Don't Look Now, But A New Japan Is Taking Shape

After more than a decade of stagnation, Japan's economic system is changing in far-reaching ways that promise to benefit both Japan and its global partners. Japanese companies are restructuring to eliminate excess capacity and improve their profitability. Perhaps more important, Japanese financial institutions are also restructuring.

The major goal of the financial reforms is to give Japanese savers a better deal--higher returns and greater choice among assets--just in time to prepare for Japan's impending demographic tsunami. By 2020, more than 40% of Japanese citizens who are now old enough to vote will be retired. Because of low returns on personal savings and private pension funds, the gap between projected health and pension requirements and the means to finance them is rather large and growing.

Over the past 16 years, the rate of return on savings in Japan has been an anemic 2.5%--less than a third the rate necessary to meet the demographic challenge of its aging population. As liberalization of Japan's financial markets takes hold, a growing number of Japanese companies are turning to foreign fund managers to improve their returns on pension funds. By the end of this year, $1 trillion in accounts held at Japan's Postal Saving System will also have become available. It's a good bet that a substantial share of that sum will seek higher returns from equity investments. This inexorable rise of pension and mutual funds as important shareholder constituencies in Japan's equity markets will transform Japan's corporate-governance structures and strengthen the influence of profitability criteria in business decision-making.

Technology, too, is fomenting change. The Internet strikes at the heart of the keiretsu system, the cozy relationships that have linked manufacturers with preferred suppliers and retailers. By blocking competition from outsiders both foreign and domestic, the system has kept prices high and discouraged productivity growth.

MERGER EXPLOSION. But the Internet has the potential to change all that. By increasing information about prices and alternative sources of supply, the Internet will confer more power on Japanese consumers at the expense of their country's antiquated and inefficient distribution system. By allowing companies to economize on inventories and reduce procurement costs, the Internet will revamp the distribution systems themselves. In Japan, as in the U.S., the lion's share of productivity increases resulting from business-to-business Internet applications is likely to show up not in the manufacturing sector but in the wholesale and retail distribution sectors, where productivity lags the most.

An explosion in mergers and acquisitions and a surge in foreign direct investment are two of the most salient indications that the traditional closed Japanese system is crumbling. But Japan still has a long way to go. Despite growth in M&A activity, it amounted to only about 7% of stock market capitalization last year, compared with about 14% in the U.S.

MORE COOPERATION. Foreign direct investment has doubled in Japan since 1997, including major investments in the financial-services, automobile, and telecommunications sectors by such high-profile companies as Merrill Lynch, Ford, and Renault. Nonetheless, Japan continues to lag far behind the U.S. in the share of productive capital that is owned by foreigners. Nearly a decade ago, Washington negotiated hard with a resistant Japanese bureaucracy to gain a foothold for retailer Toys `R' Us in Japan. Now, the Japanese government itself is actively promoting foreign direct investment to propel restructuring of its troubled companies and its financial system. Since imports and the stock of foreign direct investment tend to be positively related, the good news is that the recent expansion in foreign investment is likely to increase the country's openness to imports over time.

During the past two decades, relations between the U.S. and Japan have frequently been strained by contentious trade talks over structural barriers to Japanese markets and the resulting frustration of U.S. companies.

As these structures crumble, access to Japan's markets will improve, and the impetus behind such discussions will dissipate. This will allow U.S policymakers to devote more of their attention to strengthening cooperation with Japan to safeguard political, military and economic security in the Asian Pacific. Reforming and revitalizing its domestic economy are the most important things Japan can do to improve U.S.-Japan trade relations and to foster more balanced growth in the global economy.

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