Section 1 Business Behavior Being Normalized after Post-bubble Adjustments
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The Japanese economy has been recovering for more than four years since early 2002. Behind the prolonged recovery has been the business sector's elimination of the three excesses, in employment, capital stock and debt, to successfully enhance their strengths. As a result, their profitability has become far higher than in the past, indicating remarkable improvements. This may indicate not only a temporary effect of their restructuring efforts but also a structural shift to efficiency-oriented business behavior. The environment surrounding companies has changed dramatically through the globalization of economic activities and legal revisions. In response, changes have emerged in Japanese companies' business behavior, described as "Japanese-style management". Specifically, shareholders' role in corporate governance has grown more important as companies have unwound their cross shareholdings and reduced dependence on banks. Business accounting system revisions have prompted companies to shift their priority from quantitative expansion to cash flow. As employees' average age has grown higher, companies have reviewed traditional seniority-based wages and adopted performance-based wages.
In this chapter, Section 1 analyzes how companies have eliminated the three excesses, and whether business behavior is being normalized after post-bubble adjustments. Section 2 takes advantage of an exclusive questionnaire survey to look into the effects that so-called Japanese-style management practices seen commonly at many Japanese firms have had on their performances. Section 3 also utilizes a questionnaire survey to analyze how companies have evaluated and have been affected by legal, accounting, tax, pension and other system revisions. Finally, Section 4 looks into how the financial sector has changed through the completion of non-performing loan disposal and into their future direction. Section 5 summarizes analyses done in this chapter.
Section 1 Business Behavior Being Normalized after Post-bubble Adjustments
The business sector eliminated the "three excesses" in employment, capital stock and debt, through its tough restructuring between the late 1990s and the early 2000s. It has successfully enhanced its financial strength. As a result, corporate profits have been increasing steadily in the current economic recovery phase, lasting for more than four years, shrugging off external shocks such as the war in the Middle East and skyrocketing oil prices. From a micro viewpoint as well, positive signs have emerged in business behavior. Specifically, companies have increased business investment and expanded dividends in line with rising profits. However, business behavior has been more cautious than in the past. Business investment has still been limited to levels that cash flow (or internal funds) can cover. Wage growth, though emerging recently, has been slower than profit growth.
In this section, we review how the business sector has recovered through the elimination of the three excesses, and analyze how the elimination of excess debt in the business sector affects business investment and profit distribution. We also consider factors behind slow wage growth even after the elimination of over-employment. Finally, we utilize financial data of individual companies to demonstratively analyze how companies have improved their performances following their restructuring.
1. Business Sector Recovering on Elimination of Three Excesses
(Total factor productivity's sharp decline after collapse of bubble economy)
The 1990s, after the collapse of the bubble economy, was a tough decade for every industry. GDP growth and its breakdown in the Japan Industry Productivity Database(1) indicate the following features for the period between the collapse of the bubble economy and the start of the present recovery in 2002.
Real GDP growth for all industries slowed from some 4.4% for the 1980s to 1.1% for the 1990-2002 period. A breakdown of the growth accounting indicates that labor input's contribution to GDP growth fell by some 1 percentage point from the 1980s to the 1990-2002 period, due to a drop in labor input in terms of man-hours or the reduction of working hours, while the contribution of improvement in labor quality changed little (Figure 2-1-1). The contribution of capital input fell by a little more than 1 percentage point from the 1980s to the 1990-2002 period. Both capital quality and volume declined. This apparently indicated that capital quality deteriorated in the 1990s as equipment aged amid curbs on investment in new equipment. Finally, the contribution of TFP growth to GDP growth fell substantially from some 1.4 percentage points to about 0.3 point. Among relevant factors, the TFP growth thus made the largest contribution to lowering the GDP growth. Some analysts attribute the TFP decline in the 1990s primarily to a substantial drop in demand that lowered the operating ratio. Other analysts cite such supply-side factors as an inefficient distribution of resources and a delay in responses to information and other new technologies, as well as the demand decline(2).
