The Japanese corporate sector, the vitality of which appeared indisputable a decade ago, is currently under great stress. Since 1990, the performance of the Japanese corporate sector has lagged that of its counterparts in several large industrial countries. As a result, while a number of large export-oriented companies continue to be strong, concern has grown about the overall health of Japan’s corporate sector. A perception has emerged that the average Japanese firm is highly leveraged and in a fragile situation, and that large corporations cannot expect their considerable accumulated wealth to substitute permanently for strong rates of return from core businesses. Indeed, in the absence of genuine restructuring, the gradual depletion of these resources and poor prospects of profits had until recently led to a persistent decline in Japanese equity prices. These factors also contributed to the lowering of the credit ratings of many top Japanese corporations, including several major trading companies.

The Japanese corporate sector, the vitality of which appeared indisputable a decade ago, is currently under great stress. Since 1990, the performance of the Japanese corporate sector has lagged that of its counterparts in several large industrial countries. As a result, while a number of large export-oriented companies continue to be strong, concern has grown about the overall health of Japan’s corporate sector. A perception has emerged that the average Japanese firm is highly leveraged and in a fragile situation, and that large corporations cannot expect their considerable accumulated wealth to substitute permanently for strong rates of return from core businesses. Indeed, in the absence of genuine restructuring, the gradual depletion of these resources and poor prospects of profits had until recently led to a persistent decline in Japanese equity prices. These factors also contributed to the lowering of the credit ratings of many top Japanese corporations, including several major trading companies.

At least three factors have contributed to the fragility of the corporate sector. First, the surge in investment that occurred in the late 1980s yielded very low real returns, in part because much of it was directed to sectors in which Japan did not have a comparative advantage, while the similar diversification strategies followed by many large companies led to an excessive number of entrants in many markets (Mitsuhiro, 1994, and Moriaki and Yoshinobu, 1997). Second, Japanese companies were adversely affected by cuts in credit availability and widening credit spreads linked to Japanese banks’ attempts to maintain adequate capital. Finally, the economic slowdown in Japan was accompanied by deflationary pressures that helped erode the revenue-to-debt ratio of Japanese firms.1 These factors were compounded by weak accounting and financial control systems, and the cumulation of unfunded corporate pension liabilities.

The intensification of pressures on corporations spurred a string of announcements of restructuring plans. Increasing attention by banks to credit quality—in part because of tighter regulations and more rigorous bank supervision—together with a sharp decline in profits were accompanied by a surge in announcements of corporate restructuring plans in early 1999. Market reaction to these plans was generally positive, but guarded. This reaction reflects doubts about whether the degree of planned restructuring is on a par with the magnitude of the challenges.

During 1999, the government took a series of measures to facilitate the restructuring of corporate assets and liabilities, as well as the reallocation of resources across sectors. A three-pillar strategy emerged:

  • tax incentives to encourage business innovation and restructuring, including the reduction of production capacity;

  • mechanisms to address the debt overhang problem, such as bankruptcy law reform to provide more effective reorganization procedures, and changes in the commercial code and other legislation to facilitate debt-for-equity swaps, corporate spin-offs, and the exchange of stocks in connection with corporate restructuring; and

  • reinforcement of the social safety net to reduce the problems associated with labor mobility.

This approach attempts to spread the adjustment effort over corporations, banks, and employees, with public funds used to cushion some of the costs. This use of public funds may help mitigate the short-term macroeconomic impact of corporate restructuring, although it could bring long-term risks, particularly if large corporate bail-outs aggravate an already difficult fiscal position, or if it creates moral hazard by reducing incentives for prudent corporate governance.

This chapter analyzes the factors pushing Japanese corporations into restructuring and discusses the steps being taken in this direction. It describes the leverage of the corporate sector and increasing signs of financial strain in the sector. It goes on to discuss how much corporate restructuring is needed and recent restructuring steps. It also reviews some institutional impediments to restructuring and recent official initiatives. The chapter closes with a section discussing prospects and risks. An appendix provides a brief discussion of market reactions to recent announcements of corporate restructuring plans.

Approaching the Crossroads

Corporate Sector Leverage

Overall, corporate leverage is higher in Japan than in most other large industrial countries.2 Large Japanese firms are less leveraged than their U.S. or German counterparts (Figure 8.1),3 but the high leverage of small and medium-sized firms (around 600 percent) pushes up the overall figure for the Japanese corporate sector (top panel of Figure 8.2). It should also be noted that there is an increasing disparity in leverage ratios among large firms. For instance, the average net debt/equity ratio of the lower quartile (in terms of indebtedness) of firms listed in the first section of the Tokyo Stock Exchange (TSE1) has remained stable at around 50 percent in recent years, while the leverage of the top quartile rose from 500 percent to 700 percent (middle panel of Figure 8.2).

Figure 8.1.
Figure 8.1.

Corporate Leverage and Nonfinancial Sources of Funds

Sources: U.S. Federal Reserve; Bank of Japan; Bundesbank; and OECD.1For the United States and Japan, leverage is defined as net worth (with assets at historical prices) divided by liabilities; for Germany, leverage is defined as own funds divided by liabilities to creditors.
Figure 8.2.
Figure 8.2.

Selected Indicators of Corporate Leverage

Sources: TSE1; and WEFA, Nomura database.

Banks have been the main source of corporate credit, although large firms have increasingly substituted bond issuance for bank finance in the last 15 years (bottom panel of Figure 8.2). Roughly 70 percent of bank corporate loans are now to small and medium-sized firms, which also rely significantly on intercorporate credit. Although banks are still an important source of financing to large corporations, the reliance of such firms on market instruments (such as bonds and CPs) is well illustrated by the high share of these instruments in the liabilities of firms belonging to the six largest economic groups (43 percent).

Corporate indebtedness also varies across the economy. As is typical in most countries, leverage in Japan is higher in nonmanufacturing than in manufacturing (the consolidated net debt to equity ratio of large firms in the respective sectors is 250 percent and 60 percent). Within the manufacturing sector, large parent companies actually tend to have negative net debt. Among large firms, the average leverage has been pushed up by increases in the construction sector (the net debt to equity ratio rose fourfold since 1990), in the retail and trading sector, and in some segments of the manufacturing sector (such as electrical machinery, and pulp and paper).

