Governments around the world are adopting new tools to help them monitor and control the ownership of industries critical to national security. This summer, new rules were passed in Japan that expanded the national security designation to high-technology industries, adding 20 sectors in the information and communications industries to the list of businesses for which foreign ownership of Japanese firms is restricted. The Cabinet on Friday approved draft legislation designed to further tighten rules, but while stricter scrutiny of foreign investments is warranted, the proposal goes too far.
The proposed legislation would lower the threshold at which overseas investors must report their intention to acquire a stake in a company in the industries of weapons manufacturing, power generation and communications. The current trigger is a 10 percent stake; the bill lowers it to 1 percent. That is too low. Akira Kiyota, head of the Tokyo Stock Exchange, called the proposal “absolutely idiotic.” That characterization makes plain the concern that has been created.
A hallmark of Japanese economic reform over the past two decades and since the return of Shinzo Abe to the Prime Minister’s Office has been the opening of the country’s economy to foreign investors. Abe declared that Japan was open for business after taking office in 2013, calling on foreign investors to “buy my Abenomics.”
The world responded positively to the invitation. It is estimated that foreign investors now own about a third of the Tokyo stock market by value, and generate about 65 percent of daily trade volume. The new rule threatens to eviscerate that trend; analysts at Goldman Sachs warned that the new regulations could “undermine seven years of positive momentum in market reforms.” They also highlighted the “significant risk that Japan’s inward FDI (foreign direct investment) could decline,” which “could impede firms’ ability to raise capital.”
The severity of these restrictions resuscitates fears that Japan is becoming hostile once again to a foreign presence in the economy. That is difficult to square with the many changes that have been introduced in recent years to accommodate foreign workers and foreign capital. Nevertheless, concern persists and critics are eager to prove that their fears are justified. That the list of new industries where investment is to be scrutinized includes agriculture, forestry, fisheries, leather and marine transport bolsters the skeptics’ case.
Additional provisions that are reportedly under consideration would limit the ability of foreign investors to nominate new board members at annual shareholders meetings. This could also undercut a tool that shareholder activists have been using to increasing effect to force reform on unyielding management.
There is a need to more closely scrutinize foreign capital inflows. The United States has revised its foreign capital screening mechanism, the Committee on Foreign Investment in the U.S., to expand its jurisdiction to new fields (such as real estate), different types of transactions or changes that might affect a foreign investor’s governance rights. Other countries have followed suit. Earlier this year, the European Union adopted an investment regulation that provides a stricter screening framework. Australia tightened its investment review over a year ago and New Zealand is in the midst of doing the same.
Japanese officials concede that their controls are not as strong as those in the U.S. and Europe, and the new rules are an attempt to catch up. For example, real estate, previously excluded, will be included, which would prevent foreign companies from acquiring land close to sensitive properties or targets. Japanese officials have said they may exempt “portfolio investors” — an undefined term — from the new rules, along with investments that do not influence a company’s corporate management.
The definition of “portfolio investors” will assume great weight. Bankers often engage in block trades that exceed the 1 percent threshold; requiring advanced notice would cripple their ability to do business, giving local banks a huge advantage in market making and block trading. A Finance Ministry analysis has reportedly concluded that without qualification, the new rules would increase notifications by 800 percent, but an expansive definition of portfolio investors would exclude 90 percent of all trades.
Cabinet approval is only a step toward new legislation. The government wants to see the proposal become law by next year. In the interim, it must be passed by both houses of the Diet. Given Japan’s historical reticence toward, if not outright hostility to, foreign investment, officials are going to have to come up with a better defense to criticism than “trust us.” Investment scrutiny is needed, but reforms to this proposal are needed as well. There is still time to get it right.