https://www.wsj.com/articles/SB917995211836551500

 

Feb. 3, 1999 12:01 am ET

By Nicholas Benes, president of Japan Transaction Partners, an investment bank specializing in merger and acquisition advisory services.

Japan’s ruling Liberal Democratic Party announced last week that it was seriously considering a number of schemes aimed at accelerating the reduction of cross-shareholdings on the Japanese stock market. The schemes were first proposed last fall by such reputable groups as the Keidanren and the Daiwa Research Institute. But if they involve interference or financial support by the government, such transactions would cause more problems than they would solve.

It seemed at first glance that policy makers have finally recognized that cross-shareholdings–stocks bought to cement business ties–are the key obstacle to the formation of mature capital markets and the elimination of overhanging supply. An end to these collusive arrangements would usher in a new era of healthy corporate governance and efficient capital allocation. So a government campaign to reduce them looks like progress.

Recently, however, the desire to eliminate cross share-holdings has been subverted to the point of betraying its own free-market origins and purposes. At first, most of the schemes envisioned some sort of joint pooling of cross-held shares with a view either to subsequent stock buy-backs and the retirement of those shares by their issuers, or sale to the market over time. But as details are filled in, it has become increasingly clear that most also envision the use of public funds to support the stock market either by directly financing the purchases or extending guarantees.

There are a number of variations on the theme, but most would include some form of financial intervention by government bodies. Either the Bank of Japan will be lending funds; or the government will guarantee companies’ future buybacks; or the Postal Insurance Fund will hold all the stocks, and so on and so forth.

One might say that this is no reason for alarm–that as long as the Japanese government has its coffers open, needy hands will be extended, and the economy will soon be on the mend. However, the real purposes of such proposals are too harmful to ignore. Once again Japanese policy makers are designing a stock-buying platform in order to enlist the government’s deep pockets to support the market without regard to fundamentals, and to ensure the “survival” of certain firms without a change of management control.

In some of its versions, such a scheme is nothing more than a clever way to channel still more public money to Japan’s cash-strapped banks, while avoiding the discipline of the increasingly efficient Financial Supervisory Agency, which injects public funds only in return for meaningful restructuring steps. In short, what was originally a useful concept has been transformed into yet another “price-keeping operation” that distorts the market and postpones reality.

The potential for market distortion is indeed immense. In anticipation of government support of the market, stock prices might rise, thereby reducing pressure on management to undertake crucial restructuring. The more likely result, however, would be a drop in stock prices. Understanding these negative consequences, investors might run for the exits, sending stock prices into a tailspin that would further aggravate the banking crisis and slow the current pace of restructuring and cross-shareholding sell-offs.

Moreover, any kind of financial support or buy-up by the government would create a risky investment portfolio for the Japanese taxpayer. How will the government decide which stocks to sell and when? In effect, the government would be nationalizing a sizable chunk of the Japanese economy.

As usual, this whole fiasco began with the futile hope that the market can be fooled long enough to save the economy and incompetent managers. Business leaders can no longer afford to hang on to cross-shareholdings in the current economic climate. As capital has become more scarce, they have been unwinding their cross-shareholdings. But there is still a long way to go. The loosely defined cross-shareholding ratio is still about 35%, down only 6% from its 1990 level of 41.7%. As long as this overhang of unsold stock continues, the Nikkei Index will hit a ceiling at around 15,000.

As the remaining stock is sold, certain companies will gradually become takeover targets. While some companies have enough excess cash to undertake stock buybacks as a defense, many do not. Nor can they count on the support of their banks, which are scaling back lending. The solution? Create a new form of “quiet and stable” shareholder that struggling companies can ask to hold their shares for five years or “until we are more profitable again.” Sound to good to be true? That’s because it is.

Sadly, many of Japan’s leaders still don’t understand that the solution to their problems lies in the creation of a healthy and vigorous capital market. This does not mean an equity market where prices are always high. Rather, it is a market that efficiently allocates and reallocates capital to the sources of highest marginal return per unit of risk. Measured in this way, massive “voiceless” shareholders do not enhance value. On the contrary, they destroy it by cushioning management from the discipline of the market.

What these policy makers fail to understand is that an increase in the number of sellers of a stock doesn’t necessarily mean that the price of that stock will nose-dive. That depends on the value of the company and its management. Sellers at a price below value beget buyers.

What the presence of sellers does mean, is that more volume will be traded, enabling the market to find the appropriate price more efficiently. As most Japanese owner-managers whose companies are listed on exchanges can attest, the problem with much of Japan’s equity market is exactly this: not enough volume and liquidity.

If the government is serious about promoting venture businesses and the growth of new industries, it will have to address this defect and promote efficient capital allocation. Simply taking large blocks of stock that are packed away in one place and packing them away somewhere else does not accomplish this.

The buying and selling of cross-shareholdings on the open market can have positive effects on both buyers and the sellers. Managers at a selling company can redeploy this capital in more productive, higher-return uses. For the company whose stock is sold, there are also many cases when stock sales can be good, and even increase the share price over time.

Stock sales send a message to current management that it needs to make changes that it may have postponed out of inertia or the hope that it could hide problems. Sales by large holders also free up large blocks of stock for possible purchase by large institutions, partners, strategic investors, or acquirers. Access to capital and strategic tie-ups with these investors can increase the value of the company in question. In short, Japan needs more flows of capital in large blocks, not less.

A recent study by the Nippon Life Research Institute shows that Japanese companies that have reduced their cross-shareholdings over the past few years have outperformed the market index by a noticeable margin. What the government should be doing is finding ways to further accelerate these private capital allocation decisions, not mucking up the works with public funding. It would be much more effective and far less market-distorting to implement a temporary tax holiday or reduction of capital gains taxes. Such a policy could be applied across the board to provide incentives for private investment decisions by individuals, small businesses and large corporations alike, rather than effectively singling out only the poorest performers for undeserved “support.”

Members of Japan’s old guard feel intense trepidation at the thought of trusting their economy to market forces with such a bold step. Perhaps they are terrified that such steps would result in an uncontrollable flood of sell orders. But for the large group of domestic and foreign investors waiting in the wings–which Japan badly needs to return to its markets–it would be the clearest possible signal that “Japan is a buy.”

–From The Asian Wall Street Journal