The high leverage of Japanese corporations reflects in part the widespread reliance on external funding. For most of the postwar period, retained earnings were insufficient to finance the heavy investment schedules pursued by Japanese firms. Internal funds still accounted for less than 60 percent of corporate investment in nonfinancial assets in the late 1980s (a share that increased somewhat in the 1990s as the economy slowed down and investment rates declined); by contrast, in Germany and the United States, internal funds are typically almost as large as the amounts committed to fixed investment in years of strong economic growth, and exceed these flows when the economy slows.

Partial financial liberalization and a surge in land prices spurred the expansion of Japanese corporate balance sheets in the 1980s. Partial financial liberalization starting in the early 1980s granted large firms greater access to capital markets and allowed them to increase sharply their financial assets (top panel of Figure 8.3). This shift also prompted banks to substitute small and medium-sized firms for these borrowers and resulted inter alia in a 90 percent increase in long-term loans.4 The loosening of monetary policy after 1985 and the ensuing rise in the price of land (which was the prime collateral for bank loans) compounded these forces. Overall, corporate debt increased by about 60 percent in the second half of the 1980s (close to 50 percent at constant prices). A drive toward corporate diversification fueled a 60 percent rise in the stock of reproducible fixed assets, which was mirrored by a roughly similar expansion in corporate financial assets.

Figure 8.3.
Figure 8.3.

Selected Indicators of Corporate Liquidity and Equity Value

Source: WEFA, Nomura database.

The aggregate book value of the Japanese corporate sector continued to grow after the bursting of the “asset price bubble” in 1990, supported in part by the revaluation of latent capital gains on land-and stock-holdings. Despite the economic slowdown that followed the collapse of asset prices in 1990, the aggregate liabilities of the 300 largest firms listed in the TSE1 rose by 25 percent in 1990-97, while the book value of their equity increased by some 30 percent (Table 8.1). This increase was underpinned by a 60 percent rise in the book value of fixed assets, stemming in part from the revaluation of land. Stockholdings were also subject to a similar revaluation process, notably in the banking sector. Although an official study prepared in 1999 suggests that the top 50 firms still have sizable unrealized gains on land (the last mandatory revaluation of land occurred in 1952), the process of systematic revaluation of stockholdings appears to have run much of its course.

Table 8.1.

Combined Balance Sheet of the Nikkei 300 Non-Financial Companies

(Trillions of yen, unless otherwise indicated)

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Source: Goldman Sachs.

The progressive depletion of latent reserves has been reflected in the decline of the market-to-book value ratio of Japanese firms in recent years. In contrast with figures emerging from the aggregation of firms’ book values, national account estimates of firms’ assets and liabilities at market prices indicate a 25 percent decline in the net worth (equity value) of Japanese firms in 1990–93 (middle panel of Figure 8.3). The contribution of land to this decline is substantial, as land accounted for one-third of Japanese firms’ assets in 1990 (land accounts for about 10 percent of the balance sheet of U.S. corporations) and the overall value of these holdings has declined by around 30 percent subsequently. The conflicting trends of book values boosted by revaluations of latent reserves and the decline in the market value of the assets underlying these reserves have been reflected in a 75 percent decline in the market-to-book value of Japan’s corporate sector since 1990 (bottom panel of Figure 8.3). The market-to-book- value ratio of TSE1 firms dropped by half from 1990 to 1992. Since 1996, there has been a further decline of that ratio, especially among the smaller firms. While the market-to-book-value ratio of the largest, oldest firms is still close to 2.0, the ratio for the smallest firm in the TSE1 has fallen around one.

Signs of Increasing Strain

Until recently, the growing fragility of corporate balance sheets was cushioned in part by the relief provided by declining interest rates—a trend now being reversed. Average interest rates on loans declined from 8 percent to 2 percent in 1991–97, allowing the proportion of gross interest expenses to sales to decline by 40 percent, despite the deterioration of firms’ revenues during the period (top panel of Figure 8.4). From late 1997, however, financial turbulence and the tightening of regulatory standards by the supervisory authorities have driven a widening of credit spreads, while credit lines were curtailed. With the economy entering a prolonged downturn, sales declined 6 percent and profits dropped by roughly 30 percent in 1998. Despite the decline in market interest rates through 1998, the ratio of interest payments to sales began to increase.

Figure 8.4.
Figure 8.4.

Selected Indicators of Firms’ Cash Flow and Bankruptcy

Source: WEFA, Nomura database.

Widespread corporate losses and troubles in the banking system have resulted in an erosion of the traditional sources of mutual support among corporations and in the deterioration of the credit rating of the Japanese corporate sector. In the past, firms belonging to an economic group (kigyio shudan and associated keiretsus) could count on support from their peers, parents, and main banks when facing distress.5 The deterioration of banks’ financial standing in recent years and the increasingly widespread weakening of corporate balance sheets have provoked changes in this behavior. With the ratio of loss-making firms increasing by about one-third,6 and the depletion of reserves of large firms, it became harder to predict whether a distressed company would receive financial support from these traditional sources. For instance, several keiretsu companies refused to help related companies to raise capital or issue bonds when bank credit became scarce in 1997–98. With companies having to increasingly stand by themselves, credit agencies warned that the relationship between the ratings and corporate leverage of Japanese firms would converge toward that of U.S. companies. Moody’s downgraded 82 Japanese nonfinancial corporations between February 1998 and March 1999, while Standard & Poor’s downgraded about two dozen companies over the same period.

Corporate fragility has been manifest in a steep rise in the number and size of corporate bankruptcies. The number of corporate bankruptcies started to accelerate in 1997, with the year-on-year growth rate of new corporate bankruptcies approaching 35 percent in May-July 1998 (middle panel of Figure 8.4). Moreover, because for the first time large firms started to go bankrupt, the debt left by failing companies rose by 70 percent in 1997-98, compared to 1995-96 (bottom panel of Figure 8.4), about three times faster than the growth of the number of bankruptcies over this period. In the second half of 1998, however, the authorities took several steps to sustain credit to the corporate sector, and the number of bankruptcies subsided. Most important among these measures were the substantial public funding provided for widespread loan guarantees for small and medium-sized enterprises, and special credit lines for firms facing the imminent redemption of bonds issued in the late 1980s.

