Japan's Corporate Governance Reforms

Shinzo Abe promises to unleash the third arrow of his Abenomics agenda - structural reforms to enhance competition and innovation. One of the major prongs of this is expected to be corporate governance reforms that would seek to break to distortionary cross-holding relationships between different companies.

The government is also preparing what advisers say will be a world-class corporate governance code that requires multiple independent outside directors, formal protection of whistle-blowers, and other measures that proponents say would have been unthinkable before Mr. Abe came to power a year and a half ago. These corporate governance reforms also seek to put an end to a decades-old tradition: the practice of holding shares in one another to create a web of relationships meant to keep unwanted interference to a minimum. It is not easily visible on the surface, but Japan’s biggest corporations are linked together in a sprawling web of mutual shareholdings that shield company executives from the pressures of the stock market. Coddled in a comfortable old boys’ club, Japanese executives have long gone unpenalized for failed investments, refusing to withdraw from money-losing businesses, hoarding cash and bringing shareholders perennially low returns. Mr. Abe’s government sees the cozy arrangements as out of place these days, especially as the country seeks to win over foreign investors. Mr. Abe’s latest round of measures calls for a reduction in cross-shareholdings to “as low a level as possible.”

In simple terms, Mr Abe is proposing to introduce best-practice corporate governance reforms into a system steeped in deeply traditional Japanese culture. Now this promises to be a defining moment in the country's economic history. The objective of breaking the cozy relationships arising from the web of cross-holdings is to improve corporate governance standards. But it is difficult to say that the reforms would achieve their objective.

The prevailing corporate governance arrangement, for all its distortions, has to be seen in the light of the very deeply traditional cultural norms that steeps Japanese life. Arguably, in any modern society, which is not permeated with the deep sense of respect, deference, and loyalty that underpin personal relationships in Japanese society, such relationships are most certain to engender cronyism and corruption.

But in case of Japan, how are we to say with any degree of certainty that the modern best practice, with its own chequered history of cronyism and corruption, will be more incentive compatible that the current cozy relationships? How are we to say that the reforms would not result in an equilibrium that is more distortionary and sub-optimal? Are there not better ways to hold corporate boards accountable?