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Rethink METI's role in Japanese innovation

Forget about the government picking winners. Foster entrepreneurs

| Japan
Masaaki Tanaka, president and CEO of the Japan Investment Corp., said it would be "impossible to rebuild a relationship of trust with the government." (Photo by Wataru Ito)

The Japan Investment Corp., the latest in a series of public-private funds in Japan, imploded less than three months after it started when its nine board members, including the CEO, resigned.

The result is embarrassment all around, with questions asked about public-private cooperation, executive pay, and the role of the government in promoting innovation. But some good may yet come out of the debacle, which happened late last year, if Japanese officials develop a better way of supporting innovation -- one that relies more on fostering entrepreneurs and less on trying to select winning projects.

The newly-created fund was conceived to "develop with innovation" and provide risk capital to emerging industries as a late-stage financier.

The direct cause of the blowup was a dispute over the fund's executive compensation with the fund's top representatives, mostly drawn from the private sector, arguing for more pay and the Ministry of Economy, Trade and Industry, the sole shareholder, demanding restraint.

But the indirect cause of the failure is the fundamental flaw in the concept of a public-private fund. Managing taxpayers' money in a fund that mimics the private sector is a contradiction in terms. In particular, public-private funds have easy access to government funding so can drive up the valuations of startups in which they invest, as everybody involved knows the money comes from a very deep well. Not only are deals often overpriced -- financing can be extended for too long, with public money keeping alive zombie companies, long after the original ideas have failed.

This contradiction raises the obvious question as to whether the government should be financing innovation at all.

The question comes with a lot of historical baggage in Tokyo. After all, Japan owes its ascent as a leading postwar economic power to a coordinated public-private partnership. The Ministry of International Trade and Industry (MITI), METI's predecessor, was famed for guiding major Japanese industries, setting strategic visions and adjusting policies accordingly.

This so-called "convoy" mechanism, in which groups of companies were shepherded along to success, worked well for traditional industries such as steel because it optimized capital investment by preventing excessive competition. It also helped foster innovation as in the case of the Very-large-scale integration (VLSI) project to create the integrated circuit chip. This "research cartel," which included such electronics heavyweights as Hitachi, Fujitsu and NEC, was founded at the behest of MITI in 1976.

MITI's golden era of the 1970s and 1980s was based on the premise that even large Japanese corporations adhered strictly to rules and were often protected from external competition in the domestic market. The industry structure was orderly since it was based on the keiretsu system of cross-shareholdings among affiliated companies. Finance was usually controlled and provided at cheap rates.

But today these basic conditions no longer exist. Post-bubble corporate Japan has turned away stagnant domestic markets to seek growth overseas, where the Japanese government cannot control business conditions, competition is often intense, and market are unpredictable. Companies which succeed today are often rule breakers as in the case of the SoftBank Group. Industry structures are becoming extremely fluid as the walls between electronics and automakers, for example, crumble. Finance can come from many markets and sources. The private sector today believes that direct leadership by METI is far less necessary or appropriate.

Does this mean government should end its role in fostering innovation? Far from it. In a fast-changing world, slow and steady can still win the game. One of the duties of government is to promote innovation. There are many measures besides public-private funds and the outdated convoy system that the government can take to support the private sector, including providing long-term horizon thinking, undertaking large social and industrial infrastructure projects, training skilled labor, and backing basic scientific and engineering research.

These are policies that can benefit any entrepreneur, not the chosen few. Similarly, in finance the government can help banks and financial companies to provide low-cost transparent funds for many businesses on an equal basis rather than trying to channel money to a putative future winner.

Headline-grabbing initial public offerings show this can work. Japan saw 91 IPOs in 2018, the highest in a decade, powered by internet and artificial intelligence startups and financed by new sources of risk capital provided, for example, by venture capital firms. Perhaps there is now less need for a public-private fund to crowd this space.

But still fewer tech entrepreneurs come forward in Japan because of conservative attitudes to commercial risk-taking and the widespread preference for the safety of working in large companies. However, the knee-jerk response -- assist such entrepreneurs -- is not the only way forward and perhaps not the most effective in the Japanese context.

Better perhaps to encourage traditional corporate R&D inside the very companies where Japanese prefer to work. The government can help setting up the innovation framework, especially to support smaller companies, which, unlike the giants with their armies of R&D staff, often struggle to develop innovations. Small and medium enterprises, which employ two thirds of Japanese workers, are often strapped for resources, including skilled staff as well as finance. Copying the spirit of Germany's Fraunhofer Institute, the government could provide state-funded public research facilities where SMEs can share space, while generating new ideas and developing skilled staff who can boost to innovation.

Such facilities could be scattered across the nation offering different specialties. If this initiative is combined with collaboration with local universities, which are struggling with diminishing student enrollment, it can help regional revitalization.

The convoy system was built around a hierarchical pyramid industrial structure dominated by the keiretsu. If the pyramid no longer exists, the government can focus instead on a new approach supporting individual companies regardless of size. This could breed future "hidden champions" -- often regional SMEs with global niche technology.

Of course, large numbers of startups will fail. The government should spearhead efforts to organize a safety net for those recovering from a collapse, seeking a second chance and engaging in serial entrepreneurship. The traditional bias against people who initially fail in business endeavors must go in the dustbin of economic history.

The MITI-led convoy system is sometimes looked at fondly with nostalgia, but it no longer works. Public-private funds are not living up to optimistic expectations. However, the government still has a big role in supporting innovation. But it must stop looking at industry from the top down, and focus instead on a bottom-up approach.

Nobuko Kobayashi is a partner with EY-Parthenon, a strategic consulting group within E&Y Transaction Advisory Services. Based in Tokyo, she specializes in the consumer sector with a special focus on multinational corporations operating in Japan.

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