The Year Ahead 2024: Forecasts and Surprises

Ten twists and turns that could make for an interesting Year of the Dragon.

Forecasting is both an art and a science. Quantitative forecasts are based on probability models that cannot escape the assumption that the future will be a replay of the past. Qualitative predictions are based on a combination of experience and intuition. Like a beautiful Bach sonata, the former follows a predictable logic. Like an inspired jazz solo, the latter delivers a genuine surprise that you did not expect but cannot live without once you’ve heard it. The only certainty we have is that 2024 will bring both—existing trends evolving and genuine surprises.

I wish a happy, prosperous, and healthy New Year to you! And now here are my forecasts and possible surprises for 2024:

1. Japan’s inflation and growth outpace the United States.

We will see a full decoupling of the US–Japan business cycle in 2024 as America faces a sharp slowdown due to the 2023 US rate hikes cutting down both consumption and capital expenditure. In contrast, Japan’s economy will stay surprisingly strong, as neither the Bank of Japan nor the Ministry of Finance tighten.

2. Japan’s M&A boom goes global.

With the US recession creating opportunities to buy US companies and assets at significant discounts, Japan’s merger and acquisition activity will expand. Surprise: a major Japanese financial institution will buy a US bank, insurer, or payments company.

3. Japan’s MBO/LBO boom accelerates.

Spurred by pressure from shareholders and stock exchange, as well as low debt financing costs, management buyouts and leveraged buyouts will continue. Surprise: 2024 may be the first year when more companies go private and delist from the stock market than new startups going public and listing via IPOs.

4. Japanese CEOs step out of their comfort zone.

Rather than just relying on in-house R&D teams, Japanese CEOs will start to buy startups for future growth. One reason for US corporate dynamism is the aggressive use of “outside” innovation to supplement, improve, or disrupt “inside” businesses. Ninety percent of US startup exits are acquisitions, while in Japan, 90 percent are IPOs. Mark my words: Japan’s new generation of CEOs are taking risks and are not afraid to try and make 1 + 1 = 3 … or 4.

5. Japan’s corporate governance goes global.

So far, Japan’s corporate governance reform has been one-way, importing US “best practices” into Japanese boardrooms. A Japanese CEO appointed to a Wall Street firm’s board would be proof that Japanese governance has truly become world class. A positive surprise, yes. But if US multinationals are serious about multi-stakeholder governance, there is much to learn from Japan’s corporate leaders.

6. Japan launches its own Defense Advanced Research Project Agency.

Rising defense spending demands a fundamental rethinking of collaboration among universities, scientists, private enterprise, and public policy. Without fundamental change, the risk is that high defense spending will bring little or no positive benefit to Japan’s global competitiveness or domestic economy. The sooner Japan’s elite can agree on the rules and institutional governance for dual-use technologies and their scalable commercialization, the greater the certainty of both private and public spending on defense yielding positive multipliers.

7. Japan deregulates home-helper visas.

The combined problems of a growing labor shortage, a falling birthrate, and more Japanese women aspiring to professional careers cannot be solved without outside help for families. A very positive surprise would be if Japan followed the Hong Kong and Singapore model. There, professional couples can sponsor home helpers, with proper supervision and governance by local authorities. This is a pragmatic solution to reverse the declining birthrate and to reduce the runaway costs for public social and medical support for children and the elderly.

8. China synthetic biology moonshot delivers domestic food security.

China is the world’s largest importer of food. Dependence on the global food supply is the single biggest challenge for China’s leaders. Public and private investment in synthetic biology and the development of lab-grown and tech-assisted food is huge. The question is not if, but when, a supermassive scale-up solution will be announced by China’s biotech leaders. A science-based breakthrough on food-security for China—and thus the world—would supersize China’s credentials as the rightful global leader she aspires to become.

9. Elections shift alliances.

While all eyes are on the 2024 US presidential election in November, the vote in India in April or May could bring a big negative surprise. If Prime Minister Narendra Modi loses reelection, the impact could be far-reaching—not just for the Quad alliance comprising Japan, the United States, Australia, and India, but also the leadership of the emerging alliances around the Global South.

10. Germany wins Euro 2024.

Sunday, July 14, will bring the final of the UEFA European Football Championship. I am German, so naturally, I support Team Germany. But they have been playing shockingly poorly, and their performance has only gotten worse after they lost to Japan in the 2022 World Cup. So, the biggest positive surprise for me in 2024 would be Germany actually winning the Euro 2024 championship—especially since the final is played on the French national holiday, Bastille Day.

A Matter of Demographics

Connecting four megatrends that will shape Japan’s future.

Yes, Warren Buffett had already started buying Japanese companies two years earlier, but it was in 2023 that the global mainstream followed. The combination of cheap yen, geostrategic realities, and a newfound can-do attitude among domestic leaders has put Japan back in play as a global contender. Leaders in finance, industry, and innovation around the world are now pressed by their boards to develop concrete Japan strategies. Yokoso! Welcome back! What took you so long?

This Time Is Different

Before we get too carried away by the current Japan hype, let me outline some key forces that, in my view, will work to create sustainable Japan opportunities over the next decades, for both global and domestic companies. Here are the four Japan megatrends you and your corporate strategy must seek to exploit.

1. Demographics Forces Industrial Consolidation

Japan has about 3.6 million companies, 2.5 million of which are owned and run by founders who will be over 70 years old next year. Of these, 1.6 million do not have a successor, a son or daughter interested in taking over.

This demographic reality has unleashed a growing tsunami of mergers and acquisitions (M&As). Businesses that were never for sale are now up for grabs. Your chances of partnering with or buying a Japanese company have never been better. The M&A wave will get bigger. Roll-ups and industrial consolidation will create unprecedented opportunities for global players to raise their market share and profit from increased economies of scale.

2. Freeing Up Household Wealth

Japanese households have accumulated some $30 trillion of wealth. About $20 trillion of this is in financial assets. The remaining $10 trillion is stashed away as tansu yokin, the famous mattress money.

Again, demographics is key to unlocking real structural change. About $12 trillion of these household financial assets are owned by people aged over 70.

This means $5 or 6 trillion—or 1.3 to 1.5 times Japan’s current gross domestic product—will become unfrozen over the next decade. Even after inheritance tax, this implies a significant boost to the purchasing power of Japan’s younger generation.

Make no mistake: the legacy of the legendarily high savings rate of Japan’s baby boomers will significantly boost next-generation purchasing power. Most economic forecasts completely ignore this wealth transfer effect, thus underestimating the potential growth in domestic demand.

3. From Seniority-based to Merit-based Pay

The war for talent is intensifying and will only get worse. Japan’s young generation feels its power, and the tables have turned. Graduates are no longer begging for jobs. Companies are begging increasingly scarce graduates to join. And retention of employees is becoming tough. According to several studies, as many as one in five University of Tokyo graduates now quit their initial employer within the first five years.

Importantly, employees don’t just want higher pay. They also seek greater responsibility and impact. If you joined a top Keidanren company in the 1960s, it took on average 13 years for you to become the general manager. Today it takes 24 years.

Companies which inspire and empower their employees will pull away from those that insist on the old ways. Labor mobility will surge, and companies that offer genuine and transparent career planning and merit-based compensation are poised to move ahead. Here, global companies still have a lead, but as local Japanese companies adapt, the war for talent—and thus the need for increasingly creative leadership—will intensify. The net result? Productivity will surge, and so will employee incomes—yet another reason why standard economic forecasts are too pessimistic on domestic demand.

4. Open-Door Japan

Japan will become an immigration powerhouse. Before the pandemic, the country was on track to accept about 150,000 new non-Japanese employees per year. This more than doubled to almost 350,000 in the first half of 2023. There are now approximately 3.2 million non-Japanese residents of Japan, up from barely half a million 30 years ago. Visa and permanent-residency requirements continue to ease. Most importantly, the biggest obstacle to employing non-Japanese talent—seniority-based rather than merit-based compensation—is beginning to change. All said, it is now perfectly reasonable to expect that about 10 percent of employees will be non-Japanese by 2030. That’s more than double the current rate of just below four percent.

Common Theme

Underlying these four Japan megatrends is demographics. Far from being a negative—fewer people must equal lower consumption—Japan’s demographics will turn out to be a catalyst for positive change.

• Industries will consolidate, thus allowing greater efficiencies and economies of scale.
• The mattress-money wealth of Japanese households will be freed and reenter economic circulation.
• Increasingly scarce labor will be empowered and gain purchasing power.
• And global talent will build careers and make their fortunes here in Japan.

Importantly, all these forces represent real structural change that will remain in place for the foreseeable future.

Predictable. Reliable. Full of opportunity.

Welcome back, Japan.

In Praise of the Salaryman CEO

Japanese corporate leaders are much better than their reputation.

They are not really part of the global Davos jet set. They don’t fly around the world in their private jets. Many still proudly print the office fax number on their business cards. And in the age of the short quip, they lack a strong (or any) presence on social media. They even very much prefer to stay silent in investor-relations or press meetings.

But if you’re looking for extraordinary resilience and all-around competence to get the job done, Japan’s salaryman CEOs and their teams actually have a very impressive track record.

In fact, the data strongly suggests Japanese salaryman CEOs have absolutely nothing to be ashamed of in comparison with the superstar CEOs of Wall Street.

Decades of Growth

Since 1995, Japanese listed companies have seen their top-line sales basically stagnate, up a mere 1.1 times in 2022 from their 1995 level. But there was a whopping 11-fold surge in profits over the same period.

Anyone who has ever invested in or run a business knows how impossibly difficult it is to grow profits without the tailwinds of rising top-line sales. For one year, maybe. But for 30 years? Clearly, Japanese salaryman CEOs must have done something right.

Meanwhile, since 1995, superstar CEOs in the United States delivered a 6-fold increase in profits, generated by a tailwind of top-line sales rising 3 times. Of course, the Wall Street superstar CEOs deserve to be proud of having delivered such profits over the past 27 years. But compared with the 11-fold surge produced by Japan’s salaryman CEOs, the US superstar performance looks rather unimpressive—particularly since the salaryman CEOs got no tailwinds from rising sales. No wonder Warren Buffet is impressed by Japan’s Wall Street counterparts.

Pay for Performance

Interestingly, the impressive performance of Japanese salaryman CEOs has been reflected in their compensation. Since 1990, pay for the top CEOs has almost tripled. So, there is pay for performance in Japan for CEOs—profits up 11 times, compensation up a more modest 3 times, but still in sync with performance.

Meanwhile, in the United States, the link between corporate performance and CEO compensation is much tighter. CEO compensation has mirrored the rise in profits, both basically marking a 6-fold jump since 1990.

The biggest difference between the salaryman CEO and the superstar CEO is, of course, the absolute gap in compensation for the chief executive position relative to average employee pay. In Japan, this is now just about 12 times on average, with the top 50 CEOs making 50 times.

On Wall Street, it’s a different world altogether; the average annual salary of a CEO now is just under 400 times that of their average employee.

Put another way, a Wall Street CEO earns in one day what one of their employees earns in a year. But in Japan, it takes the 50 highest-paid CEOs about a week, and the average CEO a month to bring in what their staffers make in one year.

Don’t get me wrong. This piece is not about whether US-style or Japanese-style corporate leadership is better. It is about highlighting some of the actual performance indicators and, most importantly, demonstrating that Japanese corporate leaders did in fact deliver what had been asked of them. They focused on profits, profits, profits.

Future Focus

So why was this tremendous achievement by salaryman CEOs not reflected in higher share prices? Unfortunately, the answer is very simple: salaryman CEOs did not invest in their businesses. Since 1995, the capital expenditure (capex) of listed companies in Japan has declined by more than 10 percent. In contrast, capex for US listed companies has surged by more than 150 percent over the same period.

Also, Wall Street CEOs raised their employees’ compensation by about 90 percent since 1995, while Japan’s salaryman CEOs actually managed to decrease employee compensation almost 25 percent over the same time frame.

“Since 1995, Japanese listed companies have seen their top-line sales basically stagnate, up a mere 1.1 times in 2022 from their 1995 level. But there was a whopping 11-fold surge in profits over the same period.”

Make no mistake: share prices reflect potential returns on future corporate performance, and dreaming about future performance is basically impossible without corporate leaders investing in both human and productive capital.

The good news is that there’s absolutely no reason that salaryman CEOs cannot become great investors in their companies. In my view, because there has been a change in three parameters—human capital, technology access, and economic security—a capex and investment super-cycle is on the horizon in Japan.

A labor shortage and war for talent are forcing a complete rethink of human-capital deployment. One result is rising wages, but more important will be the growing focus on pay for performance and a shift towards genuine career development, i.e., a break with the lazy pay-for-seniority culture.

As workers grow increasingly scarce, machines and artificial intelligence will be deployed more broadly.

Ironically, the previous reluctance of salaryman CEOs to invest in better IT may turn into a classic backwardness advantage. If you’ve never embraced cloud computing, you now can go straight from hanko to blockchain. Japan’s DX protocol has a good chance of becoming best in class in the same way shinkansen bullet train technology set the global standard for high-speed railways.

National economic security and changing geopolitical realities will force new investment in supply chains and production facilities, as well as research and development centers.

Japan should be proud of its salaryman CEOs. For the past 30 years, the focus has been on growing profits by cutting excess costs (and debt), which has delivered in impressive ways. Now, the goals have been reset. You must invest and accelerate the growth of your business. Like Warren Buffet, I have no doubt they can deliver.

Japan Surprises 2023

Ten twists and turns that could make for an interesting Year of the Rabbit

Surprises are the spice of life that make us perk up and challenge our baseline assumptions. And what better time to sprinkle them on than the start of a new year? Of course, there will always be a surprise or two, but here is my annual list of possible surprises that could add up to a heaping load for Japan in 2023. Whichever may come to be, I wish a happy, healthy, and prosperous new year to all!

