Are Japan’s keiretsu withering away?

This essay will outline and describe the Keiretsu with particular reference to their eco-

political backdrop in Japan during the “lost decade” that has led to the suggestion that

they are withering away. This essay will dissect the factors that seem to be

contributing to the apparent downfall of the Keiretsu. Each will be discussed and

illustrated with reference to industry examples. The empirical evidence for the

suggested demise of Keiretsu will then be assessed and a conclusion reached.

A keiretsu organisation is a network of companies with direct and indirect ties that

enables loose but broad coordination among a set of independently managed firms.

These modern Japanese business groups evolved in the post World War II period

from family dominated groups known as zaibatsu. The modern big six horizontal

keiretsu came into being when the former zaibatsu, Mitsubishi, Mitsui and Sumitomo,

were joined in the 1960s and early 1970s by the looser-knit bank-centred groups

formed around Fuji, Sanwa and Dai-Ichi Kangyo banks (Lincoln and Shimotani

2009).

At the core of the horizontal keiretsu is the main bank, which finances member firms

through debt and equity. This internal capital market insulates member firms from

market pressures. Complementing these horizontal keiretsu are vertical keiretsu

organized around a major industrial firm such as Matsushita, Nippon Steel or Toyota,

who display a vertical division of labour with its suppliers, subcontractors and

distributors. While still reliant on other members for finance these vertical keiretsu

are more concerned with the benefits of the customer and supplier relationship. The

web of shareholding between member firms within each keiretsu made foreign

takeover almost impossible, and was eyed suspiciously by the West as a structural

impediment to trade and investment in Japan (Imai, 1990). It leveled stock market

fluctuations, which helped reduce the pressure on management to achieve short-term

goals at the expense of long-term growth.

The benefits of keiretsu membership are well documented for affiliate firms. In

relation to the horizontal keiretsu, there is significant quantitative evidence

demonstrating main bank intervention not only preventing bankruptcy of troubled

affiliate firms but also restoring them to growth and profitability. For example, the

Sumitomo keiretsu rescue of the struggling Mazda Motors in the late 1970s, where the

group cautioned other group members not to sell their Mazda shares and even

encouraged Sumitomo executives to buy Mazda cars, as well as providing loans and

negotiating lower input prices.

While the keiretsu had clear advantages both for the member firms and the economy

as a whole throughout the 1960s and 1970s, as the Japanese economy faltered during

the “the lost decade” of the 1990s; government regulators, investors, and even the

popular press began taking aim at the keiretsu. Horizontal keiretsu intervention was

strongly criticized as weakening the economy as a whole and deepening the recession

by prolonging the life of inefficient and unproductive firms while preventing fit firms

and banks from recovering (Katz and Sugawara 1998). While the Japanese economy

postponed many of the worst consequences of recession through prosperous keiretsu

members supporting weaker ones, over time these weaker firms became an increasing

drag on the economy. In fact, it has been shown that big six membership benefits the

poor performing firms at the expense of the more successful firms (Ahmadjian and

Lincoln 2008).

There was fraying of specific intercorporate ties throughout 1980s and by the

late 1990s there was serious evidence of general keiretsu dissolution, owing to several

contributory factors. The business mindset in Japan was changing in order to bring

Japanese business practices in line with international standards. The Japanese

government, once loyal supporters of keiretsu networks, demonstrated this change in

attitude in 2002 when the Nagoya Regional Tax Bureau presented Toyota Motor with

a tax bill for undeclared income. The bureau ruled that the extraordinarily high prices

Toyota had paid a struggling supplier were transparent subsidies, not operating

expenses. In an earlier era, government agencies, whether local or national, would

have tolerated, if not tacitly supported, keiretsu risk-sharing interventions of this sort.

Banking Consolidation

The law that lead to the break up of the zaibatsu prohibited the use finance holding

companies and general holding companies. However, this was revised in 1981 to

allow for more banking integration.

Amidst economic downturn, threatened by constantly eroding capital bases due to

vast non-performing loans and declining stock prices, the main keiretsu banks were

forced to sell shares in their most profitable firms. In 1990, financial institutions held

43% of the market value of publicly traded shares yet by 2000 this had declined to

30.1%. This left the keiretsu weakened with a membership of relatively poorly

performing firms. This sell-off of cross-shareholdings by major banks, leaders of the

horizontal keiretsu, and their replacement with foreign institutional shareholders did

significant violence to the cohesion of the groups (Ahmadjian and Robinson 2001).

This was particularly noticeable for Mitsubishi post 2000 (Lincoln and Shimotani,

2009).

This reduction in profitability also led to a number of mergers for example: between

Sumitomo and Sakura Banks and the formation of Mizuho Bank in 1999. This process

reduced the number of major keiretsu banks from six to four. This reduced the

willingness of banks to lend resulting in increased use of commercial paper

(Ahmadjian (2008) shows that reliance on bank debt decreased since the 1980s) and

therefore independence of firms debt obligations.

