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Japan’s problem: Too much corporate investment

Japan has long proved that it's actually possible for business to be investing too much for the good of a country's economic and fiscal health. That's the exact opposite of the long-term trend in the United States, Europe and Canada, where low corporate investment and big-time cash hoarding prompted then Bank of Canada Governor Mark Carney's famous "dead money" rebuke of corporate Canada in 2012.

Although the pace of Japanese investment has slowed, it remains the highest in the G5 (France, Germany, Japan, Britain, and the United States). Total investment comprised 20 per cent of Japan's GDP in 2011, and 20.6 per cent in 2012. And a key goal of Prime Minister Shinzo Abe's economic revival strategy, known as Abenomics, is to spur more capital spending.

But that would not solve what ails the country.

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"Japan invests too much," economist Andrew Smithers says flatly in his latest report to clients of his London-based firm, Smithers & Co., which advises investors on international asset allocation. "The result of high investment and low growth is that the efficiency of new capital investment has been very poor."

Indeed, using a measure that links investment to the growth rate, Mr. Smithers observes that Japan's return on new investment has been two to four times less efficient than in other major developed countries.

The inefficient use of capital has serious implications for everyone from investors and pensioners to workers and officials charged with narrowing Japan's gaping fiscal deficit.

Too much capital, poorly deployed, translates into lower output, weaker corporate profit growth and a smaller chunk of national income available for labour. That, in turn, puts downward pressure on wages. And the tendency of Japanese companies to reinvest profits means lower returns to investors, including less money for dividends. Both of these factors hit domestic consumption.

Mr. Smithers reckons that net corporate cash flow will come down substantially in the next few years if the Abe government sticks to its vow to rein in the ballooning fiscal deficit, using tools such as a sharply higher consumption tax. This would result in a significant drop in profits before depreciation.

"Unless the improvement in the fiscal deficit is accompanied by a large fall in the charge for depreciation, the consequent decline in profits at the pre- and post-tax levels will cause the economy to move into deep recession," he warns. If Japanese companies fail to curb their insatiable desire for investment, and the consumption tax takes its toll, profits will be badly hit.

Mr. Smithers suggests that one way to avoid this Abenomics-killing outcome would be a slow narrowing of the deficit matched by declining business investment and a return to a positive trade balance.

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In any case, given the fact that Japan's economy is unlikely to expand much faster than 1 per cent annually – even in Abenomics revival mode – there remains only one way to improve capital efficiency. Simply put, "the level of business investment in Japan will need to fall substantially from its current level."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More


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