1. Growth of Japan’s gross domestic product (GDP) outperforms that of the United States, Europe … and China.

It has been more than 30 years since Japan’s economy last outperformed that of the United States and the Europe Union, so it would be a real surprise if Japan climbs back up this year to become the top G7 growth performer.

Chances are better than ever. While both the United States and the EU poised to be pulled towards recession by the combined effects of rising interest rates and high inflation, Japan has kept interest rates stable and boosted fiscal spending while private business investment has been accelerating. Thus, outgrowing the United States and the EU should be easy. And if, as I suspect, Japan’s consumers open their wallets after three years of austerity, the country’s GDP could even outperform China’s in 2023.

2. The Bank of Japan (BOJ) maintains zero rates, but the Ministry of Finance insists on raising taxes.

By April, the BOJ will have a new governor. Many expect the new leader will, perhaps sooner rather than later, end Japan’s extraordinary monetary policy. Of course, the BOJ will only change policy and step on the monetary brakes if the economy needs slowing down. A real shock would be if the Ministry of Finance insists that the policy braking must come via tighter fiscal policy in general and higher taxes in particular. In Japan, fiscal policy priorities tend to dominate monetary ones, no matter who runs the central bank.

3. Keidanren promotes pay-for-performance compensation.

For the past six years, prime ministers have been lobbying Japanese business leaders to increase wages. A positive surprise would be if the country’s biggest business lobby, Keidanren, agrees not only to a three-percent hike in base pay for 2023 but, more importantly, endorses a push for a structural change in Japanese employment culture: merit-based compensation where possible.

Business leaders agreeing to a simple rise in base pay for workers would be good for one year only. Business leaders pushing for reform of employee incentives, however, would create credible prospects for multi-year, productivity-led growth.

4. Prime Minister Fumio Kishida loses a vote of no confidence, calls a snap election.

In politics, Japan is a bastion of stability. In many ways, Kishida appears so much better off than most of his democratically elected peers. His Liberal Democratic Party (LDP) has a de facto supermajority in the Diet and he faces no national election until 2025. A surprise would be if Kishida were forced to call a snap election in 2023. Typically, prime ministers exercise their power to dissolve the Diet for one of three reasons:

• They are riding high in the polls and think they can gain even more seats for the LDP
• They are threatened by a revolt from within and need to keep party members in line
• They want to minimize losses as the opposition begins to capitalize on growing voter dissatisfaction with LDP rule

For Kishida, the time of maximum pressure is poised to be right after he hosts global leaders at the Hiroshima G7 Summit in mid-May. If this event does not deliver the expected bounce in his popularity, he may well be forced to take dramatic action to keep his party in line.

5. Young LDP leaders promote the abolition of the inheritance tax.

Over the coming 15 years, an estimated ¥500–750 trillion of household wealth will become unstuck due to inheritance. That’s 1–1.5 times GDP. Much of this will be used to pay down the national debt.

At more than 50 percent, Japan’s inheritance tax rates are famously high. While this makes the accountants happy, it does not create growth nor does it drive investments in future prosperity. A long-overdue, positive surprise would be if Japan’s next-generation leaders started to demand reform of the inheritance tax.

Japan could take a clue from the otherwise much-admired Nordics. Recently, Sweden cut its inheritance tax to zero and Denmark dropped its to 15 percent—policies promoting ways to channel the accumulated wealth of the baby boomers into future investments. Now that’s worthy of being called New Capitalism.

6. Japan wins major global defense contract.

Japanese national security policy made a clear turn in 2022, and the defense budget will be more than doubled, from one to two percent of GDP. A real surprise would be if, on top of increased defense spending, Japan won a major global defense contract. The greater the evidence that Japan’s spending on national security is actually an investment in global competitiveness, the happier taxpayers and investors will be.

7. Japan corporate governance goes global, Japanese on Wall Street boards.

Corporate governance reform continues to be on everyone’s agenda, yet cross-national corporate board representation has basically been a one-way street. There are now just over 70 non-Japanese serving on the boards of Japanese listed companies—a healthy if small increase from last year’s 60—but you can still count on one hand the number of Japanese nationals serving on the boards of US listed companies. There’s Oki Matsumoto at Mastercard Inc., Jun Makihara at Philip Morris International Inc., Hiromichi Mizuno at Tesla, Inc., and Yu Serizawa at the Renault Group. A righting of this imbalance would be a real surprise.

Japanese corporate governance reform has gathered considerable momentum over the past decade. In my view, a good way to judge whether true progress has been made is by whether (or when) US companies begin to appoint Japanese to their boards. At the very least, it would prove that Japan’s leaders have become more global, more open-minded, and are now capable of demonstrating to global peers how Japan-style corporate stewardship can be very relevant when building a better, more sustainable, and inclusive world. Perhaps an even bigger surprise would be US CEOs actually listening to their advice.

8. Japan develops a working quantum computer.

While the world is obsessed with speculating on whether the United States or China will win the race for technological supremacy, Japan has the potential to become a surprise champ in at least one big category: quantum computing. Specifically, Toshiba’s engineering team is, by many accounts, consistently on the cutting edge of all things quantum computing, be it the manufacturing of a physical machine or the software needed to control it. Success in creating a scalable quantum computing solution would certainly mark a welcome return of the former crown jewel of Japan’s engineering prowess.

9. China starts an Asian currency war.

My biggest worry for a negative surprise in 2023 is China being forced to dramatically devalue its currency. Why? Unemployment is rising, the economy is slowing and, since last summer, China has been trying to stimulate growth by easing both monetary and fiscal policy. If China’s economy does not respond and does not begin to accelerate by late spring, pressure will rise to use currency devaluation to help kick-start growth. China starting a currency war in Asia would force a dramatic disruption of the prospects for prosperity in Japan and around the world.

10. Kyoto receives more Michelin stars than Paris.

Since 2007, Tokyo has been the world’s culinary supercity, consistently beating Paris in the annual Michelin star rankings. The 2022 tally was 263 stars for Tokyo versus 152 for Paris. Less known is that Kyoto has been gaining on Paris and, after receiving 129 stars in 2022, could well surpass the French capital in 2023 for a well-deserved Japan one-two finish in the gourmet world cup. Of course, the real surprise would be if this double defeat were to trigger a change in Parisian waiters’ attitudes. How do you say omotenashi in French?

Supply Chain Woes

Four causes of worldwide shortages and how to address them

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Presented in partnership with Grant Thornton

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Photo: Photo by Tom Fisk from Pexels

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Nowadays, it is common to hear and to read in the news that the world is experiencing unprecedented supply chain woes. China lacks coal and paper. The United States has a shortage of toilet paper and toys. And India is low on microchips. Even we, the masses, have experienced delivery delays and found that certain items, previously one click away, are out of stock. Why is this happening? Below are four current issues that negatively impact the world’s supply chains.

1. Lockdowns (Still) in the World’s Factory: China

Economists say that companies with an overreliance on factories in China are the most vulnerable in this supply chain crisis. But this describes most companies. Back in the early 2000s, when an outbreak of severe acute respiratory syndrome, or SARS, forced China to temporarily shut its manufacturing capacity to control the virus, the country had just the sixth-largest economy in the world, with a nominal gross domestic product (GDP) of $1.4 trillion. Fewer than 20 years later, China’s economy had grown to be the world’s second largest, with a nominal GDP of $14.72 trillion in 2020.

China has also become the producer of 28.7 percent of all the world’s goods, and exports $2.6 trillion of worth of products annually. This makes it the top exporting economy. Coupled with its number-two ranking for imports, it’s no wonder China has garnered the moniker “the world’s factory.”

How did China achieve such a rise? By making itself a manufacturing powerhouse and primary recipient of foreign investments thanks to a large, cheap, but capable labor force and low tax rates. With these manufacturing credentials under its belt, and huge amounts of trade coming in and out, China became a key player on the world stage.

More than two years into the coronavirus pandemic, as vaccines were being rolled out and populations inoculated around the globe, Covid-19 became a norm in our daily lives. We all thought that lockdowns were a thing of the past. But China has continued to implement a zero-Covid strategy, loosening its grip on the population only as 2022 draws to a close under growing pressure from weary citizens.

China’s zero-Covid policy required strict quarantine, even if just a handful of cases are reported. As a result, tens of millions of people in at least 30 regions of China have been ordered to stay at home under partial or full lockdowns. How changes will affect the severity and impact of countermeasures remains to be seen. Until now, these lockdowns have caused massive disruptions to China’s manufacturing activities that have translated into worldwide supply chain interruptions.

2. Worldwide port congestions and bottlenecks

As we all get back to our normal lives and try to move on from the bad memories of the pandemic, economic activity has restarted and demand for various goods are returning to pre-pandemic levels. This hefty appetite from various economies—on top of the prevailing delivery backlogs and shortages caused by the pandemic—has put massive strain on the world’s ports. The situation has been exacerbated by various businesses trying to pile up their respective stocks in the face of supply uncertainties.

Ninety percent of global trade is transported via sea. Delays caused by port congestion have driven up the cost of many goods or, in the worst cases, caused depleted stock of some much-needed items. For example, the United States, the world’s largest importer and second-largest exporter, has seen its ports experience unprecedented cargo ship backlogs. Billions of dollars’ worth of goods are stranded off the coasts of the United States as there’s neither enough manpower nor resources to unload them. Ultimately, this causes delays in delivery to end users. The same thing is happening at major ports around the world.

This existing issue has caused cargo prices, as well as average port-to-port waiting times, to multiply to record levels.  

3. Power levels: on red alert

As businesses around the world struggle to address the ongoing logistical and manufacturing disruptions caused by the pandemic and existing production backlogs, another problem has arisen: Where to source power?

It is a given that power is necessary to fuel manufacturing capacity around the world and keep goods in production, but meeting demand means overcoming challenges.

In the Pacific, China last summer experienced its worst heatwave and drought in six decades, and its power source portfolio suffered. Hydroelectricity, the country’s second-largest source of power, yielded an all-time low output due to the much lower water levels at hydroelectric plants. To conserve electricity, the government took steps such as ordering the closure of factories, demanding that air conditioners be set to above 26 degrees Celsius, or shutting down elevators for the first three floors in some provinces. The regions affected are key manufacturing centers for semiconductors, solar panels, and batteries, and the reduced production affected some of the world’s largest electronics companies.

Europe has been on red alert since March as economic sanctions imposed on Russia for its war in Ukraine, measures which include the cessation of gas imports from Russia, have diminished energy supplies. Russian gas normally accounts for about 40 percent of European Union (EU) fuel imports. As winter starts, the EU is bracing for two scenarios—one in which a few member states experience power cuts and another in which blackouts occur in many member states at the same time. Can you imagine the famous Eiffel Tower on a lights-off schedule? The EU is also the location of some of the world’s biggest manufacturing brands, hence this development will mean further disruptions to the global supply chain.

4. Russia’s economic embargo, Part II

As the West and its allies impose costly economic sanctions on Russia to cripple its economy and ability to fund its military operations in Ukraine, they have also cut themselves off from what Russia contributes to the supply chain. Aside from oil and petroleum products, industry relies on the country for metals, including nickel, palladium, platinum, rhodium, aluminum, and copper. These minerals are key components in the production of automobiles, semiconductors, aerospace components, packaging, renewable energy, and other industrial products.

Russia also specializes in chemical production, particularly of the potassium compound potash and ammonia, key ingredients in fertilizers. This area may be impacted most as Russia accounts for roughly 10 percent of ammonia and five percent of urea production globally, as well as 20–25 percent of global ammonia exports. The country is also a significant producer and exporter of potash, delivering about 18 percent of the world’s supply in 2021. Low or no supply from Russia, combined with the existing issue of high energy prices, is likely to result in significant disruption to the supply of fertilizers for the foreseeable future.

It is very evident that manufacturing companies were caught flat-footed as these developments were thrust upon us and found to be overly reliant on certain countries to produce their products. Many have preferred suppliers for materials and labor located in countries where conditions have impacted manufacturing. As these supply chain woes were often not considered in corporate contingency plans, it is normal to execute short-term reactive solutions, such as stockpiling supplies and chartering private container ships. But companies know that these are just temporary fixes and recognize the need for permanent solutions.

Recently, we began to see companies start to implement long-term strategies to “de-risk” their supply chains. Steps may include finding new and more diverse sources of raw materials, widening the list of suppliers, and setting up independent factories in multiple parts of the world to cater to demand in specific regions, diversify operations, and minimize risk.

Even though these long-term action plans will further exhaust significant resources, it is indeed worth the investment for a company to secure its operations and, most importantly, to ensure an uninterrupted supply chain to meet consumers’ unending demand for goods.

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For more information, please contact Grant Thornton Japan at info@jp.gt.com or visit www.grantthornton.jp/en

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Who Will Buy Japan?

The yen’s rapid fall may bring deep-rooted change and rising returns

Currency markets move in the direction of maximum pain. I received this insight from one of the most successful currency-market speculators in recent history, the leader of the team that broke the Bank of England 20 years ago, on September 16, 1992.

Now that yen depreciation is accelerating toward my ¥150–160 to the dollar parabolic overshoot target, outlined in the spring 2022 issue of The ACCJ Journal, it is worth thinking about where the maximum pain threshold might be, and what forces will arrest the yen’s fall from grace. Who will buy Japan?

Land of Bargains

It is now very easy to demonstrate that Japan is cheap:

• A Big Mac costs ¥390 in Tokyo versus $5.50 in Los Angeles, making your dollar’s purchasing power double this side of the Pacific
• Japanese labor costs are down to $33,000 per year on average, less than half the $69,000 payout in the United States
• A Tokyo-based software engineer now comes about 30 percent cheaper than one based in Ho Chi Minh City, Vietnam
• And at ¥150 to the dollar, a nurse in Manila would earn more than one in Tokyo

Importantly, even without the exchange rate, Japanese companies are cheap, with 49 percent of listed companies trading below book value, their assets worth more than what you must pay in the market to buy them.

