ISSN O075-6407& BUSINESS
40th

REPORT
ANNUAL'ffe'"RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1995

KOBE
ECONOMICBUSINESS&REVIEW
40th

REPORT
ANNUALC,K,`tilliilreS'

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1995

'

Page
Financial Relationships in Japan:
An International Perspective """""'•-••••••••••••••"•••••t"'• Kenji KoJIMA

1'
Structual Adjustment and Economic Growth in Mexico:With Comparisons to Indonesia""""'•-""'•••••••••"" Robert K. McCleery

43

Reorganizing for Multi-Project Management:

Toyota's New Structure of ProductDevelopment Centers '."""'."••••.."•••...••••••.•'••••••""••• Kentaro NOBEoKA

89'

Production Subsidies, Local Content Requirements

and Foreign Direct Investment:
A Theoretical Analysis """""'•••""'•••""••••""••••"""' Roger N. Strange

129

FINANCIAL RELATIONSHIPS IN JAPAN:
AN INTERNATIONAL PERSPECTIVE

Kenji KOJIMAi

Abstract
This paper describes major characteristics of Japanese financial relationships in

an international perspective. The financial relationships in Japan are examined incomparison with those in Germany and the United States. The primary purpose of thestudy is threefold: to identify important features of Japanese financial relationships,

to provide economic rationale for those relationships, and to develop insights
concerning corporate finance and capital market under institutional and regulatory
envlronments.
Keywords: Cross-share holding; Financial relationships; Main bank
JEL CIassification: G21; G32; G33

1. Introduction
As capital and product markets have become global, the differencesin corporate behaviors across the countries have been shown distinct.

Since behaviors and performances of firms substantially depend on
institutional and regulatory environments where firms operate, peculiar
patterns of behaviors turn out to be the rational economic responses tothose environments. One of the major differences in corporate
behaviors among different countries can be financing patterns,
particularly the relationships between the capital market and nonfinancial corporations. Corporate capital structures and financing
practices in Japan appear distinctive, particularly in comparison withthose in the United States. Specifically, it is commonly observed that

financial institutions in Japan tend to have much closer, longer* Financial supports frorn Foundation of Sanyo Broadcasting, Japan Securities
Scholarship Foundation, Ministry of Education in Japan, Murata Foundation, andZengin Foundation for Studies on Economics and Finance are gratefully
acknowledged. This research started when the author was a visiting scholar at
Department of Economics, Harvard University in 1993.

2

KENJI KOJIMA

relationships with their clients than do their counterparts in the UnitedStates. In large part, these differences are due to differing institutionaland regulatory environments.
To the extent that the institutional and regulatory constraints varysystematically across countries, so may financial relationship. Whilelegal and historical considerations help to explain why financial
relationships in each country have followed distinctive trajectories, weneed to expJain the djfference of patterns across the countries as wellas the similarity within each country and their sustainability with

providing economic rationales under specific institutional andregulatory environments. The key to answer these questions iscomprehensive understanding of the financial relationships with acomparative study, identifying the underlying structure of constraints.

This paper presents major characteristics of Japanese financial
relationships in an international perspective. It examines the financial

relationships in Japan compared with those in Germany and the UnitedStates. The primary purpose of the study is threefold: to identify
important features of financial relationships in Japan, to provide
economic rationale for those relationships, and to develop insights
concerning corporate finance and capital market under institutionaland regulatory environments.
This paper is organized as follows. The next section presents the
major characteristics of financial relationships in Japanese firms
comparing with the counterparts in Germany and the United States.
Section 3 describes one of the most distinctive features of Japanesefinancial relationships, that is main bank relationships, and discusses
economic rationale. Some aspects of Japanese corporate finance havechanged dramaticaliy over the last decade. Most of these changes are
the result of changes in the structure of Japanese fjnancial markets,
which in turn can be traced to regulatory changes. Section 4 discusses
recent structural changes in corporate financial policies, and capitaland credit markets in Japan. Finally, section 5 presents concluding
remarks.
2 Close Financiel Relationships
Non-financial firms have relationships to financial institutions ineach country. In Germany and Japan, these relationships are especiallyFINANCIAL RELATIONSHIPS IN JAPAN: 3

AN INTERNATIONAL PERSPECTIVE

close and long-term, and it has important implications: banks are more

likely to provide support when firms are in financial trouble, sincehelping their borrowing firms remain viable reduces the riskiness of
their loans; banks support their borrowers' long-term growth to ensure
their own; banks usually have sufficient influence to ensure thatmanagement's decisions are cornpatible with their own goals. Together
with the small portion of equity in corporate capital structures, theseclose relationships can diminish the importance of shareholder wealthmaximization as a prime goal of corporation.
U.S. corporations borrow from a broader array of sources thantheir Japanese and German counterparts, which rely more heavily onbanks for external capital. Their bank financing also differs, since inGermany lenders supply more 16ng-term financing. With an active
equities market, a vigorous commercial paper market, a strong banking
system, and a variety of long-term investors, the U.S. capital market
has no equivalent ones in other countries. Yet the widespread use of
conventional rules of thumb to determine capital structure polices andthe prevalent reluctance to issue cornmon stock for internal financing

purposes negate this advantage. By setting specific debt-equity
corporate goals and by refusing to issue equity for fear of diluting
earning per share, U.S. firms arbitrarily Iimits its available capital.
Consequently, the capital potentially available becomes irrelevant andunused asset. While U.S. firms draw almost 200/o of their external funds

from banks, their relations are not close. The natural conflict between

managers, who are supposed to represent shareholders with residual
claims in the firms, and the lenders, who have preferential claims on its

assets, never entirely resolves. Moreover, the need to negotiate terms

and restrictive covenants, which constrain management's latitude,underscore this adverse edge. U.S. Iegislation also prohibits commercialbank ownership of non-financial corporations, so U.S. banks act only
as intermediaries on behalf of other investors.

Banks enjoy a special position in German industry. The historicallyunderdeveloped capital market and burdensome corporate tax policy
have inclined to firms to finance with bank debt rather than equity.
German banks also own a significant fraction of equity in non-financial
firms, although the exact percentage of bank-owned shares is notknown. In addition to direct share ownership, banks serve as
depositories for stock owned by other shareholders. At the end of 1988,

KENJI KOJIMA

4

they held approximately 40% of the total market value of outstanding
domestic shares. Banks also enjoy Vollrnachtstimmrecht, or the right tovote shares held on deposit on behalf of the depositors. Effectively,bank control virtually half of German shares. German law has been

amended to require that banks solicit voting instructions fromshareholders whom they represent and renew the right of proxy forshares held on deposit every 15 months. In the event of a takeoveroffer, banks must inform shareholders of pending bids only if the offer
is published. Still, banks continue to obtain wide latitude in the votingof shares held on deposit. Big commercial banks and central savingsbanks, or Landesbanhen in Germany, practice universal banking, which
includes direct investment in equities and bonds. As a result, Germanbankers held directorships on the supervisory boards of the firms.

German commercial banks, facilitated by law and tax policy, own
sizable portions of many large industrial firms. Ownership gives it thepower to block any change in the firm's statues. This has resulted in aconcentration of ownership among major banks. The larger banks also
reinforce their influence through the proxies they hold.

Ties between banks and non-financial firms are also strong inJapan. Banks still play a central role in financing industries throughlarge group of industrial firms. Bankers often serve on manufacturingfirms' boards and, particularly in periods of financial distress, becomeheavily involved in managernent. Japanese firms make extensive use ofleverage and intercorporate holdings of debt and equity. Banks'
personnel move frequently between banks and firms as part of an
ongoing relationship that involve training, consulting, and monitoring.

While current law requires Japanese banks to reduce their equity
positions to 5% of outstanding equity of the firm, they still own about

21% of the outstanding shares of Japanese firms in the period of 1985
through 1992 as shown in Table 1. In contrast, individual shareholders
own only 230/o of common stocks and they exercise little influence overmanagement.`
There are the six largest industrial groups, or leeiretsu whjch have
1 In the U.S., the Bank Holding Company Act underscores it by requiring a bankpassivity in wielding stock. The law prohibits not just control of a firm, but
control of any voting stock. It deters taking proxies, voting trusts, and owning

through nonbank subsidiaries. The Bank Holding Company Act would deter the
U.S. banks with either Japanese main bank ownership or German proxy votes

even if the Act allowed day-to-day influence (Roe 1993). .

FINANCIAL RELATIONSHIPS IN JAPAN:
AN INTERNATIONAL PERSPECTIVE
Table 1
Share Ownership of All Listed Firms by Type of lnvestors in Japan

Five-Year Average(Percentage of Listed Shares)

1970-74 1975-79 1980-M 19es-89 1990-92

Government O.2 O.2 O.2 O.8 O.6
Financial lnstitutions 34.4 37.6 39.0 44.4 44.8

Banks n.a. n.a. 17.7 21.0 '21.8

Investment Trusts 1.4 1.8 1.2 2.5 3.3
Annuity Trusts n.a. n.a. O.4 O.9 1.0Life lnsurance 11.2 12.0 12.6 13.2 13.1
Other lnsurance 4.6 4.8 4.9 4.3 4.0
Other lnstitutions 1.8 1.9 2.2 2.4 1.6
Business Corporations 25.6 26.3 26.0 24.6 24.7

Securities Companies 1.4 1.6 1.8 2.3 1.5
Individual & Others 35.2 31 .9 27.7 23 .5 23 .4

Foreigners 3.2 2.4 5.2 4.4 5.0
Source: Zenkoku Shoken Torihikisho Kyogikai (The National Conference of Stock
Exchanges), Kabushihi Bunpu Jyohyochosa (Survey on Stock Distribution), 19ee, 19es,
1992.

Tabte 2
Cross-shareholdings of Major Keiretsu in Japan(Percentage)

1970 1975 1981 19es 1989 1992

Mitsui 21.32 21.17 23.13 21.61 19.46 19.29
Mitsubishi 26.78 30.26 36.93 36.94 35.45 sa.21
Sumitomo 28.94 29.58 36.57 29.68 27.46 27,95

Fuyo 16.04 18.28 18.80 17.36 16.39 16.88
Sanwa 12.50 20.30 19.95 18.03 16.45 16.68
Dai-ichi Kangin 24.51 23.77 17.50 16.78 14.60 14.24
Note; Ratio stands average ratio of the group, which is numbers of shares owned by
fir.ms in the group divided by total outstanding shares.

Source: Fair Trade Commission, Kigyo-syudan no Jittai ni tuite. (A Survey on
Corporate Groups), 1992, 1994'.

5

6 KENJI KOJIMA
their origins in the 1950s: Mitsubishi, Mitsui, Sumitomo, Fuyo, Dai-ich

Kangyo, and Sanwa. Almost half of the 200 largest firms in Japan are
members of one of these groups. Firms in the group are rnore likely to
trade with their members than non-members. These trade relationships
are reinforced by stable cross-shareholding in the group shown in
Table 2. The distinctive feature of the group is the relationships
between its manufacturing firms and financial institutions. Group firms
do a substantial fractjon of their borrowing from financial institutionsin their own group. One of these institutions is usually considered themain bank in the group, which takes a more active role in arranging

financing for the firm, even though the firm borrows from otherinstitutions outside the group. Using a loose definitjon of groupaffiliation, Sheard (1985) estimates that group firms borrow 21906o of

their borrowing from their group's financial institutions in 1980. In
addition, group financial institutions typically own equity in the firms
to which they lend. He calculates that for 72% of Japanese fjrms thelargest lender was one of the firm's top five shareholders.
Furthermore, the placement of bank personnel in top management
positions of group firms reinforces the bank's power as shareholders
and creditors.

In both Germany and Japan, these close relationships between thefinancial institutions and non-financial firms foster a longer term
perspective reducing the pressures from the capital market for shortterm stock performance that U.S. managers experience. The executivesof German and Japanese banks who oversee investments in
manufacturers manage institutions, not portfolios. Unlike fundmanagers who make the equity market in the U.S., they are committed
to their institutions's growth and not to the short-term performance of
their investment portfoljos. In sharp contrast to the high turnover rates

that fund managers in the U.S. generate, financial institutions inGermany and Japan rarely sell their equity holding. Since banks'
capita} investments are predominantly loans, they can serve theireconomic interests by expanding their business with the firms in whjchthey invest than by pressing for short-term stock price gains. For.
them, the greater a firm's growth, the greater the loan demand, andthe more competitive the firm, the higher the quality of the loans. The
high degree of leverage that banks in those countries accept decreases
the cost of capital and reduces the level of return manufacturers need

FINANCIAL RELATIONSHIPS IN JAPAN: 7

AN INTERNATIONAL PERSPECTIVE

to seek on their investments. As a consequence of these factors,
managers in German and Japanese firms do not focus as intensely onshareholder returns as their U.S. cotinterparts do, and they are willingto compromise shareholders interests for. growth that serve a broader
stakeholder.
Financial institutions may hold equity and debt at the same time.
Besides strengthening the long-term relationship between the financial
institutions and the firm, the simultaneous holding of debt and equity

clearly reduces the scope for conflict between stockholders anddebtholders over the choice of policies, particularly in situations offinancial distress. Therefore, it facilitates more leverage. In Germany
and Japan, banks own a significant proportion of client firm's equity.
In Germany banks directly own substantial proportion of non-financial
firm's equity. Moreover, over majority of total shares are held in theircustody and they may exercise proxies at the shareholders' meetingwith the consent of real stockholders. On the other hand, the U.S.
banks are prohibited from owning equity and are almost impossible to
make any coordinating effort to reconcile conflict between stockholders
and debtholders.
Financial institutions in Germany and Japan, banks in particular,
are more efficient providers of capital, and their equity ownership inclient firms represents far more than a mere portfolio investment.

Through their activities as main banks or Hausbanh, they playessential roles in the governance of nonfinancial corporations in theirrespective countries. Their close and long-term relationships with aborrower afford them greater access to privileged information andestablish them in the eyes of other lenders as delegated monitors of
their major industrial clients. They effectively function as centers of

information gathering about client firms, and their responses tovirtually any aspects of their client firms' activities represent importantsignals to other corporate stakeholder. As significant equity owners,
they enjoy direct or indirect board representation through which they
may exercise •an active voice in the governing of the corporations inwhich they invest.
More than just voice, however, they also have the capability andwillingness to suspend managerial autonomy and exert more
substantial control over client firms experiencing a financial distress orundertaking a difficult transition in management. In effect, selectively

KENJI KOJIMA

8intervening in the management of their preferred borrowers, equity-owning Japanese main banks and German hausbank help internalize
the process of reorganizing assets, financial claims, and top
management itself, thereby reducing the use of legal bankruptcy or
externally forced changes in ownership in the market for corporate
control so frequently relied upon in the U.S. In this respect, German
and Japanese banks have an indirect but critically important role in thepreservation of va)uable and long-term re)atjonships among industrial
corporations. By shielding sound corporate investment programs fromshort-term business fluctuations; by judiciously sheltering managementfrom pressures to breach commitments to one or another stakeholder
in order to improve short-term performance; yet by also acting swiftly

enough to reverse performance declines before corrections become
extremely costly if not irnpossible, major equity-owning banks inGermany and Japan help ensure the independence and longevity ofnonfinancial firms. To the extent this is achieved across a network offirms engaged in trading relationships and relying upon a common

main bank or Hausbank, the integrity of long- term business
relationship is maintained (Kester 1992).

Commensurate with their status as lead lenders and major
shareholders, main banks enjoy preferred status in the provision of awide range of financial services to client firms, and in the yields

received on their loans in Japan. Japanese main banks have been
involved deeply in the affairs of their client firms, requiring detailed

disclosures of management and investment plans on a frequent basis. It

was common for bank executives to require modification of these plans
as a condition for the continued provision of capital. Although thesecuritization of Japanese corporate finance in the 1980s has
considerably weakened main bank influence over large and highly liquidfirms, they remain important suppliers of capital to smal}er affiliatesof these larger clients.

Main banks also have been and remain important providers ofauditors and directors to many Japanese nonfinancial firms. Whereas
virtually all U.S. firms have at'least one outside director, mostJapanese boards of directors are entirely inside boards with virtually

all members being salaried executives of the firm. One or moremembers of board in Japanese firms frequently are former executivesof the firm's main bank. These appointments arise from the common

FINANCIAL RELATIONSHIPS IN JAPAN: 9

AN INTERNATIONAL PERSPECTIVE

practice among major Japanese firms, commercial banks in particular,
retiring those senior managers not being nominated to their own firms
boards of directors and placing them as directors or senior managers
of client firms. Japanese main banks will often take a leadership rolein corporate restructuring, dispute resolution, or simply the promotionof new business for client firms.

As in Japan, German firms tend to have strong relationships with
one or a few banks, called hausbank. A hausbank would be a primarylender to a firm and would often enjoy representation on the
supervisory board or an equity position in the firm. Supervisory board

members from such banks are valued for their knowledge of businessand economic conditions, as well as for their detailed knowledge of the

firm. In time of financial crisis, the hausbank would tend to be more
willing to aid the firm than would other banks. As in Japan, shares
owned by house banks are seldom traded. As early as the late 1960s,
German banks began to transform themselves in anticipation of reformin German financial market. The hausbank system has already given
way to what is called network system of financing. In the traditional
hausbank system, a firm is completely dependent on a single bank for
all of its financing needs. In the network system, by contrast, several
banks join together informally to finance entire networks of firrns.
Representatives of the banks in the network sit on the supervisoryboards of a particular firm. And often managers from one firm in the
network sit on the board of another firm also financed by the same ofbanks. In a sense, these networks are the German equivalent of theJapanese keiretsu. Their fundamental advantage is to give firms in the
network more options for financing and much greater flexibility andsecurity in planning their long-term investment needs (Baum 1992).

3 Main Bank Relationships
3.1 MQnitoring

Main banks in Japan have historically been the most likely tointervene because of their position as the largest supplier of capital to

the group of industrial firms. In addition to having an equity
investment, they have considerable amount of debt at stake. Nominally,
this debt is in the form of senior collateralized short-term loans and90-to 120 days promissory notes, which are usually routinely rolled

10

KENJI KOJIMA

over indefinitely. However, in the event of impending financial distress,

the character of main bank's loans changed dramatically. This isbecause most main banks voluntarily subordinate their debt to that ofother banks lending to the main bank's troubled clients. Whereas fearof such equitable subordination keeps most the U.S. Ienders on thesideline until a loan agreement is formally breached, and even thenrestraints the degree of jntervention, the Japanese main bankeffectively assumes such subordination from the outset and takes farreaching, early steps to limit the damage.
The main bank acts as an alert monitor of performance and begins
to act like a private, controlling shareholder well in advance of the time

when problem become acute. One effect of this intensive monitoringwith early selective intervention is to reduce some of the costs normallyassociated with the hazards of lending. Opportunities to borrow money
and then take extraordinary risks that might benefit shareholders at
the expense of creditors are reduced when banks own some equity andare able to intervene early when problems are spotted. The costs
normally associated with financial distress are reduced to the extent
that problems are identified and correeted early (Kester 1991).

Diamond (1984), among others, argues that banks serve as
corporate monitors who bear the cost of becoming informed about
their client firms and who ensure that they make efficient businessdecisions. Djamond shows that delegating the role of monitoring to abank minimizes monitoring costs. The alternative - issuing securities

like public debt and equity - may be inefficient either becausemonitoring costs are needlessly duplicated among individual security
holders or because monitoring is a public good that no one has anincentive to provide. He shows that bank diversification plays a keyrole in ensuring that banks monitor their client firms.

As Myers and Majluf (1984) point out, liquidity is an important
determinant of jnvestment when there are informational problems in
the capital market. If managers are better informed than investors
about a firm's prospects, the firm's risky securities will sometimes be

underpriced, thereby raising the cost of external finance. Managers
find it more attractive to finance investment with internal funds. Thus,

for firrns facing information problems, Iiquidity will be an important

determinant of investment. Bank monitoring is one way of overcoming
these information problems. If bank lend a large fraction of a firm's

FINANCIAL RELATIONSHIPS IN JAPAN: 11

AN INTERNATIONAL PERSPECTIVE

debt as well as own a portion of its equity, then they have strong
incentives to become informed about the firm and its investment
opportunities. It is also in their interest to ensure that managers makeefficient business decisions. In this case, there should be little
relationship between investment and liquidity for bank-monitored firms.
If firms need funds to finance investment, they can go directly to theirinformed bank to raise the money. The bank should be willing toprovide the capital provided the project is valuable. The close
relationship with the bank is likely to mitigate information problems
that typically arise when debt and equity are diffusely held and no
individual investor has an incentive to monitor the firm. Since theindependent firms have weaker ties with banks, they are likely to face
greater difficulty raising capital. Thus, it is relatively easy to
distinguish between firms that are likely to face information problems
and those that are not.
Sheard (1989) provides an economic rationale for this main banksystem focusing on the role of the main bank as an agent thatspecializes in the collection, evaluation, and transmission of information

about firrns and their managements, and that provides a mechanism
which substitutes for the inactive market for corporate control inJapan. The significance of the main bank system is the close
information-sharing relationship that exists between the bank and thefirm. It is possible to view the rnain bank system as functioning as a
substitute for the kind of screening and monitoring institutions that areprevalent in other capital markets such as bond and credit-rating
institutions and security analysis agencies. The close association thatthe main bank has with the firm means that the bank is able to obtaininside access to the firm and its management which is not readily
available to the external capital market.

The main bank system seems to exemplify in a concrete way someother important aspects of monitoring: delegated monitoring. The
main bank system can be characterized in terms of banks themselvesdelegating the monitoring of a particular firm to one particular bank:the main bank. The bank delegated to be monitoring is not only thebank with the largest loan share but also holds a significant stake inthe firm as a shareholder. Having a sufficient large loan share may be

the way in which the bank ensures that it obtains an adequate returnon its monitoring outlays. In this regard, it is worth noting the free-12

KENJI KOJIMA

rider problem may be mitigated somewhat by virtue of the fact that
non-monitoring banks will not be able to imitate the loan portfolio of
the main bank in size.

There are well-known free-rider arguments in Leland and Pyle
(1977) and Stiglitz (1985). If knowledge about the firm and its
management is a public good, it may be that no agent will undertakethe necessary monitoring since other agents will free ride on the
results. The solution to this problem is to have the monitoring agent
buy and hold assets on the basis of its specialized information, under

the assumption that outsiders cannot free ride on the agent's
information merely by observing its portfolio choices. Hoshi, Kashyap,
and Schafstein (1991) cornpares the investment behavior of these two
sets of firms, which are in a particular industrial group with the bankand independent ones. The basis of comparison is the importance ofliquidity as a determinant of corporate investment. They find thatfirms in the group is less sen'sitive to their liquidity than it is forindependent firms. It shows that liquidity is a more important
determinant of investment for independent firms than for ones in thegroup with close banking ties. This suggests that close relationships
with the bank relax liquidity constraints by lessening information andincentive problems in the capital market. This results can help to
explain the findings for at least two reasons. First, because groupaffiliated firms can take on more debt, they are better able to exploit
its tax advantages. This Iowers their cost of'capital. Second, groupfirms that need to raise capital can do so by issuing debt. They thenavoid equity issues which tend to depress share prices. Thus, reducing
the cost of financial distress facilitates investment and relaxes liquidity

constraints even when firms are not distressed.
32 Intervention

Another major eharacteristics of main bank system that is closely
related to the monitoring is the role of the main bank in corporate
intervention. Main bank intervention refers to the fact that the bankwill often intervene in various waYs in the management of the firm
when it is not performing adequately or is in need of restructuring. It

can be argued that this function of the main bank provides animportant substitute mechanism for what in effect is inactive market
for corporate control in Japan. Majn bank intervention can take a

FINANCIAL RELATIONSHIPS IN JAPAN: 13

AN INTERNATIONAL PERSPECTIVE

number of forms, ranging on the one hand from cases where the mainbank stipulates certain measures that requires the firm to take inexchange for the bank's support during a period of financial difficulty

to cases where the bank sends offieers to take over the management
and carry out the reorganization of a firm that is on the verge ofbankruptcy on the other. In the course of intervening in and managing
the reorganization of the firm, a number of things are commonly
observed. First, the bank may replace the top management, whose
incompetence it is that has often expedite the trouble. The bank willreorganize the management structures and implement major asset
liquidation. Second, the bank will often arrange some kind of tie-up or
merger with another firm, which is commonly a firm also having thisbank as its main bank.
One of unique characteristics in Japanese capital market is thevirtual absence of an active market for corporate control. The absenceof a hostile takeover market is re}ated closely to the nature ofintercorporate shareholding in Japan. The management of large firms
in Japan have been able to entrench themselves from external market
for control by arranging their shareholding structures so that amajority of their shares are held by closely and long-term related
firms. There are knewn as stable shareholders in Japan and comprise
principally long- term business partners and affiliate firms, all of whichshare the common aim of insulating themselves from the externalmarket for corporate control. Together with the system of stableintercorporate shareholdings, the main bank performs a role thatclosely parallels in its effect the external takeover market: in particularin bringing about the displacement of ineffective management and there-organization of corporate assets to improve efficiency.

In a sample of large Japanese manufacturing firms in the 1980's,

Morck and Nakamura (1992) find that banks tend to send new
directors to firms that have recently under-performed their industry
firms in terms of stock market performance or that are in industries
with depressed stock prices. Intervention is preceded by below averagesales growth, investment and especially liquidity and cash flow as well
as by low stock returns. It is thus not clear that bank intervention is
aimed prirnarily at protecting shareholders. Cash flow and liquidity
return to industry average levels quickly following bank intervention, as

does investment. Sales growth and especially employment growth

14

KENJI KOJIMA

remain low for several years, but eventually recover to and even exceedindustry average levels. This suggests that bank intervention isassociated with a period of downsizing. Public shareholders appear togain lit•tle from this, however, as stock market performance continues
to lag that of industry peers.

Kaplan and Minton (1994) attempts to shed }ights on the nature ofcorporate intervention by considering when banks and shareholders
intervene or become active in 119 large, non-financial Japanese publicfirrns. They consider an outside intervention to have occurred if a firm

appoints one or more outsiders to its board in a given period. The
likelihood of a new bank director is most closely associated withnegative pre-tax income at both one- and two-years. The results
suggest that bank appointments respond to poor firm performance anddo so over relatively short frequencies. The patterns suggest a
difference between bank interventions and corporate interventions.
Banks appear to intervene in firms with poor stock performance anddifficulty meeting their financial obligations to the banks. In contrast,

other corporation appear to intervene in firms with poor stock
performance that is not related to an inability to meet financial
obligations. Outside appointments are most closely related to stock
performance.

The pattern provide additional support for the view that bankdjrectors are appojnted in firms and situations where there is a bankloan to protect. In contrast, the appointment of bank directors is not
related to the strength of shareholdings and other relationships. Thissuggests that banks place less importance in maintaining thoserelationships. Although stock performance remains significant in thedeterminants of appointments of corporate directors, share ownershipand keiretsu membership are strongly related. These patterns provide
additional support for the view that the two types of appointment,
although related to performance, serve different purposes and protect
different interests. The results suggest that corporate appointments aremeant to protect or support intercorporate shareholdings andrelationships. Such appointments do not appear to be intended toprotect the main bank. Banks, corporate shareholders, and related
corporations respond to poor performance by sending directors tooversee or implement responses to that poor performance. The powerof a main bank to appoint directors comes from its combined role asFINANCIAL RELATIONSHIPS IN JAPAN:
AN INTERNATIONAL PERSPECTIVE
lender, shareholder, and settler of intercorporate payment accounts.
The power of corporate shareholders to appoint directors stems fromtheir share ownership and concomitant ability to withhold proxies on
the share they own. Under this interpretation, Kaplan and Minton(1994) argue that the bank and intercorporate relationships in Japan
play a similar role to outside directors and, particularly, the market

for corporate control in the U.S.. There is, however, anotherinterpretation. The injection of an outsider in response to poor
performance may be required to signal to suppliers, customers orothers that the bank or the group will support the continuation of thebusiness. According to this view, the main bank recoups any costs ofsuch insurance in normal times by charging above market fees forservices. Similarly, corporate managers are willing to agree to such an

insurance scheme in order to maintain their positions. The second

interpretation suggests that the primary role for the outside
appointment is as insurance rather than as discipline or monitoring.

The insurance and monitoring interpretations have different
implications for incumbent management. If the relationships serve toinsure managers, then the appointment of an outsider should not affectexecutive turnover. Alternatively, if the relationships replace the control

mechanisms familiar to the U.S., then outside interventions should becostly for incumbent management.
The results can be interpreted as strong evidence that both types ofoutsider appointments are disciplinary - top executive turnover,particular that of representative directors, increase substantially in thesame period. The fact that the outsiders tend to be appointed to thedirector level suggests that outside appointments oversee that transfer
of control from one internal management team to another. Outside
interventions have a disciplinary effect on top executives. Overall, theseresults suggests that bank directors are appointed to firms that are in
financial distress or in the process of contracting. After the bankdirectors arrive, these firms continue to contract, but theirperformance - as measured by stock returns and earnings - does notdeteriorate. Other corporations appear to send directors in response todifferent problems. After the corporate directors arrive, the firrn sales

and asset growth rebound, and their performance - as measured bystock returns and earnings - do not deteriorate, and, if anything,lmprove.

15

16

KENJI KOJIMAAs a consequence, the results suggest that the relationship-based

corporate governance in Japanese firms substitutes for the moremarket-based in the U.S. Appointments of outsiders increasesignificantly with poor stock performance; those of bank outsiders also

increase with negative current income. Strong evidence is found thatboth types of outsider appointment are disciplinary - top executive
turnover increase substantially in the same year. The results suggeststhat bank directors are sent to manage contraction or financial
distress, while corporate directors are sent to manage reverse
temporary problems. Current earnings and, particularly, current stock
returns are important determinants of outside appointments. It can beconcluded that a firm's current stock price plays an important role asa good measure of a firm's current and future prospects in Japanese
firms
3.3 Reducing Cost of Financial Distress

Financial distress is costly because free-rider problems andinformation asymmetries make it difficult for firm to renegotiate
problems with their creditors in times of distress. As Gertner andScharfstein (1990) point out that free-rider problems reduce the
incentive for creditors to grant financial relief of extend credit: an
individual creditor bears the full costs, but shares the benefits. When
there are many creditors it is difficult to negotiate with all of themsimultaneously. Holdout creditors can then free-ride on others.
Difficulties in negotiating with creditors may lead to underinvestment
and inefficient liquidation. Even if the firm has valuable investment
opportunities, an individual creditor may be reluctant to finance thembecause part of the greater future cash flows accrue to the holdout
creditors. Similarly, even if it is efficient for creditors collectively towrite down the debt, a sole creditor may be unwilling to do so because
he bears all the cost and receives only part of the benefit. Moreover,when credit is diffusely held, bondholders are not likely to be welljnformed about the firm and may not know whether it is profitable toprovide new capital or to give interest and principal concessions. In thiscase it is difficult to raise capital from one creditor, let alone getnumerous creditors to agree to a financial restructuring that promotes
investment and avoids inefficient liquidation. These problems can also
spill over and disrupt supplies and sales: supplier may not be willing toFINANCIAL RELATIONSHIPS IN JAPAN: 17

AN INTERNATIONAL PERSPECTIVE

provide 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.

Such problems are probably less severe for firms with strong
relationships to banks. Because substantial debt and equity stakes areheld by just a few financial institutions, free- rider problems are lessprevalent. In addition, since the main bank is well informed about thefirm and its prospects, problems stemming from asymmetric
information between creditors and firms are likely to be small. A more
subtle reason that free-rider problems may be less severe stems fromthe repeated participation of banks in lending consortiums. For
example, one main bank rnay be the main bank for a firm in the group,
but the firm will typically borrow from banks outside the group as
well. This bank will in turn participate in lending consortiums headed
by other banks that serve as the main !enders to firms outside thegroup. It is clear to all members of the consortium that the main bankis responsible for helping the firm in times of distress. Repeatedparticipation in these consortiums ensures that main bank fulfills its
implicit contract to provide relief even though doing so may not seembest in the short run. Furthermore, the customers and suppliers in theindustrial group in which they own equity are more likely to maintaintheir trade relationships. The firm's main bank may also be the mainbank for the suppliers and customers. This financial network could
make suppliers more willing to extend trade credit and invest in longterm supply relationships, and customers more willing to buy from thefirm.

Hoshi, Kashyap, and Scharfstein (1990a) show that firms withcapital structures in which free-rider and asymmetric information
problems are likely to be small perform better than other firms after
the onset of distress. In particular, they show that Japanese firms inkeiretsu invest and sell more after the onset of distress than nongroup-affiliated firms. Moreover, firms that are not in the group, butnevertheless have close relationship with a main bank, also invest andsell more than firms without close bank relationship. When member ofthe group help troubled firms they do not only infuse funds, but also
try actively to restructure the firm. If a firm is financially distressed,

it performs better than other financially distressed firms if its capital

structure makes it relatively easy to renegotiate its liabilities. The

KENJI KOJIMA

18

findings suggest that, when financial claims are spread among many
creditors, financial distress is more costly than when they areconcentrated.