New accounting and reporting rules are making firms’ vulnerabilities yet more evident. Several changes in accounting and reporting rules take effect in 1999–2002 (Table 8.2). These changes are increasing the transparency of corporate financial statements and, in part because of market pressures, motivating Japanese companies to address some problems that have until now received little scrutiny.7 In particular:

  • Consolidated accounts will help clarify the overall profitability of Japanese firms and their actual cost of capital (consolidation is mandatory as of March 2000).8 In an environment of weak profits, consolidated accounts are expected to reduce the scope for crosssubsidization, prompting parent companies to close or restructure unprofitable subsidiaries and reduce guarantees to affiliates.

  • Marking to market firms’ financial assets will expose a firm’s sensitivity to changes in the market value of their holdings of financial assets, including stockholdings. The double gearing provided by cross-shareholdings could thus become a source of profit volatility, encouraging companies (and financial institutions) to reduce the presence of these holdings in their books.

  • The disclosure of corporate pension liabilities and the extent to which they are underfunded is expected to raise the recognized leverage of Japanese firms and put pressure on corporate earnings.

Table 8.2.

Timetable for Japan’s Accounting Reforms

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Sources: Tatsumi Yamada, Chuo Audit Corporation, and The Nikkei Weekly, July 6, 1998, p. 13.

The exact amount of unfunded corporate liabilities is not known, but market analysts have estimated that in the case of large firms, it could be equivalent to one-fifth of firms’ equity. Unfunded corporate liabilities are roughly equivalent to a net debt of the firm toward its employees, although in Japan firms are not legally bound to fulfill all pension commitments. Japanese firms are not currently obliged to disclose the extent to which their pension liabilities are funded, but market analysts have prepared estimates based on disclosures made by Japanese companies listed in the United States, which file their annual reports according to U.S. standards.9 Adjusted for the current low rate of return on Japanese assets and extrapolated to cover all companies listed in the first section of the Tokyo Stock Exchange, these figures suggest that on a consolidated basis the underfunding is in the ¥50–80 trillion range (Goldman Sachs, 1998).10 This amount is equivalent to about 5–10 times the current profits posted by listed companies in FY1998 (current profits amounted to less than ¥10 trillion, and net profits were below ¥1 trillion). These estimates of liabilities, although large, may not be exaggerated, as suggested by the disclosure in the spring of 1999 of Nissan’s unfunded liabilities, which amounted to ¥330 billion, or more than 25 percent of the firm’s consolidated equity. Given the magnitude of these potential liabilities and the discretionary aspect of some pension commitments, some analysts have also raised the hypothesis that firms could also consider renegotiating these implicit contracts with workers.

Directions for Change

How Much Corporate Restructuring Is Needed?

The deterioration of corporate financial indicators reflects the underlying problem of overcapacity. Return on equity in Japan has dropped from around 7.5 percent in the late 1980s to an average of 2.8 percent in FY1991–98 (top panel of Figure 8.5). Estimates of the total cost of capital suggest that many TSE1 companies have not generated enough income to adequately compensate the resources mobilized in support of their activities.11 These financial indexes suggest the existence of significant overcapacity. Indeed, the capital-to-output ratio has been well above trend, and capacity utilization in the manufacturing sector has dropped to around 65–70 percent.12 The slack is typically larger in those industries where capacity increased more in the 1990s (middle panel of Figure 8.5), and cannot be fully attributed to cyclical factors (see Chapter 4 by Ramaswamy in this volume). Although not easily measured, overcapacity is also severe in the nonmanufacturing sector, in part because partial liberalization of some subsectors has reduced rents, implying cashflows that have not validated early investments (Ooyama, 1999).13

Figure 8.5.
Figure 8.5.

Selected Indicators of Profitability and Capacity Utilization

Sources: TSE1; MITI; and WEFA, Nomura database.1ROA, Return on Assets; ROE, Return of Equity.2Six-month average.

The burden of overinvestment has been compounded by a rise in labor costs that has outpaced economic growth. Corporate sales were 11 percent higher in 1998 than in 1990, while labor and overhead costs were 47 percent higher (bottom panel of Figure 8.5). Part of this increase in labor costs occurred in the early 1990s and, more generally, reflects the shift of the economy toward the service sector (which reduces the share of purchased goods in sales). Despite reductions in bonuses and overtime that have contributed to a decline in labor costs, the disconnect between costs and revenues has become more prominent with time. For instance, labor costs declined by 1 percent in 1998, substantially less than the contemporaneous 6 percent drop in nominal sales.

Raising the return on assets (ROA) of the corporate sector back to their historical average or to international levels would require an enormous effort. Since 1990, the ROA for the Japanese corporate sector as a whole has halved to roughly 2-2¼ percent (bottom panel of Figure 8.6), compared with 5½ percent for U.S. companies. The arithmetic of raising that ratio back to its historical average of around 3½ percent would require (assuming constant revenues) either an extraordinary reduction in assets or—given the share of labor cost in corporate revenues—a 15 percent reduction in such costs.14

Figure 8.6.
Figure 8.6.

Composition of Costs and Return on Assets

Source: WEFA, Nomura database.

Institutional Factors and Recent Restructuring Steps

Recent restructuring efforts have been concentrated among large firms. Traditionally, corporate adjustment in Japan has followed a pattern in which large firms use the shelter provided by their intra-group ties to internalize costs (such as by hoarding and reshuffling labor), while small- and medium-sized companies either downsize or close. This pattern was broadly maintained until mid-1998, as suggested by the somewhat contrasting pattern of bankruptcies, investment, and employment among small and large firms (Figure 8.7).15 Since then, there have been signs of new patterns of corporate restructuring. In particular, some large firms have undertaken significant efforts to restructure, while small and medium-sized firms have generally benefited from special loan guarantees and other measures aimed at providing them with breathing space. This shift can in part be credited to large firms’ expectation that the Big Bang financial reforms will continue to be implemented and bank supervision tightened. In such an environment, large, wealthy firms have strong incentives to reorganize their balance sheets, redeploying assets to raise profits and reduce liabilities.

Figure 8.7.
Figure 8.7.

