The time has surely come for Japan to become an economic and financial markets leader and not simply to be dragged along by global, especially Asian, momentum. But the countrys politics are in limbo, much of corporate Japan remains conservative and retail investors are terribly timid. The commercial property market may be booming, but residential property has largely disappointed. There are a few bright spots in Japans financial markets, but certainly not in that leading indicator, the stockmarket. Mark B Johnson reports on a country losing sight of its own greatness
Oh dear, here we go again. If the recent lacklustre performance of Japanese equity indices was not sufficient cause for dismay, there is still growing uncertainty in Japans political landscape following elections in July. The governing Liberal Democratic Party, for decades Japans ruling party, lost control of the House of Councillors, the upper house of the Diet, to chief opposition party the Democratic Party of Japan, bringing the real prospect of parliamentary stalemate. In September, prime minister Shinzo Abe resigned following mounting pressure to clear the deadlock created by the LDPs defeat, after less than a year in office.
On December 17, the Nikkei 225 closed at 15,207.86, not far off a 16 month low recorded on November 21 and about 17% below the years closing high of almost 18,262 on July 9. While many felt the stockmarket was undervalued, most evidently felt that it was too early to bet on a rapid rebound.
Consumer spending, which accounts for about 55% of Japans GDP, gained a tiny 0.3% in the same period. But housing investment fell 7.8%, the biggest fall in a decade, and the lowest level since the first quarter of 1994.
These pointers suggest that the market has little expectation that Japans economy and consumer spending will fortify in the foreseeable future. Even though the economy grew at an annualised 2.6% in the July to September quarter, most analysts expected that to slow to 1% in the last quarter of 2007.
The bond market has provided little cause for optimism. As fears of cracks in the worlds financial system increased during November, Japanese government bonds (JGBs) raced upwards, as global investors fled to US Treasuries and other safe haven government credits. That brought the yield on 10 year JGBs to below 1.4% on November 22.
If government bond yields slip below 1.4% where they were for most of the deflationary period from 2001 to 2006 what signals for deflation and the countrys economic prospects would that send?
Must do better
Even if there is just enough economic momentum to see the Bank of Japan keen to make interest rates more representative of market conditions raise rates by the end of the fiscal year, few are betting on Japan breaking out of the vicious circle of negatives that include weak consumer spending, a lifeless residential property market, a dreary stockmarket, uninspiring political leadership and deteriorating demographics.
While Japan can make some of the finest products in the world in many industries, while its engineering skills and diligence are excellent, the countrys financial markets are becoming ever less prominent, especially in contrast to Hong Kong and Singapore, propelled by the emerging powers of China and India.
While Japan has in Tokyo the finest commercial infrastructure and technology, contrast its corporate finance sector is disappointing, borderline dull.
Corporate finance and capital markets innovation and issuance volume are so bland that for international bankers considering career advancement, Tokyo might now be thought of as a mere backwater, whereas a just a few years ago it was a stopping off point to greater things.
Can the boardrooms of corporate Japan help change this, and help to inspire the nation? That, like the potential for political dynamism and imagination, seems unlikely. In 2007 there has been ample evidence that Japans corporate leaders, seemingly encouraged by the actions of the regulators and judiciary, remain reactionary, occasionally intransigent, and more likely to build fences than bridges.
Bull-Dogs ominous ruling
The vast number of poison pills swallowed by Japanese companies during the early summer AGM season, as well as the prevailing conservative corporate culture, highlight the near impossibility of approved or even hostile mergers and acquisitions providing a catalyst for more corporate sector zing.
The landmark rulings by the Tokyo District Court and Tokyo High Court against US fund Steel Partners in its efforts to wrest control of Bull-Dog Sauce Co. The courts decision to support the companys different treatment of one shareholder from all other shareholders was for many a depressing outcome.
And perhaps even more discouraging than either the courts decisions or the regulators indifference was the acquiescent decision of 88.7% of Bull-Dog Sauces shareholders to support the managements resolution, deemed by many critics inequitable and discriminatory.
