May 12, 2015 5:50 pm JST
Kazuhiko Toyama

Abe's 'third arrow' must target zombies

In my essay "The Curse of 'Japan Inc.' and Japan's Microeconomic Competitiveness," I spoke about the "disease" that has afflicted the Japanese economy over the past 20 years. I referred to Japan Inc. as the nation's economic management system, characterized by the union of lifetime employment, seniority-based workplaces and enterprise. This union became the established domestic corporate system during the period of high economic growth and contributed greatly to the nation's success. However, this system is outdated in the new international business environment, which has been fundamentally altered by globalization and the digital revolution. Today, strategic dynamism and the speed at which companies adapt are key success factors. The homogeneous and consensus-based nature of Japan Inc. hindered its ability to adapt to this new environment. I used the case of Sony to illustrate the strategic and structural setbacks that have affected the entire Japanese corporate sector.

     Although the essay had a pessimistic tone, I ended it on a more positive note, emphasizing the great potential Japanese companies still have, with their technical expertise and business know-how. I also pointed out some changes, such as the aging population and energy crisis, that could result in the further expansion of Japan's technology and business models.

     Now, I feel we can be even more optimistic. In the past year or two, there has been much progress. For example, the first arrow of Abenomics improved the so-called quintuple problems -- delayed free trade agreements, high labor and energy costs, the high corporate tax rate, emission reduction targets and the stronger yen. Serious struggles such as deflation and the stronger yen were used by Japanese companies to justify their sluggish performance.

     Attention has been given to issues such as the lowering of corporate tax rates as well as deregulation in the energy and agriculture sectors to bring in more foreign capital. There has also been strong progress in the Japanese stewardship code as well as the creation of a new corporate governance code.

     As a result of these changes, and individual restructurings of business portfolios for better returns on equity, some of the Japanese electronics giants, such as Hitachi, Toshiba, Fujitsu and Mitsubishi Electric, have shown signs of recovery in recent years, with growth in both scale and profitability.

     Most importantly, the current corporate governance reform, which I am personally heavily involved in, might accelerate the evolution of the Japanese management system and might make the current recovery trend more sustainable and widespread. If so, more large enterprises will be able to escape from the curse of their past success.

Work to be done

These reforms have been performed under the three arrows of Abenomics -- fiscal spending, central bank easing and structural reform -- which has improved the global perception of Japan. However, despite the progress and optimism, I believe there are still issues remaining that need to be addressed to achieve real and steady economic growth. Real economic growth cannot be left to the first two arrows of Abenomics alone. Rather, these two arrows will mainly act as a trigger to help start the growth process. We cannot expect anything more than this.

     I will focus in more detail on the strategies that I believe are necessary to bring about real and sustainable economic growth in Japan. My argument centers around industry "metabolism" and labor market issues, issues that were also mentioned by Prime Minister Shinzo Abe as being the key to Japanese economic growth in a speech at Harvard in April.

     One key concept to note here is the fundamental paradigm shift in Japan. Japan's shrinking population, due to the declining birthrate and aging, means that the nation's working population is likely to decrease before aggregate demand starts to decline. The most important and long-term constraint on Japanese economic growth is this structural labor shortage, where supply will not be able to support demand.

     I want to point out that this labor shortage has not been brought about purely by the economic recovery under Abenomics. The structural population change in Japan is the underlying reason behind this serious labor shortage. This point needs to be understood properly in order to think about policies in a constructive manner.

Structural problem

The increase in the jobs-to-applicants ratio stands out in the construction industry, which is often associated with the demand-side economic recovery under Abenomics. However, this upward trend is much more widespread, mainly in service sector occupations, and started before Abenomics was launched. It clearly implies the labor shortage is caused by structural supply-side constraints.

     In this situation, we need to tackle the issue of how we can push up the low potential growth rate, caused by demographic decline and weak productivity. Here, the third arrow of Abenomics must focus on implementing policies that improve capital and labor productivity as well as increase participation in the job market.

     Many recent policies, such as corporate governance reform, have been effective in improving capital productivity, and targeted at what I call the global economic realm. The even more important remaining challenge is to respond to the labor issue, and here, a focus on what I call the local economic realm is necessary.

     The global economic realm mainly consists of the manufacturing and information technology industries, which deal in tradeable goods. Economies of scale apply in these industries, and there is a strong drive for consolidation. Factories producing tradeable goods can be moved to any location in the world, leading to globally optimized supply chains with intense levels of competition. Therefore, it is easy to respond to domestic labor shortages as workers can be found by moving somewhere else in the world.