Selected Indicators of Corporate Adjustment, 1997–99

Sources: Ministry of Finance; and WEFA, Nomura database.

The number of announcements of corporate restructuring plans surged in 1999, with market reaction to announcements varying according to the type and scope of measures announced. The surge in the flow of announcements was in part attributed to the magnitude of losses many firms expected to incur in 1998-99 (Table 4.2),16 and possibly in part to positive market reactions to the example set by a few large, profitable firms that have announced restructuring plans. A qualitative change was also perceived in some of these plans. In the past, the majority of restructuring plans aimed essentially at restoring the firm’s near-term solvency rather than at deep corporate restructuring with a view to improving profitability on a sustainable basis. Restructuring plans consisted mainly of gradual reductions of personnel through attrition, and the occasional financial reorganization of subsidiaries (often with a component of debt forgiveness on the part of the parent company), without fundamental shifts in business strategy. By contrast, a number of more recent plans have included ingredients such as the establishment of clear lines of authority, improved accounting and financial control systems, withdrawal from noncore business, and the forging of links with foreign partners.17 In the case of nonfinancial corporations, the announcing firm’s stock price more often than not rose when markets viewed its plans as underpinned by genuine change (see Appendix).

Mergers and acquisitions involving foreign investors have become more common. The number of mergers and acquisitions by foreign companies in Japan doubled from 1996 to 1998, and is likely to have increased further in 1999. Although the absolute numbers are still small (75 in 1998), the size and nature of these deals have changed. For instance, several recent deals have involved large Japanese companies that are sectoral leaders, as the waning of the traditional support elements has motivated firms to turn, albeit sometimes reluctantly, toward foreign partners. Such deals started in the financial sector, where foreign firms acquired bankrupt institutions (for example, Merrill Lynch acquired the branch network of the failed securities broker Yamaichi) or took a major stake in a profitable part of the business of Japanese firms (GE Capital opened a new venture with the insurer Toho, and Citicorp joined with Nikko Securities). More recently, foreign investments in the industrial sector have become more prominent, as illustrated by the acquisition of a large stake in a major automaker by a foreign company, as well as the purchase of a large tire company from a major keiretsu firm and the hostile takeover of a major telecommunication carrier by foreign investors.

Several informal debt workouts were concluded following a revision of the tax treatment of loan write-downs by banks in 1998 and the injection of public funds in major banks in March 1999. Bank-led informal reorganizations of companies, which had traditionally been the dominant form of corporate rehabilitation in Japan, were hindered by banks’ weak capitalization through most of the 1990s.18 In the first half of 1999, however, about a dozen midsized companies reached agreements with their bank creditors (Box 8.1). The announced plans involved write-downs in excess of ¥1 trillion, shouldered mainly by the firms’ main banks, which typically contributed 50-85 percent of the total debt forgiveness. These workouts have been instrumental in averting bankruptcies (by contrast a leading glass-producing company that failed to complete a workout by the end of the fiscal year went bankrupt) and may presage a renewed reliance on informal mechanisms to facilitate corporate restructuring. Market analysts have, nevertheless, raised concerns that in some cases workouts have been geared more toward reestablishing the short-term solvency of the debtor than to allow the beneficiary firm to undertake a genuine restructuring plan.

Widespread corporate restructuring still faces institutional impediments, such as the high cost to firms of reducing employment. Job separation from large companies has historically been voluntary. Court rulings in the late 1970s made dismissals cumbersome (favoring the reshuffling of employees across subsidiaries), which led firms aiming at a real reduction in head counting to offer voluntary early retirement programs.Morgan Stanley Dean Witter (1999) estimated that the typical early retirement program has cost around ¥22 million (US$180,000) per worker, while noting that the payback period of eliminating redundancies through this mechanism was in some cases (such as in the oil industry) as short as 3 years. Despite this potentially short payback period, cash-strapped firms may have trouble financing such labor reductions.

Until now, tax and legal factors have not favored corporate restructuring. For tax purposes, Japanese firms can carry losses forward over five years. Owing to the structurally low profitability of Japanese firms, this relief may not, however, be a big incentive for firms to restructure: restructuring charges can easily exceed recurrent profits earned over five years. Other tax disincentives are associated with the taxation of events entailed by corporate restructuring, such as the transfer, securitization,19 or revaluation of assets.20 Bankruptcy laws, for their part, have been geared more toward firms’ liquidation than their financial reorganization.21 Although formal liquidation procedures are relatively common in Japan (some 2,000 petitions are filed every year), formal reorganization procedures are seldom used.22

Firms have responded to recent reforms to permit the creation of holding companies and to the expectation of a change in the basis of corporate taxation. Following the change in the antimonopoly law in late 1997 to permit the creation of holding companies, a number of firms have switched to this structure, reorganizing themselves along main business lines by transforming their divisions into subsidiaries under a holding company and consolidating subsidiaries. This process has accelerated since the beginning of FY1999 (the mandatory consolidation of accounts of publicly listed companies at the end of the current fiscal year and the anticipation of the shift in taxation being contributing factors). These transformations have been particularly swift among large independent companies (including the leading telecommunications company). Firms belonging to the six top economic groups (keiretsus) appear to be somewhat lagging independent firms in this respect. This lag can be in part attributed to the host of complex issues raised by this process in the case of the keiretsu firms (Box 8.2).

Recent Debt Workouts

About a dozen informal debt workouts benefiting midsized companies were announced in the first half of 1999. These agreements applied to five independent construction companies (plus a real estate subsidiary), two finance companies (one a captive company owned by a supermarket chain), and a major trading company (which had an extensive exposure to the real estate sector). These debt workouts reflected write-downs in excess of ¥1 trillion (top panel of Figure 8.8). The injection of public funds into 15 major banks appears to have been a key factor to the completion of several out-of-court debt workouts in the first half of 1999. Since late 1998, several of these companies had requested their bank creditors to provide them a degree of debt forgiveness. The expectation that the capital injection in major banks could facilitate these informal debt workouts was indicated by the large pickup in the prices of the shares of several of those companies observed on the day that those injections were announced in mid-March (for instance, the price of the stocks of the construction companies Sato Kogyo, Aoki, Haseko, and Fujita rose 60-100 percent).

