Falling share prices don't motivate executives in Japan like they do elsewhere.

Photographer: KAZUHIRO NOGI/AFP/Getty Images

Japan Needs to Shake Up Its Companies a Little Harder

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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On June 1, Japan's new Corporate Governance Code went into effect. This was a big and important step in the revitalization of Japan's stagnant economy. Increased productivity at Japanese companies will boost investment, and will also free up more resources to be used by ambitious entrepreneurs. The code will nudge Japan in the direction of shareholder capitalism, away from the stifling corporatism that has perpetuated inefficient business practices.

The code -- which is not a law, but merely a guideline -- is only a first step. In an explanatory packet I received during a visit to Japan's Financial Services Agency this October, the agency called  the code "a starting point, not a goal."  The code tells companies what to do, but more steps are needed to make sure they actually do it.

QuickTake Remaking Japan Inc.

To this end, the Financial Services Agency has established a council of experts to follow up on the implementation of the code, and to recommend further steps. The members of the council are quite a star-studded cast -- economics professors, think-tank researchers, business executives, investors and money managers. If the council has one weakness, it is that it has only one foreigner -- Scott Callon of Ichigo Asset Management.

The council is gathering evidence on the degree to which Japanese companies have complied with the code so far. Companies that reported early show almost total compliance. But this is a biased sample, since more compliant companies are almost certainly more likely to report early; the true compliance rate will not be known until the end of December.

Even at this stage, however, there are encouraging signs. The fraction of big companies on the Tokyo Stock Exchange with independent directors on their boards went from 31.5 percent in 2010 to 61.4 percent in 2014 and then to 87 percent in 2015. The fraction with two or more independent directors has gone from 21.5 percent in 2014 to 48.4 percent in 2015.

That is a pretty dramatic increase. It shows the power of administrative persuasion in Japan -- simply by publicly and privately encouraging companies to make needed reforms, the government can get a lot of traction.

So what happens if compliance rates turn out to be lower than the government hopes? The Financial Services Agency has two recourses. First, it can use more persuasion -- essentially, summoning corporate execs into its offices and grilling them. That probably doesn't sound very threatening to most Americans, but in Japan it may be more effective.

Second, the FSA can lean on companies indirectly, through investors. In 2014, even before the governance code came into being, Japan enacted a Stewardship Code for institutional investors. This code encourages investors to monitor companies, exercise voting rights and engage more energetically in corporate affairs.

Traditionally, institutional investors in Japan are relatively passive, making bets on companies without interfering in management. The stewardship code is designed to change that culture. Basically, the FSA will call investors in and harangue them until they do some haranguing themselves, pressing corporate boards to raise profitability. That, anyway, is the hope.

This may be enough to create sustained and meaningful change in Japan's hidebound corporate culture. Or it may not be. If harangues and persuasion fail, what next?

In an interview, the FSA also expressed the hope that foreign investors and the media will act as watchdogs on companies, sounding alarms when governance doesn't improve. But foreign investors are notoriously fickle, putting in and pulling out capital based on global financial trends. And the Japanese media is hardly known for its toughness.

Even if noncompliant companies' stock prices go down, it's not a big deal for managers. Most Japanese financing is done through banks rather than capital markets, so stock prices are often more of a vanity metric than a real cost of capital. Entrenched, powerful managers are hardly likely to give up their comfy empires just to look good to market reporters.

Ultimately, Japan may need to use sterner measures. Since most financing comes from banks, the FSA or other players may need to enlist banks in the fight to improve governance. The big banks depend on implicit government guarantees of bailouts, so they are probably beholden to the will of bureaucrats. In fact, Japanese banks are already responding favorably to the Corporate Governance Code by decreasing their cross-shareholdings with companies. If the FSA needs additional allies in the fight to make companies more efficient, banks would seem to be a natural candidate.

So if Japan's companies shape up in response to the governance and stewardship codes, that will be wonderful. There are positive early signs. But if they refuse, it may be time for the FSA to get really tough.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
Jonathan Landman at jlandman4@bloomberg.net