The TFP's contribution to growth fell from 1.1 percentage point in the 1980s to 0.4 point in the 1990-2002 period for manufacturing industries, and from 0.4 point to zero for non-manufacturing industries. Among manufacturing industries, electrical and transportation machinery builders achieved the same productivity growth in both periods. Others generally saw a productivity decline in the 1990-2002 period. Among non-manufacturing industries, the construction sector saw a substantial productivity decline in the 1990-2002 period. The finance and insurance industry saw a substantial drop in productivity growth. The variation coefficient (the standard variation divided by an average), which was calculated to indicate productivity gaps between industries since the 1980s, shows that such gaps widened between the mid-1980s and the mid-1990s before leveling off.
Since data that are as specific as the JIP Database have not been made available for years from 2003, TFP data before the year may not be compared fairly with the recent data. A simple calculation based on the national accounts for 2003 and 2004 indicates that the TFP growth for all industries rose back to more than 1%(3).
(Companies improve profitability by eliminating 3 excesses)
As reviewed in Chapter 1, the three excesses in employment, capital stock and debt have fallen back to the levels for the early 1990s. Adjustments to reduce the excesses might have been completed. The elimination of the three excesses has allowed break-even point ratios at companies to drop, supporting their brisk earnings (Figure 2-1-2 (1))
Manufacturing industry had less excess debt than nonmanufacturing industry, while being plagued with more over-employment and more overcapacity. However, their restructuring efforts and demand recovery have solved over-employment and overcapacity since 2005. Their break-even point ratios have fallen back to the levels for the early 1990s. For manufacturers as a whole, a half of a drop in their break-even point ratio from FY1998 to FY2005 was attributed to the reduction of the labor cost. Another half owed to a sales expansion (Figure 2-1-2 (2)). Non-manufacturers, including real estate companies, had a greater excess debt. Over-employment and overcapacity were relatively limited for non-manufacturers excluding construction companies. As a result, the reduction of the three excesses at nonmanufacturers has been less than for manufacturers. Real estate companies have substantially cut their excess debt and construction firms have made a tough cut in over-employment. A decline in break-even point ratios for non-manufacturers has been slower than for manufacturers as employment and capital stock adjustments at non-manufacturers have been more moderate.
(Rising capital productivity)
Companies' asset efficiency has improved substantially on the elimination of the three excesses. According to the Financial Statements Statistics of Corporations by Industry, the return on assets for all industries at the end of FY2005 rose back from the latter half of 2% in 1999 to around 4.5%, the highest since 1992. Manufacturing showed remarkable recovery, boosting their ROA to about 6% at the end of FY2005 (Figure 2-1-3).
The ROA, even after the recent rise, is still lower than the level for the early 1990s in the bubble economy. But this does not necessarily mean that the capital productivity in the bubble period was higher than at present. This is because some bank loans which had supported most of the investment in the bubble period became non-performing as relevant investment projects failed to produce returns meeting repayments of loans. From the viewpoint of capital productivity, the ROA still includes the cost of capital and can be viewed as the "gross" value added rate of capital.
In contrast, there is a method to calculate the "net" value-added rate that gives consideration to capital costs. The net value added is called economic value added, or EVA. Stern Stewart & Co. has proposed the method to calculate the EVA(4). Specifically, the EVA is after-tax operating profit minus the cost of capital that is calculated from weighted average capital cost combining after-tax cost of liability and cost of equity capital. The cost of equity capital represents the expected rate of return on equity, calculated from the overall stock market trend and individual stocks' fluctuation rates.
Past studies have found that the economic value added for major Japanese companies had been negative during the bubble economy period as the return on investment (after-tax operating profit divided by investment) had slipped below cost of capital (Appended Table 2-1)(5). Our estimation, which uses financial data from some 800 listed companies that can provide necessary data in and after FY1999, indicates that the economic value added has turned positive since FY2002, mirroring the improved efficiency of companies' use of the capital (Figure 2-1-4). The return on investment has risen since FY2002, while the cost of capital declined slowly until FY2003. The ROI has thus exceeded the COC. A factor cited as being behind the improved capital efficiency for Japanese companies is that companies have grown more conscious of return to shareholders as capital investors, while stable cross shareholdings between companies have been unwound(6).
