Volume 3, no. 11, November 2015
Author: Bruce Greenwald, Columbia Business School
As part of Abenomics’ third arrow of structural reform, Japan recently adopted a new corporate governance code. The new code focuses on making Japanese corporations more transparent, more responsive to shareholders — including minority shareholders — and subject to more effective oversight by boards of directors, especially outside directors. It seeks to make boards of directors not only more active and independent, but more diverse. In most respects the code moves Japan toward Western, especially US corporate governance practices. In assessing its likely impact, it’s useful to look at what we think we know about US experience with corporate governance practices.
One single factor stands out clearly. Corporate cultures completely dominate corporate behaviour in the United States. Formal governance rules have an effect that is an order of magnitude smaller. This shows up most obviously in differences in performance across US corporate managements.
Corporate cultures completely dominate corporate behaviour in the United States. Formal governance rules have an effect that is an order of magnitude smaller.
Despite the widespread adoption of ‘shareholder friendly’ governance principles, many US managements perform poorly. They fail to manage costs efficiently and seek to grow in areas where they enjoy no competitive advantages (or worse, suffer from significant disadvantages) with disastrous consequences for returns on investment. They have self-indulgent capital structures (low debt and lots of cash accumulated at the expense of shareholder distributions) and pay limited attention to effective succession planning. And they hire and fire workers promiscuously in response to short term fluctuations in market conditions (a costly practice for workers and shareholders) and pay themselves generously without regard to their performance.
US corporate managements are able to achieve this by observing the letter, but not the spirit of corporate governance rules. For example, they appoint ‘diverse’ outside directors, who are overcommitted, generally uninformed about the economics of their businesses and who are conflict averse. And a significant fraction of shareholders (institutional and individual) either give management the benefit of most doubts or fail to vote their shares at all. Other US corporations, in the same ‘governance’ environment, perform outstandingly well. The difference is culture not governance.
In some cases, ‘shareholder-friendly’ innovations have had seriously adverse social and business consequences. The movement in the 1970s and 1980s toward maximising ‘shareholder value’ as the chief goal of corporate managements and therefore promoting pay-for-achieved-performance, did not have the hoped for consequences. Instead, it led to complex compensation schemes that greatly enhanced management compensation without notable progress in relating pay to performance. The resulting shift in the distribution of corporate income has been costly for shareholders and has created significant social discontent. The shift in governance emphasis led to (or perhaps coincided with) a shift in a cultural tolerance for high management compensation that has had significantly adverse unintended consequences.
In some cases, ‘shareholder-friendly’ innovations have had seriously adverse social and business consequences.
Japan has, if anything, more deeply entrenched corporate cultures than the United States or Europe. The impact of corporate governance reform is likely, therefore, to be significantly smaller than in other western economies and particularly the United States. The consequences of the new corporate governance code are likely to be marginal.
On the positive side, this means that the strong Japanese emphasis on social cohesion and discomfort with extreme individual distinctions means that the effect on differences in compensation and employment security within firms will also be minimal. On the negative side, hopes of significantly enhanced management performance and innovation are likely to be disappointed. Japanese corporations are as capable as their US counterparts of observing the letter of the new governance code while defeating its spirit.
A second key factor in assessing the new corporate governance code is the generally high level of much of current Japanese management performance. Japanese manufacturing corporations are among the most efficient in the world. Manufacturing productivity is on average significantly higher than that in the United States and Europe. Japanese companies, like Fanuc in machine controllers, dominate major global markets and have managed to maintain their positions over many years. Japanese managements are, if anything, more disciplined than their western counterparts in pursuing focused growth that builds on well-established competitive advantages. And, although leading Japanese companies have tended to hoard cash and ignore the importance of shareholder distributions, this is hardly a shortcoming limited to Japanese companies.
Japanese managements are, if anything, more disciplined than their western counterparts in pursuing focused growth that builds on well-established competitive advantages.
The problem for Japan is that this management talent is focused overwhelmingly on manufacturing. And manufacturing is a dying sector. Manufacturing productivity growth is far higher than the growth in global manufacturing demand, which puts continuous downward pressure on manufacturing employment and prices. This pressure is exacerbated by huge additions to global manufacturing capacity by emerging market economies like China. Ultimately, manufacturing in the 21st century will suffer the fate of agriculture in the 20th century in terms of declining economic importance. It will do so for the same basic reasons — productivity growth well in excess of demand growth.
Devoting management resources to the manufacturing sector at the expense of services (such as housing, education, medical care) will inevitably lead to long-term stagnation. This is not a cultural bias that will be corrected by a new governance code alone. On the other hand, the code is likely to have benefits in terms of distributing existing Japanese cash hoards to investors through increased dividends and share buybacks. To the extent that these increased returns are invested in upgrading the performance of service firms the Japanese economy will benefit. But direct efforts to refocus the resources and management of outstanding Japanese companies on services — especially housing, healthcare and education — are also essential.
About the author
Professor Bruce C. N. Greenwald holds the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School and is the academic Director of the Heilbrunn Center for Graham & Dodd Investing.