Briefing on Japan: Politics, Economy and Foreign Investment 

Embassy of Belgium in Tokyo, Japan - September 9, 2010


Remarks by Kenneth Neil Cukier

Tokyo Correspondent, The Economist 


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Introduction 


Good evening. It is an honor to address you on a topic I care about deeply: Japan. And specifically, Japanese politics, the economy and the climate for foreign investment.


All foreigners to Japan can't help but notice that the business and culture is very different than what one is used to in Europe or America. My remarks are thus intended as a moment to take those experiences and place them into a broader context: what is contemporary Japan? And what is the future for Japan?


If one were to rely on reading the newspapers headlines back home, Japan looks bleak. Economic growth is meagre. The population is declining. Public debt is high. The strong yen is hurting exporters. In fact, Japan was recently surpassed by China as the world's second largest economy. It poses the question whether the country is headed into a third "lost decade"?

 

But I wish to use my remarks this evening to suggest that this view is actually a simplification, a superficial way of looking at the country. The reality is much more nuanced -- and more optimistic than that. Although there are some very real troubles facing japan, the country is still a technology powerhouse with incredible human and intellectual resources. 


Ultimately, Japan is a paradox -- it is a duality. It is a country with terrible liabilities and tremendous assets. I plan to look at both these facets in my remarks. I'll start with the politics, then move on to the economy, and end with the environment for foreign investment. 


But to disclose my conclusion at the outset, I plan to argue that there are "two Japans" -- one global and competitive, the other insular and under-performing. And a smart foreign company can do well by hitching its fortunes to the former, and avoid the latter. 


To understand what these two Japans are, how they emerged, and how to operate in the country, let's start with the politics. 


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Japanese Politics 


Japanese politics is in total flux. Part of the reason is that for most of the postwar period Japan was not really a "democracy", but a "bureaucracy". Let me explain what I mean by this, but going back 55 years, to 1955. 


The American postwar military occupation had ended three years earlier. Japan was still overcoming the devastation of the war. The political system was incoherent, oscillating among different parties, while a labour movement and left-wing parties were gaining strength. It made Cold War political analysts fear that Japan might fall under a communist sphere of influence. (The country's two big neighbors, after all, were Communist China and the USSR.)


Two right-wing parties merged to form the Liberal Democratic Party (LDP). It was the party of business, at a time when the biggest issue facing the country was economic development to rebuild after the war. But the LDP was not really a party but a "system" of governance. And it ended up ruling the country for 55 years. 


Political scientists referred to Japan as a "democracy within a democracy" because although the party stayed the same, different factions within the LDP would vie for power. And if a prime minister resigned, someone from another faction could take over -- and was prepared to do so. 


Initially, the LDP was phenomenally successful. By 1965, Japan became the world's second largest economy -- a title it held until this year. One reason for the LDP's success was, ironically, because it did very little. The politicians rubber-stamped the policies put forward by a very clever -- and very powerful -- bureaucracy. The highest class in ancient China was the civil service, and so too in Japan, as a society with Confucian origins, the bureaucracy held the highest rank. It made most of the decisions for the country. 


The postwar bureaucrats enacted an amazingly successful industrial policy -- picking industries and allocating financial resources to certain firms. They chose microchips -- and Japan dominated it, with a model of first copying the Western technology, producing at high volume and good quality with low-cost labour, and then incrementally innovating. (As a second example, the postwar planners needed to chose between aircraft and autos -- and chose cars. It was brilliant. A high-volume consumer good with a fairly quick sales cycle, not a low-volume industrial good with only a handful of customers -- who often would teeter on bankruptcy. So Japanese carmakers dominate the world, and American aircraft makers have consolidated or gone out of business.) 


The legacy of this bureaucratic tradition is that the government retains a large hand in the economy. Having close ties to this hub of power in Japan is vital. So a wise foreign company might want to name a former Japanese diplomat to its board, and establish close links with the trade ministry and even obtain a subsidy for setting up a facility. . . . (!)  That will not assure you success -- nothing ever does. But those links will definitely be useful when you need them. 