The exact degree of debt reduction involved in these workouts varied by the extent to which parent companies assumed debts from their subsidiaries. For instance, one of the first workouts to be announced was that of the construction company Haseko, involving a debt reduction of ¥354 billion over four years. That reduction was equivalent to 86 percent of the parent company’s bank debt at that time, but Haseko assumed ¥592 billion of debts from affiliates in late June. This was not a unique case, because most of the debt of Japanese companies is typically acquired by subsidiaries and does not appear on the parent company’s books. Although information on the total indebtedness of companies on a consolidated basis can be fragmentary, a useful indication of this burden can generally be obtained by including in the parent companies’ total liabilities the loan guarantees that they typically offer to their subsidiaries. Using this gauge, debt reductions in most of the debt workouts completed in 1999 entailed a 20–35 percent reduction in the company’s total debt (bottom panel of Figure 8.8).

Debt workouts were accompanied by broad restructuring plans, a requirement for allowing banks to deduct the write-downs from taxable income. These plans typically involved the sale of completed units (e.g., condominiums) and a gradual reduction in the labor force. In some cases, such as that of the trading company, the plan involved a major refocusing of business on selected core activities, with a two-thirds reduction in the number of subsidiaries and in the number of employees at the parent company level.

Some market analysts have voiced concerns that some workouts have aimed more at restoring the near-term solvency of the beneficiary firm than allowing it to establish long-term viability. Analysts have noted that, irrespective of long-term prospects, main banks often had an interest in providing relief to those companies to avoid greater losses that would have resulted from the bankruptcy of those companies. Despite debt relief, however, beneficiary firms still face major challenges. First, given the decline in real estate prices, a 30 percent debt write-off may still leave a sizable gap between the market value of assets and the firms’ liabilities. Second, support from non-main bank creditors remains limited. These banks have contributed little to the workouts (roughly 20 percent of their exposure). They have also expressed reluctance to continue to provide working capital to the companies, forcing companies and their main banks to resort to complicated mechanisms to raise short-term funds. Third, there is substantial overcapacity in the construction sector, and the restructuring plans agreed to in connection with the workouts may not guarantee the survival of the beneficiary firm in the medium term.

Figure 8.8.
Figure 8.8.

Recent Out-of-Court Debt Workouts

Sources: Bloomberg News, Kikkei, Goldman Sachs, Standard and Poor’s; and IMF staff calculations.

Official Initiatives

The government has proposed several measures to facilitate corporate restructuring. Since mid-1998, two bodies have been set up to advise the government on corporate restructuring and have produced a wide range of proposals.23 In particular, the many suggestions made by the Economic Strategy Council and the Competitiveness Commission helped shape later proposals made by the Ministry of International Trade and Industry. The following measures presented by the government beginning June 1999 reflected these proposals and were expected to be approved by the Diet.

  • Temporary tax incentives to reduce production capacity and promote corporate reorganization. The measures include deferral of the taxation of capital gains realized in connection with the transfer or reorganization of subsidiaries and divisions; the extension of favorable tax treatment to land transactions such as in-kind transfers of land to newly incorporated firms or land sales to the public sector; the extension of the carryforward period for losses from five years to seven years, and the option of a one-year carryback of losses; and introduction of an accelerated depreciation schedule for replacement of equipment linked with the scrapping of capacity.24 Firms will be allowed to apply for these tax benefits until late 2001, with MITI responsible for the approval of applications.

  • Legal changes to facilitate corporate reorganization and change in corporate ownership structures. Measures include steps to permit banks to exceed the 5 percent limit on equity holdings in a nonfinancial firm in the event of a swap of debt for equity; the easing of antimonopoly laws to permit Japanese companies competing in the global economy to hold a large share of the Japanese market;25 and changes in the Commercial Code to facilitate changes in ownership structures.26

  • Use of public funds, such as a public lending facility to finance capacity reductions at special interest rates; subsidies to firms that increase employment (in designated sectors); and training program for dislocated workers.27 An extension of the eligibility periods for unemployment benefits (restricted to workers laid off as a result of capacity reductions) has also been considered. The official policy remains, however, one of helping firms not to reduce their workforce and to devise short-term steps to provide support for middle-aged workers who have been laid off (as stated in the white paper issued by the Labor Ministry on July 2, 1999).

Changes in Corporate Structures in Japan: Some Implications for the Large Economic Groups

The changing institutional environment in which Japanese companies operate is transforming corporate organization in at least three dimensions. These include a shift away from the lifetime relationship between employees and their firms, compensation practices to increase the link to performance, and a reordering of the ties between firms. A growing number of companies are becoming holding companies, transforming existing divisions into subsidiaries under their direct control and consolidating affiliates in which they have a minority interest only.

Although these changes are affecting most Japanese companies, they can have special implications for the firms belonging to the six major economic groups. There are many large independent companies in Japan, but there are six major economic groups that are prominent, among other reasons, because they are present in most economic sectors (they account for 16 percent of net corporate assets) and each has close links with individual city banks. Also, the organization and behavior of many other companies are in part modeled after these groups.

Current reforms could help reduce the ambiguity of these groups’ governance mechanisms. The organization of major economic groups typically comprises a set of top companies in different fields and their respective affiliates, and is centered around a trading company and a city bank, which still are a sort of “first among peers.” Top companies themselves keep few formal direct links with each other (except for minority shareholdings). Corporate governance has largely been exercised in informal ways, including the exchange of views in the meetings of the “Presidents’ Clubs,” management rotation, and banks’ control over credit. In recent years, the perception has emerged, however, that these mechanisms, although binding the groups together, are insufficient for effective managerial control. It has been felt that the reorganization of firms into more segregated and tightly controlled structures could increase managerial accountability and profits. The recent reforms have in part been inspired by this sentiment and are likely to push companies in this direction.