2. Elimination of Bubbles' Negative Legacy and Business Behavior Changes
Excess corporate debt swelled in the 1990s and it become a factor in suppressing an increase in business investment and other business activities, contributing much to the economic slowdown. As excess debt has been reduced from the late 1990s to the 2000s, companies have grown more positive about expanding business investment. Compared with the past economic peak, however, business behavior is more cautious, indicating that companies have given greater priority to efficiency. We would like to analyze how companies' financial conditions affect business behavior.
(1) Companies Continuing Debt Repayments
(Interest-bearing debt ratio falling at companies)
The ratio of interest-bearing debt to total assets (hereinafter called the debt ratio) at companies has been falling on a macro basis, as they have raised capital funds through equity issues while repaying interest-bearing debt. According to the Financial Statements Statistics of Corporations by Industry, companies' debt ratio leveled off between the early 1990s and 1998 before falling fast (Figure 2-1-5). The debt ratio has declined persistently and moderately at manufacturing industries, and continued rising until 1998 before falling fast at non-manufacturing industries.
(Debt repayment declining as seen from flow of funds)
Based on flow of funds data, we would like to look into how the business sector has repaid borrowings. According to the flow of funds, the non-financial corporate sector reduced outstanding borrowings by some 190 trillion yen between 1998 and 2005 while posting 21 trillion yen in average annual net savings. Net savings for the period aggregate some 170 trillion yen (Figure 2-1-6 (1)). This indicates that the non-financial corporate sector used most of the net savings to repay borrowings.
Let us use the national account to indicate how net savings have emerged at the non-financial corporate sector. Gross business investment declined by 2.1 trillion yen between 1998 and 2004. However, a net investment decline came to 8.5 trillion yen, as consumption of fixed capital increased by 6.3 trillion yen in the course of overcapacity reductions (Figure 2-1-6 (2)). During the same period, savings increased by 12.6 trillion yen, reflecting a sharp decline of 11.3 trillion yen in interest payments.
Recently, however, companies' debt repayment trend has indicated some changes. According to the flow of funds data, companies reduced debt repayments from 26.4 trillion yen in 2003 to 13.2 trillion yen in 2004 before increasing borrowing by 1.8 trillion yen in 2005(7). The business sector's net savings declined from about 38 trillion yen in 2003 to nearly 12 trillion yen in 2005.
(Mechanism for excess debt to curb business activities)
Companies utilize various means for raising funds for business and investment activities. Borrowings from banks represent a fund-raising means. There are some theories about how borrowings from banks affect business activities.
Regarding companies' general fund-raising activities, the Modigliani-Miller Proposition that the choice between equity and debt does not affect corporate value may be established in a perfect market(8). If there is an information asymmetry between borrowers and lenders in an imperfect market, companies are expected to base fund-raising means choices on lower capital cost. This is the so-called "pecking order theory." Specifically, companies are expected to choose fund-raising means in the capital cost-based pecking order of internal reserves, bank loans, and equity or bond issues. Banks loans are here estimated to cost less than equity or bond issues because banks are believed to have more information than ordinary investors about fund-raising companies.
Depending on the cost of capital, companies may try to reduce costlier borrowings as their internal funds increase on earnings growth. They may also tend to use primarily internal funds for investment. Companies with excess debt may face greater financial risks depending on a rising probability of their bankruptcy. If outstanding debt increases beyond a planned level, they may have an incentive to autonomously reduce debt and limit business investment to levels that internal funds can cover.
(Debt ratio continuing falling even after elimination of excess debt)
The fact that listed companies are continuing lowering their debt ratios, even after the elimination of excess debt, indicates that they are trying to take advantage of their robust cash flow to positively and strategically cut debt. This can be reaffirmed through the following demonstrative analysis.
Many companies are still repaying debt to lower debt ratios, even though more slowly than in the past. Theoretically, however, lower debt ratios may not necessarily be desirable. Given that interest payments on bank loans are counted as losses and deducted form taxable income, these loans, which are more favorable than equity issues in terms of costs, are expected to settle down at certain levels, depending on the balance between costs and rising debt-related risks. According to the Financial Statements Statistics of Corporations by Industry and other macro data, companies are still cautious about expanding loans even after lowering the debt ratio to pre-bubble levels and eliminating excess debt. In a bid to look into factors behind changes in companies' fund-raising activities, we have utilized panel data of some 1,350 companies listed on the first section of the Tokyo Stock Exchange to conduct a model estimation regarding determinants of debt ratios. Based on the estimation results, the recent debt ratio trend is interpreted as having the following features (Figure 2-1-7).
