This Nation Is An Island

To understand Japan's economic milieu, you could do worse than to look at the current battle between famed British hedge-fund manager Christopher Hohn and the Japanese government. In January, Hohn, an activist investor who runs the London-based Children's Investment Fund, decided to double its stake in J-Power, Japan's largest electricity wholesaler, hoping to trim fat and boost returns at the top-heavy firm. The Japanese government promptly rejected the bid, citing nebulous concerns about "maintenance of public order." Hohn, who has been involved in shake-ups at ABN Amro and Deutsche Börse, wasn't deterred.

He's enlisted EU Trade Commissioner Peter Mandelson to plead his case to the Japanese, and has petitioned Brus-sels to begin trade sanctions. While the situation seems unlikely to evolve into a full-blown trade battle, Tokyo has clearly drawn a line in the sand.

The resistance toward not only Hohn, but many other foreign investors, encapsulates growing Japanese anxiety about their economy and place in an increasingly competitive global environment. Japan, of course, has always had an ambiguous relationship to the outside world. Throughout its history the country has oscillated between pathological suspicion of foreigners and eager imitation of alien ways. Recently some of the buried legacy of isolationism—manifested in a stubborn resistance to foreign investment and a reluctance to capitalize on the opportunities of globalization— has been coming back to the surface. And it's happening, arguably, at a moment when Japan can least afford it. In an age marked by the rise of the sovereign wealth fund, the non-Western multinational and near-instantaneous capital flows, Japanese insularity, say critics, is becoming a luxury that the country can no longer afford. "In the old days, foreign investors had no choice but to invest in Japan, and Japan could afford to respond to their calls [for change] gradually," says Kengo Nishiyama, strategist at Nomura Securities. "Today it has competitors in emerging countries; unless Japan moves fast, its relative attractiveness could fade."

To be sure, Japan is still plenty wealthy. It's the world's second largest national economy, it's the world's leading creditor nation and its blue-chip corporations still wield immense prestige and power around Asia and the globe. Yet Japan's relative position in the global economy has been dragged down by its own structural weaknesses (like its sagging demographics and slowing productivity) even as other countries are joining the ranks of the wealthy. In rankings of per capita GDP it has fallen from the No. 2 position 15 years ago to No. 18 today. Its share of the global economy has slid from 18 percent in 1994 to 10 percent in 2006. These shifts aren't absolute; view Japan's performance through the lens of purchasing power rather than nominal GDP figures (which can be distorted by exchange rates), and the situation doesn't look quite so dire. Yet the trend is clear.

Yukio Noguchi, a professor of finance at Waseda University, says that Japan is missing out on what he calls "the 21st-century version of globalization" based on the free flow of capital and knowledge. He has also coined a phrase that captures what he considers to be the essence of modern-day Japan: shihon sakoku (a closed capital nation).

Modern-day Japan is closed in two fundamental ways. First is its striking reluctance to allow foreign direct investment (FDI). Within the Organization for Economic Cooperation and Development, the club of the world's wealthy industrialized nations, Japan ranks dead last in terms of its ability to attract FDI. According to the Japanese Cabinet Office, the country's ratio of FDI to GDP in 2006 was 2.5 percent—compared with 8.8 in Korea, 13.5 in the United States, 25.1 in Germany and 44.6 in the U.K. The reason is a host of political and bureaucratic impediments—from product regulations to cross-shareholdings—that make it hard for foreigners to build up large shares in Japanese firms. "It all just sort of encourages foreign investors to look elsewhere, where investment rules are more transparent and predictable," notes Peter van den Heuvel, head of the trade section of the EU delegation in Japan. According to him, the attitude in Japan is that " 'we are very good; we don't need you all. If you want to come to Japan, work on our terms.' But that's not what international business is all about."

