Section 2 Japan's Business Environment

in the Globalizing Economy

As noted in the preceding section,Japanese companies have been expanding

their business activities around the world,

particularly in Asia. In fact, the globaliza-

tion of business activities is a universaltrend. Companies are selecting business

locations in countries and areas that offer

attractive markets and favorable business

environments. At the same time, however,business globalization means that places

that are not internationally attractive could

lose economic vitality as a result of the

contraction of business activities. In thissense, it is urgently necessary for Japan to

make its business environment internation-

ally more attractive. In this section, we will

discuss the business environments in anumber of other countries, and that of

Japan, and will examine some of the chal-

lenges this nation faces.

1. Global Expansion of Direct Investment

and Japan's Investment Environment

The development of information andcommunications technologies and the global

trends toward deregulation and liberaliza-

tion are adding impetus to the global expan-

sion of markets and, through the intensifica-tion of international competition, to the

trans-national development of business

strategies. This situation is seen in the

worldwide expansion of direct investmentreflecting the globalization of business

activities. In these circumstances, Japan's

outward direct investment, including the

establishment of overseas production bases,has been expanding, as illustrated by a

rising overseas production ratio. In contrast,

direct investment from abroad has remained

at a low level, giving rise to concern thatJapan's business environment may be lack-

ing in international attractiveness. In the

following, we will review major trends in

world direct investment and then develop-

ments in host countries. Subsequently, wewill consider the investment environment in

Japan by reviewing developments in inward

direct investment which is said to be at an

extremely low level.

(1) Major Trends in World Direct Invest-

ment

A regional review of recent trends in

direct investment shows that developed

countries make up, in flow terms, about 80%

of total outward investment and about 60%of total inward investment (Fig. 4-2-1). In

particular, the U.S. and the UK maintain a

high level of both outward and inward

investment. Japan is playing a large role inoutward investment but holds an extremely

small share in inward investment.

Developing Countries Beckon OverseasInvestment

As described above, developed coun-

tries account for most of direct investment.

However, developing countries have beenexpanding their shares in inward direct

investment. This seems to reflect the fact

that production is increasingly shifting to

low-cost locations abroad, reflecting risingexpectations in these growth markets and

the growing exposure of business activities

to international competition. Also notable is

progress in the privatization of state-ownedenterprises in developing countries and

areas. These moves toward privatization,

which gained momentum in the 1990s, have

spread far and wide, involving countries notonly in Latin America and East Asia but

also in Central and Eastern Europe (Fig. 4-

2-2). Foreign funds have played a key role in

a privatization program in these regions,

mostly in the form of direct investment.

These moves have opened the way for the

expansion of foreign companies into domes-

tic markets. At the same time, the fact thatprivatization has progressed mainly in

infrastructure-related areas (Fig. 4-2-3) is

expected to make investment environments

in these areas more attractive.

Global Increase in M&A Deals

Next, we will review developments in

cross-border mergers and acquisitions,which hold a key to trends in direct invest-

ment.

With inter-company competition inten-

sifying worldwide with the progress ofglobalization, development of new markets

and operations or reinforcement of core

operational divisions is a major challenge

for companies. And M&A activity, which canquickly achieve these, represents a major

option in management strategy. For ex-

ample, in the chemicals industry where

production facilities and R&D costs areenormous, there have been large-scale M&A

deals designed to reap economies of scale. In

addition, acquisitions and sales of opera-

tional divisions, designed to concentratemanagerial resources in strategic divisions,

have increased. Reviewed by industry, M&A

transactions in tertiary industries have

expanded noticeably. On a sectoral basis,these deals have increased in business

service areas where more advanced and

international services are in demand

against a backdrop of globalizing businessactivities (Fig. 4-2-4).

Reviewed by region, two-way transac-

tions (acquisitions and sales) have increased

in the U.S. and European countries. InJapan, on the other hand, M&As deals

between Japanese and foreign companies

have been exceedingly limited in number

(Fig. 4-2-5).

(2) Comparison of Investment Environmentsin Selected Countries

Fig. 4-2-6 shows changes in inward

direct investment in major developed coun-tries. In the U.S. and the UK, which have

both enjoyed relatively good economic per-

formances in recent years, both outward

investment by domestic companies andinward investment by foreign companies

have increased markedly. In Germany and

Japan, by contrast, while overseas invest-

ment has followed a trend marked by expan-sion, investment from abroad has remained

at a low level. As a result, the gap between

outward and inward investment has wid-

ened in both countries (Fig. 4-2-7). Below,we will review developments in the inward

investment in these countries.

