Imagine you’re running a country whose economy could perhaps use a bit of a boost. You could just spend some money on a few major construction projects, but you’d rather see domestic businesses grow more—especially since some have struggled to maintain high profit growth. If they improved, the whole economy would benefit.
But how do you get them to turn things around?
That’s the question facing Japan and China right now. And in late April, policymakers seemed to arrive at opposite conclusions.
China’s approach was straightforward and predictable. The State Council ordered state-owned firms (SOE) to keep profit growth over 10% a year. Just do it. Because we said so.
Well, orders are all well and good, but China’s missing a key ingredient: incentive. Where’s the motivation for firms to grow and earn more? State-Owned Assets Supervision and Administration committee chief Jiang Jiemin said firms should become more profitable because it’s their “political responsibility” to support growth. To some extent he’s right, since they’re tied to the state and run on the government’s dime. But that doesn’t necessarily give executives incentive to change the way the firms operate. Especially when they lack profit motive—even more so now, after officials have called for a greater portion of SOEs’ profits to be transferred to the state’s pension system. For executives, what’s the point of earning more if their firms can’t reap the benefits? Maybe they’re supposed to see Jiang’s statement as a veiled threat, and their incentive is avoiding retribution?
Call me crazy, but I don’t think threats are the best way to goad firms into earning more. Threats don’t inspire excellence—they just prompt people to do the bare minimum necessary to avoid the consequences. That’s not really a great way to get lasting results.
Now, that’s not to say China or its SOEs underperform looking forward—some SOEs have quite nice profits, and China has plenty of strong fundamentals in its favor, including strong economic growth, continued financial liberalization and more gains to reap from urbanization. One policy flub isn’t a gamechanger—it’s just emblematic of the government’s occasionally misguided mindset and communism’s larger shortcomings.
Japan’s strategy takes the other side of that philosophical debate and, in my view, represents a far more clever marketing idea than China’s blunt directive (provided other puzzle pieces fall into place—more on that in a bit). Fulfilling one of Prime Minister Shinzo Abe’s campaign pledges, the Tokyo Stock Exchange (TSE) revealed plans to create a new index of firms with high return on equity (ROE)—essentially a package of firms with the highest growth potential, regardless of size. The TSE’s primary index, the roughly 1,700-firm cap-weighted TOPIX, has become less attractive globally as its largest constituents—primarily the keiretsu conglomerates—have overall and on average become less profitable. Foreign investors have flocked more to regions with rip-roaring economic growth, like Emerging Markets, or with strong corporate profit growth, like the US. The new index would aim to change that by packaging firms with the highest growth potential, creating a new product that likely draws international investors not just to Japan, but to smaller Japanese companies they might not notice otherwise. A marketing plan seeking to increase investors’ awareness!
The initial batch of stocks listed on the new index would have identical business fundamentals as they do today on the TOPIX. Yet if the plan’s successful, Japan could benefit economically. First, more international investors means more foreign capital entering Japan—capital that, unlike the money from quantitative easing, would go to businesses and circulate through the broader economy. Second, to get on the index and get that investment capital, firms will have to boost their ROE. Currently, Japanese firms average a roughly 6% annual ROE—well behind the rest of the developed world—as growth-oriented investment has taken a backseat to cost-cutting amid Japan’s long-running deflation. Real gross fixed capital formation in 2012 was roughly ¥25 trillion below 1997’s peak level—that’s one of the biggest reasons for the 15-year economic stagnation. If firms were to invest more in an effort to boost ROE, Japan would regain a necessary contributor to economic growth.
And unlike Chinese SOEs under China’s “earn more now!” diktat, Japanese firms would have a strong incentive to invest and grow. Private-sector executives don’t just have profit motive—they have an obligation to maximize shareholder return. If investing more in research and development, new technology, new software and new business endeavors has the potential to boost their firm’s visibility with foreign investors—investors who could very well bid the share price up—the decision’s basically a no-brainer. Cash-based mergers and acquisitions, share buybacks and similar corporate activities would likely reemerge as well—all bullish for stock prices. But there’s a problem—the marketing plan is just a veneer.
Japan’s structural issues will not be resolved by simply creating a new stock index. There’s no easy fix for the country’s myriad problems. And as I write, Japan’s stuck in a bit of holding pattern while Prime Minister Shinzo Abe focuses on nationalist constitutional revisions instead of economic improvement. If this costs him some of his political popularity, true reform becomes difficult. But as a novel, incentive-based marketing approach seeking to boost private sector growth, the proposal to create the new index is a noteworthy development. And if it can take effect alongside other much-needed reforms to address issues like narrow labor force participation, waning productivity and protectionism, it may have minor potential to help Japan’s businesses get more profitable and dynamic in the long run.
It also suggests that despite their occasional political distractions, Japanese policymakers largely understand what their Chinese counterparts don’t—encouraging private firms to invest more and allowing them to deploy their earnings as they see fit, rather than surrendering them to a national pension scheme, is the best way to goad sustainable economic growth. If Chinese SOEs have to cough up a larger share of their earnings, they have less investment capital, which means less fodder for future growth. You’d think China wouldn’t want to handicap itself like this while it’s trying to shift to a more sustainable economic model. But old communist habits die hard.
Underneath all the red tape, protectionism and government meddling in key industries, Japan has a capitalist foundation with free markets and private property rights. If the government can discover the most sensible ways to unleash the private sector—and spend the necessary political capital to make the many needed changes—that capitalist system will enable Japan to move past the last 15 years of lackluster growth. Again though, that last “if” is a big one, and only time will tell whether there’s at least some realistic hope.
This constitutes the views, opinions and commentary of the author as of May 2013 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. No assurances are made regarding the accuracy of any forecast made. Past performance is no guarantee of future results. Investing in stock markets involves the risk of loss.
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