In the United States, debt is more diffusely held, with large firms

relying more heavily on bond financing. Hoshi, Kashyap, andScharfstein (1990a) argues that this form of financing exacerbates
problems stemming from financial distress and suggests it may havebeen wise for U.S. firms to refrajn from high debt levels. Japanesefirms have taken on a larger amount of risky debt, but haveestablished and institutional structure to cope with high leverage.
Gilson, John and Lang (1990) find that financially distressed firms in
the U.S. that rely heavily on bank debt are more likely to avoid costly
bankruptcy filing and thus more likely to restructure out of court2.
Sheard (1992) identifies major features of the main bank's role and its
behavior when corporate clients are financially distressed by examining

a large number of cases. The major roles of the,main bank arecoordinating, overseeing, and in some cases in effect carrying out an

informal reorganization of the firm. This typically involves somecombination of refinancing of existing debt, provision of bridging

finance, dispatching directors and in severe cases a morecomprehensive trouble-shooting team that works closely with promising
managers in the firm. It may also involve the displacing or demotion ofsenior incumbent rnanagers and the formulation and implementation ofa restructurjng plan centering on a program of asset disposal,
repayment of bank borrowing, and organizational re- arrangement.3
The main bank, by replacing incumbent managers with despatching its

personnel, turns to be an active participant in the corporate
restructuring process directing and implementing various measures.
This aspect of the main bank's roie is characterization of bankruptcy
2 The U.S. banks may abandon borrowers because they cannot cheaply save them.
Given that courts sometimes punish a bank for intervening in its debtors' affairs,

the bank may find rescues more often unprofitable. American judges have lookedskeptically at creditors who intervene in a debtors' business. They reason thatintervening creditors may try to restructure the debtor to their private interests.
Thus, its clairns are often subject to subordination. One does not see in the cases

equivalent of equitable subordination in Japan - any series of decisions where
judges voided security interests to punish a major secured creditor who intervenedin the debtor's affairs (Ramseyer 1992). '3 Large numbers of firms in Japan fail regularly. Average of 13,260 firms with debt
of over 10 million yen went bankruptcy every year during 1985-89 (Bank of Japan
1se4).

FINANCIAL RELATIONSHIPS IN JAPAN: 19

AN INTERNATIONAL PERSPECTIVE

via the debt contract triggering a shift in control from the incumbent

managers to the creditor.
One of the peculiar characteristics of the main bank system is thatthe main bank often behaves as if it were a kind of residual risk-bearer
among creditors and even among security- holders as a whole. Sheard(1989) suggests that residual risk-bearing is part of an incentive

structure which serves to economize on the agency cost of thedelegated monitoring relationship between main and non-main banks.
When bank assistance is directed towards a struggling firm or whenlosses are incurred as a result of the firm's failure, the main bankcommonly assumes a significantly larger burden than would be
expected. In cases of bankruptcy or major restructuring under mainbank intervention, the main bank will typically absorb a share of losses

exceeding its loan share. The main bank bearing a disproportionately
large share of the assistance burden to firms that are in the process ofundergoing adjustment. This may just reflect that the main bankpossesses superior information as a result of its past and current
monitoring and negligence problems with transferring information toother banks. At a more general level it might be claimed that there
must be a sense in which the main bank is given the correct incentives
not to shirk on its monitoring. The implicit convention in Japan thatthe main bank bears a disproportionately large share of any losses

incurred can be viewed as part of an incentive mechanism which
economizes on the agency costs of having one set of bank delegatemonitoring to one bank.
What are the incentives of the main bank to behave as it does?
The main bank is better informed than any other lender. If the mainbank refuses to refinance the firm, it must be because its information
tells it that it is not profitable to do so. But if it is not profitable forthe main bank, who already has prior claims that must be senior to
any new finance, then it cannot be profitable for the supplier ofincremental funds. The only time that a main bank wou]d want to cut
off finance would be when the firm is a bad prospect; inferring this, noot•her lender will extend finance. The decision on whether a client firmthat needs an injection of finance to remain afloat obtains the required

funds or not rests with the main bank. To the extent that main bankassumes special responsibilities when a client firm is in financial
distress, it must be adequately compensated for the additional costs

KENJI KOJIMA

20

involved. When the firm is normal times, the main bank enjoys special
benefits associated with its position as main bank, not available toother lenders. In particular, it is widely believed that the main bank isable to acquire a disproportionately large share of various banking-related business such as placement of corporate bank deposits,
operation of settlement accounts, involvement in bond issues as trustee

administer and co-underwriter, handling of foreign exchangetransactions, and access to banking business of related firms.'

One can argue that Japanese banks may rescue large borrowers
because they cannot credibly threaten to let them fail. Given thatJapanese courts will let a bank rescue a borrower without jeopardizing
its rights in bankruptcy, the bank may find some rescues profitable ex

post. The U.S. banks may abandon borrowers because they cannot
cheaply save them. Given that U.S. courts sometimes punish a bank forintervening in its debtors' affairs, the bank may find rescue more often
unprofitable even ex post. If the U.S. banks do threaten to let troubled
firms die, they may be able to do so because of the bankruptcy law
they face. At stake is the doctrine of equitable subordination: for the
4 Ramseyer (1991) argues that within the continuing relationships, the legal
structure also matters. Japanese banks and firms bargain over the legal
framework that will govern their deals and work hard to manipulate thatframework to their private advantage. The extensive use of mortgages andguarantees suggests that banks and customers customers consider the rules
critically important. Willing to make credible their promise to repay their loans,customers regularly acquiesce. The bank use the measures to improve theirbargaining position should their customers later default. The customer use themeasures to obtain a better deal now. The only merit to mortgages andguarantees lies in the legal protection they give the borrower. These security
interests were not required by law. Banks demand rnortgages and guarantees togain the power to negotiate a more favorable contract should the borrower
default.

Banks can also strengthen their position by keeping the terms of their loan
short. By negotiating shorter contrabtual terms, it can use the law to retain theright to refuse to renew the loan and thereby protect itself. Its principal advantage
from the shorter contractual term is its ability to reduce the default risks from its

borrower's opportunistic behavior. Average of 460/o of the funds Japanese banks
lend come due within an year for years 19as-89, compared with the fact that the
proportion of bank loan with terms over one year in the United States is the muchless (Bank of Japan 1995). Banks seem to be concerned about the chance theirclients will increase the risk of the project ex post. If firms did not trust theirbanks to cooperate and borrowed their money through short-term contracts, theywould then need to protect themselves against opportunistic behavior that bankcould take at the renewal. One way they could do so is by maintaining close ties
with several other banks. Japanese firms diversify their credit sources broadly:

rnost obtain less than half of their bank loans from their main bank (Fuji
Research Institute Corporation 1993).

FINANCIAL RELATIONSHIPS IN JAPAN:
AN INTERNATIONAL PERSPECTIVE
sake of fairness, a•judge may subordinate the claims of a creditort•han intervenes before Chapter 11 in its debtor's affairs. A bank canlose its priority whenever the bank has taken control of the debtor,
thus assuming the fiduciary duties of a controlling shareholders, andthen breached those duties to the injury of general creditors. Equitable

subordination does not make bank rescue impossible; it does makethem more costly. When a firm hits bad times, creditors will seldom
lend more money without controlling the way it uses it. Under the U.S.
Iaw, they can do so before a Chapter 11 filing only by gambJing all: if
the firm succeeds, the bank recovers its claim; if the firm fails and theother creditors convince the judge the bank indulged its privateinterests, it potentially loses all. For the sake of making credibie
threats, perhaps that risk often suffices. Because of this ex post risk tointervention, the U.S. banks may be more able to credibly to threaten
to abandon defaulting debtors ex ante. Japanese judges use no doctrine
analogous to equitable subordination. Whether in the U.S. or Japan, inbankruptcy cases judge$ wield enormous discretion. Although they may
phrase it differently, Japanese judges exercises this discretion in waysthat resemble a bit the American judicial concerns for equity Although
they may phrase it differently, Japanese judges exercise this discretionin ways that resemble somewhat the American judicial concerns forequity (Ramseyer 1992).
3.4 Development of the Main Bank System
Hoshi (1993) describes the development of the main bank system,

and argues that the main bank system emerged from the wartime
financial system during the World War II. For many large firms, themain bank system is a part of a larger industrial group called kigyo
shudan or corporate groups. Some kigyo shudan have their origins in
prewar conglomerates called zaibatsu, but there are some importantdifferences between zaibatsu and kigyo shudan, especially in theirfinancial arrangement. By focusing on the evolution of bank-firm
relationships from prewar period to postwar period, he also describes

how the prewar zaibatsu were transformed into the postwar kigyo
shudan.
In order to respond to increasing demand for loans for war-relatedindustries, commercial banks started to form lending consortium toshare the risk and coordinate their lending. Lending consortium during

21

22 KENJI KOJIMA
this period developed into the main bank system in the postwar period.

Although the wartime lending consortium was mainly a device for risk
diversifjcation, the postwar main bank system added another role ofdelegated monitoring among banks. By letting a main bank beresponsible for monitoring jts clients and avoiding the duplication ofmonitoring by other lenders, the de facto lending consortium under themain bank system provided an efficient monitoring mechanism. The
government assjgned a major bank to each munitions company to takecare of the fjrm's financial needs by law. In many cases, a lending

consortium was formed around the designated bank to serve themunitions company. Most designations are likely to have been based on
the past relations through loans, shareholdings, and directorship. Thus
the assignments often served just to reinforce preexisting ties between

banks and firms, especially for those zaibatsu firms and banks.
Moreover, some non-zaibatsu firms also started to have close ties tozaibatsu banks as a result of designation. Thus, even for the former

zaibatsu banks, there appear to have been new long- lasting
relationships formed because of the designation system. The main bankrelationships in 1962 were strongly influenced by the designatedfinancial institutions system during the war. The ties through thedesignated financial institutions system were long lasting even for theother firms which did not have close ties to zaibatsu.

As the firms started to depend more on external funds, especiallybank loans, the relative power of shareholders declined somewhat.
However, there were also regulatory changes that further limited thepower of shareholders: the shareholders' rights to residual income wasseverely restricted with limiting dividend pay-out. This important
restriction on the shareholders' property rights must have reduced

their incentive to influence and control the management. It isinteresting enough to point that this tendency for firms to pay anominally fixed amount of dividends has continued to the postwar
period in the name of stable dividends policy. The shareholders do notseem to have regained their rights to residual income even in the

postwar period. The shift of corporate control away from theshareholders was a result of deliberate goverpment policy, whichattempted to organize every aspect of the economy to work efficiently

for war purposes. During the war, the government viewed selfinterested shareholders, who care more about profits than national

FINANCIAL RELATIONSHIPS IN JAPAN: 23

AN INTERNATIONAL PERSPECTIVE

priorities. In addition to these financial regulations that heavily

restricted the right of shareholders as residual claimants, thegovernment passed other laws that more directly limited control by theshareholders. In addition to putting the companies under the directcontrol of the government, the managers are allowed substantial
autonomy as long as they were acting in the interests of the nation by

trying to increase productivity. Thus the power to control the
corporations was largely transferred from shareholders to managers

during this period. •As the war ended, Japan inherited a financial system with largebanks and close bank- firm relationships. Moreover, the decline ofshareholders' power during the war made room for the banks to play
important roles in corporate governance. The absence of monitoringthat characterized the wartime financing had to be corrected, and thebanks had to gain the power to monitor the firms. The swift
reorganization of financial institutions reflected the idea of Japanese
government and the Allied Forces that they should first make solvent
so that they can expect the banks to lead the postwar reconstruction.
In the process of restructuring the non- financial firms, each firm had

to select a set of "special managers." As a rule, special managers
consisted of two representatives from the firm executives and two
representatives of the firm's creditors. Thus, in almost all the cases,
former munitions companies had representatives from their designatedfinancial institutions as their special managers. The special managers
played a central role in the restructuring process. For example, it was
their responsibility to determine which assets should be included in the

new account. They were required to draw up a restructuring plan,submit it to Minister of Finance, and have it approved. In constructing
the restructuring plan, the special managers had to assess the value ofremaining assets, make plans for future production and finance, andcreate forecasts of balance sheets and income statements. Accordingly,
the restructuring of special account firms gave the special managers an

excellent opportunity te acquire information about the firms.
Ultimately, the accumulation of information and the responsibility
associated with the restructuring process must have significantly
enhanced the monitoring capabilities of the banks.

The second factor that contributed to an increase of bankmonitormg was the acute credit crunch during this period. The credit

24 KENJI KOJIMA
situation became especially serious after the implementation of Dodgestabilization plan in 1949, which cut off credit expansion by the
Reconstruction Bank. In response to these financial problems, many
fjrms turned to banks, and the banks seem to have increased theirpower over industrial firms. Banks rescued many firms from liquidity
crises, and sometimes directly intervened in their management. During
this period, however, the banks also suffered from a shortage of funds.
The situation was especially serious for large banks in the zaibatsu,
which heavily depended on deposits by large zaibatsu firms, because
those firms were in the process of restructuring and did not have muchmoney available to deposit. Thus the large banks had to compete forinter-bank loans and Bank of Japan lending to make up for the
shortage of deposits. This competition among large banks also seems
to have further helped in giving them proper incentive to monitor. Since

the banks had their balance sheets cleaned up and were now solvent,they were not inclined to waste money on loans to friendly but
unworthy firms. By adding monitoring activities by the banks to abanking system that was already characterized by close bank-firm ties,
main bank system started its development. The ties between banks andfirms were not broken up during the postwar period so that thewartime and postwar banking system show remarkable continuity. The
government of Japan and the Allied Forces failed to fully break up thezaibatsu, and bank- firm ties in zaibatsu reemerged when the former
zaibatsu firms were regrouped as kigyo shudan, or industrial groups.
Second, the bank did not suffer much from the post-war reforms andtherefore were well positioned to play a central role in starting up theindustrial groups and developing the main bank system. Following thezaibatsu dissolution, however, many of the former zaibatsu firms

gradually reunited as kigyo shudan. The personal ties among themanagers of the former zaibatsu were obviously important in theprocess of the re-affiliation. While the effort of the Allied Forces tobreak up zaibatsu was ineomplete, the attempt to break up large
financial institutions never materialized.

The institutional inertia are combined with the increase ofmonitoring ability by banks, and the main bank system started todevelop. By early 1960s, many of the features of the main bank systemwere in place. Banks were firmly established as the primary providersof external financing for fjrms. Bank also had been permitted to hold

FINANCIAL RELATIONSHIPS IN JAPAN: 25

AN INTERNATIONAL PERSPECTIVE

equity claims of their clients and were regularly taking an active rolein corporate governance. The lack of commitment by the Japanese
government and the Allied Forces to break up the close bank-firm
relationship insured that many aspects of the wartime corporate
finance were carried over to the postwar period. Then the bank gained
substantial power to monitor the firms, through their experience in the
restructuring of non-financial firms and in the period of severe credit
crunch, and the main bank system started to develop (Hoshi 1993).

4 Structural Changes
4.1 Financial Emancipation
Table 3 indicates that liquidity in the form of cash and marketablesecurities for Japanese firms has bee increasing. Furthermore, theJapanese figure is almost 4 times that for the U.S. firms. Historically,a substantial portion of cash positions at Japanese firms representedcompensation balances on commercial loans. However, the use ofcompensation baiances has decreased during the 1980s as Japaneselenders have moved toward market-rate loans and fee-based services.
Much of this Iiquidity increase occurred relatively suddenly during thesecond half of the 1980s in parallel with expansion of money supply,
lower interest rates, and rising real estates prices in Japan.

Paralle}ing the liberalization of Japanese corporate finance has
been a dramatic buildup of financial slack on Japanese corporate

balance sheets. During Japan's high-growth periods in 1948-73,
Japanese firms were confronted with a volume of attractive investment
opportunities that vastly exceeded their cash flow and the amount offunds most firms could reasonably expect to raise externally.
Throughout this period, Japanese corporate finance served simple
function. Financial managers raised the cash necessary to fund theapproved projects securing a sufficient volume of external finance.
Minimizing capital cests was a secondary concern to most of them.
For all practical purposes, there are only two major sources ofexternal funds: collateralized loans and trade credjt. These, in turn,were supplied by essentially the same institutions - banks, insurancecompanies, and major suppliers - stakeholder that were also major
shareholders in their firms. These stakeholder monitored client firms
closely, even to the point of occasionally injecting new management toKENJI KOJIMA

26

Table 3
Batance Sheets of Manufacturing Firms in Germany,

Japan and the Vnited States

Five-Year Average(Percentage)

Germany
1975-79

1980-84

1985-89

1eeO-91

10.5
20.2
22.4
32.8
67.2
26.6
4.0
26.3
32.8
16.7

13.5
21.3
25.2
26.1
69.3
29.2
2.9
25.7
30.7
14.8

13.3

22.8
26.3
22.7
70.7
30.0
3.6
23.7
29.3

16.9
24.3
23.6
21.1
71.2
28.6
, 4.3
20.9
28.8
12.0

13.9
24.8
23.6
20.5
72.2
28.8
4.7
19.9
27.8

1960-M 1965-69 1970-74

1975-79

13.8
23.4
16.7
30.2
80.2
19.0
16.8
gg.8
19.8
8.6

14.8
22.7
18.3
26.8
82.1

15.3
23.1
18.9
25.1

18.7
18.0
27.7
17.9

19.7
17.0
21.9
24.6

6.7

1960-M 1965-69 1970-74
AssetsCash and Equivalents
Account Receivables
Inventories

Tangible Fixed Assets
Liabilities

Account Payables
Short-Term Debt

Long-Term Debt
Stockholder's Equity

Stock

11.0
16.4
22.6
41.7
58.2
22.9
3.3
23.2
41.8
21.6

10.4
17.6
21.0
39.0
61.0
24.0
4.0
24.7
39.0
20.2

13.3

11.3

Japan
1980-M 1985-89 1990-91

AssetsCash and Equivalents
Account Receivables

10.7
19.3

Inventories

17.7

Tangible Fixed Assets

34.6
70.2

Liabilities

Account Payables
Short-Term Debt

Long-Term Debt
Stockholder's Equity

Stock

16.2
18.5
22.3
29.8
16.8

12.8
25.3
15.5
37.4
75.5
18.5
18.7
26.0
24.5
13.6

6.0

19.3
21.7
13.6
25.7
67.0
16.3
14.0
22.0
33.0
7.5

21.6
12.4
25.7
63.3
15.6
9.7
23.6
36.7
8.5

1975-79 1980-84

1985-89

19se-91

75.4

17.7

U.S.A.
1960-M Iee5-69 1970-74
AssetsCash and EquivalentsAcÅëount Receivables
Inventories

Tangible Fixed Assets
Liabilities

Account Payables
Short-Term Debt

Long-Term Debt
Stockholder's Equity

Stock

10.2
16.7
23.3
38.7
35.8
9.2
2.8
14.3
64.2
25.3

7.1
17.6
23.7
39.5
42.3
9.7
3.8
18.3
57.7
20.1

5.8

6.9

5.5

17.6
22.7
38.1

16.4
20.9
35.2
47.5
9.1
3.3
22.9

15.5
18.3
38.2
51.2

46.9
9.4
4.3
22.2
53.1
17.5

s25
15.0

9.2.

3.7
25.1
48.8
12.5

5.7
14.8
15.5
35.1
57.1
8.2
3.8
31.0
42.8
12.0

Source: The Bank- of Japan, Cornparative Economic and Financial Statistics: Japanand Other Countries, 1974, 1978, 1986, 1so3, 1994.

Source Note: Statistiches Bundesamt, Unternehmen und Arbeitssttitten, The Bank ofJapan, Syuyohigyo Keieibunsehi (Business Analysis on Main Enterprises in Japan),
The U.S. Department of Commerce, Quarterly Financial Report for Manufacturing,
Mining, and Trade Corporations
Note: Book values of assets in Japanese firms differs greatly from current values
because face values are much lower than market values.

4.6
13.6
14.1
33.6
59.9

7.8
4.2
34.4
40.2
12.1

FINANCIAL RELATIONSHIPS IN JAPAN: 27

AN INTERNATIONAL PERSPECTIVE

ensure a rational deployment of scare funds. Thus high growth, therigors of competition at home and abroad, the heavy use of debt andtrade credit, and the ownership of these claims by institutional
shareholders that monitored performance closely were sufficient toensure the deployment of cash in a pattern consistent with thepriorities of the suppliers of capital.

Although remarkable growth in Japan had begun to wane evenprior to 1973, the oil shock produced a sudden and dramatic reductionin Japanese econornic growth. The joint effect of investment reduction

and cost improvement was to lessen gradually the external capitalneeds of the firms. Large firms finance internally from less than 20S)(orin the 1960s and early 1970s to more than 100% by the 1990s. The !atter
figure reflects the fact that many large Japanese firms were using theirenormous cash flow during this period to repay debt and build up
liquid assets on the balance sheet rather than to increase dividends forshareholders. As a consequence, Japanese firms have accurnulated
considerable financial slack in the form of unused debt capacity andtemporary investments in marketable securities. The net debt-to- equity
ratio by Japan's largest firms has declined more or less steadily since1978, even becoming negative in 1987. The buildup of financial slack on

corporate balance sheets, the persistence of excess cash flow
throughout the 1980s, and gradual financial deregulation have led to akind of financial liberation of Japanese industrial firms from theirtraditional lenders. .

Close, stable relationships between non-financial firms and banks
have been essential elernents of Japanese corporate finance. As such,they have contributed significantly to the mitigation of takeover activity

in Japanese capital market. Today, however, this stability is being
shaken by two major changes in the world of finance: the buildup offinancial slacks on balance sheets in Japanese corporation and theglobalization and deregulation of the Japanese financial system. The
former change is altering the nature of business that banks executewith their major industrial clients and generally weakening bankcontrol over these firms. Concurrently, the latter change is causingbanks and other institutional owners of equity to demand greater
returns on their holdings of client-firm stock. Together these trends are
evoking a creeping instability in close financial relationships.

Japanese firms in recent years are in abundance of liquidity found28

KENJI KOJIMA

on most of their balance sheets. It is no mere coincidence that thisperiod of abundance has also been accompanied by weakening firmbank relationships. The increased availability of internally generated
cash to fund projects has reduced the need to raise funds externally,
thus diminishing the financial dependence of industrial firms on bank.
In addition, the growth and gradual deregulation of capital markets athome and the opening of capital markets abroad have distanced
Japanese industrial firms still further from banks. There is a hidden
cost to the financial emancipation of past success, however. In theabsence of the discipline exerted by capital market, Japanese managers
now finds themselves with far greater discretion in the allocation of
corporate resources than ever before. Since firms are unwilling tobreach long- standing implicit contracts with key stakeholder,especially long-term employment relationships, and unable to execute
past strategies of simply growing themselves out of their current
situations, they hold the direction to sustain marginal businesses andretain unrelated diversification. Thus, the free cash flow of these

corporations may be reallocated from shareholders to otherstakeholder, primarily employees. Despite the low priority traditionallyaccorded to shareholders in Japan, it is unljkely this trend can continue

for long. One by- product of the increasingly global market in which
Japanese financial institutions must compete, and of their weakening
relationship with industrial clients, has been a growing concern for
obtaining higher direct returns on their equity investments.

Although borrowing continued to shrink as significant proportionof tota] funds raised, bank loans continued to dominate security
financing in domestic markets. Moreover, lending practices began tochange in the wake of overseas financing by Japanese firms and thecontinued relaxation of domestic financial market regulation. Continued
growth in the certificated-deposits market and the introduction oflarge-denomination money market certificated in 1985 contributed togreater variability in banks' cost of funds. The introduction of acommercial paper market in November 1987 provided another viable
alternative for large firms in search of short-term funds and further
reduced the dependence of corporation on banks. For all practical
purposes, lending to large firms has ceased to be growing business forJapanese major banks.
Over the past two decades, capital market liberalization in Japan

FINANCIAL RELATIONSHIPS IN JAPAN:

AN INTERNATIONAL PERSPECTIVE

has made available financial instruments not previously available tocorporate borrowers. Firms are now free to raise investment funds
through a variety of equity, bond, and hybrid mechanisms, and in both
domestic and overseas markets. Many large Japanese firms have taken
advantage of these opportunities, and the results has been a substantial

decline in the proportion of external corporate capital coming fromtraditional sources such as bank loans. With the decreasing proportionof total capital allocation channeled through the traditional prime rate

system, the Ministry of Finance and the Bank of Japan are no longer
able to exercise the sarne degree of control over financial markets thatthey once could. It is also true that, with the new reliance on
securities-based finance, Japanese major securities firms are now more

important in financial markets than in the past. Furthermore, even as
banks and other financial institutions account for an increasing shareof securities-based capital, the ability of highly performing nonfinancial firms to fund their investments through retained earnings has

reduced their overall external capital dependency and shifted thebalance of bargaining power with lending firms in their direction.

Whereas most firms indicated that their corporate plans andinvestments were closely examined by banks during the 1950-80 period,
none reported being subjected to such scrutiny today. Although meetingwith the main bank is still held semiannually or at least annually to

discuss performance, these have apparently evolved into largely
perfunctory presentations of past performance rather than substantive
discussions of future capital investment. Banks are now more interested
in tracking the overall return earned on their total investment in client

firms rather than monitoring and influencing managerial decision
making. The exchange of information historically fostered by placing
retiring bank officers in senior management positions at client firms

also appears to be waning. Major banks have begun to experience
difficulties in placing retiring employees in second careers.

As constraints on corporate finance relax and capital and financial

markets deregulate in Japan, competition among banks has further
weakened traditional firm-bank relationships. The securitization ofJapanese corporate finance had made financing increasingly pricesensitive transactions in which past relationships count for little. A

firm's main bank may win a mandate to lead-manage a deal, but only
if it offers a better idea or a competitive quote. Nonetheless, although

29

KENJI KOJIMA

30

Japanese non-financial firms may be distancing themselves from banks,
Japanese banks and other financial institutions still own considerable

fractions of these firms' outstanding shares. However diminished theneed by no-financial corporations for a close banking relationship, theJapanese bank will maintain that strong relationships with their clientsare still central to the success of their institutions. Even though large

no-financial firms no longer rely heavily on intermediated credit tomeet financing needs, financial institutions still look to these firms foraccess to affiliated firms of commercial Iending, access to employees
for retail banking and insurance underwriting, and as customers for
new products and service offered on a fee basis.
Since newer or smaller firms continue to depend heavily on bankloans shown in Table 4, they may derive an important advantage
from the main bank system. However, financial liberalization tends toundermine the main bank system because major non-financial firms
have greater access to market debt as well as borrowing from foreign
financial institutions. This makes it potentially much more difficult forthe main bank to monitor and control clients' behavior. Consequently,
the key to an effective main bank system under these circumstances
seems to be an enforceable agreement or mechanism which restricts the

Table 4External Sources of Funds by Size of Firm in Japan(Percentage)

1975 1980 19as 1990
Loans

Large Firms 73.6 69.8 21.4 67.2

Small and Medium Firms 91.2 89.2 97.1 94.2

Bonds

Large Firms 16.3 6.3 38.6 13.1

Small and Medium Firms O.1 O.1 O.2 O.3
Stock Issues

Large Firms 10.1 23.9 40.0 19.7

Small and Medium Firms 8.8 10.8 2.7 5.5
Source: Economic Planning Agency, Keizai Hakusho, 1992 (Economic Survey ofJapan, 1992).

Source Note: Ministry of Finance, Houjinhigyou Touhei Nenpou (Annual Statistics ofCorporations), 1975, 1980, 1985, 1990.

Note: Size of firms is based on their stocks. Large firms have more than lbillon yen
value of stocks.

FINANCIAL RELATIONSHIPS IN JAPAN: 31

AN INTERNATIONAL PERSPECTIVE

access of heavy borrowers to alternative debt sources. If this condition

can be satisfied, the main bank system should continue to be viable andadvantageous for firms which need strong bank support.
Hoshi, Kashyap, and Scharfstein (1990b) examine the investment
behavior of Japanese firms before and after financial deregulation. In
the period before deregulation all of the firms in their sample had close
ties to a bank or set of banks. After deregulation, some of these firrns

loosened their ties to banks and relied more heavily on direct capitalmarket financing. Another set maintained their close banking ties. They

found that the firms that have significantly reduced their bankborrowing and increased their direct capital-market financing, exhibit astrong sensitivity of investment to cash flow after deregulation. By
contrast, the firms that maintained bank ties show no sensitivity ofinvestment to cash flow in both periods- before and after deregulation.

If bank monitoring overcomes information problems and relaxes
liquidity constraints, why did some firms weaken their bank ties?
Diamond (1991) argues that young firrns, or older ones that have done
poorly, will borrow mainly from banks and that older, more successful
firms will use public debt. The idea is that successful firms have more
capital of reputation in performance at stake and hence have more tolose by taking inefficient actions. These firms do not need to incur themonitoring costs associated with bank borrowing. By contrast, younger
firms have not yet developed a reputation and older, less successful
firms do not have a good reputation to lose. It is therefore efficient forthese firms to incur the costs of bank monitoring.

The results presented here suggest that monitoring and other costs
associated with bank financing must be large. Otherwise, firms would
not have chosen to weaken their bank relationships until they had
enough collateral to be able to get around liquidity constraints. The
first cost stems from regulations requiring banks to hold a fraction of
their assets in non- interest-bearing accounts. This reserve requirementmeans that the costs of funds to banks exceed those of individual
investors; as a result, they will require a higher gross rate of returnon their investment. In addition, bank loans are generally less liquidthan pub}icly traded debt. The difficulty that bank facing adjusting
their loan portfolio may also mean that they will require a higher
gross return. Finally, a more subtle cost of bank financing may arise
from the different objectives of banks, managers, and shareholders.

32

KENJI KOJIMA

Since banks mainly hold debt claims, they receive little of gain fromunusually good firm performance. Shareholders, in contrast, care only

about maximize the gain. This conflict may result in exeessively
conservative investment policies if bank control corporate investment
decisions. It may therefore be efficient to reduce bank ties to avoid thisproblem at the expense of becoming more liquidity constrained. As
firms generate more cash from ongoing operations, they may be more
willing to make this transition. In addition, managers may prefer tohave more control over operating decisions than a bank is willing toallow. Managers may choose to weaken the firms' bank ties and incur
greater financing costs because it gives them more control despite thefact that it inefficient to do so. Again, as firm become more liquid,
managers may be more willing to incur these costs (Hoshi, Kashyap,
and Scharfstein 1990a).
4.2 Financial Deregulation

It is clear that the ongoing financial deregulation in Japan ishaving important effects on corporate financing practices. In somerespects, financial liberalization has been taking place since the 1960s;

however, the process accelerated dramatically in the 1980s. The revised

Foreign Exchange and Foreign Trade Control Law in December 1980
removed major impediments to offshore financing by Japanese firms
and improved access by foreigners to Japanese financial markets.
Beginning around 1984, the Iiberalization process accelerated with anumber of regulatory changes which were at least partially in response

to external pressure for greater openness of Japanese financial
markets. Since then a stream of regulatory changes have eliminated avariety of interest rate restrictions, allowed trading in new types of
securities, relaxed contro]s on both domestic and foreign financial
institutions, and genera}ly promoted freer and more flexible financial

markets. However, some regulations and practices which cause
distortions and result in unusual financing patterns still remain. The

elimination of one restrictive regulation results in a regulatory
arbitrage opportunity with market participants using their increased
freedom to profitably exploit another, still=existing regulation. This
continues until the consequent pressure on the second restriction forces
its elimination or modification. Consequently, the liberalization process

tends to produce windows of opportunity permitting firms to earn

FINANCIAL RELATIONSHIPS IN JAPAN: 33

AN INTERNATIONAL PERSPECTIVE
additional profits by -exploiting regulatory differences.5

There have been several dramatic shifts in funding patterns which
can be traced to regulatory changes. It is also important to understandthat the government's own financing needs have been an important
influence on market regulations as well as the general character of thedomestic bond market. Indeed, that market has been dominated bygovernment issues since the mid-1970s with corporate issues
representing a relatively small fraction of the total market. For
example, during the 1986-1990 period, straight corporate bond issues
accounted for just 3%o of total bond issues in Japan. Table 5 provides
additional data on domestic bond issues by Japanese firms during 19601993. In recent years, other Japanese firms have essentially forsaken

the domestic straight debt market in favor of other funding sources,
including offshore bond issues. This striking aversion to domestic
issues has produced enormous pressure for regulatory and proceduralchanges.
To a large extent, the underlying problems for domestic corporatebond issues have to do with who determines issue terms and collateralrequirements. It was only after 1979, that Japanese firms were allowed
to issue unsecured bonds for the first time since the 1930s. Initially,
only two firms were eligible to make unsecured issues. This situation
continued until January 1983, when the restrictions on convertible
bonds were further relaxed so that some 30 firms become eligible toissue such bonds without collateral. Subsequently, restrictions for both
5 The "sushi bond" provides a classic example of such regulatory arbitrage. The
sushi bond was a foreign currency bond issued offshore by Japanese firrns andpurchased by Japanese insurance companies at higher prices than other potential
buyers were prepared to pay. The differentiating characteristic of a sushi bondwas that Japanese firms were on both sides of the transaction. The motivation forsushi bonds was a Ministry of Finance regulation which lirnited the foreign
currency investments of insurance companies to 10% of total assets; however,foreign currency issues by Japanese firrns were not subject to that restriction.

Consequently, such issues commanded a premium from Japane$e insurancecompanies desiring to increase their foreigh currency position beyond the 100/olimit.