Inward Investment Developments in theU.S, and the UK

A regional breakdown of inward in-

vestment in the U.S. and the UK shows that

each country holds the largest share of suchinvestment in the other, indicating strong

business bonds between the two countries

(Fig. 4-2-8).

On an industry-by-industry basis,

compared with Japan, these two countries

hold a high share in non-manufacturingindustries, particularly in the financial

service industry (Fig. 4-2-9). In the UK,

foreign financial institutions have invested

vigorously, reflecting London's establishedposition as an international financial mar-

ket. Fig. 4-2-10 shows foreign exchange

volumes in major countries. The large vol-

ume in the UK, particularly of transactionsin foreign currencies, can be said to symbol-

ize the breadth of transactions in and the

great convenience of the London market. In

1986, the UK launched a host of financialsystem reforms, or the so-called Big Bang,

to correct inefficiencies and enhance its

international competitiveness. These re-

forms have invigorated financial transac-tions and increased their efficiency. At the

same time, they have led to the concentra-

tion of finance-related industries and hu-

man resources and of advanced information.These have further increased the attractive-

ness of London as an international financial

market.

Along with these financial marketreforms, the various systemic reforms car-

ried out in the 1980s under the administra-

tion of Prime Minister Margaret Thatcher

have dramatically changed the investmentenvironment in the UK (Note 1).

For companies with overseas opera-

tions, it is essential to map out internationalfinancial strategies and to deal properly

with different systems abroad, such as legal

and accounting systems. Since the provision

of such advanced services requires theaccumulation of a large volume of special-

ized information, it is necessary to concen-

trate related industries. Fig. 4-2-11 shows

changes in the share of work force in major

countries as a way to study how financial

and business services are concentrated in

these countries. In the U.S. and the UK, it is

noted that the share is large. In these coun-tries, financial institutions are highly con-

centrated, reflecting their status as an

international financial center. In addition, a

large body of professional people who arecapable of providing such advanced business

exists and are able to provide legal and

accounting services. It can be said from the

above that the U.S. and the UK offer strate-gic bases for global companies and that even

companies gaining market access for the

first time can readily gain business support.

Investment Environment in GermanyThe large size of the domestic market

and the high level of technology can be cited

as some of the advantages of the investment

environment in Germany. Fig. 4-2-12 showsregional activities of U.S. overseas affiliates

(manufacturing). In Germany and Japan,

high levels of personnel expenses and R&D-

related activities exist.

However, as already noted, inwardinvestment in Germany remains at a low

level in absolute terms. High costs, particu-

larly high labor costs, high tax rates and an

inflexible employment environment arecited as some of the reasons (Fig. 4-2-13). As

regards the environment surrounding em-

ployment in Germany, labor practices and

systems attach importance to employmentstability. As shown in Fig. 4-2-14, workers

with a long period of continuous service with

the same company hold a large share in

Germany, as they do in Japan and France.In recent years, however, rigidity in the

labor market in Germany have become more

evident, as shown by rising unemployment

rates, particularly large numbers of long-

term unemployed. (Fig. 4-2-15). With the

international economic environment under-going dynamic change, rigidity in the em-

ployment market are thought to weaken

companies' ability to respond to such change

and thus impose heavy constraints on busi-ness activities. At a time when economic

barriers between EU states are going down

as they move toward monetary union, these

problems regarding industrial location inGermany are raising much concern (Note 2).

(3) Inward Direct Investment and Invest-

ment Environment in Japan

Developments in Inward Direct Investment

The number of cases of inward direct

investment in Japan (based on reports andnotifications) continued to rise for three

successive years from fiscal 1994 to fiscal

1996. In fiscal 1996, the value of such in-

vestment reached an all-time record (\770.7billion), due partly to an increase in large-

scale investment (Fig. 4-2-16). In the first

half of fiscal 1997, manufacturing invest-

ment decreased in value a year earlier, butnon-manufacturing investment increased

40.1% from a year earlier. By region, most

investment was from the U.S. and Western

European countries. In fiscal 1996, however,investment from Asia also expanded mark-

edly, accounting for 17.8% of the total value

(Fig. 4-2-17).

Thus, inward direct investment inJapan has followed a trend marked by

expansion, particularly in the non-manufac-

turing industry. However, as already noted,

it remains at an internationally low level.In Japan, as a result of a series of

capital liberalization measures, foreign

investors making direct investment are

required, in principle, only to report ex post

facto (Note 2). In addition, foreign affiliates

in this country are entitled to various sup-port measures. In view of these facts, the

low level of inward direct investment sug-

gests that the business environment in

Japan is less attractive than those in someother countries.

