Wednesday, February 16, 2011

Leverage in Japan and in America


In a recently published textbook on Financial management the headline “Why Japanese firms tend to be so competitive” was catchy. Given the glowing recommendation of Japanese leveraging and the competitiveness that results from it, I wanted to get some additional input so that I could understand the issue better.

The textbook article suggested that Japanese companies are highly leveraged both operationally and from a financing perspective. It stated that Japanese companies are the world leaders in high technology in their industries and that their governments support and encourage that pursuit. This pursuit of technology puts Japanese firms in a position of having high fixed costs and unlike in the United States, Japanese firms do not normally lay off their workers.

“The typical Japanese company has a debt-to-equity ration two to three times higher than its counterparts in the United States. The reason is that credit tends to be more available in Japan because of the traditional relationship between an industrial firm and its bank. They may both be part of the same cartel or trading company with interlocking directors (directors that serve on both boards).” (Emphasis mine). The textbook authors go on to state that “The key point is that Japanese firms have high operating leverage as well as high financial leverage and that makes them act very competitively”. “This, of course, may well be a virtue because it ensures that a firm will remain market oriented and progressive.”

I found this perspective fascinating and somewhat contrary to my own, so I went looking for an article on the Japanese situation and found one called “Japan’s Lessons for Managing the Crisis” by Nicholas Benes written in the Far Eastern Economic Review in October of 2008. While this is not a well-known journal, it has interesting points to make.

The article starts by pointing out that the financial crisis in the United States was preceded by a similar crisis in Japan during and that both crises were precipitated by the failure to rein in financial leverage and by the myth that real estate prices never fall. The article states that as of 2002, Japan had spent an amount equivalent to 20% of its GDP to clean up the resulting mess and that it is still not completely resolved. It goes on to state that even if Paulson and Bernancke got one trillion dollars in the States that would still be only 7% of the American GDP. As of the writing of the article the Nikkei Dow was down 34% while the Wall Street Dow was down “only” 20%. The author states that most analysts believe that the Japanese stocks are significantly undervalued and asks the valid question “Considering that the Japanese crisis is supposedly long over why aren’t world wide investors tripping over themselves to take advantage of undervalued stock?”

The author believes that answer lies in the behaviour of the American regulatory bodies as opposed to the Japanese authorities. The American market institutions and regulators are fully committed to a speedy adjustment of laws and regulations to ensure a speedy recovery. By contrast, 18 years after their bubble broke, Japan is perceived as having acted too slowly and without the will or transparency that is required. “It is as if the world has resigned itself to the fact that Japan will forever remain uncompetitive in the intermediation of capital- both domestic and foreign-and if this imposes a drag on the future growth of both the Japanese and world economies, nothing can be done about it”.

The author, a president of an investment bank in Tokyo, suggests several basic principles that could change this state of affairs and prevent the aging population of Japan from leaving this legacy to be born by the youth of Japan. These are:

1. Embrace transparency in the process.

2. Make concrete changes in the law rather than just hold discussions about it.

3. Spread out the shareholder meetings so that 97% do not occur in the same week.

4. Allow shareholders to send legitimate representatives to shareholder meetings.

5. Require companies to promptly and publicly report the results of votes on each resolution.

6. Require full disclosure by institutional shareholders with fiduciary responsibilities of the voting records when they have multiple and perhaps conflicting loyalties.

7. Legally require public company’s boards to have a majority of independent directors and empower them to be effective.

Many of these suggestions lead back to the quotes from the textbook article especially the ones pertaining to the relationship between Japanese companies and their banks. This investment banker author’s suggestions decry the lack of objectivity and transparency in these relationships. The fuller argument in the article makes the inbred relationships clear and their detrimental effects on Japan’s businesses and world wide reputation suffers from their cosy “cartel and trading company” lending practices.

Benes ends his article with the following warning:

“While tough times lie ahead for the American economy, the impulse to fully purge the dead assets from the system and undertake regulatory reforms serves the U.S. well. Japan’s apparent fate as a perpetually uncompetitive financial center serves as a stark warning to the costs of the failure to follow through.”

Too much leverage and too little transparency and regulatory oversight have consequences that go beyond the fate of a few companies and their samurai ways. While gambling can be exciting and a big wager has the potential to pay off in big money, there are down sides to excesses in every sphere. When the people at the top play too fast and loose others often pay the price. In Japan, the actions of the highly (and one might say over) leveraged companies have had a serious impact on the economy, the recovery, the confidence of world-markets and of course, the citizens of the country. Sometimes less is more.

References
Benes, N. (2008) Japan's Lessons for Managing the Crisis

Far Eastern Economic Review; Oct 2008; 171, 8; Downloaded from ABI/INFORM Global September 8, 2009.

Block, S., Hirt, G., (2009). Foundations of Financial Management (13th ed). NY: McGraw-Hill Irwin.

Degree of Operating Leverage-DOL. (2009). Investopedia.com. Retrieved September 7, 2009, from http://www.investopedia.com/articles/stocks/06/opleverage.asp.

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