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Japan in the Capital Markets Sept 2021

Japan’s reform failures make Covid era extra painful

Stagnating growth and pressure from the Covid crisis on the economy mean Japan needs to push out some large-scale structural reforms fast — or risk a much bigger economic fallout. William Pesek reports.

Japan’s government and central bank have been fighting fires for years to revive the faltering economy. All with little success, however.

Prime minister Yoshihide Suga has paid the price for his ruling Liberal Democratic Party betting it all on the Tokyo 2020 Olympics, and resigned after less than a year in office.

The strategy unravelled spectacularly as Covid-19 arrived, costing Japan the 40m tourists it planned to welcome amid the Summer Games. Rather than a windfall, hosting the delayed Olympics during a pandemic left the most indebted major economy with even more debt on its book, risking the LDP’s hold on power.

Worse, it put back at the starting line an economy that seemed set to sprint forward in 2013. And leaves the next government to pick up the pieces and devise a new plan to raise Japan’s economic game.

This 2013 marker is notable for two reasons. For one thing, it was the year Tokyo unexpectedly scored the hosting rights for the 2020 Olympics. For another, it was when Shinzo Abe, then the prime minister, changed leadership at the Bank of Japan, part of a multi-faceted strategy to reflate Asia’s second largest economy and rekindle Tokyo’s innovative flame.

Or so global investors thought. In December 2012, Abe pledged to reinvigorate an economy weighed down by the deflation and political paralysis of the 1990s. Abe planned to reduce bureaucracy, loosen labour markets, catalyse a startup boom, empower women and attract more international talent — all while trimming a crushing public debt burden.

In September 2013, as Tokyo secured the Olympics, Abe visited the New York Stock Exchange to declare “Japan is back” as an investment powerhouse. He even referenced Gordon Gekko, the protagonist in the film Wall Street, to argue that Japan is a “buy” once again. That year alone, the Nikkei 225 Stock Average Index surged 57%.

Yet the blinding speed with which Japan flamed out in 2020 demonstrates how little the economy had really changed. As exports cratered, so did gross domestic product — with real annual growth last year standing at negative 4.8% — and with it, the myth that so-called Abenomics had whipped Japan into shape.

“Growth strategies did not really move forward, since deregulation efforts were really weak,” says Yasuhide Yajima, chief economist at NLI Research Institute. “Going forward, the point is what kinds of deregulation the government will come up with.”

‘Painful’ reforms needed

These failures can be traced back to 2013. Once Abe got his new BOJ governor in place, he left economic affairs to Haruhiko Kuroda’s team. Kuroda, a former president of the Asian Development Bank, fired his monetary bazooka early and often. The Olympics, meantime, would unleash a burst of construction-driven activity that Abe argued would create enough new jobs and wage increases to shift the $5tr economy into a higher gear.

Covid-19 upended both assumptions. And then Abe stepped down suddenly in September 2020, citing health issues. That left Suga, Abe’s chief cabinet secretary for his nearly eight years in power, to salvage the LDP’s economic legacy as Japan’s new prime minister.

It proved an uphill climb, as shown by Suga’s quick exit. In mid-2020, the government rolled out a $2.2tr stimulus programme, equal to about 40% of GDP. The BOJ did its part to increase asset purchases too. As 2022 approaches, though, Japan is largely out of conventional ammunition.

The next government will have to push out supply-side reforms that have been delayed for decades.

“There has been strong pessimism in Japan about future growth prospects in both the household and corporate sectors,” says Shin-ichi Fukuda, an economist and professor at the University of Tokyo. “If effective structural reforms can eliminate the pessimism, domestic consumption and capital investment will increase and the prolonged stagnation will be resolved. To turn things around, we need to impose rapid and sometimes painful structural reforms.”

Japan is learning that what worked in decades past no longer does — especially when China is winning the lion’s share of foreign direct investment, raising its competitive game and growing its economy rapidly.

It’s not just China nipping at Tokyo’s heels. Countries like Indonesia, for example, are pushing past far more developed Japan in producing tech unicorn startups. All this makes aging, high-wage Japan a very expensive property in a lower-cost neighbourhood that’s veering upmarket.

The answer for Japan is to reinvigorate the reforms Abe and Suga promised, with some vital updates. Perhaps most needed is a pro-growth energy policy that creates millions of high-paying jobs and returns Japan to the status of regional leadership.

As China races ahead, South Korea makes inroads and Indonesia, Vietnam and others raise their technology ambitions, Japan is finding much of what it has long excelled at being commoditised in real time. South Korea alone has Japan feeling disoriented as Asia’s fourth largest economy competes in cars, electronics, robots, ships and popular entertainment. K-pop bands like BTS and Blackpink are going global in ways J-pop never did.

While the Abe-Suga tag team dreamed of Olympics glory, Chinese president Xi Jinping invested trillions in electric vehicles, semiconductors, biotechnology, biomedicine, aerospace, high-speed rail, artificial intelligence, automation, cloud computing and renewable energy. Beijing is also miles ahead of Tokyo in building a central bank-issued digital currency.

