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Hopes alive in Japan
Japan has enjoyed a healthy gross domestic product (GDP) growth rate over the
past two years. However, economic weakness over the past three quarters has
caused some analysts to question whether this progress marks a sustainable
improvement or simply reflects a cyclical upturn that has now passed.
The simple answer is there is no reason to worry about Japan's underlying
fundamentals. This conclusion can be reached through increasing evidence of
ongoing structural change, with key developments, including: 1) Dramatic
increase of foreign direct and portfolio investment, 2) Strong aggregate GDP
growth in 2003-2004 after more than five years of anemic growth, 3) Improving
corporate and financial efficiency and encouraging policy reforms, 4)
Increasing social acceptance of differentiation between winners and losers and
an entrepreneurial career path, 5) Accelerated economic divergence between
companies and sectors and use of mergers and acquisitions (M&A) as a
corporate finance tool, and 6) Rising interest in real estate and gradual
movement toward greater consumer demand.
Foreign investors
Many foreign direct and portfolio investors bypassed Japan during the 1990s and
early 2000s, believing other markets offered better returns. Their reluctance
was based on perceived barriers of entry as well as Japan's high cost
structure, burdensome regulatory infrastructure and a business and social
orientation that emphasized market share over profitability, seniority over
achievement, and exports over domestic consumption.
Recognizing the need for change, Japanese policymakers adopted an Action Plan
for Economic and Structural Reform in 1996. This has helped to introduce market
forces and trends that are dramatically transforming Japanese lifestyles and
the way business is conducted in Japan.
In the late 1990s, investors affected by the strained valuations that came to
characterize the dot-com era, began to look for alternatives. Finding little in
the US that made sense in their investment models, they sensed that Japan
offered a more attractive environment. As a result, several unprecedented
transactions, in which foreign investors such as Renault, Ripplewood Holdings
and Cerberus took control of major Japanese firms, including Nissan, Long Term
Credit Bank (LTCB) and Nippon Credit. Along with smaller transactions such as W
L Ross's acquisition of a local bank in Osaka, the possibilities that awaited
those willing to make the commitment needed to enter the Japanese market became
more evident. The high profitability of many of these transactions as well as
the bursting of the dot-com bubble and emergence of Enron and other scandals in
the US further encouraged investors to seek opportunities beyond US shores.
In recent years, this trend has gained serious momentum as both direct and
portfolio investors have significantly raised their exposure to Japan. Japanese
government data reveals that during the first six months of financial year
2004, foreign direct investment (FDI) into Japan reached approximately US$20.32
billion. This 144% increase was more than what was generated over the entire
2003 fiscal year.
Of this total, approximately 98% consisted of investments in service
industries, accounting for almost $19.9 billion - a rise of 219% over the first
half of FY2003. It included approximately $15 billion in finance and insurance
investments, $3.8 in telecommunications, $510 million in general services and
$128 million in real estate. Conversely, foreign investment into manufacturing
declined almost 79%, accounting for only 2% or $442 million of the total.
US direct investment into Japan rose more than 760% over this period -
consisting of almost 69% of total FDI into Japan during FY2004. Investors from
the European Union accounted for slightly over 15%. Net purchases of Japanese
equities and bonds by foreign investors totaled 15.26 trillion yen (US$146
billion) in 2004. This is the highest since the Ministry of Finance began
compiling these statistics in 1981. Net equity purchases by foreigners
accounted for 10.46 trillion yen - a 7% increase over 2003. Net foreign
purchases of bonds totaled 4.8 trillion yen. This was the first time purchases
exceeded sales in three years. In addition, as of September 30, 2004, 82 major
publicly traded companies in Japan were at least 30% owned by overseas
investors compared to 47 a year earlier.
GDP growth weakened
Government data released recently indicated Japan's real GDP contracted by 0.5%
in annualized terms during the final quarter of 2004. Dragged down by
weaker-than-expected consumer spending and external demand, this fall marked
the third consecutive quarterly contraction, following revised falls of 0.3% in
July-September and 0.2% in April-June.
