ISSN O075-6407

KOBE& BUSINESSECONOMIC

REVIEW
47th

VOLUMEANNUAL,Gfgiilillle2z,

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
2002

KOBE ECONOMIC & BUSINESSREVIEW
Editor jn Chief
Junichi Goto

Co-Editors
Kenjj Kojima; Ryuzo Miyao; Eiichi

ISSN O075-6407

TomiuraKOBE

ECONOMIC & BUSINESSREVIEW

47th

ANNUAL VOLUME

ttrafgva10i2az..

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY

2002

CONTENTSPage

The Theory of International Trade''''''''''""''''''''"'""'"''"'"'"'"'"''''"'''''''''''''''Ronald W.JONES 1

The Fall of `Companyism' in Japanese Corporate System''''"''•''''"'''''"'''"'"'•''""'"''"''''''''""''''''''''''''''''KenjiKOJIMA 5

Creation of New Enterprises and Development of Existent Enterprises

in East Asia and Latin America....•......••••••••••••••••••••••••••••••••••••••••••••••••••e••••••••••Akio HOSONO 23

Dynamic Export Pricing and Survey-based Exchange Rate Expectations••••••-••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••Eiichi TOMIURA 67

Technological Trajectories and the Origins of New Industries:

A Theoretical Model"'''''"''''''''''•""''"'"''''"'"'"'"''''''''''"'''''''''''Jeffrey L.FUNK 83'
JapansDefiation and the Feasibility of Negative Interest Rates•••••••••••••••••••"'••••••••••••••••••'•"'''''''''''••'''''''''Stephen J.DAVIES 93

The Past and Present of "Local Currencies"',with Especial Reference to England and Japan•••••••••••••••••••••''''•••••••••••••••'""''''•''''"'"''''"'Stephen J. DAVIES 117

KOBE ECONOMIC & BUSIIVESS REVIEM, 47 (2002), 1-3

THE THEORY OF INTERNATIONAL TRADERONALD W. JONES Uniyersity of Rochester

It is a great honor and pleasure for me to receive this award from Kobe University. I
especially wish to thank Seiichi Katayama for his work in making this possible. The steadystream of first-rate Japanese graduate students we have received at the University ofRochester since the formation of our group in 1957 has proved to be the backbone of our
graduate program these many years. I personally am gratefu1 for the opportunity to have hadthese students in class, to have supervised some of the excellent dissertations and, indeed, tohave had the pleasure of working with four Japanese co-authors.

I fell in love with international trade theory early in my career-indeed as anundergraduate at Swarthnore College. This affair continued through four years at M.I.T.
under the supervision of Bob Solow, Paul Samuelson and Charlie Kindleberger, in the firsthalf of the decade that also subsequently saw Bob Mundell, Jaroslav Vanek, Egon Sohnen,

Ron Findlay, and Jagdish Bhagwati as M.I.T. students. But perhaps the sources of thegreatest influence on my work were to emerge at the University of Rochester. Lionel

McKenzie had just taken over the department and was a huge supporter of the close
relationship between the field of international trade theory and general equilibrium theory.
Akira Takayama, our ichi ban graduate student, was already there when I arrived, and shortly

thereafter from Kobe came Akihiro Amano, to whom I owe a great debt both for his
substance and his style - indeed I should say I take my "hats" off to him. I believe that

Prof. Mizutani was responsible for encouraging young economists from the Kansai area totake their degrees from Rochester. Sent from Kobe by Mizutani, Yasuo Uekawa wasirrepressible as a student and seemed to have become a national treasure later in Japan. (Iam pleased to see his wife and daughter here today. It is not possible for me to be in Kobe

without remembering Yasuo's gracious and warm hospitality.) Nobuo Minabe showed how it
Corresponding Address
Ronald W. Jones
Departrnent of Economics, University of Rochester

Rochester, NY 14627, USA
E-mail: jonr@troi.cc.rochester.edu

Tel: 1-585-275-2688
The original version of this paper was presented by the author when he was awarded the Honorary Degree by Kobe
University on the 15th of July 2002.

2 KOBE ECOIVOMIC&BUSI?VESS REVIEva, 47 (2002?, 1--3

was possible for Japanese students to publish in such major English-language joumals as theAmerican Economic Review. Fumio Dei and Katsuhiko Suzuki were high points in the next
generation of trade students from Kobe. And the list goes on, with trade students from the

Kanto area joining those from the Kansai, including Michihiro Ohyama, Motoshige Itoh,
Makoto Yano, Kazuo Nishimura, Shumpei Takemori and, more recently, Hajime Kubota andMorihiro Yomogida.
Now it is time for me to reflect on my discipline. In searching for the key scenario that
distinguishes the broad field of international economics from other fields in our profession I

would select the scenario in which markets have overlapping domains. wnat I mean by thisis that local agents are active as producers and consumers, with some markets being
intemational, whereas others are purely national or regional. The nature of the interactions
between these markets is our central concern. In neo-classical settings the principal national

markets have been factor markets. In theory the possibility emerged that wage rates and otherfactor prices might be brought to equality between countries that share the same technology
merely by their willingness to trade commodities in open global markets, despite the fact that

foreigners are not allowed to compete directly in national factor markets. More generally
stated, it is not just the case that countries can capture the celebrated gains from trade by

producing some items for the world market, while deciding to preserve other markets (e.g.
that for labor) for themselves. The problem is that active participation in world markets
increases the degree of dependence that purely national markets have on the prices establishedin the world markets for traded goods. Therefore all countries tend to shy away fromcompletely free trade. Tension and ambiguity describe the decisions that countries must makebetween receiving the gains from reaching out to world markets on the one hand andpreserving some sovereignty and control over other markets on which countries wish to
imprint their own sets of values on the other. In the theory of international trade wesometimes use the concept of autarky, with all markets national, as a convenient benchmark.
However, our primary concern is to investigate interactions between world markets and purely
national ones as well as to examine the effects of imposing different conditions (e.g. tariffs)

on our own agents when they engage in intemational markets.
As opposed to some other fields in economics, a hall-mark of the models that we use
to study intemational trade theory is their long half-life. We still find good use for Ricardianmodels of trade, especially when the international distribution of income is at issue, e.g. withpresent concerns about the differential impact of globalization on rich and poor countries.

The Heckscher-Ohlin and Specific-Factors models have proved their worth in investigating
intranational distribution issues'e.g. how the return to unskilled labor has fared comparedwith other factor rewards. Of course most fields in economics experience "revolutions" inideas that threaten to unseat standard doctrine, and our field is no exception. In theinternational area in recent years we have had "new trade theory" and "new economic

0F l?VTERNA TIONALTRADE
10NES,• THE THEORY

geography". I would describe these as very usefu1 additions to our standard body of theory,
contributions that serve to enrich rather than to replace what came before.

I say this because a common strand running throughout all intemational trade theory is
the importance and significance of extending the scope of trade, and this has an effect on thenature of competition. Admittedly, such international competition may not be perfect-there
is room for monopolistic or oligopolistic competition, and the insights thereby obtained areimportant. However, if competition is to describe any set of markets, the description fits
especially well the set of world-traded commodities, And with any type of competition cost
asymmetries between countries are important, and therefore the composition of costs has acentral role to play. This takes us back to basics-to looking at technology, factor supplies

and wage rates. For example, a strong multi-national firm may face competition from only
a few international players, but in its activities it may have to decide where in the world tolocate production facilities, perhaps "fragments" of a previously vertically integrated

production process. Surely its decision is based importantly on considerations of costdifferentials among contending locations, even if profits are made in equilibrium so that
commodity prices eventually do not settle at the level of average costs. And the existence ofincreasing returns and improvements in technologies may prove usefu1 in explaining thelowering of the costs of service links connectjng separate production fragments and thus
allowing more geographical dispersion.
Our field of international trade theory is wide, it is deep, and it welcomes to its foldmany of the disparate new developments in economic theory. It is still concemed withcountries, with the interaction among markets with different domains, and with the importanceof cost differentials. And I expect these issues will continue to engage our attention in the
future.

3

KOBE ECONOMIC & BUSINESS REVIEPV, 47 (2002), 5-22

THE FALL OF `COMPANYISM' IN JAPANESECORPORATE SYSTEM*KENnKOJIMA Kobe University
Abstract
This paper examines the effects of structural changes in financial system on corporate system,
particularly fmance and employment in Japan, and discusses the underlying problems and the future
directions. Japanese corporate system can be characterized to be cooperative long-term relationships withfactor suppliers in the absence of strong control by shareholders, so called `companyism.' Companyismof 1arge firms has worked well in the most of the post-war period. Since substantial economic growth
can no longer be expected in Japan, long-terrn relationships with factor suppliers have been undergoingchanges. Japanese firms have found it impossible to maintain existing employment relations. It has
been getting harder for the firms to avoid drastic reduction of employees.

JEL CIassi:fication: G20; G32; J33
Kcywords: Corporate finance; Financial systems; Labor relations; Japanese firms.

1 Introduction
Japan has been managing to avoid the worst of the pain from the collapse of its bubble

economy earlier 1990s. In the 1980s, Japanese firms raised cheap equity-linked debt toinvestment in the expectation that the economy would continue to grow at a fair rate. But

rather than reduce capacity since then, the firrns borrowed to add more, encouraged byinterest rates that were close to zero. Heavy spending in the 1980s have left Japanese firms
Corresponding AddressKenji Kojima
Research Institute for Economics and Business Administration (RIEB), Kobe University

2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501 Japan
E-mail: kojima@rieb.kobe-u.ac.jp

PhonelFax: 81-78-803-7018* Ponions of this paper were presented at the 77th Annual Conference of Western Economic Association
lnternational (July 2002). I am gratefu1 for participants at that conference for usefu1 cornnients and suggestions.

Financial supports from Ministry of Education and Science in Japan are gratefully acknowledged.

6 KOBE ECOIVOMIC&BUSINESS REVIEM, 47 (2002?, 5-22

laden with debt. Although business sales have doubled since 1980, corporate debts are morethan triple their level in that year. wnile healthy manufacturing sector is abundant in cash,
the rest of the economy, particularly construction, property, retailing companies, is heavily
indebted. Firms have been able to meet the interest charges on this debt mainly because the
Bank of Japan has kept short-term interest rates at the bottom levels since 1994.
Japanese corporate system can be characterized to be cooperative long-term relationships
with factor suppliers in the absence of strong control by shareholders, so called `companyism.'

Companyism of large firms has worked well in the most of the post-war period. But, theremarkable success of Japanese firms in that period has revealed its weakness. The
managerial entrenchment against the capital markets has given rise to the expression of latentself-interests that were contained during the high-growth period. With their diminishing
control over non-financial firms, the ability of banks to monitor and undertake corrective

action is greatly reduced. It is weakening of vital control mechanism in the Japanese
corporate governance system that can substitute for market for corporate control. Since
Japanese major firrns are no longer subject to substantial control from main banks, the lackof an effective control mechanism would be detrimental to corporate value maximization in

the long run. The Japanese corporate finance is now in trouble: excess capacity andemployees, declining profits. More bankruptcies seem inevitable, as Japanese banks become
unable to withstand deteriorating their balance sheets. The only way to improve profitability

and enhance corporate value of Japanese firms is drastic restmcturing their business andresources.

Since substantial economic growth can no longer be expected in Japan, long-term
relationships with factor suppliers have been undergoing changes. Japanese banks have begun

to write off bad loans much more actively than before, and this in tum has forced firms tocarry out restructuring more thoroughly, particularly in employment. Japanese firms havefound it impossible to maintain existing employment relations, which place importance on
seniority-based long-terrn employment. Under these circumstances, the firms have tried tomaintain implicit long-term contracts. But it has been getting harder for the firms to avoid
drastic reduction of employees.

This paper examines the effects of structural changes in financial system on corporate
system, particularly finance and employment in Japan, and discusses the underlying problems
and the future directions. The primary purpose of the study is twofold: to identify importantfeatures of changes in financial system in Japan and their effects on corporate finance andemployment; to develop problems and insights concerning corporate management and capital
market under institutional and regulatory environments.

This paper is organized as follows. The next section presents the major problems in theJapanese financial system, particularly bad loan problem. Section 3 describes major problems

and changes in the Japanese corporate finance. In particular, it describes resolution ofKOJIA,L4: THE FALL OF `COMPA?VYISM' IN JAPANESE CORPORATE SYSTEM 7

cross-shareholdings and progress of corporate restructuring in Japanese firms. Section 4
discusses distinctive features and recent changes in the Japanese employment system. Some

aspects of Japanese employment system have gradually changed over the last decade. Mostof these changes are the result of changes in the structure of Japanese corporate management,

which in turn can be traced to changes of Japanese financial system and technology.