Various problems involved in the

business activities of foreign affiliates in

Japan have been identified by surveys andother studies. For example, Fig. 4-2-18,

based on a survey conducted by the Japan

External Trade Organization (JETRO),

shows high response rates for such items as

"high business cost," high level of user

demand" and "difficulty of securing person-

nel," although the overall business environ-ment has improved since the survey of 1995.

(Note 1) The Thatcher administration,

which took office in 1979, carried out vari-ous regulatory reforms with emphasis

placed on the competitive principles of the

free market. From this point of view, the

administration also expanded the tax basethrough the abolition of special taxation

measures, reduced the corporate tax rate

and privatized state-owned enterprises. As a

result of these and other reforms, inwardindirect investment in the UK has remained

at a high level since the second half of the

1980s.

(Note 2) Reflecting such concern, activedebates on revising the tax system have

been conducted in Germany. For instance, in

1997 a revision of tax system bill was intro-

duced with the aim of reducing the effectivecorporate income tax rate from 49.79% to

the 42% level by lowering the tax rate on

retained earnings to 40% in fiscal 1998 and

35% in fiscal 1995. However, the bill wasrejected by the legislature in September

1997.

(Note 3) As an exception to the rule, inward

direct investment requires advance report-ing with respect to the following: (1)

investment related to "sectors that could

impair national safety," which is generally

subject to regulation under the OECD Codeof Liberalization of Capital Movements; (2)

investment related to sectors where Japan

holds reservations about liberalization

(agriculture, forestry, fisheries, petroleumindustry) under the above code; and (3)

investment by individuals or companies

from countries for which review is recog-

nized as being necessary from the stand-

point of reciprocity.

High-Cost Structure in Japan

"High business cost" in Japan has longbeen cited in comparative surveys of domes-

tic and overseas prices. It is generally be-

lieved that foreign affiliates planning to

enter the Japanese market base their in-vestment decisions on return forecasts and

cost estimates. It can be said that high

business-related costs in Japan make for-

eign affiliates reluctant to invest in Japanas these deteriorate investment efficiency.

Fig. 4-2-19, which compares land

prices in major cities, shows that prices in

Japan remain much higher than those inmajor Western countries, although the gap

has narrowed in recent years, partly due to

land price falls in this country. In addition,

business-related costs in Japan, such aselectricity and telephone rates (Fig. 4-2-20),

remain relatively high. Meanwhile, a

sectoral breakdown of survey results con-

cerning intermediate input costs shows thatsuch costs in Japan remain relatively high,

particularly in non-manufacuring sectors

(Fig. 4-2-21). This is attributed to the fact

that internationally wide disparities in therate of productivity gains have existed

between manufacturing and non-manufac-

turing industries, reflecting different com-

petitive environments in these two areas.This situation is also reflected, as shown in

Fig. 4-2-22, in an upward departure from

the effective purchasing power parity using

the consumer price index, which includesmany non-trade goods.

In addition, the high effective corpo-

rate tax rate in Japan, as seen in Fig. 4-2-

13, can be regarded as representing a highbusiness-related cost (Note 1).

The high-cost structure in Japan such

as described above is assuming greater

significance than ever before. The globaliza-

tion of corporate activities and the resultant

intensification of international competition

between companies are increasing the

awareness of international cost disparities.In addition, the further development of

service sectors in the economy (the growing

weight of non-trade goods industries) and

the increasing complementary relationshipbetween manufacturing and non-manufac-

turing sectors are providing a background

against which the domestic-overseas price

differential, particularly in non-manufactur-ing sectors, are having major negative

effects on the competitiveness of companies

operating in Japan.

Developments in M&As in Japan

As already noted, M&A activity is

playing a large role in cross-border invest-

ment activities. Japan's M&A market is lessdeveloped than those of major Western

countries. This is often cited as a reason for

the low level of in ward direct investment in

Japan.Recent developments in M&A activity

in Japan indicates that M&As of domestic

companies by foreign companies, though

still at a low level, have been increasing andthat M&As between domestic companies

have been expanding markedly (Fig. 4-2-23).

