As a result of the Big Bang reforms investors can now buy shares via insurance companies and banks. Between January and July 1999, investment trusts sold though these channels grew fivefold.

Share investment is likely to increase even more over the next two years as an estimated Y106 trillion ($US1 trillion) of fixed-rate post office savings deposits mature. With rates on these deposits down to 0.15%, even conservative Japanese investors will need to invest in shares if they are to provide for their retirement. If just ten percent of these funds flowed into shares it would provide a major boost to the Japanese market.

Japan On Sale
On the surface, corporate restructuring and a massive flow of pension savings into shares make the Japanese sharemarket an attractive investment destination. However our experience in Europe teaches us that corporate restructuring throws up as many losers as winners. One of the keys to successfully investing in a restructuring economy is understanding the importance of action.

Our European experience taught us that many companies preach the virtues of restructuring, but just as many fail to follow through. To identify the companies that will successfully restructure you need close contact with management, suppliers, customers and competitors. That kind of in-person analysis has always been an important part of the BT investment process.

The BT investment approach also places a premium on understanding how a company manages its capital. That puts us in a good position to identify the Japanese corporates that are improving their capital management. And it is companies that manage their capital most successfully who are likely to be competitive in a rapidly changing global economy.

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