Top companies in the major economic groups have two main options to adjust to the new environment. They can become more independent, or they can try to coalesce under a very large holding company, somewhat along the lines of the structures existing before World War Two (the zaibatsu). Although three of the current six major economic groups originate from zaibatsus, and membership in a large conglomerate could provide a sense of protection to many firms, there are institutional obstacles to the resurgence of zaibatsus. The changes in the antimonopoly rules to allow holding companies, or those recently proposed with a view to easing the restrictions on corporate mergers, appear to fall short of permitting the establishment of full-fledged zaibatsus. The agency in charge of enforcing the antimonopoly law (the Fair Trade Commission, FTC) has established that holding companies are in principle not to be allowed to control the largest firms in more than a few economic fields. Also, the FTC needs to be consulted whenever a merger would result in a firm controlling more than a certain fraction of the domestic market. The proposals to weaken the latter rule are aimed mainly at facilitating consolidation in mature sectors (e.g., steel) and need not extend the scope of holding companies.

Financial liberalization can promote more independence among group members and facilitate the merger of city banks. Insofar as laws effectively limit excessive ownership, greater emphasis on profits and increasingly open financial markets are likely to provide incentives for top companies in major economic groups to use the new organizational options to increase their individual identity, e.g., by becoming holding companies themselves and asserting their control over their subordinated keiretsu, while reducing their links with other peer companies and their affiliates (a few recent episodes suggest—albeit weakly—that these incentives have started to operate). Greater independence may require and promote the unwinding (or dilution) of cross-shareholdings, for example, to accelerate divestment of noncore activities. This process of increasing (financial) independence could also facilitate mergers between city banks by reducing the impact of such mergers on companies belonging to different economic groups.

The authorities are also amending bankruptcy laws with the aim of increasing their effectiveness. Specifically, the Ministry of Justice has announced the acceleration of plans to supplement the law typically applied to small and medium-sized companies with a new Financial Rehabilitation Law.28 The latter would incorporate several provisions paralleling those in Chapter 11 of the U.S. Bankruptcy Code, aimed at increasing the protection against secured creditors and the use of the debtor-in-possession principle (this principle typically translates into allowing incumbent management to maintain control of the firm during the procedure). The law would also permit debtors to satisfy secured claims by paying the current (estimated) value of the claim’s collateral and lumping the residual part of the claim with other unsecured debts. This provision is likely to facilitate the renegotiation of real estate loans (for example through debt-for-equity swaps), because it reduces the extent to which secured creditors can cling to their original claims in the expectation of capturing a future upside in the real estate collateral.

Prospects and Risks

Initial strides toward genuine corporate restructuring need to be followed by resolute actions, because a half-hearted process of corporate restructuring could dampen economic growth for many years and contribute to an unsustainable fiscal position. Particularly, progress is being made with large corporations, while small- and mid-sized companies have been given some breathing space. This two-tiered approach could prove effective if large firms undergo a genuine restructuring process, and recent measures to foster start-up firms and the reallocation of resources to the service sector succeed in providing some dynamism to the economy. Some observers have noted, however, the risk that the positive reaction of markets to recent announcements of corporate restructuring, or signs that the worst of the recession is now over, might result in complacency. If top-tier corporations, including those in mature or labor-intensive sectors, do not undergo a deep restructuring, the current approach could add new strains to a fiscal scenario already burdened by the effects associated with the projected shifts in the Japanese demography.

The government has recognized the importance of establishing an environment conducive to corporate restructuring, while ensuring that primary responsibility for initiatives rests with individual firms. Fiscal incentives are being introduced to encourage large firms to adjust and stimulate small and medium-sized firms. In addition, legal impediments to reorganization are being reduced, while steps are being taken to help dislocated workers to find new jobs. Tax incentives can be a powerful and cost-effective tool, helping the corporate sector to absorb some of the costs of restructuring, although it will be important to ensure that their application is nondiscriminatory and based on clearly defined conditions, rather than on ministerial discretion. Moreover, tax incentives can cushion the burden on banks, and possibly reduce the magnitude of the public injections of capital necessary to maintain the stability of the bank system. On the expenditure side, the proposed public funding of training programs could help cushion the shock of dismissals and facilitate the needed reallocation of labor within the corporate sector. The subsidization of jobs in designated sectors, on the other hand, has the potential to introduce distortions into the market mechanism.

Effective corporate governance will be an important factor in promoting restructuring of the corporate sector. Big Bang financial reforms are expected to gradually enhance market discipline and the impending changes in accounting rules will impart a higher degree of transparency to corporate accounts. An increasing number of Japanese companies have professed that their main goal is to maximize shareholders’ value. Nevertheless, mechanisms to enforce management accountability remain limited. In particular, the high degree of corporate cross-shareholdings still limits the scope for “hostile takeovers.” The unwinding of such cross-holdings is expected to be encouraged by upcoming rules requiring firms to mark them to market. On the other hand, some proposals that would allow companies to shift the ownership rights of these holdings to trusts (set up in order to fund corporate pension commitments), but retain the associated control rights, could help to perpetuate the problem.

Recent measures that facilitate the vertical integration of economic groups are also an attempt to respond to concerns about corporate governance. The law permitting the creation of holding companies was in part a response to a growing perception in Japan that the present system of governance can be too diffuse to allow for effective management in a more competitive environment, in which official guidance does not have a role and maximization of shareholders’ value is becoming the priority. Together with the possible introduction of consolidated corporate taxes, this reform could encourage large firms to adopt a more tightly controlled structure, which could increase managerial accountability and corporate profitability.

Corporate specialization could be a key ingredient to enhance the efficiency of Japanese companies. International experience since the 1980s suggests that improvements in profitability and economic growth have often been associated with specialization and the streamlining of conglomerates. In most countries, asset reallocation has resulted both from voluntary divestment of affiliates in sectors outside the conglomerate’s core businesses and from “hostile” takeovers. Although often involving intermediate steps, hostile takeover activity in the United States generally resulted in the allocation of assets to firms in the same industries as the targeted assets (Bhagat, Shleifer and Vishny, 1990). Gains would typically result from consolidation of (sometimes declining) industries.

The development of a market for noninvestment grade bonds could facilitate the streamlining of existing keiretsus and corporate specialization. In the United States, corporate restructuring has been facilitated by the development of a market for noninvestment grade (speculative) instruments that provide scope for increased competition in the market for corporate control. In Japan, limitations in financial disclosure standards have been a deterrent to the development of a market for such instruments. Expected improvements in corporate accounting and the new options of saving vehicles offered by the Big Bang reforms could now foster such a market and facilitate an aggressive divestment policy on the part of the keiretsus. The development of such a market could also provide a potentially lucrative advisory business to banks.