Increased investment from outside would bring countless benefits to the economy—not only fresh management expertise and ideas but also a competitive jolt that could spur innovation and productivity. And that's exactly the sort of inspiration Japan desperately needs if it is to overcome the limits of a work force that's both shrinking and graying. The last three Japanese governments have called robust growth in FDI an "indispensable condition" if the aging economy is to prosper in the 21st century. Japanese officials vow to increase the level to 5 percent of GDP by 2010—but that "seems extremely difficult," says van den Heuvel. "And if they do [achieve], it's still then a low level."

The other problem is Japan's inability to get better returns out of its assets. Little over half of individual financial assets—over $15 trillion—are kept in the form of bank deposits, which yields almost no returns. And most of them are in yen, with foreign-currency denominated assets accounting for less than 5 percent. That's hard to do at home, given the country's near zero interest rates and lingering deflation. Koji Shimamoto, chief strategist at BNP Paribas Securities, Japan, notes that the Japanese approach to financing pensions, for example, has always tended to be insular by definition—consisting of investments in Japanese government bonds and equity. In the old days, he says, "[t]hat was OK since it was the domestic economy that was growing. Today, Japan needs to seek outside markets for growth. Yet we don't seem to be equipped to make the change." Noguchi notes that compared with other developed countries, Japan's outward investment is conspicuously low. At 10.3 percent of GDP, it's merely about half that of the United States'.

Case in point: Japan's relationship to its own Asian hinterland. While other Asian countries were busily setting up free-trade agreements and trying to boost regional cooperation over the past decade, Japan remained aloof. Only recently has Tokyo woken up—to find itself lagging far behind Beijing, which has been especially aggressive in setting up FTAs with its regional trading partners.

According to a recent study of global capital flows by the McKinsey Global Institute, most of Japan's cross-border investments are in developed markets such as North America or Europe. But it's Asia that has been the source of the world's most dynamic growth for years, and it's there, surprisingly, that Japan remains a minor player. From 1990 to 2006, the report notes, Japan's share of global financial assets in Asia fell from 23 percent to 12 percent, while China's share increased from less than 1 percent to 5 percent. The report also says the financial assets of Asian countries outside Japan are growing much faster and that emerging markets have seen their share of financial assets slowly rise over time. By 2006, the report noted, financial assets in other Asian countries grew to $18.8 trillion, just shy of Japan's $19.5 trillion. While Japan's total financial assets remained flat, the rest of Asia's grew with astounding rapidity—led, of course, by China. For the time being, the study concludes, "Japan remains shut out of Asia's financial integration."

That judgment seems particularly ironic in light of the Japanese government's oft expressed intention to transform Tokyo into an Asian financial hub that might one day rival London or New York. For about one year now Japanese officials have been pushing the idea of an "international zone" in the city's downtown area where overseas bankers, insurance companies and investment funds could enjoy cosmopolitan culture and liberal regulation. The supporters of Tokyo's bid argue that making the city into a hub would give a much-needed jolt to Japan's calcified business culture by fomenting competition and spurring the modernization of its relatively staid financial establishment. "To make Tokyo change we need to have an international financial center here," says Ken Yagi, CEO of Bayview Asset Management, a Japanese investment fund based in Tokyo.

Sounds like a great idea—except that, given recent developments, it now seems virtually dead in the water. The recent turbulence in world financial markets has triggered a flight from Japanese stock markets that has sliced away nearly a quarter of the value of Japanese shares since last summer—despite the fact that Japanese credit institutions have had only minimal exposure to the subprime crash. A key reason is that foreign investors, who began piling into Japanese shares during the 2001–2006 term of the reform-minded prime minister, Junichiro Koizumi, have lost faith in the reform ability of his successors, including the present government of Prime Minister Yasuo Fukuda.

Others say they've been disillusioned by the efforts of corporate managers and bureaucrats to prevent foreign shareholders from exercising significant control over Japanese companies. The case of the Children's Investment Fund is only the most recent. Last fall, the Bull-Dog Sauce Co.—a 100-year old iconic company—diluted the shares held by Steel Partners, a U.S. investment fund that was angling for a takeover. The move was later approved by Japan's Supreme Court. "From the investors' point of view, this suggests that there is an enormous risk" in investing in Japan, says Nomura's Nishiyama.

