Let Japan’s zombie firms die



Imagine that you’re a Japanese 26-year-old with big dreams. You graduated from Waseda University, an elite private school, with a degree in electrical engineering. You and your college buddies used to hang around your apartment, watching anime on your LCD television, which was made by Sharp Corp. — the world’s 10th-largest LCD TV manufacturer. Even then, you had ideas about how to improve the product.

Now, after graduating and working for four years in the research division of an LCD manufacturer, you’re sure that you have figured out how to make LCD panels more cheaply, at higher quality. You also believe that you could market these TVs more effectively to young people with cool, fun designs. Instead of giving the idea to the higher-ups in your giant corporation — which, knowing Japan, might get you little more than a pat on the head — you decide to leave your job and start a business with your college buddies. You just know that you can beat lumbering, struggling incumbents like Sharp.

Everything goes well for the first couple of years. Your main rival, Sharp, is floundering so badly that it’s begging its own workers to buy its products. Meanwhile, you manage to secure venture-capital funding and even a bank loan. The interest rate is high, but with your rapid growth, you should be able to pay it back.

Then one day, in May 2015, you open your newspaper and see that Sharp has been bailed out by two of Japan’s largest banks, Mizuho Bank and Bank of Tokyo-Mitsubishi UFJ. These banks are themselves backed by government bailout guarantees, meaning that Sharp has been indirectly rescued by the government — a prime example of the zombie-firm phenomenon that economists have been complaining about for decades. With those cheap bank loans, the ailing Japanese giant can afford to keep putting out TVs at fire sale prices, making no profit but squeezing your own margins.

But you soldier on. The bank bailout does nothing to improve Sharp’s corporate strategy — the company’s managers are content to drag out the status quo for as long as possible. Eventually, you think, Sharp will quit, the market will become less crowded, and your innovative products and manufacturing processes will be rewarded with bigger profit margins.

Then, this month, the Japanese government steps directly into the fray. The Innovation Network Corp. of Japan offers to bail out Sharp with an injection of ¥200 billion. INCJ, which is funded by industrial giants but backed by government guarantees, will keep Sharp’s struggling LCD division alive and merge it with a rival, Japan Display Inc., itself a consortium of large corporations.

Faced with this kind of firepower, there is no way you can stay in the market. Nor can you expect a similar bailout — you employ only 100 people, while Sharp employs 50,000. You fold your startup and move across the Pacific to Silicon Valley, following in the footsteps of other Japanese entrepreneurs.

The story of this young Japanese entrepreneur is fictitious, though there are some real-world parallels. But the part about the Sharp bailouts — first by the banks and now by the government — is all too true. Japan Inc. looks dead set on keeping the flailing electronics giant alive. That will keep the market flooded with artificially cheap Sharp products — mobile phones, solar panels, air conditioners, printers, microwave ovens and a host of other items. Entrepreneurs looking to use the Japanese market as a launching pad for innovative products and processes will find themselves blocked by zombies. In reality, prospective Japanese entrepreneurs know this, and avoid taking the plunge in the first place.

Economists have been shouting about this problem for years now. Way back in 2003, Joe Peek and Eric Rosengren wrote a paper called “Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan.” They found:

“Japanese firms are far more likely to receive additional credit if they are in poor financial condition, and these firms continue to perform poorly after receiving additional bank financing. Troubled Japanese banks allocate credit to severely impaired borrowers primarily to avoid the realization of losses on their own balance sheets.”

In 2008 — before the global financial crisis had hit Japan — Ricardo Caballero, Takeo Hoshi and Anil Kashyap published another paper, “Zombie Lending and Depressed Restructuring in Japan,” which declared:

“Large Japanese banks often engage in sham loan restructurings that keep credit flowing to otherwise insolvent borrowers which we call zombies. . . . The congestion created by the zombies reduces the profits for healthy firms, which discourages their entry and investment. . . . Zombie-dominated industries exhibit more depressed job creation and destruction, and lower productivity.”

A 2009 paper, by Mariassunta Giannetti and Andrei Simonov, found that the Japanese government’s bailouts of major banks made these problems worse.

These papers all came before the creation of the INCJ and other similar government bailout funds. The government hopes that the INCJ and its ilk will impose more stringent conditions on the companies it rescues, but the bailout funds obviously offer an incentive for bad behavior. Japan still just can’t let its bad companies die.

If Japan’s bailouts remind you of the U.S.’s rescue of its auto companies, you’re not alone. There is a strong argument that the auto bailouts only delayed the day when General Motors and Chrysler lose out to nimbler competitors like Tesla Motors. But there are also some important differences.