However, a lack of competition in the political sphere is akin to a lack of competition in the economic sphere: it leads to poor performance over time, and becomes a bastion of corruption and favoritism. In recent years -- since Japan's economic bubble burst in 1989 -- the LDP has failed to come up with any way to improve the economy. Its only strategy was to spend money on public works projects. While this kept unemployment low, and crime low, its biggest consequence was to dramatically increase the national debt -- to two times annual GDP, the highest among industrialized countries. 


This political system, called the " '55 system" only ended last year, when an opposition party called the Democratic Party of Japan (DPJ) -- like the LDP, formed by the union of two parties -- beat the LDP in an election and took over the reigns of government. The DPJ promised a break with the discredited policies of the past, in which unaccountable bureaucrats ran things and public debt soared. But the DPJ has been as ineffectual as the LDP, for three reasons. 


First, its members lack experience in governing. Second, the party grew up in a system that is so rotten and ineffectual that it can't help but embody those traits. Because leadership and original thinking is not valued, there are few politicians that are leaders or have bold ideas. And the younger ones that show promise are still placed in a Japanese environment where one must wait one's turn behind one's elders. So it will probably be about a decade before we see a new generation of Japanese leaders take over. Third, the DPJ is internally incoherent and divided -- combining reformers with old-style politicians -- so very little gets done.


Indeed, the tensions of this old and new Japan is visible in the recent leadership race for the head of the DPJ that is going on right now -- and will be decided next Tuesday, September 14th. It pits a populist, old-guard politician who wants to spend more money that the government doesn't actually have, against the current prime minister who started as a social activist, and is reformer and fiscal conservative, but who has shown to be as inept as all the other politicians. Whoever wins will become the prime minister. So the country is facing a potential sixth head of government in four years. 


The politics might give grounds for pessimism. However, it is not totally bleak. The DPJ did break the LDP system last year, and so the first half-step towards reform has been made. 


The problem is that the messy politics is taking place in the context of a failing economy. Let me now pass on to that. 


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Japanese Economy 


The story of Japan's economy starts in the 80s -- either the 1980s, or the 1880s. Let me take a moment to go into some history, before I look at recent trends, and where we are today. 


In the late 1800s, Japan achieved the impossible: it modernized within a generation, under orders of the emperor Meiji. The country had been "closed" for centuries, and resisted foreign influences. The legacy of this is still seen today in Japan's sometimes insular practices and resistance to international norms and practices. In technology, it is called the "Galapagos effect" -- because the country evolves in its own way, very differently than other markets. 


Emperor Meiji was wise and young, and realized that adopting Western practices was not only a way to improve his poor, feudal country -- but to avoid being colonized. It worked stunningly. 


For example, Britain in the late 1800s dominated the market for textiles. Japan imported technology and made poor quality products. But through industry collaborations under the aegis of bureaucrats, the output improved. When silk worm disease decimated Europe's stocks, Japan started to dominate the market. They used their foreign capital to invest in more sophisticated technology. Eventually, they developed their own intellectual property. 


In a few decades after opening to trade from the West, Japan's economic strength was incredible. For instance, by the turn of the century, it was one of only five countries that were self-sufficient in the manufacture of locomotives (the others being France, Germany, the UK and America). Japan beat a Western power in a war -- defeating Russia at sea in 1905. Japan sat at the victors table at the Treaty of Versailles. 


I raise this history to stress a few things that are present in today's business environment. First, the country has a diligent work force that can do extraordinary things. Second, it can advance quickly when it wants to. Third, Japan follows a model of imitating the West and then innovating far better than the West. For instance, Japanese textile looms by the early 1900s were the best in the world. In fact, in 1929 a loom maker in Nagoya decided to diversify its business. It licensed its patent to a British company -- and used the proceeds to get into the nascent car manufacturing business. The firm was Toyota. 


