In international headlines on the ongoing saga of Carlos Ghson, former Chairman and CEO of the Renault-Nissan-Mitsubishi Alliance, Japan’s “hostage justice” system has been compared to that of China. Ghosn stands accused of concealing his salary and benefits on official disclosures, and has spent over 108 days in jail prior to being tried.
In fact, the underlying scandal was that Nissan had almost no corporate controls, which could have brought this situation to light earlier. Beyond that, even though Nissan was probably one of the worst offenders, it is only one of a string of Japanese corporate scandals in recent years, including accounting and quality control problems in some of the biggest Japanese brand names.
These ongoing stories serve to highlight the importance of reforms to the corporate boardroom. Back in December 2012, Japan’s newly re-elected Prime Minister Shinzo Abe unveiled “three arrows” to turn around the country’s long-ailing economy, which collectively became known as “Abenomics.” Two of the arrows involved conventional macroeconomics: monetary and fiscal easing. The third one, on the face of it, looks both uncontroversial and unrelated to the business cycle: structural reforms.
In addition to scandals as with Nissan, the Japanese corporate sector has been long plagued by low valuations and excessive cash holdings. Decades of economic troubles have caused a risk-avoidance mentality to become ingrained in Japanese business. Thus, in 2014, Abe proposed a new Stewardship Code aiming to push “institutional investors to fulfill their fiduciary responsibilities, e.g. by promoting medium- to long-term growth of companies through engagements." The code aims to reduce cross-ownership, a unique Japanese phenomenon in which companies buy each other’s stock and work together to fend off hostile takeovers, and was followed by a Governance Code in 2015.
In fact, not only is there a clear connection between corporate governance and interest rates, but the ideas behind the reforms are also bolder than they might appear. Low or negative interest rates have a tendency to create stagnant companies that remain in the market longer than they should. Recent research indicates that the increase in monopoly power for market leaders may even be strong enough to cancel out the stimulatory effect of the low rates. Smaller firms can find themselves unable to compete against larger ones with good credit, even if their competitors have lax management practices.
A bit of mathematics can demonstrate how lower rates increase time horizons. It might seem intuitive to think about interest in terms of fees – a 2% fee after a year, for instance. For the same year, you can add them up easily. For instance, there might be a 4% risk premium on top of that 2% interest rate – clearly twice as much. But then, due to the nature of compounding interest, that relationship no longer holds for the second or third year or beyond.
In fact, it is more intuitive to think about interest in terms of time to a certain goal. After three years, one of those years is spent paying off the base interest rate, and two years is spent on the risk premium. This relationship, unlike the dollar relationship, holds true for any length of time. That is to say, the unit of interest is time, not money.
Therefore, when rates approach zero, on the surface it reduces costs, but it also increases the time horizon allowed for any given reform to take effect. Negative rates now comprise around 30% of global investment-grade bonds, according to recent figures from Bloomberg.
In this context, it is not surprising that Japan has pushed for alternative ways to increase productivity. Excessive cash holdings are one of the classic problems that investor activism is meant to solve. Furthermore, they prevent monetary stimulation, as abundant as it has been in recent years, from reaching consumers. In February of this year, 56% of Japanese non-financial corporations on the benchmark Topix index held net cash reserves – meaning cash left over even after covering all debts.
Many parts of the world are now pondering the different ways that this environment affects previous assumptions about business. Europe is dealing with a zombie bank problem and fragmented banking industry in the aftermath of its sovereign debt troubles. Meanwhile, American economists are reassessing their previous textbook wisdom that a business model like Amazon’s, in which a company could indefinitely postpone profitability while shareholders wait patiently, would prove impossible in practice. This assumption formed the basis for longstanding anti-monopoly policy, which now appears to be a likely target for reform.
Finding the Sweet Spot
Back in Japan, although initiatives to improve corporate governance have the backing of the Abe administration, not everybody agrees with the premise of Western-style activist boards. They come with an entire institutional framework that may not apply in all situations. In Japan’s case, even when activist initiatives are successful in the short term, they are not widely accepted, resisted, and often incompletely applied.
One of the main criticisms of the American style of capitalism in particular is its focus on short-term results at the expense of longer-term initiatives like R&D. Initiatives to encourage performance-related pay, for instance, have resulted in a broader ‘financialization’ of the economy, with benefits that continue to be debated.
Although this approach isn’t perfect, it is useful to compare the case of the US to an under-financialized economy: China. China has long suffered from a dearth of mid-level management who can transform large, ideological goals into concrete objectives. This vagueness means that private-sector companies are often centered around charismatic leaders, a problem that is only overcome in the state sector, which has entirely different incentives.
Outsiders often look at China’s booming business sector and see it as a shining capitalism success story. Clearly, it was looser restrictions on private economic activity that originally propelled China’s breakneck growth, but a closer look reveals that it was only one part of the process that was ever liberalized. From the perspective of the project side, things are relatively open. In the classic export model, a merchant could sell commodities to elsewhere without an undue amount of interference, although perhaps with some creative capitalization (and capital-saving) arrangements.
From the lending perspective, though, it was always a different story. Capital movements are largely controlled by the state banking sector, which disbursed funding for policy, rather than business reasons. For example, banks could get approval to fund projects overseas, but they wouldn’t generally lend to a non-Chinese project or invest in some unrelated corporate paper in order to boost their capital adequacy. Lenders were never truly independent from their projects, and severe overcapacity was the result in a number of industries.
A Country in Miniature
It is striking how much these debates about corporate governance correspond to ones about political governance. In politics as well, it is possible to point to the dangers of styles of democracy that are too direct. Brexit was decided by a single referendum. It was not clear what exactly was on the ballot, since no potential deal had yet been negotiated with the EU. Turnout was not great, perhaps based on the presumption that the measure would never pass. The US state of California, where some questionable policies have resulted from direct referendums, has also used an example of the dangers of issue-based voting.
Such examples offer fuel to detractors of democracy. Nevertheless, it is clear that whatever problems they represent, there is more danger on the other side of the spectrum. In both the political and corporate cases, less visible long-term problems can eventually overwhelm any short-term initiatives to eventually determine the overall direction of an organization. For complex organizations, the most important measure of a leader isn’t the number of projects they implement, but rather the number of safeguards they have against some sort of catastrophic event or fateful missed opportunity.
Despite Britain’s short-term problems, internal and external Brexit negotiations are forcing longer-term reforms. The political spectrum is in the process of re-organizing itself around this issue, reflecting a more modern orientation. In business, the most consequential missed opportunities often involve disbanding entirely. Although this sort of decision is painful for employees, the invisible costs of continuing to work on a task that has already been completed can eventually overwhelm everything else.
Policies to encourage shareholder activism cannot be implemented as shock therapy. The issues created must be dealt with in turn, but this process in its own right often forces clearer thinking about trade-offs. In the US, for instance, President Trump has proposed ending quarterly reporting, which aims to reduce earnings pressure while still maintaining transparency. A financial transaction tax has also been discussed as a way to reduce the influence of short-term shareholders, although on a different time scale.
Because China has not passed the first step of political democracy, it will not be able to implement the equivalent system in business. Taiwan, however, has the opportunity to think about a greater variety of ways to professionalize its management class. Its private-sector labor force already works long hours; further growth will come from more efficient resource utilization.