2 Problems in Japanese Financial System

2.1 Bad Loan Problem
In the late 1980s, deregulation of interest rates, which raised the cost of funds to banks,caused the change of bank portfolio. Then the bank increased easy collateralized loans toinvestment in real estates. Prices of assets have been declining since the early 1990s in
Japan. This decline of asset values has caused the large amount of bad loans to investments

in real estates. Large amount of bad loans has deteriorated banks `equity and major banks
were unable to meet BIS (Bank for International Settlements) capital requirement. Japanesebanks issued the subordinated debts to recover their capital-assets ratio. Non-perforniing loans

to real estates have caused the serious problems with banks' own balance sheets. The capital
adequacy ratios of major banks have risen thanks in part to the infusion of public funds andstood at an average of 12.20/o at the end of fiscal 1998, 4.2 percentage points above theinternational standard of 80/o. On the other hands, those ratios of some local banks and otherfinancial institutions are below the required level, 40/o (Economic Planning Agency, 2000b).

Many of Japanese banks are still in trouble with bad loans. Since the early 1990s, thebanks have written down almost twice their entire capital and reserves in an attempt todispose their bad loans. But those bad loans have stubbornly remained in the balance sheets.
After the most recent crisis in 1997-98 the goverrment set up a special body, the Financial

Reconstruction Commission (FRC), to clean up the stmcture of financial system. The FRC
has not completed its task by 2001. Japanese banks are still far from meeting the goals set

out for them by the government in 1998; they remain burdened with bad debts, poor
profitability and economic slowdown.

The outstanding balance of risk management loans at Japanese sixteen major banks
decreased to 17.2 trillion yen at the end of fiscal 1999, after rising from 18.9 trillion yen at

the end of fiscal 1997 to 30.2 trillion yen at the end of fiscal 1998. The cumulative totalof their non-performing loans disposed and reserved built up from fiscal 1992 to fiscal 1999
reached 45 trillion yen. On the other hand, the balance of risk management loans at regionalbanks increased to 10.6 trillion yen at the end of fiscal 1999 from 7.4 trillion yen at the endof fiscal 1997. The cumulative total of their non-performing loans disposed and reserved built

up from fiscal 1995 to fiscal 1998 came close to 10 trillion yen. This rise in the disposal

8 KOBE ECONOIt,firC&BUSINESS REVIEM, 47 (2002), 5-22

amount could be due to each bank's efforts to dispose of non-performing loans amid moves
toward reorganization of the financial institutions, a deterioration of debtors' financial
conditions, and a decline in land prices (Economic Planning Agency, 2000b).i
The accuracy of banks' self-assessment of non-perforrning loans has improved as a resultof the intensive examination and inspection conducted by the Financial Supervisory Agency,

and other govemment agencies. Intemationally operating banks are disposing of their
non-performing loans in accordance with guidelines provided to them by FRC in connection
with injecting public funds into their capital base. The non-performing loan situation has
become more transparent and disposal of non-performing loans is carried out more properly
than in the previous phase of economic recovery in 1995-1996.
Part of the trouble is that Japanese banks are incorrectly classifying their loans. The loan

books of The Long-Term Credit Bank and Nippon Credit Bank, two nationalized banks,
illustrate the extent of such erroneous classification. They have been stripped of theirdeadbeat loans by the FRC, and then sold to third panies. But even after the official clean

up, loans to companies such as a large department store that later went bankrupt, wereclassified on the books as good assets.

In addition, the banks have overestimated the value of the property backing many of
their loans. Urban land prices for commercial use have fallen by as much as 750/o in 1999
since their peak in the early 1990s, and they are expected to fall fUrther (National Land

Agency, 2000). This means that the banks have undervalued the portion of those loans
without collateral, that is, the portion against which they need to hold reserves. The banks

are estimated to have problem loans being substantially below the market value. The banks
are unable to lift themselves out of trouble because they find it hard to make decent profits.

The banks have to resort to such last-ditch measures largely because they are still losing
money on their core lending business, and they have been unable to develop fresh fee-based
business as an alternative source of revenue (Economist, January 27th 2001).
The economy is slightly recovering, but this is not helping the banks much. Most of therestmcturing that is the basis for recovery is in firms, which are able to withstand someshort-term troubles. So healthy fmns are getting stronger while the bad ones remain weak.
The healthy firms are also shifting fimd-raising directly to the capital markets, with the resultthat the banks' clients are becoming increasingly concentrated on the problem firms.

'
1 The scope of disclosure of non-performing loans has been expanded gradually since fiscal 1992. In fiscal 1997,
loans in arrears by three months or more and less than six months and restructured loans were added to the items
that all banks must disclose along with loans to borrowers in legal bankruptcy and past due loans in arrears by

six months or more. As a result, disclosure is now no a par with the SEC standard in the U.S. In fiscal 1998,
the calculation standards for loans to borrowers in legal bankruptcy and past due loans in arrears six months ormore were changed, and major banks disclosed bad loans under the Financial Reconstmction Law (Economic
Planning Agency, 2000b).

9
KOJIILL4: THE FALL OF `COMPANYISA4' IN JAPANESE CORPORATE SYSTEM

The banks have been able to disguise their problems because of the unrealized equity
gains that they have on their balance sheets. But plunging stock markets are removing mostof these because of introducing market-value-based accounting in 2001 meaning that
unrealized securities losses will start being deducted from the capital. The banks will be lesswilling than ever to undertake write-offs of their bad loans with such losses to account for.

The banks and the rest of the economy are caught in a vicious cycle. Banks have been
all too willing to forgive debt or to provide new credit lines in order to keep deadbeats on
their feet, and this has hindered the structural reforms needed to revive the economy. This,in turn, is sapping the banks' own strength, leaving them reluctant to take on more risk bylending to the promising businesses that should be leading Japan economy out of slowdown(The Economist, January 27th 2001).

2.2 Corporate Bankruptcy
ln November 1997, Yamaichi Securities, the Japan's fourth largest security firm, andHokkaido Takushoku, a large city bank, went bankrupt. These bankruptcies had two
important implications: that even large firms can fail, and that a main bank's implicit promise
to rescue its major client firms is doubtfu1. The Japanese corporate finance is now in trouble:

excess capacity, too much debt, falling demand, and declining profits. 'Japan's heavily indebted fimis are still struggling to increase the sales under constrainsof rising burdens of debt. This is because the economy is not growing in nominal terrns
although growing in real terms. Since debts are always nominal, the ability of firms toservice their loans rises only with nominal increases in profit, not with deflation-adjusted

increases. Hence, cleaning up afier Japan's asset-price bubble is getting harder. Many offinancially distress firms need to be reorganized. Japanese banks need to deal with its

exposure to bad loans, before it can commit with conviction to new lenders. But suchworkout is now under way and remains still debatable. Thus the rise in major bankruptcies
has been far exceeded by a surge in debt forgiveness, as banks have written off debts to givea fresh start to otherwise viable firms, or have done just enough to allow the weak firm tosurvive. Although some forgiven firms may be worth saving, writing off debt in exchange+- Jt

for restructuring plans is rarely rewarded with a tumaround m the firms wealth, particularly

construction and retailing companies.2 More bankruptcies seem inevitable, as firms become

2 The civil reorganization law that replaced the Composition Law was promulgated as the basic law to provide
procedures to reorganize financial distressed firms in December 1999, The main features of the law, which went
into effect on Apri1 2000, are that (1) a firm facing fmancial distress can apply for court-mandated reorganization

proceedings before it goes bankrupt, (2) it covers a wide-range of small and medium-sized firms, while the
Corporate Reorganization Law covers oniy incorporated firms, (3) its procedure is simplified compared with the

Corporate Reorganization Law, thus enabling prompt proceedings, and (4) the management can stay in control/

KOBE ECONOA(flC & BUSINESS REVIEM, 47 (2002), 5-22

10unable to service their debts. Table 1 shows that number of bankruptcies and average amountof debt default have been growing since 1995. Without growth, the only way to improve theprofitabjljty of Japanese firms js drastic restmcturing to remove excess capacity andemployees, and unrelated businesses.

Furthermore, the listed firms have been required to make preparations for the
introduction of new accounting standards, such as consolidated accounting, market-value-based
accounting, and retirement-benefit accounting since Apri1 1999.3 Strict new accounting rules

seem to have been the strong impact on recent corporate bankruptcy as well. A requirement
to value assets at market, rather than book value, have made clear the extent of the problem
in corporate finance.

Table 1. Bankruptcy of Japanese Firms Five-Year Average

Number of Cases
1970-74
1975-79
1980-84
1985-89
1990-94

1995
1996
1997
1998
1999
2000

9,199
15,725
18,522
13,26011,977
15,108
14,834
16,464
18,98815,352
18,769Amount of Liabilities(100 million yen)

Average Amount of Liabilities(100 million yen)

8,588
23,65028,072
26,84560,446
92,411
81,229140,447
137,484
136,214238,850

O.934
1.540
1.515
2.025
5.047
6.116
5.475

8530
7.240
8.872
12.725

Sources: The Bank of Japan (1974, 1978, 1986, 199S), Economic Statistics Annual, Toyo-Keizai Tokei Geppo(Toyo-Keizai Statistics Monthly) (Apri1 2001).

Source Note: Tokyo Shoko Research Ltd.

Xwithout losing the management position and thus continue reorganization effort even after the start ofcourt-mandated proceedings. Since an application filed for court-mandated reorganization proceedings, unlike anapplication for the Composition Law, cannot be dropped after a court injunction, there are many firms wishing

to file an application (Economic Planning Agency, 2000b).
3 Staning with the financial year beginning on Apri1 1, 1999, (1) the scope of subsidiaries and affiliated companies

will be expanded as a result of the introduction of the controlling standard instead of the conventional
share-holding standard in the preparation of consolidated fmancial statement, (2) tax-effect accounting will be
introduced to individual financial statements in addition to consolidated financial statements, (3) the disclosure of

consolidated cash flow statements become mandatory. Starting in the fmancial year beginning on Apri1 2000,
financial assets, real estate for sale, securities other than cross-held shares, and pension assets and liabilities haveto be eyaluated at market values. It is scheduled that cross-held shares are evaluated at market values in thefinancial year begiming April 2001 (Economic Planning Agency, 2000b).

KOJIML4: THE,F7ALL OF `COMPANYISM'
IN JAPANESECORPORA TESYSTEM

3

3.1

11

Changes in Japanese Corporate Finance
Cross-shareholdings

As shown in Table

2, therapid growth of assets andlow profitability of Japanese banks

has ledto concem about their

Table 2.

Profit Performances of Commercial Banks in Germany, Japan, and the U.S.A Five-Years
Average (Percentage)

capitaladequacy. Japanese banks need to watch their financial

Gross Profit Margin

GermanyJapan

U.S.A.

1980-84
1985-89
1990-94

2.24
2.21
2.10

1.75
1.35
1.23

1995
1996
1997
1998
1999

1.95

O.47
O.40
O.36
O.39
O.50

1.99
3.47
3.35
3.42
3.39
3.30
3.18

Pre-tax

1.80
1.62
1.45
1.41

3.31

Return on Assets
1980-84
1985-89
1990-94

1995
1996
1997
1998
1999

O.54
O.70
O.54
O.73
O.71
O.68

O.54
O.40

O.53
O.58
O.26
-O.16
O.03
-O.75
-O.80
O.29

O.90
O.78

14.43
16.41

15.34
11.13
16.04
22.42
22.03
22.39
20.63
23.92

1.10
1.80
l.82
1.89
1.75
2.03

Return on Equity

1980-84l985-89
1990-94

1995
1996
1997
1998
1999
Equity to

6.11
-3.35
O.60
- 14.95-12.37
5.73

Assetsi980-84
1985-89
1990-94

1995
1996
1997
1998
1999

14.06
12.11
10.49
9.58
10.52
10.56
9.21
6.39

5.89
6.84
8.15
7.66
6.74
6.43
5.91
6.33

3.69
3.64
4.41

4.90
4.92
4.99
6.50
5.02

6.19
6.50
7.20

801
8.27
8.43
8.49
8.49

Sources: The Bank of Japan (1974, 1978, 1986, 1994, 1996, 1997, 2000), Comparative Economic and Financiai
Statistics: Japan and Other Countries.
Source Note: Statistiches Bundesamt, Untemehmen und Arbeitsstatten, The Bank of Japan, Syuyokigyo Keieibunseki(Business Analysis on Main Enterprises in Japan), The U,S, Department of Commerce, euarterly Financial Reportfor Manufacturing, Mining, and Trade Corporations

12 KOBE ECONOMIC&BUSINESS REVIEM, 47 (2002), 5-22

performance carefu11y. In contrast to the low-margin, volume-oriented banking practices,Japanese banks are now restraining growth and carefu11y tracking the profitability of theirrelationships with clients. Increasingly, banks according to the profitability of the relationshipwith them are ranking clients. Just as industrial clients are now short listing the banks withwhich they do business, banks are now beginning to identify and terminate relationships withclients that do not provide them with sufficiently attractive rates of return.

