Why Japan could be on the brink of a historic mistake

Japan’s stock market does not look like one facing Armageddon. At Wednesday’s close, the Topix equity index was at a 10-month high after a healthy 9 per cent gain so far this year.

But the private conversations of lawyers, investors and bankers are replete with such apocalyptic language about a potential change to the rules governing foreign investment. In their eyes, the country stands on the brink of an epic mistake.

The on-record warnings about the Japanese government’s proposed amendment to the Foreign Exchange and Foreign Trade Act have ranged between cagey and candid. A couple of strategists caution that draconian new rules on foreign investment may “hurt” Japanese stock prices. The president of the company that owns the Tokyo Stock Exchange described the whole plan as “idiotic”. Neither statement really tells an investor what to expect.

Behind the scenes, the prognostications are bleak about the rushed introduction of a regime that could determine how far foreign investors — which have been net sellers of this market this year — maintain their long-term interest in Japan.

The proposals stem from a conviction within the Ministry of Economy, Trade and Industry and the Ministry of Finance that Japan needs to tighten its rules on foreign investment in sensitive industries (including aeronautics, software and agriculture). In doing so, it would join a number of developed economies taking similar measures, most with China in mind.

Companies can fall into those categories, say lawyers, when only a small — and sometimes hard-to-identify — proportion of their revenues are derived from security-sensitive businesses.

Under Japan’s current regime, foreign investors in potentially sensitive companies must file a pre-notification if they intend to own a stake of 10 per cent or more. The approval process is already cumbersome, expensive and time-consuming.

The proposed new rules cut the 10 per cent threshold to just 1 per cent, a level chosen because that is the minimum stake required for an investor to submit a proposal at a listed company’s shareholder meeting. Purchases on that scale happen all the time.

Lawyers say that there is a substantial risk that the new pre-notification obligations will simply overwhelm whatever resources the Japanese government puts in place to process them. Hence a wave of panic, as the extensive range of parties who would be affected by the change ponder its deliberate and unintended consequences.

Details remain unclear. The government has suggested that it will exempt “portfolio investors” — normally understood to be pension funds, asset managers and the like — but has yet to settle on how far those exemptions will extend, or whether a demand for higher dividends, buybacks or a change of management by such an investor would cancel such an exemption.

Some analysts foresee an immediate chilling effect on the kind of shareholder activism that has been led by foreign investors and helped propel half a decade of progress on corporate governance. Others fear it will act as a deterrent against foreign investment in a Japanese stock market where foreigners hold about 30 per cent of shares by value.

The criticism is not of Japan’s right to protect sensitive industries from foreign control, but the likelihood that the implementation creates a flawed, unbalanced and baffling system.

What is most striking about the proposal is how quickly it has emerged from the ether and how rapidly it could now pass into law. It was first reported just last month, but the cabinet may well approve the amendment by the end of October. Parliament could pass it by the end of the calendar year.

There would then follow a period of about six months of public consultation on the implementation — the only real window in which interest groups could register misgivings over the whole project.

The key to understanding the proposal may lie in asking why it has arisen so suddenly and why it has such momentum behind it. There are two main theories. The first is that this represents Tokyo’s response to pressure from the US to ensure that Japan not be a conduit for technology leakage to China.

Japanese policymakers have studied other, tighter regimes and decided to go even stricter in the initial proposal. But they are more likely to be pragmatic, the theory goes, when it comes to the application of the new regime and not risk huge disruption of the equity market.

An alternative understanding is that, after observing the steady and successful rise of foreigner-led shareholder activism in Japan, the whole “national security” narrative masks a more fundamental wish by Meti to place the Japanese state between Japanese companies and investors.

Meti has been motivated to do that, according to one official, since the 2017 corporate crisis at Toshiba drew feisty foreign capital on to its shareholder register and eventually forced the sale of the prized chip business to an international consortium of buyers that included South Korea’s SK Hynix.

If the second theory proves correct, and this represents Japan’s backlash against activism and rising pressure on conservative management teams, then prophecies of doom may move from private discourse to the mainstream.

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