As Japanese firrns became able to issue foreign currency bonds offshore andswap the proceeds into yen, they discovered that this was less costly than acomparable domestic yen borrowing. Apparently some borrowers simply re-lentthe proceeds of their sushi bond issues at an arbitrage profit. The resulting surge

in sushi bond issues caused Ministry of Finance to relax the restriction on

insurance companies' foreign currency assets. As a consequence, Japanese
insurance companies were no longer prepared to accept the lower yields on sushi

bonds. Then, issuance of such bonds ceased almost immediately (Hodder andTschoegl 1992).

34 KENJI KOJIMA'

convertibles and straight bonds were relaxed in stage until several
hundred firms were eligible for unsecured issues as of November 1988.
The official logic for a collateral requirement has been the protectionof investors. However, this restriction has also made bond issuance inJapan relatively unattractive. Not only did corporate issuers have to
pay management fees and underwriting commissions, but they also had
to compensate a trustee for a variety of services which substantially
increased issue costs. Firms also has to obtajn approval on the terms
and timjng of issues from a committee dominated by a group of largebanks. This procedure is cumbersome and lacks flexibility regarding
issue terms. This bond issuing procedure endowed the Japanese bankswith considerable control over non-financial firms' access to debt

markets. Under the main bank lending system, such control was
Table 5
Direct Finencing of PubSic Firms in Japan

Five-Year Average( Percentage)
1960-oo 1965-69 1970-74 1975-79

19eo-84

1985-89

1990-9338.4 60.0 53.3
36.4 43.8 31.2

43.2
29.6

38.3
24.3

37.6
12.2

Amounts 25.7

61.0 33.4 29.0
58.9 42.1 43.0

15.0
22.7

3.1
4.6

22.5

No. of Cases O.2

O.2 O.3 5.1
2.9 O.7 6.9

8.4
8.9

8.3
7.6

20.9
24.7

9.6

Stock Issues

No. of Cases 63.7

Amounts 72.2

Straight Bonds

Domestic

No. of Cases 35.7
Overseas

Amounts O.4

7.9

Convertible Bonds

Domestic

No. of Casbs O.1

O.l 6.1 5.0

8.8

O.4 12.9 8.7

14.2

22.3
30.8

12.4

O.3 O.2 7.6

20.3
21.0

9.6
7.0

4.3
3.7

No. of Cases n.a.

Amounts n.a.
Overseasn.a. n.a. n.a.
n.a. n.a. n.a.

O.6
O.4

O.5
O.7

1.0
2.7

No. of Cases n.a.

Amounts n.a.

n.a. n.a. n.a.
n.a. n.a. n.a.

2.9
3.2

17.9
25.0

19.5
21.8

Sources: Tokyo Stock Exchange

Annual Securities Statistics

Amounts O.1

Overseas

No. of Cases O.3

Amounts 1.6

1.4 O.5 10.2

Warrants Bonds
Domestic'

1993.

FINANCIAL RELATIONSHIPS IN JAPAN: 35

AN INTERNATIONAL PERSPECTIVE

important for dealing with highly levered clients. In recent years,
financially sound firms have naturally tended to view this process as an

expensive nuisance. Consequently, offshore issues have been attractive

as a way around cumbersome and expensive procedures in the domestic
market.
Table 6 il!ustrates the rapid growth in offshore bond issues byJapanese firms over the last decade. It was not until the early 1980s
and Japanese participation no Ionger required permission of Ministryof Finance that the offshore market began to really take off. Total
corporate issues during the 1985-1993 period were greater in theoffshore market than domestically. The fact that a very large fractionof offshore issues would up in Japanese investors' portfolios provides
a strong indication that the domestic market was inefficient.
In the domestic market, convertible bonds have dominated straightissues since 1983. There seem to be several reasons for this. First,
collateral requirements have been relaxed more rapidly on convertibles- resulting in lower effective issue costs for more firms. Second, issuingterms on straight corporate debt have been tied to government bondyields in ways which made many corporate issues relatively
unattractive for initial purchasers. In contrast, terms on convertibles

were more easily adjusted to make them attractive for purchasers.
Third, the lower coupon rate on a convertible coupled with thegenerally low dividend yield on shares after conversion implies a lower
cash flow drain relative to issuing straight debt. Fourth, historically, afirm could not issue bonds in excess of its paid in capital plus reserves.

The June 1990 revision to the Commercial Code roughly doubled thelimit; but even this relaxed constraint can be binding for a rapidly
growing firm needing external funds. A convertible issue provided
immediate funding but, as it was converted into shares, enhanced afirm's ability to issue additional bonds in the future.

The main concern for corporate bond issues during the last decade
has been the shift to issuing overseas. This is clearly due to reduced
regulatory constraints on access to offshore markets where there isgreater flexibility and lower costs. The rise of the offshore primarymarket has, however, seriously undermined the domestic primarymarket. Consequently, efforts are currently underway to reform
domestic bond issuance procedures and make them more competitive
with offshore markets. This will presumably require more flexibility

KENJI KOJIMA

36

Table 6Japan

Financing of Public Firms inFive--Year Average

Direct(Billion Yen)
1eeO-M 1965-69

1970-74

1975-79

1980-84

1985-89

1990-93

3,O14
2,673

1,366
1,352

2,342
3,743

1,623
4,463

1,227
6,173

2,1os
18,376

1,356
5,843

Domestic
No. of Cases

1,os9

2,172
2,187

1,3ca
3,5ea

sw

427

171

287

Amounts

953

6,152

4,725

3,478

iO,721

Stock Issues

No. of Cases

Amounts
Straight Bonds

Overseas

No. of Cases

8

8

10

155

240

455

754

Amounts

17

109

55

988

1,848

5,785

11,775

3

3
15

237

153

272

1

1,1oo

1,246

2,951

1,227
23,360

5,923

15
61

9
52

9
46

230

575
4,3M

529

156

1,456

5,311

1,761

n.a.
n.a,

n.a.
n.a.

n.a.
n.a.

n.a.
n.a.

16
87

26

35

su

1,307

n.a.
n.a.

n.a.
n.a.

n.a.
n.a.

n.a.
n.a.

81
678

983

704

18,934

10,377

No. of Cases

1,692

954

2,175
2,202

1,541

Amounts

4,704

1,037
7,397

7,763

1,424
27,382

17,950

23
78

17
1oo

19
101

2,444

6,890

1,ee7
30,0301,614
23,913

4,729
3,7oc

3,558
3,715

3,so2
8,5ng

3,045
14,303

2,838
20,826

5,497
75,7883,609
47,705

Statistics,

1co3.

Convertible Bonds

Domestic
No. of Cases

Amounts

317

Overseas

No. of Cases

Amounts
Warrants Bonds
Domestic
No. of Cases

Amounts
Overseas

No. of Cases

Amounts
Sub-Total of Bonds

Domestic
715

639

Overseas

No. of Cases

Amounts
Grand Total
No. of Cases

Amounts

Sources: Tokyo Stock Exchange, Annual Securities

am

8os

FINANCIAL RELATIONSHIPS IN JAPAN: 37

AN INTERNATIONAL PERSPECTIVE

with regard to pricing and issue terms as well as largely eliminating

the additional costs imposed by the commissioned bank system.
Otherwise the dominance of the offshore markets is likely tocontinue(Hodder and Tschoegl 1992).
4.3 Reorientations of Financial lnstitutions

The securitization and globalization of Japanese corporate financedramatically changed the business of major banks in Japan. As nofinancial firms have been changing the sources of funds, Japanesemajor banks have aggressively sought to offer product-oriented, feebased banking services such as currency and interest swaps, leveraged
lease arrangement, and M&A advisory work. The rapid growth and low
profitability of Japanese banks has led to concern about their capital
adequacy. Foreign banks have sought protection from the onslaught ofJapanese competition by calling for Japanese banks to operate withcapital ratios comparable to those required in the United States andEurope. Japanese banks are watching their financial performance
carefully. In contrast to the low-margin, volume-oriented banking
practices, Japanese banks are now restraining growth and carefully
tracking the profitability of their relationships with clients.
Increasingly, clients are being ranked by banks according to the
profitability of the relationship with them. Just as industrial clients arenow short listing the banks with which they do business, banks are
now beginning to identify and terminate relationships with clients that
do not provide them with sufficiently attractive rates of return.

Competition for corporate pension fund management has alsofueled the rising performance orientation of both insurance companies
and trust banks in the management of equity investments. Historically,

corporate pension funds were almost insignificant size and fundmanagers, who were restricted to trust banks and insurance companies
only, were selected on the basis of business relationships. According to

the practice of a particular firm, for example, pension funds wereallocated to institutional managers on the basis of their share of loan
volume to a particular firms, the extent of their equity ownership, andthe volume of their purchase from it. Until relatively recently, fundperformance was not a factor since there was virtually no difference inperformance among the trust banks and insurance companies.

Today, however, pension fund management has become a38

KENJI KOJIMA

substantial, rapidly growing business vital to the long-term prosperityof the trust banks, which have also has to find the new sources ofgrowth and profitability to replace their plateauing loan demand. At
the end of the 1988 fiscal year, corporate pension fund assets undermanagement amounted to 26.3 trillion yen and were growing at anannual rate in excess of 15%o. Corporate pension fund owners have also
become more demanding today. Corporatjons were indicating theirsearch for better fund performance by steadily shifting assets away
form trust banks to insuranee companies. The upshot of this sort ofactivism by pension fund owners has been an aggressive pursuit ofshort-term capital gains by fund managers; the proportion of pension
fund assets invested in equities doubled from 12.7%o in 1981 to 25.8% in1988 (Kester 1991).

The shifting patterns of Japanese corporate finance, and thecompetitive and regulatory pressures on Japanese financjal institutions
to increase their return on assets, are collectively resulting in a gradual

unbundling of claims held against non-financial firms. Rather thanbeing key shareholders, lead lenders, and primary vendors of financial
services in long-term relationships with clients, Japanese banks are
now being reduced to the position of minority shareholders that mustcompete fiercely for a client's business on a transaction-by-transaction
basis.

5 Conclusions

Corporate financial patterns and practices in Japan appear quite
different, particularly in comparison with those in the United States. In

large part, these differences are due to differing institutional andregulatory environments. Then, a peculiar financing pattern turns out
to be the rational economic response to a constraining regulation. The

key to understanding such patterns is identifyjng the underlying
structure of constrains.

Japanese financial institutions may hold equity and debt at thesame time. Besides strengthening the long-term relationship between
the financial institutions and the firm, the simultaneous holding of debt

and equity clearly reduces the scope for conflict between stockholders
and debtholders over the choice of policies, particularly in situations offinancial distress. The significance of the main bank system is the close

FINANCIAL RELATIONSHIPS IN JAPAN: 39

AN INTERNATIONAL PERSPECTIVE

information-sharing relationship that exists between the bank and thefirm. It is possible to view the main bank system as functioning as a
substitute for the kind of screening and monitoring institutions that areprevalent in other capital markets such as bond and credit-rating
institutions and security analysis agencies. The close association thatthe main bank has with the firm means that the bank is able to obtaininside access to the firm and its management which is not readily
available to the external capital market.

The main bank system can be also characterized in terms of banks
themselves delegating the monitoring of a particular firm to one
particular bank: the main bank. The bank delegated to be monitoring
is not only the bank with the largest loan share but also holds asignificant stake in the firm as a shareholder. Having a sufficient large

loan share may be the way in which the bank ensures that it obtains
an adequate return on its monitoring outlays. In this regard, it isworth noting the free-rider problem may be rnitigated somewhat by
virtue of the fact that non-monitoring banks will not be able to imitate
the Ioan portfolio of the main bank in size. It can be argued that thisfunction of the main bank provides an important substitute mechanism
for what in effect is inactive market for corporate control in Japan.
Main bank intervention can take a number of forms, ranging on the
one hand from cases where the main bank stipulates certain measuresthat requires the firm to take in exchange for the bank's support
during a period of financial difficulty to cases where the bank sends
officers to take over the management and carry out the reorganizationof a firm that is on the verge of bankruptcy on the other. As aconsequence, one can suggest that the relationship-based corporate
governance in Japanese firms substitutes for the more market-based in
the U.S.

Much of corporate finance in Japan have evolved around the mainbank relationship. This is changing for many firms. Indeed, financial
liberalization in Japan has created serious difficulties for the mainbank system. Nevertheless, that system seems likely to ddapt andcontinue to provide valuable support for rapidly growing firms. Exactly

how this will come about is not yet clear; however, there aresubstantial incentives for preserving the system's advantages. Moregenerally, the effects of financial liberalization over the last decades

have been enormous. The process of change will continue, both because

KENJI KOJIMA

40

of continuing liberalization and because some financial patterns change
sluggishly. Increasing financiaj sophjsticatjon and ability to exploit

opportunities arising from regulatory changes will also continue toalter corporate financial practices for some time to come. It isreasonable to expect that the role of offshore financing will not decline.

Untangling the web of domestic regulations, traditional practices, andconflicting interests of various financial constituencies will take time.

During that period, offshore financing will probably growsubstantially; and we will continue to observe arbitrage situations
bring about market efficiency.
Financial liberalization tends to undermine the main bank systembecause major non-finaneial firms have greater access to market debt
as well as borrowing frorn foreign financial institutions. This makes it

potentially much more difficult for the main bank to monitor andcontrol clients' behavior. Consequently, the key to an effective mainbank system under these circumstances seems to be an enforceableagreement or mechanism which restricts the access of heavy borrowers
to alternative debt sources. If this condition can be satisfied, the mainbank system should continue to be viable and advantageous for firms
which need strong bank support.

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Ramseyer, J. M. (1994), "Explicit Reasons for Implicit Contracts: The Legal Logic to

the Japanese Main Bank System," mimeo, in M. Aoki and H. Patrick, ed.,The Japanese Main Banh Systern: Its Relevance for Developing andTransforming Econornies, Oxford University Press, 231-257.
Roe, M. J. (1993), "Sorne Differences in Corporate Structure in Germany, Japan, andAmerica," Yale Law Journal, 102, 1927-2003.

Sheard, P. (1985), "Main Banks and Structural Adjustment in Japan," Pacific
Econornic Paper,Australian National University.
Sheard, P. (1989), "The Main Bank System and Corporate Monitoring and Control inJapan," Joumal of Economic Behavior and Organization, 11, 399-422.
Sheard, P. (1992), "The Role of the Japanese Main Bank When Borrowing Firms are

in Financial Distress," discussion paper, Center for Economic Policy
Research, Stanford University.

41

KENJI KOJIMA

42

Stiglitz, J. E. (19as), "Credit Markets and the Control of Capital," Journal of Money,

Credit,and Banhing, 17, 133-152.
Tokyo Stock Exchange (1oo3), Annual Securities Statistics.

Zenkoku Shoken Torihikisho Kyogikai (The National Conference of Stock Exchanges)(1983, 1986, 1992), Kabushihi Bunpu Jyohyochosa (Survey on Stock
Distribution).

Structural Adjustment and Economic GrowthWith Comparisons to Indonesia

in Mexico:

Robert K. McCleeryi

Those who do not rernember the past are
Descartes. lt-condemned to repeat

1. Introduction

In the month of December, 19st, Mexico experienced a financial
crisis that rocked not just the country, but the entire hemisphere,
including the United States. The value of the new peso fell from 5 tonearly 7.8 to the dollar. Foreign exchange reserves reached criticallevels, down from nearly $26 billion in the first quarter of 1994.

Growth of the Gross Domestic Product (GDP), which had been
forecast at four to five percent in 1995, will now be negative in 1995, asa new round of import restrictions, interest rate hikes, and public
spending cuts are imposed to try to stabilize the economy.
The tragic part of the scenario is that this crisis is so similar to

the many that have come before, despite changing international
circumstances. Notwithstanding the significant trade liberalizations thatwere undertaken in the late 1980, effective deregulation andprivatization campaigns, and the signing of NAFTA, exchange rate
overvaluation and destabilizing capital inflows led to capital flight,

balance of payments crisis, and macroeconomic collapse. The elusive
pursuit of growth with macroeconomic stability had clearly failed once
agaln.

This paper is an attempt to identify and prioritize the reasons for

Mexico's macroeconomic instability and projected negative growth rate
for 1995 as well as past disappointments, in contrast to the apparently
more effective and beneficial stabilization efforts in Asia. Particularly

in Indonesia, a country that has many similarities to Mexico,
1 Associate Professor, RIEB, Kobe University. Helpful comments from Michelle
Matel and Neantro Saavedra-Rivano are gratefully acknowledged.

44

ROBERT K.MCCLEERY

stabilization efforts seem to have been more effective in rapidly
reducing inflation and reestablishing macroeconomic balance. The
stabilization achieved seems to have been more beneficial in terms of'higher rates of GNP growth, increased wages and consumption levels,and rates of increase in total investment (foreign and domestic). And

the stabilization, once achieved, has been maintained; Indonesia has
now enjoyed a decade of stability, in contrast to repeated requirements
for stabilization and austerity in Mexico.

Several factors will be considered as being responsible for thedifference in the experiences of these two important countries.

Economic reconditions will be examined. Did the difference inperformance during and after the periods of stabilization Iie in the

difference in levels of development, structure of production,
employment, or trade, or economic institutions? To address thispossibility, a brief historical background of the Mexican economy ispresented in section 2.1, the crucial choice made in Mexico in 1970 and
its implications for the problems of the 1980s is discussed in section 2.2,

and some comparisons to Indonesia's experience follows in seetion 2.3.

Alternatively,iteouldbethatthepttesin nd l tato of"stabilization olicies" differed substantially in the two instances. In
addition to the policies themselves, covered in sections 3.1 (1982-88) and3.4 (1988-94), included in this broad category of factors is theintangible "commitment to liberalization" as it relates to the proper
sequencing of reforms (section 3.2) and business/government relations
and stabilization (section 3.3). A third possibility is that the two
economiesmayhaveexperienceddjd!ig!:s}nL!gspgpsgslg-silpi!Q!ms!ill}!!!ifft t 1t1

ustnd mcentives accounting for the subsequent differences in
performance. Part of this difference may lie in different externalsituations, and Mexico's participation in NAFTA is an obvious example.
Section 4.1 considers the differences in the international context of thedifferent stabilization periods and the nature and magnitude ofexogenous shocks, with NAFTA given special treatment in section 4.2.

The two countries are examined in the context of the economic
performance of a larger group of developing countries in section 4.3. A

fourth possibility not explicitly dealt with in this paper is thatdifferences in political systems and institutions explain the differences

in both the stabilization periods and their macroeconomic impact.
Conclusions are presented in section five, along with some implication

Structural Adjustment and Economic Growth in Mexico: 45
With Comparisons to Indonesiaof the current Mexican crisis for other developing countries.

2. Economic Preconditions'

2.1 Historical Background--The Mexican Econorny to 1970
Mexico's economic history is characterized by boom and bust, andthe recent economic and political turbulence is nothing new. After the
Mexican revolution in 1910, the economy stagnated until the start of thesecond world war. The revolution itself was a response to a period of
rapid economic growth, but of the wrong kind, growth with increasing
inequality and political repression. From 1940 to 1970 came the period

now known as the "Mexican economic miracle."2 This period can befurther decomposed into a "take-off" phase from 1940-54 and a periodof stable growth from 1954-70. As shown in table 1, the first period
was characterized by nearly 6 percent annual gross domestic product(GDP) growth, moderate inflation, a modest fiscal surplus, and amanageable current account deficit. The combination of rapid growth
and the settlement of a number of claims from the nationalization of
the assets of foreign oil companies reduced the debt/GDP ratio fromover 40 percent to the modest 11.3 percent shown in table 1. Growth

was motivated by a combination of infrastructure investments(especially in power generation and transmission and irrigation) andprivate sector dynamism.
The period from 1954-70 was even more remarkable, in that therate of GDP growth increased to 6.8 percent, while average annua}
inflation dropped to under 5 percent. The only danger signs apparent in
the macroeconomic figures were the shift of the public sector balance
into deficit and the mounting increase in the current account deficit.
Even at the new, higher level, the foreign resources required to support

the rapid growth rates were modest, and the external debt grew atroughly the same rate as GDP, keeping the ratio constant. However,three more insidious problems were developing in the Mexican economy
during that time. The nominal exchange rate was pegged at 12.5 pesos
to the dollar over the entire period; thus, part of the increase in thecurrent account deficit was a result of a creeping overvaluation of thepeso. More fundamentally, the limits of the so--called first stage of'2 For details of this period, see Reynolds 1970.

46

ROBERT K. MCCLEERY

import substitution were reached by 1970. The choice was then whether
to advance from the production of fairly simple consumer goods undertariffs for the home market to either production of the same goods forthe world market (the choice being made at about the same time by
Korea and Taiwan) or to move into the second, more difficult stage ofimport substitution, the production of more sophisticated intermediate

and capital goods. Mexico chose the latter option. The third problem,
which is common to the import substituting industrialization (ISI)development model, was that the quality of domestic manufactures was
low and prices were high, by international standards. While thesefactors (among a wealth of other nationalistic and populist reasons)may have been seen as reasons to continue ISI rather than attempt topenetrate developed country markets, the movement into moreadvanced intermediate products and capital goods in the ISI model
exacerbates the problems of high cost and low quality. For jnstance, if

domestic steel is high cost and domestic machine tools are of low
quality, any product made with those inputs will be high cost and low
quality.

Another crucial problem with the ISI growth model is that theovervalued exchange rate distorts the relative prices of labor andimported capital goods. This problem is often intensified by government
regulation of the labor market in an attempt to protect workers, in theform of hjgh minimum wages and protection against lay-offs. In 1970,
it was apparent that Mexico's private sector could not possibly employ
the new labor force entrants, much less absorb the estimated 20 to 40

percent underemployment in agriculture and traditional services. To

make matters worse, population growth in predominantly Roman
Catholic Mexico during the 1960-70 period averaged 3.3 percent, so it
was clear that the labor force would be growing by at least that ratein the next decade. Yet another problem was that growth wasworsening the distrjbution of income, leading to student unrest andrumblings among certain factions within the PRI. Reynolds summarizes
ag follows: "Apparent successes of the economy during the `stabilizing
development' of the 1960s caused the deferral of difficult solutions tounderlying fiscal, financial and social problems. (Mexican President)
Echeverria's `shared development' policies heightened the instability ofthe economy by avoiding tax reforms, postponing inevitable peso
devaluation and failing to implement measures to reduce social

Structural Adjustment and Economic Growth in Mexico: 47
With Comparisons to Indonesia

inequalities."3 The flaws and instabilities of the earlier "development

models" must be acknowledged by internal and external critics of theeconomic performance in recent years.
2.2 1970: The Choice
At this critical juncture, Mexican policymakers were faced with achoice. They could have attempted to broaden participatien in economic
growth through liberalization, deregulation, and trade policy reforms,
but these were seen as increasing their dependence on the international
system (in particular, the United States) for trade and investment
linkages; however, the sentiment of academics and populists was tomove in the other direction. Political considerations argued for quick
action, not a slow improvement through "trickle down" that might notboost the economic well-being of key factions within the PRI in time
for the 1976 presidential elections.

A three part economic program was put in place over the next
twelve years that served to magnify rather than reduce the structuralproblems in the Mexican economy. The first part was the decision tomove into the next stage of ISI, raising tariffs on basic manufactures
such as steel, cement, and capital goods. Secondly, as in India, thestate took responsibility for the "commanding heights" of the economy,

leading to a massive expansion in the government payroll, in partthrough the development of many state-owned enterprises (SOE). The
third pillar of the economic program was the sharp restrictions on new
foreign investments (and indeed all private investment) embodied in the

Law to Promote Mexican Investrnent and to Regulate Foreign
Investment of May, 1973. In addition to restricting foreign ownership to49 percent of equity, all private investment was banned from certain
economic activities (oil, petrochemicals, some mining activities, sometransportation and communication areas) and foreign investors were
further restricted from participating in forestry, other transportationand communication fields, and gas distribution.` These policies, and thenationalist and statist rhetoric used to justify and support them, served

to make the private sector highly suspicious of the motives ofgovernment, and intensified the mistrust of pursuit of profits in generaland foreign investment in particular as agents of economic growth.
3 Reynolds (1978), p.1005.
4 For more details, see Whiting (1992).

K. MCCLEERYROBERT

48

This mutual mistrust, escalated by the nationalization of the banks andthe forced conversion of Mexican dollar-denominated accounts into
pesos at ruinous exchange rates5, seriously hampered the stabilization

efforts themselves and delayed the subsequent return to growth.
These policies had a number of unfortunate consequences, although
they apparently accomplished the short-term goal of continued politicalstability under the PRI rule. For instance, the political benefits of

having many more people directly dependent on the government for

their livelihood came at a large economic cost: a burgeoning
government deficit that rosie from 2-percent of GDP in 1969 to 16.9
percent in 1981 (see table 1). Also, the apparent increase in sovereignty

from lower foreign investment was more than offset my the ballooning
foreign debt, which grew from less than $5 billion to nearly $60
billion. Growth was maintained at 6 percent per annum, but at theexpense of stability, with both inflation and peso devaluation runningat about 20 percent per year. This does not mean that the realexchange rate was constant, however. Large devaluations in 1976 and1982 meant that the peso was subject to wide swings of over andundervaluation. Each large devaluation heralded the end of a period ofcurrent account crisis and macroeconomic imbalance.' The first
Table 1
Growth and Stabitity of the Mexican Economy, 1940-1991
Macroeconomic variables Take-off Stable Growth Unstable Populism Stabilization Stability?

1940-1954 1954-1970 1970-1982 1982-1989 1989-1991

Real GDP growth rate 5.8 6.8 6.2 O.6 4.0
Inflation

averageperiodend10.5
10.84.7
4.419.8
61.2 74.5
26.5 25.1
17.5

Public Deficit/GDP

average-1.4'
11.7
periodend
1.21.22.07.6
16.9
5.53.7
1.5

Peso-Dollar exchange rate

period end 12.5 12.5 148.5 2681.0 31oo.O

average annual depreciation 6.2 O.O 22.9 51.2 5.0
Source: Adapted from OECD 1992,p.14.
1 Federal only until the 1960s. Minus sign indicates surplus.

5 These 1982 policy actions are discussed in more detail in

the following section.

Structural Adjustment and Economic Growth in Mexico: 49
With Comparisons to Indonesia

prompted incoming president Lopez Portillo to adopt an International

Monetary Fund (IMF) program of stabilization and austerity.
However, the large oil finds in the Gulf of Mexico led to an abandoningof the plan and an intensification of the state-led ISI development plan.
Foreign borrowing against future oil revenues (on the assumption ofever higher prices) fueled massive government spending programs and8 percent average GDP growth.
When real interest rates moved strongly positive, after being
negative in much of the 1970s, and oil prices weakened, a possible crisis

was perceived. Strong action was called for, including immediate
devaluation and other measures to restore the confidence of investors
and wealth holders in the economy, combined with spending reductions

and interest rate hikes to slow the overheated economy. Yet thePortillo administration was loath to take such unpopular measures in
the last months of its rule, and took a desperate gamble that it could
hold out until the change of administrations in December of 1982.
Because everyone knew the actions that ultimately had to be taken,
even though policymakers were reluctant to take those action forpolitical reasons, capital flight quickly stripped the country of its
foreign exchange reserves. By late 1981, the overvaluation of theexchange rate was so acute that: (1) oil constituted about threefourths of exports; (2) virtually all of the $20 billion in new borrowingthat year left the country as capital flight; (3) in combination withgovernment controlled prices, the incentives to produce agricultural
products were so distorted that Mexico had to import $8 billion worthof grains, in contrast to surpluses in the 1970s; and (4) the protected
and heavily regulated auto industry alone accounted for about half of
the $4.9 billion trade deficit, despite a 1977 decree that exports andimports must balance for each firm in the industry.
In December of 1981, responsibility for econornic management wastransferred from the politicians to the technocrats. At this point, thesituation was critical, with perhaps as little as three weeks of reserves

remaining.6 The technocrats made the correct economic move, but
without fully understanding the politics of the situation. They elected todevalue by more than 40 percent in January, reasoning that since the30 percent overvaluation of the peso was responsible for the capital
6 Based on private conversations with Jaime Serra-Puche, former Secretary ofCommerce and Finance under President Salinas.

se

ROBERT K. MCCLEERY

flight, then the "extra" ten percent devaluation would trigger an
immediate return flow of capital to Mexico. The failure of the "megadevaluation" to restore stability, confidence, and thus reverse the flowof flight capital is one key to understanding the subsequent policy
responses and economic problems.

'

2.3 The Contrasting Historical Background of lndonesia
Modern economic history in Indonesja dates from the ascendanee
to power of President Suharto and the "New Order" government. The
last years of President Sukarno, in the mid-1960s, were marred by highinflation, stagnation in GDP and exports, and ethnic violence under theguise of suppressing communist insurgency. Thus the initial phase of
the Suharto rule was as much an exercise in national building as instabilization and economic reform.
By 1970, macroeconomic stability had been achieved and growth
was starting. Although inflation averaged 17 percent per annum in thedecade of the 1970s, this was stable relative to the turbulent 1960s. GDP

growth averaged 7.6 percent, and industrial production averaged awhopping 12 percent, significantly exceeded only by South Korea.
Positive DFI flows returned, particularly in the oil sector.

Considerable structural change accompanied this rapid growth. The
agricultural sector declined in relative terms, even though yields
increased. From 55 percent of the labor force in 1970, agriculture
employed less than one-third of the labor force in 1980. Export growth
exceeded output growth, with both being spurred by huge increases inoil prices and modest increases in production and export levels.

In comparing Indonesia and Mexico in 1980, two importantsimilarities and two crucial differences should be noted. Both countries

were highly reliant on oil revenues in total exports, production, andgovernment revenues. In fact, the fraction of oil in total exports, GDP,and government revenues was somewhat higher in Indonesia, despite
the complete government control of the petroleum sector in Mexico, in.contrast to the significant role of multinationals in Indonesia. The
second clear similarity is the strategic importance of each in theirrespective geopolitical regions. In addition to bein.g "safe" suppliers ofoil to the United States and Japan, at least relative to the Middle East,

Indonesia controls the Straights of Malacca, a crucial trade route forJapan and East Asia, while Mexico shares the longest land borderStructural Adjustment and Economic Growth in Mexico: 51
With Comparisons to Indonesia
between countries at'very different levels of development. Economic andpolitical stability in those two countries thus carries important
collateral benefits to the United States and Japan.

The most important differences were in the overall level ofdevelopment, and the structure of production, particularly thedevelopment of the manufacturing sector. At market exchange rates,
Mexico's GDP per capita was more than 6 times Indonesia's level, andthe difference narrows only to 4-1 when looking at purchasing power
parity figures for 1990.7 As mentioned above, Mexico had largely

exhausted the "simple" economic gains from absorbing surplus
agricultural labor into import substituting manufacturing of simple

consumer goods by 1970. In 1980, Indonesia was still enjoying
productivity gains from transferring labor from lower productivity
agricultural work into first stage import substitution, and the reduced

growth rates of manufacturing output observed in Indonesia were morea function of growing domestic monopolies, protected by trade andinvestment regulations.S In addition to the large oil sector, othernatural resources are important in Indonesia's production and export
pattern, including wood and wood products, rubber, coffee, and someminerals. Thus the manufacturing sector still constituted less than 15
percent of GDP in 1980, despite the rapid growth in the 1970s. Mexico's
manufacturing sector was larger in both absolute and relative terms,

and produced a wider range of products, including more capitalintensive and technologically sophisticated goods.

Although the Indonesian economy was •fairly open, m'easured bytrade as a share of GDP, the manufacturing sector in particular was
rife with tariff and non-tariff barriers and restrictions on both
domestic and foreign investment. This system of protection andregulation was firmly entrenched, with the institutions and departments
administrating the programs protective of the power and opportunities

for rent-seeking available under the system. Furthermore, it seemed
difficult or even counter-productive to battle these entrenched interests
piecemeal, since, for instance, large distortions in financial systems, tax

system, exchange rates, investment, and trade made the welfare

7 Computed from data in OECD (1992), McCleery (1991 and 1992a), IMF (1so4 and1995), and the World Bank (1994).
8 Barichello and Flatters (1991).

52 ROBERT K. MCCLEERY
implications of any given reform uncertain.g

In terms of political system, the stability brought by the Suharto
regime, balancing military, industrial, and religious factions, prevented

the political-economy cycles observed in Mexico. Yet it complicated thestructural adjustment process, as the privileges of key elements of thecoalition had to be preserved, at least in the short run.

Indonesia's status as a low income developing country and its
strategic importance combined to give it access to concessional
financing. As a former Dutch Colony supplying oil to East Asia
produced by American and other multinationals, it was in a special
position with regards to international donor agencies. Mexico had nosuch opportunities; its borrowing was largely from commercial banks
at market rates of interest. In fact, once the crisis began in late 1991,

what commercial loans that were available were short term and at a
substantial premium over the London Inter-Bank Offer Rate.