The changing patterns of Japanese corporate finance and the competitive pressures on
Japanese financial institutions to increase their return on assets has resulted in a separating ofclaims held against non-financial firms. Rather than being key shareholders, lead lenders, andprimary vendors of financial services in long-term relationships with clients, Japanese banks
are now being reduced to the position of minority stakeholder that must compete fiercely fora client's business on a transaction-by-transaction basis. For their part, Japanese banks, underpressure to meet BIS capital requirements are becoming more sensitive to performance on
their equity investments. Japanese banks are now forced to liquidate some of their equity
holdings to maintain adequate profitability.

Cross-shareholding has provided a defense against takeovers and strengthened thediscretion of corporate managers. Large shareholders have given corporate managers
considerable discretion and intervened only when the firm perforrns poorly. Reflecting on thecharacteristics of Japanese corporate system such as the accumulation of relationship-specificinformation, cross-shareholding has prevented outside parties without relationship-specificinformation from gaining control over firm management. There have been cases in which theinterests of shareholders have not been respected so as to induce the excess assets andemployments (Economic Planning Agency, 1996).
The sluggish economy in Japan has destabilized a number of traditional relationships andresulted in sales of shares previous held under cross-shareholding relationships. Many salesof stable-held shares were little more than efforts to book current period gains that could be

used to boost sagging profits, and were followed by near immediate repurchases. Other sales
represented only a fraction of stable held stock, not the entire amount; still others were sales

to some other stable owner of the stock in question.

The bad loan problem has resulted in weakening Japanese banking system, causing
substantive change in the cross-shareholding relationships. Falling asset price are weakeningbanks' balance sheets. Urban land prices for commercial use have fallen substantially since
their peak in the early 1990s, and they are expected to fall further. Because they rarely makeprovisions for loans backed by real estates, the banks have found plunging land prices
especially detrimental. As long as the banks keep the bad loans on their balance sheets, they

end up setting aside more money to deal with their losses every year. Thus, the banks andnon-financial firms to reduce their balance sheets have been selling substantial amounts ofcross-held shares. Japanese banks are under increasing pressure to restmcture and improveKOJIILtL4: THE FALL OI7 `COMPANYIS?L4' IN JAPANESE CORPORATE SYSTEM 13

performance. As a result, the banks are reconsidering holding large equity of client firms.
As non-financial firms gradually sell their bank shares as their reliance on bank loans falls,

the banks have less of an incentive to hold shares of non-financial firms for the purpose ofstrengthening business relationships. Decline in cross-shareholding is the fact that it is nolonger as beneficial as it once was. Japanese firrns are being forced to carry out corporate

restmcturing. Their capacity to share risk is disappearing, and the high costs of business
relationships are beginning to make a serious drawback.

Cross-shareholding among firrns with common interests made it hard for outsider
shareholders to apply pressure on banks to lend more profitably. wnile the system worked

reasonably well while the economy was growing and money was scarce, but now that theeconomy has got mature and money more plentifu1, the system has become counterproductive.
Furthermore, stable cross-shareholding isolates firm's executives from the control of stock

market, depriving managers of an effective mechanism for checking against the accumulationof extra assets. Stable cross-shareholding insulates managers from short-term oriented
investors, thereby enabling managers to carry out long-term investments. Cross-shareholding,however, leads to a lack of close monitoring on management, leaving it up to managers todiscipline themselves. Japanese managers could be entrenched to run the firms as they want.

Pressure from liberalized and global capital markets has increased. The decrease incross-shareholding has reduced the discretion of managers and strengthened the disciplines of
the capital market. Cross-shareholdings of non-financial firms and financial institutions havedecreased sharply. Then, foreign investors increased stock holdings drastically to enhancetheir influences on corporate management.

3.2 Corporate Finance
Most of the restructuring undertaken by Japanese firms in the 1990s failed to improve
corporate profitability. Much of the improvement in firms' financial performance in the last
decade was a reflection of inexpensive capital rather than improved efficiency. Japanese firms
made excessive use of capital in the late 1980s, failing to take into serious consideration thelong-run return for their investments.

In the bubble economy of the late 1980s, Japanese executives could look forward to an
immediate impact on sales and asset growth of large-scale investment projects, ignoring thelong-term risk to corporate profitability and to shareholder wealth. Japan's economy in the
1990s is one of Japan's worst and potentially long-lasting slowdown in the post-war period.
Japanese major firms have been experiencing a substantial downward trend in profitability thathas pushed returns on investment to their lowest levels in the postwar era. Now most ofJapanese firms need to focus more on corporate value maximization. As well as cost
reducing efforts, the firrns make every effort to restmcture business units and projects.

14 KOBE ECONOILtllC&BUSINESS REVIEM, 47 (2002), 5-22

The retention of much of their cash flow and fewer growing investment opportunities inmajor businesses has produced considerable financial slack for Japanese major firms since thelate 1980s. Coupled with freer access to international capital markets, this has led to
distancing of Japanese non-financial firms from their banks, widening of managerial discretionover the allocation of resources, and a drive to diversification. Freedom from capital market

discipline is prompting Japanese managers to deploy cash in ways more likely to benefit
themselves and employees by maintaining jobs than to benefit shareholders. The problematicuse of excess cash to speculate in capital markets and plunge into strategies of unrelated
diversification is two major deployments ending in failure.

The remarkable success of Japanese firms in the post-war period has revealed its
weakness. The manageriai entrenchment against the capital markets has given rise to theexpression of latent self-interests that were contained during the high-growth period. With

their diminishing control over non-financial firms, the ability of banks to monitor andundertake corrective action is greatly reduced. It is weakening of vital control mechanism inJapanese corporate governance system that can substitute for market for corporate control.
Since Japanese major firms are no longer subject to substantial control from main banks, thelack of an effective control mechanism would be detrimental to corporate value maximizationin the long run.

Retums on investments (hereafter, ROI) of Japanese firms are considerably lower thanthose of the U.S. firms. As shown in Table 3 retums on assets have been consistently higher
in the United States than in Japan since 1960.` It suggests that Japanese firms are much lessprofitable than their U.S. counterparts. The relatively low returns of Japanese firms have been

attributed to differences in accounting practices, corporate tax rates, and exchange rates,

capital stmcture, and cost of capital. Even after adjusting for differences in tax rates,

accounting practices, and debt levels between the two countries, Japanese firrns in mostindustries have consistently lower operating margin and return on assets than equivalent U.S.
firms.

Capital structure policies and profit objectives of Japanese firms usually enhance theirlong-term corporate growth by allowing the savings from lower capital costs and return
standards to be reinvested in cost reduction, capacity expansion, and product development.
Investment decisions are not made on a discounted cash fiow basis in most Japanese firms.
4 Brown, Soybel, and Stinckney (1994) compare the operating performance of Japanese and U.S. firms using
financial statement data restated to a similar reporting basis during the period of 1985-88. The result show thatneither country appears to generate systematically higher profit margin, but that U.S. firrn has higher turnoverassets and therefore higher rates of return on assets. Although financial statement ratios of Japanese and U.S.
firms are not directly comparable because of the use of different accounting principles, their results suggest thatalternative accounting principles do not seriously distort the comparability of financial statement data in bothcountries. Return on assets of U.S. firms are significantly higher than those of the Japanese for the year 1985
to 1988 do, primarily because turnover rates of assets are higher for U.S. firms.

KOJI?LM; THE FALL OF `COMPANYISM' IN JAPANESE CORPORATE SYSTEM
15

Japanese managers usually view the cost of equity as the firm's expense to serve this sourceof capital, that is, dividends. With this view of cost-of-capital, it is easy to see why themarket price of their stock has little impact on investrnent decisions of Japanese firms.
Rather, baning market-imposed capital constraints, Japanese managers' investment decisions
are guided by what they believe the cost of capital by what is quite different from prevalentfinancial theories in the U.S. apanese managers care about borrowing costs and they pushtheir banks and securities firrns to get the best terms.

The most important criterion of Japanese firms has been long-term goal of maintaining
and enhancing their positions in the Japanese industry. Serious considerations of ROI andcapital costs thus play only a minor role in investment decisions of Japanese firms. If an
investment is necessary to keep up with a competitor or offers an opportunity to grow, thenthe investment may be made. Strategy of major Japanese firms has been simply to increase
recurring profits without giving proper consideration to the interests of shareholders. Thus,
Japanese firrns have continued to make investments that earn low retums, creating a situationin which extra assets with low return can easily build up under the strategy for long-term

growth. Growths in market share and continued employment clearly have been two of thedominant corporate goals in Japanese firms for most of the post-war period. Annual
Table 3. Profitability of Manufacturing Firms in Germany, Japan, and the United States Five-Year

Average (Percentage)
Return on Assets

GermanyJapan

U.S.A.

1960-64
1965-69
1970-74
1975-79
1980-84
1985-89
1990-94

3.00
3.07

3.19

187

2.60
1.39
2.16
2.37

6.28
6.94
5.92

1.80

O.97
3.87
2.66
2,99
2.74

3.31

7.21

5,68
5.24

324

n.a.

1.65
1.38
1.58
1.43

Return on Sales

GerrnanyJapan

U.S.A.

1970-74
1975-79
1980-84
1985-89
1990-94

1.49

2.94

453

129

1.37
1.92

5,20
4.34
4.66
3.09
5.72
6.17

1995
1996
1997

1995
1996
1997

O.65
2.54

223
1.95
1.80
n.a.

2.24
1.70
1.31

1.48
1.34

6.08
6.48
6.S9

629

Sources: The Bank of Japan (1974, 1978, 1986, 1994, 1996, 1997, 1999), Comparative Economic and Financial
Statistics: Japan and Other Countries.
Source Note: Statistiches Bundesamt, Unternehmen und Arbeitsstatten, The Bank of Japan, Syuyokigyo Keieibunseki(Business Analysis on Main Enterprises in Japan), The U.S. Department of Corrimerce, euarterly Financial Reportfor Manufacturing, Mining, and Trade Corporations
Note: Book values of assets in Japanese firrns differ greatly from current values.

16

KOBE ECONO?VtflC & BUSINESS REVIEM, 47 (2002), 5-22

profitability has been considered an important financial goal, whether it is attaining an
increase in annual profits or achieving certain level of profits to satisfy the requirement ofgenerating adequate cash flow to cover debt interests of banks. But Japanese managers havenot appeared to consider consistently their earning stream, return on equity, or capita1
stmcture with a viewpoint of corporate value maximization.

Japanese corporate finance is now in trouble: excess capacity and employees, declining

profits. More bankruptcies seem inevhable, as Japanese banks become unable to withstanddeteriorating their balance sheets. The only way to improve profitability and enhance
corporate value of Japanese firms is drastic restmcturing their business and resources. The
numbers of firms moving to that direction have been increasing.

4 Changes in Japanese Employment System
4.1 Distinctive Features in Employment
It is generally agreed that Japanese employment system, the most salient features ofwhich are seniority-based wages, lifetime employment, and enterprise unions, played an
important role during the high growth period in postwar Japanese economy.
Lifetime employment refers to the practice in Japanese firms of selectively recruiting new

school graduates and retaining them until a mandatory retirement age. Lifetime employment
is not a contractual state, but a pervasive norm affecting the treatment of regular workers(Lincoln and McBride, 1987). The average length of service in Japanese firms is about
eleven years. The ratio of workers with the length of service of less than one year to thetota1 workers in Japanese industry is low at approximately eight percents, compared withtwenty-six percent in the U.S. Since lifetime employment accounts for a large proportion in
the other countries as well, the practice of long-term employment are not peculiar to Japan.
The ratio of workers with a long length of services is higher in Japan than in other countries(Ministry of Labor, 1999a).
Workers, particularly white collar ones, are recruited at relatively low-level ports of entry

into the firm, receive on-the-job training in firm-specific skills, and compete solely with one
another for promotion into higher positions. Carefu1 screening of new recruits for entry level

positions, long tenure with the same firm, intensive on-the-job training, and fi11ing higher

positions through internal promotion are common in Japanese large firms. By encouraging
lifetime careers within the same firm, competition for promotion among the employees, andskills not valued much in the labor market, firms can foster dependence and loyalty inemployees. As far as ski11s are firm specific, seniority indicates ski11 and familiarity of thejob in the particular firms better than the external job training and experience (Lincoln and

McBride, 1987). The investment in firm-specific human capital increased the value of

17
KOJIAtL4: THE FALL OF `COneANYISM' IN JAPANESE CORPORATE SYSTEM

long-term commitment. Their supervisors monitor the perforrnances of workers, who arepromoted to higher ranks as they satisfy certain criteria at each rank. The earnings ofworkers are ties to their ranks. The ranking hierarchy characterizes the employment practices

in Japanese firms. Both workers and the firm commit to long-term relationships. Ranking
hierarchy relies on long-term relationships between workers and the management.