     On the other hand, the local economic realm consists of nonmanufacturing, face-to-face service industries that deal with nontradeable goods such as public transport, wholesale, logistics, retail, restaurants, hotels, medical services, social welfare and education. The core issue under the third arrow should be to address the labor issue in the local economic realm. The distinction between the two realms is increasingly important: The trickle down from the global economic realm to the local economic realm has become weaker.

Big impact

There are a number of other reasons to prioritize addressing issues in the local economic realm.

     First, the local economic realm makes up around 70% of gross domestic product, as well as employing around 80% of labor in the Japanese economy. Therefore, growth strategies targeting this realm should have more of an impact on Japan's economy as a whole.

     Secondly, this realm is mainly made up of nonmanufacturing service businesses, which are fundamentally labor-intensive. The labor supply in this realm cannot be substituted either, so severe labor shortages are a risk. For example, you cannot move a bus company from Tohoku in Northeast Japan to Southeast Asia.

     Thirdly, businesses in the local economic realm have very low productivity and wage levels when compared with other countries or with the Japanese manufacturing sector.

     Therefore, we must increase labor productivity and participation in this local economic realm by increasing wages, especially to encourage women and the elderly to re-enter the workforce. This is low-hanging fruit -- labor productivity in the local economic realm in Japan is still at extremely low levels. Therefore, with the appropriate policy package, the economy should grow in this sphere.

     In fact, my company owns the third-largest local bus company in Japan, which is located in the Tohoku region. The company also owns some hotels and other tourism-related businesses. We have hired more than 3,000 employees in the region. Despite the fast-declining population, the tsunami damage and the nuclear plant accident in Fukushima, we are successfully turning a profit there and managing operations well. We have actually increased the number of staff on our books and raised wages by 2% annually for the last five years. We have identified many opportunities to innovate from a managerial and technological perspective in this poorly managed industry realm.

Worlds apart

As I said, the productivity of the service sector in Japan is low, in comparison with other advanced economies.

     In particular, the productivity of local service sectors such as public utilities, transportation and logistics, wholesale and retail, restaurants and hotels is much behind that of the U.S. My impression on the business front line is that top-class manufacturing companies such as Toyota, Komatsu or Omron are like Olympic athletes running the 100 meters in 10 seconds, while many of the service sector players take as long as 30 seconds to get the same distance. There are many reasons why there is such low labor productivity in the local economic realm.

     The key characteristic of local businesses is that customers consume services at the time and place that they are supplied. Therefore, economies of density apply -- areas with more people can generate more revenue and attract more businesses. For example, even if the service at your local hospital is clearly bad, if there are no others in your area, you have no choice but to go there for medical treatment. Therefore, the local economic realm can be explained by fragmented industry economics with imperfect competition. Even entities with low productivity can survive relatively easily. In addition, improving the capital-labor ratio, through measures such as implementing advanced information communications technology, will not increase labor productivity. These businesses are fundamentally labor-intensive.

     On top of these factors, there are also Japan-specific historical and political reasons that have played a significant part in keeping productivity low. Many of the industries in the local economic realm are for the public good by nature, so some level of regulation is necessary. However, very little deregulation has been implemented in Japan's local economic realm.

     Moreover, the local economic realm was treated as a useful tool to absorb any excess labor during recessions; governments provided excessive support to protect companies in the local sphere to keep unemployment levels low. As a social policy tool, low labor productivity was preferable.

     As a result, even with the bubble economy collapsing, the repercussions of the bankruptcy of Lehman Brothers and the long-term recession, Japan has maintained an abnormally low level of bankruptcy, despite the fact that more than 70% of incorporated companies are loss-making and have not paid corporate tax in the last 20 years.

Transition time

Given the fundamental paradigm shift in the economy, all this needs to change. Even badly managed companies, the so-called zombies, propped up by government protectionist laws face bankruptcy. The zombies are unable to carry out operations because of the lack of labor.

     The political incentive to continue supporting these businesses with irrational protectionist policies should be much weaker as there is a lower risk of unemployment. In reality, this change is the real reason why agricultural reform, an area that could not be touched for a long time, has made progress recently.

     The main way to improve labor productivity and labor participation is to encourage economic metabolism -- promoting consolidation and innovation in the local economic realm. Inefficient companies with low productivity need to exit the market, so that the existing companies can consolidate under fewer good businesses paying higher wages, and also so that new and capable companies can challenge by innovating.

