Business in Japan: Going Hybrid

Going hybrid

Nov 29th 2007
From The Economist print edition

ONCE it was the Walkman. Then it was the PlayStation. Today it is the Toyota Prius that epitomises Japan's technological and industrial prowess. Built by Japan's largest company, which is now on the verge of becoming the world's largest carmaker, the Prius is a hybrid car propelled by the combination of a petrol engine (for range) and an electric motor (for energy-efficiency). The Prius was the first commercial hybrid car and has become by far the most successful, with sales of over 1m since its launch in 1997. Although that is a modest figure compared with Toyota's annual output of around 8m vehicles, it has transformed the company's image. Toyota is now known for greenery and innovation as well as manufacturing efficiency.

But the Prius also symbolises another transformation: that of Japan itself. Just as a hybrid car combines the distinct advantages of petrol and electric propulsion systems, Japan has been developing a new hybrid model of capitalism that brings together aspects of the old Japanese model, which ran into trouble in the early 1990s, with carefully chosen elements of the more dynamic American or Anglo-Saxon variety of capitalism. The resulting hybrid model has been adopted by many firms and has already helped to transform Japan's fortunes. After wrenching political and corporate reforms, the country in 2002 emerged from over a decade of economic stagnation. Since then the recovery, originally export-led, has spread to the economy as a whole (see chart 1). Japanese firms have restructured, paid down their debts and are now posting record profits. The banking system has been cleaned up. Yet despite this progress, Japan still faces huge problems.

Government debt, at around 180% of GDP in the current fiscal year, is the highest for any developed economy (see chart 2). The government will soon have to raise consumption taxes just to stop the debt from growing. Japan also faces a painful demographic squeeze as its population ages and the workforce starts to shrink. This will put a premium on increasing labour-productivity growth, which at 1.2% is only half the OECD average, largely thanks to the hugely inefficient service sector, which accounts for 70% of GDP and two-thirds of employment. Japan's average labour productivity in services fell from 88% of the American level in 1993 to 84% in 2003. This highlights another of Japan's problems: its two-tier economy, made up of an efficient, globalised manufacturing sector and an inefficient, inward-looking services sector.

Japan also risks losing its edge in innovation. Although it spends far above the OECD average on research and development (R&D) as a share of GDP, this money is not always put to good use. The Science Council of Japan estimates that Japan's R&D is only about half as efficient as Europe's and America's. Entrepreneurial start-ups account for only around 4% of firms in Japan, compared with 10% in Europe and over 14% in America, and Japan comes bottom in several rankings of entrepreneurship. Despite the might of its big exporters, Japan is also a laggard in globalisation, with the lowest levels of foreign direct investment, imports and foreign workers in the OECD. With a domestic market that offers little scope for growth, Japan is missing out on opportunities overseas.

Time for a new model
Its old industrial model, which formed the basis of the “Japanese miracle” in the second half of the 20th century, was devised under very different circumstances: high growth and a pyramidal population structure, with far more young people than old, notes Atsushi Seike, a labour economist at Keio University in Tokyo. This old model was founded on three main elements: first, lifetime employment, in which workers spend their entire career at the same firm, slowly working their way up the ranks; second, seniority-based pay, which links wages to length of tenure rather than ability; and third, company-specific unions, which promoted close co-operation between unions and management.

Another typically Japanese practice was a close relationship with a “main bank” and other companies organised into corporate groups known as keiretsu, bound together by a web of reciprocal cross-shareholdings. The old model was well suited to the times: it delivered social stability and cohesion as Japanese workers pulled together to catch up with Western nations, and helped Japan to become the world's second-biggest economy.

But the population structure has changed beyond recognition and Japan is no longer a developing country, so the old model no longer fits and many of its strengths have become weaknesses. It hinders consolidation among Japanese firms, which is necessary if they are to become more globally competitive. It prevents the efficient redeployment of labour and a proper use of women and elderly workers, which will be vital if Japan is to cope with its ageing population and shrinking workforce. The old model hampers entrepreneurship and innovation in small companies, an important component of a dynamic and responsive economy. All of this acts as a brake on growth. At the same time, Japan needs to become more closely integrated into the global economy, both to gain access to fast-growing foreign markets and to enable competition from foreign firms to spur improvements in the stodgy services sector. That is why a new, more flexible model is needed.

In the late 1990s, when Japan had endured almost a decade of stagnation, the American model seemed to have all the answers—a reversal from the 1980s, when American firms were trying to emulate the seemingly unstoppable Japanese model. America's economy was booming, fuelled by a flourishing technology industry. Its approach seemed more successful at promoting innovation and growth in the internet era, and its vibrant start-up scene was a far cry from Japan's staid big-company capitalism.