Proposed changes to encourage debt-for-equity swaps could play an important role in supporting financial reorganization in Japan, particularly if other constraints on corporate restructuring are addressed. These swaps could be instrumental in reducing firms’ debt overhang, while allowing creditors to share in the gains from improved performance. Banks could be reluctant to engage in such operations, however, when firms are limited in their ability to shed labor or take other measures needed to improve their performance. Banks’ reluctance will be heightened by the fact that, after FY2001, equity holdings will be marked to market. In these circumstances, banks will have an interest in ensuring a rapid turnaround of firms in which they have taken equity (or, at least, in establishing a sound profit profile for those firms), so that equity claims can be sold without incurring additional losses.

In summary, there are encouraging signs on both the official and private fronts, but challenges remain large. Firms are increasingly committed to change and the authorities have shown growing resolve in advancing this process. Labor unions have also in many cases expressed some support for change, focusing demands at times more on the provision of mechanisms facilitating job search and improved training than on insisting on absolute job protection. Although corporate restructuring could have a negative short-term impact on aggregate demand, the government can alleviate this impact and its associated social costs by ensuring an adequate social safety net and effective means for corporations to seek financial rehabilitation. On the other hand, if complacency were to take hold following a rise in economic activity or stock prices, a prolonged period of halfhearted corporate restructuring could result in yet more years of mediocre economic growth and considerable fiscal costs.

Appendix. Market Reaction to Restructuring Plans

During the first three months of 1999, several listed Japanese firms announced restructuring plans, often coinciding with the forecast of large losses for the fiscal year. The ultimate effectiveness of these plans was difficult to discern, although, at least on the surface, they appeared more ambitious than the wave of announcements that followed the appreciation of the yen in 1995. Changes in stock prices in reaction to announcements are one way to gauge the potential effectiveness of these plans, because they provide insight into the market’s reaction to these announcements. This appendix reports an event study, based on a sample of about 60 announcements made in the first two-and-a-half months of 1999.

Event studies are a standard method to identify the information content of market news by measuring abnormal returns on stocks around corporate actions or announcements. In these studies, the actual return on a share within a time window around the event day is computed and compared to the prediction of some benchmark model such as the Capital Asset Pricing Model (CAPM) portfolio model. Here, abnormal returns are also computed against the average returns in the second half of 1998, in order to address the possibility that the results using the CAPM might be biased by the cumulative effect of announcements on overall market sentiment.

Variables that reflect the nature of the announced plan, recent changes in the firm’s profitability, and the firm’s industry sector are used to assess market reactions. Plans were grouped into five categories, and firms were grouped in three sectors: manufacturing (37 observations), finance (13 observations), and other sectors (construction, services, and light industry) (20 observations). Two financial variables were used; the percentage change in earnings per share between FY1998 and FY1999, and a discrete variable indicating whether or not the 1999 dividend was expected to be zero. The allocation of plans into the five categories was based on news reports and comments by market analysts from major investment banks in Japan, which unavoidably involved some judgment. For instance, major restructuring plans typically involved reductions in the labor force and divestment in non-core activities, and divestment of single lines of business could be considered a merger and acquisitions activity. Results were, however, broadly unchanged by the reclassification of some plans that had ambiguous features. Also, the results using the CAPM and those based on historical average returns were similar.

The results suggest that markets were in general cautious about restructuring announcements, particularly those of financial institutions (Table 8.3). Only a small fraction of announcements resulted in cumulative abnormal returns during the subsequent four days that were in excess of two standard deviations from those predicted by the CAPM or from the average return on individual stocks in the second half of 1998. It is noteworthy that some of the largest increases were associated with an announced acquisition by a foreign firm. The low significance of stock price changes around announcements could also reflect information leakage, market skepticism, and simply the high level of volatility of Japanese stock prices in recent months owing to macroeconomic factors that are not captured fully by the CAPM.

Table 8.3.

Stock Price Response to Recent Restructuring Announcements

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Source: IMF staff estimates.Note: The numbers in parentheses indicate the significance ratio of the coefficient (i. e., .050 means different from zero at the 5 percent level).

Industry excludes construction and beverages.

An alternative to the above approach is simply to assess the qualitative reaction of markets rather than attempt to assess the magnitude of these effects. A Probit model was used for this purpose (it predicted the right sign of the change in stock prices in two-thirds to three-quarters of the cases, depending on the specification used). A main finding from the Probit analysis is that an announcement by a financial institution involving a reorganization plan was viewed by the market, more often than not, less positively than those made by other companies. A second finding is that announcements of major core business were generally viewed favorably by the market, while plans based on attrition were associated with a decline in stock prices. The coefficient on the variable indicating plans based mainly on a multi-year reduction in the workforce through attrition was significantly negative in all model specifications. In contrast, the coefficient associated with plans based on other strategies was uniformly positive. A third finding is that financial variables appear to suggest that market discipline contributed to more rigorous corporate restructuring; expected declines in earnings per share were negatively correlated with changes in stock prices.


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  • Ramseyer, M., M. Nakazato, 1999, Japanese Law, an Economic Approach (Chicago: University of Chicago Press).


The impact of the debt overhang on business investment is discussed by Ramaswamy in Chapter 4 of this volume.


Leverage is the ratio of net debt to equity.


The average leverage of companies listed in the first section of the Tokyo Stock Exchange is 350 percent, compared with 450 percent for the U.S. companies included in the S&P Industrial Index, and 460 for large German non-financial corporations.


The traditional restriction excluding city banks from offering long-term loans was also weakened.


The structure of the typical Japanese large economic group comprises a set of top companies in different fields (kigyio shudan), which are the head of the vertical structures grouping their respective affiliates (keiretsu).


The increase in FY1998 compared to FY1997 was 50 percent in the case of listed companies, with more than ⅓ of the companies declaring negative net profits.


The authorities have also expressed increasing interest in the quality and independence of corporate auditors. There is room for improvement in this area. The Fair Trade Commission, for instance, has recently reported that about two-thirds of the external auditors supervising the accounts of the major six economic groups and their affiliates were employees, former employees, or directors of companies belonging to the respective groups.