Among the factors contributing to the ex-

pansion of M&A activity are active sales ofnon-core business divisions -- moves that

reflect a review of the upbeat business

strategy that followed during the period of

the bubble economy -- and stepped-up reor-ganizations in sectors where deregulation

has been making headway, such as finance,

distribution and communications (Fig. 4-2-

24).The low level of M&A activity has been

ascribed in part to the strongly negative

perception of corporate sales and to the

various impediments to acquisition, such as

cross-shareholdings among companies and

the difficulty of obtaining the necessarycorporate information. However, the need

for M&As is expected to increase in the

years head, partly because importance has

been attached in recent years to the sale ofstrategic divisions and partly because com-

panies planning to enter new business areas

have come to regard acquisition as an effec-

tive means of doing so (Note 2).

Developments in Activities of Foreign Affili-

ates

Next, we will review developments in

the activities of foreign affiliates in Japan,

particularly trends in their profits. First, the

ratio of current profits to sales has exceededthat of domestic companies by a wide mar-

gin. The gap has widened in recent years

(Fig. 4-2-25). This is due partly to the fact

that foreign affiliates usually withdraw frompoorly performing operations. However, the

more important reason seems to be that

they maintain a high level of competitive-

ness in Japan that is supported by theirexcellent managerial resources.

The ratio of current profits to total

assets, or return on capital investment, is

also much higher than that of domesticcompanies. This shows that foreign affiliates

have been using their capital more effi-

ciently. The return on equity (ROE) was

12.1%, or about four times that of domesticcompanies, in fiscal 1995 (Fig. 4-2-26).

These indicate that foreign affiliates are

more strongly inclined than domestic com-

panies to increase capital efficiency withemphasis on shareholder interest (Note 3).

Reviewed by the scale of company,

large foreign affiliates that are believed to

have accumulated extensive managerialresources in their own organizations hold a

large share (Fig. 4-2-27). By contrast, a

large percentage of companies that entered

the Japanese market relatively recentlyhave been running deficits, indicating that

they face considerable difficulties in the

initial period of operations (Note 4). This

suggests that it is not easy for foreign affili-ates to do business in Japan. In fact, a

regional comparison of profit margins based

on U.S. statistics shows that profit margins

in Japan are the lowest (Fig. 4-2-28).

Growing Presence of Foreign Affiliates in

Japan

Japan, which has the second largest

market after the U.S. and a high level of

purchasing power, can be said to be an

attractive market for countries around theworld. For example, as shown in Fig. 4-2-29

on local sales ratio of U.S. overseas affili-

ates, most production in Japan is destined

for the domestic market. This shows thatU.S. affiliates in Japan position Japan as

their marketing bases in their global strate-

gies. However, the number of foreign compa-

nies entering the Japanese market has been

relatively limited (Note 5). This seems to

suggest that it has been difficult for foreign

companies to open up new business pros-pects in Japan as existing markets reach

the saturation point as a result of the matu-

ration of Japan's economy (Note 6).

Meanwhile, as described above, in-ward direct investment in Japan has been

increasing in recent years. As a result, the

presence of foreign affiliates in this country

has been gradually expanding. This is duepartly to the fact that the correction of the

yen's overvaluation beginning in 1995 and

the recent fall in asset prices have improved

the Japanese investment environment forforeign companies. It also should be noted

that the series of deregulation measures

taken by Japan in recent years has encour-

aged foreign companies to enter the Japa-nese market.

For example, an increasing number of

foreign companies have expanded into the

distribution area as a result of deregulation,including the abolition of the large-Scale

Retail Store Law (Note 7). The retail indus-

try in particular has seen a spate of new

entries in such sectors as toys, records andfashion apparel. What is notable about

these newcomers is that they are trying to

differentiate themselves from established

companies on the strength of their own

concepts or brand power (Note 8). Further-more, these newly expanding companies

include those which are having a great

impact on Japan's existing distribution

systems by introducing new marketingmethods, trading systems, etc.

In addition, a series of financial liber-

alization measures in Japan, starting with

the revision of the Foreign Exchange Lawthat took effect in April 1998, are arousing

great interest in Japan among foreign-

affiliated financial institutions. It is said

that in the background of such interest is ahuge potential market symbolized by more

than \1,200 trillion in personal financial

assets.

Foreign-affiliated financial institutionsare expanding aggressively into the Japa-

nese market by seizing these business

opportunities, in addition to promoting their

existing operations. Thus, their presence inJapan has been increasing. For example,

foreign banks have been markedly expand-

ing their share in domestic deposits out-

standing, as shown in Fig. 4-2-30.In addition, the expanding business

activities of foreign-affiliated financial

institutions are creating new demand in the

Japanese market by providing new servicesand more advanced financial services here-

tofore unavailable in Japan, in ways that

make better use of the techniques and

know-how they have cultivated in existingmarkets.