Seniority-based wage afid promotion system concems the practice of primarily basing
internal promotion and pay decision on the employee's age, seniority, and life stages. Wages

increase based on age and the length of services in the seniority-based system. While
fu11-tirne workers receive wage lower than their levels of productivity in the younger ages,

they receive wages higher than their levels of productivity in the older ages. The higher
wages in the older ages could be regarded as compensation for the lower wages they received
in the younger ages.

Seniority-based wage system can also be regarded as a means of building up
firm-specific skills with a firm. Wage system with highly progressive pay incurs a
discrepancy between productivity and the various pay grades. If the pay schedule isstructured so that young workers are paid less than their productivity would merit, and thenmake up for it after they have been with the firm for a certain length of working, they willbe less likely to leave their jobs after only a short time. Seniority-based wage system isclosely linked to the system of long-term employment. Wages below the worker's
productivity level while he is young can be tolerated if a certain level of growth is expectedin the firm, because future returns will be forthcoming in the form of higher wages. Youngworkers accepted wages, which were less than commensurate with their productivity, and then
their wages caught up with and surpassed their level of productivity as they aged. Over thelong run, the wages of individual workers were on a par with their productivity (Economic

Planning Agency, 1996).
Lifetime employment, seniority-based wage, employee loyalty, and firm-specific humancapital are considered complementary in Japanese large firms (Hashimoto and Raisian, 1989).
First, this system helps a firm to build up firm-specific skills within its workforce. Second,

this system reduces costs with job turnover. Job turnover means, for workers, the loss offirm-specific skills acquired within the firm, and the need to acquire new skills for a new job.

Short-term turnover prevents firms to• recover the cost of training and it generates new
training costs. Third, this system reduces management costs. Long-term employment makes
firms possible to keep track of employee capability and build up an organization to enhance

productivity. Moreover, long-term employment encourages employees to identify morestrongly with the firm and to be more royal to the firm (Economic Planning Agency, 1996).
wnile keeping fluctuations in the number of employees to a minimum, firm can regulate
the amount of labor they use and the costs associated by adjusting wages and the number ofworking hours. In addition, there are two other mechanisms which are important to JapaneseKOBE ECONOMIC & BUSJNESS REVIEM, 47 (2002), 5-22

18

labor market.

One is flexible deployment and transfers, which are made possible by intra-firm labormarkets. Intra-firm labor markets in Japanese firms involve a great deal ofjob rotation forboth production and office workers, and thus lead to the cultivation of a variety of ski11s in

employees. The investment in human resources is the way in which Japanese firms maintainlong-term employment and deployment and transfer of employees with a broad range of skills
to responding to changing business conditions.

The other is utilization of irregular workers such as part-time and temporary workers,
who play a role of buffer against the business fluctuation. The irregular workers are hired attimes of brisk business and released again when business drops off, thus constituting amechanism, which allows firms to regulate the amount of labor they use. Temporary and day

workers account for 120/o of the total workforce in 2000 (Statistical Bureau of Japan,
February 2001). Japanese firms rely on irregular workers to provide more stable employment
for regular workers. The jobs of temporary workers and regular workers in small firrns arevulnerable to buffering by business fluctuations whereas regular workers in large firms areprotected (Economic Planning Agency, 1996).
Employment relations observed in large, unionized Japanese manufacturing firms havebased on implicit and ambiguous collective agreements between employers and enterprise
unions with long-term relationships. Employment practices on the shop-floor in those firms

have incorporated broadly and ambiguously defmed jobs, high firm-specific human capital
investment, periodic wage raises and promotions based not only on seniority but on subjective
performance evaluations, various non-wage benefits beyond the legal obligation, and implicit

long-tem employment guarantees for regular workers. Joint labor-management councils arewidely used among large manufacturing firms in order to facilitate prior consultation, andmost disputes over collective agreements are settled internally and informally without
appealing to a legal third party (Moriguchi, 2000).

Implicit and ambiguous employment contracts in major manufacturing firms arecomplemented by joint labor-management councils and enterprise unions. The commitment tolong-term employment has been reinforced by the absence of active labor markets. Moreover,the practices of long-term employment relationships have discouraged the development oflabor markets for mid-career job changes. A well-organized labor market for managers has
not developed in Japan. The majority of managers in Japanese firms are promoted internally,
and the board of directors is just the finishing stage for the winners of internal toumament.

Even when directors come from outside, they are most often dispatched by stable shareholders

or retired govemment officials. The lack of managerial labor market makes it hard forJapanese managers to move from one firm to another, and improve the credibility of
theirlong-term commitment.

KOJIIV`L4: THE FALL OF `COMI?ANYISM' IAr JAPANESE CORPORATE SYSTEM 19

42 Changes in Employment
Appreciation of the yen and intensive competition in overseas markets has made laborcosts in Japan extremely expensive by comparison. In order to reduce labor costs, Japanesefirms have set up operations abroad and carried out restmcturing at home, but these efforts

will have to be accompanied by changes in the employment systems that have been in use
to date. Japanese firms have been able to avoid drastic reductions of workforces by limiting
hiring of new graduates, but there have been cases in recent years in which workers have notactually been able to remain in the particular firm for an entire career. The firrns have copedby resorting to such measures as out-placement of employees at affiliated firms and byforgoing pay rise for high-paid older workers eroding the seniority-based wage system(Economic Planning Agency, 1996).
Since substantial economic growth can no longer be expected in the post-bubble period,
long-term relationships have been undergoing changes. Financial institutions have recently

begun to write off bad loans much more actively than before, and this in turn has pushed

firrns to carry out restmcturing more thoroughly, even in the area of employment. Somefirms have found it impossible to maintain existing employment relations, which place
importance on seniority system. Under these circumstances, the firms will have to devise
ways to reduce the risk associated with long-term contracts, taking no newly hired employees.

The labor turnovers for both men and women in the second half of the 1980s and the 1990s
were higher than in the period between the second half of the 1970s and the first half of the

1980s. For both men and women, the younger one is, the higher the labor turnover is(Ministry of Labor, 2000).

Diversification of personnel hiring is spreading in Japanese firms. Although theemployment rate of new graduates is still prevalent, the recruitment of mid-career isincreasing. Utilizing short-term employment and outsourcing jobs required special skills is

also increasing. Japanese firms have recently begun trying to make active use of external

labor market. At the same time, many firms faced to rising labor costs, have cut back onhiring of new graduates in order to assure the jobs of current employees.
Japanese firms have been focusing on restructuring themselves to downsize the assets andnumbers of employments. Restructuring efforts place the emphasis on reduction of excessive

corporate resources such as assets and employees. Japanese firrns are increasing the
proportion of part-time workers to adjust to the fluctuation of their businesses. The rate ofunemployment has been increasing as firms regard the current levels of employments as anexcess level, particularly middle-aged white-collar workers. The rate of unemployment due tobankruptcy, dismissal, and early retirement is higher in the middle-aged workers. Moreover,blue-collar workers are considered to be excessive levels of employments reflecting a decline

in production in the manufacturing and construction industries. Levels of employments in

20

5-22
KOBE ECONOAtfirC & BUSINESS REVIEW, 47 (2002),

clerical workers and middle managers have been considered to be excessive, but Japanesefirms have been slow in adjusting their employments and kept them on the payrolls. Japanesefirms are concerned about excessive levels of employments and reduction of employments ofclerical and managerial positions (Economic Planning Agency, 2000a).
Although major Japanese firms still maintain the practice of lifetime employment, thedecline in the economic growth has affected the employment policy. Japanese firms slashedprimarily part-time workers during the period immediately after the collapse of the bubble

economy. The levels of fu11-time workers are getting to be excessive and are required
reduced (Ministry of Labor, 1999a).

As far as the size of the firm has expanded and the numbers of young workers exceeded

those of older workers, the seniority-based wage can sustain. Since the numbers of older
workers exceeded, it has been difficult to keep wages under the seniority-based wage and theflattening of the wage structure is expected to continue. The seniority-based wage is closely

related to lifetime employment. Workers tend to stay in the same firm as long as possible

under the seniority-based wages. The flattening of the seniority-based wage system canweaken incentives of workers to stay in the same firms and encourage them to seek other job

opportunities outside. The proportion of workers wishing to change jobs has increased,
particularly among young workers. This trend can certainly change the practice of lifetime

employrnent in Japanese industry (Economic Planning Agency, 2000b).

Taking advantage of the benefits of long-term employment and enhancing humanresources, major Japanese firms must reform employment practices that are capable ofresponding to changing environments. It is required for the firms to make more fiexible useof wage systems, in which performance-based wages and corporate-value-related incentives
such as stock options. As a consequence, wage structure in major Japanese firms has beenshifting from the seniority-based wage to the performance-based one. First, the move towardplacing an emphasis on capability and achievements with respect to wages is increasing. The

proportion of the firm planning to attach importance to the performance-based wage system
in determining the wages of their regular workers was 400/o in 1993, and the figure increased
to 500/o in 1999 (Ministry of Labor, 1999b). Along with progress made in the shift from theseniority-based wage system to the one based on the performance-based system, the wage
differential between the young and older workers will narrow. At the same time, it will
widen the differential withjn the same generatjon. As the background of the jncreasing moves

to place an emphasis on the merit system in performance evaluation, there are many workers
who see the necessity of self-improvement.

The environment surrounding employment is changing. The progress in information
technology has a great impact on the environment surrounding employment and has asked
individuals to acquire skills. The structural shift toward knowledge-intensive industries haschanged the significance of efforts to build up firm-specific skills in the particular firm. The

KOJIMA: THE ,FALL OF `COMI?ANIYISM' IIV JAPANESE CORPOR,4TE SYSTEM
21

relative importance of building up firm-specific skills has declined, and firms now find it
preferable to hire technical engineers directly from outside labor markets (Economic Planning

Agency, 1996). In addition, demand for workers capable of coping with the rapid
technological innovation with regard to information has been rising sharply. The capability toutilize information is one of the most important ski11s one has to acquire in order to adapt
to technological changes.

Demand for white-collar workers, specifically those in the mid- and older-age groups, hasapparently declined as the IT revolution has lowered information costs. The Labor Survey

indicates that administrative employees have recently decreased. The amount of young

employees has also decreased as firms have tried to hold down the employment of new
graduates. However, the mid-and older-age groups have also seen declining employment. A
surplus of white-collar workers began to rise in 1997 and has remained at a high level.

While information-related job offers have been increasing, the number of temporary
employees has been increasing since the middle of 1999. This indicates that the IT revolution

has led to an increase in jobs that can be undertaken by temporary employees rather thanregular employees who are more familiar with their environments. Dairy hours workers spend

on Ieaming and studying during off-duty hours are increasing. The need to enhance theirknowledge and ski11s among workers can be increasing (Economic Planning Agency, 2000c).

References

Bank of Japan (1974, 1978, 1986, 1994, 1996, 1997, 1999, 2000), Comparative Economic and Financial
Statistics: Japan and Other Countries, Tokiwa Sohgoh Service.
Bank of Japan (1974, 1978, 1986, 1995), Economic Statistics Annual, Tokiwa Sohgoh Service.
Brown, P. R., V. E. Soybel, and C.P. Stickney (1994), "Achieving Comparability of U.S. and Japanese

Financial Statement Data," Japan and the Morld Economy, 6, 51-72.
Economic Planning Agency (1996), Economie Survey oflapan 1995-1996, Printing Bureau Ministry of

Finance
Economic Planning Agency (2000a), Economic Survey ofJapan 1998-1999, Printing Bureau Ministry of

Finance
Economic Planning Agency (2000b), Economic Survey ofJapan 1999-2000, Printing Bureau Ministry of

Finance
Economic Planning Agency (2000c), KIokumin Seikatsu Hakusho Heisei-11nen-ban (White Paper on the
National Lifestyle Fiscal Year 1999), Phnting Bureau Ministry of FinanceHashimoto, M. and J. Raisian (1989), "Investments in Employer-Employee Attachments by Japanese andU.S. Workers in Firrns ofVarying Size," Journal ofthe Japanese andInternational Eeonomies, 3,31-48.
Lincoln, J. R. and K. McBride (1987), "Japanese Industrial Organization in Comparative Perspective,"

Annual Review of Sociology, 13, 289-312.
Ministry of Labor (1999a) Rohdo Hakusho Heisei-12nen-ban (White Paper on Labor Fiscal Year 1999),

REVIEM, 47 (20027 5-22
KOBE ECONOMICBUSINESS&

22

Japanese Labor Research Institute.