Japanese companies trade on a 12-times price-to-earnings (PE) multiple, which is cheap compared with the 24-times PE multiple commanded by those in the United States.

When buying Japan Inc., you basically earn back your investment in half the time—corporate earnings alone will let you recoup your investment in just 12 years in Japan, while you must wait 24 years in the United States. So, the costs of buying and operating productive assets has become very attractive in Japan.

Land of Opportunity?

Where, exactly, are the opportunities, and who will seize them? Here it gets interesting because, in my view, the forward-looking dynamics are poised to force much more deep-rooted change than old-style models of inward investment would suggest.

This is because the coming investment wave will be primarily in the service sector, not the industrial or manufacturing sectors.

Clearspeak: neither Japanese nor global manufacturers will begin to build significant new factories or add production capacity here in Japan. Against this, all aspects of the domestic service sector are poised for an unprecedented investment boom.

Why? For manufacturing, labor costs are an increasingly minor factor in deciding where to build a factory. Much more important is proximity to market, proximity to suppliers, and full end-market reach. Moreover, national economic security forces an additional steep discount on produce-for-export strategies. Specifically, recent US legislation has made it uneconomical for global carmakers to compete in the US market unless they produce onshore. The new subsidies and incentives to redirect energy and environmental consumer preferences in the United States dictate as much.

“When buying Japan Inc., you basically earn back your investment in half the time—corporate earnings alone will let you recoup your investment in just 12 years in Japan, while you must wait 24 years in the United States.”

To wit, within mere weeks of US President Joe Biden’s new economic policy bill having been passed, both Honda and Toyota, as well as electric-vehicle battery maker Panasonic, announced plans for new US-based production sites and research-and-development facilities totaling more than $15 billion. All this to ensure that their “made by Japan” products are eligible for the new US industrial and consumer-policy incentives. I have no doubt that the industrial onshoring wave in the United States is only just beginning.

In contrast, Japan’s service sector is poised to be swept away by its own wave of onshoring. Unlike in manufacturing, labor costs are a dominant factor driving service companies’ performance. And here, Japan has become cheap and, now, has a competitive advantage. Watch for a pickup in direct investment, with more global service giants buying into Japan following PayPal’s $2.4 billion acquisition of Tokyo-based startup Paidy last year and the growing success stories of Salesforce, Inc., Amazon Japan G.K., Yahoo Japan Corporation, Google G.K., SAP Japan Co., Ltd., Aman Resorts Ltd., and law firm Morrison & Forester LLP in Japan, to name but a handful.

All said, I am very much looking forward to seeing more and more US and global service companies buying into and expanding business here in Japan. Most important, developing a service business in Japan has become more attractive than ever, labor market mobility having increased greatly, primarily because the pandemic has freed many from traditional corporate loyalties and unlocked a quest for better opportunities and higher pay. Potential employees are available, cheap, and motivated.

Zombie Killer

What does this have to do with the yen? Well, if I am right and global investment in Japan starts to pick up, this is one potential source of demand for yen. However, in the end, it will always be Japanese investors who hold the key to the yen’s fortunes. Japan is, after all, the world’s largest creditor nation, so where Japan invests matters.

So far, Japanese investors have not been investing in their own markets. They will only do so if and when Japanese domestic companies present credible business plans and productive investment strategies. Clearly, Japanese investors do not believe the value proposition outlined above, namely, that half the companies are trading below the value of their assets. They think the assets are underutilized, are not sweated hard enough, and that Japan is a heaven for zombie companies rather than a breeding ground for corporate excellence and best-in-class performance.

Can Japanese Prime Minister Fumio Kishida’s new capitalism deliver the end of zombie capitalism? There is no question that, since the end of the bubble economy in the early 1990s, Japan’s model of capitalism has become increasingly focused on providing more-or-less-free capital in a bid to shelter local companies from the forces of asset deflation, technology-induced disruption, rising capital costs, and other forces of creative destruction.

Twenty years on, rather than having global top performers, the result is a capitalism marked more by zombie companies that drag down industry, macroeconomic performance, productivity, and financial returns. This is where Kishida’s promise of a new capitalism could have real meaning.

If new capitalism marks a departure from zombie capitalism, and actually seeks to incentivize sector-by-sector industrial reorganization and streamlining, then prospects for a true productivity-led growth spearheaded by the service sector come into sight. The combination of global entrepreneurs wanting to seize unprecedented attractions and opportunities offered by Japan’s domestic service sector, combined with domestic political capital invested in accelerating the long-overdue consolidation and reinvention of local service providers, could be an incredible force for future prosperity.

I know this is a big if, but let’s give optimism a chance.

Clearspeak: if the current pain of yen depreciation feeding cost–push inflation delivers both long-overdue industrial reorganization and the emergence of true Japanese service-sector national champions, Japan’s investors will be rewarded handsomely. This will be not just from a tactically expedient increase in yen equity allocations because, say, the United States enters a recession, but from a strategic Japan overweight position, where yen companies deliver rising returns based on, yes, the domestic service sector.

Inflation!

Who’s afraid of the big I? Not Japan.

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A specter is haunting the world economy, the shadowy specter of inflation. Economists are fiercely debating from where it has come, politicians are busy blaming their opponents and, as always, the average citizen is left with no choice but to pay up. Yes, we all know inflation is lurking all around when you now must pay $50 for your $40 haircut that you used to get for $25 when you had hair.

Japan stands out as the one economy in the world with a relatively benign inflation shock. Whereas in the United States consumer prices are up by almost nine percent from a year ago, Japan’s consumer price index prints barely above two percent. This may come as a surprise, given the global nature of the inflation shock: excess money and credit, supply bottlenecks, the war in Europe, the surge in pent-up demand as the pandemic abates. Further, the global cost-push pressures—from rising energy, electronic component, and food prices—have been compounded by a falling yen.

Oil and Oligopoly

In the United States, the price of oil is up about 60 percent in US dollars compared with the end of December. In Japan, the yen price of oil is up almost 85 percent. And yes, the United States is a net exporter of energy—and food—while Japan is one of the world’s largest importers of energy—and food.

So, how come, despite greater and more severe exposure to global inflationary pressures, Japanese consumers are much less affected by the global inflation tsunami than their American counterparts?

There are two primary reasons:

• The government here is not afraid to intervene in markets to preserve the purchasing power of the people
• Japan’s industrial structure is more cutthroat competitive

The net result of this seeming contradiction—government intervention going hand in hand with extraordinary competition—is a much lower inflation equilibrium here in Japan compared with what we get in the less interventionist and more oligopolistic US economy. There, a few producers are price-leaders and effectively control the market.

Let’s start with the industrial structure. In the United States, of all the industries in the services and the manufacturing sectors—from hairdressers to pharmacies to steelmakers and semiconductor companies—on average, the top four players in each sector control about 32 percent of their respective total market. In contrast, here in Japan, the leading four companies command less than 15 percent. Clearspeak: Japan is much more fragmented and more competitive, while the US industrial structure has been consolidated and has, de facto, become more oligopolistic.

The net result is significantly lower price power for suppliers of goods and services in Japan relative to the United States. No matter how differentiated a product or service you offer in Japan, within days or weeks, a competitor will follow suit offering something similar but at a lower price point. Remember: every two weeks, a new soft drink is launched, and just about every 12–15 years, the equivalent of the entire central Tokyo grade A office supply comes onto the market. Good luck raising soft drink prices or rent.

Capitalism without Costs

There are, of course, complex reasons that excess competition has prevailed in Japan. The first investment report I ever wrote in Japan, back in the late 1980s, was entitled Capitalism without Costs. In it, I argued that corporate Japan effectively had no cost-of-capital constraint. In contrast to those in the United States, owners of capital in Japan simply did not hold corporate executives accountable to maximize return on capital.

Today, this still holds true, because just as the changes in capital stewardship and corporate governance have shifted private-sector capital allocation closer to the US model of demanding higher returns, Japan’s public sector intervention in capital markets has been stepped up dramatically. The Bank of Japan has purchased up to 10 percent of the TOPIX equity market as well as capped the cost of long-term debt at just about zero for almost a decade.

Whether this public sector provision of a cushion in capital markets is good or bad policy is subject to debate. But, for the purposes of trying to determine whether Japan does or does not face an inflationary threat, there is no question that the reality of a relatively low cost of capital has kept many marginal companies afloat. This, in turn, continues to restrict the price power of Japan Inc. in the domestic market. If your competitors don’t have to care about delivering a proper return or profit, whoever raises prices is doomed to lose customers and market share.

Which gets us right back to the first reason Japan is not afraid of inflation: government intervention and de facto price controls.

When you analyze Japan’s consumer price index, you quickly find that about one-quarter of the goods and services for which Japanese consumers pay are subject to government rules and regulation, i.e., de facto price controls.

Healthcare services and pharma are an obvious important example, as is education, much of transportation, and several staple foods. For the last of these, the Japan Agriculture Cooperatives, commonly known as the JA Group, plays a key part in expertly balancing fiscal support for producers while preserving the people’s purchasing power.

Line in the Sand

The willingness to fight immediately against threats of inflation that undermine consumer well-being was just demonstrated by Prime Minister Fumio Kishida. In April and May, he drew a line in the sand for the consumer price of regular gasoline at ¥170 per liter and passed, in record time, a supplementary budget to fund this price-keeping operation.

Again, the contrast with US government priorities could not be greater. Not only does the Japanese government see its primary mandate as protecting its citizens from economic shocks, but it also has the necessary parliamentary control and supermajority to act decisively and quickly. It is both the willingness to act and the ability to act that, in my view, make Japan’s parliamentary democracy and model of capitalism a worthy role model for the free world.

Be that as it may, practically speaking, the fact that Japanese political leaders actually can—and do—mobilize fiscal resources in a timely manner allows much greater flexibility for Japan’s central bank. Where the de facto political gridlock in Washington makes it unlikely that government policies can be mobilized to cushion US consumers against the ills of inflation, here in Japan the government can be counted on. No wonder, then, that the United States must rely on the Federal Reserve as the lone fighter against inflation, while here the Bank of Japan gets plenty of backing from all the other parts of the policy toolkit available.

All said, the current strong surge in global inflation is very real and is definitely having a strong impact on Japan. However, the Japanese system is responding well to the challenges and is doing so on its own terms. Resilience to shocks is what Japan excels at and, in my view, the inbuilt systemic priority placed on preserving consumer purchasing power makes it unlikely that inflation will force another lost decade.

The Yen’s Fall from Grace

Who will stop it? When and why?

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The Japanese yen is on track toward a parabolic move, with global and Japanese macro players set to become increasingly aggressive in betting on an overshoot toward ¥150–160 to the US dollar.

Why? Because the same economic forces that pulled the yen out of the remarkably stable range of ¥105–110 to the dollar, in which it was boxed for the past six years, are poised to get even stronger in the coming months. No mystery, no magic, no speculative excess. We got to ¥128–131 because of a decoupling of monetary policy. With Bank of Japan (BOJ) Governor Haruhiko Kuroda digging in his heels and the US Federal Reserve now floating the idea of accelerating the pace of rate hikes to possibly 75 basis points a pop, it very much looks like the yen’s slide is just beginning.

Policymakers: United America versus Disjointed Japan

The United States is mobilizing an all-out attack on inflation—raising rates and cutting the central bank balance sheet while, importantly, policymakers, politicians, and opinion leaders are busy signaling that more aggressive monetary tightening will have to come. Nobody knows how many rates hikes are necessary, or when the US monetary brakes will start to cut into demand, but everyone agrees that a strong dollar is good for the United States’ fight against inflation. After all, it reduces import prices.

Japan, in contrast, has a central bank that goes out of its way to keep on buying 10-year government bonds, determined to assure markets—through both action and talk—that nothing has changed, that deflation is still viewed as a bigger threat than inflation.

More importantly for investors looking for clues about the yen’s direction, neither the BOJ nor the Ministry of Economy, Trade and Industry, the Ministry of Finance (MOF), politicians, nor pundits agree on whether a weak yen is good or bad for Japan. Yes, everyone does agree that imported inflation is bad inflation, but many hope that a cost-push shock is just what is needed to break Japan’s deeply entrenched deflationary mindset and expectations. Remember: not so long ago, Nobel Prize winner and chief US economic commentator Paul Krugman, along with others, argued that an inflation target of seven to eight percent may be necessary to snap Japan out of deflation.

“Neither the BOJ nor the Ministry of Economy, Trade and Industry, the Ministry of Finance (MOF), politicians, nor pundits agree on whether a weak yen is good or bad for Japan.”

Personally, my work and investments away from macro theory, hands-on deep-dives into Japanese companies dealing with corporate chief executive officers and institutional chief information officers, and direct policymaking engagement with Japan’s industrial structure and demographic realities all have me convinced that inflation/deflation in Japan is not much of a monetary phenomenon, but primarily a regulatory and structural one.

Specifically, capital markets here are more or less explicitly designed to function far differently from the capital return-maximizing axioms underlying most of monetary policy theory in general, and the transition channels from central bank action to private capital allocation in particular. In my view, Japan Inc. works more in spite of monetary policy rather than because of it. Japan’s elite is far too pragmatic and realist than to entrust allocation of capital to some textbook theoretical models or economics dogma (particularly when they come from Chicago … just kidding).

