U.S.-Japanese corporate finance.
For at least two decades, Japanese corporate investment consistently has outpaced U.S. corporate investment. One of the leading explanations of this phenomenon--and a favorite among U.S. corporate managers--is that the cost of capital is lower in Japan than in the United States. The combination of lower real interest rates and higher stock prices makes it cheaper for Japanese firms to borrow money and issue equity, enabling them to invest more. But how do we square this explanation with the view held by many economists that capital is mobile across national borders? If capital is indeed cheaper in Japan than in the United States, why don't U.S. companies go bargain hunting for capital in Japan?
The answer may lie in differences in the structure of corporate financial markets between the two countries.
1) In 1977, the average debt-equity ratio of Japanese companies was roughly four times that of U.S. companies; it is now about the same.
2) Until fairly recently, about 90 percent of all Japanese corporate debt took the form of short-term bank loans; during the same period, only about 30 percent of U.S. corporate debt was financed by banks.
3) In a sample of financially distressed U.S. public companies, roughly one-half filed for reorganization under Chapter 11 of the Bankruptcy Code; in a comparable sample of Japanese companies, none filed for bankruptcy protection.
These stark differences in financing behavior suggest tha there is more to understanding the cost of capital differences than a simple comparison of interest rates and stock prices. I have conducted research with Takeo Hoshi, Anil K. Kashyap, and David N. Weil that may shed some light on how structural differences in the two financial markets--many of which are quickly disappearing--could explain in part why corporate investment in Japan has been higher than in the United States.
Relationship Banking in Japan
Historically, the linchpin of Japanese corporate finance has been the close relationship between a firm and its main bank. The main bank provides debt financing, owns some of the company's equity (by statute, no more than 5 percent), and may even place bank executives in top management positions. This system is similar in many respects to West Germany's, but it contrasts sharply with U.S. financing practices. Here, large companies generally have a more arm's-length relationship with the capital market; their debt and equity tend to be held diffusely. Japanese banking practices are driven more by relationships, while U.S. banking practices are driven more by price.
For many Japanese companies, the main bank relationship is part of a larger industrial structure known as the keiretsu, a group of companies centered around affiliated banks and other financial institutions. These companies also have strong product--market ties to each other that are strengthened by cross-share ownership. Historically, the links have been strongest in the six largest keiretsu--Mitsubishi, Mitsui, sumitomo, Fuyo, Dai-ichi Kangyo, and Sanwa.
This corporate financial structure can facilitate investment through at least two distinct channels. first, the main bank and keiretsu system can provide a ready source of funds to companies that otherwise would be unable to raise capital in a decentralized market. Thus, even though the system may not affect the cost of capital, it can affect the availability of capital. Second, the main bank and keiretsu system can lower the costs of financial distress. This facilitates investment in two ways: by ensuring that companies with valuable investment opportunities are able to exploit them; and by enabling companies to take on more debt, which generally is thought to be cheaper than equity. I consider each of these channels in turn.
Liquidity Constraints and Investment
In a frictionless capital market, companies with valuable investment projects should have to trouble raising the funds they need to finance these projects. but if the capital market has a hard time distinguishing good investment from bad, or if the capital market suspects that managers may squander the funds, companies may be frozen out of the market for new capital.
Information and incetive problems of this sort probably are most severe in situations in which shareholders and debtholders have small stakes: no small shareholder or bondholder has an incentive to become informed about the company and ensure that its funds are used appropriately.
The model of the uniformed, small shareholder and bondholder is probably an apt description of many large public companies in the United States. However, this model--implicit in the leading theories of corporate finance--simply is not accurate for most large Japanese companies. Because banks own both large debt and equity stakes in their client companies, they have much stronger incentives to monitor the companies than a small bondholder or shareholder does
Hoshi, Kashyap, and I tried to see whether this is the case by comparing the investment behavior of Japanese firms with close bank relationship to those with generally weaker bank ties. (1) We implemented this by comparing firms with strong keiretsu affiliation to the smaller number of independent firms that were unaffiliated with a keiretsu.
