Long disparaged for underperforming compared to U.S. and European competitors, the Tokyo Stock Exchange had a good 2021, with the Nikkei average having its highest year-end close in 32 years.

That performance is a good sign as the TSE prepares for a restructuring in early April that is intended to revitalize corporate governance and attract global investors.

Early assessments have raised questions, however, about the ability of the proposed reforms to rejuvenate the market and win over skeptical investors. Much will depend on how firmly market regulators implement reform.

The TSE, which hosts 3,777 stocks, currently has four sections: first, second, Jasdaq and Mothers. The April reform will consolidate these indexes to three: prime, standard and growth. More important than the consolidation will be new requirements imposed on companies that seek to list on the prime section. Those new regulations will address market value, the number of outside directors on the board, the number of floating shares and other factors.

Most attention has focused on this prime section of the index, which is supposed to include the “best” companies in Japan. Currently, the TSE first section has 2,158 companies, or more than half those listed.

By all accounts, the current first section is bloated, with companies rarely removed once they gain admission, even if they have low liquidity and low-market caps. It’s hard to believe that there has been much winnowing when the new division will include 1,841 companies, 84% of the current occupants. Of the remaining companies, 1,477 (39%) will be in the standard section and 459 (12%) in growth.

Those that make the cut to join the prime market will have a hard time competing with companies in leading sections of other exchanges. The median market capitalization of those Japanese companies is only $520 million, while it’s about $2.8 billion in the NYSE and about $1.7 billion in the London and the Nasdaq Global Select markets. Just less than half of the prime members have price-to-book ratios of less than 1 — meaning they are valued at less than their net worth; in the United States and European markets, the number ranges from 10-20%.

Investors and analysts are skeptical that proposed reforms will close the gap. For example, the prime companies will be required to have tradable shares worth at least ¥10 billion ($87 million). Global asset managers typically seek out investment targets that are worth 50 times that amount.

Moreover, many shares are not actually available for purchase. Instead, they are part of cross-shareholdings, arrangements that are designed to insulate management from any outside pressure. Those deals will not count as tradable shares, which is why the lower threshold is even less inviting.

A second problem is the flexibility given companies to meet the new requirements. Fearful that too many may not qualify for the prime section, the authorities have decided that they will have an indefinite amount of time to transition as long as they submit a reform plan. It is believed that 296 companies will make use of this provision, which was reportedly included to mollify politicians who feared intense criticism if long-established members of the first section could not make the transition. It effectively strips the reforms of substance, however. There are reports that a deadline will be set. That is essential.

There is a tension between the desire to use membership in the TSE first section to signal acceptance and status — and earn money on the initial listing — and the need for quality control to ensure that prime section companies merit international attention. Thus far, the status concerns have prevailed, which was long a problem with the old system.

TSE officials duly recognize these concerns. Their statements invariably note that the forthcoming changes are merely the beginning of a process. Hiromi Yamaji, president of the TSE, noted that “the announcement is the starting line of a long road toward sustainable growth and medium- to long-term enhancement of corporate value.”

Central to that effort is a focus on changes that will make Japanese equities more inviting to foreign investors. The TSE aims to do that by increasing disclosure in English, increasing the number of independent nonexecutive board members to more than a third and requiring climate change-related disclosure in line with the Task Force on Climate-Related Financial Disclosures recommendations. These mandates can force change: The TSE requirement that first section members have more than two independent directors increased the share of companies with that representation from 21.5% in 2014 to 97% last year.

Those changes do not exist in a vacuum, however. Also important are changes to the Foreign Exchange and Foreign Trade Act as well as the Corporate Governance Code. The former’s provisions are intended to limit investor opportunities to acquire intellectual property by dubious means, but they can be abused to undermine shareholder activism and governance reform.

The latter was revised in June of last year to encourage a focus on sustainability as well as environmental, social and governance issues. Those changes have been applauded but here too much depends on rigorous implementation.

Japanese officials, politicians and businesses know that they need to change business practices to generate sustained attention, enthusiasm and investment from international investors.

TSE reform, like other structural changes to the economy, is intended to do just that. But investors will not be mollified by cosmetic alterations. Real change is needed to win them over. They remain unconvinced.

The Japan Times Editorial Board

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