But what may be true for the economy is not true for the currency. The yen is very much a slave to the masters at the BOJ and MOF. (Arguably, the yen is the only major capital market in Japan where, after decades of deregulation and liberalization, capital does flow relatively unencumbered. For example, it follows neoliberal market principals much more so than is the case in the bond, credit, or even equity markets. This has led to a relative loss of control, with both institutional and retail investors now much less influenced by “administrative guidance” than they were in previous decades.

An Asymmetric Risk

So, right now, if your job is to make money investing in currency markets, the contrast between a united US policy elite beginning to act—and poised to do so more aggressively (on the monetary front)—and a disjointed Japan elite only barely beginning to build consensus on a potentially necessary change, you’d be a bold trader to go against the rising US rates; and stable Japan rates equal weaker yen trade.

That’s why I think an overshoot toward ¥150–160 to the dollar is more probable than a return to the ¥105–110 range seen until a couple of quarters ago. Speculating against the yen has an asymmetric risk–reward profile now.

How long will this last? What forces could break the current dynamics? Yes, eventually Japan will follow the US lead. The BOJ always does. The one time it did not—and insisted on a decoupling from US policy—Japan got its bubble economy. Nobody, least of all Prime Minister Fumio Kishida, wants to go through that again.

Photo: gintsivuskansphoto/123RF.COM

Can Kishida Change Kuroda’s Mind?

Probably not. At least not until it becomes clear that Kishida is here to last. There is an upper house election in July. After that, yes. Kishida gets to appoint Kuroda’s successor early next year. If, by then, inflation becomes a political problem, Kishida may be well advised to pick an inflation hawk. That, however, is at least six to eight months away—an eternity for currency markets.

Again, the contrast between the United States and Japan is striking. For President Joe Biden, inflation is an immediate danger—a key reason for his continuing drop in popularity. Against this, Kishida’s popularity keeps climbing, and inflation running at barely one percent is far from becoming a political make-or-break issue. However, if, against the odds, the prime minister were to pick an open fight with the BOJ before the election, he is more likely to add to a yen-depreciation speculative frenzy.

Why?

First, Kuroda is both intellectually proud and politically pragmatic. He won’t risk his historic legacy of being the governor who beat deflation without seeing firm evidence of genuine demand-pull inflation. He does not want to go down in history as yet another BOJ governor who tightened too early. And, politically, he understands more than anyone the risk that rising interest rates pose to Japan’s fiscal flexibility. With public debt at nearly 2.5-times national income, public finances will be the biggest loser if and when interest rates go up too early (i.e., before domestic demand has entered a self-sustaining upcycle).

Second, markets want to see action and facts, not talk and debate. Show me the money. And with most forecasters now predicting an outright economic contraction during the latest quarter, it’ll get even harder to deny that Japan is indeed at the opposite end of the business cycle from the United States. Again, it is difficult to argue against the yen depreciation momentum accelerating in the immediate future.

When the Facts Change

But what about longer term? What structural dynamics might unfold that could trigger a reversal of fortune for the yen? Here are five primary moves that can or will force a change of direction from yen depreciation towards appreciation:

• The United States or China accuses Japan of starting a currency war
• The United States falls into recession
• Global investors, corporates, or tourists start buying Japan assets
• Japan’s investors and corporates start buying yen assets
• The BOJ starts following the Fed

From Fears of a Yen-led Currency War

Right now, the risk of Japan being accused of starting a currency war is low. If I am right and the US elite is indeed united in fighting inflation, it will continue to welcome a strong dollar and weak yen.

But what if China were to complain about excessive yen weakness? They did so the last time the yen weakened past ¥135–140 to the dollar in mid-1998. At that time, China successfully persuaded the Clinton administration to publicly abandon the strong-dollar policy that the United States was running at the time.

But times have changed. In 2022, Chinese complaints are unlikely to get much of a hearing in Washington. In 1998, the United States was focused on getting China to join the World Trade Organization and was happy to try and be helpful. Today, the United States regards China as its principal competitor, while Japan’s position as its principal ally in Asia is firmly reestablished. The more you believe the New Cold War rhetoric as an overarching US policy priority, the less you will worry about China triggering an end to yen depreciation.

US–China Agreement on Renminbi Devaluation?

However, rather than being lulled into a false sense of security by mainstream rhetoric, a pragmatist investor will constantly evaluate actual policy developments. Specifically, the latest overtures to China made by US Secretary of the Treasury Janet Yellen, suggesting US readiness to negotiate on reducing punitive tariffs still placed on US imports, is a potentially very significant about-turn in US–China economic policy.

Will US economic policy pragmatism prevail after all? Because, yes, Americans spend almost four times more on imports from China than they do on imports from Japan ($541 billion versus $140 billion in 2021). If a weak yen and strong dollar are good news for US consumers, a weak yuan is potentially four times more powerful.

No matter what the new cold warrior rhetoric says, given the deceleration of China growth and threats from asset deflation, the immediate economic policy (and domestic political) goals of China and the United States are now complementary—China wants inflation, the United States wants deflation.

Although very much a long-shot, given Biden’s industrial policy priorities—less from China, not more—a restart of US–China trade negotiations may set the stage for a devaluation of the yuan implicitly tolerated by the US Treasury.

Of course, for Japan and the yen, renminbi devaluation tolerated by the United States would add new fuel to the yen’s decline. So, while the risk of the United States accusing Japan of currency manipulation and engaging in a currency war is low, the possibility that it would tolerate the start of a currency war in Asia may well be underestimated as a next trip wire for dollar strength.

From a Strong Dollar to the Next US Recession

Of course, dollar strength will not be in the United States’ best interest forever. The turning point will come when US recession and deflation risks overpower the current inflationary pressures. More specifically, that point comes when Fed rate hikes begin to cut into US asset prices in general, and US equities in particular.

Never before has the combination of rising rates and falling corporate profits not brought troubles to Wall Street—a bear market at best, a crash at worst. And nothing will focus the minds of the US policy elite like the specter of asset deflation.

The numbers speak for themselves. With just about 40–45 percent of US listed-company earnings coming from global sales, a strong dollar forces weaker earnings. So, while a strong-dollar policy is a welcome tool in the fight against consumer price inflation right now, eventually a switch to a weak-dollar policy will become necessary.

Of course, we can debate whether, in the United States, “this time is different”; whether the threat of stubbornly high consumer price inflation cutting the purchasing power of the people is more important than the loss of capital gains on Wall Street. The Main Street versus Wall Street debate is very real. However, in practical terms for investors, a crash on Wall Street is poised to deliver an about-turn in Fed priorities faster than you can say “American dream.” This is how the dollar’s strong run will end.

US Stagnation Fueling Protectionism in the Run-up to 2024

The bad news is that reality probably won’t be that clear-cut. It is easy to imagine what will happen in the extremes of an inflationary boom and a deflationary bust. What about something more real world, more messy, less clear-cut? Many serious forecasters are predicting a US stagnation scenario—i.e., stubborn but no-longer-accelerating inflation, with growth (and Wall Street) not crashing, rather just meandering and going nowhere.

What are the policy options then?

In my view, the US stagnation scenario will also make it tempting for politicians and policymakers to begin advocating a switch to a weak-dollar policy. The potential windfall to help turn around corporate fortunes is one reason. A more worrying dynamic is that US stagnation is poised to fuel a next wave of protectionism.

Blaming “unfair” cheap imports, pointing to China, Mexico, and Japan, then accusing them of taking jobs from US workers becomes a more tempting narrative the longer stagnation depresses any feel-good factor among US voters. This isn’t likely now, in my view—not for the 2022 mid-term elections (inflation is the more immediate problem this year)—but it becomes a credible scenario for the 2024 presidential fight.

Personally, I worry more about stagnation feeding populism more so than inflation. Under inflation, there are winners and losers. But under stagnation, all you get is an increasingly corrosive disillusionment among every part of society. The American dream very much depends on the celebration of winners; maybe that’s why stagnation will not be tolerated for long. But to get out of it, promises of radical, populist, “only I can fix it” extremist solutions are bound to gain political currency.

Be that as it may, as far as global currency markets are concerned, the higher the US stagnation risk the greater the risk of the United States abandoning its current strong-dollar policy. Moreover, who will want to buy—or even hold—dollars if US interest rates, equities, and real estate prices are going nowhere?

Who Will Buy Japan Assets?

So, it looks like it will become easier to argue for selling US assets as the United States cycle flips from inflationary boom to either frustrating stagnation or deflationary bust. But for the yen to strengthen, investors will have to buy Japan. Why, and when, will this happen? Who will do the buying?

The last point is key, in my view. There is plenty of great analysis demonstrating Japan is cheap. Here are just some of the highlights:

• Japanese equities trade on a 13-times price-to-earnings (PE) multiple, which is cheap against its own 30-year history as well as against the 22-times PE you pay for US equities (TOPIX vs SPX500)
• Japanese labor costs are now down to half (!!) of US ones, $34,000 in Japan versus $69,000 in the United States
• A Big Mac costs ¥399 in Tokyo versus $5.30 in LA, so a US tourist could get two for one

Or at least they could if Japan allowed free travel. Personally, I think the most immediate and impactful way to begin creating new marginal demand for yen is for Kishida to open Japan’s borders. Inbound tourists spent about ¥5 trillion per annum before they were shut out. Although small in absolute terms, relative to the roughly ¥500 trillion daily currency market transactions, creating net new demand for yen is poised to have a positive impact. Markets thrive on new marginal demand.

Welcome to the World, Japan Service Sector Workers and Entrepreneurs

Structurally, the fact that relative Japanese labor costs have fallen so dramatically does open opportunities for more substantial global arbitrage, creating demand for yen. Here, don’t think industrial workers, but rather computer coding, information technology, and other location-agnostic service workers. A yoga class via Zoom with a teacher in Tokyo is now almost half the price of one taught by a Los Angeles- or New York-based yogi.

In fact, several US and Israeli venture capital firms have begun scouting for software engineers based in Tokyo, Fukuoka, or Osaka to do work they had originally planned to have done in Vietnam. Again, Japan engineers are now about 30-percent cheaper than their Vietnamese competitors—never mind Silicon Valley ones.

“Japanese labor costs are now down to half (!!) of US ones, $34,000 in Japan versus $69,000 in the United States.”

Clear speak: The combination of relative cheapness and the realities of remote work and Zoom-based individual services having become more acceptable suggests there is a real chance the world will begin to buy more Japanese services. More specifically, the entrepreneurial opportunities for Japan here are enormous as a much broader section of the service sector transitions from local-only and non-tradeable to global and tradeable. Bonzai classes from a true bonzai master, anyone? This is true not just for traditional Japanese expertise but, more importantly, for newly created Japanese deep tech, patents, and all forms of intellectual property-based innovation. I expect a buying spree by US venture capitalists, snatching up previously hidden innovation bargains created by Japanese private and public scientists and engineers.

Soft Onshoring? Yes. Hard Onshoring? No.

Against this, it is highly unlikely the world will begin to build factories here in Japan. Labor costs are one factor in deciding where to build a factory, but much more important is proximity to market and suppliers. Just look at how difficult it was for the government to persuade Taiwan Semiconductor Manufacturing Company Limited and Sony Semiconductor Solutions Corporation to commit to building a new factory here in Japan.

Labor costs matter in the service sector much more so than in the industrial sector, where capital costs, stakeholder and supplier proximity, and end-market reach are the much more dominant factors. So yes, soft-onshoring—global service sector companies raising their Japan-based footprint—absolutely; but hard-onshoring by industrial companies is unlikely, in my view. Watch for a pickup in inward direct investment, with more service sector global giants buying into Japan, following PayPal Holdings, Inc.’s $2.4 billion acquisition of Tokyo buy now, pay later startup Paidy last September, and the growing success stories of Salesforce, Inc., Amazon Japan G.K., Yahoo Japan Corporation, and law firm Morrison & Foerester LLP here in Japan, to name just a few.

Clear speak: in the coming months, I shall watch carefully for signs of a pick-up in cross-border merger-and-acquisition (M&A) flows into Japan for a possible source of new marginal demand for yen that could help break the current depreciation trend.

Big Guns to the Rescue

When all is said and done, however, Japanese investors hold the key to the fate of the yen. Japan’s status as one of the major global creditors dictates as much. As long as Japanese institutional and retail investors refuse to invest in their own markets and, instead, continue to prefer global or US assets, the case for yen appreciation will be hard to substantiate.

Here it is interesting to recall the history of the world’s single biggest asset manager, Japan’s Government Pension Investment Fund (GPIF). The GPIF manages $1.7 trillion, of which about 26 percent is in global bonds and 24 percent in global stocks. In all the grandstanding about the merits or demerits of yen depreciation, it should not be forgotten that Japanese pensioners are thus a major beneficiary of yen depreciation: a 10-percent decrease in value of the currency should create a two to three-percent upside performance windfall profit (obviously depending on hedge ratios and equity/bond markets performance). I am not a public pension actuary, but some friends who are suggest it is quite possible that, at ¥140–150 to the dollar (and on current asset allocation), Japan’s public pension may actually become overfunded.

“Japanese pensioners are thus a major beneficiary of yen depreciation: a 10-percent decrease in value of the currency should create a two to three-percent upside performance windfall profit.”

Importantly, the GPIF contributed greatly to forcing the last major inflection point in the yen’s fortunes when it announced a major reallocation out of domestic Japanese government bonds into global bonds and equities during the early years of former Prime Minister Shinzo Abe’s administration.

Market participants remember well how the GPIF inflection lent credibility and broader confidence that decades of yen appreciation had come to an end. The GPIF showed the money (with Japan Post Bank and Japan Post Insurance adding welcome firepower).

Performance Pressure: GPIF Public Pension Fund Beats Private Managers

Yes, Kuroda’s BOJ launched an all-out attack on deflation in early 2013, but only when Japan’s (and the world’s) largest asset manager began to act and switched asset allocation did the yen’s fortunes inflect from decades of appreciation towards depreciation. In other words, the GPIF became the primary “agent” for transmitting monetary priorities into the real world.