The second reason why I bring up the history is to emphasize that Japan tends to drags its feet in the face of problems, but respond quickly to big shocks. The first shock that jolted it into action was the threat of colonialism. The second was the destruction of World War II. The third was the collapse of Japan's bubble economy in 1989. But here, its reaction has been less impressive. 


It is hard for people to comprehend the extent of the damage of Japan's property and stock bubble of the 1980s. In the current financial crisis, Americans lost around $13 trillion in the six months after Lehman failed -- basically one year's worth of GDP (and much of that has since recovered nicely). Japan's bubble wiped out three times GDP -- and it never recovered. The stock index is trading today at one quarter of its 1989 peak. Property followed a similar trajectory up -- and over the past 20 years, land prices have largely continued to fall. 


Two consequences of this is, first, people are very risk averse, as businessmen and as investors. Second, companies hoard cash rather than rely on banks or financial markets (and as a result, the quality of financial services are less mature than elsewhere). Consider: Japanese firms hold more than $2 trillion in cash -- in cash! -- on their books. Households have $15 trillion in financial assets -- a full half held in cash under the mattress or in banks earning virtually no interest. At the same time, share prices are so depressed that a huge number of companies on the Tokyo Stock Exchange trade below their book value. 


Following the bubble, Japan entered what is called the "lost decade." Unemployment rose, business investment was cut, and banks needed to get cleaned up (which they did, around 2002). GDP was stagnant at around 1.5% a year, and this has continued for 20 years. So it is really more accurate to talk about "two lost decades". The good news is that until 2009 and the current financial crises, Japan's GDP never went negative -- the economy always grew. The bad news is that relative to the rest of the world, Japan is forever falling behind. America grew at 3-4% a year. China grows between 8-10%. 


Yet what defines Japan's economy today are large macro concerns that are far larger than GDP growth, as important as that is. They can be categorized as the "four Ds": demographics, debt, deflation, and depression. Let's look briefly at each one. 


Demographics: The population is declining, and aging. The economic effects of this are tremendous. First, GDP growth suffers as there are fewer people (and Japan resists immigration). But it strains the economy too. The number of workers to support each retiree has fallen from ten in 1950, to four in 2000, and is estimated to be two by 2025. 


Debt: As I mentioned, it is two times the level of GDP, and growing. In fact, a quarter of the country's roughly $1 trillion government budget is spent on just servicing the interest on its debt. And because the economy is not growing, it is hard to reduce government spending, either on social services or stimulus measures. So while tax receipts fall, the government needs to issue more debt. As much as half of Japan's annual budget is raised through government bond sales. And the buyers are Japanese banks, capitalizing on people's outsized level of savings and aversion to risk. (In surveys, retail investors say their top investment priority is not to lose principle.) 


So companies are starved of investment, making them more cautious and leading them to underperform their global peers. It is a vicious cycle. In fact, the dirty little secret of Japan is that if the economy were to grow, it would put upward pressure on bond yields, forcing the government to pay even more to service the debt. Thus, paradoxically, if Japan's economy were to strengthen, the country might go bankrupt! 


Deflation: Consumer prices have been falling around 1% year for half decade. Wages have have been going down for 15 years. Little wonder that domestic consumption is weak. No one has the discretionary income to spend. Japan used to pride itself on being one of the most egalitarian societies in the world, with almost everyone felling they were middle class. But Japan is now above the OECD average in terms of income inequality, working-poor and child poverty. 


Depression: This is not the economic sort, but the psychological. The Japanese are deeply pessimistic. Japan is a group-oriented, consensus-based society. So just as there was a nationwide euphoria that led to a massive bubble 20 years ago, today there is a ubiquitous belief that the country's prospects are bleak. But some of the problem is just a malaise of the mind. 