After controlling for other factors that might affect the attractiveness of investment, we found that liquidity was a more important determinant of investment for independent firms than for keioretsu films. A Y100 increase in liquidity (as measuredd by cash flow net of interest payments) led to a Y50 increase in depreciable investment for independent firms, but only a Y4 increase in investment for kereitsu firms.
One interpretation of these results is that companies with close bank relationships find it easier to raise external funds than those with more arm's-length, price-driven capital market relationships. As a result, investment by keiretsu firms tends to be unconstrained, while investment by independent firm--many fewer in number--appear to be liquidity constrained.
This finding suggests that, while there may be no difference in the cost of capital between the United States and Japan, there may be difference inthe "availability of capital" between the two countries. Because large firms in the United States generally lack the kind of close bank relationships that Japanese firms have, their investment may well be more liquidity constrained. This could explain why Japanese companies appear to invest more and U.S. companies appear to be reluctant to sink funds in long-term capital investments, as many observers argue.
The Costs of Financial Distress
Financially distressed companies often have a difficult time raising capital. This is not surprising: the factors that led them to financial trouble in the first place may make further investment unattractive. But it also may be that, if a firm has many creditors, free-rider problems reduce their incentive to grant financial relief or extend credit to distressed companies: individual creditors bear the full costs of providing capital or forgiving debt, but share the benefits with others. These problems can spill over the disrupt supplies and sales: suppliers may not be willing to extend trade credit and make long-term commitments; and customers may be wary about whether the firm will be able to meet its implicit and explicit warranties. As a result, purely financial difficulties can create cripping economic ones.
These problems are likely to be less severe for Japanese firms with strong main bank relationships. Because the debt and equity of individual Japanese firms are held in large amounts by just a few financial institutions, it is hard to believe that free-rider problems are important. And for keiretsu firms there is an additional benefit. Because suppliers and customers of keiretsu firms typically own equity in the distressed firm, and because they also have close ties to the banks that are lending to the firm, they will tend to be more willing to help in times of trouble.
Hoshi, Kashyap, and I found evidence consistent with this view? (2) Controlling for other factors that might affect investment, we found that keiretsu firms tend to invest 46 percent more after the onset of distress than their unaffiliated counterparts do. If the firm is not in a keiretsu, but nevertheless has a close main bank relationship, it also tends to invest more. A 10 percent increase in the fraction of a firm's bank debt that comees from its main bank results in an increase in investment of 2.4 percent. We found similar results for sales.
Interestingly, these workouts occured outside of the Japanese bankruptcy courts. By contrast, U.S. companies rely much more heavily on the bankruptcy courts to resolve disputes arising from financial distress. Although bankruptcy laws differ somewhat in the two countries, this difference probably is attributable to the greater reliance on bond financing in the United States. Bonds are simply more difficult to restructure than bank debt. Indeed, the U.S. Trust Indenture Act of 1939 prohibits companies from changing the principal, interest, and maturity of a bond without unanimous consent of the bondholders. This effectively forces U.S. firms to take one of two steps: either to try to buy back their bonds, which for a number of reasons is quite difficult to do, or to file for Chapter 11 reorganzation to use the court's powers to restructure the firm's liabilities. (3) The reliance on the bankruptcy courts certainly adds considerable administrative expense and may lengthen the period of financial distress.
The historically higher leverage of Japanese companies can be understood in light of this evidence. If Japanese firms have lower costs of financial distress than U.S. firms, do, they can take on more debt. This also means that they can take advantage of debt's tax-favored status, thereby lowering their cost of capital.
High Land Prices and the Cost of Capital
As is often noted, an acre of commercial land in Tokyo is worth 150 times more than an acre in New York, and the value of all the land in Japan is estimated to be worth three times all the land in the United States. In a recent paper with Kashyap and Weil, I argue that high Japanese land prices actually may have been a boon to Japanese investment. (4) When land prices increase--and they have nearly tripled in the last five years--firms that own land earn a capital gain on their land. They can use this valuable land as collateral for new loans. Firms that otherwise might have had a hard time raising new funds now have a much easier time raising capital.