No, this is not a conspiracy theory. Both the BOJ’s and the GPIF’s assets are owned by the same principal, the Japanese general public. What is interesting, however, is that Japanese private pension managers, whose principals are not the general public but company- or industry-specific employees and pensioners, did not follow the GPIF’s lead and, to this day, have maintained much more conservative allocations to global securities. In contrast to the approximately 50-percent allocation to non-yen assets by the GPIF, private pension managers have slightly less than 30 percent in overseas securities.

Given the now accelerating trend of yen depreciation, the relative outperformance of the public GPIF fund over the private, “independent” ones will, before long, add more pressure for long-overdue professionalization of the stewards of Japanese private-pension schemes. There is no question the GPIF is a best-in-class global steward of capital, while many private pension schemes here are still ensnared in clientelism, cushy amakudari (descent from heaven) positions, and a general lack of financial professionalism.

The $850 Billion Question

When will the GPIF cut non-yen allocations? The bottom line is this: When predicting the yen’s fortunes from here, the real focus for practitioners is not so much whether the US Treasury will agree to let the MOF sell its US-dollar reserves, but whether—or more specifically when—the GPIF will cut down on the global allocations that have served it so well since it started buying dollars in 2013–14, when the yen was ¥80–100 to the dollar.

Make no mistake: the GPIF has evolved into the de facto primary agent for BOJ and MOF monetary policy objectives and stands at the very core of Japan’s capitalism in general, and the transmission from savings into investments in particular. The yen will pivot and start appreciating when the GPIF announces a cut in its global allocation in favor of the deep value offered by yen assets.

When will this happen? My money is on right around the time of the Fed’s third rate hike—i.e., when equity markets have no choice but to admit that the risk-reward of buying stocks makes no sense. To wit, an equity earnings yield of five percent and falling (because earnings are in a downward cycle), and a risk-free rate of three percent and rising, will leave no other choice to the financial professionals at the GPIF and other institutions. Contrast that to an earnings yield of 7.5 percent and a risk-free rate of 0.2 percent in Japan, and you know not just where to hide but where outperformance is likely: here in Japan.

Clear speak: Japan’s deeply engrained reputation as an equity “value trap” will be corrected exactly when Japanese investors begin to recommit to their home-country risk-assets markets. If the GPIF were to lead this charge, fellow global long-term investors are bound to follow—sovereign wealth funds in particular.

But Japanese investors will have to show us the money.

Kuroda’s End Game

How can the negative correlation between the yen and Japanese risk assets in general—and Japan equities in particular—be broken? In my personal view, Kuroda is exactly right to force this realization onto local asset allocators by de facto encouraging a currency overshoot toward ¥150–160 to the dollar. The yen can—and will—be a key force to defeat the deeply entrenched bias against domestic risk assets that Japanese asset allocators have been insisting on for more than 30 years.

If I am right, the current policy decoupling between the BOJ and the Fed will lead to a much more fundamental parting. When Japanese investors begin buying Japanese risk assets instead of non-yen ones, Japanese equities will begin to rise in tandem with yen appreciation.

Although still a long shot at this stage, here is the real escape hatch for Japan from deflation. The long-established negative correlation between Japanese stocks and the currency must be broken. The fact that, for the past 30 years, Japanese equities only go up when the yen goes down while yen appreciation always depresses local stock markets.

“When Japanese investors begin buying Japanese risk assets instead of non-yen ones, Japanese equities will begin to rise in tandem with yen appreciation.”

For this to be supported by fundamentals, domestic Japanese profit margins will have to rise to above those earned from overseas operations and sales.

Here, Kuroda is doing his bit by encouraging yen depreciation, but his efforts will be in vain if Kishida and his stewards of industrial policy do not follow through. For Japanese corporate profits to rise despite yen appreciation, Japan needs a serious round of industrial reorganization and domestic investment.

This is because yen depreciation offers a potentially misleading path. At ¥110 to the dollar, Toyota Motor Corporation’s most profitable factories were the ones in the United States; at ¥130, the ones in Japan will reclaim that spot. However, this windfall is unlikely to last due to the inherent volatility and cyclicality of any exchange rate. As explained above, the moment the Fed changes direction as US recession risks rise, the dollar is set to fall.

From Kuroda’s Cost-Push Stock Therapy …

Sustainable improvements in productivity and profitability will have to be earned through business investment at the level of individual companies and industrial reorganization at the sector and macro levels.

In other words, Kishida and his team must focus on removing regulatory obstacles to industry consolidation, incentivize M&A, and push harder for technological upgrade and capital deepening. Importantly, the current round of cost-push inflation actually creates a strong tailwind for this, because companies with outdated technology and old-fashioned customer acquisition strategies are poised to be squeezed out and lose market share which, in turn, will force them to either start investing in better human and physical capital or have them seriously considering M&A.

To wit, in Japan’s various industries and sectors—from hairdressers to banks to machine tool makers—the top three companies in each command barely 15 percent of their market on average, while in the United States the top three control about 33 percent. This degree of excess competition is also born out when comparing listed companies. US equity markets are almost seven times larger than those in Japan (by market capitalization), but the number of listed companies is almost the same: 4,266 in the United States versus 3,754 in Japan. In other words, Japan Inc. is as good a definition of “red ocean” cut-throat competition as you’ll find.

… to Kishida’s New Capitalism

There is no question that, since the end of the bubble in the early 1990s, Japan’s model of capitalism became increasingly focused on trying to shelter local companies from the forces of asset deflation, technology-induced disruption, rising capital costs, or other forces of “creative destruction” by providing more or less free capital.

Twenty years on, the result is a capitalism marked more by zombie companies that drag down industry and macroeconomic performance, productivity, and financial returns rather than by global top performers. This is where Kishida’s promise of a new capitalism could have real meaning. If new capitalism marks a departure from this zombie capitalism, and actually seeks to incentivize sector-by-sector industrial reorganization and streamlining, then prospects for a sustainable decoupling of Japan’s financial performance from the exchange rate dependency will come into sight. I know this is a big if, but let’s give optimism a chance.

“If new capitalism marks a departure from this zombie capitalism, and actually seeks to incentivize sector-by-sector industrial reorganization and streamlining, then prospects for a sustainable decoupling of Japan’s financial performance from the exchange rate dependency will come into sight.”

Clear speak: if the current pain of cost-push inflation delivers long overdue industrial reorganization and the emergence of true Japanese national champions, the GPIF and other professional investors will be rewarded handsomely—not just from a tactically expedient increase in yen equity allocations because of a Wall Street downcycle, but from a strategic Japan overweight position where yen companies deliver rising returns independent of the currency’s fortunes.

Either way, the yen’s decline will stop and reverse exactly when Japanese investors begin buying their mother markets here in Japan. With a little luck, they’ll do so not just for fear of a US crash, but for realistic expectation that Japanese corporate leaders will not just sweat existing assets but begin to actually invest in both human and physical capital at home.

That’s the optimist’s view. Until then, a pragmatist should prepare for parabolic speculative overshoot towards ¥150–160.

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Japan Surprises 2022

Ten possible twists and turns in the Year of the Tiger

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With the Year of the Tiger well underway, here is my annual list of Japan Surprises. These are not baseline scenarios or probability-ranked results of quantitative models but, rather, some of the things that keep me up at night thanks to that nagging suspicion that some events could change everything. And yes, there is plenty of room for positive surprises from Japan in 2022. Enjoy, send me your comments, and I wish you a prosperous and happy Year of the Tiger.

1. Kishida’s Dream Comes True: Wages Rise 3 Percent

After decades of wage restraint and unions lobbying for long-term job stability, rather than short-term pay hikes, Japan’s job market is now super tight. The war for talent is intensifying. Prime Minister Fumio Kishida is opportunistic and right to follow his predecessor’s top-down call for higher wages; and his chances of success are higher than Abe’s ever were. Still, aggregate wage growth of more than 1.5–2 percent would be a big surprise. An even bigger surprise would be if Japan’s wage and income growth actually feeds higher consumption rather than an even bigger pile of under-the-mattress savings.

Watch out for more companies following Hitachi’s lead this year. Japan’s top conglomerate recently announced they’ll switch to hiring and promoting based on professional skills, rather than generalist ability and seniority. A switch to performance-based compensation starting this year is now corporate policy. If, as I suspect, Hitachi’s break with deeply entrenched labor compensation practices catches on and spreads to other companies, then we may see change. Japan’s average wage may not move up as much as Kishida desires, but the variance inside companies and among industries is poised to rise significantly.

This, in my view, is the reason Japan’s consumer spending could surprise on the upside in the second half of 2022: skills-based compensation equals higher job satisfaction, equals greater confidence, equals higher spending. Kishida watches out for the low end, while companies begin to incentivize human aspirations. And yes, this is exactly how Japan’s productivity boom will come about. If I’m right, prepare for positive surprises not just this year, but throughout the 2020s.

2. From Tax Liability to Regional Investments: Furusato Nozei 2.0

Japan runs one of the most innovative and successful redistribution policies in the world, its hometown tax program, furusato nozei.

Designed to revitalize rural communities, the scheme lets taxpayers nationwide buy goods and services offered by approved vendors from small towns and villages, with your purchase offset against next year’s tax bill. Of course, there are limits on how much can be deducted, but there is no question that furusato nozei works extremely well. Local producers are competing and beefing up their marketing to attract more “free-money” customers they did not have before, while Japanese taxpayers enjoy self-directing their hard-earned money towards goods and services they actually want, rather than just giving it up to the anonymous government. Make no mistake, Japan’s furusato nozei has made paying taxes fun and satisfying.

A positive surprise would be if Japanese leaders learn from this success and create furusato nozei 2.0. The current scheme channels income tax liabilities into consumption. In other words, it redirects the flow economy. A next generation version should focus on channeling assets into investments by redirecting the stock economy.

How? Just as local private producers now compete for national taxpayers’ yen, let local public leaders, activists, and politicians propose soft and hard infrastructure projects that need investment funds to get started. Again, national taxpayers all over Japan would be invited to evaluate and select the projects they want to support. When they make their investments, the amount would be credited against future fixed-asset or inheritance tax liabilities.

The economic impact is win–win. First, opening up prospects for investment money will energize local activists and leaders to get creative and propose concrete local soft and hard infrastructure improvement projects. Second, the scheme offers concrete incentives for Mr. and Mrs. Watanabe to unfreeze some of their massive pile of personal assets. Anything that can be done to turn mattress money into investments will be good for Japan.

Even better, if taxpayers can self-direct their hard-earned assets to socially productive investment projects of their choice, they will create a legacy for themselves and a better future for Japan’s coming generations. Here is a project worthy of being called New Capitalism, because the current system encourages you to do nothing but wait until your assets disappear into the black hole of inheritance tax payments.

3. Entitlement Reform: Asset-based Means Testing

Cutting public benefits and entitlements is unpopular in any country; but it is popular to tax the rich and redistribute wealth—particularly in Japan. As pressure mounts to fix runaway deficits, creative and unorthodox policy proposals to do so by cutting entitlements are being discussed.

Introducing financial means testing is one option. This is where, for example, anyone with net financial assets greater than, say, ¥10 million and no mortgage debt is no longer eligible for the full public pension or national healthcare. Here is an elegant policy solution that cuts entitlements and taxes the rich.

Importantly, asset-based means testing would redistribute wealth from the older generation (which owns the vast majority of financial assets) to the younger generation (which pays the vast majority of taxes). Yes, it’s a radical rethinking of the intergenerational contract, but nobody should be surprised by the creativity of Japan’s new generation of policymakers and politicians. Specifically, asset-based means testing is a pragmatic redistribution policy that can easily lend credibility and appeal to the design of New Capitalism. It would be a positive surprise to see concrete proposals along these lines in 2022, possibly even before the July upper-house elections.

4. Corporate Japan Starts Buying Startups

With very few exceptions, Japan Inc. has never really grown through acquisitions. In-house research and development and a proud our-team-first-and-only mentality have dominated, while mergers and acquisitions (M&As) have primarily produced turf battles and legacy redundancies rather than positive synergies. Case in point: two decades after Japan’s bank mergers, the three megabanks are still fighting shadow wars to stubbornly defend the proud legacy procedures and systems of the original partners.

For most Japan M&As, 1+1 barely adds up to 1.5. However, there has recently been some positive change, with younger chief executive officers—Recruit Co. Ltd.’s Hisayuki Idekoba, Sompo Holdings Inc.’s Kengo Sakurada, and Suntory Holdings Ltd.’s Takeshi Niinami, for example—unafraid to turn the challenges of growing through acquisitions into a real transformational opportunity. So, the 2022 surprise will be Japanese CEOs stepping out of their comfort zones and embarking on a full-blown, growth-through-acquisition strategy in general, and buying startups in particular.

The numbers speak for themselves. As in the United States, there are plenty of innovative and potentially transformative startups in Japan. Unlike the United States, Japan has establishment players that don’t buy outside innovation. Almost 90 percent of startup exits in Japan are through initial public offerings.

Meanwhile, about 90 percent of US startup exits are through acquisition. This difference in corporate growth strategy and leadership culture goes a long way in explaining the reason Japan’s established companies are less dynamic and less globally competitive than their US establishment counterparts.

In my view, a lack of startup innovation power is not Japan’s problem. The real issue is the almost utter unwillingness or inability of established players to leverage outside creativity to realize synergetic, transformational growth strategies. In fact, any analysis of the startup ecosystem in Japan quickly reveals that established corporations appear to be more interested in stealing from, or killing off, creative challengers.