3. Designing and tmplementing the Reforms

3.1 Stabilization Policies: 1982-88 .

The reaction in Mexico to the mega-devaluation in January of 1982
can best be described as panic. In part because of the poor business-government relations, the devaluation did not trigger a return ofcapital flight; i't led instead to a crisjs of confidence, continued capitalflight, and a moratorium on the repayment of the public sector's
foreign debt in August 1982. Inflation rose from 20 percent in 1981 toover 100 percent per year, annualized, by the end of 1982.
In response to the unexpected deterioration of the situation, theeconomic technocrats were once again discounted. Two importantmoves were made, for prjmarjly politica] reasons, with further
alienated and disquieted private business and private investment. First,
all private banks were nationalized, in an emotional speech that laid theblame for capital flight, devaluation, and assorted other economic ill

squarely at the feet of the "greedy" bankers. Secondly, in August adual exchange rate system was introduced; a preferential rate wasused for offjcial transactions (government imports and debt service),while private business had to import raw materials, intermediate goods,
9 Devarajan and Lewis (1991).

Structural Adjustment and Economic Growth in Mexico: 53
With Comparisons to Indonesia

and capital goods at•the more expensive, "market" rate. At the sametime, the government took the rather short-sighted measure of freezing
all "Mex-dollar" holdings and converting them to pesos at the official
exchange rate.'" Thus forced conversion effectively taxed asset holders
who had not engaged in capital flight, and forced them to hold dollars
abroad if they were afraid of further currency risk. A third move,
motivated by both political mistrust and the severe current accountproblems, was the introduction of many new quantitative restrictions
on foreign trade. One result of these policies was further devaluation
until rates were controlled in September, 1982. The peso fell from 26 tomore than 100 to the dollar in less than 12 months.

The stabilization plan introduced by the incoming de la Madrid
administration was called the "Immediate Program for Economic Reordering" or PIRE. Its aims were to correct the massive fiscal andcurrent account imbalances and reduce the runaway inflation rate. Two
important instruments in this correction were the official exchange

rate, which was devalued by 90 percent in 1983, and administeredpriees, which had not been raised in years, despite rapid inflation (seesection 3.5 under privatization for a detailed discussion of the affects ofadjusting administered prices). The two greatest accomplishments of

the 1982-83 period were both related to austerity and adjustment,
rather than stabilization. Austerity and adjustment were evident in the
sharp reduction of the public sector deficit and the shift of the current
account balance from large deficit to Iarge surplus, a turnaround of 8

percent of GDP, through a combination of aggregate demand reduction
and direct import restriction. These measures imposed large costs on
the economy, especially workers. GDP contracted by 4 percent andunemployment rose, but the largest adjustment was borne by the real
wage, which fell nearly 40 percent.

The continuing austerity appeared to be paying off in 1984.
Inflation fell to 60 percent and real GDP growth was 3 percent. The
only major disappointment was the failure to continue the deficit
reduction begun in 1983; the budget deficit remained over 8 percent ofGDP, well above the target level of under 6 percent. In 1985, the public

deficit and inflation both began to worsen, the IMF support programtt
10 Mex-dollars were holdings in dollar-denominated accounts in Mexico that hadprovided Mexican nationals with a way to hedge against the risk of devaluation
without engaging in capital flight.

54 ROBERT K. MCCLEERY
lapsed, and the result was another crisis of confidence and financial
market panic. It appears that the problems of capital flight, peso
devaluation, and loss of reserves were already surfacing before thedestructive earthquake that rocked Mexico City in September of 1985
(see section 3 for details). Mexican policymakers at the time spoke ofthe "inertia" of inflation, the difficulty in purging the inflationary

expectations of the people. As a result of these problems, Mexico djd
not come close to meeting its PIRE targets for inflation reduction,
deficit cutting, or real GDP growth (see table 2). .

The start of 1986 brought more bad news. Oil prices, which had
been weakening since 1982, dropped sharply in 1986. Mexico, which had
insulated itself somewhat from earlier price reductions with longerterm contracts, found the average price it received for oil down 50
percent in 1986, costing the country about $8 billion, or 4 percent of

GDP and about 13 percent of government revenues."
Once again, Mexico proved better at implementing austerity thanstabilization. Reestablishing external balance required a contraction inreal GDP of 3.8 percent, while inflation increased to over 100 percent
for the second time in four years. The only positive result that may

have arisen from the oil price fall and recession in the Mexican
Table 2
PIRE Targets and Actual Performance, 1983-85.
1982

1983

1984

19as

o.o
-4.2

3.0
3.7

6.0

-O.6

55
82

30
59

18

99

Real GDP Growth (percent)Plan
infA18IiU'oa: (cpi change, December year on year)

Plan
ActualCurrent Account (percent of GDP)

Plan

'

Actual

2.6

M

-2.2

-1.8

-1.2

-2.7

5.4

4.2

1.2

-8.5
-8.6

-5.5

-3.5

-16.9

8.5

-9.6

Public Sector Balance (percent of GDP)

Plan •

Actual 'Sources and Notes: From OECD 1992 and Lustig 1992. PIRE targets reflect joint
forecasts by the Mexican government and the IMF, which contributed $3.7 billion
during the period.
''

11 OECD (1992), p.31.

Structural Adjustment and Economic Growth in Mexico: 55
With Comparisons to Indonesia
economy is that everyone, inside Mexico and abroad, now realized thatthe country faced not a "liquidity crisis" but a structural one. If thatrealization had come in 1985, it is possible that the disastrous
relaxation of stabilization measures in response to improving economic
conditions would not have taken place.'2 One example of this realizationis the acceleration of progress on debt relief through the "Baker Plan."

The negotiations resulted in about $10 billion in new money, andadditional rescheduling and interest rate reductions on other debt, but

did not alter the basic fact that some6 percent of Mexico's GDP wasbeing transferred abroad each year. Other indications include Mexico's
entry into the GATT, and in fact, the ambitious reform efforts begun
in 1987-88 and discussed in section 2.4 below.

In 1987, Mexico saw a return to a modest rate of real GDP growth,
but little progress in reducing inflation. In fact, nominal interest rates

rose in 1987, indicating that the high inflation surprised no one, unlike

1986. By 1987, the official position in Mexico was that "conventional"
stabilization policies had not been effective over a five year period.
Technocrats decided that the problem was the conventional wisdom on
the sequencing of reforms. Pedro Aspe, Minister of Finance of Mexico
under President Salinas, stated the case as follows: "...countries that
carefully followed these (conventional stabilization) measures usuallycame up against great costs in terms of output, with little or no
success in price stability....The eonceptualization and implementation ofthese types of programs (heterodox stabilization plans adding micro
adjustments in the form of trade liberalization and "income policies" toconventional fiscal and monetary controls) stem from the idea that
although monetary and fiscal adjustments are necessary conditions forstabilization, these are not sufficient."'3 These ideas comprise theprimary difference between the Pact of Stability and Economic Growth(PECE or Pacto in Spanish), begun by de la Madrid in 1987 andaccelerated by President Salinas in 1988, and the earlier PIRE. Before

covering that period's policies and performance, an examination ofIndonesia's reform process and some relevant theory is appropriate.

12

Of course, another interpretation of events that cannot be completely discredited isthat without the shocks of 19es and 1986 Mexico could have gotten away with oreven speeded up the return to growth with the relaxation of controls in 1985.
13

Aspe (1992), pp.320-328.

56

ROBERT K. MCCLEERY

3.2 Stabilization and Reform in lndonesia 1983-86: A Contrast

Several strong contrasts can be drawn between the early Mexicanand Indonesian reforms that followed. However, it should first beemphasized that the basic thrust of the reforms was the same in bothcountries: (1) To reduce public spending and decrease the dependenceon oil in total tax revenues; (2) To stimulate non-oil exports throughtrade policy reforms; (3) Take any other necessary and appropriate
measures to stabilize consumer prices and the exchange rate in hopesof restoring domestic and foreign investment.
The differences between the referm policies can be summarized asfollows:(1) "The most remarkable aspect of Indonesia's policy response to theoil erisis is that it was undertaken voluntarily, quickly, and in abalanced fashion."'` In contrast, Mexico's reforms were imposed, tosome extent, by international lenders through the IMF, postponed for
as long as possible to try to make someone else take or share theblame, and designed without direct regard for distributional
considerations. Partly as a result of these differences, particularly in

the greater commitment to reform that comes from designing thereforms one's self, Indonesia's reforms were inherently moresustainable.

(2) Further aspects of the timing of reforms are that a domestic
consensus can be reached and consistent signals can be sent if thereforms are not rushed into the breach in the midst of crisis. For
instance, every liberalization in Mexico in the 1983-87 period followed acrack-down; trade liberalization in 1985-87 followed tighter importcontrols in 1982-83, financial liberalization followed the banknationalization of 1982 etc.

'
(3) Tighter coordination of reforms took place in Indonesia, both
among agencies and ministries in government and across policies. For
instance, the two most successful trade policy reform packages inIndonesia, announced in April 1985 and May 1986, transferred
responsibilities for tariff setting and other administrative functions

away from the regulating agency to a new deregulation agency, sinceregulators have proven to be poor deregulators.'5 Seeondly, close
coordination was maintained between technocrats and administrators
14 Thorbecke (1991).
15 Barichello and Flatters (1se1), pp.280, 284, and 290.

Structural Adjustment and Economic Growth in Mexico: 57
With Comparisons to Indonesia

responsible for taxation policy reforms, financial market liberalization,and trade policy reforms in Indonesia. No such policy coordination wasevident in the Mexican case, and the implicit cornpetition among
Secretaries of Finance, Trade, Budget, etc. for the next presidential

nomination makes such coordination and cooperation politicallydifficult.

(4) The importance of this point is debateable, but much less genuine
trade liberalization took place in Indonesia, compared to Mexico. The
reform of the customs service, the shift from non-tariff to tariff

protection, and the devaluation all were important factors in
stimulating exports and allowing exporters to operate in a near-freetrade environment, but none of these measures reduced the level of
effective protection in Indonesian industry. One possible argument isthat Mexico's rapid trade liberalization may have hampered its
adjustment in the short run, necessitating sophisticated adjustmentsthat its private sector, already overwhelmed with external shocks andfluctuating relative prices, could not handle. A second possibility is thatIndonesia, being at a lower level in terms of the development andsophistication of domestic industry, needed further protection for mostof its manufacturing firms; the time had not yet come for significant
trade liberalization. Fifteen years later, trade liberalization under

AFTA and APEC may be appropriate in sustaining growth withstability into the next century.

3.3 Digression on the Ordering of Reforrns
Few serious economic analyses have been conducted on the optimal
sequencing of economic reforms.'6 Many feel that the sequencing iscountry dependent; others believe that political considerations dominate

economic efficiency arguments such that governments should do asmuch as they can, when they can. One piece of "conventional wisdom"that has developed is that macroeconomic stabilization should precede
microeconomic adjustment, such as trade liberalization. "In countries

with acute macroeconomic problems, structural reforms designed toincrease efficiency and restore growth, whose own efficiency depends
on a predictable macroeconomic situation, should be initiated only
when sufficient progress has been rnade in reducing the macroeconomic
16 One exception, though semewhat dated now, is Mussa (1986).

ss ROBERT K. MCCLEERY
imbalances...The importance of this sequence--first reforms oriented
mainly towards reducing severe macroeconomic imbalances and thenreforms aimed at improving the allocation of resources and the restoration of growth--has become increasingly clear with experience."" Butin many recent cases, including Mexico since 1987, Bolivia since 1985,
Poland since 1990, Argentina since 1991, and Israel, this advice was notfollowed.'S Trade iiberalization accompanied stabilization in each ofthese cases, and fo!lowed the early stages of stabilization in Indonesia
in 1985-87.

The conventional wisdom relies on three primary arguments. It is
generally accepted that trade liberalization is particularly difficult intimes of crisis, since increased imports always precede jncreased
exports, worsening the current account deficit, and the loss of tariff

revenues would also hurt government revenues, as most developing
country governments are heavily dependent on indirect tax revenues.
Second, high inflation generally means highly variable relative prices,and "getting prices right" is extremely difficult in such an environment;

thus the benefits from increased allocative efficiency through thecorrecting of microeconomic distortions are seen as quite limited.
Thirdly, trade liberalization generally requires a sharp devaluation, inpart, due to the balance of payments considerations mentioned above,
and also because wages are sticky, so real wages can only be adjusted
quickly through the exchange rate, which can be inflationary.'9

On closer inspection, the arguments seem rather weak, andcounterarguments can be made in support of simultaneous or near

simultaneous microeconomic reform along with macroeconomic
stabilization. Taking the arguments one at a time, we know thattariffication of NTBs can sharply raise revenues, as can eliminating
loopholes, increasing transparency, and reformjng the customs service20.

Lower tariff rates and tightened customs procedures reduce the17 Corbo and Fischer (1992), p.7.

18 Enumerated in Rodrik (1se3b), and Aspe (l992), op.cit. The excellent paper by
Rodrik makes many of the same points introduced below in detailed and wellsupported fashion.
19 For more detailed discussions of the above ideas, particularly using the nominal
exchange rate as an anchor for reducing inflation, see Sachs (1987), and Edwards(1992).

20 Note the extreme case of Indonesia's experience with trade liberalizationaccomplished along with a shift to the Swiss firm SGS handing customs, discussed

in Barichello and 'Flatters (1991). •Structural Adjustment and Economic Growth in Mexico: 59
With Comparisons to Indonesia

incentives and ability to smuggle, so duties may be collected on goods

that had entered illegally in the past. Overall, considering also thelikely increase in trade levels, tariff collections are as likely to rise as

to fall; this ambiguity is confirmed in empirical work.2i

The second argument, while correctly pointing out that the benefitsof trade liberalization may be less in the absence of macroeconomic
stability, does not imply any direct cost to such liberalization. Indeed,

two arguments can be made to support not waiting for macroeconomic
stability. On purely economic grounds, once the decision has been madeto liberalize, any delay in proceeding merely continues the misallocationof resources, if any new investment is taking place. The longer it takes

to "stop the bleeding" of resources to inefficient sectors, the morecostly is the subsequent adjustment.22 In a political economy sense,
often the government will have more resolve and independence frominterest groups in times of crisis, thus being able to push through morecomprehensive and deeper reforms than would be possible once
macroeconomic stability is achieved.
The third argument is more difficult to refute. "The problem arises
here from the constraint that the exchange-rate can be used in onlyoRe of two ways: either as an instrument to achieve a real target (thetrade balance or employment), or as a nominal anchor for thedomestic price levei...."23 In fact, theory tells us that both are possible;

either an initial mega-devaluation or a crawling peg could make export
competitiveness consistent w'ith an anchor against high inflation.2' Yet
once again the key is the credibility of the government commitlnent to
the peg or crawling peg.25 As I argue elsewhere, it is possible to do
everything "right" and fail; if you do not have sufficient credibility, thepessimism of private sector and foreign actors will be self-fulfi}ling and
21 Greenway and Milner (1991), pp.sc-132.

22 This is not necessarily an argument for a "big bang" liberalization. If thegovernment is credible, it can stem the rnisallocation of resources (except for thehighest yielding, short-term projects) by announcing a comprehensive
liberalization plan and sticking to it.

23 Rodrik (1993b), p.3, author's emphasis.
24 For a detailed argurnent on the conisistency of a sliding or crawling peg andreducing inflation, see Krueger 1978. An opposing view is taken by Kenen 1992.
25 Rodrik (1993b) both recognizes this fact, saying "Therefore a cornmitment to apegged exchange rate can, if credible, actually solve rather than intensify thepotential conflict between trade liberalization and exchange-rate stability. " (page6, emphasis added) and goes beyond it to consider ""'a crucial question: how'does early trade liberalization affect the credibility of the disinflation itself?"(page 24), but no general conclusions can be reached.

K. MCCLEERYROBERT60

the reforms will at best lead to stabilization or growth, but not both.

What do the above arguments mean for Mexico's attempt toliberalize trade and simultaneously reduce inflation? More evidence will

be introduced before conclusions are drawn regarding the specifics ofthe Mexican case, but on a theoretical basis, heterodox stabilization
was no less likely to succeed. For one thing, policy makers were muchhappier with this set of reforms, compared to those pushed by the IMF
in 1982-86, and this acceptance alone can translate into more effective

and sustainable reform. Indeed, eombining stabilization and tradeliberalization in some ways increases both the potential gains ofsuccessful stabilization and the potential risks to failure. In fact, once

you have "doubled your bets," the credibility of government
policymakers may increase, as the costs of abandoning the programrise.

3.4 lntangibles--Business/Government Relations and the Credibility of

Reforms

Why weren't the commitments to reform by the Mexican
government believed by the private sector? Credibility is criticallyimportant in areas like investment, where profitability depends on anumber of assumptions about the time paths of economic variables likewages, prices, and interest rates. Furthermore, the inflation demon ismuch more diffjcult to exorcjse when inflationary expectations are
firmly rooted in the actions of the private sector. Rudiger Dornbuschraises some of these questions in a paper on the post-stabilization
capital repatriation problem.26 Consider the decision facing investors

who pulled out of Mexico before or during an economic crisis. They
must choose between reinvesting in Mexico (which, in this simple
model, earns them either return rg or rb corresponding to good and bad
outcomes of the stabilization process) or taking the safe return of r'

in the United States. Although each individual investor takes theprobability q of instability persisting in the next period as exogenous,

the probability may depend crucially on the amount of returninvestment that takes place, in aggregate. Thus, if investors in Mexico
were more pessimistic than investors in Indonesia, after their respective
stabilization plans (one reason would be if the Indonesian government
26 Dornbusch (1990), pp.143-147.

Structural Adjustment and Economic Growth in Mexico: 61
With Comparisons to Indonesia

was seen as more'committed to and/or better able to ensure
macroeconomic stability), a larger premium (r"-r') would be required
to stimulate capital inflows in Mexico. Dornbusch suggests that there

may be two equilibriums, one where pessimism leads to failure andanother where optimism leads to success.
Going beyond the Dornbusch model, we see additional problems in
the case of Mexico. Remember that real interest rates are only visible
ex-post. Suppose, after a year of 100 percent inflation, that Mexico

announces that nominal interest rates on treasury bills for thefollowing year will be 70 percent, which will be a 10 percent real return,since inflation will fall to 60 percent. This is quite a risky proposition,

since much depends on the credibility of the government to act in its
long term interest. In the short term, it would be better to extract an
inflation tax from government bondholders by allowing inflation tostay high. Only the fact that these negotiations will have to be repeatedover and over again during and after the crisis give the government an
incentive to be credible. Thus, stable, long-term governments have a big
advantage in terms of credibility relative to unstable governments orgovernments that are facing elections.
Finally, consider that the discussion above pictures only one half ofthe government's problem. What are called "investors" above are bond-holders; what about those considering investment in plant andequipment? They want: (1) macroeconomic stability, which reduces therisk associated with long-term investments (and makes productive
investments more attractive relative to rent-seeking or inflation hedges
like gold) for risk-averse investors and (2) low real interest rates, sothat they can raise funds in capital markets and still make a profit.
Abstracting from international capital markets, which were closed to
the Mexican private sector for most of the decade of the 1980s, thesecond point brings investors in plant and equipment solidly in conflictwith the interests of the bond-holders, since they have to compete withthe government for limited funds in domestic financial markets.
Furthermore, high real interest rates and other, complementaryausterity measures lower aggregate demand, reducing the initial sales

and profits on new productive investments. In the above example,
suppose inflation really is 60 percent next period. Then the Ievel ofprivate investment will depend critically on whether the government
convinced bond-holders of this and were able to raise the capital they

ROBERT K. MCCLEERY

62

needed at nominal interest rates of about 62-63 percent, or if bondholders required nominal rates of 70 percent or higher to compensate
them for the risk of failed stabilization. Depending on the government's

track record and credibility, there may not exist a nomjnal interest
rate that is acceptable to both bond-holders and private investors. In
that case, stabilization must be chosen over growth, in the hopes thatsuccessful stabilization will improve the credibility of government to thepoint where an equilibrium with growth is possible.27

Table 3
Historical Perspectives on Savings and lnvestment in MexicoOrdaz
1965-70

Total Savings

Echev Portillo la Madrid Salinas
1971-6 1977-82 1983-88 1989-1991

21.3
2.9
2.9
(o.o)

21.8

18.4
3.7
14.8

18.1

3.e
15.2

Total Domestic Investment

21.3

21.8

Public5.2

Private

15.7

7.0
14.9

Et2!!g!na!-SayingteIS

Foreign Capital Inflows
Domestic Capital Outflows!t}gll!gsi!Lig-SaldllgstS

PublicPrivate

3.7
4.8
(1.1)

19.7

21.4
3.8

25.1
3.1
5,4
(2.3)

1.9
(3.3)

22.1
5.0
17.0

21.1
7.7
13.4

17.6
7.9
9.7

25.1
9,7
15.4

19.7
6.1
13.6

21.4
5.5
15.9

-1.4

Sources and Notes: From Ize 1991 and OECD 1992. Column titles are the Mexicanpresidents and their periods of rule, as given by Ize 1991. More complete names, as

they were known, are Diaz-Ordaz, Echeverria, Lopez-Portillo, de la Madrid, andSalinas de Gortari.

It is worth mentioning that savings rates were fairly constant in
Mexico (see table 3).28 Domestic savings were actually higher in the
1982-88 period than in the 1965-71 or 1972-76 periods. Total savings were

only marginally lower, at 20 percent instead of 21 or 22 percent; thatdifference is completely explained by the negative foreign savings. The

problem was converting domestic savings into domestic investment.
There are three basic reasons for the decline in investment: the relative

price of imported capital goods is much higher during thjs period of.
27 This, of course, is an economist's perspective; a government facing a closely
contested election may see a very different mandate.

28 The table is drawn from Ize (1991), which discusses the savings and investment
performance of the Mexican economy during the$e periods in more detaH.

Structural Adjustment and Economic Growth in Mexico: 63With Comparisons to Indonesia
general (but not consistent) undervaluation of the peso; ex post rates

of return were higher in the U.S. during parts of the period; and theclimate of halting growth and limited government credibility
contributed to high levels of risk. It is no wonder that a significant
part of a Mexican investor's portfolio consisted of U.S. financial assets,
real estate, etc. Yet even the differential in investment rates explains

only a small part of the relative growth performance in the five
periods.

Note that "political stability" may have worked against economic
stability, as it took several years for the de la Madrid administration
to distance itself from the policies pursued in the }ast year of the
Lopez Portillo administration, and until 1988 to actually reverse thepolicies. "These two government actions (nationalization of the banks
and exchange controls) produced the worse conflict between the private
and public sectors in over 50 years and fueled unprecedented capitalflight."29 Salinas' reputation as architect of the de la Madrid
administration's stabilization plans from his position as Secretary of

Budget and Planning aided the smooth transition in 1988-89. The
immediate vilification of Salinas by his successor President Zedillo,
which the Mexican people have apparently taken to heart, as a way to
try to establish instant credibility (or at least a blank slate) by

repudiating past policies is a new development in Mexican political
economy. Of course, the designated successor to President Salinas, Mr.
Colosio, was shot and killed before the election, so President Zedillo isclearly a second choice.

In East Asia, government-business relations are much more cordial
and this sort of mutual mistrust is not evident. From the side ofgovernment, business is seen as the heart and soul of the country,
representing the wealth of the people, employment, and the industrial
base that signifies strength and importance in the international arena.
Business sees the government a$ providing important services in returnfor taxes collected, including managing markets to some extent andnegotiating the best possible terms for foreign market access, inaddition to the normal functions of maintaining macroeconomic
stability and stable relative prices. Of course, in Indonesia a riumber ofkey business leaders are close relatives of President Suharto, and this''29 Humberto Vera Ferrer (1991), p.43.

64

ROBERT K. MCCLEERY

problem of government-business mistrust and friction is unlikely toi3earlse.
Issues relating to NAFTA are covered briefly in section 4.2, but itis worth mentioning here that NAFTA clearly had an effect on thecredibility of reforms in the Mexican case. But just as clearly, theeuphoria of the 1991-93 period led to policy miscalculations, and when
the collapse came, it was a fall from a greater height than would havebeen possible without NAFTA.
3.5 Stability and Growth: 1988-1994

As mentioned above, the iast year of the de la Madrid
administration and the early years of President Salinas represent a
departure from conventional stabilization programs. This section covers
the policies of those years in some detail, with particular attention paid

to the writings of Mexican policymakers themselves. Some factors
leading to the latest crisis will also be identified.

The PSE plan of de la Madrid, which developed into the "Pacto,"
was a comprehensive set of austerity measures, liberalization, andstructural reforms. Fiscal reforms, privatization, financial market
reforms, debt agreements, trade and exchange rate measures, andother deregulation measures were pursued in concert, although notalways in a perfectly orchestrated fashion. Each set of measures will
be dealt with brjefly below.

Fiscat reforms were a high priority, both for improving fiscal
balance and control and for improving the equity of the tax system.
Mexjco was able to increase direct tax revenues while reducing
maximum tax rates, primarily by broadening the tax base. The marked
increase in the number of taxpayers also reflected the understandingthat the government eould not be run solely on oil revenues. It was
clear that everyone, including the agricultural and transportation
sectors which had been exempted for technical and political reasons,had to pay their share. Indexation of taxes to inflation, elimination of
30 Of course, from an American perspective, the "cozy" government-business
relations in Asia create their own, different problems in the form of lack ofadequate regulation, standards, etc. RegardlesS of whether one favors the "hand-in-hand" East Asian method or the "arms length" American system, it seems
clear that the "adversarial" approach in much of Latin America, South Asia, and

Sub-Saharan Africa must take a share of the blame for their slow and halting
economic growth and stagnation in living conditions. •Structural Adjustment and Economic Growth in Mexico: 65
With Comparisons to Indonesia

some tax credits for large companies, and a sharp rise in theprosecution of tax evaders also increased the perception of the fairnessof the system. In addition, a two percent asset tax addressed the
problem of 70 percent of all corporate tax returns declaring no tax
liability.3' Lastly, the inflationary bias toward debt finance and against

equity finance was cut by making only the real component of interest
payments tax deductible (see financial reforrns below for the impact onequity markets). Real tax revenues substantially outpaced real GDP
growth in the 1988-91 period.32

Privatization was a difficult but necessary element of the program.
Twelve years of populist policies, followed by six more years of thegovernment acting as "employer of last resort" during recessions left
the legacy of a bloated public sector. Some limited privatization efforts

had been underway in the early years of the de la Madrid
administration, but in 1986 state-owned enterprises (SOE) excluding
PEMEX (which alone contributed 7.1 percent of GDP) accounted forrising shares of GDP and employment (5.8 and 5.2 percent,respectively), although the share of SOE in total investment had fallenfrom 30 percent in 1982 to 20 percent in 1986.33

The share of GDP grossly understates the importance of SOE inthe economy. First, some government production or distribution
activities had negative value added, and thus actually reduced thefraction of SOE value added in GDP. One example is CONASUPO, a
distribution agency whose mandate was to buy food at market prices(or government determined support prices) and sell to the poor at
subsidized prices. The agency targeted the poor only by locating storesin poorer neighborhoods; anyone could walk in and buy food there.
And everyone did, making it consistently one of the five largest SOE bysales volume. The underpricing of output, which affects virtually all

SOE, is a symptom of a more general problem, namely the attempt to
31 OECD (1992).
32 The figures given in Aspe (1992), while somewhat ambiguous (terms like "lastyear" are used), indicate that real tax revenues rose by about 30 percent, 2.5 times
the approximately 12 percentage point rise in real GDP, over the 1988-91 period.

33 Figures from the Secretary of Budget and Planning (SPP in Spanish), reported in

Humberto Vera Ferrer (1oo1). In Ferrer's words, "If we accept the second
definition (Privatization reflects the state's recognition that it cannot effectively

perform economic activities and that private sector is more efficient-hence thetransfer of public enterprises to this sector), then there has been no privatizationin Mexico (through 1987)."

66 ROBERTKMCCLEERY
satisfy the conflicting goals of increasing equity, providing a social

safety net, and promoting efficiency. A further problem is thecompartmentalizing of decision making, such that the pricing decisions

are made independently of employment and output decisions. This canlead to massive losses, as production strives to meet near infinite

demand and fixed nominal prices approach zero in real terms. For
instance, at various times in the early to mid 1980s the prices of atelephone call fell to 1/10th of a cent, the price of a subway ride to 1

cent, and energy subsidies (in large part a highly regressive gasoline

subsidy, but also extremely low rates for electricity and all otherenergy, with the goal of increased industrialization) alone accounted
for nearly half the government deficit in 1981-82. It is not uncommon
for the cost of running an SOE to far outweigh the benefits to its
customers, making it preferable on efficiency and equity grounds toclose the SOE and replace it by a direct subsidy. Thus the losses of

SOE as a fraction of GDP might better show their weight in theeconomy. From over 6.5 percent of GDP in 1980, thLose losses rose to 11
percent in 1981 before dipping to 9 percent in 1982.

Massive losses from SOE can be addressed in three basic ways.
They can be privatized (51 percent or more sold to the private sector),

corporatized (incentives created and personnel hired so that they are
run like businesses despite government ownership), or closed down. If

either of the first two methods are tried, reforms of the regulatoryenvironment (in addition to macroeconomic stability) may be needed tomake the operations commercially viable, much less attractive enoughto the private sector to raise significant revenues through their sale.

Mexico handled this tricky problem extremely well. From 1983-86,
there was little room for privatization per se, due to the lack ofmacroeconomic stability and low levels of private investment. Thus
progress was slow and concentrated on phasing out or merging small,non-viable entities. From 1986 to 1988, some of the smaller firms were
sold, allowing the relevant government agencies to acquire experience inthe process. By 1989, the number of SOE had been reduced to 379 from1155 in 1982 and 737 in 1986. In the context of relative stability andgrowth, (inflation of 20-30 percent and 3-4 percent real GDP growth),deregulation of the telecommunications and transportation industries,

further deregulation in banking, and the establishment of a good
regulatory system in mining, substantial and lucrative privatization

Structural Adjustment and Economic Growth in Mexico: 67
With Comparisons to Indonesia

took place in 1989-90. By May of 1992, the number of SOE had been

reduced to 223 and about $12 billion had been raised throughprivatization, or about 6.3 percent of GDP per year.st Rather than risk
spending increases based on this inherently transitory revenue source,
the government created a special fund dedicated to reducing the public
debt.

In concert with privatization, which increased the role of theprivate sector in the economy, came a reinterpretation, then revision, of

the restrictive foreign investment law. Beginning with the IBM case in

1985, exceptions to the "49 percent rule" for foreign equity had been

implemented on a case by case basis. The transparency of theregulatory regime was improved by major revisions in the law in 1990-

91, including the opening of a number of petrochemical sectors toforeign investment. The NAFTA negotiations further modified theregulatory environment in the direction of more openness to foreign
mvestment.
Financial rnarleet reforms accompanied the privatization of thebanks. Indeed, the banks could not have been sold for more than bookvalue unless the crushing reserve requirements had been reduced,
controls on interest rates and the allocation of credit greatly loosened,

and other changes made. May 1987 marked a substantial lowering of
the high reserve requirements and the fraction of reserves that had to
be used to purchase goverpment debt from 58 percent to 35 percentes.

Even after this change, banks were subject to various implicit taxes
estimated at O.7 percent of GDP in 1988, and only about 30 percent ofbank credit was free from sectoral restrictions and interest rate
controls.36 Bank credit ceilings were used as a way to control money
supply growth until 1989. Controlled deposit rates and high inflation
caused negative real interes•t rates and financial disintermediation.
Depositors turned to non-bank financial institutions such as investment
houses and insurance companies, while large investors had the optionsof dealing directly in government financial instruments or investing
abroad.
As mentioned above, the main commercial banks were privatizedbegjnning in 1990, after an increase in cornpetition and a reduction in
34 Aspe (1992) and OECD (1992).
35 The Economist Intelligence Unit (EIU) (1987).

36 OECD (1992).

K. MCCLEERYROBERT

68

regulations. In particular, compulsory (additional) reserve requirements
and interest rate ceilings were abolished in April of 1989. The national

development banks also underwent significant reform. Equity markets
boomed, fueled in part by foreign investors.
Debt agreements were reached with its major creditors through the

Brady Plan in 1989. The turnaround was dramatic, with foreign
investment inflows and new lending shifting the net resource outflow of

6 percent of GDP in 1988 to a net resource inflow of nearly 2 percent
in 1990. As a resu!t of growth, debt relief, and sound management theexternal debt fell from almost 74 percent of GDP in 1987 to just over 30
percent in 1991 (see table 4).

Table 4More Mexican Macroeconomic Data, 1982-91.
1982 1983 1984 1985 1986 1987 1988 1989 1990 1ce1
Gross Capital Formation (1)National Savings (2)PrivateL
Public'2
Foreign Savings (1-2)

22.9
19.3
14.4

20.8
es.3

19.9

21.2

22.5

16.6

15.3

22.0
15.8

4.9
3.6

8.7

7.2

6.2'

-4.5

-2.6

-O.8

12.9
4.0
1,4

Tota1 External Debt (percent of GDP)

49

os

52

76

M

18.3
16.9

22,2

3.0

21.8
18.8
12.8
6,O
3,O

ca

ss

30

19.3
22.2
14.5

20.5
17.9

21,6
18,6
16.0

7.7

12

2.6

-2.9

1.4

74

59

19.1

17,5
10,9

6.6
4.7

Monetary Policy Indicators

Change in Monetary base/GDP

3.2

-2.6

-1.1

-4.4

-1.4

-3.1

-2.4

-O.6

1.4

Real Interest Rates

-2o.e

-14.9

-6.3

6.4

-O.1

10.1

11.5

21.1

8.4

Inflation

ss.8

eo.8

59,2

os.7

105.7

159.2

51.6

19.7

Real GDP Growth

-O.6

q.2

3.6

2.6

-3.8

1.7

1.4

3,1

oo.9
3.9

5.6

6,O

6,3 7,4

3.9

3.7

3.5

3,7

4,2

thcial Spending Human Resources
Public Expenditure on Education,

Health, and Welfare (% of GDP)

8.4s

6.4'

Total Education Expenditure

5.3 3.8

4.2 4.0

Wages, Income Distribution and Poverty

Rebl Wage Index (1980=1oo)

Wage Share of GDP

77

73

73

oo

ee.4

28.7

28.7

ns.5

26.6

-5

.es

7

Income share of poorest fifth
Income share of richest fifthTerms of Trade (percent change)

4.8

49.5

-6 -21

1

Sources and Notes: Data from Aspe 1992 and OECD 1992.
1 Adjusted for inflation.