Significance of Inward Direct Investment

It is expected that inward direct in-vestment will lead to the introduction of

excellent managerial resources held by

foreign companies and to the invigoration of

the domestic market through competition

induced by the entry of foreign companies.These effects will be studied with

respect to the U.S. where foreign affiliates

maintain a relatively large presence. Fig. 4-

2-31 shows relationships between salesshare of foreign affiliates and producer

prices in the U.S.. It is noted that producer

prices tend to be held at lower levels in

sectors where foreign affiliates are moreactively engaged.

The revival of the U.S. automotive

industry is often cited as an successful

example of the introduction of excellentmanagerial resources. Fig. 4-2-32 shows

changes in rates of productivity gains in the

Japanese and U.S. automotive industries,

with all domestic manufacturing industriestaken as the standard. In the U.S. the car

industry stagnated from the 1970s to the

1980s, but its productivity improved mark-

edly in the 1990s. The revival of the U.S. carindustry is ascribed in large part to the fact

that the Japanese-style production control

system was adopted by U.S. makers through

U.S. investment by Japanese automakers.In Japan as well, it is expected that

market activation through the entry of

foreign companies will contribute to improv-

ing the productivity of domestic companies.

It can be said that introduction of a competi-tive environment through inward direct

investment has great significance particu-

larly to non-trade goods industries, which

are hardly exposed to competition throughthe international market.

Business customs have often been

cited as impediments to the entry of foreign

companies into the Japanese market. Whilethese practices are losing economic rational-

ity as a result of changes in the economic

environment and other liberalizing forces,

there are still quite a few practices that are

blocking efforts to increase efficiency. It is

likely that foreign affiliates not bound bytradition will also play a large role in

prompting a review of these customs and

practices.

The more important point, however, isthat many impediments to the business

activities of foreign affiliates in Japan are

also standing in the way of domestic compa-

nies, particularly newly investing compa-nies. As already noted, foreign affiliates

have been actively investing in deregulated

sectors. But at the same time many domes-

tic companies have also expanded into thesesectors. It can be said, therefore, that devel-

opment of conditions that create new busi-

ness opportunities will greatly contribute to

the revitalization of the Japanese economythrough stepped-up investment by both

foreign and domestic companies.

It may be said, moreover, that develop-

ment of conditions conducive to the invigo-ration of the M&A market, which plays a

large role in inward direct investment, will

also promote the entry of foreign companies

into the Japanese market. On the otherhand, M&As are expected to make possible

the more efficient utilization of managerial

resources through the combination of exist-

ing and new managerial resources. In addi-tion to introducing managerial resources

from foreign companies, these M&As, even

where they involve deals between domestic

companies, will contribute to the revitaliza-tion of the Japanese economy through

restucturing of managerial resources that

have been accumulated over the years.

(Note 1) The effective tax rate in Japan has

dropped by 3.6% to 46.36% as a result of tax

system revisions for fiscal 1998.

(Note 2) In recent years, needs for M&As

have increased particularly among small

and medium enterprises beset by the suc-

cession problem.

(Note 3) Returns on equity by nationalityare as follows: 13.1% for U.S. affiliates,

11.0% for European affiliates; and 6.3% for

Asian affiliates.

(Note 4) According to the "Survey of Trendsin Business of Foreign Affiliates in Japan,"

MITI, about 60% of the companies that

entered the Japanese market in and after

fiscal 1993 are in the red. A questionnaire-based poll taken during the survey shows

that 30% of companies replied it took them

more than five years to put their operations

on course.(Note 5) According to a JETRO poll of for-

eign affiliates, the status of Japanese bases

in their global strategies is as follows: (1)

marketing base, 83.2%; (2) informationbase, 29.4%; (3) production base, 22.3%; (4)

headquarters for Asian operations, 18.7%;

and (5) R&D base, 18.7%.

(Note 6) According to a survey of Japanesecompanies doing business abroad (Survey on

Japanese Business Activities Abroad, MITI),

the percentages of replies that described

market potential as "great" were as follows:the U.S.--41.5%; the EU--14.9%; and Japan--

12.3%.

(Note 7) The law governing the coordination

of activities of large-scale retail stores.During the last regular Diet session the law

was abolished, and a bill for the "Large-

Scale Retail Store Site Law" was introduced.

(Note 8) For example, so-called categorykillers, most of them affiliated with foreign

retail companies, are conducting business by

limiting the products they handle, with wide

product variety in selected areas and lowprices their main sales points.

