Productivity — it’s the magic word. Japan’s future prosperity depends on it. Whether you are discussing the economy with global central bankers, corporate leaders, policy makers, or just debating with your friends, sooner or later everyone agrees that, yes, Japan must raise productivity. After all, in its simplest form, economic growth is derived from the combination of growth in the population and growth in productivity. So in Japan, since the population is going down, all the hard lifting will have to come from productivity.

The good news is that Japan is about to have a big productivity boost. Why? Because after years of under-investment, Japanese companies are finally beginning to make the necessary investment in both human and physical capital. And yes, you need to spend on both humans and machines to get truly sustainable productivity growth. Smarter machines need smarter operators.

Let’s have a look at the numbers. First of all, Japan does indeed lag behind in a global comparison of overall productivity. OECD data suggests that growth in real GDP per capita — which is the broadest measure of an economy’s productivity — has averaged 2.9 percent per annum over the past 20 years. This is lower than the 3.3 percent growth recorded in the United States or the 3.6 percent achieved by Germany during the same period.

So not only is Japan’s population declining, but whoever is left to work actually works less productively than their American or German peers. And by the way, China’s per capita real GDP growth averaged 10.9 percent since 1998. Clear speak — Japan has to step it up significantly to avoid being left behind in the global race.

So why my optimism? It stems from the next layer of detail and analysis. Japan’s overall productivity is being held back by a huge difference in sectoral productivity: While Japan’s manufacturing sector has remained a clear global productivity leader, the domestic service and non-manufacturing sector has fallen behind.

Non-manufacturing companies managed absolutely zero productivity growth in the past two decades. The contrast is shocking: Between the year 2000 and 2017, manufacturing sector workers’ value added produced per hour surged from about ¥4,000 to approximately ¥5,800; but non-manufacturing sector workers’ value added per hour stayed absolutely flat-lined at about ¥4,600 — no growth whatsoever.

Make no mistake — for an economist, this stagnation of service-sector productivity is the very core reason for Japan’s two-decade-long stagnation and global under-performance. Fortunately, economists also can explain what exactly forced the stagnation in service sector productivity — chronic underinvestment: Since 2000, the amount of productive capital employed per worker has fallen from approximately ¥24 million to just below ¥22 million in the non-manufacturing sector.

Yes, service companies did hire more employees — service-sector employment has risen by more than 5 million people since 2000; but those employees were not given more modern or upgraded machines and technology to do their job. Incredibly, capex spending in Japanese services has flatlined since 2000, which suggests basically that Japan’s service sector completely ignored the IT revolution. In contrast, Japanese manufacturers increased capital investment spending steadily (and did cut approximately 1.2 million people from the payroll), so the capital intensity in manufacturing rose from approximately ¥20 million to just above ¥26 million between 2000 and 2017. Generally speaking, Japan’s industrial workers do work with the best machinery available while service sector workers work, at best, with last-generation technology.

More detailed analysis supports a clear-cut causality. To be productive, firms need to invest in both human and physical capital, and all the evidence suggests Japanese service-sector companies have not invested enough in productive capital and technology.

Partly, this may be explained by the legacy of “zombie companies,” a negative legacy of the bubble era’s excessive investment. In the non-manufacturing sector, Japan had many “zombies,” particularly in real estate, construction and retail. “Zombies” have low productivity and low profitability. They really should not exist and should be forced into bankruptcy or restructuring.

In the manufacturing sector, zombies did come under pressure to restructure — like steel companies or even car companies relatively early on after the collapse of the bubble. In contrast, the zombies in the domestic, Japan-only non-manufacturing sector were able to stay in business with support from banks, government lending, super-low interest rates and forbearance lending to compensate for losses.

In other words, non-manufacturing sector companies were incentivized to invest in maintaining past business models and operational practices, rather than forced to modernize, innovate and compete. Domestic service companies over-invested in the past and under-invested in the future.

That was the past two decades. Now, there are solid indications that Japan’s service-sector companies are beginning to invest in the future. All the latest surveys on business investment spending plans point to a smart and positive inflection.

Japanese banks, for example, have emerged as global leaders in investment on blockchain technologies. And Japanese retailers are finally getting serious about multi-channel strategies, i.e., they are now investing in building e-commerce strategies that complement their store-front operations. This is a welcome change after decades of ignoring the internet and merely protecting old-style brick-and-mortar distribution channels.

All said, a positive dynamic is beginning to develop, pointing toward a potentially smart upturn in Japanese service-sector productivity. Importantly, the growing labor shortage is now forcing zombie companies out of business or into mergers and acquisitions; and it’s turbo-charging service companies’ management drive for investing in better technology. If, as I suspect, the technology upgrade goes hand-in-hand with new work practices and routines, Japan is poised to lead the world not just in productivity growth, but also in demonstrating how both technology and humans can work together to build a better future.

Based in Tokyo, Jesper Koll is WisdomTree’s head of Japan. Researching and investing in Japan since 1986, he’s been consistently ranked as a top Japan strategist/economist. He publishes blogs at www.wisdomtree.com/blog.

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