2 Federal government, including SOE under budgetary control.
3 1981-82 average.
4 19gg-84 average.

M 25.9ss 61

se
ss.2

25.5
4.4
ss.5

46

62
24.7

10

Structural Adjustment and Ecofiomic Growth in Mexico: 69
With Comparisons to Indonesia

Trade and exchange rate policies were pursued that greatly
increased the openness of the economy to foreign goods and capital. In

the first stage (1985-87) most non-tariff barriers (NTB) had been
removed, a process know as tariffication. This process is extremely
important, because even when an NTB is converted to a tariff rate thatleaves imports unchanged, the allocation of imports is now done by themarket in a transparent fashion, rather than through politicalconnections, rent seeking, etc. In the latter period, tariffs were rapidly

reduced, first tD the world then further by treaty to Latin America,
Chile, and the United States and Canada through NAFTA. Tariffs fell
from a maximum of 100 percent in 1982 to a maximum of 20 percent
and average of 11 percent in 1991. Since 1989, most items have been
subject to a uniforrn 10 percent tariff and customs procedures havebeen simplified and harmonized to international standards (rememberthat Mexico only joined the GATT in 1986).
International economists are in agreement that tariff reduction
promotes efficiency and growth in an economy. But many have asked
if Mexico's pace of liberalization was too fast. This may be true.

Economic models generally examine comparative statics: in otherwords, they compare the current situation in the economy with ahypothetical situation in which macro variables such as labor force,money supply, capital steck, etc. are at the same level, but tariffs havechanged, and the economy has fully adjusted to the changes. Thus theprocess of adjustment is ignored, and Iittle can be said about it. In
short, the more flexible the economy is (defined by how well expanding

sectors can make use of labor and capital released by contracting
sectors), the quicker and less painful the adjustment process will be.
Ideally, policymakers would like to gear the speed of liberalization to
the flexibility of the economy, but at the same time, announce the final

targets of the program in order to limit new investment in areas inwhich competitiveness in the domestic market hinges critically on
protection that will be phased out in the future. But this requires

credibility beyond what the Mexican government had, either forpolitical or historical reasons. Thus President Salinas felt that tradeliberalization had to be rapid.

0ne lesson from the East Asian experience that Indonesia hastaken to heart is that export promotion and import substitution can be

pursued simultaneously, in different sectors. For instance, Japan,

70 ROBERT K. MCCLEERY
Korea, Taiwan, etc. all reduced (but not eliminated) protection for
their electronics and garment industries once they became established,

shifting protection to heavy and chemical industries, then again
reducing protection in those industries to move into higher technology

areas. Additionally, East Asian countries were careful not to force
exporters to use low quality or high priced domestic inputs, andpromptly refunded import duties on intermediate goods that were
reexported. Thus exporters operated in essentially a free tradeenvironment, while domestic consumers were discouraged frompurchasing foreign products. A uniform ten percent tariff removes thepolicy discretion to support developing industries while forcing matureindustries to compete in world markets. Additionally, a uniform tariff
provides less effective protection to final goods producers and more to
primary product and intermediate goods producers, which is generally
the opposite of the goals of industrial promotion policies.
Exchange rate policies centered on using the nominal exchange rate
as an anchor against run-away inflation. This can be justified as ashort-term policy when inflation is out of control, but Mexico continued
its policy of devaluing at a rate considerably under the differential in
inflation rates between it and its trading partners (essentially theUnited States) even after inflation had fallen to a 6.7 percent
annualized rate in August of 1994. 0ne justificatjon for this policy,
which apparently contributed significantly to the crisis in early 1995
was that although the real exchange rate was considerably overvalued
considering the changes in the price levels, if wages were used as the
deflator in computing the real exchange rate, the real exchange rate
was at about the right level. On the export side, it does appear that theovervaluation was not yet severe enough to stop the growth in non-oil
exports, but on the import side, it seems that import growth of 6 to 7
percent per quarter in late 1993-early 1994 contained a large componentof consumer goods, generated by the strong peso.

4. Differentiat Responses''

4.1 Externaf Factors: Mexico's Bad Luck?

Mexico was affected much more strongly than Indonesia by theinterest rate shock of 1981-83 (see below). Mexico's growth was being

financed by commercial bank borrowing, while Indonesia relied moreStructural Adjustment and Economic GrowthWith Comparisons to Indonesia

in Mexico:

heavily on concessionary finance (aid from a consortium of countries
and international organizations and yen loans from Japan) and direct
foreign investment, especially in the oil and gas sector. In retrospect,

Indonesia's approach looks "correct," but further analysis is needed.
First, Mexico as a higher income country did not seek or qualify forconcessionary lending. Second, Mexico is squarely in the U.S. sphere of
influence, while Indonesia can play the U.S. and Japan against eachother in some cases.37 Third, for better or for worse, Mexico did notallow private investment in any part of the oil and gas sector (see note3), and thus bore considerably more risk. Fourth, real interest rates oncommercial debt were negative through much of the 1970s, and the rise
to extremely high levels by historical standards in the early 80s took
everyone by surprise.ss Mexico was more vulnerable to the interest rateincreases, having a debt that was larger and composed more of shortterm debt at market rates.
Two external events marred the steady reduction in the public
sector primary deficit between 1982 and 1988: the 1985 earthquake andthe drop in oil prices in 1986. These two events both lengthened thenecessary adjustment period and deepened the necessary economic
contraction. For instance, the direct cost of the earthquake and its
aftermath (primary reconstruction, not counting lost tax revenues,
decreased tourism, and production losses) was more thap $3 billion.39
The fall in oil prices dealt an even sharper blow to the government'sbalance sheet and thus to stabilization efforts. One estimate has theprimary surplus falling by 1.8 percent of GDP in 1986, versus an
expected rise of 1.4 percent in the absence of the shock.`O

The third exogenous shock in three years hit Mexican financial
markets in October of 1987. The sharp drop in U.S. stock prices spilledover into the Mexico market, setting off a collapse in stock prices and

37 An indirect advantage of location is that rapid economic growth in surrounding
countres benefits you through trade and investment linkages (the "contagion
effect" in Petri 1se2) and successful policies are observed and emulated (the"demonstration effect"). See Naya and McCleery (1994) for details.
38 Indonesia has received its own unpleasant surprise, as yen appreciation against

the dollar, the currency in which an overwheming percentage of Indonesia's
exports are invoiced, has increased the effective interest rate on yen loans by two,
three, or even four times the stated three percent rate of interest.

39 EIU (1985).

40 OECD (1992).

71

ROBERT K. MCCLEERY

72

another burst of capital flight.`' The collapse of equity markets, coming

before the liberalization of financial markets was well underway, had acontractionary effect on private investment.

Was the timing of the crisis important? Mexico's first crisis since1950 surfaced in 1976, but was postponed by oil discoveries andborrowing until 1981--82. The crisis was particularly bad because of
global recession, tight money, and a virtual halt in financial flows todeveloping countries. By the time of Indonesia's crisis (Mexico's third),

some foreign assistance was available through Bretton Woods
institutions, bank lending, and private capital flows. Also, by this time

Indonesja's credjbjljty was much higher than Mexico's, given Mexico's
failed stabilization attempts and economic stagnation in the past.

Much of the growth of Mexican manufactured exports to theUnited States rested on the strength of the California economy.
California and the Arnerican Southwest had been essentially recessionproof since the second world war, until the 1991-92 recession. In fact,
California's diversification away from direct dependence on military
expenditure and its strong commercial links to Asia were put forward
as reasons why the 1991-92 recession would "not affect the state in thelong term so deeply as many others, so that those Mexican activities
linked to California also need not be threatened."`2 In fact, both the
djrect and indirect impact of military cutbacks hit the state hard, as

did a reduction in other federal transfers as part of the deficit
reduction programs, and a strong middle-class exodus in response tohigher taxes and a perceived "Mexicanization" of the state allcontributed to make the California recession deeper than thatexperieneed by the country as a whole. By most accounts, the state's
economy just emerged from recession in early 1995, two years after the
economic recovery in the country as a whole. Thus, at the critical time
for the Mexican economic transition, the California econpmy was notan effective engine of growth and source of expansion in the
manufacturing sector. Instead of capital from savvy border investors
directed to the expansjon of vibrant manufacturing concerns, what
Mexico got was mutual fund capital, engineering a run-up of stock
prices and the creation of paper profits, new financial instruments for'

41 OECD (1992). Repurchases of public debt at market prices by the government
agency FICORCA also contributed to the capital outflows.
42 Harris (1993), p. 157.

Structural Adjustment and Economic Growth in Mexico: 73
With Comparisons to Indonesia

wealthy investors and individuals, and support for an unsustainable
Ievel of the peso.

4.2 NAFTA
Many good summaries of the NAFTA provisions and their likely
impact on the Mexican economy have been written, and I will notreview them here.`3 The deregulation and trade liberalization mandated

under NAFTA over the next 5-15 years (the phase-in periods fordifferent sectors) do not constitute a major break wi'th the policies
implemented since 1989. In some cases there is a significant accelerationof processes that were already underway, such as provisions for
opening certain areas of transportation and financial services toforeign participation and investment, and the revision in land laws andphasing-out of support programs in agriculture. It has been said that
Mexico gave away too much in negotiations, particularly in areas likebanking and corn production, where domestic firms cannot yet compete
on equal footing with U.S. firms. Yet all of the provision of NAFTA
should help the Mexican economy in the long run.
NAFTA predictably generated a spurt of foreign capital flows, andthe failure to sterilize these flows led to appreciation of the currency.
So NAFTA can indirectly take some of the blame for the current crisis.

Yet NAFTA also changes the external support situation (see section
5.1, (1) below). At this time, it is too early to tell what the effects of

the $50 billion stabilization package, put together with strong U.S.
support, will be in terms of the achievement of macroeconomic stability
and a prompt return to growth. But in October of 1995 it appears thatinvestor confidence is still shaky and the apparent rapid return tonormal may have disguised deeper problems.

4.3 Mexico and lndonesia: Economic Performance in an lnternational

Context
All developing countries suffered shocks in the 1979-86 period fromthe wide fluctuations in oil prices and interest rates. Yet their economic

performances show clear distinctions. "These differences (in economic

performance) are commonly attributed (in the literature) to four
factors: the size of the external shock to which countries were
43 For instamce, see Lustig et al (1992), Hufbauer and Schott (1992 and 1993), etc.

74

ROBERT K. MCCLEERY

subjected, their historical experience with inflation, the extent to which

their economies were outwardly oriented, and the degree to which theirgovernments were authoritarian and thus presumably could control
economic policy."44

Taking these four factors one at a time, we see that the interest

rate shock of 1982-83 was large for Mexico and non-existent forIndonesia, as Indonesia had very littJe commercial bank or varjable
rate debt at the time. Mexico's real imports in 1983 were down 26
percent from 1978, while Indonesia's imports were 46 percent higher.
Yet Cooper says that the correlation between the size of the shock andeconomic growth in the 1980s is negative but not significant. It may bethat his sample of 18 countries is too small or not representative of theuniverse of developing countries. He concludes that although the size ofthe shock does define the size of the adjustment problem, how quickly
and how well adjustment was carried out was perhaps more important.
Next he considers inflation. Again, he finds a negative correlation
between past inflation and growth in the 1980s, but not a statisticallysignificant one (he does not present the forms of regressions,coefficients, or t-statistics in this paper). The negative correlation of

growth with prior inflation (in the period 1965-80) comes, he claims,
solely from the inclusion of two extremely high inflation countries thatexperienced low growth in the 1980s--Argentina and Chile. Although it
js hardly proper to exclude two countrjes from an already very small
sample just because they are not representative, the relatively strong
performance of the two countries since the study was done seems tovalidate his conclusions. But another possibility is that inflation in the

recent past (perhaps a moving average of inflation in the past ten
years) may be negatively related to growth. He does find what hejudges to be a statistically and economically significant negative
correlation between the variability of inflation and economic growth.
Mexico's inflation was higher and more variable than Indonesia's
during the 1980s, while the two countries had remarkably similar
experiences with inflation in the 1973-80 period. Cooper might argue
that Mexico's high inflation in the 1980s was not the cause of its poor

economic performance, but a symptom of its adjustment problems.
44 Cooper (1991), p.69. His paper is based on research done for a major World Bank
study, along with Max Corden, Ian Little, and Sarth Rajapatiraha. Section 3.2
follows his discussion on pages 69-81, in highly condensed from.

Structural Adjustment and Economic Growth in Mexico:With Comparisons to Indonesia

Does having an open economy help a country to better adjust to
external shocks? Cooper finds no significant correlation between
openness and growth, either. Others have found such a correlation(Dollar 1992, Edwards 1992, and Easterly 1992), and one's results seemto depend critically on both the measure of openness selected (Pritchett1991) and the functional form of the regression (Levine and Renelt
1992).`5 Indeed, his objections rest on statements such as "But some of
the relatively open countries, such as Cote d'Ivoire and'Nigeria, also

had a difficult time during the 1980s."`6 He then looks further at asample of nine countries that have substantially changed their degreeof openness in the 1974-85 period. Once again he finds that increased
openness is no guarantee of improved growth performance.`'
The final candidate is the difference in political systems. Briefly,
Cooper considers both an index of relative political freedom (which initself is subject to at least as much criticism as indices of openness)
and a categorization of political stability (ex post, thus with Sri Lanka
and Mexico classified as "stable") and finds no strong relationshipwith economic growth.
After discrediting, to some extent, the conventional wisdom, hesearches for alternative reasons. First, he separates the shock (termsof trade deterioration in percent and debt service increase as a percent

of GDP) from the import contraction resulting from the shock, andnotes that there is imperfect correlation between the magnitude of theshock and the magnitude of the contraction (reduction in imports andtotal aggregate demand). This was a key difference between the
45 An extended discussion of these points is found in Rodrick (1991a).
46 Nigeria is actually one of the most distorted econornies in the world, althoughtariff protection is not the main source of distortion. It is "open" only in the senseof high trade share of GDP, from exports of oil and a few other primary products
and imports of everything else. In an interesting if somewhat exaggerated story, it

is said that Nigeria, with a combination of exchange rate overvaluation,
corruption and inefficiency in customs, and trade taxes made neighboring Beninone the leading exporters of cacao in the world-although virtually none is grownin Benin! From 1983 to 1987 Nigeria's cacao exports fell from $361 million to$156 million, while Benin's rose from $2 rnillion to $47 million (and exports ofNigeria's eastern neighbor, Cameroon, rose by about $50 million from $150
million to $200 million). Goods were smuggled out of Nigeria and exported fromformer French colony, whose participation in the CFA franc system prevented
such severe distotions. Data from UN (1986 and 1990).
47 A careful examination of Cooper's language indicates that he does not dispute a
general relationship between the two variables in the .expected direction, but
merely wants to point out that notable exceptions to the rule exist.

75

K. MCCLEERYROBERT76

experiences of Mexico and Indonesia. Cooper does not follow up on theobservation to note that external capitaJ flows are the main reason

countries like Mexico had to make massive adjustment while
Indonesia's adjustments and subsequent loss of production were moremodest. Yet no causality can be inferred from this argument, since atleast private capital flows are themselves predictions of whether or nota successful adjustment will be made. Was Indonesia's adjustment
successful because it was supported by foreign capital, or was itsupported by foreign capital because it was expected to be successful,or both?
Cooper also considers the level and stability of the feal exchange
rate to be factors that influence growth rates.`8 However, since bothIndonesia and Mexico had alternatively over and undervalued exchange
rates during the 1980s (Indonesia's coefficient of variation on the realexchange rate was actually higher than Mexico's, 26 to 20, during theperiod 1978-88, as shown in table 5), this factor does not explain the
difference in economic performance,. Table5
Mexico and lndonesia: Some Macroeconomic Comparisons
1or2 1976 19SO 1984 1988Average
Government Deficit (percent of GDP)

Mexico 2.8
Indonesia
2.3!9orZl}8

4.4

3,O

7.1

9.7

5.4

1.4

2,.2

O.6

1,6i

1.6

1982

L983

19M 1985

72
es

92

1979 lltl

1986

19or

Coef. of1988 var.

Real Effective Exchange Rates (1980=1oo)

Mexico122M
Indonesia

ev

114

ee

oa

1co

118

M

ee

oo

sc

eo

69

51

69 20
49 as

Sources and Notes: From Cooper, 1991, who uses IMF data.
1 1987.

Fiscal and monetary "discipline" is then introduced as animportant variable, but Cooper defines it subjectively. "In particular,
fiscal discipline is not we]1 measured by the size of the budget deficit...

but those who have observed a government in action can readily form
a judgment of whether or not strong fiscal discipline is present."`9 Suchng For theoretical and empirical justfication for this belief, see McCleery and James(1992) and Easterly (1992).
49 Cooper (1991), p.78.

Structural Adjustment and Economic Growth in Mexico: 77
With Comparisons to Indonesia

subjective measures•can be manipulated to readily explain past
performance, but have no explanatory power for the future, unless they
can be codified.

'
5. Conclusions, lmplications, and Call for Further Research
5.1 Conclusions
After reviewing certain theoretical determinants of stabilization andgrowth, reflecting on the economic policies and performance of the
Mexican economy,'and looking at the broader international context,

are we any closer to evaluating Mexico's performance andunderstanding why the performance of Indonesia was so different? The
above discussions should point out how difficult it is to identify andrank the most important reasons for the different experiences withstabilization policies during and after the periods of stabilization in
Mexico and Indonesia. Observed differences before and during thestabilization periods may or may not explain differences in theirsubsequent economic performance. The following five points are
candidates for the best way to explain those differences, in order frommost to least important.

'(1) Timing of and support for the stabilization program: Sustained
import compression was the single most important reason for the fallin output in Mexico, and waiting too long to adjust made theadjustment much more painful. By contrast, "The two Asian countries(Indonesia and Malaysia) managed to reconcile adjustment and equity
better than any of the others partly because they adjusted before thecrisis. In the first place the imbalances were less serious, so that the

reduction in overall demand was less drastic. This had several social

consequences:...there was no sharp increase in unemployment...and
there was no fall in real wages...we see that a major advantage ofanticipated adjustment was that it guaranteed a substantial andcontinuing flow of foreign capital before and during the adjustment
period...."so50 Morrisson (1992), p.28 (author's emphasis). Of course, nothing can "guarantee"
foreign capital inflows, any more than one can "guarantee government stability,"
which he calls for on page 29. Yet the chances can be increased.

78

ROBERT K. MCCLEERY(2) Credibility of the program: Stabilization and adjustment programs

were initiated in Mexico in 1976-77, 1982-83, 1988-89, and are being
instituted again in 1995. In each case, with the exception of the mosteffective stabilization and return to growth in 1988-89, a new PRI
government bore the brunt of the stabilization efforts. Without ahistory of credibility, each had to convince various domestic andinternational constituencies that its policies would be a significant
break from past policies (despite the president being hand picked byhis predecessor, and the same faces being shuffled around in thecabinet), and that his policies would not be abandoned once the crisis
abated (as happened in 1978 wjth the oil discoveries, in 1991 with themassive private capital inflows that anticipated NAFTA, and to a lesser
extent with the return to growth in the twelve months preceding theearthquake in 1985). The credibility problems in Mexico were intensified

by the deep mistrust between government and business and exacerbatedby the sometimes capricious policies of government, such as the banknationalizations and exchange controls instituted in 1982.

Indonesia has several advantages in the credibility department. Not
only can President Suharto and his advisors clearly afford to take along-term view of the development process, but the track record of theadministration in maintaining economic stability prior to the crisis wasexce]lent. Although there is little love lost between some of the ethnic
Chinese business leaders and the administration an effective market'
signalling device does exist. In some ways, the posjtion of Suharto's
children in Indonesian business circles is a problem, but if their firms
take positions that will be highly profitable if stabilization is pursued
successfully, can other firms in the economy fail to do the same?

(3) Other historical preconditions: Two decades of strong economic
growth and industrialization, followed by twelve years of strong
populism and nationa}ism led to two particular problems for Mexico's
stabilization and adjustment in the 1980s. It led to faulty perceptions ofwhat the government couJd do for its people (on the part of both thegovernment and the people) and to a misperception of the maximum
sustainable non-inflationary growth rate of the economy. Many of themistakes of the 1983-85 stabilization period can be traced to thegovernment trying to do too much (nationalizing banks, instituting
exchange controls, etc.), while policy errors may have been committed

Structural Adjustment and Economic Growth in Mexico: 79
With Comparisons to Indonesia
in 1985 and 1993-94 in attempts to recapture historical levels of growth5i.

Mexico's equilibrium growth level has been estimated at 4.4 percent
before NAFTA and about 5 percent with NAFTA.52 Many people in bothbusiness and government seemed unable to accept the fact that the 8
percent growth rates of 1978-81 were not sustainable then and are notsustainable now. Indonesia, in contrast, still has substantial room for

growth from transferring surplus agricultural Iabor into market
activities and the monetization of other activities. Its maximum
sustainable growth rate appears to be in the 6 to 6.5 percent range.

(4) Exogenous shocks: Exogenous shocks did play a role in thecollapse of Mexico's stabilization efforts in 1985-87, and to a lesser

extent in the crisis of 1995, through the predominance of portfolio
investments. Even when an event has only a moderate direct fiscal
impact, it can have important psychological implications for investors,
and lead to additional objects that policymakers must try to pursue
using the same instruments. Yet these problems were clearly second
order in magnitude relative to (1) and (2) above.

(5) Content and management of the programs: The actual content of
the stabilization plans were not so different in the two countries. In

fact, the Mexican plan went farther in terms of reforms in equity
markets, deregulation, and privatization than did Indonesia. It is truethat the bureaucrats were not committed to the first wave of reforms
in 1983-85, and this showed in their implementation and management of
the early stabilization policies. Yet this foot-dragging and lack ofcommitment was not evident in the reforms of the 1988-91 period. In

51

As mentioned above and detailed in Reynolds (1978), those historical levels
themselves we' re not achieved without imbalances and instabilities.

52

McCleery (1992). In this model, NAFTA increases investor' confidence in the
Mexican economy, which reduces the risk premium required on investments in

Mexico and generates over $5 billion in new investment per year. Actual
investment in 1992-94 was significantly greater (see table 6), but, as it turned out,

not sustainable. But even in 1so2, some were forecasting a return to an
equilibrium of 6 percent growth with 5 percent inflation by 1955-ee "based on
unchanged policies and absence of major shocks" (see OECD 1992, p182). Another,pre-NAFTA, growth model in 1991 gives a range for Mexico's equilibriurn growthrate of 4.4 to 6.3 percent, for low and high levels of foreign savings. As in the
McCleery model, actual foreign savings in the 1991-94 period exceed his high-end
estimate, implying that growth should have been well in excess of 6 percent.

ROBERT K.MCCLEERY

80

fact, it can be said that some policies, like deregulation, tradeliberalization, and privatization were accelerated in this period, perhaps

changing at a pace faster than the private sector could match. Despite

the often heard assertion that NAFTA "locked in" the economic
reforms in Mexico, it seems that a concerted effort was make to pushthrough as many reforms as possible before the end of the Salinas

administration, while the long term vision of the Suharto
administration allows more gradual and orderly progress in some area.
Each of these points is influenced by others. For instance (1) and(2) both relate to political stability, while (2) and (5) were both
determined in part by the historical situation and preconditions. These

problems can also interact in ways that make them worse incombination than the sum of their parts. For instance, one can argue

that the earthquake gave policymakers who were not committed toreforms an "excuse" to fail to meet spending reductions and otherstabilization targets, while limited international assistancedemonstrating the weakness of the international support for Mexico's
reforms. Overall, the comparison strengthens the position that soundmacroeconomic management and political stability are far more
important to both stability and growth than getting domestic relative
prices right by eliminating microeconomic distortions.

''

5.2 Mexico's Development Strategy in Crisis: implications and Outline

for Future Research
As mentioned above, the most recent erisis is remarkably simjlar tothe "standard" Mexican economic crisis, despite the fact thatpolicymakers have had plenty of experience with these problems.
Creeping overvaluation of the peso led to expectations of a devaluation,and the capital outflows during 1994 forced the government to doexactly that. Defense of the overvalued peso in an attempt to maintaininvestor confidence continued for far too long, causing the devaluation

to be much sharper than should have been necessary, causing a greaterloss of investor confidence than if the government had responded intimely fashjon. Interest rates on treasury bills have soared to 90
percent, forcing business loans and mortgage rates over 100 percent. In

response to tight money, expensive imports (after the sharp
devaluation), and other austerity measures, the Mexican economy willStructural Adjustment and Economic Growth in Mexico: 81
With Comparisons to Indonesia
likely contract by about 4 percent in 1995.53

The current crisis threatens not only stability and growth in
Mexico, but has triggered sharp stock market drops in distant andunrelated economies in South America's southern cone. In Asia, boththe Thai Baht and the Indonesian Rupiah came under brief speculative
attack.5` Why is this? The issue at stake is the viability of the"Mexican" foreign capital-led growth model. Was the problem
economic mismanagement in Mexico or the inherent instability of
reliance on foreign capital, particularly the "hot money" of portfolio

investment? The short answer is that Mexico must take most of the
responsibility for the crisis and its spill-over to other countries. Again,
the fault lies not merely in the failure to sterilize a sufficient fractionof the capital inflows to avoid potential destabilizing outflows or the
failure to manage the exchange rate to avoid obvious overvaluation andthe expectation of devaluation. Part of the failure lies in the fact thatpast policy failures reduce the trust investors (both domestic andforeign) place in the government's ability to handle the current crisis.

One can argue that Mexico was on the right track, but proceeding
too quickly. Even if imports were destined for expanding production
and increasing productivity in the tradeables sector, why were they
allowed to expand from $13.3 billion in 1987 to $48.2 billion in 1992,
reversing a $7.2 billion trade surplus into a $20 billion deficit thatpersisted in 1993 and 1994 (see table 6)? Why were only 4 percent of
the $27 billion of capital inflows sterilized in 1992, and just 19 percentof the $32 billion in 1993, leaving unsterilized inflows of $26 billion ineach year? After accumulating $18.6 billion of additional reserves aspart of the sterilization process in the four years from 1990-93, whywere more than half that total allowed to leave the country insupporting the exchange rate in the second quarter of 1994, fully six

months before any significant adjustment was made? Althoughgovernment spending was well controlled and the government actually
ran a surplus of O.7 percent of GDP in 1992, policymakers have muchto explain in terms of their handling of the international trade and
53 As of late 1995, the peso is still unstable and new austerity and stabilization
measures may have to be introduced that will delay economic growth once again.
Indonesia continues its steady growth rate of 6 percent or more, with the only

potential problem being the economic implications of the coming political
successlon.
54 Crosby Securities, "Quarterly Economic Review," (April 1995).

82

ROBERT K. MCCLEERY

finance side of the economy.

Mexican policymakers in the Ministry of Finance and Credit andthe Central Bank explained their actions as follows in a paper prepared
for a conference on September 29-30, 1994.55 They state "...the stabilityof foreign capital inflows, as well as the capacity of the economy toretain domestic savings, largely depends on the determination withwhich sound and consistent economic policies are implemented. As longas such policies are adopted, and confidence in the economy ismaintained, there is no reason to expect a sharp fall or reversal of
capital inflows."56 On the issue of sterilization, they note that thedemand for money increased substantially with the stabilization during
the 1989-93 period as inflation and interest rates fell and economic
activity increased, "Thus, a substantial part of the capital inflows to
Mexico has been, jn a sense, automatically `sterilized' by the rjse indemand for money."5' They do not point out that the reverse is also
true, that the additional liquidity in the system is another source offunds for capital flight if confidence is lost. While no one plans for
failure, it seems that insufficient attention was paid to the potential
problems, and the costs and benefits on the margin of the last few
billion dollars in capital inflows were not examined.

Thus pursuit of more moderate foreign capital inflows as a part ofan outward-looking development strategy still seems quite reasonablefrom the perspectives of Argentina, Brazil, and Chile. Their successdepends on whether there is guilt by association in the minds ofinvestors to the extent that this option will not be open to them forseveral years. Asian countries, including Indonesia, have relied much

more on equity investment than on the more volatile portfolio
investment. Direct investment has the additional advantages ofpromoting technology transfer, employee training, and long term tradeties with the jnvesting country. But stock market booms have attracted

foreign capital to well developed equity markets in Hong Kong,
Singapore, Taiwan, and Korea, to star performers like Thailand andChina, and even to inconsistent performers like India and thePhilippines, without destabilizing those economies.58 Why did Mexico
55 GarciaLLopez Loaezo and Guzman Clafell (1994).
56 Ibid, p.18, emphasis added.
57 Ibid, p.19.
58 China and Korea limit foreign participation in their stock markets.

Structural Adjustment and Economic Growth in Mexico: 83
With Comparisons to Indonesia

push too far? Does the answer rest in Mexico's rather distinctive
political system, institutions, or situation? In the different roles oftechnocrats in the decision-making process? In any event, someanswers seem to lie outside the traditional boundaries of economic
analysis, challenging us to further incorporate perspectives frompolitics, sociology, international relations, and other disciplines inapplied work.

One small step towards the answers is to acknowledge thedifference between the one party system in Mexico and the one person
system in Indonesia. Before the Chiapas rebels in 1994, and even before
the controversial presidential election of 1988, in which leftist candidate

Cardenas drew approximately the same number of votes as Salinas, the
PRI candidate, the elite consensus holding the country together was
breaking down. Stabilization and Iiberalization were weakening thepower base of the PRI among farmers and unionized labor (including
government workers), its two largest support groups. Corresponding

gains from the small business sector and urban poor did notmaterialize, with the former favoring the pro-business PAN, and thelatter the populist PDR. The breakdown has led to an exaggeration ofthe "political business cycle" in Mexico, as simultaneous pressures forstability and growth on one hand and consumption subsidies and realearnings protection on the other hand force the culmination of thecycle prior to presidential elections, with often disastrous results.

REFERENCES(1)

Aguilera, Luis Bravo (1989), "Mexico's Foreign Trade Policies andCommercial Relations with the United States " in William Glade and Cassio'
Luiselli (eds.), The Economics of Interdependence:. Mexico and the UnitedStates (San Diego: Center for U.S.-Mexican Studies, University of California,

San Diego).

(2)

Asian Development Bank (ADB) (1992), Asian Devetopment Outlooh 1992
(Oxford University Press).

(3)
(4)

Aspe, Pedro (1992), "Macroeconomic Stabilization and Structural Change in
Mexico," European Econornic Review, 36.
Barichello, Richard, and Frank Flatters (1991), "Trade Policy Reform inIndonesia," in D. Perkins and M. Romer, eds., Reforming Economic Systems
in Developing Countries, (Harvard: Harvard University Press for Harvard
Institute for International Development), pp.271-291.

ROBERT K. MCCLEERY

ew

(5)
(6)

Brown, Drusilla K., Alan V. Deardorff, and Robert M. Stern (1992), "North
American Integration," The Economic Journal, 102, November, pp.1507-1518.
Cooper, Richard (1991), "Economic Stabilization in Developing Countries,"
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(7)

C8)

Corbo, V. and Fischer (1ee2), "Adjustment Programs and Bank Support:
Rationale and Main Results," in V. Corbo et al, eds., Ad]'ustment Lending
Revisited: Policies to Restore Grotvth, (Washington DC: The World Bank).
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Countries, (Harvard: Harvard University Press for Harvard Institute forInternational Development), pp.159-187.

(9)

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87

REORGANIZING• FOR MULTI-PROJECT MANAGEMENT :TOYOTA'S NEW STRUCTURE OF PRODUCTDEVELOPMENT CENTERS

Kentaro NOBEOKA

Summary
The purpose of this paper is to discuss an emerging organizational
structure for new product development at large Japanese automobile
firms. This study specifically focuses on describing the purposes andoutcomes of changes in product development organization implemented
at Toyota in 1992 and 1993. This reorganization is considered to be themost fundamental change in the product development organization

Toyota has ever implemented in the last 30 years. The neworganization is aimed at the multi-project management, featuring threevehicle development centers in which multiple projects are grouped
together, in contrast with either traditional single-project-oriented orfunction-oriented organization.

This study utilizes a single-case study approach as a researchmethod, based on interviews with three general managers, four productmanagers, fifteen engineers, and three cost management planners
between 1992 and 1994. The primary contribution of this paper to theliterature is to propose a conceptual framework for multi-project
management organization, as well as to describe processes involved inchanging from a heavyweight product manager organization to a multiproJect management organlzatlon.