For the full year, however, strong 5.8% growth during the first quarter helped
push up real GDP by 2.6% over the course of 2004. This marked a second straight
year of growth and reflects Japan's best performance since the economy grew by
3.4% in 1996. The fourth quarter data was worse than expected by economists
surveyed by the Dow Jones and Nikkei news service, who predicted an annualized
quarterly rise of 0.5%. Domestic demand remained positive, though added only
0.1% to overall growth. This was not enough to make up for weaker external
demand, which declined for two consecutive quarters. It was not due to weak
exports, which rose by 1.3%, but an even larger 3.1% rise in imports, which
were affected by rising prices and global demand for steel, energy and other
raw materials.
Private consumption, accounting for approximately 55% of Japan's GDP, also came
in lower than expected, registering an anemic 0.3% decrease during the fourth
quarter. Many analysts attribute this weakness to a relatively warm winter,
which hurt demand for clothing, and the impact of typhoons and earthquakes that
impinged on consumer spending.
Corporate optimism, however, is reflected in the 0.7% rise of capital spending
in the fourth quarter - an improvement over the 0.4% registered in the third
quarter. Corporate expenditures are expected to stay strong, with February data
revealing Japanese core machinery orders - a leading indicator of capital
spending - rose 6% during October-December over the same period the prior
quarter.
Corporate efficiency and change
One of the most important objectives of Japan's ongoing transition has been the
need to remove structural barriers. This includes cross-shareholdings,
relationship-based main bank lending and an overly cumbersome regulatory
environment. While these practices helped Japan to industrialize, they now lead
to a misallocation of resources and protect marginal companies and other
entities at the expense of the nation's overall efficiency and competitiveness.
As a result, the current slowdown, while unfortunate, may represent a blessing
in disguise. It can be seen as a long-term positive - exerting additional
pressure on companies and individuals to maintain the pace of change now taking
place in Japan. Nobuyuki Koga, president and chief executive officer of Nomura
Holdings, was recently quoted by the media as saying, "It has become clear that
there is no future for businesses that are protected only by corporate laws and
restrictions."
Substantial changes - in government policies, corporate actions as well as the
orientation of Japanese companies and the lifestyles of Japanese citizens -
have been reported. These changes are expected to continue and there are few
analysts - even among those that are not presently optimistic - who believe
that economic growth in Japan over the past few years was achieved strictly on
the basis of cyclical factors. Moving forward, Japan will need to redouble its
efforts to maintain the pace of corporate and regulatory reform. While much
needs to be done, there are already many encouraging signs.
Private sector
Aggregate pre-tax profits of listed Japanese companies is predicted to grow
19.2% to $229 billion for the year ending March 31, 2005, according to data
compiled by the Nihon Keizai Shimbun. This is the second consecutive year of
record profitability. The bad loan ratio of major banking groups fell 0.6% in
the six months preceding September 30, 2004. This is only 0.4% away from the
50% reduction goal that has been scheduled for March 31, 2005.
Japan's unemployment rate fell to a six-year low of 4.4% in December as
companies moved to hire more workers. The ratio of job openings to applicants
is also at its highest since 1992. Bankruptcies keep falling as banks continue
to clean up their balance sheets.
Listed rents for newly built office space in Tokyo rose sharply in 2004, while
overall commercial vacancy rates have fallen. This is significant given the
large amount of construction that has taken place in Tokyo over the past few
years. Vacancy rates are reported to have declined in Osaka as well and
supply-demand in areas such as Nagoya are improving. It has also been reported
that assets in private real estate funds have soared 120% over 2004 to a total
of 2.2 trillion yen.
Public sector
Japan's Legislative Council has recommended additional changes to its
Commercial Code. This includes allowing foreign investors to purchase Japanese
companies through using stock swaps from 2006. The Accounting Standards Board
of Japan plans to increase the transparency of M&A within corporate groups
by requiring that all unrealized losses be included within their income
statements.
To make local governments more independent, Japan's central government and
ruling coalition approved a fiscal reform plan in November. This will slash
subsidies over the next two years in exchange for granting local governments
greater tax collection authority.
These and many other achievements are dramatically changing the Japanese
economy. The progress can be seen in the words of Chief Economist at Merrill
Lynch Japan Securities, Jesper Koll, who in a presentation before the American
Chamber of Commerce in Japan (ACCJ) noted, "Cross-shareholding is down,
accounting transparency has improved, household propensity to save is dropping,
the cost of labor by unit has dropped since 1994, and the Bank of Japan has a
clear policy goal to end deflation."