We found evidence to support this view. Throughout the late 1970s and the 1980s, firms with large land holdings tended to invest more than firms with small land holdings. These effects were largest in years when land prices increased a lot. They also were more important for firms in slow-growth industries, such as steel, in which the costs of raising new funds otherwise would have been very high.
Of course, the high price of land also can discourage investment, because it raises the price of building new plant and equipment on land. But it can be an unambiguous spur to certain types of investment, such as mergers and acquisitions and investment abroad. The high price of land may explain why Japanese firms have been able to invest so aggressively in the United States and Europe.
Changes in Japanese Corporate Finance
The Japanese main break may be collapsing. Substancial deregulation of Japanese financial markets has enabled many companies to go directly to domestic and foreign bond markets to raise capital. With this shift to direct finance has come a dramatic decline in debt-equity ratios. Increasingly, Japanese companies are beginning to resemble U.S. companies with diffusely held debt and equity.
This raises an important question that Hoshi, Kashyap, and I have tried to address in a recent paper. (5) If bank financing is so efficient, why are firms moving toward direct finance and away from bank finance? We do not know the answer, but here are some possibilities:
1) Bank financing actually was efficient. Deregulation enabled firms to choose the more efficient form of direct financing.
2) Director finance is ineffect, but managers prefer it to bank finance with its intense monitoring of their activities.
3) Bank financing is more efficinet for some firms, while direct finance of others. Firms choose the type of financing that is more efficint for them.
I suspect that there is some truth to all three explanations. It seems that the firms that now rely more heavily on bond financing are the most successful cash-rich firms; those that have continued to use bank financing have tended to be sess successful. Sucessful firms may not need bank financing, either because they have proved themselves to be realiably creditworthy over many years or because they have so much and valuable collateral tht anyone would be willing to lend to the firm. For these firms, it makes sense to avoid the greater trasaction costs of intermediated finance and go directly to the capital market. On the other hand, less successful firms without much need to be monitored. For them, bank system is more efficient.
An important question arises if this interpretation is correct: Is them Bank, system sustainable if only unsuccessful firms use it? Good firms implicity may have subsidized bad ones through the main bank system. Without other options, successful firms were forced to borrow from high-priced banks. But, with financial deregulation, successful firms have had other, cheaper alternatives. Banks may no longer be willing to provide guaranteed funding or to bail out distressed firms, if they no longer can lend to successful firms. In the end, financial deregulation actually may have undermined the main bank system, driving Japanese companies away from relationship banking and toward the U.S. system of price banking. An open and important question remains: What effects will this have on the cost of capital, the availability of capital, and economic performance in Japan?
(1) T. hoshi A.K. Kashyap and D.S. Scharfstein, Corporate Structure, Liquidity, and Investment: Evidence from Japanese Industrial Groups," Quarterly of Economics forthcoming
(2) T. Hoshi, A.K. Kashyap, Scharfstein," "The Role of Banks in reducing the Coasts of financial Distress in Japan," NBER Working Paper No. 3435, September 1990, and Journal of Financial Economics, forthcoming.
(3) R. Gertner and D.S. Scharfstein, "A Theory of workouts and the Effects of reorganization Law," unpulblished, 1990.
(4) A. K. Dashyap, D. S. Scharfstein, and D. N. Weil. "The High Price of Land and the Low Cost of Capital: Thoery and Evidence from Japan," unpublished, August 1990.
(5) T. Hoshi, A. K. kashyap and D. S.Scharfstein, "Bank monitoring and investment: Evidence from the Changing Stuructur of Japanes Corporate Banking Relationship," in R. G. Hubard ed. Asymmetric Infomration. Corporate Finance and Investment chicago Press 1990.
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|Title Annotation:||Research Summary|
|Author:||Scharfstein, David S.|
|Date:||Sep 22, 1990|
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