Ministry of Labor (1999b) Koyo Kanri Chosa Hokoku (Report on the Survey of Employment
Management 1999), Japanese Labor Research Institute.
Ministry of Labor (2000), Rohdo Hakusho Heisei-12nen-ban (White Paper on Labor Fiscal Year 2000),
Japanese Labor Research Institute,

Moriguchi, C. (2000), "The Evolution of Employment Relations in U.S. and Japanese Manufacturing
Firms, 1900-1960: A Comparative Historical and Institutional Analysis," working paper,

NBER.
National Lands Agency (2000), Tochi Hakusho Heisei-12nen-ban (White Paper on Lands Fiscal Year
2000), Printing Bureau Ministry of Finance.

Statistics Bureau of Japan (February 20el), Monthly Statistics of Japan Februar:y 200I, Japanese
Statistical Association.

The Economist (January 27th 2001).
Toyo-Keizai Tokei Geppo (Toyo-Keizai Statistics Monthly) (Apri1 2001).

KOBE ECONO?uarC & BUSINESS REVIEM, 47 (2002), 23-66

CREATION OF NEVV ENTERPRISES AND DEVELOPMENT OF
EXISTENT ENTERPRISES IN EAST ASIA AND LATIN AMERICAAKIO HOSONO Kobe University

Abstract
This paper intends to address the relationship between financial depth and development of private
enterprises by classifying the growth of business activities into two parts: one part that is due to thecreation of new firms and the other part, due to the expansion of existing firms. After examining theprevious studies related to this issue, the paper compares East Asia and Latin America in terms of these

two aspects of corporate growth and their relations to financial depth or financial development. It
compares the evolution of financial depth and related indicators of East Asia and Latin America andanalyzes their implications on new firms formation and expansion of existing enterprises. It finds thatshallow financial depth in Latin America affects considerably development of private enterprises in theregion, where economic growth and export is much less dynamic in comparison with East Asia.

JEL CIassilt}cation: D2, G2, G3, Ol, 02
Keywords: Latin America, East Asia, enterprises, financial depth, entrepreneurship

Introduction

Many Latin American countries have experienced unprecedented, comprehensive anddrastic economic reforms in the 1990s. Nevertheless, the IDB (2001) pointed out that in the

1990s "economic growth in the region had been disappointing." There has been extensive
research addressing the issue of the effects of reforms on the growth, the most recent of
which is that prepared by the IDB entitled "Competitiveness: the Business of Growth." (IDB2001) This study hypothesized that reforms can strengthen competitiveness, which willsubsequently guarantee sustained growth. ECLAC (2000) and the World Bank (1998) have

Corresponding Address:

Akio Hosono
Research lnstimte for Economics and Business Administration (RIEB), Kobe University

2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501 Japan
E-mail: hosono@rieb.kobe-u.ac.jp

Phonensax: 81-78-803-7006

KOBE ECONOvaC & BUSINESS REVIEM, 47 (2002), 23-66

24

also discussed issues related to such reforms and continued levels of growth.

The present paper intends to address the issue from a different perspective, byquestioning the inaction of the enterprises of the region, in terms of neglecting to take fu11

advantage of the reforms of the last decade and of other new phenomena, such as
globalization, regional integration and technological development, which have characterized the90s. Private sector initiatives matter considerably, as not only is this sector essential tosustained economic growth, but subsequent to the above-mentioned reforms, the private sector
should be the principal actor in economic activities. As such, given the lack of initiative
taken by these regions to exploit the advantages of such reforms and new opportunities, thereis need to analyze the existing constraints.

Another distinctive feature of this research is the use of the East Asian experience as abencimark for comparison. Sorne studies have compared Latin American countries wnh East

Asian economies, but there has been no research thus far on the aspects of reforms andgrowth which this paper is attempting to analyze.

I arn commencing this research on the basis of one of the most important factors which
affect corporate activities and growth, that is fmance. Financial development is considered to

be an essential element for growth by many authors. As a matter of fact, when we compare
Latin America and East Asia, it was discovered that one of the most striking differences isthat of financial depth.

According to the cited IDB report, "the major problem faced by businesses in Latin
America and the Caribbean is accessing fmancial markets." "On average, the ratio of credit
to the private sector to GDP in the 1990s was close to 33 percent, roughly a third of the sizeof the average credit markets in East Asia...." "Estimates suggest that, on average, a large

firm can increase assets by nearly 5 to 8 percent for every 10 percent increase in the
fmancial depth of its host country."
Although there exists significant research on the relationship between growth and finance,

the majority of such research is based on econometric regressions which analyze therelationship between variables. Currently there are studies which offer some clarification on
the black-box of the relationship, that is, how financial depth concretely affects corporate
activities, but such studies are indeed scarce. This paper intends to address this point byclassifying the growth of business activities into two parts: one part that is due to the creationof new firms and the other part, due to the expansion of existing firms. Chapters 3 and 4
will compare East Asia and Latin America in terms of these two aspects of corporate growth
and their relations to financial depth or fmancial development. Chapter 1 will review research

related to finance and growth and will also present some relevant stylized facts. Chapter 2
will compare the evolution of financial depth and related indicators of East Asia and Latin
America and Chapter 5 will discuss the policy implications of the findings in this paper.

HOSONO: CREATIOAr OF NEPV ENTERPRISES AND DEVELOPneNT OF EJVSTENT ENTERPRIrSES 25

1. The Objective of the Study and a Review of Related Studies.

1.1 The Objective of the Study,
As was mentioned in the Introduction, the main objective of this study is to analyze theeffects of reforms in the 1990s in Latin America on the sustainability of growth, by focusing

on the relationship between financial development and the response of enterprise to new

business environments as well as the opportunities generated by reforms and other new
factors of the 1990s such as globalizatiofi, regional integration and technological ohange. Two

major features of the study are:(a) its attempt to open to some extent the black box of correlation between finance on
the one hand and new firm creation and expansion of existing firms on the other; and(b) it also intends to analyze Latin Arrierican experiences using cases of East Asian
economies' as a benchmark. This approach is illustrated in a simplified way, as shownin Figure 1-1
Thus the review of related studies should be made, by mainly regarding the following
four areas:(a) effects of reforms on growth;(b) the relationship between financial development, among other financial depths, andgrowth;(c) a comparative study of development in Latin America and East Asia; and(d) new firms creation and expansion of existing firms.

1.2 Effects of reforms on growth.
In recent times, several studies have been done with regard to the effects of reforms of

Latin America in 80s and 90s. Among others, we should refer to the studies of threeinternational organizations, namely the IDB's studies: Latin America after a Decade of
Reforms (IDB 1997) and Competitiveness:Business of Growth (IDB 2001), the World Bank's
study: The Long March: New Agenda for Reform in Latin America (Burki and Perry 1998)
and the UN ECLAC's studies: Growth, Employment and Equity: The Impact of the Economic

Reforms in Latin America and the Caribbean (Stallings and Peres 2000) and Economic
Reforms, Growth and Employment (Weilner, Jurgen 2001)
All of these studies analyze macroeconomic aspects of the relationship between reforms

and growth. In addition, the most recent study of the IDB analyzes the implications ofbo"Figure 1-1.
Reforms, New Business Environment, New
and Responses of Private Actors (Expansion of Existing

Business Opportunities

Firms and Creation of New

Firms)g
ill

Reforms considerably advanced,

The most advanced

Less advanced reforms

but not enoughreforms
Liberalization
Deregulation
Privatizationg,

Fiscal reform, Tax reform,(Financial sector reform: Banks,
Capital Market; Pension system;

Judicial system reforms(including bankruptcy law)Labor market reforms)
i

i

g
:
gr2

v

tzC-5

Globalization

Still shallow

New Business Environment

Regional<.--.--.--.-....-..-.-..-.--.--..-.

Integration

New Business Opportunities

financial depth(low level oflDevelopmentg-domestic
credit to theTechnologicalag

private sector)

.N

S
g.
s•
Ei]

Response of private actors:(Note:(l)

Expansion of existing enterprises (Chapter 4)(2)

Creation and development ofnew enterprises

Dotted arrows indicate constraints until reforms are completed)g

HOSONO: CREATION OF NEM ENTERjPRISES AND DEVELOPMENT OF EMSTENT ENTERPRISES

reforms on competitiveness including new aspects such as the capacity to innovate (Part V ofthe study) as well as industrial and investment policies. (Part VI of the study). The World
Bank's recent study also discusses some new aspects such as intra-industry trade and the roleof knowledge and the institution. On the other hand, ECLAC's study discuses the impact ofreforms on industrial sectors ("macrolmeso-level" analysis).

This paper focuses on the response of the enterprises to a new environment and to theopportunities created by reforms. In this sense, it tries to analyze using a different angle, therelationship between the above-mentioned factors and the sustainability of growth, paying
much attention to new firm creation and expansion of existing firms. Therefore this paper ismeant to act as a complement to the above-cited studies. The characteristics of thispaper's approach in comparison with those of previous studies is shown in Figure 1-2. This
figure is prepared just for illustrative purposes and does not pretend to make a rigorouscomparison of approaches.

1.3 Relationship between financial development, financial depth and growth

1.3.1 General analysis on relationship between financial development, depth andgrowth.
Many empirical studies have confirmed that deeper financial depth is positively correlated

to higher economic growth. A positive relationship between initial financial intermediation

depth and subsequent long-run growth performance was found by King and Levine (1993a,
1993b). Levine, Loyaza, and Beck (2000) have also presented robust evidence that financial

development and depth lead to an improved growth performance. This information wasprovided using data panels of 74 countries with non-overlapping five-year averages covering
the period 1960-95.

A recent World Bank study mentions that there is a solid body of empirical researchwhich strongly suggests that improvements in fmancial arrangements precede and contributeto economic performance, as opposed to the view that finance merely follows and adapts toreal economic progress. It also emphasizes that the widespread desire to see an effectivelyfunctioning financial system is warranted by its clear causal link to growth, macroeconomic

stability, and poverty reduction. (World Bank 2002, p.31) We have several articles anddocuments that survey basic and recent literature on financial development and growth.'
1 For a comprehensive review of literature on financial development and growth, see following publications: Chapter

4 on financial system of World Bank (2002), Morld Development Report 2002; World Bank (2001), Financefor6rowth: Poticy Choicefor a Volatile Mortd (World Bank Policy Research Report); Khan, Mohsin S, and Abdelhak

S.Senhadji (2000), Financial Development and Economic Growth: An Overview (IMF Working Paper); WorldBank (1989) Morld Development Report 1989

es

Figure 1-2. Comparison of Approach of Studies on

Reforms and Sustainability of

Growthg
gg

Macro level approach

Macro level approach

Macro-micro level

at lDB (1997)

at ECLAC (2000)

approach of this paper

Macro

Reforms

Socialpolicies(Sta11ingsandPeres)Reforms

policies

g
g,

E
s

Reforms

Trade r.

S.,qXX
XXX>t•L,iosg,,•

Financial r.

Productivity

Tax r.

Investment
ent

Investment

Technical

New businessenvrronmentchangev Newbusinessag

opportunities

Ntu

.N

Labor r,S
rbox

Privatization

Growth

Employment

EquityCreation of
new firms"oExpansionof

vbo

existingfirms

.

bo
bo
,

q
q
GrowthGrowthHOSONO: CREIATION OF NEPV ENTERPRISES AND DEVELOPneNT OF EMSTENT ENTERPRISES

Levine, Ross and Maria Carkovic (2001) reassess the relationship between stock markets,banks and economic growth, given differing theoretical predictions about the impact of stock
markets, banks and economic growth. They concluded that the results are consistent with theview that stock markets and banks independently influence long-run growth and the positive

link between financial development and growth does not seem to be linked to outliers,
omitted variable bias, or endogeneity.

1.3.2 Financial crisis, financial depth and growth with special reference to Latin America.

On the other hand, Loayza and Ranciere (2001) show that credit booms do precedebanking crisis and that the relationship between financial interrnediation and growth isnegative in the years surrounding banking crisis. They cite the study of De Gregorio andGuidotti (1995) which presents evidence that in cross-sectional regressions involving aworldwide sample of countries, financial intermediation is positively linked with growth.