Differentiating winners from losers
Over the years, Japan has faced significant criticism over its perceived
inability to differentiate between winners and losers. Reforms passed in the
late 1990s as well as the success of early investors, however, have helped to
dramatically change the way business is conducted in Japan. It is true many
Japanese firms resist these changes. However, the entry of companies such as
Toys 'R Us, Wal-Mart, Cisco and Starbucks as well as firms such as GE - which
has more than tripled the number of employees and doubled the revenues
generated from Japan over the past 10 years - and Pfizer, Citibank and AIG have
created a competitive need to adjust to these pressures. This is true not only
for individual firms and domestic financial institutions, sectors and regions,
but also for employees and students who are just beginning to plan their
careers.
At the same time, current changes in Japan are also helping to ease the pain of
business failure so that entrepreneurs and employees are able to start again
and assets can be put back into productive use. In fact, Ministry of Economy,
Trade and Industry (METI) data released in 2003 reveals that nearly 14% of
entrepreneurs who had filed for bankruptcy had gone on to start new
enterprises."
As Japan continues to introduce a more flexible business environment, greater
efficiencies will be achieved and winners and losers identified. Therefore,
while it was always a mistake to view Japan as a nation where everyone worked
together to pursue common goals, in the future it will be increasingly
necessary to look beyond the macro data. The resulting differentiation will
help to improve Japan's underlying competitiveness. It will also create firm-
and sectoral-level opportunities for investors who devote the attention
necessary to discerning the trends, companies, individuals and opportunities
that are best positioned to succeed.
For example, exporters have traditionally done well in Japan and their
performance has helped to drive the recovery seen in 2003-2004. Unlike past
recoveries, however, today about 80% of Japanese exports are going to China
rather than the US. In addition, the variety of goods exported are much wider,
so this activity benefits a greater number of industries. This is a positive
change and signifies the underlying competitiveness of Japanese companies and
products.
Speaking of technology exports in particular, Koll in his ACCJ presentation
noted his belief that Japan continues to "upgrade the quality of its capital
stock" and by doing so, will stay a technology leader. Koll stated that while
"this year's sexy machine, the iPod" that sold about 10 million units comes
from a US company, "approximately 40% of the components are made in Japan and
at this time can only be made in Japan".
That said, many consumer electronics companies, which had been doing very well
early in the year given the strong demand for flat panel displays, DVD
recorders and other devices are now showing slower growth. Data for December
reveals the Ministry of Economy, Trade and Industry's index for electronic
devices and parts posted a 1.7% decline and one for IT and communications
equipment dropped 4.9%. Some firms, however, such as Mitsubishi Electric Corp
and TDK are still experiencing strong profitability (29% and 10% growth
respectively during current fiscal year). Nidec, which possesses an approximate
90% share of the ultra-small hard-drive motor market, rose an even more
impressive 120%. On the other hand, Pioneer saw its operating profit decline by
95%.
Higher energy and resource prices are also affecting the Japanese economy. But
many major trading houses and other firms that focus on this sector are
benefiting from rising commodities prices. Mitsubishi Chemical and other major
chemical companies, for example, all reported record profits for the first half
of FY2004. Similarly, Komatsu forecast an 85% rise in profits due to strong
demand for its mining equipment.
Emerging Japanese venture companies are also worthy of attention. While their
small size and illiquidity place these firms beyond the reach of most foreign
investors, many show strong promise. The JASDAQ index, the oldest market for
young companies in Japan, has more than doubled in little more than two years.
There are currently 944 companies listed on JASDAQ, including 175 initial
public offerings in 2004, the highest since the dot-com bubble of 1999-2000.
The Mothers Market, run by the Tokyo Stock Exchange, lists 122 additional
companies, and the Hercules market, run by the Osaka Securities Exchange, lists
110.
The combined market capitalization of these exchanges is approximately $176
billion. That does not come close to the Tokyo exchange, which has almost 20
times their market capitalization. However, these firms represent a powerful
force. Their growing presence is helping to reshape Japan's institutional
equity culture, the ability of Japanese citizens to pursue an entrepreneurial
career path. It is also influencing the overall business culture in Japan.
