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Corporate reforms to free up the deployment of capital will yield an enormous payoff.
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Japan rose from the ashes of World War II to become the world’s second largest economy in only a quarter century. Today, Prime Minister Shinzo Abe has an aggressive program to revitalize an economy that has stagnated for two decades.
Mr. Abe’s “Three Arrows” program consists of renewed fiscal stimulus, aggressive monetary easing and significant structural reform. We believe he will succeed—if he aims his “third arrow,” structural reform, at Japan’s capital allocation and corporate governance practices.
Japanese corporate assets are inefficiently managed by international standards. For example, from Organization for Economic Cooperation and Development data one can calculate that the Japanese private capital stock amounted to ¥2,137 trillion ($27 trillion) in 2011, a year in which this stock generated private-sector GDP of ¥370 trillion. This implies a Japanese private-sector capital to output ratio of 5.8 to 1, versus 2.9 to 1 for the United States. Simply put, each unit of Japanese private capital produces only one half the amount of output generated by one unit of American private capital.
The same differential shows up glaringly in the return on capital for publicly traded corporations. The total gross assets of Japanese financial and nonfinancial companies was ¥1,848 trillion in 2011, but these assets generated a total net profit of only ¥32 trillion, a return of 1.7%. By contrast, the total gross assets of publicly traded companies in the U.S. was $35.9 trillion and generated additional value of $1.38 trillion, a return of 3.8%—more than double the Japanese figure.
With shareholders ill-served by Japanese managers, do stakeholders benefit instead? According to both countries’ official government statistics, Japanese workers are underpaid relative to their American counterparts. Overall Japanese GDP, including tax revenue to the government, is likewise lower. The sluggish management of Japanese corporate capital is not only depressing profits; it is also depressing wages, GDP and tax receipts.
Defenders of the status quo tend to explain such disparities by saying that “Japan is different.” We agree. But do the differences necessitate such inefficiency? Perhaps if Japanese management paid more attention to the returns on assets and the interests of shareholders, capital could be more effectively deployed.
To help Japanese corporations allocate their capital more efficiently, the government can streamline the regulatory process. It also can allow companies and employees to enter into working arrangements making it easier to hire and fire employees more freely. It can lower its 38% corporate tax rate—the highest in the world—to globally competitive levels. It can provide for tax-free stock mergers between companies. Finally, the government can ease restrictions to allow companies to shutter failing divisions and spin off businesses that would operate better as stand-alone entities.
Still, the government’s influence on corporate behavior can go only so far. Ultimately, the Japanese will have to reconsider their corporate governance, which is characterized by primary bank relationships and insider directors, which limit transparency, accountability and efficiency in business dealings.
Many companies, including Sony, 6758.TO +2.65% have already implemented important changes, for example, having a majority of its directors from outside the company. But for Mr. Abe’s third arrow to succeed Japanese corporations will need to reframe basic concepts of their governance—in particular the relationships between management teams, boards of directors and the shareholders they serve.
To better align the interests of board members with shareholders, we recommend that a meaningful portion of directors’ fees be in stock. Second, the role of the major shareholder should be reconsidered, as it has been in the United States. In the U.S., for example, it is not unusual for large “activist” shareholders to join boards to drive better corporate results. In Japan, the idea of shareholders as active owners is undeveloped. As a last resort, shareholders need to become comfortable with replacing directors of failing companies.
Reshaping corporate Japan may be painful at first. In the U.S. this process began in the 1980s, urged on by the boom in mergers and acquisitions. These changes led to enormous gains in productivity and growth, and produced some of the strongest companies in the world. Since Japan has shown itself to be a great student and a great teacher of management techniques, there is no reason to believe that it can’t transform itself. Opening Japanese management and corporate ownership to the international marketplace would seem to be an obvious step, and the lagging returns on capital suggest that an enormous payoff would result.
Japan’s corporate sector has the chance to reclaim its role as one of the most admired in the world. If, with the government’s encouragement, it does so, then all of Japan will benefit from the consequent increase in growth and, ultimately, wealth creation—and Prime Minister Abe will deserve his place in history alongside great economic reformers like Ronald Reagan and Margaret Thatcher.
Mr. Lindsey, a former Federal Reserve governor and assistant to President George W. Bush for economic policy, is president and CEO of the Lindsey Group. Mr. Loeb is the CEO and founder of Third Point LLC, a hedge fund that owns a significant position in Sony Corp. This op-ed is based on a study, “The Right Target for the Third Arrow: Corporate Managerial Efficiency in Japan compared with the United States” (www.aei.org).
Learn more about co-author Daniel S. Loeb.
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