First, economic recovery has led to improved profit ratios and robust cash flow at companies, working to lower their debt ratios. A time series of debt's response to the ROA indicates that the debt ratio's decline responding to an ROA improvement after 1995 has been faster than in the first half of the 1990s. This apparently means that companies have given greater priority to the utilization of cash flow improvements for debt repayments than in the past.
Second, the debt ratio adjustment speed (1 minus the debt ratio coefficient) has been higher for non-manufacturing industries than for manufacturing industries. This means that non-manufacturing industries that have had relatively higher debt ratios than manufacturing industries have lowered debt ratios faster.
Third, a time series of optimum debt ratios as indicated by the estimation results shows that the ratio has persistently declined since the early 1990s. This apparently means that the companies subject to the estimation here are likely to continue lowering their debt ratios for the immediate future (Figure 2-1-7).
(2) Reduction of Excess Debt and Expansion of Business Investment
(Debt ratios having greater impact on business investment)
Higher debt ratios are theoretically expected to curb business investment, as companies with excess debt give priority to debt repayments rather than business investment. In accordance with the above theory, we have developed a model where companies' business investment can be affected by fund-raising factors such as internal funds and debt ratios, as well as by the basic factor of investment profitability as represented by a gap between the profitability of real assets and interest rate costs(9). The model has used panel data of companies for estimation.
The estimation results indicate the fund-raising factors have really affected business investment. Estimated data between FY2000 and FY2004 on a consolidated basis show that more cash flow leads to more investment and that a higher debt ratio brings about less investment (Table 2-1-8). Considering the possibility that a firm's business investment could be curbed by a relevant bank's balance sheet deterioration, we used a debt rating for each firm's main bank as a variable for estimation. The results indicate that the lower the rating is for the main bank, the less the firm invests. Given such estimation results, we can suspect that companies' business investment can be affected by excess debt, relevant banks' vulnerability and other financial constraints, as well as investment profitability.
In a bid to compare the past and present effects of fund-raising factors on business investment, we have estimated the same model each for the first and second halves of the 1990s and the first half of the 2000s using a company's financial data that is available on a persistent basis. In any of the periods, more internal funds tended to mean more investment. As for the effect of the debt ratio on investment, the debt ratio had an insignificant positive effect on business investment in the first half of the 1990s when a higher debt ratio accompanied higher business investment. In the second half of the 1990s when the effect was still insignificant, however, business investment tended to decline under a higher debt ratio. In the first half of the 2000s, the debt ratio had a significant negative effect on business investment. This means that a higher debt ratio worked to significantly curb business investment. Indications are that companies have recently been more conscious of outstanding debt sizes in making business investment decisions than earlier.
In the recent period, the ROA continued increasing with cash flow growing sharply, while the debt ratio dropped back to the levels of the early 1990s. All these factors have apparently contributed to the expansion of business investment. However, companies are now more conscious of balance sheets and cautious about business investment than in the past. They are now unlikely to excessively expand capacity on relaxation of financial constraints as seen in the bubble economy period.
(3) Growing Dividends
(Companies increasing dividends)
The Financial Statements Statistics of Corporations by Industry show that companies' dividend payout value remained almost unchanged irrespective of cyclical economic changes in the 1990s and the early 2000s. In and after FY2002, however, the dividend payout value turned up in tandem with earnings recovery (Figure 2-1-9). As net profit growth has exceeded dividend growth in recent years, companies have internal reserves as well. This tendency is not new. Even in the past, Japanese companies tended to pay fixed dividends irrespective of earnings. Their dividend payout ratios have tended to increase during a recession and decline during an economic expansion.
(Improved profitability and lowered interest-bearing debt ratio supporting dividend growth)
A traditional theory may be used to explain how much of profit companies pay out as dividends. Companies are expected to increase dividends without considerations given to financial constraints when they enjoy high profit ratios and robust cash flow or have great growth opportunities. But companies with high debt ratios are expected to curb dividend payments. We have used panel data of companies to estimate a model where a dividend rise or drop is an explained variable(10).