The coverage of such consolidation will change to include affiliates and subsidiaries into which the parent company exerts “effective control,” although it may not have a majority of capital. The appointment of managers, for instance, will be considered an indication of exercise of effective control. Many companies already publish consolidated accounts on a voluntary basis, but the lack of uniformity in methods sometimes renders the interpretation of these accounts difficult.


The issue of pension liabilities actually involves two aspects: underexpensing and underfunding. The distinction between the two is the following. Underexpensing is the failure to fully recognize the pension rights accrued, i.e., the amount of liabilities; underfunding is the difference between those rights and the assets accumulated to support them. Correcting underexpensing would have an immediate impact on firms’ equity through an accounting charge-off, while correcting underfunding would not necessarily have such an impact, to the extent that the firm may already have recognized those liabilities and has borrowed against them (by not funding them). Correcting underfunding affects earnings because the firm has to “repay” the pension fund. The discrepancy between expensing and funding pension commitments is typically driven by tax considerations. Corporate contributions to pension funds are not tax-deductible in Japan and, given the very low rate of return on assets, it may be cheaper for the Japanese firms to defer those payments, i.e., borrow against the pension funds.


Recent financial disclosures of Japanese companies that have adopted U.S. accounting standards for their financial statements indicate that the majority of these companies have started to reduce the discount rate used for projecting their pension benefit obligations. For the most part, these firms reduced the discount rate by 100 b.p. (to around 3–4 percent), which resulted in a 20–30 percent increase in the net present value of these obligations.


A typical measure of total cost of capital assumes that corporate debt should earn the risk-free interest rate (proxied by government bond yields) and equity should yield a 3 percent premium over that rate.Matsui, Suzuki, and Katayama (1997) show that, during 1984-96, the return on capital was systematically lower than the cost of capital in 8 out of 12 leading sectors in the Japanese economy. The problem of inadequate return on capital was identified many years ago. Kester (1991) noted that it amounted to a diversion of economic rents from suppliers of capital to other stakeholders. In his view, it resulted from managers’ unwillingness to breach long-standing implicit contracts with key stakeholders, specially lifetime employment commitments, and firms’ inability to execute past strategies of simply growing in their original business areas. Thanks to the discretion in the allocation of funds that Japanese managers had in the late 1980s, Japanese companies pursued unrelated diversification strategies and kept sustaining businesses that were either marginal or in areas where the economy could not remain competitive internationally, a process that could not be sustainable in a global economy.


The Economic Planning Agency has suggested that the excess in production capacity is equivalent to a capital stock of ¥85 trillion.


In the case of the retail sector, this problem was compounded by the decline in real estate prices, because investments in new stores often involved the purchase of land and the decline in land prices widened the gap between the actual value of firms’ assets and debts.


The reduction in the leverage of small enterprises, which fell by 25 percent in the 12 months to early 1999, nevertheless continues.


Recurrent profits of non-financial companies fell 26 percent and net profits dropped by 70 percent in 1998 vis-a-vis 1997.


For instance, some plans took advantage of the upcoming introduction of consolidated accounts to simplify corporate structures and establish “in-house” units aimed at identifying cost and profit centers. These organizational changes are expected to help increase managerial accountability by allowing the timely evaluation of financial results of different units in a company. They are typically associated with a tilting of labor compensation rules toward giving greater weight to performance (e.g., by reducing the weight of seniority and raising the weight of stock options).


Discussed further in Chapter 9.


The passage of an asset-backed securitization law in 1998 and the special treatment of special vehicles have helped promote this type of operation, particularly in what concerns the securitization of low-credit-risk assets such as auto loans, receivables, and high-grade corporate loans, which have grown since. A few obstacles for the use of this technique still remain, however. For instance, there are still doubts about the effectiveness of existing perfection mechanisms (i.e., about the extent to which the securities are insulated from problems with the issuer). With respect to the securitization of real estate loans, the complex structure of the liens typically attached to the collateral of these loans and deficiencies in loan documentation continue to inhibit investors.


Of course, there a ways to sidestep these problems (e.g., Ramseyer and Nakazato, 1999, pp. 232-44), but they are cumbersome.


Only about 300 petitions are filed in a typical year, of which a large number are withdrawn before proceedings actually start. By contrast, some 20,000 petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code were filed every year in the United States during 1983–93.


The first of these groups was the Economic Strategy Council set up in August 1998. The Council, which was relatively autonomous in its deliberations, comprised 10 members from business and academia, and produced a comprehensive report in February 1999. In March 1999, the Competitiveness Commission comprising several Ministers, heads of agencies, and representatives from the business sector was set up. The Commission is chaired by the Prime Minister, with MITI being in charge of directing its agenda.


These measures could help, for instance, a steel company to absorb the costs of closing a plant. The company could carry forward closing charges (including severance payments) for two additional years, reducing tax payments for up to seven years. In balance sheet terms, special treatment of capital gains on landholdings would help the firm to use its latent reserves to shore up its equity position, offsetting asset write-downs associated with the closedown of plants. Alternatively, steelmaker A could join steelmaker B to spin off specializing activities, consolidating them into a new firm. The new measures would reduce the cost to register the new firm and transferring the assets to it (payment on capital gains on these assets would be reduced until they are realized, and real estate acquisition taxes would benefit from a rebate). In addition, the new firm could benefit from a favorable depreciation schedule.


Previously, the Fair Trade Commission had to be consulted on any merger in which the resulting company would hold more than 25 percent of the domestic market (10 percent if the resulting company is the largest in the market). The new criteria would look at resulting shares in the global rather than local market.


These changes aim to increase the ability of corporate boards to dispense with a general shareholders’ meeting when deciding on the sale of businesses or other restructuring steps; to force minority shareholders to sell their shares when a bidder has acquired over 50 percent of company shares or when they disagree with a spin-off; and to allow the acquiring company to pay shareholders of the target company with its own shares.


These measures build on a system introduced in December 1998 that entitles workers who complete a training program designated by the Ministry of Labor to be reimbursed for up to 80 percent of the associated expenses (to a maximum of ¥200,000). The main distinction between the new programs and the traditional approach is that support will now be provided directly to the individual rather than to the employer.

How Japan Responded to Asset Price Collapse