BoJ Briefing Sheds Light On Abe's Third Arrow

As part of a continuing effort by the Bank of Japan to increase the investment community's understanding of its policies, the representative office here in NY hosted a meeting with a Tokyo-based BOJ executive director.

Reforms
The key take away is that investors should not rush to judgment about Prime Minister Abe's third arrow -- structural reforms. Many observers shared our disappointment with the structural reforms Abe announced recently. Structural reforms, we thought, had to be at the heart of efforts to revive the world's third largest economy.

New, expanded and targeted structural reforms will likely be announced in late Q4. These reforms are likely to concentrate on the supply sides and may include efforts to encourage foreign direct investment. A chart the BOJ official displayed showed the stock of FDI was less than 4% of Japan's GDP at the end of 2011, compared with 19.5% in the US, 25% in Germany, 34% in France, almost 50% in the UK and 12% in South Korea.

Part of the supply-side reforms may include efforts to modify the legal framework to facility restructure failed businesses. Counter-intuitively, Japanese officials think that by making it easier to close inefficient businesses will help encourage Japanese entrepreneurs to start more businesses. Ostensibly, the idea is that making the exit easier will encourage more entries.

Patience
Japanese officials think that to boost the country's growth potential, it has to encourage businesses to replace the existing and old capital stock. Changes in corporate governance, the structure of ownership and reducing taxes are seen as essential means.
Japanese officials want investors to be patient and to recognize structural changes take time to implement and to take effect. This is evident in the Abe government, like the DPJ-led governments, efforts to promote increased women participation in the workforce.

Without knowing more of the specifics, it is difficult to evaluate the content of today's presentation. We share this information so our clients also know what Japanese officials are talking about in this "road show". Our preliminary sense is that Japanese policy makers are not thinking big enough terms. We would urge them to think bolder, outside the box.

Market Share vs. Margin
Moreover, we see the institutions in a country as part of an organic whole. Changes in corporate governance cannot simply be grafted on to existing institutions. For example, the function of Japan's stock market is not so much about the distribution of risk as it is about forging business alliances. Japanese businesses rely more on the patient capital of banks for investment funds rather than the impatient capital of markets. This means that Japanese businesses are incentivized, for example, to compete by preserving market share rather than profit margins.

The problem, we suspect, is that Japan's developmental model no longer works and, frankly, has not worked for many years. However, Japanese officials are reluctant to do more than cut and paste piece meal reforms, when they need the revolution that Abe had promised.