No doubt this happens in Silicon Valley, but there is ample evidence that Japan’s establishment leadership culture is well behind in seeing startups and outside ventures as a pathway to new growth or a catalyst for often long-overdue internal transformation. Japan Inc. going on a startup buying spree would be a very positive surprise for 2022.

5. Japan Corporate Governance Goes Global, Japanese on Wall Street Boards

Corporate governance reform is on everyone’s agenda. Even the top stewards of US capitalism, the Business Roundtable, is advocating for a shift in focus from shareholder value to multiple stakeholder interests.

Well, thank you, but isn’t this exactly the sort of leadership at which Japanese CEOs supposedly excel? Yet, cross-national corporate board representation has been basically a one-way street. There are now just over 60 non-Japanese serving on the boards of Japanese listed companies, but you can count on one hand the number of Japanese nationals serving on the boards of US listed companies. There’s Oki Matsumoto at Mastercard Inc., Jun Makihara at Philip Morris International Inc., and Hiromichi Mizuno at Tesla, Inc. Looking beyond the United States, Japan is represented on just one other major global board, that of the Renault Group, on which sits Yu Serizawa. A righting of this imbalance would be a real surprise.

Should Japan-style corporate governance go global? Certainly not in its convoluted, insider-obsessed, accountability-light, and generally opaque manifestation of the keiretsu and post-bubble era. Reform is very necessary and has gathered considerable momentum over the past decade. In my view, a good way to judge whether true progress on corporate governance reform has been made is by whether (or when) US companies begin to appoint Japanese to their boards. At the very least, it would prove that Japan’s leaders have become more global, more open-minded, and are now capable of demonstrating to global peers how Japan-style corporate stewardship can be very relevant when building a better, more sustainable, and inclusive world. Perhaps an even bigger surprise would be US tycoons actually listening to their advice.

6. US Supply-Side Push Brings Good Deflation to the United States, World

Just as 2020 forced us all to become fast-study experts in virology, 2021 triggered a rush to understand inflation. By early 2022, the consensus was overwhelmingly that, yes, inflation is real and is structural, not transient.

The Federal Reserve is well behind the curve and will have to step on the brakes much harder and longer than we all thought likely just three months ago. The contrarian in me is thus on high alert. A real 2022 surprise would be a full-blown US supply-side recovery, pushing down prices and delivering good deflation to, first, the United States and then the world.

Possible? Absolutely. Just look at the sharp, and now increasingly structural, acceleration of US business formation, running at more than two times the pre-pandemic norm. It could well be that 2022 brings that magic combination of new enterprise meeting new super ambitious labor. It’s high time to point out that, for every three Americans who are part of the Great Resignation, there are four signing on for new (and higher-paying) jobs. All said, the real 2022 big surprise would be that, thank you, the American Dream is alive and well.

7. Bitcoin Accepted for Tax Payments

When asked to explain the difference between the US dollar and cryptocurrency, I often quip that the dollar is backed by approximately $4 trillion in tax liabilities. If these are not settled, the US government comes with guns and handcuffs to take away your freedom. Against this, bitcoin is backed by absolutely nothing. Unlike the governments of China, Japan, or European nations, the US government has remained remarkably tolerant of the open attack on the state’s currency monopoly led by crypto tycoons and evangelists. The American spirit of innovation before regulation and challenging authority appears to be alive and well. A real surprise would be if US lawmakers took the next step and moved from tolerance to acceptance. A new era of global finance will start on the day the US Internal Revenue Service agrees to accept bitcoin or other cryptocurrencies to settle tax liabilities. Until then, have fun trading crypto, but don’t ever forget to have enough of a real-dollar-liquidity cushion at least to pay your taxes.

8. China Synthetic Biology Moonshot for Domestic Food Security

China is the world’s largest importer of food, and this dependence on global food sources is perhaps the biggest tactical and strategic challenge leaders of the most populous nation face. So, it comes as no surprise that China has created massive incentives for its top scientists to speed up progress in synthetic biology in general, and the development of lab-grown and high tech-assisted food in particular. The question is not if, but when a super-massive solution will be announced by the country’s biotech leaders. The sooner it comes, the more of a surprise it will be. Just as the United States has become a net exporter of energy over the past decade, China moving towards food self-sufficiency will fundamentally change more than just trade patterns and economic dependencies. A science-based breakthrough on food security for China, and thus the world, would supersize the country’s credentials as the rightful global leader it aspires to be.

9. United We Stand: Global Covid Policy Commission

The pandemic has been with us for more than two years, yet it feels very much as though we’re nowhere close to agreeing on the optimal public policy response. Rebuilding public trust in both science and policymaking is poised to be one of the biggest post-Covid challenges. Surely, we should be able to do better than the every-strongman-for-himself response we have gotten almost everywhere. A huge positive surprise in 2022 would be the setting up of an independent global Covid policy commission, mandated to analyze—without fear or favor—all the policy measures taken around the world, including hard lockdowns, soft lockdowns, border closures, and quarantine regimes. The goal would be to acknowledge common ground for what has and has not worked.

In my view, the sooner global leaders pull together and demonstrate that they actually want to learn from the various responses to the pandemic, the better the chances that mankind in general, and public life in particular, will emerge stronger and more resilient from the calamity.

10. Germany Beats Brazil to Become Soccer World Champion

On December 18, the FIFA Soccer World Cup final will take place in Qatar. While it is still uncertain if Japan will qualify, Germany was the first team to do so. Team Deutschland not making it to the World Cup final would be not just a surprise, but a real shock. After all, I am German and, every four years, when the World Cup is held, I cannot help but unashamedly reveal a massive bias. May the best team win in 2022, the Year of the Tiger!

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This Time Is Different

A new and stronger Japan emerges

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“This time is different.” These are four very dangerous words. When you hear them, it always pays to be extra skeptical—especially in the context of someone giving you financial advice or presenting an economic forecast. Personally, I always hold on to my wallet extra tight when the “trust me, this time is different” clause is invoked. We’ve all been there in our respective professions and passions; it takes a thief to know a thief.

As an economic strategist and professional Japan optimist, I certainly do have an extra hard time trying to make my case. The legacy of Japan’s lost decades (1991–2009) is incredibly strong. I often get a similar reaction to the one that hard-core Elvis fans must get when they insist that the King lives on. However, unlike the King of Rock ’n’ Roll, the Japanese economy is very much alive. In fact, there is plenty of hard empirical evidence that Japan not only has changed, but also that it has what it takes to be an economic powerhouse—and the envy of the world in terms of economic sustainability.

So, what’s different this time? Why won’t Japan slide back into another lost decade? That won’t happen because three fundamental forces have changed from negative to positive:

• Corporate ownership
• Public policy
• Focus among the elite
• Competition Welcome

The ownership structure of corporate Japan has changed from a closed, insider-based system to an open, competitive one.

In economics, nothing matters more than ownership. Equity ownership dictates the allocation of resources. It is the very basis of power for all the essential corporate decisions: financial, strategic, human capital. Ownership defines the true corporate culture. Twenty years ago, more than half the equity ownership of Japan Inc. was tied up in mochiai (cross-shareholding). Today, it is less than five percent.

This breakdown of Japan’s keiretsu (company network) ownership structure is the key reason to be bullish on Japan. The old Japan Inc. was a system of insider capitalism that incentivized bad economic decision-making. Group banks kept lending to group companies, not on the basis of economic merit but for the sake of maintaining relationships. Supply-chain group companies were forced into utter dependence on the conglomerates and the banks that owned them. This allowed de facto zero price power and no room for competitive diversification or independence.

Imagine if your company had been built using your brother-in-law as a supplier. Cutting him off when a more efficient and better supplier emerged basically would be impossible, while incentivizing him to change his ways would take time.

In finance, the mochiai fueled a debt bubble and then kept zombie companies alive for much longer than their economic worth warranted. In management, this enforced a “closed fortress” corporate culture of rule followers and yes-man workers who, in the case of failure, had nowhere to go, because the other fortresses were not open to them.

“While the past decades were marked by defeatism and fatalism, today’s Japan is marked by ambition, confidence, and a newfound idealism.”

— Quote Source

In contrast, today’s corporate Japan has liberated itself from the group-ownership straitjacket and has turned from a membership-only club to an open-for-business structure.

The recent case involving attempted shareholder vote suppression at Toshiba Corporation proves the point. The old Japan Inc. would have gone out of its way to keep Toshiba in the group, thus holding the company’s assets hostage to continued in-group control. Instead, Toshiba’s ownership has fundamentally changed.

Outside capital has come in and the assets are being strategically refocused on core competence. This includes previously unthinkable actions. Shareholders ousted the chief executive officer and chairman, while the board has become dominated by outside directors’ opinions—even going so far as to propose a breakup of the company as the best forward strategy for all stakeholders.

Just a couple of years ago, such moves were unimaginable; but now they are happening. While Toshiba is a dramatic case, we are seeing many examples of economically rational changes in corporate strategies across all industries.

Make no mistake—this new openness has been made possible by the removal of the cross-shareholding structure. Japan Inc. has turned from being closed and insider-focused to being open; not just for business, but to new strategic partnerships, open innovation, and letting core-competence assets sweat like never before. Yes, it is different this time.

Pro-growth Policy

Public policy has changed from political instability and ad hocism to stability and pro-growth consistency.

From 1990 to 2012, Japan had one of the most unstable political leadership regimes in modern history. In contrast, today’s Japan has become a bastion of political stability. Yes, we’ve just had an election, and a new prime minister, Fumio Kishida, has taken office, but the policy team is full-on Liberal Democratic Party (LDP). In sharp contrast to the aforementioned period of regime uncertainty, today the LDP controls just about two-thirds of the Diet.

Make no mistake: Japan’s LDP is the envy of the democratic world. Unlike the situation for leaders in the United States and most European countries, where ruling parties are struggling to secure a majority, Kishida’s political and parliamentary control is rock solid. He can actually get things done. This is good news for the private sector—whether we identify as entrepreneurs, business leaders, investors, consumers, pensioners, or a combination thereof.

Of course, you may agree or disagree with some of Kishida’s policies but, most importantly, he is turning out to be completely predictable and his actions are consistent with those of his predecessors. Just like former Prime Minister Shinzo Abe, he immediately got to work and ordered a record boost in fiscal spending. Also like Abe, he instructed the central bank to reaffirm the two-percent inflation target.

Again, Japan stands out compared with the United States and European nations, which all are beginning to cut back on policy stimulus. Clearspeak: Kishida may have campaigned on promises to create a new form of capitalism; but the moment he took office, he turbocharged exactly the same old engines of growth used by his predecessors.

For the private sector, the predictability and consistency of policy is often more important than the content. The worst thing the government can do is to flip-flop. The less trust entrepreneurs and business leaders can place in stable policy—whether tax and labor laws, investment rules, energy policy, or healthcare costs—the more cautious they become. Just as Japan’s political stability during the 1960s, ’70s, and ’80s was important to her economic success, the trap of political instability and regime uncertainty was a huge negative factor cutting down corporate animal spirits and the private sector’s willingness to take risks and invest for the future.

Whether or not you like Team Kishida, the major players do have a solid track record of being pro-business and pro-growth. There’s no question that more could be done to promote entrepreneurship and growth, but the basic direction is constructive. Most importantly, a premature tightening of policy is now unlikely. Where the 1990–2012 period was marked by repetitive stop-go-stop monetary and fiscal boom–bust cycles, Team Kishida is keeping a steady course of modest fiscal and monetary support.

In turn, this creates ideal conditions for the private sector to develop not just stable growth, but to reach escape velocity. Yes, this time is different—but not because Kishida is creating a new kind of capitalism, but because he’s Machiavellian enough to begin by sticking with old and trusted methods.

Ominously, in Kishida’s inaugural policy speech to the Diet, he chose not to mention the word reform even once. He is basically the first prime minister in more than two decades to omit it. I am told this is because he sees himself as a builder, not a reformer. If so, that could be great news. Japan thrives on the concept of kaizen, (step-by-step, incremental improvements). A builder and master-craftsman is much more revered than an ambitious reformer.

A Transformed Elite

Corporate ownership and political stability are the deep structural changes that have taken place but, perhaps most importantly, the motivation and ambition of Japan’s ruling elite has found a new focus. Simply put, the rise of China from developing economy to global competitor has focused their minds as nothing else has in decades. No, Japan does not want to become an economic colony of China.

While the past decades were marked by defeatism and fatalism, today’s Japan is marked by ambition, confidence, and a newfound idealism. Whether they are new entrepreneurs, the next generation of big-business CEOs, or the new leaders of the LDP, Japan’s elite are now united in their ambition to reassert Japan’s rightful place as a globally relevant, top-tier nation and global rule maker.

Japan wants to be Japan, not the United States and not China. Nobody yet knows what the new Japan will look like, but make no mistake: a new Japan is being created.

Yes, this time is different.

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Japan as 196th

The true nature of inward FDI and how to improve it

One hundred ninety-sixth out of 196 countries. Just behind North Korea. That’s how Japan ranked in 2019 when the United Nations Conference on Trade and Development (UNCTAD) measured the cumulative stock of inward foreign direct investment (FDI) as a share of gross domestic product (GDP).1 FDI ranges from foreign companies setting up new facilities to them buying domestic companies. What a shocking result considering the 20 years Tokyo has spent trying to increase its cumulative stock of FDI.

Unless policymakers understand why past efforts have failed, Tokyo is unlikely to realize the new goal it announced in June: to hike inward FDI to 12 percent of GDP by 2030. That would triple today’s ratio. The main hurdle is Japan’s impediments to carrying out the primary form of FDI, namely, foreign companies buying healthy ones to gain a built-in labor force, customer base, brand name, suppliers, and so forth. Typically, in a rich country, 80 percent of inward FDI takes the form of mergers and acquisitions (M&As). In Japan, it’s only 14 percent.

