The missing arrow of Abenomics

In his drive to kick start the Japanese economy, Prime Minister Shinzo Abe, shortly after taking office in 2012, introduced a large fiscal stimulus and put in place a bold programme of monetary easing.

Since then, Japanese policy makers have been working to launch what Abe calls the third “arrow” of his agenda: arduous reforms of key industries and the demolition of structural barriers to growth.

But the focus on public policy has left a “fourth arrow” — the private sector — untouched and seemingly ignored.

This is unfortunate, because the government cannot fix Japan’s ills on its own.

Annual productivity growth has been stubbornly sluggish, rarely rising above 2 per cent for much of the past two decades, reflecting both missed opportunities and declining cost competitiveness.

Japan’s productivity slump permeates the entire economy; labour and capital productivity gains have nearly stalled in almost every sector — even in Japan’s signature advanced manufacturing industries.

Labour productivity in the transport-equipment sector, for example, is barely half that of Germany.

This trend puts annual GDP growth on course to average only 1.3 per cent through 2025, implying a third consecutive decade of stagnation.

Such an outcome would coincide with — and exacerbate the effects of — an adverse demographic shift that will constrain fiscal revenues and drive up costs for universal healthcare and pension benefits.

Japan’s ability to alter its trajectory depends on individual companies making decisions to invest, change workplace policies, deploy new technologies and test untried business models.

Abe’s structural reforms will take time and political will to enact, but Japanese companies cannot afford to sit still. They can and must act, without waiting for the government to change its policies.

In many cases, the economy’s bottlenecks are not regulatory in nature, but stem from entrenched ways of doing business.

New research by the McKinsey Global Institute examines Japan’s advanced manufacturing, retail, financial services and healthcare industries in detail — and finds substantial untapped productivity potential in every area.

For starters, Japanese firms must become more globally integrated. Exporting to the fastest-growing overseas markets is one obvious route to overcoming sluggish demand growth at home.

But, rather than just selling products abroad, Japanese enterprises need to expand operations beyond their borders and cast a wider net for international talent.

Japanese companies have formidable R&D operations, but most will need to reconfigure them to obtain better returns and impact. The process must start with an understanding of what the customer wants and a determination to deliver solutions accordingly.

Closed and tightly managed R&D operations must be transformed into more fluid, open processes involving collaboration with customers and suppliers.

Japanese companies will also need to improve their capabilities in areas such as marketing, pricing and talent development. While there are some pockets of excellence, most Japanese firms are severely lacking in these areas.

To compete in global markets, they will need to achieve the same consistency in these areas that they have in their traditional areas of strength.

Many Japanese companies have yet to digitise paper-based processes and replace outdated information technology systems. Others would benefit from moving beyond basic digitisation to next-generation technologies, such as big data analytics.

Companies can also head off looming labour shortages with intelligent software systems and robotics. Manufacturers can augment or replace their assembly lines with technologies such as the Internet of Things and 3D printing.

More broadly, Japanese companies have to organise for performance and discipline. 

As policy changes unleash market forces, businesses will face greater competition. Some may need to reorganise or exit unprofitable markets; others may have to undertake mergers and acquisitions to achieve economies of scale.

Finally, shareholders and senior executives should tie performance goals to incentives. Some of Japan’s corporate giants have already begun shifting from traditional seniority-based advancement towards merit-based pay structures.

Others should follow their lead. Promoting younger and more diverse talent can create agile organisations with fresh ideas.

If Japan’s private sector rises to the challenge, it can move the economy onto a path of faster growth. Innovations in one company would cascade across its entire industry by forcing competitors to raise their game. In the 1950s and 1960s, for example, Toyota introduced more efficient production processes that were eventually adopted by the entire automobile industry.

Instead of settling for a future of 1.3 per cent annual GDP growth, Japan could attain roughly 3 per cent annual growth through 2025. Doing so would require the growth rate of labour productivity to more than double, but this is an attainable goal.

More than half of this growth increment can be met by adopting best practices that companies around the world already use, while technology can close much of the remaining gap.

Japanese business leaders need to combine big thinking with a focused attention to detail.

They will need to create innovative products, penetrate new markets, and make bold investments in equipment, technology and talent, while simultaneously scrutinising every aspect of their operations for inefficiency and waste.

Traditional ways of doing business may have to be abandoned. But there is ample scope to make progress and spur faster economic growth.

Immense trade flows, the rise of billions of new consumers in the emerging world, and technology breakthroughs are rapidly transforming the global economy.

Japan can shift its current trajectory by turning this wave of disruption into opportunity.

Seki Obata is a professor at Keio University’s Graduate School of Business Administration and a former official in Japan’s Ministry of Finance. Georges Desvaux is the managing partner of McKinsey and Company’s Japan office. ©Project Syndicate, 2015. www.project-syndicate.org