As a result banks also retreated from their role in bailing out firms, and were rewarded

for doing so, and not punished as in the past, by the stock market (Lincoln and

Gerlach 2004). Sumitomo Bank, well known for its rescue of Mazda in the early

1970s, refused to play the same role twice, allowing Ford to take a controlling stake in

the troubled automaker in 1996 (Hoshi and Kashyap 2001).

Accounting Rule Changes

Changes to accounting rules certainly helped to unravel the keiretsu. 1996 brought a

big bang in the financial reforms taken by the Japanese government. From 1999

public firms were required to produce consolidated accounts, thus preventing the

practice of ‘tunnelling’ where firms could hide both assets and liabilities in partner

firms. Additionally in 2001, firms were forced to use mark to market accounting.

This is because firms were overpaying for acquisitions and then failing to adequately

depreciate them. To reduce exposure banks further reduced their cross holdings. I

believe these changes indicate recognition by the Japanese government that the

antiquated and inward Japanese business practices were detrimental to their

international competitiveness.

Foreign Ownership

The shift towards IFRS lead attracted foreign investors. From 1990 to 2002, foreign

investment in Japanese shares increased from less than 5% to about 18% (Dow and

McGuire, 2001). This change coincided with increased pressures towards Anglo-

American performance expectations as many foreign portfolio investors were from

the USA and UK.

This affected Horizontal and Vertical Keiretsu differently. Foreign ownership in

horizontal keiretsu firms led to weakened group affiliation but among vertically

affiliated firms foreign ownership actually reduced the likelihood of tie strength

dissipation (Dow and McGuire 2001). Empirical evidence actually shows vertical, but

not horizontal, keiretsu-based alliances formed for economies of scale and efficiency

actually accelerated in the late nineties (Lincoln and Shimotani 2008). This appears to

be motivated by a desire to prevent foreign takeover of strategically important

suppliers, with the liberalization of M&A rules and rise in foreign investment, as well

as seeking gains from closer ties in a fiercely competitive global market. Perhaps this

marks a revival of the vertical keiretsu whose claim to economic rationality was

always stronger than the horizontal groups and had yet dissolve to the same degree.

When the Brazilian CEO of Nissan, Carlos Ghosn, undertook to dismantle the Nissan

supply keiretsu he was heavily criticized but as his turnaround of Nissan succeeded

his methods were vindicated, public opinion shifted and the keiretsu-style supplier

relations became less sacred.

Corporate Governance Reform

Traditionally, large boards, whose interests came before those of the shareholders, had

played an integral role in the keiretsu system of executive exchanges and interlocking

directorates. Due to the cross-holdings within the keiretsu, shareholder pressure has

traditionally been minimal while there is also a systematic failure of Japanese boards

to question management. However, changes to corporate governance codes of practice

have encouraged firms to adopt the ‘North American’ style with a smaller board and

an increased role of independent outside directors. For example, in 1997 Sony

reduced its board from thirty-eight to ten while increasing its outside directors from

three to five. In spite of this, the recent 2011 Olympus scandal illustrates that while

keiretsu ties may have loosened during the domestic recession and despite the

corporate governance reforms, the cronyism has remained. Japanese business still

displays the practices of old despite the general trend of reform. According to a recent

Financial Times article, the outcome of the Olympus scandal will send a strong signal

to the outside world about whether Japanese attitudes towards corporate governance

have really changed. (M Nakamoto 22/2/2012)

Conclusion

Despite the recent restoration of equity ties, without the other characteristics such as

preferential business and personnel transfer, such cross-shareholding cannot constitute

a revival of the “keiretsu” in the traditional network sense. While the Japanese

economy retains its distinctive features, the restructuring and management of its

business organizations it is now much closer to the Anglo-American West, as shown

above.

While some core features of the post war keiretsu remain, the underlining business

mentality has been eroded away such that these traditional business groups no longer

represent a significant feature of the Japanese economic landscape. I suggest the

banking reform, with less cross-shareholding and fewer core banks, allied with the

new mindset of the government, recognising change was required to compete

globally, did the most destructive damage to the keiretsu. A spiral occurred with the

corporate governance reform and foreign ownership introducing greater transparency

into the business groups, which encouraged and allowed greater foreign ownership

and corporate governance. This promoted a more efficient and capitalist

environment, with a “sink or swim” mentality.

The disintegration of the keiretsu should be seen as a positive process for the Japanese

economy. The modern global economy is fiercely competitive and for Japan to attract

foreign investment, especially with a stagnating domestic economy, it is imperative

they have open and transparent corporate governance, a willingness to embrace free

market economics and efficient business practices. While the keiretsu certainly held

benefits in the past, the structure is unsuited to the interdependent and open modern

economy where national boundaries are less relevant.

Some groups will survive and others will not. This split is already apparent in the

contrast between Toyota and Nissan, which have now established two very different

models: one of existing Japanese-style group management and the other with a far

more arm's-length stance towards its suppliers. It is not clear which model will win.

Nissan has overcome a near-death experience, while Toyota has been achieving

record profits.