2. Improving the Business Environment

Toward A Vigorous Japanese Economy

In light of globalizing business activi-

ties, it is necessary to create an internation-

ally attractive business environment in

Japan so as to reactivate business activities,which are the main source of economic

vitality.

It is no longer impossible, particularly

in Japan, to achieve sustainable growththrough catching up with industrialized

Western countries, a process the nation has

pursued in the past. It is increasingly impor-

tant that Japan create new sources ofgrowth on its own. In other words, it is more

important than ever before to create a

business environment that gives full plash

to creativity. This is also necessary to createnew business seeds and new growth indus-

tries in Japan. Furthermore, since globaliza-

tion makes it easier for companies to move

managerial resources to regions where thesecan be most effectively and efficiently uti-

lized, it can be said that creating an envi-

ronment that makes it possible to introduce

a wide variety of excellent managerialresources is essential in order to increase

economic vitality.

In the following, we will review, while

keeping these points of view in mind, someof the changes that have taken place in

recent years in the environment surround-

ing Japanese companies. We will then dis-

cuss the kind of business environmentwhich Japan needs to create in the future.

(1) Developments Concerning Industrial

Financing

It can be said that the financing that

forms the basis of industrial activities

greatly affects corporate performance,

depending on whether its functions are

effectively performed. In particular, finan-

cial "intermediation," whereby funds are

redistributed through financial institutions,improves overall economic efficiency

through the supply of funds to entities

capable of effectively performing these

functions. Furthermore, financing is onearea in which the progress of globalization is

most evident. It is therefore increasingly

important that corporate management also

take global points of view in raising fundsthrough financial markets. In the following,

we will review some of the recent develop-

ments in industrial financing.

Changes in Corporate Fund Procurement

Structure

The large share of bank borrowings in

the composition of corporate liabilities (Fig.4-2-33) and the high ratio of deposits to

personal financial assets, a pool of perma-

nent fund surpluses in the economy (Fig. 4-

2-34), both indicate that banks have beenplaying the central role in performing finan-

cial intermediary functions in Japan. It is

said that this financial intermediary struc-

ture has played a vital role in supplyingfunds on a stable basis to the chronically

fund-short corporate sector during the

period of Japan's high-rate economic

growth. However, changes in the domesticand international business environment

have markedly changed this structure.

As shown in Fig. 4-2-35, corporate

dependence on bank borrowings has contin-ued to decline in recent years. One back-

ground factor is the fact that, with capital

markets developing as a result of financial

liberalization, creditworthy companies,particularly large ones, have diversified

their means of fund procurement -- by

shifting from indirect to direct financing, for

example -- in order to reduce funding costs.

In addition to using more efficient means offund procurement, companies also face a

growing need to pursue more sophisticated

financial strategies, including fund manage-

ment and settlement, that reflect the global-ization of corporate activities and the accu-

mulation of internal reserves. In particular,

the globalization of financial markets and

the global development of financial tech-niques make it increasingly likely that the

degree of corporate competitiveness will

depend largely on the sophistication of

financial strategy and the availability of

advanced financial services. In these cir-cumstances, companies are expected to shift

the emphasis in their dealings with finan-

cial institutions from maintaining stable

relations, such as they have held in thepast, to selecting financial institutions

primarily on the basis of their financial

needs. At the same time, this means that

the ability of Japan's financial institutionsto develop financial instruments, which is

said to fall behind that of Western financial

institutions, will be tested more severely in

the midst of mounting international compe-

tition.

Corporate Management Open to the MarketThe shift from indirect to direct financ-

ing, such as is seen in the fund procurement

structure, makes it increasingly necessary

for companies to pay greater attention thanever before to how they are evaluated by

investors. Furthermore, the growing pres-

ence of foreign investors in Japan is having

a great impact on corporate management inthis country. Fig. 4-2-36, which illustrates

stockholding shares by group of owners,

shows that the share of foreign investors

has been rapidly increasing; it reached11.9% at the end of fiscal 1996. In addition,

Fig. 4-2-37, which gives a sectoral break-

down of stock turnovers, shows that turn-

over has been relatively low for industrialcorporations and financial institutions, both

of which have been central shareholders,

and that turnover for foreign investors, with

their growing ownership share, has been thehighest.

Foreign investors have increased their

presence in major Western countries as well.

