Why Nobody Invests in Japan

This article originally appeared in Foreign Affairs.

Japan stands apart. In the rest of the world, countries seeking to boost growth encourage foreign companies to set up new facilities on their soil or buy domestic companies, ventures known as inward foreign direct investment (FDI). China is the most spectacular poster child for this strategy, but many other countries—from India to the new market economies of eastern Europe—enthusiastically court foreign enterprises. FDI allows the fresh ideas of foreign companies to spill over into the broader economy, boosting the performance of their local suppliers, business customers, and sometimes even their own competitors. For example, when Japanese automakers brought “transplant” factories to North America, Detroit learned that it cost less to prevent defects in the first place than to fix them afterward.

Only one major country has said “no, thank you” to these benefits: Japan. In 2019 (the latest data available), the United Nations Conference on Trade and Development (UNCTAD) ranked 196 countries in terms of cumulative inward FDI as a share of GDP. Japan came in dead last—just behind North Korea.

Results in other countries suggest that an increase in FDI could substantially jump-start Japan’s economic growth. The nations that benefit the most from increased FDI are those that lag furthest behind global benchmarks of efficiency. Yes, Japan does excel in a few sectors—the automotive industry, for instance—but in many other fields, it is a laggard. Take digital technologies, which are becoming increasingly pivotal throughout the economy. When one business management institution graded 64 countries on how much economic benefit each derived from its investment in digitization, Japan ranked a dismal 53rd. If Japan hopes to reverse its stagnant economic growth, increasing FDI is an essential ingredient in the recipe.

Japan’s struggles are rooted in decades-old formal and informal hurdles placed in the way of foreign enterprises’ efforts to acquire domestic firms. Fortunately, there are some signs that the country is opening up to the benefits of FDI—though it will likely take determined efforts by political and business leaders for Japan to start climbing in UNCTAD’s rankings.

DISTORTED DATA

What makes Japan’s dismal ranking even more shocking is that almost 20 years ago, leaders in Tokyo incorporated inward FDI into their economic growth strategy. When Junichiro Koizumi took office as prime minister in 2001, Japan’s FDI was a minuscule 1.2 percent of GDP, compared with 28.0 percent in a typical rich country. Koizumi first vowed to double FDI, then in 2006 set a goal of FDI reaching 5.0 percent of GDP by 2011. At first, there was marked progress: by 2008, FDI had risen to 4.0 percent. Then momentum stalled. Despite the pledge made in 2013 by his successor, Shinzo Abe, to double FDI, as of 2019 the ratio was only a smidgen higher, at 4.4 percent. Meanwhile, the ratio in the typical rich country leaped to 44.0 percent.

To make matters worse, the Japanese government is hiding from itself how badly it has failed. The Finance Ministry reported that inward FDI climbed to roughly $359 billion in 2020, thereby achieving Abe’s goal of doubling the level from 2013. In reality, the 2020 figure stood at around $215 billion according to the International Monetary Fund, the Organization for Economic Cooperation and Development, and UNCTAD.

How is such a huge discrepancy possible? In short, the government is using a misleading set of figures. The IMF approves two measurements but recommends only one of them—called the “directional principle”—for looking at changes to a country’s FDI over time or for comparing countries. Japan’s Finance Ministry, by contrast, highlights the other set, called the “asset/liability principle.” Although the latter has legitimate purposes, it includes items having nothing to do with real FDI, such as loans from overseas affiliates back to their parents in Japan.

An OECD spokesperson, when asked about Japan’s numbers, confirmed that the directional principle “is better suited to analyze the economic impact of FDI.” If the first step in solving a problem is recognizing that you have one, Tokyo is in trouble.

WHY JAPAN CAN’T CLOSE THE SALE

Why have Japan’s efforts to attract greater FDI failed? Other countries have seen FDI soar once they shifted from resisting foreign investment to welcoming it. In South Korea, for example, the ratio of inward FDI to GDP leaped from two percent in the late 1990s to 14 percent today. In India, the share climbed from a negligible 0.5 percent in 1990 to 14.0 percent now. For eight former Soviet-bloc countries in eastern Europe, the ratio exploded from seven percent to 55 percent following the end of communism. The scholars Takeo Hoshi and Kozo Kiyota calculated that if Japan performed like other countries with similar characteristics, its ratio would have reached 35 percent of GDP by 2015.

The Japanese market is also clearly attractive to foreign businesses. In survey after survey, multinational companies list Japan as a top place to invest owing to its large, affluent market; a very well-educated workforce and customer base; and high technological capacity among potential suppliers and partners.

The main hurdle to increased inward FDI is that foreign businesses face trouble buying healthy Japanese companies. In a typical rich country, 80 percent of inward FDI takes the form of mergers and acquisitions (inbound M&A)—but in Japan, it’s only 14 percent. Total inward FDI is meager mainly because inbound M&A is so small.

This impediment is a legacy of the era immediately following World War II, when Tokyo restricted FDI out of fear of domination by foreign companies. In the 1960s, when Japan had to formally liberalize its restrictions in order to join the OECD, the government devised what it called “liberalization countermeasures” to create indirect impediments to inbound M&A. These ranged from reviving cross-shareholding among corporate giants and their financiers, to shoring up the horizontal and vertical corporate groups, known as “keiretsu,” to cumbersome rules about cross-border transactions.

Koizumi dismantled some of the legal barriers to FDI. In a two-year fight with domestic vested interests—and with input from foreign business executives in Japan, such as Nicholas Benes, the chair of the FDI Committee of the American Chamber of Commerce in Japan (ACCJ)—his administration made changes to Japan’s commercial laws to make inbound M&A easier. While most of the overt impediments have now been removed, the corporate group system remains and continues to pose a major hurdle.