China is also planning a unicorn blitz. Granted, the crackdowns on Alibaba Group Holding, as well as high-profile firms like Didi Global, Tencent Holdings and other peers, are grabbing global headlines, but few can refute the Silicon Valley-style setup that has already been created in the country.

Japan’s rejoinder to all this? Hosting an Olympics with no GDP payoff. Had Japan spent the last eight-plus years remaking its economy instead, its status would be remarkably different.

Startup focus

The Japanese government’s best chance of regaining momentum starts with curbing Covid-19. Just like Korea and Taiwan which outmanoeuvred the pandemic at first, Japan got complacent about vaccinations. The emergence of the Delta variant, coupled with a post-Olympics infection surge, now has Japan playing virus defence.

When it comes the pandemic, views are mixed. After a slow start, Suga’s government had rapidly ramped up vaccinations.

“As a result, we’re cautiously optimistic that a strong recovery is just around the corner,” says Tom Learmouth, Japan economist at Capital Economics. “Japan’s vaccine coverage is now not far off the rates seen in developing markets where most domestic restrictions have already been lifted.”

The next government must boost moves to revive structural reform.

On September 29, the LDP will choose a new party president to replace Suga. That successor will then represent the LDP in a general election expected to be held in October.

Candidates include Taro Kono, state minister in charge of administrative reform who also heads the national Covid-19 vaccination programme; Fumio Kishida, an ex foreign minister; Shigeru Ishiba, former defence minister; and Seiko Noda, a former internal affairs minister. Noda would be Japan’s first-ever female leader.

Given that opposition parties are in disarray, the LDP is widely expected to maintain power. One wildcard: analysts wonder if Yuriko Koike, Tokyo’s popular governor, might take a run at the premiership.

Japan’s next leader will have to multitask right out of the gate. In the immediate term, Japan might need a jolt of conventional support. “In the short run, fiscal stimulus is needed,” Heizo Takenaka, an economist and an adviser to Suga, said in an interview in July. “It’s also very important at this moment to control Covid-19.”

Japan needs more than just stimulus, though. The BOJ pioneered quantitative easing in 2001, two years after it became the first major central bank to cut interest rates to zero.

In 2013, Kuroda pushed Japan even further into uncharted territory. The central bank cornered the stock market via exchange-traded funds. By late 2018, well before Covid hit, the BOJ’s balance sheet topped the size of Japan’s entire economy. Since then, it’s only grown bigger. At the end of 2020, the BOJ became the biggest owner of Japanese stocks, holding over $400bn.

Yet Japan has gone as far as it can with monetary easing. The problem is no longer the supply of yen sloshing around the financial system, but productive uses for them. The missing link is deregulation that gives businesses and households confidence that the next five years will be more vibrant than the last five.

“Advocating for a more middle class-friendly Abenomics — without calling it that — might well be able to take with the electorate,” says Corey Wallace, an economist and assistant professor at Kanagawa University in Japan. “The focus would be on parents and SME owners. Essentially, find ways of relieving economic insecurity now so that these two groups would feel emboldened to spend. There are various ways that could be done, but I think the anticipated cost of education is a major concern.”

Economists and Japan experts suggest other priorities. First, a strong Cabinet, something Japan has lacked for years. For example, Suga’s deputy prime minister and finance minister, Taro Aso, was also Abe’s. What, really, did Aso, now in his early 80s, achieve in eight-plus years on the job? The gulf between the advertised big bang and the modest tweaks Aso’s staff achieved grew wider which each passing year.

Japan has also been slow to catalyse a startup boom. The latest leaders have made the same mistake as every Japanese government over the last 20 years: prioritising the interests of corporate behemoths at the top of the economic food chain over generating new economic energy.

Beginning in 2013, for example, the BOJ’s main focus was a weaker exchange rate. It boosted profits at Toyota Motor, Nippon Steel, Mitsubishi Heavy Industries and Sony Corp — and the broader Nikkei index. It did little, though, to incentivise the other end of the economy: twentysomethings disrupting a change-averse economic system.

A new government could shift tax breaks to entrepreneurs and cut red tape to increase Japan’s share of tech unicorns and boost competitiveness.

“This, unfortunately, is Japan’s plight: a failure of its business institutions to make the needed adjustments from the analogue era to today’s digital world,” says economist Richard Katz, a Japan expert at the Carnegie Council for Ethics in International Affairs.

Among 34 rich countries, Katz says, Japan ranks a dismal 25th in overall digital competitiveness. “To be sure, Japanese companies spend plenty on information and communications technology,” Katz says.

The good news is that two developments suggest change is coming. One: Kathy Matsui, Goldman Sachs’ former Japan vice-chairwoman, set up the M-Power Partners venture capital fund. Its all-female board aims to support growth-stage startups that champion environmental, social and governance (ESG) values — a real rarity in Japan.

In late August, SoftBank Group, led by billionaire entrepreneur Masayoshi Son, said it’s creating a post to focus on Japanese startups. Though SoftBank’s $100bn Vision Fund lavished billions on entrepreneurs around the globe, it has essentially invested zero at home.