In the background are the expansion ofinternational money flows resulting from

financial globalization and the rising pres-

ence of institutional investors who are

increasingly concerned for investmentreturns (Fig. 4-2-38). Among these investors

are U.S. pension funds and others whose

basic stance is to hold shares on a long-term

basis and who are working actively oncorporate management to increase the value

of their stock holdings (Note 1) (Note 2)

The increasing weight of direct financ-

ing and the growing voice of shareholdersmean that financial intermediary functions

and the disciplining of corporate manage-

ment for greater efficiency are being per-

formed in a more open market. It is there-

fore important to create conditions condu-

cive to the full performance of market func-

tions. To that end, it is essential not only to

develop a system for adequate disclosure ofcorporate information but also to increase

the number and improve the quality of

information intermediaries, such as finan-

cial analysts and credit rating agencies, whosecure financial information needed for

proper corporate evaluation and at the same

time improve the utility of such information.

Smooth Fund Supply to New Growth Indus-

tries

It is increasingly important in the

Japanese economy to create conditions thatencourage creativity. Consequently, it is

desirable to ease the constraints on the

activities of innovative companies trying to

demonstrate creativity and open up newmarkets on their own.

Companies exploring opportunities in

new business areas often face constraints in

fund procurement because, generally, theirfuture prospects are considerably uncertain

and therefore high risks are involved in

their operations. These are believed to be

major problems particularly for youngcompanies, such as venture-capitalized

businesses, which, having been established

not long ago, do not enjoy ordinary credit

standing or have an absolute shortage ofinternal reserves. To supply so-called risk

money to these companies is also important

from the standpoints of creating new indus-

tries and reactivating the Japaneseeconomy.

In the following, we will study develop-

ments in venture capital, the main source of

funds to venture businesses.Fig. 4-2-39 shows shares in venture

capital investment by number of years after

establishment. Investment in companies

with a history of 10 years or more accounts

for more than half the total. Investment in

companies within five years of establish-

ment also has been expanding. However,

compared with the U.S. where investmentin start-up companies immediately or a

short while after establishment holds the

lion's share, the level in Japan remains low

(Fig. 4-2-40). One reason given for the highlevel of investment in young companies in

the U.S. is that investment is recovered

through public stock offering in a relatively

short period. NASDAQ, the U.S. over-the-counter stock market, is playing a vital role

as the place where stocks are sold and

where funds are raised through public stock

offerings. Because of its great convenience,this market has grown almost as large as

the domestic stock exchanges (Fig. 4-2-41).

In addition to playing a key role in fund

supply to start-up companies, it is pointedout that venture capital in the U.S. is also

taking a large part in developing these

companies through management support,

such as coordinating needed specialists suchas lawyers, accountants and investment

bankers (Note 3).

Next, regarding sources of venture

capital, in Japan corporations and financial

institutions are the main suppliers (Fig. 4-2-42). In the U.S., by contrast, such capital is

supplied by a broad range of investors,

notably pension funds (Fig. 4-2-43). Pension

funds and other institutional investors whohave large reserves of funds are capable of

maximizing profits and dispersing risks by

holding diverse portfolios, including risk

assets. In Japan, too, these investors can beexpected to play an important role as suppli-

ers of risk money.

In Japan it can be said that fund

supply routes to companies with an uncer-tain future are narrow, as shown by the fact

that personal financial assets, the final

supplier of funds, are concentrated in risk-

free assets. In order to ensure smooth fundsupplies to diverse businesses, it is hoped

that diverse investors with different risk

preferences will enter the market. To that

end, it is considered important to develop anenvironment conductive to free fund man-

agement (Note 4).

(Note 1) For example, CALERS (CaliforniaPublic Employee's Retirement System) is

noted for its positive approaches to manage-

ment, such as moves to improve information

disclosure to shareholders and the board of

directors.

(Note 2) A number of background factors are

cited, including the autonomy of theseinvestors in fund management, the require-

ment for prudent fund management under

the so-called prudent man rule, and the

difficulty of withdrawing from the marketbecause of the enormous size of investment.

(Note 3) See Section 2, Chapter ‡W, White

Paper on International Trade and Industry,

1997.(Note 4) In this sense, the abolition of regu-

lations governing asset management, such

as the "5-3-3-2 regulation" on the private-

sector employee pension funds, is to bewelcomed.

(2) Changes in the Environment Surround-

ing Employment

With business activities going global,

it is important that the employment envi-

ronment, a key element of the businessenvironment, be made internationally more

attractive.

In Japan, too, there are moves under-

way to explore various modes of employ-ment in a globalizing competitive environ-

ment. For example, as shown in Fig. 4-2-44,

the share of non-regular employees has been

expanding at a level exceeding 20% of the

total work force. In addition, a growing

number of companies have adopted a sys-

tem of variable working hours, such as theflextime system (Note 1). Thus, the modes of

employment and work have been diversify-

ing. Furthermore, the modes of remunera-

tion also have undergone marked change, asshown by an increasing number of compa-

nies adopting an annual pay system reflect-

ing individual ability, achievement, etc. (Fig.