Japanese manufacturers including Toyota have become moreconcerned with efficiency in developing an accelerating flow of new

products. A project management system that assigns too muchautonomy to each product manager tends to result in the developmentof too many proprietary components for each project. In order toachieve economies of scale and scope, firms may want to leverage theirfinancial and engineering resource investments on new technologies anddesigns by effectively sharing these among multiple projects.

90

KENTARO NOBEOKA

Therefore, automobile manufacturers may need an organization that issuitable for managing inter-project coordination, in addition to astrong individual project management. Because most existing studies
on the efficiency of a single project, they are not helpful for managers

and researchers to understand the management of multiple projects.
A traditional function-oriented, rather than a project-oriented,

organization may seem to be more appropriate to manage the interproject interdependencies. However, the importance of cross-functional
integration will never have to be under-evaluated, and function-orientedorganizations have a critical problem in this aspect. Therefore,
organizations should be aimed at achieving both cross-functional
coordination and inter-project coordination simultaneously. This paper

focuses on how Toyota's approach has solved the apparent
contradiction between these twotgoals. Toyota's reorganization into

the center organization represents one way to manage multiple
projects. By establishing three centers, Toyota has improved interproject coordination among technically related projects. At the sametime, Toyota has strengthened the authority of product managers overfunctional managers, and this has improved cross-functional
mtegratlon.

1. Introduction
In the automobile industry, the central issues with regard to the
product development in the 1980s included speed, efficiency and productquality. Clark and Fujimoto (1991) have found that in order to achievethese goals, product development projects need to utilize projectoriented management, an approach which a few leading Japanese firms
have successfully adopted. In recent years, however, the competition in

the management of the entire product portfolio at the firm level isbecoming a critical factor (Fujimoto, et. al., 1992; Ellison et. al., 1995).

For example, effective management of inter-project interdependencies atthis level should lead not only to effective sharing but also to thetransfer of technologies and technical knowledge among multiple
product development projects. However, few studies have explicitly
addressed the management of multiple projects within the firm. The
purpose of this paper is to discuss an emerging organizational
structure that explicitly considers multi-project management.

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 91

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
This study specifically focuses on analyzing the objectives, inherent

processes, and outcomes brought about by changes in productdevelopment organization implemented at Toyota in 1992 and 1993.
Toyota has often been considered to be a leader in adopting neworganizational structures and managerial processes in the areas ofmanufacturing and product development. For example, the Toyota
production system, symbolized by its JIT and Kanban systems, hasbeen targeted as one of the best practices in manufacturing by many
firms, not only in automobile production but also in other industries.

With respect to product development organization, Toyota took the
initiative in establishing a project-based management system that aimed
at coordinating activities in different functional areas into a wellintegrated new product. Clark and Fujimoto (1991) have described thisas an organization featuring "heavyweight" product managers, who
facilitate quick completion of a project by integrating different
functions such as design engineering, manufacturing engineering, andmarketing.
This reorganization at Toyota is the most fundamental change inproduct development organization implemented since it established the

Shusa (heavyweight product manager) organization system around1965. The new organization strives for multi-project management. It
consists of three vehicle development centers in Which multiple projects

are grouped together, in contrast to either traditional single-projectoriented or function-oriented organizations.

In addition to the efficient development of individual products,

many studies have shown that Toyota as well as other leading
Japanese automobile firms have been developing new products to add
new product lines or replace existing products more frequently than
U.S. or European competitors (Abegglen and Stalk, 1985; Womack etal., 1990). Their capability in developing individual products efficiently

through a project-oriented organization helped implement the strategy
of prolific product introductions. This frequency has been considered

as one of the sources of Japanese firms' competitive advantage inworld markets (Fuji'moto and Sheriff, 1989, Nobeoka and Cusumano,
1994). In the past 15 years, for example, the number of passenger
vehicle lines at Toyota has more than doubled, rising from 8 to 18.
Toyota also has been able to maintain a four-year product life cycle
for most of its product lines, which is much shorter than that of

92

KENTARO NOBEOKA

Western firms.
In recent years, however, all Japanese manufacturers, including
Toyota, have becorne more concerned with efficiency in developing new
products. In most of their major markets, demand has slowed or evendeclined, while the cost competitiveness of Japanese firms has
considerably decreased because of the appreciation of t•he yen andimprovements by Western competjtors. Japanese manufacturers havebeen facing profitability problems that are related at least in part tothe high costs of developing and manufacturing so many new products
or product variations. Therefore, Japanese firms are attempting todevelop new products more efficiently while maintaining both a highfrequency of new product introductions and high design quality inindividual projects. Toyota seems to be at the forefront of these
efforts with its new multi-project center organization.

In the multi-project organization, companies try to optimize notjust one project at a time but a portfolio of projects and technologies.

In order to achieve economies of scale and scope in productdevelopment as well as in manufacturing, it is common for firms toleverage their financial and engineering resource investments by reusing

existing technologies and designs in multiple projects. Firms also haveto consider how to share many components among multiple projects
without sacrificing an individual product's design quality anddjstjnctiveness. A key challenge facing managers in terms of productdevelopment is how to share technology across multiple product lines

and across multiple generations of products without overly
compromising design quality and competitiveness.

This study utilizes a single-case study approach as a researchmethod. Because a theoretical framework for multi-project
management organization is still in an embryonic stage, we believe thata detailed description of a firm's transformation into such anorganization is important at this exploratory stage. The primarycontribution of this paper to the literature is to propose a conceptual

framework for multi-project management, as well as to describe
processes involved in changing from a heavyweight product manager
organization to a multi-project management organization. This casestudy is based on seven interview visits to Toyota between 1992 and1995. The interviewees included three general managers who wereinvolved in the planning and implementation of this reorganization, as

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 93

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
well as four product managers, fifteen vehicle engineers, and three costmanagement planners. In two of the interviews, the general managers,
utilizing internal documents, explained the purposes, processes, andoutcomes inherent in the reorganization. In interviews with otherdevelopment personnel including product managers, engineers, and costmanagement planners, we made inquiries about their own perspectives
regarding the reorganization including specific influences to their own
tasks and processes. These procedures played an important role indetecting any potential personal biases of the interviewees.

2. Framework for Multi-Project Management
A stream of studies on new product development have discussed thestructure of engineering organizations and management. One of thecentral issues examined is the difference between project-oriented
versus function-oriented organizations (Marquis and Straight, 1965;
Galbraith, 1974; Davis and Lawrence, 1977; Tushman, 1978; Katz andAllen, 1985; Clark and Fujimoto, 1991). Most studies have argued that
product development organizations require two different coordination
mechanisms to achieve two major goals. First, in order to increase thequality and quantity of inputs of technical knowledge, a high degree of
coordination among technical specialties is needed. Second, in order tointegrate all technical knowledge toward well-defined products, a highdegree of coordination within a project is required. These two aspectsof coordination requirements have primarily been discussed withrespect to the balance between project and function orientations in the

new product development organization. Past literature, however, has

not paid much attention to the rnanagement of the inter-projectinterfaces except for resource-sharing efforts within each function.

Existing studies on automobile product development have concluded
that a project-oriented approach, rather than a function-oriented
approach, leads to a higher performance in terms of lead time andefficiency for individual projects (Takeuchi and Nonaka, 1986; Clarkand Fuji'moto, 1991). However, a project management system thatassigns too much autonomy to each project may concentrate tooheavily on developing multiple new products through relatively
autonomous projects. This system tends to result in the developmentof many proprietary components for each project, and may requireKENTARONOBEOKA

94

excessive financial and engineering resources.

Firms that try to optimize the management of multiple projects
simultaneously need an organization that is suitable for coordinatinginter-project interfaces and interdependencies (Nobeoka, 1995; Nobeoka

and Cusumano, 1995). Most product-management research that has
focused on the management of single projects is not helpful for
managers and researchers attempting to understand the complexity of
coordinating multiple projects. It may seem that a traditional function-oriented, rather than project-oriented, organization may be more
appropriate to manage inter-project interdependencies. However, thistype of structure is weak at cross-functional integration. Functionalorganizations also lack a mechanism to ensure that individual products
retain distinctive features and a high degree of product integrity. A
product development project is a system consisting of closely coupledmultiple engineering functions (Rosenberg, 1982), and an automobile isa typical example of complicated system product. Firms have tomanage multiple projects, while recognizing the importance of "productintegrity" in each project. Therefore, this paper argues that multi-

project management has to consider the coordination beyond thatwithin each function. Effective multi-project organizations may need aproduct development organization that achieves both cross-functional
Figure 1 Framework for Multi-Project Management
Strong

Function-oriented

Management

Multi-ProjectManagement

Inter-Project

Coordination

Project-oriented

Management

Weak
Weak

Cross-Functional

Coordination

StrongREORGANIZING FOR MULTI-PROJECT MANAGEMENT: 95

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
coordination and inter-project coordination.

Figure 1 summarizes the above discussion. Most of the paststudies have discussed the need for a balance between project andfunction orientations. For example, Katz and Allen (1985) discussed

the balance of authority that product managers and functional
managers should have. On the other hand, a primary issue regarding

multi-project management organizations is the simultaneousachievement of cross-functional coordination and inter-project
coordination through the way the firm organizes and controls multiple
projects. Inter-project interdependencies must be coordinated within

the context of a specific project as an integrated system. Crossfunctional integrity in each project must be maintained. To sharecomponents while retaining the distinctiveness of individual products,
firms also need organizational structures and processes that enablesystem-level coordination across multiple projects. Therefore, firmsthat consider a new multi-project management organization should use

a new framework that moves beyond the baiance between project andfunction orientated organizations.

This case study examines the possibility that Toyota's
reorganization into product development centers may represent one
way to manage multiple projects. By establishing three centers, eachof which contains several vehicle development projects, Toyota has
improved inter-project coordination among technically related projects.

At the same time, Toyota has strengthened the authority of productmanagers over functional managers, and this has improved crossfunctional integration. This paper focuses on how Toyota's approach
has solved the apparent contradiction between these two goals. The
next section describes Toyota's multi-project organization and theprocesses of transformation to such organization.
3. Toyota's Restructuring for Multi-Project Management
3-1 Problems of the Traditional Shusa Organization at Toyota
ln 1953, Toyota assigned the first shusa, or product manager, to a

new vehicle project (Ikari, 1985)'. When Toyota started productdevelopment for the 1955 Crown, Kenya Nakamura became the first
1 I referred to Ikari's book with respect to the information regarding the early
period of the Shusa organization in the 1950's and 1960's.

96

NOBEOKAKENTAROshusa to head a project. At that time he was a member of theEngineering Management Djvision. The shusa organization was
strengthened in February 1965 when Toyota formally established theProduct Planning Division to organize and support shusas. At thattime, there were already ten shusas, and each shusa had five or six
staff members, which totaled about 50 members in the division. The
basic organizational strueture with respect to the roles of the Product

Planning Division and shusas did not fundamentally change until 1992,

when Toyota introduced the center organization. One of the minorchanges before that time was a change in the title name for a,productmanager from "shusa" to "chief Engineer" in 1989. In order to avoid
any confusion, the rest of this paper will eonsistently use the new term,
chief engineer, to refer to this position, rather than shusa or productmanager.
After having maintained the same basic structure for more than
two decades, in 1990, Toyota decided to evaluate its entire product andtechnology development organization and to change it if necessary, sothat the organization would fit the competitive environment at the endof the twentieth century. Toyota launched an initiative, called the

Future Project 21 (FP21), to study any problems in its productdevelopment organizational structure and processes. The leader of the
project was Yoshiro Kinbara, an executive vice president in charge of

product and technology development. A manager at Toyota explainedthat no specific threats triggered this project. At that time, Toyota

was actually doing better than most of its competitors. People at
Toyota, however, recognized that organizations sometimes needed to bereviewed and overhauled to continue to be competitive in a changing
environment. A consulting firm2, which was hired for this project,evaluated the organization performance at Toyota as a starting pointof the FP21.
Soon after the FP21 started its studies, the team identified two

important problems. These problems led Toyota to conclude that it
would need a major reorganization. First, there was an organizational
2 Toyota chose the Nomura Research Institute, a Japanese consulting firm rather

than prestigious U.S. based firms such as McKinsey. A persoh at Toyota
mentioned three reasons for this decision: (1) A Japanese consulting firm may
know more about Japanese firms. (2) Toyota wanted plans for implernentations,rather than grand strategies. And (3) a Japanese consulting firm seemed likely toprovide rnore value per cost than a U.S. firm.

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 97

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
problem. A primary point was that Toyota's product development
organization had become less efficient in communication and had cometo need more coordination tasks than before to manage new productdevelopment. Second, the competitive environment for the Japanese
automobile industry started changing drastically around 1990, which
seemed to require Toyota to change its product development strategy
and organization. Due to various factors such as the appreciation of
the yen, the Japanese auto industry faced decreasing competitive

advantages against most competitors in the world. The following
sections discuss these two problems in more detail.

Organizational Problems
Figure 2 shows Toyota's product development organization before
its reorganization in 1992. There were, at that time, as many assixteen design engineering functional divisions, and each had afunctional manager. There were about fifteen projects proceeding
concurrently, even though Figure 2, a simplified model, depicts only
nine projects. Each project had a chief engineer, who was located in
the Product Planning Division under a general manager.
The product development organization was actually a huge matrixorganization rather than a project-based organization. Chief engineersand general managers in the Product Planning Division did not directly

oversee the engineering divisions in this organization structure.
However, chief engineers at Toyota were supposed to have considerable

authority over the entire product development process, including
different engineering stages, manufacturing, and product concept
creation. According to the definition by Clark and Fujimoto (1991),
chief engineers at Toyota were supposed to be typical examples ofheavyweight product managers.
However, in reality, the product development organization at
Toyota had become much larger than before, and chief engineers
started to find it difficult to control and integrate different functional

divisions when developing a new product. As the number of productdevelopment projects increased, the number of engineers also increased.

At the same time, the degree of specialization in the engineering
divisions had become narrower, reflecting the increasing number ofdifferent engineering divisions. As of December 1991, there were about
7000 people in the sixteen product development engineering divisions.

NOBEOKAKENTARO

98

They were working, on average, on fifteen concurrent projects. In

addition, Toyota had a Research and Advanced Development Group
located at the Higashi-Fuji Technical Center. This had about 2000
additional people3.

In 1991, a chief engineer had to coordinate people in 48 departments

in 12 divisions to manage new product development. This estimate

comes from Toyota's internal data on the number of frequent
participants in meetings a product manager held`. In 1976, there were
Figure 2 Toyota's Productin 1991

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3 7000 people in the sixteen engineering divisions and 20oo people in the RAD group

added up to 9000. There were, in total, about 11,5oo people working on productdevelopment. The rest of the people were engaged in supporting activities such as

patent management, certification process managernent, CAD system development,
and prototype development.
4 Even though there were sixteen design engineering divisions, a chief engineer for aparticular project did not necessarily need to rnanage all of these.

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 99

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
only 5000 people in the entire product development organization. A
chief engineer had to coordinate only 23 departments in six divisions.

At that time, a chief engineer generally needed to talk with only six
division managers to integrate all the design engineering functions.
This change indicated that, during the fifteen years, coordination tasks

had become much more complicated for chief engineers.
In addition to this added complexity, there was another problem

that made it difficult for some chief engineers to manage a new
product development project. Some relatively junior chief engineers
started to complain that they did not always have enough authority
over senior functional managers. Originally, only a limited number of"charismatic" senior managers tended to rise to the position of chiefengineer. Toyota people often considered them as "gods" within theirprojects. However, in recent years, Toyota has assigned relatively
junior people to the position of chief engineer. There are two reasonsfor this change. First, the number of chief engineers required to cover
all new vehicle projects had increased. Second, Toyota recognized thatpeople needed particular talents to be excellent chief engineers, andtheir seniority was not as important as their ability.

Functional managers also found it difficult to spend sufficient timeon managing engineering details of all the vehicle projects, because
most managers had to oversee about fifteen different projectsS. They

did not have enough time to oversee complicated interfaces andinterdependencies between these projects either. Due to the large
number of functional divisions and vehicle projects, each chief engineer

was able to arrange for regular meetings with all the relevant
functional managers only about once every two months.
There was a problem also at the engineering level. Because of theirnarrow specialization, engineers did not have a "system view" of the:entire product. For example, some engineers only knew about the
inner body of doors and did not know much about the outer body
because interior engineering and body engineering divisions wereseparate. This kind of excessively narrow specialization had a negative

impact on the development of a well-integrated product. In addition,
5 There were a few exceptions. For example, as of 1991, there were already two
separate body engineering divisions, each of which was responsible for frontwheel-drive and rear-wheel-drive vehicles, respectively. Therefore, each functional
manager was in charge of about a half of the entire vehicle projects.

100

NOBEOKAKENTARO

Toyota realized that the narrow specialization caused another problem
for engineers when they were promoted to become a manager in chargeof a larger engineering task such as the entire body. It was difficult
to train general engineering managers in this organizational structure.

Engineers also found it difficult to have a strong sense ofcommitment to a specific vehicle development. Because of the narrowspecialization and the large number of projects, each engineer
frequently had to transfer between unrelated vehicle projects. This
may sound useful to transfer technical knowhow between different
projects. In reality, 'however, despite the frequent transfer ofengineers, Toyota found that it could not transfer system knowledge inthis way. Nor was this strueture particularly appropriate for interproject knowledge transfer.
Toyota's rapid growth in size partially caused these organizational
problems. One way to increase the chief engineer's authority and toeliminate problems caused by narrow specialization is to create a pureproject team organization, such as the one Chrysler adopted for its LH

and Neon projects6. In this organization, almost all engineers
exclusively work for a single project for its entire duration. However,Toyota did not consider the project team organization efficient. This

type of organization can work well for firms with a small number ofprojects and little technical interdependency between multiple products
concurrently being developed. Because Toyota has many projects anda limited number of engineers, jt cannot assign engineers to a specificproject for the entire duration of the project. The peak period fordesign engineering work for engineers in a specific project lasts only
about one and half or two years out of a four-year project. Therefore,

when a project task is outside of the peak, engineers should betransferred to other projects to be utilized efficiently. In addition, achange in the competitive environment discussed in the next section also

made the project team approach inappropriate. In the newenvironment, effective inter-project technology sharing has become
more lmportant.
Even the organization at Toyota prior to 1991 had problems withrespect to inter-project coordination. One of the policies of Toyota's
6 Many business magazines and industry journals have described the organizationalchange into the project team at Chrysler. Scott (1994) has summarized thesearticles and his own interviews at Chrysler. 'REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 101

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
chief engineer organi•zation was to encourage the autonomy of eachchief engineer with respect to his own vehicle project. Generalmanagers in the Product Planning Division above chief engineers,
therefore, did not supervise chief engineers in the details of individual

projects. In addition, the number of vehicle projects was too large forfunctional managers to deal effectively with multi-project management
issues such as resource allocation, technoiogy transfer, and component
sharing across all projects.

Finally, there was a problem regarding coordination with the

Research and Advanced Development (RAD) Group located at theHigashi-Fuji Technical Center'. The center was maintained relatively
independent of specific vehicle development projects, so that it could
focus on research and advanced engineering. However, both vehicle
projects and the RAD group were dissatisfied with this organizational
structure. Engineers for specific vehicle projects did not think that the

RAD group developed technologies that could be useful for theirprojects. On the other hand, engineers in the RAD group felt
frustrated because vehicle projects did not use technologies that they
developed. Toyota reached a conclusion that these two groups needed
more integration organizationally.

In summary, Toyota's product development organization had fiveproblems. These caused difficulties in both project integration andinter-project coordination:

1. There were too many functional engineering divisions with too

narrow specialization of engineers. •2. There were too many vehicle projects for each .functional
manager to manage the engineering details of each project aswell as inter-project coordination.

3. It had become much more complicated and difficult for chiefengineers to oversee all the engineering functions.

4. The chief engineer organization was not appropriate for inter-

project coordination. •5.The RAD group and vehicle projects were not sufficiently
coordinated.
7 Because Research & Advanced Development Group was mainly located in the
Higashi-Fuji Technical Center, these two names are interchangeably used.
Higashi-Fuji is located about 150 miles east of Toyota's headquarters, whichcontains the primary functions for product development. This paper uses a
shorter name, RAD group, which is original here and is not used at Toyota.

102 KENTARO NOBEOKA
Change in the Competitive Environment

The competitive environment surrounding Japanese automobile
firms started changing around 1991. There were two interrelated
issues. First, rapid growth in production levels at the Japanese firms

virtually ended. The aggressive product strategy of Japanese
automobile firms in the 1980's, such as frequent new productintroductions and replacements, had been partially based on theirassumption of continuous rapid growth. The new environment seemed
to require some changes in this strategy, as well as in company
organizations. Second, the importance of cost reduction became evenmore critical for international competition than before. In addition to
the appreciation of the yen, Japanese advantages in development andmanufacturing productivity have been diminishing. Both factors have

had a strong negative irnpact on the cost advantages they had been
enjoymg.
Because of these changes, the traditional chief engineer system,
which primarily focused on building the best individual products onceat a time, needed to be revised. Chief engineers always thought about
the success of only their own projects. A general manager who used
to be a chief engjneer said, "Each product manager wanted to increase
sales of his own project even by developing many new proprietarycomponents and by expanding the target customer segments of his
project into other product lines within Toyota." He explained that,during the period when Toyota's production volume was growing
rapidly, these characteristics of Toyota's chief engineer system worked

well for the Company. Because total production was growing rapidly,
cannibalization of individual product lines was not a major problem.
The market in each product segment also expanded, and this growth
made it possible for each project to expand its target market.
In addition, Toyota was able to sell more of most new products
than it had expected. Therefore, high development and production
costs caused by many new proprietary components was not much of aproblem either. A manager in charge of cost management admitted
that, "Prior to 1991, few new products met an original target cost when

it was introduced to the market. However, the sales volume for eachnew product was usually larger than its original plan. The large sales
volume lowered the actual production cost compared to its originalplan through scale economies. In the end, a new product usually

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 103

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
reached the production cost that had been originally planned, when theentire production during its life cycle was fully considered." Becauseof a faster depreciation of manufacturing equipment than originalplans, production costs also appeared to be lower than expected. Given
this common pattern, a chief engineer primarily tried to develop a new

product that would sell well, rather than a product that would meet aconservatlve cost target.

However, starting in 1990, Toyota's production volume stopped
growing and even started declining, as shown in Figure 3. Profit fromeach new product also started decreasing. Under these circumstances,
Toyota needed a new product development strategy and organization,
particularly with respect to cost management. One particular aspect of
the chief engineer system was considered inappropriate in this newenvironment: The rnanagement of each individual project was too
independent. Toyota concluded that multiple related projects needed
more coordination.
Figure 3 Production Units at Toyota
Annua] Production (OOO)

4000
3500
3000
2500
2000
1500
1000

500

o

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93

Source: Automotive Yearbook 1994

First, in the stagnant market, new products should be more
carefully positioned to each other so that any cannibalization would
not occur. Within a limited total sales volume, the expansion strategy
of one product line would easily cannibalize some portion of sales ofneighboring products within Toyota. Second, in order to reduce
production cost, Toyota needed to increase in commonalty ofcomponents and technologies among multiple new products. Sales
increase, which used to help cover shortage in cost reduction efforts,

could not be expected anymore. Under the Toyota's chief engineer
system, there was a tendency that each project overly developed its
proprietary components. There are many symptoms of the old product

104

KENTARO NOBEOKA

strategy and organization at Toyota. For example, there are now
three distinctive platforms for three products that are similar in size

and technology: the Corona/Carina, the Celiea/Carina ED, and the
Camry. A chief engineer for each project wanted to develop an ideal
platform for each product.

In view of these organizational problems and changes in thecompetitive environmental, Toyota decided to change its productdevelopment organization rather extensively. A new organizationneeded to strengthen the integration mechanisms for engineers in
different functions so{ that they could create a well-integrated new
product, as well as to facilitate coordination among different projects
so that technologies and components can be effectively transferred andshared. These two objectives are in a sense contradictory, because
Toyota needed both to strengthen its project orientation as opposed tofunction orientation, and to enhance inter-project coordination. For
example, a project-oriented team approach might be appropriate for astrong project orientation, but might be inappropriate for inter-project

coordination. On the other hand, strengthening the functional
orientation to enhance the efficient usage of specifie components
throughout multiple vehicle projects would be totally unsuitable toenhance an individual product's level of integration or coherence.
Therefore, Toyota decided to consider a new organization beyond themere balance between these two alternatives. Thus, Toyota reached aconclusion that it would fundamentally change its organizational
structure for product development.

3-2 Establishment of Development Centers

Toyota made two major changes in its product development
organization. These changes did not reduce the total number of people
working on product development at Toyota. At the end of 1991 before

the reorganization, there were about 11,500 people in productdevelopment, and the number rose to about 12000 in 1993. Rather thechanges specifically targeted the problems discussed in the previous
sectlon.

First, in 1992, Toyota divided all of its new product development
projects into three centers as shown in Figure 4. The center grouping
focuses on the similarity in platform design. Center 1 is responsible
for rear-wheel-drive platforms and vehicles, Center 2 for front-wheel-

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 105

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
drive platforms and• vehicles, and Center 3 for utility vehicle/vanplatforms and vehicles. Each center has between 1500 and 1900 people,
and works on about five different new vehicle projects simultaneously.
Toyota had considered other grouping schemes, such as by productsegment (luxury vs. economical vs. sporty cars, or small vs. medium vs.
Iarge cars). Toyota chose platform design similarity because thiswould lead to the highest level of inter-project design interdependencies

within a center. In addition, because new platform development
requires the most resources, sharing a platform design among multiple
product lines would save the most in engineering investment and reduce
production costs most effectively.

'
Figure 4 Toyota's Product Development Organization as of 1992

2•
-ti
n
:, se
,:
S8

=
.n-"-s'A'- y'ths. ,?' inli :.g :- c•? 'E si fi" 'ts,StfQ= ]9 .
b'. •8S-8•g .ta•,vas .g ;g l, g•
L/=tl=/y-Center 1

Center 2

Center 3

e
" e
e
e
" e
e
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" e
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1

-

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-

-

1

=

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-

-

-

-

-

-

-

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)hrCenter HeadeChief Engineer

IFunctional Manager

106 KENTARO NOBEOKA
Second, in 1993, Toyota created Center 4 to develop components
and systems for all vehicle projects. It reorganized the Research andAdvanced Development Group (the RAD Group), and assigned mostpeople from this to Center 4. While the RAD Group used to work on
research and advanced development rather independently, Center 4
closely supports vehicle development by providing specific projects withcomponents and systems. In addition to engineers in the RAD group,Center 4 added engineers working on some components such as
electronics and new engines that did not need much daily coordination
with a vehicle project.

As discussed earlier, the center organization changes were
supposed to improve both project integration and inter-project
coordination. This section specifically describes how some key aspectsof the reorganization related to improvement in these two areas.
Important features of this reorganization include: '(1) Reduction of the number of functional engineering divisions.

(2) Reduction of the number of projects for each functional
manager.
(3) Changes in the roles of the center head for multiple vehicle
proJects.
(4) Establishment of planning divisions in each center.
(5) Adoption of a hierarchical organization for chief engineers in
related projects.
(6) The roles of Center 4.
(1) Reduction of Functional Engineering Divisions

In order to decrease coordination tasks required for a wellintegrated vehicle project, Toyota reduced the number of functional
divisions for design engineering. The complexity raised by the large
number of functional divisions made it difficult for chief engineers tomanage vehicle projects. While the old organization had sixteen
different functiona} divisions, each new center has only six engineering
divisions.

This simplification into the center organization prompted two otherchanges. First, specialization in each functional engineering division

widened. For example, as shown in Figure 5, Toyota used to have two

separate divisions for designing bodies and interior/exterior
equipment: the Body Engineering Division and the Interior Engineering

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 107

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
Division. In the new organization, the Interior Engineering Division
merged with the Body Engineering Division. Another example is themerger of two different chassis engineering divisions, each of which
had been separately responsible for suspension systems and brakes.
Each design engineering division now has wider design responsibilities.
Figure 5 Old and New Organizations for the

Body Engineering Function

Old Organization (1991)

BodyEngineeringDiv.1(Front-wheel-drive)

Body Outer Parts
Body Structure

BodyEngineeringDiv.2(Rear-wheel-drive)

Body Outer Parts
Body StructureInterior Engineering Div.

Exhaust Parts
Instrument Panel
Seat

Door, Ceiling, Flooring
Interior Equipment
Airconditioning Parts

New Center Organization (1992)

BodyEngineeringDiv.1

ProductA
ProductB
ProductC
ProductD

BodyEngineeringDiv.2

ProductE
ProductF
ProductG
ProductHCenter1

Center2

BodyEngineeringDiv.3
Center3

ProductI

ProductJ
ProductK
ProductL

108 KENTARO NOBEOKA
An important point is that this did not enlarge the size of eachfunctional division, because each functional division is now responsible

for only a limited number of projects within the center.

Second, Toyota also reduced the number of functional divjsjons to
be managed in a specific vehicle project through the usage of Center 4,
the component and system development center. In order to simplify thework of the first three centers, Toyota separated development of somecomponents and systerns that can be managed outside specific vehicle
projects. Toyota considered three factors to decide whether particularengineering functions. should be in a vehicle project or the component

center. First, managers decided that components that need to beextensively tailored to each vehicle project should be managed within aproject. Second, components that have to be carefully coordinated withother parts of the vehicle design should also be developed within the

project. On the other hand, some components with modular
characteristics can be developed separately from specific vehicle
projects and still be inserted into a product design relatively easily.

These may be developed in Center 4. These types of components andsystems tend to be shared by multiple vehicle projects, and it is notefficient to develop them in a specific project. Third, component

development that needs much new technical knowledge should be
developed in Center 4. Such development usually requires a group oftechnical specialists working together. These types of components also
sometimes need a long time to develop and do not fit the time frame of
specific vehicle projects.

Following these guidelines, Toyota allocated the development ofsome components or systems to Center 4. For example, the upperbody design directly visible to the customer has to be differentiated ineach product. It should also be extensively interdependent with otherparts of the automobile design, such as the chassis and interior.
Therefore, the upper-body design should be managed within the project,

and Toyota maintained this function within Centers 1-3. 0n the other
hand, components like batteries, audio systems, and air conditioners do
not usually need to be tailored to each different vehicle project.
Therefore, Toyota moved the Electronics Engineering Divisions thatdeveloped these electronic components to Center 4.
The example of the Electronics Engineering Divisions is actuallymore complicated and indicates the extensive thought and analysis that

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 109

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
Toyota put into implementing this reorganization. Toyota carefully
examined characteristics and interdependencies of each component
development, so that Centers 1-3 can be simplified and yet contain all

relevant components that need extensive coordination within eachvehicle project. For example, among the electronics components, thewire harness usually needs to be tailored to each vehicle project andhas considerable interdependency with the body structure. Therefore,

Toyota merged this engineering function into the Body Engineering
Divisions and kept wire harness development within Centers 1-3.
Another example of eliminating activities from the vehicle project
centers is the development of totally new engines, which is now Iocatedin Center 4. There are many engineering tasks involved in new engine

development that are not related to integration tasks within aparticular vehicle project. In addition, the time frame of new engine
development does not fit that of specific vehicle projects. New engines
usually need about six to eight years to develop, which is longer than
the 4-year lead time of the average new vehicle project.

In this way, only component engineering that needs extensive
project integration remains in the vehicle project centers. In the oldorganization, part of the product development organization was
responsible for both vehicle projects and most component development.
This mixture made the old organization complicated and difficult tomanage.
In summary, by widening the engineering specialization within eachdivision and by transferring some component development into Center
4, Toyota limited the number of functional divisions in Centers 1-3. In

addition, because Toyota divided each function into among threecenters, the wider specialization did not require larger functional
divisions.

(2) Reduction of the Number of Projects for Each Functional Manager

Each functiona} manager is responsible for a smaller number ofprojects in the new center organization. For example, managers inCenter 1 can focus only on vehicle projects with rear-wheel-drive
platforms. Because, in some functional areas, there used to be too
many projects for functional managers to oversee, it was difficult forthem to pay careful attention to all the projects. For example, as
shown in Figure 5, the functional manager for interior engineering was

110

KENTARO NOBEOKA

responsible for all different vehicle projects, which usually added up to
about 15 concurrent projects. In the center organization, all functional

managers are responsible for only about five product lines that are alltechnologically related to each other. Each functional manager now
can spend sufficient time on the coordination with each chief engineer.
In addition, this reduction of the management scope for each functional

manager should result in more effective multi-project management insuch areas as resource allocation and technology sharing. Eachfunctional division can also focus on fewer types of vehicle
technologies. This focus may lead to more efficient development andaccumulation of technical knowledge as a division.
(3) Roles of the Center Head for Multiple Vehicle Projects

Each head of Centers 1-3 officially supervises the entjre productdevelopment operations, including both chief engineers and design
engineering functions within the center. Equivalents to the center heads

in the old organization were three deputy general managers above chiefengineers in the Product Planning Division. Each of the deputy generalmanagers was in charge of small cars, large cars, and trucks/vans.