Estimation results, as expected earlier, indicate that such coefficients as the ratio of operating profit to total assets and the total asset growth have significant positive effects on dividends, while the interest-bearing debt ratio has significant negative effects. This means that companies expand dividend payments when seeing internal reserves growing on high profit ratios, but curb dividends and increase internal reserves when having high debt ratios (Table 2-1-10).
These estimation results apparently indicate that a decline in the interest-bearing debt ratio, as well as rising profitability factors such as the ratio of operating profit to total assets and the total asset growth, contributed much to the dividend payout expansion from FY2002 to FY2004.
3. Companies Still Curbing Personnel Costs and Lowering Labor Share
The labor share remained high in the 1990s and fell fast in the 2000s. It has now fallen back to the level of the early 1990s. Recently, wage growth has remained far lower than earnings growth. We would like to analyze factors behind the fall in the labor share and the slow wage growth after the fall.
(Labor share fell substantially in early 2000s)
In the 1990s, the labor share increased faster than indicated by productivity and capital deepening(11) (Figure 2-1-11). Hourly labor cost increased on the reduction of working hours, while the seniority-based wage system supported the downward rigidity of nominal wages even amid deflation. These factors in the 1990s are described as having worked to boost real wages in the 1990s(12). However, the labor share posted a remarkable decline in the early 2000s.
In a bid to analyze factors behind the labor share decline in the early 2000s, we assumed an ordinary negotiation-based wage model and considered two hypotheses - (1) that companies could curb wages as excess debt prompted them to give priority to their survival rather than the maintenance of certain wage levels, and (2) institutional changes such as the introduction of performance-based wages affected wage levels(13).
(Excess debt prompts companies to cut personnel costs)
As for the bargaining-based wage model, employees' bargaining power against managers is expected to influence wages. In addition to earnings conditions, employees' bargaining power (a change in the number of employees is used as a proxy variable) is assumed to have effects on wages(14). Industry average wages and the unemployment rate as the indicators of the supply-demand relationship in the labor market are also expected to affect wages.
According to the estimation results, the unemployment rate that indicates the supply-demand relationship in the labor market does not have any expected kind of effect(15). But the debt ratio is indicated as working to curb wages (Table 2-1-12-2)). From the 1995-1999 period to the 2000-2004 period, a wage adjustment speed (1 minus a wage coefficient for the first period) increased, indicating that wages were adjusted more quickly in the second period and that employees' influence on wages declined (Table 2-1-12-1)). Employees' bargaining power against managers might have decreased on personnel cuts under restructuring pressures.
(Adoption of performance-based wages can eventually curb personnel costs)
As for the effects of the performance-based wage introduction, the estimation results show that the cross section coefficient for the profit ratio and the performance dummy has significant negative effects on wages. This means that wages do not rise as much as indicated by earnings growth at companies that have introduced performance-based wages (Table 2-1-12-3)). Therefore, the introduction of performance-based wages might have worked to curb wages irrespective of earnings conditions, apart from whether companies intended to reduce wages through the performance-based wage system. The introduction of performance-based wages does not necessarily lead to a fall in wages for average workers. If companies pay aged workers more wages than warranted by their productivity under a seniority-based wage system, their introduction of performance-based wages may work to curb their overall personnel costs.
These estimation results indicate that the decline in the labor share in the 2000s might be attributable to a drop in employees' influence on wages after restructuring and high debt ratios curbing wages, rather than to the deterioration of the labor supply-demand relationship on a rise in the unemployment rate. In addition, it has become difficult for earnings conditions to be reflected in wages at companies that have introduced performance-based wages. This may be the reason wage growth remains slower than earnings growth even after the labor share decline.
4. Restructuring's Effects on Business Behavior
As reviewed above, the business sector has improved its performance, with productivity rising for the whole of the economy, as the sector has reduced the three excesses in employment, capital stock and debt. We here would like to analyze the performances of companies that implemented restructuring in the past.
(Wide-ranging restructuring measures adopted at companies)
Companies might have combined and implemented various restructuring measures to reduce the three excesses.