The U.S. auto bailouts were undertaken in the middle of a deep recession, and are highly unlikely to be repeated. Japan’s bank- and government-led bailouts come all the time, repeatedly, during normal economic times.

Additionally, U.S. startups such as Tesla can look to capital markets for funding, while Japanese finance is dominated by large government-backed banks that want to preserve the supremacy of their large zombie clients. So while the U.S. bailouts might have hurt productivity somewhat, the situation in Japan is just much, much worse.

If Japan wants to generate long-term growth, it needs to allow creative destruction. New companies can’t grow when they are blocked by failing incumbents. The aspiring entrepreneur watching cartoons on his TV at Waseda University must be allowed to do his thing. Japan’s cycle of bailouts must end.

Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for a number of finance and business publications.

  • AJ

    Interesting for the author to not consider the scenario where Japan’s vaunted electronics industry gets hollowed out and never replaced, much like manufacturing in the US, which causes a rise in unemployment and inequality.

    The easy answer “kill the zombie companies” requires several key cultural shifts. It must become easier for Japanese to be laid off and rehired by other employers. Venture capitalists and entrepreneurs must forge a new path in Japan, with the burst of successes like Silicon Valley and relatively minor consequences for failure in high-risk ventures. Then Japan must allow cheaper foreign brands to compete and replace lost Japanese brands, which accelerates the failure of other companies to low-cost producers. These are not easy changes to adopt!

    • kyushuphil

      And these changes aren’t easy to adopt as schools mire in status quo.

      Schools could change. They could give up on the conformities built into all the emphasis on group activities, regimented call-and-response in class, short-term info cramming, and all the perverse “traditions” of nobody ever questioning anything.

      Students could more regularly keep journals and write essays. They could value seeing and refering to the essays of other students — keeping horizons open, contexts wide, and all values grounded in the human.

      Shuji Nakamura, winning the Nobel Prize for Chemistry in 2014, observed how Japan’s powers-that-be cripple Japanese abilities to market otherwise fine Japanese products.

      So why do the schools mire in cowardly, patriachal, conformist status quo?

  • Liars N. Fools

    My comment from original Bloomberg posting. The big development is the reported takeover of Sharp by Hon Hai/Foxconn.

    I lived in Osaka when Sharp took a huge risk, investing in a multi-billion dollar facility with several partners, including Corning Glass, in the city of Sakai. The plan was to make so-called 10th generation panels, which would lead to giant LCD TVs that would wow the competition, and Sharp was literally at the top of its game — a huge seller with Korean and Chinese companies regarding Sharp as the model to emulate.

    Problem was that the Sharp product was extremely expensive and its perceived quality advantage was not pronounced or obvious. In the TV game, LG Display is number one in panels, followed by Samsung Display, then Taiwan’s Innolux, with China’s BOE rounding out the top 4. Competition is vicious, and LG and Samsung are hoping their early adopting of OLED (organic light emitting diode) can keep them in the lead, but with especially the Chinese in the rear view mirror. Sharp and Japan Display are also rans, with Samsung and Hon Hai making some takeover offers for Sharp, which the nationalistic Japanese are reluctant to approve lest companies from former Japanese colonies take over a flagship Japanese company.

    I feel sorry for Sharp. The company was not resting on laurels and was not risk averse. Quite the opposite. They took the huge risk at Sakai and other places. It was just a major mistaken business decision. It may indeed be a zombie but one that still makes a hell of a product.

    This made up story of the Waseda graduate is not realistic. Instead it should be a story of enterprise and innovation and risk taking at what used to be second line electronics companies in Korea (LG and Samsung) chased now by Taiwan and Chinese upstarts. So it is not merely the Japan establishment creating zombies but putting up a lot of chauvinistic capital.

  • texastea

    Samsung has one of its largest overseas R&D facilities in Yokohama, staffed by Japanese engineers. It is a huge 6 floor building. So as least Samsung is getting the benefit of some of those frustrated young Japanese engineers.

  • GIJ

    I’m sorry, but I find it amazing that American commentators like Smith have the gall to continue writing this sort of thing. The USA and its people lost all authority to lecture any other country on the need to stop bailing out underperforming firms after Morgan Stanley & Co. were propped up during the 2008-09 financial crisis. Never again will Timothy Geithner, Lawrence Summers, and Alan Greenspan have any credibility in traveling to Japan (as they all did repeatedly in the 1990s) and telling the Japanese that they need to let underperforming banks and other firms fail. I’m not sure why some professor of finance at Stony Brook should be taken any more seriously.

    In 2008 and 2009, the USA made it clear that it would simply not take its own medicine when salaries and bonuses for banking executives appeared to be at risk.