While the government has yet to see the light, two new conditions may drive substantial change anyway.

One of these is a succession crisis at small and medium-sized enterprises (SMEs). Over the coming years, according to the Ministry of Economy, Trade and Industry (METI), 600,000 profitable SMEs may have to close because their owners are over age 70 and have no successor. Up to six million jobs are at risk.

To prevent this, a 2020 interim report of the cabinet-level FDI Promotion Council advocates helping these SMEs find suitable foreign partners by “facilitat[ing] business transfers between third parties,”; in other words, M&As. Unfortunately, the final report, published in June, has purged all talk of inward M&A. Clearly, some powerful forces feared foreign purchases more than the closure of hundreds of thousands of healthy companies. Still, the fact that the proposal even made it to the interim report is an encouraging sign.

A second potential driver is the push for corporate reform, as exemplified by the 2014 Stewardship Code and the 2015 Corporate Governance Code. The latter was proposed to the government by Nicholas Benes, a former American Chamber of Commerce in Japan (ACCJ) governor. Many ACCJ leaders believe that, as listed corporations face increased pressure to focus on profitability rather than just sales, they will increasingly focus on core competencies. Consequently, they will hive off lackluster divisions as well as hosts of affiliates that some other company could operate more productively. If so, this will not only boost Japan’s growth rate, but also greatly increase the number of companies available for foreign purchase.

To assess these potential drivers, let’s examine the lay of the land.

Sine Qua Non of Successful Reform

Increasing FDI was incorporated into Japan’s growth strategy by Junichiro Koizumi during his time as prime minister (2001–06). That was a welcome reversal of attitude. Hardly any country has succeeded in economic reform without embracing inward FDI. Success stories range from the developing countries of Asia to the Eastern European transition states to mature economies. A study of 19 rich countries—where cumulative FDI had risen from six percent of GDP in 1980 to 44 percent by 2019—shows that inward FDI mainly lifted growth by improving output per worker.

It is not the higher efficiency of foreign-owned enterprises that provides the main fillip to the host country. Rather, it’s the spillover effects as their new ideas boost the performance of local suppliers, business customers and, sometimes, even competitors. For example, when Japanese automakers took “transplant” factories to North America, Detroit learned that it cost less to prevent defects in the first place than to fix them afterwards. Japanese economists, such as Yasuyuki Todo, Toshihiro Okubo, and Kyoji Fukao, have found that foreign firms bring similar spillover benefits to Japan.

When Koizumi came to power in 2001, the stock of inward FDI was a minuscule 1.2 percent of GDP. In 2003, Koizumi vowed to double FDI. In 2006, he set a goal of five percent of GDP by 2011. At first, there was marked progress; by 2008, FDI had risen to four percent.

Then momentum stalled. Despite Prime Minister Shinzo Abe’s 2013 pledge to double FDI, as of 2019 the ratio had barely risen to 4.4 percent. That figure is dwarfed by the 44 percent median ratio in other rich countries. To make matters worse, the government glosses over how badly it has failed. The Ministry of Finance (MOF) reported that inward FDI climbed to ¥40 trillion in 2020, thereby ostensibly achieving Abe’s goal. In reality, however, the 2020 figure was just ¥24 trillion, according to the International Monetary Fund (IMF), the Organisation for Economic Co-operation and Development (OECD), and UNCTAD.

How is such a huge discrepancy possible? Two sets of numbers are approved by the IMF, but only one—called the directional principle—is authorized for looking at a country’s FDI over time or for comparing countries. MOF, by contrast, highlights the other set, called the asset/liability principle. The latter has its uses, but it also includes items having nothing to do with real FDI (e.g., loans from overseas affiliates back to their parents in Japan). A spokesperson for MOF confirmed that such loans accounted for most of the discrepancy. Asked about MOF’s choice of numbers, an OECD official replied: “The directional principle is better suited to analyze the economic impact of FDI. It is the recommended presentation for FDI statistics by country and industry.” If solving a problem requires recognizing that you have one—in this case low levels of inward FDI—then Tokyo is in trouble.

Why Did Japan Come in Last?

FDI has soared in other countries that switched from resisting FDI to welcoming it. In South Korea, inward FDI has leaped from two percent of GDP before reformer Prime Minister Kim Dae-Jung came to power in 1998 to 14 percent today. In India, the share has jumped from 0.5 percent in 1990 to 14 percent now. In post-Communist Eastern Europe, the ratio has mushroomed from seven to 55 percent. Why, then, have Japan’s efforts failed?

In its June policy statement, the FDI Promotion Council wrote as if Japan didn’t appeal to foreign companies. Hence, most of its focus was on creating an “attractive business environment.” But the premise is inaccurate.

In survey after survey, multinational companies list Japan as a top target due to its large, affluent market, well-educated workforce and customer base, high technological levels, and so forth. In fact, Japan came in fourth out of 27 rich countries in the 2020 Kearney Foreign Direct Investment Confidence Index, an annual, global survey of senior executives conducted by the US-based global consultancy Kearney. Scholars Takeo Hoshi and Kozo Kiyota calculated that, if Japan performed like other countries with similar characteristics, the ratio of inward FDI to GDP would have already reached a very impactful 35 percent by 2015. In the 2021 survey, Japan slipped to fifth overall, but topped the list for economic outlook in net terms. Business leaders were most optimistic about Japan, Germany, Canada, and Switzerland, with the United Arab Emirates and Australia tied for fifth.

The real problem is that Japan’s most attractive companies are largely off limits to foreign purchasers. The press covers the spectacular exceptions where foreign enterprises rescue failing giants such as Nissan Motor Corporation, Sharp Corporation, and Toshiba Corporation. But the data shows that most foreign investors seek good companies that can not only help their sales in Japan, but offer resources that enhance the parent’s global expansion. By contrast, most domestic purchases are largely rescue operations. The foreign firms are not pursuing companies that need downsizing. In fact, the usual Japanese target for foreign acquisition has higher profits, better technical capacity, and a greater willingness to adopt new practices than the typical organization in its industry.

Foreign companies also select fairly sizeable targets. From 1996 to 2020, non-Japanese paid $112 million for nongroup companies on the stock market and $60 million for unlisted ones. Domestic buyers bought much smaller companies: group members worth just $11 million and nongroup companies worth $30 million.

Unfortunately, the most attractive SME targets are out of reach because they belong to corporate groups—the vertical keiretsu (company networks). Japan’s 26,000 parents and their 56,000 affiliate companies employ 18 million people, a third of Japan’s employees.

This does not count other attractive companies among unaffiliated subcontractors and closely allied suppliers where the parent holds no company stock. The Toyota Group, for example, has 1,000 affiliates plus 40,000 suppliers, of which the majority are subcontractors. From 1996 to 2000, non-Japanese were only able to buy a trifling 57 member companies of corporate groups, whereas they bought about 3,000 unaffiliated companies.

This obstacle is a legacy of the early postwar era, when Tokyo restricted FDI out of fear of foreign domination. In the 1960s, when Japan had to liberalize to join the OECD, the government devised what it called liberalization countermeasures to create structural impediments. These ranged from reviving cross-shareholding among corporate giants and their financiers, to shoring up the horizontal and vertical keiretsu.

Under Koizumi, with input from ACCJ leaders such as Benes and despite the resistance of the Keidanren (the Japanese Business Federation), Tokyo reformed the company law in 2007 to make inward M&A easier. For the first time, foreign companies were allowed to use cash in so-called triangular mergers to buy 100 percent of a Japanese company’s stock and, for the first time, they could use their own stock to pay for a company using a triangular merger. In both cases, they could squeeze out small holders of stock.

In a triangular merger, the foreign buyer sets up a Japanese subsidiary as a vehicle for the purchase, and that subsidiary must meet certain conditions. Would-be buyers still face some unwieldy rules and unfavorable tax treatment, including the way capital gains are counted and taxed in stock swaps.

The good news is that, over time, many of these formal hurdles in the M&A rules have been ameliorated, or companies have found a way to outflank them, according to Benes, ACCJ FDI and Global Economic Cooperation Committee Chair Kenneth Lebrun, and former committee co-chair Bryan Norton.

Both Lebrun and Benes have, in their professional careers, represented companies involved in inward M&A. The reported intention of Western Digital Corporation to use a stock swap to pay about $20 billion for Kioxia Corporation (the chip company spun off from Toshiba), will be a test case for the ease and cost of using an option that is more common and less tax-burdensome in other countries.

Despite the remaining legal and regulatory hurdles in rules, the biggest impediment these days, said Benes, is the reluctance of companies to sell off divisions or affiliates to foreign strategic buyers. Yet he added that, largely due to governance reforms, even here the ice is beginning to crack.

“The difference now compared with 2005 is like night and day. Domestic M&A is common and, in some cases, shareholders have forced management’s takeover defenses to be dismantled. This new atmosphere may be the biggest reason to expect more FDI via M&As in the future. Still, the floodgates will open more slowly than is optimal for Japan.”

Despite this progress, many legacies of the past—from the vertical keiretsu to obsolete attitudes among some policymakers—still curb inbound M&As. One prominent US business executive noted how Toshiba’s management and METI used the pretext of “national security concerns” in a failed attempt to block a shareholder vote against management. He feared that the same thing might occur in other cases.

Officials sometimes claim they are simply acquiescing to the public’s fear of foreign takeovers. The reality is that the government lags a big change in the public mood. As early as the mid-2000s, 47 percent of respondents in surveys said the impact of foreign companies on the Japanese economy was positive, whereas only eight percent thought it was negative. Just four percent held the once-common view that foreign companies and financiers were “vultures” who wanted to buy Japanese companies on the cheap and then sell them to make a quick buck. Twenty percent of respondents said that they wanted to work for a foreign business while another 20 percent said that they did not want to. The rest offered no opinion.

Business leaders are divided. While the Keidanren has often been obstructionist, the more progressive Keizai Doyukai, the Japan Association of Corporate Executives, has welcomed FDI. In 2005, during the debate over Koizumi’s Commercial Code reforms, it called for increasing inward FDI to 10 percent of GDP, twice Koizumi’s goal. It advocated revising the tax code to allow deferment of capital gains taxes on M&As financed via stock swaps while warning against proposals that would impose a more difficult capital gains tax environment. In a 2015 document, it once again advocated better tax treatment of inbound M&As.

Keidanren, by contrast, recalled Benes, successfully lobbied METI to make the tax treatment for cross-border stock swaps as “burdensome and difficult as possible.” At the very last minute, a senior METI official reversed the agreement that its own team in charge had already agreed on with MOF for convenient tax treatment. Unfortunately, the Keidanren continues to have much more sway with the government on these matters than does the Keizai Doyukai.

Three Drivers

Could inward FDI take a leap forward despite the government’s resistance to inward FDI? Yes, it’s possible because of three drivers. First, as detailed above, is the sea change in attitudes among the general public as well as parts of the business community and some officials. Second is the succession crisis at SMEs, also noted above. If necessity truly does give birth to invention, this could be the entrance ramp to making inward M&A a standard tool. How many 70-year-old owners of SMEs would refuse to sell to a foreigner, let their business die, and leave the employees jobless if the government or a big trading company made the introduction and vouched for the buyer’s intention to help them grow rather than engage in mass layoffs?

Japan already has a number of companies, such as Nihon M&A Center Inc., which arrange domestic M&As for healthy SMEs with no successor. That has made M&As more acceptable. So far, however, almost none of these cases have involved foreign buyers. There is also Japan Invest, a program of the Japan External Trade Organization (JETRO), which actively courts foreign companies to set up greenfield operations in Japan; but it makes no effort to recruit foreign companies to buy Japanese ones. Inbound M&A should be added to JETRO’s mandate. Japan’s giant sogo shosha (general trading companies) and megabanks, with their skill sets and extensive networks inside Japan and overseas, are very well suited to act as matchmakers for inbound M&As for these SMEs. It could be a very lucrative business for them.

Studies show that SMEs are more likely to sell to a foreign company if they see that other SMEs have done so successfully. Hence, as foreigners buy and improve SMEs, the process is likely to snowball.

Will better corporate governance become a driver? Many US executives expect that it will. Speaking of return on equity (ROE), one noted: “Ten years ago, when I used the term ROE, many Japanese executives asked me what I was talking about. Not these days.” Some analysts point to companies such as Hitachi, Ltd. and Shiseido Japan, Co., Ltd. that sold healthy divisions to foreign private equity (PE) firms to focus on their most lucrative activities. Lebrun noted that, “the stock market has certainly rewarded companies that are taking these steps.”

This logic may eventually bear fruit, but it will take years to see how much impact these reforms will have. Hitachi and Shiseido are the kind of globally active corporations that are most likely to improve efficiency for their own strategic reasons, not because of new governance rules. In fact, Hitachi began divesting before the change in the two codes. While “select and focus” has been a big buzz phrase in boardrooms during the past decade, it’s hard to find data measuring how much the typical corporate giant has really implemented it, either by narrowing the range of products or shedding affiliates. In any case, the total number of subsidiaries and affiliates in 2017 was more or less the same as in 2007.

In anticipation of a boom in carve-outs, KKR, Bain & Company, Inc., CVC Capital Partners, and about 80 other domestic and foreign PE firms are building up their war chests. So far, however, the anticipated upsurge has yet to emerge. Since 2004, there have only been 10–20 domestic divestitures above ¥10 billion ($100 million) to PE firms per year, a figure that has not increased over time.

The typical sale has been priced at about ¥50 billion ($500 million), with the notable exception of 2017, when a group led by Bain paid $18 million for 40 percent of Toshiba’s memory unit. There has so far been no trend increase in the total value of deals. The delay, Bain commented in a 2018 report, is due to the fact that there is still “insufficient pressure on corporates to sell quality assets” and that “boards and shareholders do not yet push for strategic divestitures,” i.e., selling profitable but lackluster units that don’t enhance core competencies. Instead, Bain added, corporations are taking easier routes to show better ROE numbers, such as stock buybacks and selling low-quality assets, namely, those that are unprofitable or suffer declining sales and a worsening competitive position.