But, alas, they are not alone retail shareholders in Japan almost invariably support incumbent corporate leaders. After Bull-Dog Sauces case, foreign investor proposals of more than 30 companies were reportedly all rejected at shareholder meetings. This might speak volumes about the countrys culture, social structure and stability, but it also speaks volumes about favouring uniformity at the expense of adventure.
And Bull-Dog shareholders are paying a hefty price. The share price hit ¥1,776 on May 18 and on December 18 was quoted at ¥255, meaning a paper obliteration of 85.6% of the stocks value. For shareholders of a company to have rejected Steel Partners ¥1,700 per share tender offer even if Steel did present itself in a less than engaging light was plainly ludicrous given the companys miserable performance. Profits in the year to March 31, 2007 were down 18% on 2006.
Conspiracy theorists also had a field day after the July court ruling. According to the Nikkei newspaper, the National Tax Agency stated almost exactly at that time that shareholders would not be taxed for new shares "received in cases when a company exchanges equity warrants ahead of the exercise date, for the purpose of diluting the stake held by a would-be acquirer".
However, the Nikkei noted, "capital gains would be taxed when the unwelcome acquirer receives cash instead of new shares in exchange for the equity warrants", adding that the rule was to be applied to the Bull-Dog Sauce situation.
And the newspaper reported the views of economy, trade and industry vice minister Takao Kitabata before the court decision, essentially that Steel Partners was a greenmailer, quoting him as saying "There have been no examples of corporate value rising via a takeover like those pursued by Steel Partners", adding that Bull-Dogs plan to issue equity warrants to stave off the Steel Partners advance "is a legal measure under the new Commercial Code".
Toeing the line is not working
Whatever the rights and wrongs of Steel Partners takeover methodology and much of the criticism was levelled in the US as well as Japan the Bull-Dog case is seminal. Added to data emerging around the same time that Japanese companies have again been targeting cross-shareholding arrangements, backtracking on a decade of unwinding, and sceptics can see a pattern forming: given the opportunity to modernise corporate processes, Japans reaction is often to shun economic rationality in favour of toeing the line.
This, combined with the widespread reluctance of company boards to talk to financial buyers and a preference among companies to sell to a fellow company, preferably domestic, have led to a precipitous decline in leveraged buy-outs and management buy-outs.
According to data company Dealogic, the total value of LBO and MBO deals in Japan was just over $10.1bn by December 19, and that figure was already saved from near total ignominy by the buy-out of agricultural chemicals company Arysta LifeScience by UK private equity fund Permira. In 2006, when optimism about the leveraged finance market was high, some $26bn worth of deals were completed.
Japanese companies are cash-rich and so are most of the banks, especially the megabanks. So is the retail market, sitting on more than $13.5tr of savings. The reality is that Japan does not need foreign capital, and the evidence is that it does not want it, unless in an exceptional case.
But a contrasting view is that Japan desperately needs foreign capital, provided by corporate and investment fund activity that, it is hoped, will stimulate corporate reform, greater capital markets issuance, innovation and transparency. It is the foreign investors that have led the market gradually upwards since 2001. But there has not been enough follow-up support from the retail market, from the corporate sector and from the government to support their initiative.
So little of that vast pool of retail savings flows into risk assets such as equities or hard assets such as residential property; there is little over 10% of this money in securities and more than 50% in extremely low yield cash or savings. The average Japanese individual, immobilised by fear or a lack of optimism, appears to be condemning himself to arduous work deep into his 60s or even 70s, rather than investing in anticipation of incremental returns and an earlier, easier retirement.
Japan sidesteps subprime
But why take the lead, when nobody else follows? In almost an epitaph to a miserable year in the equity market for small-to-medium sized companies, which should be the lifeblood of a vibrant economy, homebuilder Hinokiya Juutaku listed on the second section of the Nagoya Stock Exchange on November 15. Not a single buy order was logged, the bourse was swamped with sell orders and the stock ended that day untraded.