These "four Ds" -- demographics, debt, deflation, and depression -- are interrelated in pernicious ways. For example, companies have tried to cut costs by paying younger workers less. Instead of giving them full benefits as a "regular worker" and invest in them, with lifetime employment, they hire them as part-time or temp staff. These "non-regular workers" get paid as much as 40% less than regular staff for the same work. They lack career advancement or training (particularly the tacit knowledge that is so critical for a company, and that simply gets passed down as young and old employees work together). Because this underclass of workers exist, deflation is persistent and consumption is low. And because young workers lack job security and financial resources, they put off marriage and having children -- contributing to the low birth rate. 


These facets of the economy might depress you too. But again, I believe that there is more to the story than just this. In many technology sectors, Japan has SMEs that make the very best products in the world. For example, in many of the tools and materials for LCD panels and microchips, Japanese firms have 100% market share. No one can produce these products -- not the Koreans, Taiwanese or Chinese -- without being a customer of Japan Inc. 


Moreover, it is hard to find as diligent and loyal and hard-working a labor force in the world. The group-oriented, consensus-based approach that is so maddening when it means sluggish delays over trivial things is a real benefit when decisions needs to be executed and all employees are aligned towards the same goal. 


This is why Japan is a fantastic place to do business, find partners and acquire technology -- if a company is smart enough to do it in the right way. So with this, let me now take a look at the environment for foreign investment. 


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Foreign Investment 


The level of foreign investment into Japan is extremely low relative to the size of the economy and compared with other countries. Prior to the financial crisis, inward FDI reached $25 billion, or 8% of GDP. 


This is not impressive. Japan ranks last compared with other major economies: in America FDI is 13% of GDP, and the figure is between 30% and 40% in Germany, France and Britain. Moreover, the paucity of foreign affiliates in Japan is dire, with a share that is five to 15 times smaller than countries in Europe and the US.


In the past, the Japanese market was closed or hard to do business, partly due to non-tariff trade barriers and partly because the Japanese are quite different as employees or customers. But even though Japan is far less closed than in the past, the issue now is that many firms simply bypass Japan, and go to higher growth markets like China. 


That's fine for focusing on consumption in a domestic market. But it misses the "gems" of Japan: the country's incredible technical and manufacturing resources. This is why in recent weeks the CEOs of GE and 3M have come to Japan with an open cheque book, saying that they want to acquire firms. 


The problem, however, is that companies do not want to sell -- and especially not to foreigners. And although Japan's biggest assets are its high-tech SMEs with an aging founder-president, these are the firms that are the most reluctant to place their hands into a new structure. Part of the frustration of foreign firms is that these founders are not motivated by price, but something else. 


What is happening here -- and how can this obstacle be overcome? It turns out that some foreign firms are successful. Here is how they do it. First, patience. Second, presence. 


Japan is a society based on long-term relationships and strong ties. Outsiders are resisted -- just as they were for hundreds of years during the era of the samurai and shogun, before the country was "opened" to the West by emperor Meiji. So a foreign company has to take time, and become an insider first. 


Opening up offices, and establishing ties with official bodies like the trade ministry are important first steps. Because you, like so many others, have not been able to buy your way into the country, you've needed to open greenfield operations. 


But one way to look at it is that one's greenfield operations are actually the first steps of your M&A strategy. Without demonstrating your commitment to the country and your permanent presence in the country, other firms won't take you seriously as a partner, and perhaps eventually, as a potential acquirer. 


Why are Japanese managers and owners so resistant to selling? The reasons are complex, but it can simplified into three factors. First, selling a firm in Japan usually suggests that the company wasn't run well, so it couldn't remain independent. This sounds odd to Westerners, but it is the business culture in Japan. So the bosses may feel they will lose face if they sell. 


On top of this, Japan's culture of implicit relationships -- between company and employee, and among business partners -- may not be respected by the new owners. After all, they are implicit, not in a contract -- since such things. almost by definition, don't need to be contractually defined in Japan. So bosses resist selling, because it shakes things up. Often in negotiations with a buyer, a Japanese firm will place a condition against layoffs -- which makes a potential suitor balk: the whole purpose of an acquisition is to take control of a firm, and manage it in a new way. 