     What the local economic realm needs is a certain degree of deregulation. However, deregulation for the sake of deregulation will create more problems. A typical unsuccessful example of this is the taxi industry in Japan. When deregulation leads to excessive competition in the market, less-capable management will exploit their workers in a struggle to survive. In Japan, the increase in these exploitative companies has recently made the headlines. I believe what we need is something I call smart regulation -- a combination of well thought-out regulation and deregulation that increases competition and innovation effectively.

     One measure would be to increase minimum wages in the service industry. The minimum wage has a negative effect in the manufacturing industry, as production can be moved elsewhere, leading to deindustrialization. However, a higher minimum wage for the service industry will not have the same detrimental effect: Supply cannot be moved abroad. Rather, companies with low productivity will not be able to hire staff, which will eventually lead to these companies exiting the market. Companies with relatively high productivity are already paying staff more, so a higher minimum wage should not have much impact.

     The minimum wage in the Tohoku region is now only $5. It is too low and has no real meaning. In fact, the manufacturing industry in Japan no longer competes at this low wage level at all. Having survived the 80-yen-per-dollar era, they have already shifted their competitive positioning.

Time to get cold

The key thing is that the government should not help weaker companies to survive. It needs to encourage economic metabolism so that the labor force can gradually move to the stronger companies with higher wages, which will also encourage labor participation.

     Enforcing a stricter labor standard on the service industry and on small and medium-size enterprises can also be effective. Service industry companies with low productivity tend to exploit their employees, forcing them to work long hours in bad conditions. In the past, governments were lenient on these smaller companies as they assumed a safety-net role for jobs in Japan. With the paradigm shift, it is time to stop protecting these companies and enforce stringent labor regulations.  

     As a result of these labor market reforms, we should end up with a situation with higher wages and a better working environment. This should encourage those who were traditionally "weak" in the labor market, such as women and the elderly, to participate in the workforce. This is another point Prime Minister Abe mentioned as important in his speech.

     Here, it is also important to focus on the role that women can play in the local economic realm, rather than just focusing on women corporate executives or business leaders. I believe that women participating in the job market can also drive innovation by increasing labor diversity.

     The Japanese Credit Guarantee Corporation also needs to be reviewed: It still provides a safety net to zombie companies. The size of the Japanese credit guarantee is excessive compared with other countries, which enables zombie companies to survive when they should not be allowed to. Besides this, Japan has many political instruments sustaining zombie companies and industries. Getting rid of these would be a big chance to improve productivity and the potential growth rate.

     For example, a review of debt governance is important. Banks, which are the capital source for many local-realm companies, need to look more carefully at the true potential of their businesses rather than judging a company by whether it has net assets or liabilities on its balance sheet.

     Bankruptcy laws also need to allow companies to exit the market in a more reasonable manner. A big problem here is how to treat personal guarantees of corporate debt. A system needs to be put in place to allow bankruptcy without forcing the individual bankruptcy of the owner, in order to incentivize people to close their companies.

Slow turnover

Japan's rates of new business openings and closings, which both indicate metabolism, are very low compared with other advanced economies. This slow metabolism suggests that those zombie companies are less challenged and thus less likely to exit the market, if current protectionist policies continue. On the flip side, we can say that there is huge upside potential here.

     For these reforms to be discussed and implemented, political capital to back these policies will be crucial. The political sector quickly needs to change its mentality from "protecting jobs in the local economic realm" to "increasing productivity in the local economic realm." In other words, politicians need to stop helping the weak and start supporting the strong.

     To summarize, there is a structural change in Japan's supply side economics, where a severe labor shortage will prevail for the next 10 to 20 years. In this situation, it is crucial to increase labor productivity and participation, especially in the local economic realm, which accounts for most of the Japanese economy. Although Abenomics has had a positive impact, it is not enough to bring about real economic growth, which can only occur by creating self-sustaining circulation in the Japanese economy.

     Given the social-economic changes, the current situation provides a very good environment for reforms under the third arrow of Abenomics to work successfully. However, the inertia of the old economic policy structure, which became established during the long period of insufficient demand and excess labor, is still very strong. In particular, in the local economic realm, the whole of society, including politics, industrial companies and financial institutions, has become deeply embedded in this old structure.

     I can fully understand, as Prime Minister Abe mentioned, that it is not an easy task to overcome this inertia to bring about change. For this, highly substantial, long-term political capital and force is necessary. I am hopeful that this can be provided by the current Japanese government.

Kazuhiko Toyama is the CEO of Industrial Growth Platform (IGPI), a Japan-based business consultancy.

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