Conversely, in panel regressions for only Latin American countries, the relationship isnegative. De Gregorio and Guidotti suggest that their results for Latin America may reflect
the lasting impact of the repeated financial crisis that the region has suffered. (Loayza andRanciere 2001, p.5)

Loayza and Ranciere (2001) conclude that the dynamic relationship between economic
growth and financial intermediation is negative around financial crisis. They point out
fUrthermore that the positive link between "long-run" economic growth and financial deepening
is smaller in countries that have suffered from banking crisis than in the rest. Using recent

econometric methods for the estimation of dynamic models with panel data, Loayza andRanciere (2001) find that a positive long run relationship between financial intermediation andoutput growth co-exists with a mostly negative relationship. They propose that this is as aresult of an empirical explanation for the apparent contradiction between the crisis literatureand the endogenous-growth literature on the effects of financial deepening. tp.21)

On the other hand, in a recent study canied out by the IDB (IDB 2001, p.57),
econometric results confirm the positive influence of financial reform on credit expansion for

18 Latin American countries over 1985-99. The size of the financial sector as measured by
the ratio of private credit to GDP is significantly related to the financial liberalization index
constmcted after controlling for other relevant factors.

Bekaert, Geert, Campbell F.Harvey and Christian Lundblad (2002) conclude that equity
market liberalization (allowing foreign investors to transact in local securities and vice versa)

did increase economic growth. Some of the liberalization effect can be accounted for bycoincidental macroeconomic reforms as well as financial development. However their analysis
shows that even after controlling for a broad range of variables, a statistically significant andeconomically important role is played by equity market liberalization.

30 KOBE ECONOMIC&BUSINESS REVIEM, 47 (2002?, 23-66

1.3.3 Industrial structure, domestic finance and growth.

'

Raghuram G. and Luigi Zingales found evidence that is consistent with the hypothesisthat industries which rely heavily on external finance grow faster in countries with
better-developed financial systems. They use data drawn from a panel of 42 countries and 36

industries over 1980s. Furthermore, they show that the effect of financial development on
industrial growth runs mostly through a growth in the number of establishnents rather than

through a growth in the average size of establishnent. So financial development improves
disproportionately to the prospects of young firms in industries that rely heavily on externalfinance. (Beck, Thorsten and Ross Levine, 2000, p.8)

Beck, Thorsten and Ross Levine (2000) find that industries that are heavy users ofextemal finance grow faster in countries with higher overall levels of financial development

and in countries that rigorously protect the rights of outside investors. Moreover, theirfindings show that the overall level of financial development along with strong creditor rights,

shareholder rights, and contract enforcement mechanisms foster new firm formation. (p.27)'
1,3.4 Financial development, new firms creation and expansion of existing firms.
Rajan, Raghuram G. and Luigi Zingales (1998) assert that industrial growth is comprisedof a part due to the creation of new firms and the other part that is due to the expansionof existing firms. As was mentioned above, they show that the effect of financial

development on industrial growth runs mostly through a growth in the number of
establishments rather than through growth on the average size of establishments.

Beck, Thorsten and Ross Levine (2000) found that economies thriving with overall
financial development (development of market-based and banked-based systems) stimulates theestablishnent of new firms, which is consistent with Schumperterian view of creative
destruction.

1.4 Comparative study of development of East Asia and Latin America.

The World Bank study on the "East Asian Miracle" was the first comprehensive
analysis on the high performance of East Asian countries for approximately three decades
from the 60s or 70s through the beginning of 90s. (World Bank 1993) Although this study
focuses on East Asian High Performing Economies, it frequently draws comparisons with theexperiences of other regions. Therefore this study could be considered as one of the earlycomparative studies on development of East Asia and Latin America. Subsequently, given theencouragement provided by such a comparative study, some other studies related to bothregions have been carried out.

HOSONO,• CREATION OF NEM ENTERPRISES AND DEVELOPneIVT 0F ELk7STENT ENTERPRISES 31

1.5 Entrepreneurship and new firms creation.
Although there have been several important studies regarding this subject, the mostrecent study is OECD's Science, Technology and Industry Outlook: Drivers of growth:
Information technology, Innovation and Entrepreneurship (OECD 2001). Another recent andcomprehensive study regarding the creation and development of new firms, was conducted by
Kantis, Hugo, Masahiko Ishida and Masahiko Komori (2002) and is entitled Entrepreneurshi

in Emerging Economies: The Creation and Development of New ]Firms in Latin America andEast Asia.2

2. Financial Depth and Related Indicators: Comparison of Latin America and East Asia'
2.1 Financial sector reform, liberalization and financial depth
The financial development in terms of "domestic credit to the private sector" in Latin

American countries is lagging behind considerably in comparison with East Asia. In 1999,
the average domestic credit to the private sector as a percentage of GDP in Latin America
remained at the level of 29.4, while this indicator in East Asia rose to 104.1. (See Table 2-2)

Furthermore, this value of "domestic credit to the private sector" in Latin America is very

shallow in comparison with that of the average of middle income countries (58.3 in 1999)
and with the average of high income countries (129.3, same year).

Latin American countries implemented a wide-range of financial sector reforrns andliberalization in the 90s, which undoubtedly improved the financial depth in Latin America.

According to a recent study carried out by the IDB (IDB 2001, p.57), econometric results
confirm the positive infiuence of financial reforrn on credit expansion for 18 Latin Americancountries over 1985-99. The size of the financial sector as measured by the ratio of private
credit to GDP is significantly related to the financial liberalization index constructed after
controlling for other relevant factors.

Nevertheless, the same study finds that on average, the ratio of credit to the private

sector to GDP in the 1990s was close to 33 percent, roughly a third of the size of theaverage credit markets in East Asia and the developed countries. Estimates made by the IDB(2001) suggest that, on average, a large firm can increase its assets by nearly 5 to 8 percent
for every 10 percent increase in the financial depth of its host country. Therefore, companies

in countries with tight credit constraints face severe impediments to expansion. The study
2 The concept of entrepreneurship generally refers to enterprising individuals who display the readiness to take risks

with new or innovative ideas to generate new products and services, In most cases focus is on the ability of

individuals to start up new ventures, the quantity and quality of start-up firms, and the ease with which
enterprises can enter and exit the market, (OECD 2001)

32 KOBE ECONOvaC&BUSINESS RE771EPV, 47 (2002), 23-66

concludes that while these findings suggest that financial reform has in fact had a significant

impact on the development of Latin American financial sectors, there still are several issues

that need to be addressed. Table 2.1 shows the changes of financial depth of major Latin
American countries before and after the financial liberalization.

2.2 Financial depth and increased role of private sector in Latin America comparedwith East Asia
In addition, in the context of the reforms of the 90s in Latin America, we should
remember that, due to the intensive process of privatization in 90s, the private sector was

supposed to be the main actor of investment. Private fixed investment as a percentage ofgross domestic fixed investment increased from 74.3 to 79.8 in Latin America, while thisindicator decreased from 63.3 to 50.2 in East Asia. (See Table 2-2)
Table 2-1. Financial Depth Before and After the Financial Liberalization in Latin America
Argentina

BrazilColombia

Mexico

Peru

9.6

13.6

13.3

15.4

5.3

a.Creditexpansionperiod
End-of-PeriodratiosCreditiGDP

1991-98

1991-94

1991-98

1991-94

1991-98

24.2

16.9

34.1

27.3

b.Creditslowdownperiod

1999-2000

33.4
1995--99

1999-2000

23.4

26.7

18.1

DepositMoneyBanks
1.Preliberalizationperiod(1980-1990)

End-of-PeriodratiosCreditiGDP
2.Postliberalizationperiod

End-of-PeriodratiosCreditiGDP

1995-2000 1999-2000
13.1

25.8

Source: Barajas, Adolfo and Roberto Steiner, 2002 based on Intemational Financial Statistics, and authors' calculations

Table 2-2. Comparison of Domestic Credit to Private Sector and Private Fixed Investment
between Latin America and East Asia
Domesticcredit(O/.Of'toprrvatesector

GDP)

Privatefmed' mvestment(O/oof
grossdomestic fixedinvestment)

1990

1999

1990

1998

Argentina

15.6

38.9
47.2

67.4
76.7
79.5

915

Brazil

25.0
34.5
67.5

m

92.1

Chile

Mexico

17.5

16.2

159.4
93.4
144.0
115.3
130.1
29.4

HongKong

165.1

Korea

65.5

Malaysia
Singapore
Thailand

69.4
97.5
83.4

LatinArnericaandtheCaribbean

28.5
71.4

EastAsiaandthePacificSource: World Bank, World Development Indicator, 2001.

104.1

88.1

64.5

-

84.8
74.3
63.3

82.9
87.7

79.5
65.4
66.2
79.8
50.2

HOSONO: CREATION OF NEPV ENTERPRISES AND DEVELOPMENT OF EM[STENT E?VTERPRISES 3

This means that in Latin America, the size of domestic credit to the private sector
remained considerably low in terms of international comparisons, precisely when the private
sector is expected to accomplish a much more active role in economic activities in the region,

because of the deep economic reforms which were implemented in the 90s, especiallyprivatization and deregulation.

The World Bank (1993, p.275) compared the two regions from a larger perspective.

Financial depth (coefficient of M2 to GDP) was deeper in High Performing East Asian
economies (HPEAs) than Latin American countries in three decades beginning in the 1960s.

In East Asian economies, it increased from around 35 percent in the 60s (1960-70) and 48
percent in the 70s (l971-80) to almost 70 percent in the 80s (1981-90). As was mentioned
above, this indicator continues to increase in the 90s. In Latin America, it increased from 20

percent in the 60s and 28 percent in the 70s to 38 percent in the 80s. The study concludes
that in East Asia, the combination of rapid growth of financial assets in the banking systemwith rising savings during the past two decades has meant that banks have played anincreasingly important role in capital allocation. (p.275)

2.3 Financial depth and the fiscal deficit in Latin America and East Asia
Another aspect of reforms of the 90s which has implications for the level of financial
Table 2-3. Domestic Credit Provided by the Banking Sector, Domestic Credit to Private Sector
and Interest Rate Spread as vvell as Fiseal Deficit in Latin America and East Asia
(All indicators expressed as a percentage of GDP)
Overall

Domestic credit
providedby

Interest
Domestic,topnvatecreditsectorbanking sector

ratespread(lending

minus

deposit rate

percentage points)(figuresin

budgetbalance
theparenthesisareinterestpaymentofcentral

government aspercentageof
cufrent

Argentina
BrazilChile

MexicoHongKong
Korea
Malaysia
Singapore
ThailandLatinAmericaandtheCaribbean
EastAsiaandthePacificMiddleincomecountries
Highincomecountries

revenue)

1990

1999

1990

1999

1990

1999

1990

32.4
89.8
73.0
36.6
156.3
65.7
75.7
75.7

35.6

15,6

25.0

51.8

38.9

34.5

-O.4
-5.8

72.5

47.2

67.5

4.1

O.8

288

175

162

163

-25

-7.3(14.4)
O.4(3.0)-1.4(16.5)

140.8

165,1

96.6
151.6
94.7
141.9
41.6

65.5

-

-1.3(2.5)

69.4
97.5
83.4
28,5

1.3

32

2.7

4.1

2.2

4.3

1145

7L4

7e.5
147.8

11O.9

159.4
93.4
144.0
115.3
130.1
29.4
104.1
58.3
129.3

-

3.0

.
-

-

91.1

59.2
73.4
65.0
137.2

Source: World Bank, World Development Indicator, 2001.

45.4

8.6
3.3

-

4.0
1.4

-O.7
-2.0
+10.8
+4.6
-3.5
-O.8
-2.5
-3.0

1998

-1.5(162)-+2.9(10.2)+3.4(2.9)-7.7(1.2)-4.2(122)-3.0(9.9)-3.0(11.6)-1.1(8.6)

34 KOBE ECONOAtflC&BUSINESS REVIEPV, 47 (2002), 23-66

depth, is a persistent fiscal deficit, in spite of efforts of fiscal reform in Latin America. As

known, a fiscal deficit produces crowding out and restricts finance to private sectors. Here
we should take into account not only the level of the fiscal deficit compared with GDP, butalso the relative size of the fiscal deficit compared with financial depth. Crowding out would

take place even with a lower fiscal deficit if the financial depth is shallow. This is what

happened in Mexico and some other Latin American countries, where a fiscal deficit is notas high with intemational comparisons, but it still does affect loans to the private sector due

the overall shallow financial depth. Therefore a fiscal deficit has been causing crowding out

in these countries. Banks have invested a large amount of resources in govemment bonds andhave been able to make a considerable amount of earnings, but were still not motivatedenough to expand their lending to the private sector. This aspect will be discussed in iaterusing the case of Mexico.
In spite of the fact that Latin American countries have made strong efforts to reduce
fiscal deficits, the low level of domestic credit for the private sector is still related to someextent to the fiscal deficit in the govemment budget, because of the "crowding out" mentioned

above. In East Asia the opposite type of combination is observed: lower fiscal deficit isaccompanied by a deeper overall financial depth. Therefore, the effects of "crowding
out" is stronger in Latin America than East Asia. It is confirmed by the Table 2-3.
Table 2-4. Latin America and East Asia: Recent Credit Slowdowns
Credit to the Private Sector by the Banlcing System (except where otherwise indicated)

Slowdown
periodCreditiGDP

Differencevs.

atendofmostrecent

slowdown

peak

24.1

11.4

-O.7
-6.4
-6.7
-9.5
-4.7
-29.6
-l8.0
-5.5
-19.3

25.8

-15

8.0
5.9

-56.0
-23.4

-L8

49.3
43.2
101.1

-32.2
-1.4
-35.6

-10.7
-1.4
-11.9

Averageyearly
fallfrompeak

LatinAmericancountries
Argentina
Brazil1999-2000
1995-99

DepositMoneyBanks
Colombia

1999-2000

DepositMoneyBanks
Chile

1985-91

40.0
38.0

1995-2000

13.1

DepositMoneyBanks
Mexico

32.4
26.7
25.7
17.9

DepositMoneyBanks
Peru

1999-2000

Venezuela

1983-95

DepositMoneyBanks

-O.3

-L3
-L3
-4.8
-2.3

-42
-2.6

-L8
-3.2
-O.7
-4.3

EastAsianCountries
Indonesia

Korea(DepositMoneyBanks)
Thailand

1997-99
1997-98
1998-2000

Source: Barajas, Adolfo and Roberto Steiner, 2002 based on Intemational Firiancial Statistics, Bank of Korea andauthors' calculations.