The media tend to cover spectacular cases where foreign companies rescue failing giants such Nissan, Sharp, and Toshiba, but most foreign investors want to buy good companies that will enhance the parent’s global expansion. Unfortunately, the most attractive targets—whether large or medium-sized—are largely out of reach because they belong to keiretsu. Traditionally, members of a keiretsu never sold themselves to members of another keiretsu, let alone foreign firms. While Japan’s economic travails have somewhat reduced resistance to inter-keiretsu mergers and acquisitions, most keiretsu remain strongly opposed to acquisitions from a foreign buyer.

Japan’s corporate groups, which include 26,000 parent companies and their 56,000 affiliates, employ 18 million people, a third of all employees in Japan. This does not even count other attractive firms among unaffiliated subcontractors and closely allied suppliers. The Toyota Group, for example, has 1,000 affiliates and 40,000 suppliers, of which the majority are tightly linked subcontractors. From 1996 to 2000, foreigners were able to buy only a trifling 57 members of corporate groups, whereas they were able to buy around 3,000 unaffiliated companies.

Worse yet, obsolete attitudes from the past still linger among too many policymakers. For instance, a 2020 draft paper issued by the FDI Promotion Council, an advisory body to the government, argued that inbound M&A could be a great help in dealing with the huge succession crisis at Japan’s small and medium enterprises (SMEs). The report noted that 600,000 profitable SMEs may have to close by 2025 because their owners will by then be over 70 years old and have no successors. Up to six million jobs are at risk. As part of the effort to prevent this looming disaster, the report called for “some mechanisms” to help these SMEs find suitable foreign partners and to “facilitate business transfer between third-parties (merger & acquisition).” That would have been a big step forward. But the final document released by the Cabinet Office in June purged all mention of inbound M&A. Clearly, someone thought foreigners buying Japanese companies was more dangerous than massive job losses.

DRIVERS OF CHANGE

Fortunately, there are some new forces that offer the potential for change. The first is a big shift in the public mood. In the early 2000s, Japanese readers soaked up books attacking foreign investors as vultures and blood-suckers—one such novel sold 150,000 copies in just a month. By contrast, only a decade later, foreign executive Carlos Ghosn became a folk hero for saving Nissan after the French automotive company Renault bought a large share of the embattled Japanese firm.

Polls show that far more people now see a positive impact from foreign companies than a negative one. There is also a shift in the business community: while the powerful Keidanren business federation remains resistant to inbound M&A, a politically weaker group of executives called Keizai Doyukai is supportive.

A second potential driver is the succession crisis at SMEs. Consider all the 70-year-old owners of SMEs who genuinely worry about their staff’s future once they step down. How many would refuse to sell to a foreigner if the government or Japan’s big banks and trading companies made the introduction?

Japan’s existing bureaucratic infrastructure could easily pivot to accomplish this task. The Japan External Trade Organization actively courts foreign companies to set up new operations in Japan but makes no effort to recruit foreign companies to buy Japanese firms. Finding foreign buyers for at-risk SMEs should be included in JETRO’s mandate. Japan’s giant trading companies and megabanks, with their skill set and extensive networks both inside Japan and overseas, would find it very lucrative to act as matchmakers. And as studies show that SMEs are more likely to sell to a foreign firm if they see others have done so successfully, the process has the potential to snowball.

A third driver is the push for corporate reform, as exemplified in the 2014 Stewardship Code promulgated by the Financial Services Agency and the 2015 Corporate Governance Code adopted by the Tokyo Stock Exchange (TSE) in response to government pressure. The Stewardship Code pressures institutional investors to use their equity holdings to push companies to enhance shareholder value. The Corporate Governance Code pressures listed companies to increase their transparency and responsiveness to shareholders, while paying more attention to profitability and not just size or market share.

This may seem unrelated to FDI, but foreign firms in Japan see a connection. ACCJ leaders, who proposed the Corporate Governance Code to the government, believe that as big corporations face pressure to maximize profitability, they will increasingly focus on core competencies. Consequently, they will sell noncore divisions as well as hosts of affiliates that would have better synergy with another company. That would not only help national growth directly but also increase the number of firms available for foreigners to purchase. In anticipation of this development, KKR, Bain, CVC, and dozens of other domestic and foreign private equity firms are building up their financial war chests.

This logic may eventually bear fruit, but so far, the anticipated upsurge has yet to emerge. Since 2004, there have been only about ten to 20 domestic divestitures above $100 million to private equity firms each year, a figure that has not increased over time. Aside from some exceptional cases—such as the $18 billion sale of Toshiba’s memory chip unit to a Bain-led consortium in 2018—there also has not been any clear trend in the overall value of such deals. The holdup, Bain commented in a 2018 report, is that “boards and shareholders do not yet push for strategic divestitures.”

Bain added that corporations are instead taking easier routes to show higher “return on equity,” such as stock buybacks and the sale of divisions or affiliates that are either unprofitable or suffering declining sales. To that list, we’d add wage cuts. If shareholders don’t care how profits are attained, then it’s not clear whether increased shareholder power would lead to more beneficial strategies, such as the shedding of healthy but noncore sections and affiliates.

Whatever the eventual impact of these three drivers, the likelihood is that a leap in FDI will only occur following a concerted policy effort by the government and business leaders to promote inbound M&A. Otherwise, Japan will likely remain in the cellar of the FDI rankings—and growth will remain as listless as it is today.