They.reported to the general manager of the Product Planning
Division. However, they officially managed only chief engineers, notfunctional managers and engineers as seen earlier in Figure 2. These

general managers above the chief engineers, therefore, were notsupposed to manage design engineering in detail. In addition, there
were also general managers above the functional managers, and it was
not often clear which general managers - those above chief engineersor those above functional managers - had more authority. In thecenter organization, each of the three center heads manages
engineering details for multiple vehicle projects within the center. Fromthese perspectives, while the old organization was officially a matrixorganization both at the chief engineer level and at the generalmanager level, the new one is organized primarily around projects.
Using their positions, the center heads are supposed to play two
important roles that have to be deliberately balanced. First, a cente.r.
head helps each chief engineer integrate different functions. One of the
key elements of the Toyota chief engineer system has been the strong
leadership of a chief engineer. However, as discussed earlier, chiefengineers recently found some difficulties in coordinating all the

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 111

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
functional managers. In the center organization, chief engineers canuse the center head's support to manage different functions. Second,each center head is responsible for the coordination of different vehicle

projects within the center. A center head can now effectively implement
this because he manages all the operations in the center. The separate
planning division in each center, discussed next, also helps the center
head coordinate projects.

(4) Establishment of Planning Divisions in Each Center
Each center has a planning division to support the management ofeach center. The Planning Division consists of staff members and three

departments: the administration department, the cost planningdepartment, and the product audit department. There are about 170 to

200 people in each planning division of the three centers. The
administration department is responsible for personnel management,
resource allocation, and the long-term product portfolio planningwithin each center. It also conducts an advanced concept study for
individual projects, before these projects become a formal project anda chief engineer is assigned.
The equivalent of the PIanning Divisions in the old organization

was the Product Planning Division. One of the major structuraldifferences is that chief engineers used to be located within the Product

Planning Division. Most members in the Product PIanning Division
directly worked for individual chief engineers. For example, most costmanagement people in the division used to be divided by vehicle projectand primarily reported to individual chief engineers. On the other

hand, in the new organization, cost management people are more
independent of chief engineers and report to the planning division
manager and the center head in each center, although they continue towork closely with chief engineers. This reflects one of the central

concerns at Toyota, which is that each center needs to reduce
development and product costs by efficiently leveraging resources andcomponents across multiple projects.
Each center also does long-term product portfolio planning. The
management scope used to be so large in the old organization that the
project portfolio planning and resource allocation for each project were

too complicated to be effectively managed. Now the Planning Divisionin each center can consider technology sharing and resource allocation

KENTARONOBEOKA112

among multiple projects in the present and the future more carefully

than before, by focusing on a limited number of closely related
projects. This type of center-oriented management support may be
critically important to the effective operation of the centerorganlzatlon.

(5) Hierarchical Organization of Chief Engineers
Another feature in the center organization is the hierarchical chiefengineer structure for managing product families as shown in Figure 6.
. strengthen the multi-project perspective of theThis structure also helps
center organization. For example, there used to be two separate chiefengineers for the LS 300 and the Supra projects. Now, there continue
to be two chief engineers, but one of the two supervises both the LS
300 and the Supra projects, and primarily manages the LS 300 project.
The other chief engineer manages the Supra project and reports to thechief engineer of the LS 300. Toyota also made the same kind ofchange for another pair of projects: the Tercel and the Starlet.
Although this type of structure is not adopted for all projects, Toyota
appears to be moving the organization in this direction.
Figure 6 Hierarchical Chief Engineer Organization for Multi-Project Management

Discrete Chief Engineer Hierarchical Chief Engineer

Organization(Old) Organization(New)

Chief Engineer- Product A

chi ,' :,eeg.i:,el:,T,r

Product A
Product B

Chief Engineer- Product B
ch ze:,?rgE#,eri,T,r

Product c

Chief Engineer- Product C
Product D

Chief Engineer- Product D' ' of these pairs of projects
Eachshare almost identical platform anddrive-train designs, even thoughthese two projects target completely
different customer segments and haveseparate product concepts. For
example, the LS 300 is a luxurycar. Therefore, it is important topersonal car and the Supra is a sports
manage the two projects separately,
so that each project develops
a product that fits with its own customer
needs. A planning division manger at Toyota says that it is difficult

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 113

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
for a single chief engineer to develop two products with widely separate

concepts and to give the same level of commitment to each of these.
However, at the same time, because these two projects should share thesame platform design, they need extensive coordination. Therefore, theprojects have to achieve differentiation in product characteristics andintegration in product development at the same time. The hierarchicalchief engineer organization is one way to pursue these two goals
simultaneously.

(6) Roles of Center 4

As explained earlier, Toyota based Center 4 primarily on the RADgroup in the old organization. As shown in Figure 7, the basic
structure of the organization and technical areas have not significantly

changed. Technical areas of both the old and new organizations
include vehicle (body and chassis), engine and drive train, electronics,

and materials. The most important aspect of the change was that,while Center 4 focuses on developing components and systems forvehicle projects, the RAD Group was relatively research-oriented. The

relationship between the RAD group and vehicle projects was thatbetween upstream and downstream organizations. Center 4 hasvirtually become a part of the vehicle development organization, and is

responsible for system components that could be better developed
outside specific vehicle projects.

The RAD group had about 2000 people, while there are about 4000
in Center 4. As discussed earlier, some components or systems likeelectronics and new engines can be developed more appropriately
outside specific vehicle projects. Centers 1-3 can now focus onachieving project integrity.

One of the most significant improvements regarding Center 4 was
the introducUtion of a new organizational mechanism, called the cross-area system project. Development of some new systems need newtechnical knowledge in multiple technical areas. To develop such new

systems, Toyota forms project teams containing engineers andresearchers from multiple technical areas. These projects aretemporarily located in the Planning Division in Center 4, and theirleaders are selected and assigned by the head of Center 4. In the old
RAD Group, different technical areas usually worked separately andtheir coordination mechanism was not strong enough to deal with thisKENTARO NOBEOKA

114

type of project.

For example, Toyota recently developed a new low-cost anti-lockbrake system (ABS). Center 4 was responsible for developing the newABS. In this case, similar systems could be used for all vehicle
projects. It is not efficient if either an individual vehicle project or a

product deveiopment center develops this type of new system. Its

development needed new technologies in the areas of chassis,
electronics, and materials. Toyota thus formed a project teamincluding people from these teehnical areas to develop the new ABS. A

manager at Toyota says that the cross-area system projectsignificantly improved the efficiency of developing this type of new

system component.
Figure 7 Center 4 and its Original Organization
Old Organization: Research & Advanced Deveropment Group (RAD Group)
Administration
VehicleDiv.

Research& Advanced Eng. Div.

Senior Managing Director
in charge of Reseach &Engine Research & Advanced Eng. Div.

Advanced Development

R & D Div.

I(Engine)

R & D Div.

ll(Materials)

R & D Div.

M(Electronics)

New Organization:

Cross-Area System Projects

Center 4

PlanningDiv.
-':-:::::-

VechicleEngineeringDiv.

ChassisComponentEng.Div.
Center HeadEngineEngineeringDiv.I-M
Drive-TrainEng.Div.I-M:

ElectronicsEng.Div.I-IV

MaterialEng.Div.I-M'

The head of Center 4 is supposed
divisions of

the different technicalpredecessor in the old organization.

to work on integrating allareas More actively thanIn the oldorganlzatlon,

the
his

the

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 115

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
division rnanagers of the different technical areas were relatively
independent. Because in the RAD group, technical inventions withineach technical area were important, top management gave each division
relatively strong autonomy with respect to research agenda and timeframe. The introduction of the cross-area system projects represents
the new orientation of Center 4, as well as the important role of its
center head.

Toyota did not completely discard its basic research functions.
Toyota Central Research & Development Laboratories, Inc., which has
about 1000 researchers, continues to work on basic research as aseparate R&D unit. In addition, because Center 4 becarne lessresearch-oriented, Toyota established a new Research Divisioninternally, and assigned about 500 researchers to this, primarily fromthe old RAD group.
Summary of the Changes in Organizational Structure

Figure 8 summarizes the changes in the vehicle development
organization from the old product development group to Centers 1-3,
and in the component/system development organization from the RADgroup to Center 4. The product development group was simplified in
two ways by the new center organization. First, it excluded someareas of component and system development in order to focus on the
integration of product development activities, rather than component
and system development. This change reduced the number of people inthe core product development organization from about 7000 to 5000.
Second, the entire organization was divided into three centers. As aresult, each center has only about 1500 to 1900 people. It is a drasticchange with respect to management scope, if compared with theoriginal size of 7000 people.

Regarding the component and system development organization,
there was a shift in orientation from research to system development.

Because Center 4 is responsible for the development of morecomponents and systems than the RAD group, the number of people
increased from about 2000 to 4000.

3-3 Outcomes of the Organizational Changes
Because of the introduction of the center organization, Toyota
achieved significant improvements in several areas. In particular, itNOBEOKAKENTARO

116

Figurethe Vehicle Development
8 Changes in the Coverage ofComponent/System DevelopmentOrganizations
Development Organization

Change in Coverage of ProductComponents

VehiclesSysterns

Basic Researchand theProduct
Development&

Development

Group
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Development/wi,/,mawa/x/ee1/ee.ma..ww.//tttw,,\',wwi',..fmum

Product
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Changein Coverage of Component Development Organization

Components
Basic Research&

Systems

Vehicles

RAD Group(Higashi-Fuji

Technical Center)

Development#iiegi'lg/il"

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'tstl---.lva. "Et$itL'ilv'(' •:!-hum.E.'l"'-'"

Advanced"'Engineeringtt
gtxx•,71i.•

Development'c,.wh'.kl-i.ttttwa•irw.lt'//..pa,".,i,/is•'/gtag///'Nii:'Xgi

ter 4

mponent
Product
Development

Systern
Center)OOId Orgnaization @New Organization
Source: Based on "Outline of Toyota Technical Center

1993", Toyota Motor Corp.,

1991 andREORGANIZING FOR MULTI-PROJECT MANAGEMENT: 117

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
simultaneously improved both cross-functional project integration andmulti-project integration. This section discusses some important
outcomes of the reorganization, focusing on these two perspectives, aswell as some potential problems of the reorganization.
Project lntegration through Streamlined Structure

Figure 9 summarizes the outcomes of the reorganization withrespect to the reduction of coordination tasks for chief engineers tomanage different functional groups. As discussed earlier, before thereorganization, each chief manager had to coordinate, on average, 48

departments in 12 divisions to manage new vehicle development.
Primarily because of the reduction in the number of functional divisions

and departments, in the new organization a chief engineer has tomanage only 15 departments in 6 divisions. Toyota also comparedthese numbers with those back in 1976, when there were only about
5000 people working for product development. At that time, each chiefengineer had to communicate with 23 departments in 6 divisions. Thechange into the new organization reduced the communication
complexity down to the level in 1976, when the Shusa organization
worked more effectively than the time just before the reorganization.
Figure 9 Changes in the Number of Divisions to be CoordinatedNumber of Divisions/Departments

50
ng

40

ZDivis[]Depa

30
20
10
o

23
12

6

1976 1991 1993

Source: Based on "Activities and Achievenzents of IiTP21", Toyota intemal
document, 1994

Each functional manager and engineer now covers a wider portionof the automobile design. Because of this, cross-functional
coordination tasks had naturally decreased among chief engineers aswell as engineers, which directly affected the effectiveness and the118 KENTARO NOBEOKA
efficiency of project integration. In addition, it has become relatively

easy for funetional managers and engineers to see the entire picture ofa vehicle project. This change also solved some other problems in theold organization. Engineers can train on the job for the time when
they will be promoted to a manager, because they can now obtainknowledge of a broad scope of component engineering. Engineers can
now also obtain more sense of achievement regarding specific vehicle
projects. This seems to have positively affected the level of engineers'

commitment and job satisfaction.

Because each functional manager is responsible for fewer vehicle
projects than before, it has become easier for a chief engineer tocommunicate frequently with functional managers. There used to be
regular meetings among a chief engineer and the entire functional
managers only about once every two months. Now, chief engineers andthe six functional managers, as well as the center head, have weekly
meetings, called the Center Management Meeting.
The introduction of the center heads also greatly contributed to theimprovement of project integrity. Chief engineers both in the old andthe new organizations have not assumed formal authority overfunctional managers. On the other hand, center heads oversee all
product development projects, including the work of functional
managers. The center heads can work directly on integrating different
engineering functions. Using this position, they also support chiefengineers to coordinate different functions. For example, when a chiefengineer encounters difficulty in negotiating with a strong functional
manager, he can discuss the issue in the Center Management Meeting,and the center head may support the chief engineer. Decisions made asa center can be smoothly and quickly implemented. In this sense,
through the combination with the center head, chief engineers regained
the strong authority that the original Shusas used to enjoy.

Table 1 summarizes achievements on some importantmeasurements. The new organization helped reduce development costson the average project by 30 percent. The number of testing
prototypes used in the average product development project decreased
by 40 percent. This reduction of prototypes was a primary source forthe reduction in development costs. The reduction of the number of
testing prototypes has reflected the effective communication in theorganization. In order to test many different items in one prototype,REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 119

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
Table 1 Outcomes of the Reorganization to the Centee
Performancechange
Developmentcost(averageproject)

Numberofprototypes(averageproject)

-30%

-40%

Ma'orfactors.Reductionofprototypes.Increaseincomponentsharing..Intensivecoordinationbetween
differentengineeringandtestingfunctions.IncreaseinCAEusage
Leadtirne(averageproject).Reductionofprototypes

Shortenedbyafew .Moreextensivesimultaneous
monthsengineering

Source: Based on "Aetivities and Achievements of FP21", Toyota intemal document,

1994
an intensive coordination among different design divisions and testing
divisions is needed. For example, without appropriate communication,
it is difficult to install the testing items for interior equipment andchassis into a single prototype. Because of the simplification of theline of communication and project coordination, Toyota has also
increased the extent of simultaneous engineering, which has helped cut

project lead time by a few months. Stronger project management
supported by the center head may also have contributed to quicker
decision making and development processes.
Multi-Project lntegration withj'n a Center

The new organization strengthened the multi-project management
perspective with the strong leadership of the center head and strong
support from the center-oriented planning division. Because of thelarge number of vehicle projects, it. was difficult to manage Toyota's
entire project portfolio and inter-project coordination. Now, the weekly

Center Management Meetings discuss the details of multi-project
management. In addition, each center now has its own building so that
all members within a center can be co-located. Co-location at Toyotaemphasizes the geographical integration of the center members rather

than just the members of an individual project, which is•becoming
common in the U.S.
8 A general manager we interviewed said that these numbers are based on acomparison of similar projects. These numbers include not only direct outcomesof the change in the organization structure but also those of accompanying processchanges. In addition, some factors that are not directly related to thereorganization, such as the increase in CAE usage, are also included.

KENTARO NOBEOKA

120

In order to achieve the integration within a center, to begin with,each center defines its own vision and theme for product development.
Sharing a basic vision that focuses on projects within the center helps
members effectively coordinate engineering activities. The current
development themes of each center are:
. Center 1: Development of luxury and high-quality vehicles. Center 2: Development of innovative low-cost vehicles. Center 3: Development of recreational vehicles that create newmarkets.

One example of the changes can be seen in cost management
activities. Targets for development and product costs used to be set
and managed mostly at the indjvidual project ]evel, Ied by individual

chief engineers. Most cost management staff members used to work
directly for chief engineers and their orientation was the cost
performance of individual projects. In the new organization, in
addition to the cost management at the project level, each center
manages the cost target of all the projects within the center, led by thecenter head. Cost management staff members are now located in the
Planning Division in each center and report to the planning division
manager and the center head. Through this new organizational setting,cost management is supposed to add the multi-project management
perspective. Specifically, eaeh center has been working on morecomponent-sharing among multiple vehicle projects, which is one of themost effective ways to reduce product costs. In order to achieve this,project-level management alone was not sufficient.
With respect to component sharing, one critical issue each center is

now working on is the reduetion of the number of basic platforms
utilized among multiple products. For example, in Center 2, currently
there are five distinctive platforms: 1. Celica / Carina ED / Caren, 2.

Camry / Vista, 3. Corona/ Carina, 4. Corolla / Sprinter, and 5.
Tercel / Corsa / Starlet. The planning division manager in Center 2
believes that five different platforms for these compact-size frontwheel-drive models are too many. Center 2 is planning to significantly
reduce the number of the platform desjgns within several years.
People at Toyota tended to think that, because each of the fiveplatform designs had been produced at the level of more than 200,OOO
units/year, a distinctive design could be justified by economies of

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 121

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
scale. This is true with a distinctive die that is needed for different
platform designs, because at that level of production, each die is fully
used for its life cycle. However, there are many other areas that could

benefit from the reduction of platform designs. Some areas that could

expect much cost reduction from platform sharing include prototype
production, testing, designing, and component handling. The planning
division manager concludes that one of the major challenges for thecenter in general is to develop multiple products that use as many
common components as possible, and still enable each product toprovide customers with as much differentiated functions and values as
possible. The focus of each Planning Division on the limited number oftechnically related projects within the firm has facilitated more carefulproject portfolio management within the center.

With respect to component systems smaller than the platform
design, Toyota has started a component sharing program thatmonitors component and system usage in individual projects. Toyota
chose 290 different component systerns for this program, which ranges

from a system assembly like an instrumental panel to a small
component like a door regulator. Toyota makes a list of a limited
number of component variations for each component group. A new
product development project is then supposed to choose a component

from the list. When a vehicle project wants to invest in thedevelopment of a new component design, it must come up with a new
design with a better cost-value ratio than any of the existing

components on the list. When a new component design meets therequirement, it replaces one of the components on the list, so that the
total number of variations will not increase within the firm. Because of

the center organization, management of this program has become
practical and effective. In the eld organization, because of the large
management scope, this type of sharing was not managed properly.
One of the other signs of the integration of center members is asense of inter-center competition that center heads and members havebegun to possess. The three centers have been competing with eachother regarding the percentage of cost reduction compared to past
projects that had been developed before the reorgahization. This
competition has a positive impact on organizational learning. The
center head encourages engineers to learn any superior processes fromother centers. The competition may have a negative impact on

122

KENTARO NOBEOKA

organizational learning in some other firms, if each center tries not totransfer its good processes. At Toyota, this does not seem to be thecase. Each center has its own engineering functional divisions such as
body engineering and chassis engineering. Three engineering divisions
for the same type of technologies and components are competing. For
example, when one body engineering division comes up with an effective
idea for cost reduction, the other two divisions are strongly encouraged
to learn the idea, so that they will not stay behind other centers.

Other activities have started within each center to strengthen thecenter integration, which directly or indirectly helps multi-project
coordination within the center. For example, Center 1 held a designand engineering competition in which groups of young designers andengineers compete with innovative cars for a motor show. Center 3 has

started a program called the "Let's Challenge Program," which
encourages center members to submit any interesting and useful ideas
for new models. Each center also publishes its own newsletter. These
activities and programs enhance the intra-center integration.
Potential Problems of the Center Organization
The plannjng division manager of Center 2 raised two challenging
problems. First, it is difficult to balance the chief engineer's autonomy
and the center integration. Extensive guidelines given to each chiefengineer from the center management may cause a negative impact on

the motivation and commitment of chief engineers. Toyota doesn't
want chief engineers to think that they should work only on what thecenter decides. This planning manager believes that the center
management provides basic and critical guidelines, in which chiefengineers maintain authority. There are six people who play a criticalrole in the center management: three center heads and three planning
division managers. Except for the planning division manager of Center
3, who used to be an engine design manager, five of the six used to be

chief engineers. This personnel assignment may help avoid any
unnecessary misunderstanding between the center management andchief engineers.

Second, there may be some problems regarding inter-center
coordination. The center grouping based on technology and design
relatedness aimed at minimizing the inter-center coordination
requirements. For example, the old GM organization, which was based

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 123

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
on divisions such as Chevrolet and Buick, created difficulties because
similar designs and technologies were utilized by products in different

divisions and resulted in excessively similar products. Compared tothat kind of grouping, the center organization at Toyota is more
appropriate for a product development organization that tries to sharecomponents and produce distinctive products. However, there are stillsome problems. The planning manager in Center 2 mentioned one
example. When sports-utility vehicles became a hot segment, all threecenters proposed the development of such models. Because Toyota
doesn't need to develop three sports-utility vehicles in parallel, inter-

center coordination was required. Although inter-center coordination
could become the next problem for Toyota, benefits from the interproject integration within the center seem to surpass the potential
problems at this point of time.
4. Discussion and Conclusion
This case study has discussed a new organizational structure that
pursues multi-project management by analyzing changes in productdevelopment organization at Toyota. There are several important
points we can learn from this case. First, this paper confirrns that

Toyota has shifted beyond a traditional product development
organization that is oriented towards either single project orengineering functions. Figure'10 describes this evolution pattern withrespect to the organizational orientation in product development.
Toyota shifted from a function-oriented to project-oriented matrix
structure in the 1960s (Ikari, 1985). As Clark and Fujimoto (1991, p.
276-280) discussed, by the mid-1980s, some other Japanese firms, which

had followed Toyota, had also shifted to strong project-oriented
management systems.
This paper has come to conclusion that, during 1992 and 1993,
Toyota shifted from project-oriented management to multi-project
management. One of the most important aspects of effective multiproject management is to improve both cross-functional and interproject integration simultaneously. The center organization at Toyota
improved inter-project coordination among technically related projects.
At the same time, Toyota has improved cross-functional integration bystrengthening the authority of product managers, who are supported

KENTARONOBEOKA

124

Figure 10 Evolution

Pattern to Multi-Project

Functional Org.

@

StrongManagement

Multi-Project Org.
(Toyota, 1990s)- Toyota@- Chrysler@
Inter-ProjectLightweight PM Org.

Coordination(Chrysler, 1980s)

PM:ProductManager

He?ly,w,gi,g.?tlgPsll(l)O'g•@

Weak

Project Team Org.
(Chryster, 1990s)@

Weak Cross-Functional Strong
Coordination

by center heads, over functional managers. Cross-functional integration
tasks were also streamlined so that additional tasks for inter-project

integration can be carried out more effectively. The Toyota centerorganization seems to be an effective multi-project management
organization, even though we understand that this paper is limited interms of generalizability due to the fact that it employs a single-firmcase study method.
With respect to organizational evolution, Toyota's movement can becontrasted with the one at Chryslerg, which is also described jn Fjgure
10. A primary issue for Chrysler in the 1980s was a lack of crossfunctional coordination and integrity. Because Chrysler wanted tostrengthen cross-functional integrity, in 1989 it changed theorganization from one with lightweight product manager to a project

team organization by discarding barriers between engineeringfunctions. Scott (1994) has argued that the new Chrysler organization
worked effectively to optimize the development of individual products

such as the LH and the Neon. In contrast, because Toyota aimed at
multi-project management, it changed its organization into a centerorgamzatlon.
9 See- Scott (1994) for description concerning the reorganization at Chrysler.

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 125

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
There is one common similarity, though, between organizations at
Toyota and Chrysler. Both organizations are not traditional matrixorganizations but project organizations. The organization at Chrysler
focuses on individual projects, each of which is managed by a productmanager, while that at Toyota considers multiple projects, which aremanaged together by a center head, At Toyota, there remain some
aspects of a matrix organization within each center. However, becauseof the active management roles played by the center heads, who
officially supervise all functional engineers, the center organization canalso be considered as a project organization covering multiple projects.

Second, this in-depth case study has offered evidence that in order
to benefit from the center organization, a structural change of simply

grouping some projects together is not sufficient in itself. Other

automobile firms in the world also employ some type of productgrouping. However, grouping alone does not necessarily lead toeffective multi-project management, and organizations at other firms

do not seem to work as effectively as at ToyotaiO. Toyota madeseveral important changes along with the introduction of the multiproject center organization. For example, first, it reduced the numberof engineering functions in Centers 1-3, and added the component andsystem development center (Center 4). In this way, each center issimplified enough to simultaneously manage multiple projects within thecenter. The management scope of center heads and planning division
manager is small enough to oversee all activities within the center.
Second, a powerful planning division with more than 150 people in eachcenter a}so seems essential to support the eenter head. Third, clear
goal-setting specific to each center helps integrate center activities.
Fourth, each center is encouraged to compete with other centers in
performance, which leads to effective learning within the firm. The
center organization at Toyota works effectively because all of these
supporting mechanisrns have been carefully designed.

The international competitive environment facing Japanese
automobile firms has been in a transitional period (Fujimoto and
10 This statement is based on interviews at Nissan, Mitsubishi, and Mazda. At thesefirms, one example of the differences frorn Toyota is that some key functions suchas planning, chassis/engine engineering, and cost management are not divided
into centers. In this sense, it seems that these firms have been changing
organizations in the same direction as Toyota, but has reached only incomplete
multi-project organization.

126

KENTARO NOBEOKA

Takeishi, 1994). Toyota has taken the initiative in adopting a neworganizational form. Historically, during periods of transition, a few

leading firms that achieved early tight fit with the new competitiveenvironment by pioneering a new organizational form were successful(Miles and Snow, 1994). Toyota may have established anorganizational structure and process for product development that will

set new standards for large international automobile manufacturers.

This change has also come at an appropriate time. Because manyother competitors have adopted heavyweight product manager system,

in which Toyota had enjoyed leadership in the 1980's, Toyota's
advantage over its competitors had been disappearing (Ellison, et. al.,1995).

Even though this study has provided a detailed description of an
emerging organizational form that Toyota has adopted, there are manyquestions that remain for further study. First, this paper cannot
concisely conclude whether Toyota's approach is the most effective

arnong other organjzational options in this new competitiveenvironment. Now, competitors may or may not be following Toyota
and adopting a similar style center organization. We need to continue
to study similar organizational changes in other automobile firms to beable to carry out more systematic comparative studies. Second, it isalso important to examine details of organizational evolution patterns

from functional to project, or from project to multi-project
organizations. These patterns rnost likely depend on various factors
including competitive environment and product strategy. The role
played by management in organizational transitions may also affectthe adoption of a new structure and processes.
Lastly, we need to develop further the theoretical framework withrespect to the multi--project management organization. For example,
more conceptual discussions should elarify theoretical distinctions
between the center organization and traditional structures including
functional, project, or matrix organizations, as well as divisionalorganlzatlons.

REORGANIZING FOR MULTI-PROJECT MANAGEMENT: 127

TOYOTA'S NEW STRUCTURE OF PRODUCT DEVELOPMENT CENTERS
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(1)

(2]

Abegglen, James C., and George Stalk, Jr.: 19ss. Kaisha: The JapaneseCorporation, New York, Basic Books.

Clark, Kim B., and Takahiro Fujimoto: 1991. Product Development
Performance: Strategy, Organization, and Managernent in the World Auto
Industry, Boston, MA, Harvard Business School Press.

[3)

Davis, Stanley M. and Paul R. Lawrence: 1or7. Matrix, Massachusetts,(4)

Addison-Wesley.
Ellison, David, Kim Clark, Takahiro Fujimoto, and Young-suk Hyun: 1995.
"Product Development Performance in the Auto Industry: 1990s Update,"
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(5]

Fujimoto, Takahiro, and Antony Sheriff: 1989. "Consistent Patterns in
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(6)

Fujimoto, Takahiro, Kim B. Clark and Yaichi Aoshima: 1992. "Managing
the Product Line: A Case of the Automobile Industry", Unpublished Working
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(7)

Fujimoto, Takahiro and Akira Takeishi: 1oo4. Jidoshasangyo 21-Seilei eno

Sinario (Scenarios of the Automobile Industry toward the Twenty First
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(8)

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PRODUCTION SUBSIDIES,LOCAL CONTENTDIRECT INVESTMENT:REQUIREMENTS AND FOREIGN
A THEORETICALANALYSIS

Roger N. STRANGEThis paper provides a partial equilibrium analysis of the welfare effects ofinward direct investrnent for the host economy in the presence of domestic production
subsidies and local content requirements. The main conclusion is that if a production
subsidy is to be used to increase domestic output and employment, then the reductjon

in national welfare is Iess if the subsidy is made available to both domestic andforeign firms. Furthermore a production subsidy is a rnore efficient way of protecting

a component industry than a local content requirement on the final-goods industry.

Introduction
This paper provides a partial equilibrium analysis of the welfare

effects of inward direct investment for the host economy in thepresence of domestie produetion subsidies and local content
requirements. The analysis throughout assumes a "small" domestic
economy, which allows terms of trade effects to be disregarded. Partial
equilibrium analysis is used to highlight the distribution of the welfare

gains/losses from the foreign direct investment (FDI) within thedomestic economy - particularly the distribution of producer surplus
between domestic and foreign firms. Partial equilibrium analysis
focuses on individual industries, but ignores second-order effects
arising from changes in relative prices of goods and/or factors of
production. Both trade restrictions and FDI, however, have effects on

domestic prices, and thus typically give rise to inter-industry
movements of factors of production. FDI thus has repercussions
throughout the domestic economy beyond the industry directly affected.

The structure of the paper is as follows. The standard welfare
effects of production subsidies and local content requirements are first

briefly summarised. Then the effects of subsequent FDI are analysedusing familiar demand and supply diagrams. The final section

Roger N. Strange

130

summarises the main conclusions.
The Welfare Effects of Trade Restrictions

Trade protection may be provided in a variety of ways, notably
through the use of import tariffs, import quotas, and voluntary export

restraints (VERs). The equivalence of import quotas and (suitably
calculated) tariffs is a standard result of international trade theory,

though several instances have also been identified in the theoretical
literature where the equivalence breaks down'. VERs have also become
popular in recent years.
An alternative form of protection is the use of subsidies to promote
domestic production. Production subsidies are superior to both tariffs
and quantitative trade restribtions on efficiency grounds since their use

avoids the consumption costs of protection. Yet, as Baldwin notes,
governments typically prefer to assist industries through importprotection rather than production subsidies2. The reasons for thisapparent anomaly are perhaps twofold. First, subsidies require
expenditure by the government and this must be funded by borrowing
or taxes. In contrast, tariffs and quotas do not impose a fiscal burden,

though the welfare loss to the general public is rather greater. The
welfare loss is, however, less transparent and thus is likely to elicit lesspolitical resistance. If elected officials may be assumed to be motivatedby self-interest then they will prefer this line of least resistance.
Second, the burden of helping an injured industry through protective

measures falls upon the consumers who pay a higher price for theindustry's product. A production subsidy spreads the burden across all
tax-payers including those who do not consume the imported good.
A local content requirement is usually portrayed as a method ofprotecting domestic producers of intermediate goods (hereafterreferred to as components) but it may well be applied in a way which
protects domestic producers of the final good by discriminating against
the local production of the good by foreign firms. The requirement isthat producers of the final good purchase a minimum specified
percentage of their components from domestic producers. If the final-

good producers satisfy this requirement, they may then import the
1 See Strange (1995) for a general discussion.

2 Baldwin (1os9) p.119.

PRODUCTION SUBSIDIES, LOCAL CONTENT 131

REQUIREMENTS AND FOREIGN DIRECT INVESTMENT:A THEORETICAL ANALYSIS
remaining percentage of their component needs duty-free; if not, they

may have to pay a penalty tariff on the imports3. Local content
requirements may be specified in either value or volume terms. A
volume-based scheme is more likely if the components and final good
are reasonably homogeneous; a value-based scheme is almost inevitable

if heterogeneous products are involved. In comparison to atariff/quota on imported components when the final-good producers
pay the same price for all units purchased (imported or otherwise), a
local content requirement allows the final-good producers to purchaseimported units at a lower price than domestically-produced units. If theaim is to protect the domestic components industry, then a local
content requirement entails a lower welfare cost than a tariff/quota.

The Welfare Effects of Foreign Direct tnvestment
In Figure 1 (and the diagrams that follow), SdD refers to the supply
schedule for domestic manufacturers of the final good, SF to the supply

schedule (assumed to be infinitely elastic) of goods imported fromforeign firms in the foreign country at price pF, and Sm to the supply
SdD

Price

P,

--

--- -g- --

P.

l

J

PD'

:
7,
'

t-- /

ISM

.--

/

r-

SD

/

--- -.-------SF

1- T---Zl t-L -.--.1 --

ll11
/Il
1t
It
11
tt
l1
ll11
tt
1lqs
q2 q`
l

t

l
t
1
1
,
t
'

Figure 1

The Welfare Effectsof Foreign Direct lnvestment
lmports are lmpossible,
lnfeasible or Unprofitable

3 Or a penalty tariff may

be placed on the price of the final good.

D.
quantltywhen132 Roger N. Strange
schedule of goods manufactured in the domestic economy by foreign
firms. In drawing the supply schedule SfD it is assumed that there are
addititional fixed costs incurred by the foreign firms, but that theirelasticity of supply is rather greater than that of domestic firms`. SD(passing through points line AIT) is thus the effective domestic supply
curve. DD represents domestic demand for the good. It is assumed thatneither the foreign nor the domestic suppliers of the good are able toexploit market power, and thus that the market is a competitive one.
There are no barriers to entry, and it is further assumed that industry
costs do not vary with the level of output - i.e. there are no external

economies or diseconomies of scale. The foreign firms' producer
surplus is untaxed, and assumed to accrue to residents in the firms'

homecountries. 'The situation depicted in Figure 1 shows a domestic market inwhich imports play no part, either because they are impossible (e.g.
certain services), infeasible (e.g. because short supply lines are

required by customers), or unprofitable (e.g. because of hightransportation costs). For the sake of argument, suppose thatimporting is possible but only at a high price, pF. In the absence of
FDI, equilibrium is reached at point X at which q4 is the quantity of
final goods supplied by domestic firms (=domestic demand) and pD isthe domestic price. As pD < pF there are no imports. But, at price pD,

jt js profitable for foreign firms to manufacture in the domestic
economy. The additional domestic supply pushes down the equilibrium
market price to pD' while the quantity demanded increases to q6 (pointT).