In the bank sector, a dismal performer this year, foreign investors which on average hold nearly 40% of the leading banks are becoming disillusioned, partly because interest rates have failed to rise and boost their profits, but also because, lacking the sense of crisis and urgency of a few years ago, the banks seem to have slipped into a lethargic attitude.
While Japanese banks seem largely to have sidestepped the subprime landmines, this good fortune might have as much to do with a lack of adventure as it does with good judgment.
At least dividend yields are improving, even if the sheen on the latest numbers is brighter because of the weak Topix, which has fallen from a 2007 high on February 26 of 1,817 to trade below 1,500 by late November, when the weighted average yield was about 1.55%, according to Tokyo Stock Exchange data, or slightly more than the yield on 10 year JGBs, thereby providing some underpinning for the stockmarket.
Moreover, companies are embarking on more stock buyback programmes. The Nikkei reported in early November that in the six months to September, listed companies repurchased a record ¥2.7tr in common stock, up from the previous record of ¥2.1tr for the same period in 2006.
The positive spin on these initiatives is that they boost shareholder returns through both an improved return on equity and earnings per share, and they improve the demand-supply dynamic.
However, there is a more negative connotation. Critics argue the increase in buybacks is partly due to the lack of real investment opportunities in Japan, and partly because of the unwillingness of much of corporate Japan to expand via acquisition, especially overseas. And in some cases buybacks are encouraged to help defend companies against potential takeover attempts.
Property, international yen offer hope
The regulatory environment is not helping. Tighter regulations governing pre-marketing of equity issues, far tighter surveillance and rules on third party allotment instruments, the most well known of which is the moving strike convertible bond (see equity capital markets chapter on page 34), unnecessarily restrictive rules on J-Reits, which are not allowed to buy overseas assets, and a host of tax, supervisory and even court decisions are sucking the life blood out of Japans fading aspirations to be a global financial hub.
Overseas companies several years ago stopped buying businesses in Japan, being met with too much corporate, government, regional and employee diffidence. Next to curtail investment in Japanese companies might be the global investment banks and investment funds that have helped propel the countrys recovery since the 1998 financial crisis.
In the commercial property sector, things are more encouraging. Foreign investors can take control of commercial property and do not have to deal with any potentially recalcitrant senior management or non-compliant minority shareholders.
The property index of the TSE has been consolidating, falling from a 10 year high of 2,438 on February 23 to trade around 1,800 in December. But it has risen 537% from a decade low of 382.61 on March 14 2003, and has outperformed other Japanese financial markets. The commercial property market has also produced remarkable returns and has shown no signs of slowing or consolidating, with prices and liquidity soaring.
In the equity capital market, the miserable year for equity new issues volume by the end of October was down about 60%, on an annualised rate, on 2006 has partially been offset by improving distributions from companies to shareholders.
Nevertheless, even if Japan is becoming increasingly marginal as a corporate finance and capital markets centre, there are a few encouraging areas, other than commercial property and its associated strong non-recourse lending, CMBS and RMBS markets.
The yen has regained some of its former appeal as a currency for debt issuance, even if international investors remain very underweight in yen relative to the global bond indices.
Primary yen market issuance has ballooned in 2007, with Euroyen and global format yen issues up 77% annualized on 2006. And Samurai bond issuance is on track for the best year since 2000 and up more than 170% from an unusually quiet 2006, when US issuers faced tax issues, which are now mainly resolved.
Japans public sector finance market has also enjoyed a creative spell. The countrys first auction of 40 year JGBs took place on November 6, priced to yield 2.435% and continues the diversification of JGB product in the market.
But despite pockets of dynamism, Japan's corporate finance sector and capital markets are listless and uninspiring. This is a dreadful shame and terribly wasteful, not least because with the right political and economic leadership they need not be. Japan has all the ingredients needed to be a global and regional financial hub, including a wealth of corporate excellence, intellect and innovation. But time is running out for Japan to snap out of its inertia and fulfill its potential.