H/OSONO: CREATION OF ?VEPV ENTERPRI[SES AND DEVELOPneNT OF EXJSTENT ENTERPRISES 35

We must add that the size of the financial depth such as "domestic credit provided bybanlcing sector" and the "domestic credit to private sector" is not very stable. They are
considerably volatile, especially in the period of crisis and reforms. Barajas and Stein (2002,p.17) demonstrate how these indicators changed in the 90s. However, the magnitude of thedifference between East Asian and Latin American leading economies still remains. (Table
2-4)

2.4 Development of capital market
The low coefficient of domestic credit to the private sector relative to GDP is notcompensated by other means of financing in Latin America. We should point out that thecapital market is considerably less developed in Latin America as compared with that of East

Asia. (See Table 2-5)

2.5 Financial depth and growth in Latin America and East Asia
As was discussed in Chapter 1, several authors found a high correlation between
indicators of financial depth and growth. Nevertheless, in today's age of globalization,national and international actors have greater and better access to international financing

through loans from foreign banks and directly from intemational capital market through theissue of bonds, ADRs, etc. These sources of financing could be the determinants of theshallow domestic financial depth in Latin America.
Table 2-5. Market Capitalization, Value Traded and Listed Domestic Companies in Latin America

and East Asia
Marketcapitalization(O/eofGDP)

Value traded

Turnover,ratloListed(o/,Of

GDP)
1999

1990

1999

1990

33.6
23.3

4.8

43.5

179
581

215

l990

1999

1990

Argentina

2.3

2.7

3.5

29.6
30.3

O.6

Brazil

1.2

1L6

Chile

45.0

101.1

2.6

10.2

6.3

9.4

Mexico

12.5

31.8

4.6

7.5

32.3

199

HongKong

11L5

3832

46.3

154.1

51.4

Korea

43.8
110.4
93.6
28.0

44.0
43.1
61.3
24.6

284
669
282

Malaysia
Singapore
ThailandLatinArnericaandtheCaribbean
EastAsiaandthePacificMiddleincomecountries
Highincomecountries

75.8

30.1

180.3

184.0

24.7

55.4
26.8

7.7

233.6
46.9
29.7

61.4
115.4
33.5

2.1

7.3

21.3
21.2

52.4

132

68.1

41.1

8.0

55.3

138.7

31.8

30.6
120.9

domestic.

companles

92.6
29.7
117.2
78.3
49.3

2332
44.6
66.9
53.2
20.8
139.4
81.6
94.0

150

214
1,748
1,443

4,914
17,064

2000
127

459
258
179
695
704
795
355
381
1,938
3,754
16,53924,741

36 KOBE ECONOAtfiC&BUSINESS REVIEM, 47 (2002), 23-66

The level of demand of "domestic credit to the private sector" for growth could vary
among countries because of the following factors. First of all, if the FDI of transnational

corporations is high, demand for domestic credit could be lower, as FDI will provide
investments and generate growth. Both East Asia and Latin America experienced FDI-led
growth during the 90s. As a matter of fact these two regions were the main destination of

FDI among developing regions.
Furtherrnore, there is some empirical evidence that in countries which are rich in natural

resources, less financial depth is needed to grow as compared to countries with a low
endownient of such resources. It is understood that this differential stems from the fact thatthe development of natural resources is normally carried out with foreign resources. In mostof the cases, projects in this field are undertaken by transnational enterprises which haveaccess to international finance. It is therefore said that, in countries that are rich in natural

resources, domestic financial development is not as deep in the cases of countries which are
not well-endowed with natural resources.
Moreover, as financing in the international market is much more available now, financial
deepening (domestic finance to private sector) is evidently less necessary, if the country is

endowed heavily with natural resources and development (exploration, development,
production and commercialization) can be carried out by finance from sources in international

market. Large copper mines, iron ore mines, bauxite, alumina and aluminum, pulp and paper,
oil and natural gas, oil refining and petrochemical industries developed by investments andfor
finance by transnational companies are typical cases of these kind of sectors.

Gylfason, Thorvaldur and Gylfi Zoega (2001, p.22) identify a direct link between natural

resources and economic growth, through saving and investment. They point out that anabundance of natural resources may hamper the emergence of a well-developed financial
system.3 Having this relationship in mind, one of the conclusions of a recent study by
Levine, Ross and Maria Carkovic (2001, p.3; pp.28-29) holds some interest. They found that

Chile does not fall neatly along the regression plane corresponding to the estimatedrelationship between stock markets, banks and economic growth and also tliat Chile has muchless liquid markets and less developed banks than other rapidly growing economies such as
Taiwan, Hong Kong, Thailand, Singapore and Malaysia, even after controlling for many othergrowth determinants.
Similarly, in countries for whigh growth depends strongly on foreign direct investmentsby transnational companies, as in the cases of automobile production as well as some autoparts production, maquiladora type assemble processes (especially, apparel and electronics),
3 With regard to this aspect, they argue as follows: When a large part of national wealth is stored in a natural

resource, renewable or not, there is less need for fmancial intermediation to conduct day-to-day transactions.
Dissaving can take the form of more rapid depletion of the resource and saving can take the form of less rapid
depletion or of more rapid renewal in the case of renewable natural resources,

HOSONO: CREATIOAr OF NEM ENTERPRISES AND DEVELOPMENT OF EM[STEIVT ENTERPRISES 37

public services such as electricity and telecommunication, financial deepening (domestic
finance to private sector) is less necessary as compared with other cases.

On the other hand, if the industrial stmcture of a country is characterized by a highweight of sectors which are heavy users of "external finance," the country needs greater

financial depth. These sectors would benefit from greater disproportionate financial
development than sectors that are not naturally heavy users of "extemal finance." In this

scenario, the term "extemal finance" is used to indicate any type of finance other thanself-financing by the company. Rajan and Zingales (1998) found evidence consistent with the

hypothesis that sectors which rely more heavily on "external finance" grow faster incountries with a better-developed financial system. According to their study, such sectors are

drugs, plastic products, office and computing products, radios, professional and scientific
goods, electric machinery, glass, other industry, ships, machinery, textile, motor vehicles,

petroleum and coal products, transportation equipment. (These correspond to approximately
one third of all sectors and have an indicator of "extemal dependence" higher than O.3)

Additionally, the need for financial deepening could be higher when the country needs
to develop clusters of supporting industries (subcontracting firms, firms for outsourcing) andstrengthen supply chains around large national or transnational companies.

The above-mentioned factors can somewhat explain the remarkable differences infinancial depth between Latin American countries and East Asia countries. East Asian
countries had to develop a financial system to satisfy their financial needs and to advancea " catching-up--product-cycle-phase," which involved the diversification and expansion of their

Furthermore fore-runners of the East Asian region such as Korea, Taiwan and Hong
Kong did not have easy access to international finance and FDI was not mobilized enough,when they carried out their early industrialization process. On the other hand late--comers of

the region such as Thailand, Malaysia, The Philippines and Indonesia were able to get alarger amount of international finance because they started this phase of the process wheninternational capital flow increased enorrnously. Therefore, the latter countries preferredfinancial liberalization to get abundant external finance, while the former countries had noother alternative than to develop their own domestic financial system. The latter countries

however, also tried to expand the size of the domestic financial market, in spite of thepossibilities of access to international financial market through financial liberalization, in order

to finance national enterprises, especially small and medium businesses. The comparison
between Latin America and East Asia discussed above is summarized as shown in Table 2-6.

In summary, it could be pointed out that less financial depth does not matter
considerably, if a country remains as a natural resources exporting country or if abundant FDI
flows into the country. It would begin to matter if the country should try to shift its strategy

of development from natural resources-based growth, to that of more diversified economic

38

KOBE ECONOAttZC & BUSINESS REVIEva, 47 (2002), 23-66

activities. As the World Bank (2000) emphasizes, the transition from natural resource-based

development to knowledge-based development is one of the leading concerns of Latin
American countries in recent years. (World Bank, 2002) Professor Michel Porter also pointed
out that based on international comparisons, countries shifted from a factor-based phase, to an

investment-based phase and to an innovation-based phase as their levels of income increased.`
However, it is not new industrial policy that is needed for such transitions to take place in

Latin America, but rather a taking stock of measures to improve their financial system, inorder for companies with a potential for high growth to expand their scale and scope ofactivities and for dynamic new companies to be created, in response to these new emerging
opportunltles.

Having discussed the demand side of financial development, we should briefiy discuss
the supply side of domestic financing, which is obviously closely related to the rate ofsaving, but at the same time, restricted by the fiscal deficit as a result of crowding out as
was discussed above. In addition, the legal system as it relates to banlcruptcy law, collaterallaw (recuperation of collateral of loans) as well as the efficiency and predictability of the
judicial system facilitates strong financial development. These aspects are summarized in the

Table 2-7

Table 2-6. Demand of Domestic Finance, Availability of International Finance and Characteristics
of Industrial Sectors
DiversifiedanddifferentiatedSectors

Naturalresourcesl

manufacturedproducts

Commodities(Demandofdomestic.financeincreasesalongwiththe(Demandofdomestic
financeislower)

formationofsupplychainsand
participationofSMEs)

Periodof70sand80s:

Relativelylowdemandof

Veryhighdemandofdomestic

Lowavailabilityofinternationalfinancedomesticfinance.financeJapan,Korea,Taiwanin
theirindustrializationprocess

Periodof90s:
HighavailabilityofinternationalfinanceVetylowdemandofRelativelyhighdemandof

domesticfinanceMexico,domestic.financeThailand,

Chile,Brazil

Malaysia

4 In addition to these phases, other phases, such as "natural resource-based phases" and "catching-up-product-cycle-

phases" could be included, bearing in mind the abovementioned experiences of Latin America and East Asia. It

should be convenient to distinguish this "catching-up-product-cycle-phase" from the simple "factors-based
phase" of Professor Michel Porter. The former could be considered an intermediate phase between the latter andthe "innovation-based phase" of Professor Porter. Furthermore, we should recognize that in some countries
different phases overlap.

HIOSONO; CREATION OF NEPV ENTERPRISES AND DEVELOPMENT OF EX]ISTENT ENTERPRI[SES

Table 2-7. Conditions for Increase of Supply of Domestic FinanceImprovedjudicialsystem
Sectors(Propertyrights,-bankruptcylaw,

Judicialsystemstill

tobe improved

predictabilityofjudicialprocess,etc.)

High fiscaldeficits

BrazilPeru,Argentina

Low fiscaldeficits

Chile;LeadingEastAsianeconomies

Mexico;Other East Asian

2.6 Micro-enterprise, micro-credit and "missing middle"

Latin American countries have made serious efforts to establish and strengthen
micro-credit institutions for the poor and informal micro-enterprises, and as such a few
clarifications regarding micro-enterprises and micro-credit is required. We need to distinguish

the formation of new enterprises seeking new opportunities and those which originated fromnecessity or subsistence. Some Latin American countries are among the highest ranked in theworld, in terms of number of new enterprises created. Nevertheless new firms for necessity
or subsistence are not necessarily forrned because of the high expected rates of return basedon new opportunities which justify the formation of the firms, but are formed even if the rateof return is lower than the market interest rate.5 They will be financed by own savings ormore probably by micro-credit. Therefore enhancement of micro-credit institutions does notnecessarily imply that real financial deepening is taking place. The formal financial
development should allow enterprises to be forrned in response to new opportunities.