The welfare implications of the inflow of FDI are as follows.
Consumer surplus increases by area pDpD'TX. The reduction in the
producer surplus of domestic manufacturers is given by area pDpD'JX,
so the domestic welfare gain is area XJT. However, producer surplus
equal to area JIT accrues to the foreign firms5. The net national
welfare effect is thus equal to the difference between areas XJT and
JIT, and will depend upon the various supply and demand elasticities.
In partieular, the more elastic is the supply schedule of final goods
4 These assumptions seem plausible - alternative assumptions could also be
investigated.

5 Total producer surplus is given by area pD'AITJ, of which domestic producer
surplus is area pD'AIJ. The foreign producer surplus is thus area JIT.

PRODUCTION SUBSIDIES, LOCAL CONTENT 133

REQUIREMENTS AND FOREIGN DIRECT INVESTMENT:A THEORETICAL ANALYSIS
manufactured in the domestic economy by foreign manufacturers (SfD),
t.he greater will be the net welfare benefit of FDI to the host nation.

Now consider the case where the cost of importing final goods
from the foreign country is not prohibitive (Figure 2). The free-tradeequilibrium is at point H where total market demand is qg, and thedomestic market price is equal to the price, pF, of imported final goods.

//
--/

/ll
--

/l

/T

-/
7-l

-!

!-I
P,

s.

:

AI
l

t

1

1

l

q, qg quantity

Figure 2 A Domestic Market satisfied through lmports and throughLocal Production by Domestic Firms.

Dornestic manufacturers supply a quantity qi, and imports account for(qg-qi). There is no incentive for FDI as the supply schedule SfD lies

wholly above the domestic price Ievel pF. The domestic industry now
lobbies for protection from imports6.
Protection through a Production Subsidy.
Suppose now that protection is provided by means of a production
subsidy - see Figure 3. Again the free-trade equilibrium is at point H
where total market demand is qg, and the domestic price is equal to theprice (pF) of imported goods. Domestic firms supply a quantity qi, andimports account for (qg-qt). There is no FDI.
Assume that the objective of the subsidy is to raise the production
6 See Strange (1995) for an analysis of the effects of FDI in the presence of importtariffs, import quotas, and VERs.

D.

1su Roger N. Strange'of domestic firms from qi to q3. This can be achieved by a per-unit
subsidy for each unit produced and sold by domestic firms, and thiswould rotate their supply schedule from SdD to SdD". If the domestic
firms receive a subsidy equal to (p2-pF) in addition to the world priceof pF, they will be prepared to supply a quantity q3. Consumers,
however, continue to pay the world price pF and to purchase a quantity
qg (rather than qs jf they had to pay a prjce p2). The volume of imports
falls to (qg-q3)8. The production subsidy thus provides the same level ofprotection as the equivalent tariff, but avoids the consumption effect of

the higher domestic price, and thus may be achieved at lower welfare
cost. The cost of the subsidy is equai to area p2pFCR, of which p2pFBR
is an increase in domestic producer surplus. Only the production effectequal to triangle BCR is a net cost to the economy.

Y

Ps

Sdlh
1
1
I
1
1
1
1
1

Price

l

1 Sn

l

p, -------R-.. S ltl

1
pi -----Ji-il---ÅÄ/ -'-Ti ..s,,,,lt 11 --

1 -ll' l l.ll ---p".2ii-;z'Li'ILi16'c----ili:-:':'it'E1-------"'-F-d---srF

1 ll t1 l Dl)

Fiqg'ure 3 q2ThZ" weifa/`e Effectqse of Foreign Direct tnvestqm'ent inq"tah"etitY

Presence of a Domestic Production Subsidy.
7

A lump-sum subsidy would give rise to a rightward, parallel shift of the supply
schedule.

8

The reduction in imports is smaller than under the equivalent tariff. If theobjective of the protection is to reduce imports to a quantity equal to (qs-qs) thena larger subsidy will be required.

PRODUCTION SUBSIDIES, LOCAL CONTENT 135

REQUIREMENTS AND FOREIGN DIRECT INVESTMENT:A THEORETICAL ANALYSISThe introduction of the subsidy (assuming it is only available todomestic firms) provides no incentive for FDI. The price of final goodsin the domestic market (pD) is still equal to the world price pF, so
foreign firms will still export from their own countries.

Suppose instead that the objective is to increase domestic output to
q6 - i.e. the level of output produced domestically when prote6tion isprovided by a tariff of p2-pF. This could be achieved either by giving
domestic firms a unit subsidy equal to (p3-pF), or by giving a unit

subsidy of (pi-pF) for domestic production by both foreign anddomestic firms9. In the former case, the net.welfare cost of the subsidy

would be equal to the triangle BEY. In the latter case, there would be
an incentive for FDI and the market demand of qg would be satisfied
partly by imports (qg-q6), partly by domestic firms (q2), and partly
through local production by foreign firms (q6-q2). The cost of thesubsidy to the government is now only pipFET, of which ptpFBJ is anincrease in domestic producer surplus. JIT is the foreign producer
surplus and BETI is the deadweight production loss. The net national
welfare loss is thus the area BETJ, which is less than the triangle BEY.
If the objective of the protection is to increase domestic output'O (andemployment?), there should be no discrimination and the subsidy
should be offered equally to both foreign and domestic firms. In otherwords, if subsidies are to be used to promote domestic output, thenthose subsidies should be given to the most efficient producers
irrespective of their nationality. Furthermore, this policy is alsopreferable to a tariff which gives rise to domestic production of q6, as

it avoids the deadweight loss equal to triangle HET of the consumption
effect.

Protection through a Local Content Requirement
The introduction of a local content requirement will have effects
upon both the component industry (industries) to which it provides
protection, and upon the final-good industry to which it is appliedi'. As
9 Or by providing a subsidy somewhere betwere (pi-pF) and (ps-pF) only to foreign
firms.
10 A production subsidy could also be used to increase domestic output beyond qe to,for example, qg where there would be no imports. This objective could not be
achieved with any other form of trade restriction, except a quota/VER set equal

to zero together with some form of consumption subsidy. •11 The precise effects will depend upon the form of any trade restriction on importsof the final good.

136 Roger N. Strange''

regards the latter, an effective loÅëal content requirement will entail

firms purchasing more domestically-produced components than theywould otherwise choose, and will thus push up their costs. If the local

content requirement is applied equally to both domestic and foreign
firms producing the final-good in the domestic economy then the effectwill be to rotate all the supply schedules anti-clockwise, to push up thedomestic price, and to reduce demand for the good. The foreign anddomestic firms affected will all reduce output. If the local content
requirement is only applied to foreign firms'2, then the effects will be
only to rotate the SfD and SD schedules anti-clockwise, but not to affect

the SdD schedule - see Figure 4. Again the domestic price of the final
good will rise (from p to p') and this will induce additional output

from domestic firms (up from qd to 'qd'). Total market demand,
however, will fall (from qD to qD') as will output by foreign firms in thedomestic economy (from qf to qf'). A discriminatory local content
SdD S'mPrice

Sm S'D

//
//
//
/ //
PP'
lt

1

L

/

A

ll

Z

h

1

ll
ll
llt

//

/

---- ---Z`'T
1e/
i-' l
1/lt l
11• 1

l
l
1

t
l

l
t
t

t
'

'

II

1
1

11

'

p)l '

qdqdqf qr qD qp quentlty
Figure 4 The Effects on Domestic Output of a Discriminatory Local
Content Requirement
12 Article III of GATT stipulates that foreign firms must be afforded the samenational treatment accorded to domestic producers. The TRIMs accord from the

Uruguay Round prohibits the• use of local content requirements that areinconsistent with Article III, and existing measures have to be phased out. Until

such time as the accord becomes effective though, a local content requirement
could be set at such a level that it is only binding for the foreign firms.

DD

PRODUCTION SUBSIDIES, LOCAL CONTENT 137

REQUIREMENTS AND FOREIGN DIRECT INVESTMENT:A THEORETICAL ANALYSIS
requirement may thus be seen as a means of protecting domestic
producers of the final good.
As regards the component industry, consider Figure 5i3. DD is the
final-good producers' demand for components. In the absence of a local
content requirement, the domestic price of components will be equal tothe price of imported components (pF), and total demand will be qs.
Domestic firms will supply qi and imports will account for (qs-qi).
Assume initially there is no local production of components by foreign
firms.

Now suppose that the domestic government imposes a local content
requirement which specifies that a proportion k of total component
demand must be purchased domestically. The introduction of the Iocal

content requirement will push the price of domestically-produced
components up to pD, but will leave the price of imported components
at pF. The demand curve for domestically-produced components is kDD.'`
Both DD and kDD are functions of the Qygelz{}gg price of components,

N

x

Price

Sdl)

Sl)

x

x
Eii
P.

IN
- iS. ts-

P.

L -L- -X
IL

P,,'

l1
-I-- l-'-Ji

P.'

P,

R

'
'
1
1

N
A- --J-.----

x

l

il!i
xl
iB -1---lc---1
6II
AI
lIl
lt
qi q2
q3 q4

l

E--i.LF-----

l ll

I

IK

KD.

I

1
l

1

1

qf, q6 q7

Figure 5

The Welfare Effects of Foreign Direct
Presence of a

H--- .-'

tG----.-

qs
lnvestment in

Local Content Requirement

13

Note that the prices/quantities identified by letters etc. do not correspond to tho$e

14

in the earlier diagrams.
If the local content requirement is only imposed on foreign firms, then the kDp
schedule will be further to the left for any given size and structure of the industry.

- .-sf,-Dl,quantltythe1sa Roger N. Strange
where the average price is p. = k.pD + (1-k).pF. That is, k%o ofcomponents are purchased at price pD, and the remaining (1-k)% at
prlee pp.

At this average price, total demand for components js q6 (point R),of which q3 is produced domestically and (q6-q3) is imported. The line

ENT shows the priee (pD) that the final-good producers are preparedto pay for domestically-produced components, knowing that theremaining (1-k)% may be imported at the lower price pF. Domestic
producers are prepared to supply q3 because they receive the higher
domestic price pD. The introduction of the local content requirement
thus gives rise to a loss of consumer surplus equa} to area p.pb•HR,
offset in part by the gain in producer surplus given by area pDpFBT.
The deadweight loss is equal to triangle BCT (the production effect)

plus triangle HFR (the consumption effect)'5. •A tariff to yield domestic output of q3 would have entailed thefinal-good producers paying pD for all components, and thus a muchlarger consumption effect. On the other hand, if protection of thecomponent industry was the only objective, a direct production subsidy
to the industry of (pD-pp) would achieve the desired result with noconsumption effect.
The high price (pD) paid for domestically-produced eomponents issufficient to encourage foreign component manufacturers to establish
local production facilities. The effective domestic supply schedule is now

SD (passing through points ABIN). Total domestic component
production is now q4 and demand is q7 (point K). The average price of

15thenAs(p.-pp)
p. = =k.pD+(1-k).pp
k. (pD-pF)
and (pn-p.) = (1-k).(pD-pF)
therefore (pn-p.) = (1-k)(p.-p,) k. Also qs =: k.qfi
therefore (qe-qs) = (1-k)

qs kHenÅëe (pb-p.) = (1-k) = (qG-q3)(p.-pF) k q3

and (pD-p.).qs = (p.-p,-).(qfi-q3)

i.e. area pbp.ST =: area SCFRPRODUCTION SUBSIDIES, LOCAL CONTENT 139

REQUIREMENTS AND FOREIGN DIRECT INVESTMENT:A THEORETICAL ANALYSIS
components has fallen to p.', but the price received by firms (bothforeign and domestic) producing locally is pD'. Domestic firms thus
supply q2, foreign firms supply (q4-q2), and (q7-q4) is imported. The
welfare effects of the FDI in the component industry are unclear. Thereis a gain in consumer surplus equal to area p.p.'KR and a loss ofdomestic producer surplus equal to area pDpD'LT. The deadweight
production loss is now area BDNI (the production effect) plus triangle

HGK (the consumption effect). The consumption effect of the local
content requirement is thus reduced as a result of the FDI, but the FDI
has an indeterminate effect upon the production effect. The foreign

producer surplus is given by area LIN. The net effect on national
welfare depends upon the various supply and demand elasticities.
Given that a simple production subsidy would be a superior way toprotect the indigenous component industry, what explains the
popularity of local content requirements? Part of the answer is givenby the political economy arguments above. Part of the answer,
however, lies in the fact that local content requirements may be used toprotect domestic producers of both components and final goods, and ina way which is not transparent. The interdependence butween thecomponents and final-good industries also makes it difficult to offer
definite conclusions about the welfare effects of FDI in the presence of
Iocal content requirements.

Concluding Remarks
The partial equilibrium analysis of this paper has suggested thefollowing conclusions regarding the welfare effects for a domestic
economy which is host to inflows of FDI.
* a production subsidy can offer the same level of protection to
the domestic industry as an equivalent tariff, but at lower
welfare cost. If the subsidy is only made available to domestic
firms, then its introduction (unlike a tariff) provides no incentive

for FDI.
* if a production subsidy is to be used to increase domestic output
and employment, then the reduction in national welfare is less if
the subsidy is made available to both domestic and foreign firms.

* in the presence of a local content requirement on the final-goodindustry, FDI in the component industry will have an140

Roger N. Strange

indeterminate effect on national walfare. A production subsidy
would be a superior way of protecting the component industry.
* positive production externalities may be associated with the
inflows of FDI, and their existence will confer welfare benefits on

the domestic economy.
Five final points should be made with respect to the theoreticalanalysis. First, the "small" country assumption allowed terms-of-tradeeffects to be disregarded. The commercial policy of a "large" country
necessarily affects world markets, and the country should no longer be
regarded as a "price-taker" . In general, any form of trade restriction
will lead to an improvement in the terms of trade of a large country.
FDI, to the extent that it substitutes local production for imports, will

have analogous effects, though these may be offset by increased
imports of components etc. These terms-of-trade effects should beincorporated in any full assessment of the welfare effects of FDI.
Second, partial equilibrium analysis has been used to highlight the
distribution of the welfare gains/losses from FDI within the domestic

economy - particularly the distribution of producer surplus between

domestic and foreign firms. The weakness of partial equilibrium
analysis is that it ignores second order effects arising from changes in

the relative prices of goods and/or factors of production - changes

which mean that both trade restrictions and FDI have repercussions
not just for the industries direetly affected but throughout theeconomy. General equilibrium analysis captures this interdependence
between sectors of the economy, and reveals how resources move in
response to price changes, but is more abstract (relying on community
indifference curves and production possibilities frontiers). The various

welfare effects are thus not so readily identifiable as in partial
equilibrium analysis, but it is important to be aware that the generalequilibrium effects - however small in certain industries - do exist andshould not be ignoredi6.
Third, it has been assurried throughout that the foreign producer

surplus accrues to residents in the foreign firms' home countries. If
this surplus is not repatriated, or is subject to local taxation, thenthere will be consequent benefits for the domestic economy.
16 See Strange (19sc) for a consideration of the technology transfer aspects of FDI,
and for a fuller discussion of the iiterature on its general equilibrium effects on

the host economy. •PRODUCTION SUBSIDIES, LOCAL CONTENT 141

REQUIREMENTS AND FOREIGN DIRECT INVESTMENT:A THEORETICAL ANALYSIS
Fourth, the analysis has assumed throughout that the domestic
market is competitive. A domipant domestic firm is forced to charge
the world price for its output under free trade, as potential imports
provide competition. Quantitative import restrictions remove thisconstraint on the price charged by a domestic monopolist, withconsequent welfare losses for the domestic economy. The possibility of
FDI performs a similar role to imports in that it reduces the domestic

firm's monopoly power by providing competition if the price is raised
too high.

Fifth, the assumption of a competitive domestic market with freeentry and constant industry costs is perhaps an over-simplification of
the situation in many industries where FDI is commonplace. Industries
such as motor vehicles, semiconductors, and pharmaceuticals should
rather be categorised as oligopolistic industries subject to increasing
returns to scale. This then leads on to questions of the use of strategic

trade policy. The issue of trade protection when there are external
economies or diseconomies of scale raises additional questions which
require further analysis. In support of the approach adopted in thispaper, however, it can be argued that the competitive model does
provide a limiting position for an imperfectly competitive industry
where there is no collusion between firms.

Bibliography(1)

Baldwin, Robert E. (1989). "The Political Economy of Trade Policy." Joumalof Eeonornic Perspectives, vol.3, no.4, pp.119-135.

(2)

Strange, Roger. (1993). Japanese Manufacturing Investrnent in Europe: its

Impact on the UK Economy. (Routledge)(3)

Strange, Roger. (19sc). "Capital Inflow and Embodied Technical Progress: aGeneral Equilibrium Analysis." Kihg's College London Management Centre.

(4)

Strange, Roger. (1995). "The Welfare Effects on the UK Econorny of Japanese
Inward Manufacturing Investment: a Theoretical Analysis." Paper presented
at, the lst Conference on East Asia-EU Business, Birmingham, January 4-6th(5)

Vousdon, Neil. (19oo). The Econonzics of Trade Protection. (Cambridge

1995.

University Press)

& BUSINESSREBIEW
KOBE ECONOMIC

CONTENTS
NO. 33 (1988)
Agency Problems and Accounting Communication •••••••••••"'•'••'•••••••• lsao Airahano

Strategic Corporate Innovation andJapanese Management """"•••••••••••••••••-••••••e•••••••••••••••••••• th'deke' Yosinhara

Financial Deregulation and Financial
Relationships between Japan and Australia ••"""'t•••'•••••••••• Kenibhi lshigaki

Keynes' User Cost and the Theory ofInternational Trade •••"""••••••""•••••••"""'•••••""""""""••• Ktzauo Sht>nomura

A Note on International Transmission ofDisturbances and Policy Interdependence
under Flexible Exchange Rates """••••""""•""""""""""""""' "Ui'deke' lvatua
M'onetary Policy and Foreign Disturbances

in a Small Open Economy under Flexible
Exchange Rates and Rational Expectations •••"""""""""""""' Hi'dela' lzaiua
A Sketch of the Theory of Trade Cycle """""•"""""""""""'•' !V7ebuo 0kishio

NO. 34 (1989)
Recent Inflation of Land Prices in Metropolitan

Areas of Japan-A Case Study of Regional Accounting- ••""""""""""""' Nobuko Nosse
Little Basics and Emloyeeism

Japanese Management inInternational Perspetive ""'•""""""•"""'•••••"•'•••••••""•t••• flZdeki Yoshihara

Bank's Loans to Developing Countries:
A Normative Approach """•••""•••••••'••••t••••••"""•••••"""'•••• Kazwh'ro lgawa

Japan's Trade Dip}omacy:
Yesterday, Today, Tomorrow •"'•'•••••••""""•••"""""••""""'••' Peter Dr ysdole

A Labour Union in Every Country-A Game-Theoretic Approach- ••••••""""'••"""""""'r"' Ktzguo Sin'momura
The Costs and Benefits for Firms of

Accounting Information Disclosure """"""""""""""""' th'detosin' YamalZ'
Increasing Returns to Scale and Optimal

Investment Policy of the Regulated Firm """""""""""" 4Sgiiehi Kataytmza

iFrwnio Abe
Problems and Method of Economics""""••""""•'•"""""""""""" ?Vobuo 0kishio
Industrial Organization and International Trade-Textile Industries in theWestern Pacific Region- •••••"•••••••••t•••••••••••"••••••••••••••••••••• Katuin'ko lkedu

NO. 35 (1990)
Some Implications of the Present-Value-

Based Depreciation Within the
Historical Cost Framework •'••••••••••••••-•••••••••••••••••••••••••"""" lsao 7Vahano

Foreign Subsidiaries as Contributors

to Parent Companies-A New Paradigm of Multinational
Enterprises-•••""'•••••••""•••••••'•••••••••••'••••••••••""••••••••'•"•'•' th'dekl Yoshihara

The Gains from Free Trade for a Monetary
Economy ••••'••••-'•""•-""""""""""••-••••••'••••••••-"'•••••••" Murray 0. Kemp

On the Optimal Timing of Foreign Aid""••••••""'••'•""""•"""" Murray 0. Kemp

7Vgo Van Loag
Kazuo Shimomura
A Simple Union-Ridden General

Equilibrium Model """""""`"""""'•"""""'•""""""""" Kazuo Shimomura
Industrial Policy under International

Oligopoly """--•'""'-"'"""'-""'""••••""""•••••"""•••••"""•••' ffenjZ Kojlma
Realtime Distributed Control of World Link Models
in the International Computer Networks ••••"••••••••••••••••••••"'•••• Ko Mlyazaki

NO. 36 (1990)
Outward Direct Foreign Investment
and Structural Adjustment in a
Small Open Economy -'•"'"'••""'""'•"••••-"••-•-•••••••t•••••••-•• 022zng ll. Lee

An Approach to Transaction

Contracts with Asymmetric
Information ••••••••••••••••••••"'•••••••"",•••••'•""••••••""'•••••"""' Kczeutiro lgawa

A Mathematical Note on the
Impossibility of Global Absolute Advantage ••••"""•••••••• Kacuo Shimomura
On Reform of the International
Monetary System: A Survey '•••••"""'•••""""••""""'•••""""'•'•' ff7i'deki lzawa

NO. 37 (1992)
Corporate Behaviors on Disclosure of Social Responsibility

Information and Distrust Dissolution Accounting'A Survey of Reserarches Not Based on Rigorous Models '••••' lsao 7Vahano
Loca] Entrepreneuership and Reverse

Technology Transfer-Messages
from Foreign Companies in Japan- '•••••••""•••••"""'•••""" flZdeki Yoshihara
The Forms of Enterprises and Transactionin General Equilibrium:A Note on
Analytical Framework ••••""••••"""'•••""""'••""""'••••-"""' KazLthiro lgawa
A Note on the Flatness of theTransformation Surface •••".••••••"""••••"""'•"""""•"""' Kacuo Shimomura
The Long.Term Relationship in theJapanese Distribution System:

GameTheoretic Viempoints '.••••""""•••""""•"""""••'•"""'••" Kenj Kol'ima
Recent Developments in the Theoryof Trade with ImperfectCompetition "••••••""'•••••'•""'••••••""'••••••••••••••••••••••'••••••• ua'nston M Chang

Sleilchi Katayama
Long-term Expectations and Economic

Growth-A Post Keynesian Theoryof Long-term Growth' """••••"""t••••••••""••••"""'•""""" Hideydei Atlachi

NO. 38 (1993)
Generalized Lower-of-Cost-or-Market Rule for Inventory

Valuation for Quasi-rational Managers """"""""""•"""""••••• lsao ?Vahano
Effects of Financial Deregulation on Australian Financial

System """"""""""""""""""""""""""""""""""""""" Kezaiethi lsigaki
NAFTA and Asia-Pacific Economic Relations """""""""""""""'•••••• Seiji 7Vaya

The Asian Development Experience and Its Relavance toAfrican Development Problems ""•"•••"""""••'••••••••••"""'•••••""" Seip 7Vaya

Robert K.il4bCleer v
A Qualitative Assessment of the Effects of NAFTA on Japan'sForeign Investment and Trade with East Asia and Mexico:
Opportunity or Diversion? ••••'••••••••••""•'••••••"""••••••'••••• PVilliam E. James

Dynamic Effects of Tax Policies in A q
Model of Investment """"•'••"'••••••••••••••••••••••••••••••••""•••••• Tahao 0hhawa

Ka2uo `stimomura
Corporate Governance in Germany, Japan, and theUnited States : A Comparative Study """"'••""""""""""""' Kenl)' KolZma
Economic Issues in International Debt:A Survey ••••••••••••••••••••••t•••• Hideki laawa

A Note on the Estimation of Scale Economies and their
Use in Modeling Free Trade Agreements ••••••""'••••••e"' Robert K MeCleer ),NO. 39 (1994)
Labour Unions and Nominal Prices "'••••••"""••••••""""••••""" Kaguo Shimomura
An International Perspective on Japanese Corporate Finance ""•"" Ken1't' KoP'ma
Measuring Natural Resource Rents and their
Macroeconomic Significance for Developing Countries,
with Reference to Latin American Suger Producers ••••""' Robert K.MtCleery
The Influence of Product Development Strategy on
Inter-Project Learning •"""•••••""""•••t"•••••••••••••••••••••••••••• lrentaro 7Vobeoha

A Comparison of Japanese and UK Welfare ••••••••""'••••••"""" Stephere JDavies

KOBE UNIVERSITY ECONOMIC REVIEW 41, 1995
Egi.tebd,bt?I.jg,".C,"jlYY,f}f.bEe903gpMa`CnS'

CONTENTSThe Permissible Range of Relative Prices
in the Light of Labor Values """"'••""""""'••••••••••••-"••• Taheshi 7Vahatanl""""""""""""""""""""""' Nobuo 0leishe'o
The ECU as an "Artificial Currency" "'••••"""""'•"""""""•••'•"" `Slaiichl 17ul'ita
Grain Price Fluctuation on Fifteenth Century Ghent ••••••••""••• Tahasin' 0kwulshi

A Note on the Small Sample Propertiesof Generalized Method of Moments Estimators
under Non-Normal Error Conditions ••••••••••••"'.••••••••""".•• Shigayulei Hamori
or2rRfRrtrK?rRrK)-tf?vrtrlrmartr2,r?vRfN2vma2kr2trRfRflv2r2"fRf?v?r?v2-rKtrlv2rRrK.

THE ANNALS OF THE SCHOOL OF BUSINESS ADMINISTRATION,
KOBE UNIVERSITY No. 40, 1995
Edited by the School of Business Administration,
University,
Kobe, Japan
Kobe

CONTENTS
Technical Innovation in the Japanese Paint Industry ••......"••.•......' Takupt' Hara

Organisational Structure and Employee's Job Content:
From Job Design to Organisation Design •"""••••••••"""'•• 7Vorio hambayashi

A Game Theoretic Analysis of the Competition in Marketing Channels•••••t•••••••••••••••••••••••••••••••••••••••••••••••• Masayoshi Marayama

The Quality Competition among Japanese Major Airlines
after the Regulatoly Change of 1os5 •••••t'•""••••••••"""'••• fli`dent Murahaml

Relationship Between Corporate Groups and Auditors in Japan••••••••"""••••"""""'•••""""""•.••....'••'•"...•••• Kazumi Sueuki
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KOBE UNIVERSITY LAW REVIEWInternational Edition No. 29, 1995
Edited by Faculty of Law Kobe University, Kobe, JapanCONTENTS
Proposals for Solving Japan's Land Use Problems •••••••••••••••t••••• Ytzsutaha ABE
NPT: The Indefinite Extension And After ••••••••••••••••••••••••••••••••• Shueo KIMURA"Market Friendliness" in Public Policy '••••••"•"""••••••••"""'••••••••"' lkuo KUME
For the Liberal Transformation of Japanese Legal Culture:

A Review of the Recent Scholarship and Practice ••"""' sS2?tsao MIYAZA rz4
The Evaluation of Japanese Single Non Transferable Vote System-Is CHUU-SENKYOKU-SEIDO "Semi" Proportional ?"" Yutaha SH17VADA
Contracts of Guarantee and the Bank's Duty ofDisclosure in England and Canada:
An Examination of Doctrines of Undue Influenceand Unconscionability in Consumer Guarantee Contracts "' ffitoshi KIMURARESEARCH INSTITUTE FOR ECONOMICS AND
BUSINESS ADMINISTRATION, KOBE UNIVERSITYHISTORICAL SKETCH
In 1919, a research organization named the Institute for Commerce

was founded in Kobe Higher Commercial School, one of the chief
predecessors of Kobe University, with a gift made by F. Kanematsu &Company, a leading mercantile firm in Kobe. The organization was
designed to carry on and facilitate integrated research on business andcommerce and to formulate arid publish the results of these studies andinvestigations in such form as to make them available to the business

commumty.
With the founding of Kobe UnLversity of Commerce, successor of
Kobe Higher Commercial Schco1, in 1929, the Institute extended its
research activities by adding several divisions. One was the famous
Latin-American Library, which soon became the center of research inthis field in Japan. A room for statistics equipped with various
computing machines was established and began publication of J6yo

Keizai T6kei and Sekai B6eki T6kei annually. A filing room was
prepared to deposit press clipping files systematically arranged by
topics and dates. Another room was designed to become the center ofall possible original records and data having to do with the beginningand progress of Japanese business.

On the campus of Kobe University of Commerce, anotherorganization named the Institute for Business Mechanization was
founded in 1941 utilizing business machines donated by the IBM
Corporation and others. With Professor Yasutaro Hirai as its head abroad and forward-looking plan for business mechanization in Japanwas developed.

In 1944, Kobe University of Commerce changed its name to Kobe
University of Economics. After the War, however, the University was
consolidated with three other colleges in Hyogo Prefecture to become
Kobe University. With this development, the two Institutes were also
amalgamated into the Research Institute for Economics and Business
Administration, Kobe University. At present, the Institute, with its
twenty-one full-time professional staff members, carries on studies andinvestigations in international economics, international environment,international comparative economics, international business,management information systems and international cooperation.

ORGANIZATIONThe Institute consists of six sections. Each section and its researchsubjects are as follows:
1. International Eeonomic Studies
International Economics, International Monetary Economics,

Maritime Economics, International Labor Relations
2. International Environmental Studies
Resource Development, International Organizations,International Industria! Adjustment
3. International Comparative Economie Studies

Pacific Basin I (Oceanian Economy)
Pacific Basin ll (Latin American Economy)
Pacific Basin M (North American Economy)
4. International Busines's Studies

Comparative Business, Multinational Enterprise,International Business Finance

5. Management Information Systems
Business and Accounting Information, Information Processing
System, International Comparative Statistics

6. International Cooperation
In addition to the ordinary work of each section, several

research Groups, whose members are not limited tp theInstitute staffs, are regularly held to carry on joint studies. At

present, there are eight standing research groups, as follows:

Group of International Trade, Maritime Economics, Dynamic
Internd"tional Economic Analysis, Multi-media Information
Systems, International Economic Comparison, International
Comparative Financial Studies, and Business Finance andGovernmental Rules, and International Comparative Statistics.
For convenience and greater efficiency in carrying out its
research-activities, the Institute has a general office which is

responsible for 1) the collection and preservation of acomprehensive collection of books, periodicals, pamphlets, andoriginal records and data of finance, trade, commerce,industry and business generally: 2) the classification,
cataloguing, indexing arranging, annotation and compilation ofthese research materials: and 3) the formulation andpubli'cation of the results of the investigations and studies

accomplished by the professional staff members of theInstitute.

As an affiliated institute, the Documentation Center for
Business Analysis has been established in 1964. It is the firstsystematic information facilities in the field of businessadministration in Japan that has been recognized andauthorized by the Ministry of Education. The purpose is tocollect and to make intensive control of all kinds of materials

on business administration and to make them available toscholars, universities, governments, and business world withthe aid of modern documentation techniques.

RESEARCH INSTITUTE FORECONOMICS & BUSINESS ADMINISTRATIONKOBE UNIVERSITY
Director: Hideki YosHiHARA
Secretary: Koji UNNo

INTERNATIONAL ECONOMIC STUDIESInternational Econornics Prof. Kazuhiro lGAwA
Assoc. Prof. Robert Kenneth MccLEERy

International Monetary Economics Assoc. Prof. Hideki lzAwA

Maritime Economics Assoc. Prof. Masahiro ToMiTAInternational Labor Relations Prof. Kazuo SHiMoMuRA
Prof. Kouji SHiNJoINTERNATIONAL ENVIRONMENTAL STUDIES

Resource Development Prof. Shigeyuki ABEInternational Organizations Prof. Junichi Gcrro

International lndustrial Adjustment Prof. Makoto loKiBE

INTERNATIONAL COMPARATIVE ECONOMIC STUDIES

Pacific Basin I Prof. Kenichi lsHiGAKi(Oceanian Economy) Assoc. Prof. Ryuzo MiyAo
Pacific Basin ll Prof. Shoji NisHiJiMA(Latin American Economy)

Pacific Basin M Prof. Seiichi KATAyAMA(North American Economy)

INTERNATIONAL BUSINESS

Comparative Business Assoc. Prof. Kenji KociMA
Multinational Enterprise Prof. Hideki YosHmARA

Assoc. Prof. Kentaro NoBEoKA
International Business Finance Prof. Hidetoshi YAMAJi
Prof. Koji CkuBAyASHi

MANAGEMENT INFORMATION SYSTEMSBusiness and Accounting lnforrnation Prof. Isao NAKANo

Information Processing Systems Prof. Komayuki l[[owInternational Comparative Statistics Prof. Yasuo KoNisHi

INTERNATIONAL COOPERATION ProL Shyam SuNDER
Prof. Roger Nicholas STRANGEDOCUMENTATION CENTER FOR BUSINESS ANALYSIS
Lect. Akira KAJiwARA
Office:RESEARCH INSTITUTE FOR ECONOMICS & BUSINESS ADMINISTRATION(TheKa..nsel.llitg.U,..M,.,elllrliisii,aT.iy.".ai.')