Consumers show promise
Given the realization that a sustainable recovery must be based upon improving
domestic demand, analysts have been closely watching the Japanese consumer. As
latest data show that households lowered their consumption by 1.3% during the
fourth quarter of 2004, many have expressed concern whether Japan is making any
progress in stimulating consumer demand.
But a report from Japan's Cabinet Office noted that Japanese consumers grew
less pessimistic in January as the outlook for incomes and employment improved.
Confidence among households with two or more people rose to 47.4 from 44 in
December. A reading below 50 indicates pessimists outnumbering optimists. In
Tokyo, confidence rose to 47 from 43.5.
Foreign companies, including GE Capital and Citigroup, are moving to take
advantage of the growth forecast by expanding their consumer finance operations
in Japan. Their optimism is based upon recognition of the underlying
fundamentals and the fact that there is so much potential to be realized,
especially considering the consumer debt loads and extended consumption
patterns seen in the US and other markets.
Japanese firms are also moving to offer a broader range of services to
consumers. Orix Corp, for example, holds a dominant position in the
auto-leasing market. This generates over 10% of the company's consolidated
pre-tax profit. It also benefits from strong growth in real-estate-related
financial services. Orix's annual return on equity exceeds 14% - comparing
favorably with GE Capital itself. Nissin Co, a smaller firm that engages in
unsecured lending to individuals, including consumers and small business
owners, recently purchased Yamagen Securities. This will help it to expand its
offerings to include services such as investment, leasing/installment credit,
real estate financing, and insurance.
Domestic restructuring
Close relationships and cross-shareholdings between business partners and
financial institutions have traditionally protected Japanese firms from
unwanted suitors and activist shareholders. As a result, many public firms,
despite possessing attractive assets and business models, have attracted little
attention from outside investors given that there was little chance that any
transformation could be realized.
Changing regulations and lending practices, along with a generational transfer
of assets and a changing business orientation are creating a need for a wider
range of corporate finance techniques. This includes management buyouts,
M&A transactions and asset securitization. Through this process, many
corporate subsidiaries are being forced to support themselves. A recent Nikkei
account highlighted a management buyout by Omron Amakusa Corp following
original plans to liquidate and to dismiss its workforce several years ago. The
shared adjustment as an independent company and a sense of ownership within the
firm has allowed it to become profitable once again. Fifteen people have been
hired over the past two years and 13 graduates will join the company this
April.
As foreign and Japanese institutional investors, hedge funds and corporations
involve themselves in these transactions, several firms such as Tokyo-based
M&A Consulting or New York-based Steel Partners are moving to initiate
US-style takeover battles. Many of these efforts have not been successful. On
the other hand, last December, Steel Partners Japan Strategies, a US private
equity fund, decided it wasn't getting enough return on its investment in
Yushiro Chemical Industry Co, a mid-sized firm. Trading well below its book
value, Steel Partners, with an 8.9% stake, launched a hostile takeover bid.
Steel was not successful, yet to fend off this offer Yushiro management
increased the company's dividend 14 times, to $1.80 a share. They also moved to
supplement their investor relations capabilities. Yushiro's stock has since
risen over 50% in less than two months. Businessweek reported on this story and
quoted a top Steel executive who commented "the environment in Japan is
changing". Some of the impact of this and similar efforts can be seen in a
recent Nikkei Weekly article that lists seven additional Japanese firms which
have moved to enhance their investor relations capabilities - many for the
first time - in response to equity purchases by Steel Partners alone.
As more corporate and institutional investors see the potential that can be
realized in Japan, this type of activity is likely to be more prevalent.
Shareholder relations will become more important and senior managers who do not
realize their objectives and profitability targets will be required to justify
their efforts. This forecast would probably not surprise many Japanese
corporate insiders. In a recent Nikkei news survey, almost 73% of the Japanese
corporate presidents surveyed noted their belief that there would be an
increase in the number of M&A transactions between domestic companies over
the course of 2005. US and other foreign direct and portfolio investors are
advised to pay closer attention to these developments so that they might
benefit from these trends and the many opportunities that are emerging.
Compiled by the Japan External Trade Organization (JETRO) in New York in
cooperation with KWR International, Inc. |
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