Many members of the Japanese elite seem to like it that way. Tony Miller of the investment fund Ramius Capital says the problem is less a matter of irrational xenophobia than a deep fear of change, no matter who's bringing it. "The concern that companies with entrenched management have is that a new investor will come and force them to change doing business the way they have for years," says Miller. "They have the same level of resistance to domestic agents of change as they do to foreign agents of change." The establishment's fear is quite understandable. Thanks to the protections they've enjoyed at home, Japanese companies are now valued far less highly by the global market than international rivals are, making them potential targets for foreign takeovers—such as Arcelor Mittal v. Nippon Steel, the world's largest steel maker. Hence the recent rush among Japanese companies to set up poison pills and other takeover defenses—including a revival of cross-shareholdings, which allow a conglomerate to protect its subsidiaries behind a complex mesh of ownership ties. Under the cross-shareholding scheme, companies own shares with each other on the long-term basis and mutually become "stable shareholders." Such cozy webs appeared to be disappearing under Koizumi.

Then again, a lot of the reluctance to open up seems to have its roots in plain old complacency. Ordinary Japanese can be forgiven for thinking that their economy is still big and rich enough that there's no need to court outsiders. "On a certain level Japan just doesn't need money from the outside world," says R. Taggart Murphy, a professor of international business at Tsukuba University. "It's not like the U.S., which daily requires inflows of foreign savings." Kiyoshi Kurokawa, special adviser to the Japanese cabinet, frets that fewer Japanese are traveling to the United States to study—in striking contrast to the Indians and Chinese who are queuing up for foreign M.B.A. degrees. Kurokawa notes that one recent South Korean TV-sitcom told the story of two Koreans who fall in love at Harvard. "Can you imagine? For the Japanese that would be impossible." Tsuyoshi Komori, president of Mercer Japan, says there's "not enough sense of urgency here. The domestic market is so big that many people think they don't have to change right away."

Exhibit A: the striking lack of conversational English among many educated Japanese. In the past, says Komori, many assumed that they didn't need English, given that the primary task of the economy was making things for export. "Manufactured goods in and of themselves served as the medium of communication. But now the structure of the Japanese economy is changing. The service industry, which requires personal communications, matters far more than before." Whatever the reasons, it's clear that something has to give. Japanese companies, says Komori, have to globalize themselves. "The nature of money has changed profoundly in recent years," he says. "Capital moves so much faster than it did before. And Japanese companies [still putting emphasis on the consensus] just can't keep up with the trend."

So, how to break out of Japan's self-imposed culture of isolation? There are no quick fixes, as the obstacles are deeply rooted in Japan's economic model.

Some voices in Japan, including ex-economic reform czar Heizo Takenaka, are now calling for assets to be diversified into higher-return investments—perhaps via a Japanese sovereign wealth fund à la China or Abu Dhabi. Any unwinding of those American bonds would cause the yen to rise, something that no one in Tokyo wants to see.

But beyond the sheer economic challenges, there are massive cultural hurdles to overcome before Japan can take its rightful place in the global economy. The broadcaster NHK recently aired a memorable exchange between Charles Lake, a former U.S. trade official and present-day business executive in Tokyo, and a few of his fortysomething friends from the days when he attended Japanese school as a young expatriate. Over dinner, Lake—who also happens to be the head of the American Chamber of Commerce in Japan—found himself defending Western investors against the accusation that they're "vultures" who buy shares in Japanese companies merely so that they can plunder them and run. One of the Japanese friends wondered aloud whether Americans can work for American interests without somehow shortchanging Japan. When Lake responded that it's not a "zero-sum situation," one of the men shook his head skeptically. "If Japanese people say something is win-win, I'd understand that. But if an American says it's a win-win, I'd think, 'Is that true? Does he really mean it?' " The name of the documentary that contained the scene is revealing: "Nihon Banare," or "Battle Against Japan Passing." It's a phrase that's becoming ubiquitous, as Japan watches the world go by.

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