http://www.feer.com/features/2008/april/Japans-Great-Leap-Backward

April 2008 
Japan's Great Leap Backward
by Marc Goldstein
Posted April 10, 2008 

Tokyo — Japan’s stock markets are caught in a vicious cycle, a downward spiral 
of take-over fears and flagging stock values that politicians and regulators 
seem incapable of bringing to an end. Sadly, the biggest losers here are not 
those who play the market, but those Japanese households that are unable to 
rely on the markets to provide an adequate return on the pension-fund assets 
invested there. 

Japan’s benchmark Topix index has fallen more than 25% over the past 12 months, 
compared to a near 5% drop in the S&P 500. Part of this decline can be 
explained by the pressure on Japanese earnings from the weak U.S. economy and 
the yen’s strength against the dollar, and by profit-taking by foreign 
investors. 

But there are other factors at work as well. 

In response to a series of (unsuccessful) hostile takeover attempts, Japanese 
companies have rushed to implement poison pills, rebuild cross-shareholdings, 
and otherwise protect themselves against even the possibility of a hostile 
acquisition. In the absence of a genuine market for corporate control and the 
attendant pressure on management, merger premiums still lag behind those in the 
U.S.—as do dividend payout ratios and returns on equity—meaning that the 
Japanese market offers neither developing country growth rates, nor developed 
country income. It is hardly surprising that foreign investors have been 
reducing their holdings of Japanese shares, and hardly surprising that Japanese 
investors have not been rushing to replace them. 

As stock valuations plunge, companies find themselves even more vulnerable to 
an opportunistic takeover, which only increases their motivation to take 
defensive steps, which in turn drive away ordinary investors, perpetuating the 
cycle. In the U.S., poison pills designed to lessen a firm’s attractiveness are 
supposed to be used by target company boards as negotiating tools to win better 
terms from a would-be acquirer, or a white knight. But in Japan, where boards 
are still dominated by lifelong employees, pills have been used to delay such 
negotiations or avoid them completely. The reluctance of domestic investors to 
file lawsuits in such cases means that boards get away with blatant 
entrenchment. 

In a sense, the return of cross-shareholdings—reversing 15 years of progress in 
unwinding such relationships—is even worse for the market than poison pills. As 
Japanese companies learned when the 1980s bubble burst, tying up corporate 
assets in the shares of a business partner is a risky strategy: By committing 
to hold such shares indefinitely, and vote them with management in all 
situations, corporate shareholders are denying themselves both a voice and an 
exit—a situation which is hardly conducive to maximizing the value of the 
investment. According to estimates by Japan’s Nikkei newspaper, the overall 
value of corporate shareholdings fell 30% in 2007-08, meaning that such 
holdings underperformed the Topix and the Nikkei 225. Yet out of fear of 
hostile takeovers, Japanese companies seem determined to ignore the lessons of 
the post-bubble years, and are continuing to buy shares. Mark-to-market 
accounting is forcing companies to take losses as the value of these holdings 
declines, and once again the falling profits and falling share prices reinforce 
each other in a vicious cycle. 

But cross-shareholdings do more than put corporate assets at risk. They reduce 
liquidity by lowering the free float, and send a signal to the market that 
ordinary shareholders’ interests are not a priority. Owning shares in a 
customer or supplier is bad enough, but companies in Japan’s steel and paper 
industries are buying shares in companies that are ostensibly their 
competitors. Why should a fund manager buy shares in a company whose own 
executives would rather use spare cash to invest in a rival than to invest in 
their own business?
Japan’s Ministry of Health, Labor and Welfare has jurisdiction over the pension 
system, but is unable to regulate corporate behavior that threatens the 
solvency of that system. The Ministry of Economy, Trade & Industry, meanwhile, 
claims to want to increase foreign investment in Japan, but has also been 
helping companies block any investments they’re not ready to accept. And 
addressing the market downturn seems far down on politicians’ list of 
priorities. 

That leaves the Tokyo Stock Exchange, which could ameliorate the situation with 
stricter rules on free floats and concentration of ownership, and above all by 
requiring the appointment of independent directors to help protect 
shareholders’ interests. The TSE has historically been more attuned to the 
interests of issuers than those of investors, but if it truly wants to be one 
of the world’s leading markets, it will have to do more to ensure that the 
companies listed there are attractive investments. Japan’s pensioners and 
future pensioners have the most to gain from such a development. 

Mr. Goldstein is head of research at RiskMetrics Group/Institutional 
Shareholder Services in Tokyo. The views expressed here aren’t necessarily 
those of RMG. 



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