TOKYO -- A quarter-century of declining results by its vaunted manufacturers is pushing Japan to face a disconcerting question -- must it accept the disinterested harshness of a U.S.-style capital market to instill discipline on the heart of its economy?
Any shift in that direction might be as shocking for Americans who have worked with Japan as it would be for the Japanese themselves. Only two years ago, a widely cited study by the U.S. Congress and Harvard Business School lauded the Japanese model for fostering investment and long-range objectives.
Conversely, U.S. manufacturers, routinely harassed by Wall Street analysts, short-term institutional investors, and takeover sharks, have often turned longingly to Japan, where such pressures don't exist.
On a more visceral level, the Japanese system provided a refuge from the layoffs and often destructive takeovers common in the United States, suggesting a more humane way of managing an economy.
Yet a protracted postwar recession in Japan has exposed a darker side of the Japanese system, according to a recent report by Shigeru Watanabe, a senior researcher of the corporate finance research group and Nomura Research Institute Ltd. and author of a recent book on the subject.
Entrenched generations of managers in cash-rich companies have made poorer and poorer decisions, abetted by what economists refer to as a lack of monitoring -- the scrutiny managers of American companies face from either shareholders in public organizations or owners in private ones.
The first sign of corporate decline in Japan began as long ago as 1969 when return on equity for Japanese manufacturing companies -- the basic measure of how efficiently they transform investment into returns -- peaked. Since 1979, the slide has been pronounced. During the 1980s, when Japanese corporate Goliaths seemed most dominant and business books on Japanese management were considered essential reading, their performance was steadily deteriorating.
Much of the erosion was dismissed as the natural consequence of being part of a maturing economy, or justified as a Japanese willingness to look beyond earnings -- or simply missed. As Japanese companies ballooned in size, earnings did in fact expand, but at a far slower pace. Toward the end of the last expansion, in 1991, roughly twice the investment was required to generate the same operating profits, Mr. Watanabe said.
Money had run ahead of ideas. A check of the bottom line showed an improvement; but taken in context of what was required to create results, the evidence suggested that Japanese industry had gotten big and fat, not strong.
The consequences of lower returns go beyond unattractive numbers on the bottom line or shallower returns for shareholders. Returns are an indication, Mr. Watanabe argues, of how effectively a society's resources are being allocated. An inability to productively use investment played a decline in Japan's overall growth rate, Mr. Watanabe said, as well as being a major cause of Japan's recent recession.
At the core of this decline, Mr. Watanabe said, is a ] "maladjustment of the basic framework of corporate management." A system of cross-shareholding places as much as 50 percent of the shares of Japanese corporations in the hands of suppliers and customers looking less for return than stable relationships. That mitigates the impact of the equity markets on lagging corporate performance.
In the past, the crucial financial monitoring performed in the United States by the financial markets was provided instead by the major Japanese banks. In the aftermath of World War II, when Japan's economy took off, manufacturers were starved for capital. The interest on bank loans was a key in determining the validity of any project. The banks themselves, as gatekeepers on a crucial resource, were allowed to play an intimate role in corporate decisions, becoming the hub of vast business groups. The banks, in turn, depended on the growth of their clients for their own expansion.
By the late 1970s manufacturing companies were essentially able to finance themselves. By the late 1980s, the companies were, on average, receiving more on interest income from
investments than they paid on their banks' loans. The banks lost their leverage, and whatever authority remained became further diluted because of the rise of alternative sources for funds. Importantly, no other outside source of scrutiny emerged.
An abundance of cash creates challenges in any complex system of organizations. The interests of owners and managers diverge and, possibly also the interests of society and managers. A common response by a U.S. corporation would be to repurchase stock, returning capital to outsiders who might rechannel it to more promising areas. But that wasn't even permissible in Japan until this month. Large one-shot dividends are similarly constrained.
Lacking the threat of corporate raiders -- or shareholder ire -- companies here have had little pressure to maximize returns. Perhaps not coincidentally, they didn't. Mr. Watanabe notes that returns on equity have fallen to their lowest level in almost half a century.
A positive consequence of the underlying resources of Japanese companies, as well as the lack of financial pressure, is how gently they have sailed through the recent economic hard times. In sharp contrast to what has occurred recently in the United States, there have been almost no layoffs.
The model for Japan may be the Toyota Motor Corp., often referred to as Toyota bank because of its multibillion dollar cash reserves and lack of any debt. It intends to trim its payroll slowly. To do so, it recently lowered the mandatory retirement age for each position.
Throughout Japan, unemployment remains enviably low, as well as the related social ills like homelessness and slums. And yet, the industry that emerges from this recession will likely retain the same problems they carried on the way in. Mr. Watanabe contends that if no changes are made in how companies are governed, inappropriate investments and declining profits will continue.
A radical shift, like cutting out cross-shareholding, could trigger an explosion in takeovers and widespread economic upheaval. In a painful and dramatic way, it may solve the problem. But Mr. Watanabe says it will ultimately prove potentially too disruptive to be accepted in Japan.
Some more modest proposals for altering the structure of Japanese companies include adding outside directors and permitting employee stock options. Mr. Watanabe said another factor within the current framework -- pride -- is already prompting many of the best companies, like the trading firms Mitsubishi Corp., Marubeni Corp., and the electrical components manufacturer Omron, to boost their returns.
"The only hope," he said, "is that "the a company itself will develop self-discipline."
Some, he acknowledges, won't change. And if too few do, the outlook for Japan's vaunted economy is grim.