In the Cabinet Office's FY2001 Annual Survey of Corporate Behavior conducted in January 2002, over-employment was sensed by more than 50% of respondent companies, overcapacity by nearly 30% and excess debt by nearly 50% (Figure 2-1-13). The three excesses prompted companies to take various restructuring measures. Specifically, nearly 50% of the respondent companies implemented financial measures to improve their financial profiles, including reduction of excess inventories and interest-bearing debt, and sales of financial and real estate assets. Regarding business realignment and reorganization, some 50% downsized or consolidated unprofitable or less profitable divisions. Many companies also liquidated deteriorating subsidiaries and affiliates and realigned business divisions through mergers and acquisitions, or the holding company system. About 50% of the respondent companies took personnel cost reduction measures including the introduction of performance-based wages, bonus cuts, the reduction of recruitments and the replacement of regular employees with part-timers or temporary employees. Some 20% implemented direct measures to cut personnel costs, including wage cuts and the solicitation of voluntary retirement.
(Earnings improvements resulting from various restructuring measures)
How have these restructuring measures contributed to improving performances of companies? We have utilized the FY2001 business behavior survey and companies' financial data to estimate how restructuring measures implemented in the five years before the survey in early 2002 influenced relevant companies' earnings and stock prices by FY2004. Specifically, we have looked into how the return on assets changed between 1998 and 2004 at companies that implemented financial, business realignment and reorganization, and personnel cost reduction measures as reviewed above. We have also analyzed how these measures influenced Tobin's q (the ratio of a company's total market capitalization and debt to its assets) in 2005.
According to the estimation results, the ROA and Tobin's q increased at companies that took financial measures to reduce excess inventories and interest-bearing debt and sell real estate assets. Sales of shareholdings and securitization of assets also contributed to boosting the ROA (Figure 2-1-14). In a bid to confirm whether the reversed cause-effect relationship existed between restructuring measures and performances (performance data's influence on restructuring measures), we have also conducted a logit analysis of characteristics of companies that reduced inventories and debt. ROA figures for these companies were significantly lower than for other firms when such restructuring measures started between 1998 and 2000. Since 2002, however, ROA figures for the companies implementing financial restructuring measures have been higher or not less than for other firms (Appended Table 2-2). This may indicate that these financial restructuring measures have contributed to the ROA improvement.
The ROA and Tobin's q also rose for companies that implemented business realignment and reorganization measures to downsize or consolidate unprofitable or less profitable divisions and liquidate unprofitable subsidiaries or affiliates. But the introduction of the group-oriented management, as well as mergers and acquisitions, worked to lower the ROA. According to the logit analysis, to confirm whether the reversed cause-effect relationship existed between downsizing and consolidation measures and performances, as used above, ROA figures for companies that implemented measures to downsize or consolidate unprofitable or less profitable divisions and liquidate unprofitable subsidiaries or affiliates were significantly lower than for other firms between 1998 and 2000. Since 2002, however, ROA figures for the companies implementing such restructuring measures have recovered to levels as high as those for other firms. This may indicate that these restructuring measures have contributed to the ROA improvement.
The ROA rose at companies that implemented personnel cost reduction measures such as a shift to performance-based wages, replacement of regular employees with part-timers or temporary employees, early retirement incentives and executive pay cuts. The logit analysis, to look into the reversed cause-effect relationship, also endorsed these measures' positive effects on the ROA. On the other hand, the ROA declined at companies that reduced bonuses and recruitments. The reversed cause-effect relationship is seen as significant, indicating that companies faced with deterioration of earnings are forced to take such measures.
Next, we looked into relations between restructuring measures and corporate governance variables such as foreign ownership, main bank ownership and the ratio of outside directors to total board membership(16). The estimation results indicate that a company with its main bank's equity ownership at a higher level implemented such restructuring measures as sales of shareholdings and reduction or consolidation of unprofitable or less profitable business divisions. They also indicate that a firm that features a higher ratio of outside directors to total board membership conducted such restructuring measures as sales of real estate holdings, reduction or consolidation of unprofitable or less profitable business divisions and early retirement incentives. On the other hand, a company with a higher foreign equity ownership tends to limit restructuring measures. This may not indicate that a higher foreign equity ownership works to curb restructuring measures, but it may indicate that a company in which foreigners buy shares features fairly good earnings performances and does not have to take restructuring measures.