Investors should note that Japan is dismantling some old defences

After a strong run for Japanese equities, which were flying high before the coronavirus outbreak, sentiment from foreign investors has soured. Some fear another false dawn for the country’s capital markets, which have often promised to make strides only for investors to be left disappointed.

Japanese stocks are down 6 per cent this year while Wall Street has already erased its losses for 2020, for example.

However, there are good reasons to think that change is around the corner. At last, improving corporate governance standards are starting to have an impact. It is encouraging to see a rise in the appointment of external directors, accompanied by a drop in anti-takeover measures.

But perhaps most important is that authorities have begun to tackle the problems arising from cross-shareholdings, where Japanese companies and banks hold large equity stakes in each other, as a way of cementing business ties.

These dense webs of equity ownership have often been a source of frustration among investors — and not just because they introduce needless volatility into companies’ financial statements. The tendency for cross-holders to vote steadfastly with management means the practice has been linked to propping up underperforming executive teams.

Cross-shareholdings continue to play a pivotal role in many investors’ decisions, as they can be an obvious sign of poor governance and thus an excuse to sell a position. But any assessment taken solely on this premise would be heavily influenced by Japan’s past.

After several halfhearted attempts by previous administrations, the government of Shinzo Abe, the prime minister, has pushed hard for lasting reform, most notably by enhancing requirements around disclosures of cross-holdings and their business rationale. But legislation is only one component for change; there must also be a willingness from businesses to act.

Cross-shareholdings as a percentage of total market capitalisation within Tokyo’s Topix share index fell to 10.1 per cent in 2018, having been as high as 34 per cent in the 1990s, according to the Nomura Institute of Capital Markets Research. Since then, this figure has dropped even further, below 10 per cent.

The decline shows the direction of travel is clear. But it may accelerate in coming years. Notably, from 2023, Japanese banks will have to adopt new standards on capital adequacy, which should encourage them to liquidate their huge equity portfolios. Those that fail to do so risk higher capital charges.

Companies that do not tackle these corporate governance issues now run the risk of being left behind, particularly as many of their rivals are making this transition and, as a result, will most likely attract increased interest from foreign investors.

Of course, despite the huge shift taking place, problems remain. Notably, the liquidation of cross-shareholdings with non-listed companies presents a practical challenge. Regulators must step in to help overcome this — an outcome we see as likely, given the strong overlap of views with the Japanese government on this matter.

We have also seen the rise of what we can describe as “neo” cross-shareholdings, whereby companies hold shares in other groups purely for investment objectives. Here, it is critical that companies clearly explain how such holdings differ from legacy cross-holdings, which date back to alliances formed after the second world war to solidify relationships. Failure to do so will again lead to these companies being shunned or discounted by foreign investors.

There will be a reasonable percentage of groups that will not meet these changes in governance standards. But these companies will be outliers and, as mentioned, their stock price performances will probably lag as they are rebuffed in favour of rivals that adapt to the new normal.

Now that Japanese companies are less wedded to such traditional practices, the overall cross-shareholdings figures will no longer be the best proxy for the quality of Japan’s corporate governance standards — especially given the differing meanings between the more recent “neo” cross-holdings and longer standing legacy ones.

Japan is known to be slow at making decisions, as reflected by the lack of progress on corporate governance made in the decade after the market crash of the late 1980s. However, it is also true that once clear rules are in place, Japanese companies tend to swiftly follow them.

The framework has now been set and Japanese companies are falling into line. Such improvements in governance point to Japan’s potential to make up significant ground on US and European rivals over the next five years.

The writer is Japan equity fund manager at Russell Investments