Corporate governance reforms proposed by the government in Japan promise to improve the country's business climate for foreign and domestic investors alike. However, the implementation of these reforms looks set to be a long and winding road.
"Since the 1950s, Japan’s approach to the problem of corporate governance has differed from that in other countries," say Organisation for Economic Co-operation and Development (OECD) economists Randall Jones and Kotaro Tsuru. Close relationships between the main banks and large corporations provided long-term stability, as did cross shareholdings within corporate groups. Company board members were typically insiders, coming from a main bank, the corporate group and the corporation itself.
According to Hugh Patrick, director of the Centre on Japanese Economy and Business at Columbia University, it "was a system of cosy backscratching, some might say collusion, among the management of Japan's large industrial companies, financial institutions and the government bureaucracies".
This meant that management was weakly supervised, and companies were substantially protected from mergers and acquisitions, especially from overseas.
Picking up the slack
This system seemed to serve Japan well during its high-growth period leading up to the financial crisis that hit the country in the early 1990s. In reality, poor corporate governance probably contributed to some of the bad lending that led to the crisis, and to the sluggish response that followed – as well as to the chronically weak profitability of the country's corporates over the past two decades.
Reform of Japan’s corporate governance – particularly in disclosure, transparency and accountability – has been on the agenda for more than two decades. And the need for reform has only been highlighted by incidents such as the 2011 accounting scandal at Olympus, when it emerged that the company had concealed considerable investment losses. But, as Mr Patrick points out, reform has been mainly “legal and institutional reform, rather than a fundamental change in the management mindset”.
To the surprise of many observers, Japan's prime minister Shinzo Abe has now placed reform of the country’s corporate governance (along with 'womenomics') at the centre of the government’s revised growth strategy (known as 'Abenomics') with the objective, Mr Abe says, of “restoring Japan’s earning power”.
The government has expressed concern that Japanese companies have lower productivity than their Western counterparts (about 30% lower, on average, than those in the US), and that they are struggling to quickly respond to market environment changes, which, in turn, is having an adverse effect on the Japanese economy.
Better corporate governance would push the management at these companies to pay more attention to shareholders’ interests, and to withdraw from unprofitable activities and invest excess cash in new areas. It is also necessary to achieve the government’s goal of doubling Japan's stock of FDI by 2020.
The government has thus asked the Tokyo Stock Exchange and the country's Financial Services Agency to draft a corporate governance code for publicly traded companies by April 2015. Japan is virtually alone among advanced economies in not already having such a code.
The draft will be based on the OECD’s principles of corporate governance, which stipulate that the board should have a sufficient number of non-executive members capable of exercising independent judgement. Currently, only half of the Tokyo Stock Exchange’s top-tier companies have outside directors, and most that do only have one. By contrast, outside directors must make up at least one-third of boards in Hong Kong and Singapore. The code will also look at cross-shareholding voting rights, and will require companies to 'comply or explain'.
The government has also called on companies to “link their proactive utilisation of outside directors to the evolution of their business strategies”, a virtual war cry to the cosy boardrooms of corporate Japan. The date when these decisions were announced, June 24, 2014, will “go down in history as the day when the modernisation of corporate governance in Japan began in earnest”, says Nicholas Benes, representative director of the Board Director Training Institute of Japan.
Time to act
These promised corporate governance reforms come on top of the creation of a 'stewardship code', which looks to impose accountability on companies without outside directors. Growing numbers of institutional investors as well as the huge Government Pension Investment Fund have decided to participate in the code.
But what is driving the move to reform Japan’s corporate governance now, and will reform really happen?
The government realises that it must act to revive Japan’s economic fortunes, especially in light of the country’s demographic crisis and low productivity, says Kenneth Lebrun, a mergers and acquisitions lawyer at Shearman & Sterling's Tokyo office. Improving productivity is the only means to grow Japan's economy now that the population is declining and could fall by as much as one-third by the end of the century.
Counter-intuitively, the politics of corporate governance reform may be less complex than some other big-ticket reform issues, such as agricultural reform.
Other Tokyo-based commentators emphasise the significance of the deterioration in Japan’s relations with China as a motivation to reform. To remain relevant and respected in the region, Japan must have a strong economy. Better corporate governance could also help Tokyo in its quest to become a more important regional financial centre. At this stage, both Hong Kong and Singapore have a distinct edge over the Japanese capital.
Another pressure for change has come from the rising number of foreign investors active in Japan’s stock market, says Mr Lebrun. Foreign investors currently hold about one-third of the stock market, accounting for a higher proportion in certain companies. They trade stocks more frequently than local investors, and account for up to two-thirds of market trading. These investors are seeking high rates of return, and have been pushing for better corporate governance.
The real deal
The government is conscious that the stock market is regarded as a barometer for the success of the 'Abenomics' programme, says Jerry Schiff, deputy head of Asia-Pacific for the International Monetary Fund. The Nikkei Index rose by about 60% in 2013, driven substantially by foreign investors, but has been seesawing in 2014.
Some experts are sceptical of the proposed corporate governance reforms. This in unsurprising since, in the past, Japan has promised reform without delivering. Moreover, Japan’s peak industry lobby organisation, Keidanren, is resisting the reform agenda. But Japan’s political landscape has stabilised beyond the revolving door of prime ministers of the recent past, which saw five different prime ministers in the five years prior to Mr Abe’s appointment.
Mr Abe now enjoys strong support for his reform ambitions, and there is a growing realisation that he may well be in office for some years to come, which augurs well for the full implementation of reform.
In short, there is a sense in Tokyo that this time corporate governance reform might be for real. But, it will be long road home. As Mr Benes says “Japanese companies face major challenges in raising the quality of all their directors,” and comprehensive director training will be necessary.