Third, Japan's culture of lifetime employment, seniority wage system, and loyalty to a company means that once a sale happens and new mangers are put in change, the existing employees, or the former president and founder, have nowhere else to go. It effectively ends their careers -- unlike in the West, where managers can use the experience to get an even better position elsewhere. 


Ultimately, it becomes understandable why money is not the prime motivation for Japanese firms and why negotiations that focus on that fail. Moreover, there is a view that a company's value is its employees, its tacit knowledge, and the business relationships that took decades or centuries to develop. And that this worth cannot be captured in the share price alone, which changes every day. 


How to overcome these inherent obstacles in Japan's business culture? When I think about it, it strikes me that foreign companies in Japan need to treat M&A in a similar way as thoughtful charities see philanthropy. 


I serve on the board of directors of a Geneva-based non-governmental organization that promotes legal rights around the world, called International Bridges to Justice. What we appreciate in fundraising is two-fold. First, it is about developing a long-term relationship with a donor, not simply asking for a cheque and getting it -- or not. It may take many years to obtain a substantial donation. But that is the natural cycle. 


Second, you cannot "sell" the mission of your organization alone, because no matter how important you feel the work is, there will always be another organization that can "compete" with you in importance -- legal rights, saving whales, feeding the poor, housing orphans. They are all good causes. So the appeal to a donor has to go beyond the mission of the organization. Instead, the donor needs to see how investing in your organization helps them realize their own dreams; how it fulfills their ambitions for making an important contribution to the world. 


This is a crucial distinction. And it also suggests that one needs to get the donor actively involved in the operation of the organization. This shouldn't be seen as meddlesome -- since if the person is successful enough to earn or at least not lose a fortune, he or she probably has some judgement that the charity can benefit from too, beyond just money. 


The parallel with M&A is this: the Japanese bosses, owners or managers aren't simply motivated by money -- so just offering more won't clinch the deal. The smart foreign company needs to present the deal in such a way that the Japanese firm feels it is the best way for it to realize its own ambitions; that the best way to achieve success is by being part of a larger, international structure. That's the first part. 


The second part is to establish a way to keep the previous owners or bosses involved with the new structure after the deal -- perhaps by creating a "Japan advisory board" that meets at a plush resort twice a year, and provides advice and feedback to management on business issues. This will keep a degree of engagement that will not only benefit the acquirer after the deal goes through, but may be what it takes to make the transaction happen in the first place, since the boss won't feel he's losing face -- or resist because he'd be losing all responsibility, and with it, his identity. 


In other words, doing business in Japan means doing things differently than elsewhere. But as a journalist covering the country for many years, I've found that successful foreign companies adapt in precisely this way. 


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Conclusion


Ultimately, what these thoughts on Japan's politics, economics and investment climate suggests is that the country is very different compared with other markets, and can be a difficult place to do business. But it is precisely these barriers that push away other firms, and leave room for companies that are willing to be patient and committed, to capitalize on. 


Over time, Japan Inc -- like Japanese society overall -- will face a chasm. It will be split between ailing firms, management that is domestic focus, and a workforce with declining skills and poor pay. And those firms that are globally superlative -- not just dominant, but superlative -- that make technologies and goods that the world relies on. 


My experience as a journalist here, and as a student of Japanese economic history, is that foreign firms are well placed to help Japanese firms to reform, adopt global best practices and succeed. The Japanese even have a term -- "gaiatsu", or "foreign pressure" -- to describe the importance of outsiders to strengthen the hand of reformers within the country, to overcome domestic resistance to useful changes to improve the country. 


Japan's politics is a muddle. The macroeconomy is a mess. The environment for foreign investment is not easy. But despite these things, I am very bullish on Japan as a place of opportunity. Its workforce is excellent, the technologies they produce are world-class, and they need the support of outside capital and management to excel in a global setting. 


If a Western firm approaches its business here in the right way, so that it fits smoothly in with Japan's business culture, I believe it can be extraordinarily successful. 


Thank you. I'd be pleased to answer any questions you have. 



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