4-2-45). In the background of these movesare not only attempts by companies to meet

their needs in response to changes in the

economic environment but also changes in

work ethics on the part of workers. Whereworkers are given opportunities to choose

freely from these diverse employment

modes, companies are likely to be able to

make more effective use of their humanresources, while workers themselves are

likely to be induced to give full play to their

abilities and creativity.

Furthermore, with the economic envi-ronment changing rapidly, an environment

conducive to the hiring of the necessary

personnel can be said to be a key componentof an attractive business environment. In

this sense, it is vital to create conditions

that help to increase flexibility in and se-

cure workers through the labor market. Forthat, it is necessary to enhance labor force

supply-demand adjustment functions

through such measures as revision of the

temporary service system and to re-examinesystems concerning separation allowances,

pensions, etc. so that workers who change

jobs will not be placed at a heavy disadvan-

tage. And realizing smooth labor movementthrough the external labor market, in addi-

tion to putting the right man in the right

place in each company, may be said to be

also highly significant from the standpointof ensuring more effective utilization of

human resources, a key element of manage-

rial resources, in the economy as a whole.

(Note 1) According to the "General Survey

on Wage and Working Hour Systems," Labor

Ministry, the percentage of companies on

the variable working hour system increasedmarkedly from 13.2% in 1990 to 40.5% in

1996.

(3) Flexibility in Corporate Organization

Required

In order to efficiently use managerial

resources such as personnel and capital it is

desirable that corporate organizationsthemselves exist in ways that ensure most

effective utilization of these resources. In

fact, Japanese companies, too, are making

efforts toward business restructuring, suchas developing new business areas in re-

sponse to new needs and technological

innovations, and rationalizing existing

operations. In doing so these companies aremoving toward re-examining their organiza-

tions so as to ensure more efficient distribu-

tion of managerial resources.

In addition, sales of inefficient orunprofitable operations, or corporate acqui-

sitions and mergers designed to secure

managerial resources needed to improve

business efficiency are likely to contributematerially to the more effective utilization

of existing managerial resources. For ex-

ample, in the U.S. where business reorgani-

zation is gaining momentum, active M&Adeals involving high-tech companies, par-

ticularly in the software area, have been

concluded (Fig. 4-2-46). As a factor contrib-

uting to this, it has been pointed out thatacquisitions aimed at securing technologies

and personnel and sales designed to raise

investment funds needed for new operations

have been conducted from a strategic pointof view. Generally, the activation of the

M&A market, which will ease these con-

straints, may be of great significance to

rapidly growing companies, given theirabsolute shortage of internal managerial

resources.

With market needs diversifying and

rapidly changing along with rapid techno-

logical innovations, companies are increas-ingly required to make quick decisions. If

companies are managed as in the past by

holding all managerial resources in their

own organizations, they could not only loseflexibility but also end up holding consider-

able managerial resources they cannot

effectively use. Furthermore, the develop-

ment of means of communication throughprogress in information technology has

made it easier to access external resources.

In these circumstances, utilization of exter-

nal managerial resources, such asoutsourcing, where they are required will

make it possible to enjoy the merits of

information and increase managerial flex-

ibility (Note 1). In other words, a businessenvironment in which managerial resources

can be flexibly redistributed and organiza-

tion promptly changed in response to exter-

nal changes can be said to be a major factorin corporate efforts to improve performance

on a sustainable basis.

As the world economy undergoes

dynamic change, it is essential that, in orderto achieve sustainable growth, Japan make

its business environment internationally

more attractive and induce more active

business activities at home. To that end, it is

important to develop a domestic environ-

ment that allows diversity and freedom of

choice. Such an environment will enableindividuals and corporations to exhibit

creativity and thereby help to create new

growth industries essential to the Japanese

economy.In addition, since the globalization of

business activities inevitably confront com-

panies with systemic differences abroad,

any extreme departure of Japanese systemsfrom the international standards would not

only hamper the overall efficiency of Japa-

nese companies with global operations but

also seriously impede the entry of foreigncompanies into Japan. In other words, in

efforts to improve the business environment

in Japan it is essential to harmonize domes-

tic systems with the global standards. Thatis also of vital importance in order to fully

enjoy the merits of globalization.

(Note 1) For details of information:s rela-tionship with outsourcing, see Section 3,

Chapter‡U.