“We wanted to start a movement from the ground up to change Japan,” says Yumiko Murakami, an M-Power general partner. “But we can’t do it alone. So, the more the merrier.”

There’s concern, though, that Japan Inc more broadly squandered years of corporate welfare.

Nicholas Smith, Japan strategist at CLSA, says that of the 69 industries he tracks, Japanese companies trail the US and Europe in return on equity over a five-year period in 37 and lead in just six. “The need for industry consolidation and restructuring is pressing,” Smith says.

Oddly, stronger corporate governance has long been thought to be the LDP’s biggest reform win over the last eight years. This perception owes much to a UK-like stewardship code of corporate conduct imposed in 2014. Boards were encouraged to add outside directors, including welcoming more women into executive suites.

Yet the upgrades lacked clarity and teeth. They proved insufficient to head off the Carlos Ghosn drama at Nissan Motor in 2019 or the more recent dustup at Toshiba Corp over board seats. It’s the third scandal at the electronics icon in six years.

Antiquated practices still abound. “CEOs will often be on the nomination or compensation committee and chair it,” says Chris Vilburn, head of Asia stewardship at Goldman Sachs Asset Management. “I would love to be on my own compensation committee, but there is clearly an issue with [this].”

Gender equality is fertile ground for change. Early on, the Abe-Suga governments talked enthusiastically about empowering women. It was a bow to the vast amount of research showing that nations which best use female workforces are most innovative and productive. But pledges to make women “shine” amounted to little.

In fact, Japan appears to have gone in the opposite direction. In the World Economic Forum’s global gender gap report of March 2021, Japan ranked 120th, last among the Group of Seven nations. Within East Asia and the Pacific, Japan ranked 18th, just above Papua New Guinea and Vanuatu. After taking office in September 2020, Suga seldom even mentioned Womenomics, a policy introduced by his predecessor to boost women in the workforce.

“The policy priority definitely dropped,” says Nobuko Kobayashi, a partner and co-lead of the consumer practice at EY-Parthenon, the strategic consulting arm of EY Strategy and Transactions. “It’s very hard to snap out of it. So, we need some kind of a shock to the system.”

Trouble is, the force with the patriarchy remains strong despite the rhetoric emanating from government circles, says Kumiko Nemoto, a professor of management at Senshu University.

Look no further than the myriad sexist-comment scandals that tarnished the run-up to the Olympics. Former prime minister Yoshiro Mori, at the age of 83, had to resign as head of the Tokyo 2020 planning committee for complaining women talk too much.

Nemoto says that was a microcosm of how “Japanese businesses and politics continue to be controlled by men in their 70s, 80s and 90s”. After rising through the ranks of Japan’s post-war growth, she says, the older generation seem reluctant to make changes to existing corporate systems, including gender-skewed customs.

The good news is that foreign shareholders are prodding Japanese corporations to embrace global standards of workplace gender equality. But Japan is still far from being a meritocracy.

Nemoto says that women still confront “an age-based system of hierarchy, pay and promotions, plus daily overwork are central to Japan’s tradition of lifetime employment”.

At the same time, she says, promotion chances are largely determined by age, not by individual skills or performance and it can take 20 to 30 years to become a manager. Long years of work before promotion and daily overwork, combined with caretaker responsibilities, make it difficult for women to coordinate career and family and reduce aspirations for leadership.

Transition finance

Japan also needs a pro-growth energy policy. One of Suga’s boldest pledges was carbon neutrality by 2050. It falls to his successor to flesh out the policy.

These goals “are more ambitious than before,” says Robert Feldman, chief economist at Morgan Stanley MUFG Securities. “However, questions remain on consistency, budgeting, implementation, and awareness of global technology and cost trends. Given these ambiguities in the basic plan, the key driver of energy transition in Japan will likely be the economics of new energy technologies, rather than government plans.”

Regulatory tweaks are needed first, including tax incentives and perhaps even government subsidies.

In July, the BOJ set out plans for inducements that would channel lending toward greener pursuits. The hope is to prod the private sector toward greater investments in sustainability.

Perhaps, BOJ’s policy innovation could even get Tokyo there much sooner by, say, 2030. Experts reckon Tokyo could broaden the BOJ’s mandate so it can accelerate the transition away from coal, oil and other fossil fuels. This means prioritizing innovation in batteries, solar, wind and geothermal power sources to invent and commercialise ways to grow sustainably.

Right in Japan’s backyard — China, India and Indonesia — are nearly 3bn people who risk choking on rapid GDP, Feldman notes. Governments throughout the region would pay generously to balance 5% growth with cleaner skies and rivers and better public health trajectories. Who better than Japan Inc to fill the void with — and profit from — new clean-growth technologies?

What’s needed, though, is a clear government push in the direction of change and disruption. University of Tokyo’s Fukuda says: “To revitalize the Japanese economy, the implementation of effective growth strategies has become indispensable.”