Regardless of any rules on paper, shareholders’ power over management is limited by a simple financial fact: Japan’s 5,000 biggest corporations have little need to raise money on the equity markets to fund new investments, since their internally generated cash flow regularly surpasses their investments in new plant and equipment. The overall decline in stable shareholders (i.e., cross-shareholders plus other management allies) should be a force for improving shareholder power. However, as Benes points out, the Financial Services Agency (FSA) has issued rules that make it hard for minority shareholders to act collectively to make suggestions to management, as they can in the United States and the UK.

Beyond that, companies can make financial measures look better without any improvement in real efficiency. For example, if companies use current profits to measure ROE or return on assets (ROA), then the Bank of Japan’s continual lowering of interest rates will make the measures look better. However, when ROA is measured in terms of operating profits—profits before interest—it’s hard to find much improvement so far.

At the 5,000 biggest corporations during 1996–2012, ROA averaged just 3.5 percent. It rose only a smidgeon to 3.8 percent from 2013 to 2019. Worse yet, these companies increased their profits primarily by cutting wages rather than improving efficiency. In 2019, operating profit per worker was 70 percent higher than in 1996, even though sales per worker were only three percent higher.

How did companies pull that off? By cutting wages three percent per staffer and thereby shifting a big chunk of value-added from wages to profits. However, for an economy to be healthy, it is necessary for productivity, profits, and wages to grow in tandem. Unless shareholders care how better profit numbers are achieved, it’s not clear how increased shareholder power would lead to more productive corporate strategies.

Perhaps changes in corporate governance rules, the succession crisis, and other drivers will eventually add up to a force powerful enough to alter deep-seated mindsets regarding product diversification, vertical keiretsu, and sales to foreign strategic investors. Still, the likelihood is that the magnitude of change required in inward FDI will require a concerted policy effort by the government and business leaders. Otherwise, when 2030 arrives, Japan might still be little better than in 196th place.

This article was adapted from Katz’s forthcoming book on reviving entrepreneurship in Japan.

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Misplaced Pressure

National security must strengthen, not close, Japan Inc.

The government of newly elected Japanese Prime Minister Fumio Kishida deserves to be congratulated for having elevated national security to a top priority by establishing the new position of economic security minister, filled by former Ministry of Finance bureaucrat Takayuki Kobayashi. Global investors and business leaders will certainly welcome the creation of a “control tower” to coordinate, focus, and, hopefully, streamline the increasingly complex trade and investment rules and directives now governing global engagement with Japan Inc.

Unfortunately, there is significant risk in this undertaking. More bureaucracy can easily backfire. Instead of streamlining and centralizing procedures, there is a great danger of duplication and increased bureaucratic red tape, given the vested interests and institutional pride of the incumbent ministries.

Kishida’s new ministry could end up making it more difficult and cumbersome for global investors to buy Japanese companies and trade with Japanese suppliers. In the name of national security, the new Ministry of Economic Security could actually bring on a new trend of insularity and ossification in corporate Japan.

Path to Security

Of course, it is easy to understand the reason Japanese leaders feel pressured to follow the lead of the United States in seeking to raise bureaucratic and political oversight over global investment flows.

However, the fact that all this happens in the name of supposedly protecting national security is, in my view, the real red flag. Why? Because the best way to ensure economic security is to ensure that your nation’s corporate sector is strong, innovative, and globally competitive.

If corporate Japan is to have a bright future, it certainly needs more active debate with the stewards of global finance. And yes, sometimes the investors’ threats to challenge board members and existing corporate structures are absolutely key to the mid- and long-term competitiveness and sustainability of all stakeholders.

In fact, the empirical reality of Japan’s market verifies this point with great clarity. Almost all successful corporate turnarounds in past decades originated in either substantial foreign direct investment (FDI) or global investors’ lobbying for change. Nissan, Sharp, Sony, Fanuc, and Shiseido are just some of the highlights.

Make no mistake: for global relevance and future competitiveness, the more interaction with global investors, the better it will be for Japan’s national competitiveness and, thus, her national security.

Poison Pill?

Leveraging global investor knowledge and insight is an existential imperative for Japan. For all the talk about self-sufficiency, let us remember that slightly more than 60 percent of listed companies’ profits come from global sales. From here, Japan’s domestic economy probably will see lower growth than other global markets, so the need for more global and open perspectives—as well as challenges to the status quo—are poised to grow in importance.

Unfortunately, some Japanese leaders appear ready to use the powers of the new ministry to shut out global challengers and justify business as usual behind the excuse of national security.

Clear speak: Kobayashi could easily find himself leading a “poison pill” ministry, preventing necessary renewal and innovation. Domestic corporate leaders will get busy and, in the name of national security, lobby the new ministry for protection. The new ministry could easily become a creeping liability for the future dynamism and global competitiveness of corporate Japan. Clearly, corporate ossification and a retreat from globalization cannot be in Japan’s national interest.

Specifically, new and tighter rules are poised to, in effect, shut out Japanese companies from the forces of the global competition for risk capital. Under the mantle of national security, this could also feed complacency and stagnation. Already, Japanese conglomerates have fallen behind in many new leading-edge areas, such as cybersecurity, quantum computing, and drone technology.

Whether we like it or not, global finance is the most efficient and effective tool to force senior management to stay on top of their game. Therefore, there is a great risk that the new rules will merely protect already outdated technologies, feeding a new breed of so-called zombie companies in Japan. This is particularly true since, unlike the United States, where the move toward tighter restrictions began, Japanese companies no longer have a natural competitive strength in cutting-edge technology.

FDI

What about global investors? Technically, tightening national security supervision will raise both the cost of investing here as well as the risks. Internal compliance and controls will have to be tightened to ensure that new potential criminal liabilities are minimized.

Here, transparency is key. Right now, we know that rules will be tightened, but we don’t know how and where, nor on what basis. Kishida would be well advised to be more proactive and engage with foreign investors and business leaders on how to best balance national security with technology transfer, innovation, and transformation.

However, no matter how smooth the procedures may become, the net result is a higher compliance–cost base for investing in Japan. For large, established players, this should not be a problem. But smaller startups that are trying to explore opportunities in the Japanese market are poised to suffer disproportionately from the higher compliance and legal costs resulting from new rules. Tokyo’s reputation as the global finance-compliance center will grow.

From a Japan equity strategist’s perspective, much of the bull case for Japan depends on unlocking the deep value offered by Japanese businesses that is well documented in the historically low valuation metrics and high cash balances of listed companies.

We need a catalyst to unlock this value. Unfortunately, making it more difficult for non-Japanese to buy into and trade with Japan does not make it easier for Japanese to buy into Japan.

Real Needs

To truly strengthen security, the government should step up public incentives for technology companies to:

• Stretch and sweat their engineers harder by exposing them to more, not less, global exchange and interaction
• Raise R&D spending for university and corporate researchers
• Stimulate commercialization of new technologies deemed to be in the national interest by offering tax breaks to researchers, to startup entrepreneurs, and for in-house development

Protection is typically backward-looking, and what Japan needs is forward-looking incentives to unlock next-generation innovation and commercialization. To get there, Japan requires more, not less, pressure from global financial investors.

What Japan really needs are more active and engaged domestic investors and fund managers who aren’t afraid to engage and challenge senior corporate leaders. Policies designed to help domestic asset owners unlock corporate value are not just welcome, but essential to allowing a new catalyst for corporate revival.

This is where policy action is needed, to promote Japan for the Japanese. National security is based on homegrown strength and policies to unlock domestic aspirations, not on restricting global capital from becoming partners in this process.

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Make Japan a Startup Nation

How can government best encourage economic growth?

If you had two minutes with the new prime minister, to give your best-shot advice on how to create a better economic future for Japan, what would you say?

From a macro perspective, by far the best answer is: Do whatever you can to make Japan a startup nation.

But where does economic growth come from? Not from the stuff politicians and technocrats talk about most of the time—e.g., monetary, fiscal, or trade policy. And importantly, it doesn’t come from population growth. It comes from entrepreneurs.

Clear-Cut Correlation

History has confirmed again and again that we only get sustained economic growth when human ingenuity and ambition are allowed and encouraged, and people are empowered to start an enterprise and build their own business.

China long had one of the world’s highest rates of population growth, but it only started becoming an economic miracle when the Communist Party encouraged entrepreneurship and private business in the early 1980s.

More generally, the numbers speak for themselves. When you analyze the world’s 40 leading economies over the past 30 years, you find a clear-cut correlation between the percentage of entrepreneurs in the adult population and the sustainable growth of the country’s gross domestic product (GDP). More entrepreneurs create higher sustainable growth. In fact, if you raise the number of entrepreneurs in the population by one percentage point, your potential GDP goes up by about half a percent.

In even simpler terms, employment data confirms the positive power of entrepreneurship: startups have created 60–70 percent of new jobs in G7 countries over the past 20 years. Specifically, here in Japan, new companies set up after 2010 have provided about 2.3 million jobs over the past decade. In contrast, companies older than 20 years actually destroyed some 800,000 jobs over the same period.

So, dear prime minister, make no mistake—startups and entrepreneurship are a nation’s single most important source of growth and prosperity.

Finding Founders

The need for entrepreneurs is clear, but where do they come from?

Unfortunately, there is no magic bullet, no one simple policy tool that can be turned on to deliver entrepreneurs and create Startup Nation Japan. However, the key ingredients are all in place and, in my personal view, I firmly believe Japan stands at the brink of a golden age of entrepreneurs and startups.

Why? It’s a combination of cyclical and structural forces. Cyclically, the Covid-19 crisis has not only freed up resources but, more importantly, has become a catalyst for many people to rethink their career and life priorities. No matter how small, a startup can finally hire people and build teams, investing in what always yields the highest returns for any new venture: human capital. One of the biggest obstacles for growth and expansion has finally disappeared.

Even the most techy of tech companies, such as Google or Amazon, did not grow by the force of their superior algorithms, business models, or charismatic leadership vision. Instead, they grew as a result of the sweat equity and animal spirits of their team leaders, sales managers, and back-office clerks who pulled all-nighters. Elon Musk’s biggest problem is not tech, engineering, or digital transformation; it is his teams, the people who actually get stuff done.

In Japan, the bar for startups to attract talent has always been especially high because top graduates strongly prefer established companies. Bigger is supposedly safer. Here again, the current recession may well mark an important turning point. Not a week goes by that we don’t read about establishment companies announcing a restructuring plan. All of a sudden, big-company job security is not what it used to be. This is great news for entrepreneurs.

To be specific, I have the good fortune of working as an adviser and angel investor for a couple of Japanese venture capital funds. Over the past six months, all the startups with which we deal have grown their staff and partners. Several have more than doubled the size of their teams. Most importantly, the quality of potential candidates has grown enormously.

One young woman from a top establishment company, who has had no overseas or global experience, told me: “Working at my current employer has been great, but now that I know how good I am, and what I want, staying there puts me at risk. I don’t want to be reassigned to some random project by some random salaryman superior. I want to create my own destiny. Your startup is the best place to do that.”

To be sure, this young woman almost certainly is exceptional, and it may very well be wrong to present her as anything like the new norm for Japanese employees. However, unlike five or 10 years ago, candidates such as her do exist, and it would be wrong to underestimate the powerful ambitions—and awareness of opportunities—that Japan’s young talents and employees are prepared to explore.

Taking the leap from exploring to actually quitting one’s job and beginning a new career at a startup venture is likely to become easier. There’s no doubt that opportunities will increase, large established companies will continue to stagnate, and more young startups will demonstrate high, sustainable growth. Opportunities worth watching include:

• Healthcare and biotech
• Professional services and process automation
• Education and deep tech-based materials
• Anything serving wealthy Japanese retirees

Some will make a fortune building the Louis Vuitton retirement communities of Japan.

Learning from the Masters

On the structural side, Japan has developed a true and sustainable ecosystem of support for startups and aspiring entrepreneurs. Not a day goes by that the major newspapers don’t advertise a startup competition or venture capital symposium. Even Keidanren—the Japan Business Federation, which is the proud sanctuary of Japan’s corporate culture—now fully embraces innovation and entrepreneurship in its strategic vision. Japan’s elite establishment now knows that BAU—business as usual—is no longer an option.

Most importantly, Japan has a new generation of successful entrepreneurs, people who have built true going concerns, who commercialized and monetized an original idea, who overcame many obstacles and difficulties to build their dream. Sure, they have money to invest; but more fundamentally, many of these new successful entrepreneurs are focused on creating a positive legacy by giving back, mentoring, and advising the next generation.

Hidden from view by media obsession with Silicon Valley superstars, Tokyo, Osaka, and Fukuoka have become hotbeds of private initiatives to grow and develop a startup culture. These include mentorship programs, incubators, accelerators, venture capital funds, and daily discussions on the drop-in audio chat app Clubhouse. This private-sector ecosystem of open discussion, sharing, and networking is vital because a sustainable startup culture can only develop if success is celebrated and, more importantly, if failure is peer-encouraged to become a catalyst for another try.

As Japan’s most successful entrepreneur, Yanai Tadashi, founder of FastRetailing, which owns Uniqlo, supposedly once said, “I failed about 25 times before I finally succeeded.”

All said, the new Japanese golden age for entrepreneurs is very exciting. If I am right, we will have to become more optimistic about the overall outlook for Japan. Because one thing is certain: private entrepreneurship—not government handouts—will build future prosperity.

Dear prime minister, I trust you understand.

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