So policymakers rewrote corporate law to allow Japanese companies to adopt an American-style model of corporate governance, and some companies began to adopt Anglo-Saxon practices such as performance-based pay, share options, outside directors, promotion based on ability, pursuit of shareholder value and hiring new employees in mid-career. The banking system was recapitalised, cross-shareholdings were unwound and companies embarked on a programme of restructuring. “But a funny thing happened on Japan's way to the American model—it never got there,” observes Steven Vogel, a political scientist at the University of California, Berkeley. Many of the reforms met with opposition and were scaled back. Then the dotcom crash and the Enron scandal caused the American model to lose its lustre, to the delight of Japan's old guard.

Instead, forward-looking Japanese firms have devised a hybrid model that combines elements of both the old Japanese and the Anglo-Saxon model. “We have been going through a process of trial and error, of what to change and what not to change,” says Fujio Cho, the chairman of Toyota. The effect has been to move Japan somewhat closer to the American way of doing things, at least in some areas and in some companies. “You pick and choose which bits you adopt,” says Hirotaka Takeuchi, dean of the school of corporate strategy at Hitotsubashi University. “Japan has tilted more towards the Anglo-Saxon model, but wants to go its own way. The debate is about how far to tilt.”

Sir Howard Stringer, the first non-Japanese boss of Sony, the Japanese electronics giant, embodies the attempt to combine Japanese and Anglo-Saxon approaches. “In our company, as in others, there was a lurch towards the Western model,” he says. “My job is to manage that without alienating Japanese sensibilities. Some of the virtues of the Japanese model have to be retained. It is a balancing act, sometimes stimulating, sometimes frustrating, but there is merit on both sides.” It helps that he is a foreigner but not an American, admits Welsh-born Sir Howard.

Finding the right balance
But now that the economy is growing again, there is much debate about whether Japan has found the right balance or whether more reform is needed—or even whether it is time to reinstate some of the old ways. After the departure of Junichiro Koizumi, the charismatic and reformist prime minister who held office between 2001 and 2006, there is a sense that the political momentum for change has been lost. Instead, there is growing concern that the spoils of the recovery have not been equitably distributed, and that inequality is rising—a worrying phenomenon for a society in which 75% of people once identified themselves as middle-class.

“There has been a backlash recently, particularly since we recovered from the recession,” says Mr Seike. This contributed to the fall of Mr Koizumi's successor, Shinzo Abe, who resigned in September. Japan's new prime minister, Yasuo Fukuda, said in his first policy speech in October that “in promoting structural reform, we have seen disparity and other problems surface.” He was committed to further changes, he said, but would also address the inequalities arising from previous reforms.

Japan is now at a crucial stage. “Owing to the recent resurgence of the Japanese economy, support for reform is beginning to fade and the future of Japan can be said to be hanging in balance,” notes a report from Keizai Doyukai, a business lobby. Much of the political wrangling in Japan, and the various takeover battles and showdowns between activist investors and corporate executives, can be seen as part of the debate about how much more Japan needs to change, and how large a component of American or Anglo-Saxon capitalism ought to be incorporated into the new hybrid industrial model. “Japan has to Anglo-Saxonise, but in a Japanese way,” says Yasuchika Hasegawa, the vice-chairman of Keizai Doyukai. “Japan has to find its own capitalism style.”

Not everyone shares his enthusiasm for the hybrid model, which pays more attention to shareholders at the expense of other stakeholders in a company—in particular, its employees. There is obvious ambivalence about the adoption of American practices at Nippon Keidanren, Japan's conservative big-business association, which has campaigned to slow the pace of reform. When there are two models, says Masakazu Kubota, Keidanren's managing director, globalisation means the more competitive model will prevail. “Unfortunately, the most competitive system is in the United States,” he says.

In part, Keidanren is trying to shield its more dinosaur-like members from reform. But its scepticism reflects a wider concern. Japanese companies are social institutions, providing social cohesion and taking on many roles that in other countries are performed by the state. By contrast, the Anglo-Saxons view companies as money-making machines that can be freely bought, sold, merged and dissolved in order to maximise returns to shareholders. “What makes Japan interesting is that it's a society having a debate about shareholder versus stakeholder capitalism,” says David Marra, a Japan specialist at A.T. Kearney, a consultancy. “Japan is at a potential tipping point for the next few years.”

Yet despite the current political paralysis, reform has taken on its own momentum. The slow drip of legal and regulatory changes, many of them passed by previous administrations or introduced by Japan's powerful bureaucracy, continues. Individually, some of them do not amount to very much, but collectively they add up to a change in the Japanese business environment. “Retrospectively, the changes during the past decade were significant, and we are a different country now in many respects,” says Mr Hasegawa.

This special report will look at four of the most important areas of change: corporate governance, the labour market, the climate for entrepreneurs and innovation, and Japan's response to globalisation. It will examine what has changed and what has not; how and where Japan has struck compromises between the Japanese and Anglo-Saxon models; how widely the new hybrid model has been adopted; and whether it will be able to solve Japan's many problems.