In some countries, we observe bipolar phenomena in which micro-enterprises proliferate
and large enterprises expand. In these cases enterprises of middle size, or small and medium

enterprises are generally missing. This "missing middle" syndrome is caused by lower
financial deepening of formal financial systems on the one hand and by the enhancement of
5 According to the Global EntrepTeneurship Monitor's 2001 Exeeutive Report, about 1.4 billion working-age
individuals (20 to 64 years old) live in the 29 countries surveyed by the Global Entrepreneurship Monitor in
2001. Slightly less than 10 percent of these people are, at any point of time, in the process of creating andgrowing new businesses, About 54 percent (i,e., 80 million people) of those involved in creating and growing
new firrns claimed they were pursuing a business opportunity for personal interest, often at the same time they

were working in a regular job, These efforts are referred to as "oportunity entrepreneurship", reflecting thevoluntary nature of participation. ln contrast, about 43 percent (i.e., 63 million people) reported they wereinvlolved because they had "no better choice for work'1 Such efforts are referred to as "necessity entrepreneurship" reflecting to the individuals' perception that such actions presented the best option available for employment
but not necessarily the preferred option. According to the same report, four countries ranked highest in opportunity

entrepreneurship (in alphabetical order): Australia, Mexico, New Zealand and the United States. Five countries

ranked among the highest group for necessity entrepreneurship (in alphabetical order): Brazil, India, Korea,
Mexico and Poland. The analysis indicated that developing countries generally have a higher prevalence rate fornecessity entrepreneurship. Global Entrepreneurship Monitor (2001)-economles

40

KOBE ECONOII(ffC & BUSIIVESS RE"EWr, 47 (2002), 23-66

micro-credit institutions for micro-enterprises as well as improved access for large enterprises

to international financial andlor capita1 market on the other hand. We should also add that,in this situation, even successfu1 micro-enterprises remain as they are because of scarcenessof finance for upgrading them to formal dynamic small and medium enterprises.

2.7 The case of Mexieo: Moderate growth in spite of extremely shallow financial depth
2.7.1 Shallow financial depth and its causes
Although the coefficient of domestic credit to the private sector is reported to be 16
percent (World Bank 2001), the "effective" domestic credit to the private sector is estimatedat 11 percent of GDP, if we exclude the "titulos de IPAB" which are inactive. After the
Mexican crisis banks have to be very cautious, as they lost their capital during this crisis

which has forced them to recapitalize. Such banks have invested in Treasury Bonds, with
rates of interest that have been very attractive until recently. On the other hand, the demandof the private sector for credit has decreased due to the recent recession, even though theinterest rates have been recently lowered.
Given the constraints of domestic credit to the private sector, the following three sources
have been widely used as alternative sources of finance: foreign credits, suppliers' credit andnon-bank financial intermediaries called SOFOLES. However, foreign credits, as financial
sources, have not been as important and the surplus of the capita1 account has not been as
significant, but foreign direct investment has been quite substantial. As exporting companies
can use trade credits and suppliers' credits and exports correspond to 30 percent of GDP in

Mexico, the economic growth can be attained as far as exports continues to expand.

2.7.2 Consequences of low level of domestic credit to private sector
At any rate, the major source of fmancing for enterprises is retention of profits, thatis "internal finance." It means that private sector investments depend very much on the levelof profits due to difficulties in accessing "extemal fmance" (banks credits andlor direct
financing in the capital market). This form of fmancing is very procyclical. Until now, theprincipal source of growth in Mexico has been trade in NAFTA. As mentioned above,
exporting companies can use trade credits and suppliers' credits as sources of financing andexport corresponds to 30 percent of GDP, the economic growth was attained as far as export

continued to expand. But the country would face 1imited growth, because NAFTA could havebeen causing an effect of "one-shot" nature.
On the other hand, as there has been a lack of domestic credit to the private sector in

Mexico, sectors which are able to grow have been those that can use some kind of credit.

HOSONO: CREATJON OF ?VIEM ENTERPRISES AND DEVELOPIL`ffilNT OF ELUSTENT ENTERPRISES 41

As was mentioned above, the export sector was the major sector experiencing growth because
they used suppliers' credit, trade credit and credits from abroad. Recently availability of

consumer credits (credit cards, loan of foreign retailers such as foreign supermarkets) is
expanding so that consumption of those who can use consumer credits is also increasing.
Therefore regarding this process, the following two issues should be addressed now:(a) Although scarceness of credits to private sector have not been serious constraints ofgrowth, it will be so now because Mexico cannot depend always on export sector for
its growth; and(b) Credit should be allocated in more balanced ways among sectors and much more
actors should get access to such credits. If there exists some sectors (for example,
service sector and SMEs) which have difficulties gaining access to credits, it would
produce less balanced growth and less socially dynamic development.

2.7.3 Remaining issues
Banks have been able to recapitalize and are now in a condition to increase their credits

to private sectors. Nevertheless there are still some problems to be solved. Although theTreasury bond rate has been decreased from 17 percent in February 2001 to 5 percent inApril 2002, the spread still remains to be high. Factors such as lack of competition andinefficiency of banking operations as well as costs of regulation or problems related torecuperation of credits are main impediments to the lowering of the spread. On the other
hand, until now, lack of credit has not been the cause of high spread, because the demandfor credit has been low due to the high rate of interest.

The problem of recovery of collaterals is caused by the very slow judicial process andthe fact that each State has different form of applying the Civil Code. Because of these
problems, particularly the slow judicial process, banks prefer to look for extra-official
solutions, although creditors remain in unfavorable negotiating conditions. However there has

been some improvement because the legal framework has been strengthened. Recently the"Ley de Concurso Mercantil" (Bankruptcy Law) and Law of Collateral was promulgated anda system similar to that of the United States is now being introduced. Nevertheless it will
still take time to solve these problems related to the recovery of collaterals.

3. The Creation and Development of New Firms and their Accessibility to FinanceThe creation and development of new firms is one of the most important driving forces
behind economic growth and is closely related to accessibility to finance. As was pointed out

earlier in Chapter 1, when we classify growth into two parts, creation of new firrns and42 KOBE ECONOMTC&BUSINESS REVIEM, 47 (2002), 23-66

expansion of existing firms, we find that the former is more seriously affected by theconstraints of finance. It is at this point that we should assess the extent to which shallower

financial depth in Latin American countries, as was discussed in Chapter 2, affects thecreation and development of new firrns in Latin Arnerica in comparison with East Asian
economies. This aspect has been analyzed in a recent comprehensive research carried out by

the IDB6, and much of this chapter can be attributed to this Study. The findings of thisStudy as related to accessibility to financing, coincide with what many authors haveemphasized as weak aspects of the Latin Arnerican environment for the staning up ofenterprises, especially those that are based on technology. Let us first take a close look at
the magnitude of the differences between the regions in this aspect.

3.1 Start-up and early development phases of new firms and their accessibility tofinance'
The IDB Study found that access to external sources for financing is clearly higher in
East Asia than Latin America, both at the start up stage, and at the early development stage.
At the start up stage, the role of venture capital, as well as of business angels, in East Asia
is double that of Latin America (60/e vis-a-vis 30/o for venture capital, 160/o vis-a-vis 80/o forangel investors). Bank loans are also more frequently used in the former than the latter (230/o
vis-a-vis 180/o). Even loans from public institutions, a resource used less frequently comparedto other financing sources, are used much more commonly in East Asia than Latin America(100/o vis-a-vis 20/o). In addition to this basic difference, the Study found that more dynamic

firrns use these sources to a much greater extent. Furthermore, compared to their East Asian
counterparts, more Latin American entrepreneurs mentioned the limited or total lack of accessto external financing as a significant factor.

The Study also made it clear that sources of external financing in Latin America do notnecessarily meet the needs of the region's entrepreneurs. wnen consulted about why they did

not use extemal financing sources, two thirds of the Latin American entrepreneurs stressedthat those sources did not suit their needs in terrns of high interest rates, requirement ofcollateral, etc. However, half of them preferred to avoid sources of external financing,
6 IDB (2002) As the subtitle of this Study indicates, it focuses on the creation and development of new firms in

Latin America and East Asia. The Study analyzes data drawn from surveys of more than 1,200 new
entrepreneurs in East Asia and Latin America, East Asian economies covered by the Study are Japan, Korea,
Singapore, Taiwan Province of China. Latin Ameriean countries included in the Study are Pffgentina, Brazil,
Costa Rica, Mexico and Peru. The author of this paper participated in the Study as senior adviser. His article(Hosono 2002) is included in the Study. A part of this Chapter was written on the base of this article. Someof the figures referred to hereinafter do not appear in the published version of the Study of IDB because they
were taken directly from the data set compiled by the Study's coordination team. This Chapter also includes otherinformation net contained in the Study.

HOSOIVO: CREATION OF ?VEPV ENTERPRISES AND DEVELOPMENT OF ELUSTENT ENTERPRIISES

because they wanted to maintain control of their business, did not want to take on more debt,

andlor they lacked faith in institutions, according to the Study. As regards East Asian
entrepreneurs, on the other hand, less than one out of five said that they preferred to avoid
the use of external financial sources or that they considered them inappropriate to their needs,

according to the same Study. (See Tables 3-1 and 3-2)
At the early development stage, the strong differences regarding accessibility to financing

between the two regions are even more pronounced than at the start up stage. The
predominant role of personal savings decreases at this advanced stage, when the need forextemal finance increases because of the more expanded scale of business. In fact, thenumber of firms using bank loans and public institutions at the early development stage isalmost twice as great than during the previous stage (start up stage) in East Asia, while in
Latin America only a small increase is observed. This impressive difference at the advanced
stage reflects the enhanced access of East Asian entrepreneurs to the above-mentioned sourcesof external financing as compared to their Latin American counterparts. The two mostimportant sources of financing at this stage for dynamic enterprises in East Asia are loans

from commercial banks and national public institutions. The percentage of dynamic firms inTable 3-1. East Asia: Where to Get Financing at a Start-up Stage
Total

Internalsources

77.2
67.4
33.5

Personalsavingsoffoundingpartners

Dynamic
group(O/o)
76.5

Less

dynamic
group(O/o)
79.2
69.5

16.1

66.7
33.7
10.6
42.3
17.4

5.7

5.9

5.1

Banks:Loans

22.9

24.8

17.1

Banks:Overdrafts
Nationalpublicinstitutions:Loans,guarantees
Nationalpublicinstitutions:Grants

5.6

6.1

4.3

10.3

12.1

5.1

5.5

5.3

17.1

5.0

5.8

4.3

3.1

3.1

5.1

37.0

378

Relativeslfriends

Personalcreditcards
Externalsources
Privateinvestorswhoarenotrelativeslfriends(angels)
Venturecapitals

9.8

39.9

Localgovernments:Loans,guarantees
Localgovernments:Grants
Othersources

33.1
7.4

32.8
12.1

Clients(advances)
Suppliers(tradecredits)

10.2

36.8
10.2

17.1

15.6

21.4

Factoring

2.9
3.0

29
29

2.7

Postponementoftaxpayment
Postponementofpaymentforservices

2.9

1.8

6.2

Postponementofwagespayment
Buyingsecondhandequipmentinsteadofnew

2.2

1.4

4.7

23.0

23.2

22.2

Others

2.6

2.3

3.4

Source: Prepared on the base of the statistics compiled by IDB(2002)

10.1

3.5

44 KOBE ECONOjLCC &BUSINESS REVIEM, 47 (2002?, 23-66

this region that use bank loans (400/o for bank loans and 240/o for loans from public
institutions) is substantially higher than the case of Latin iinierican firms (240/o and 40/o
respectively).

As for corporate venture capital, its role increases for dynamic firms in East Asia at thisadvanced stage, while in Latin America it decreases (110/o vis-a-vis 10/o). On the other hand,

although the role of business angels tends to decrease during the early development stage inboth regions, it is still relatively more important for dynamic firms in East Asia than in Latin
America (150/o vis-a-vis 70/o). (See Tables 3-3 and 3-4)
The findings of the Study are generally consistent with the results of other recent studies
related to the start up of enterprises. For example, the start up index constructed by Professor

Andrew M. Warner (2000) refiects loan availability (with little collateral), venture capitalfinancing availability and "the ease of activating new business". Latin Arnerican countries
obviously rank significantly lower on this index compared to East Asian countries (the highest

score is the United States with 2.02, and the lowest is Ecuador with -2.01): Brazil -O.59,

Argentina 'O.82, Mexico '123 and Peru -1.53 as compared to Singapore 1.31, Taiwan
1.04, Korea O.19 and Japan -O.21. In terrns of loan availability (obtaining a loan with only

Table 3-2. Latin America: Where to Get Financing at a Start-up Stage
Total

Internalsources

Personalsavingsoffoundingparmers
Relatives/friends

Personalcreditcards
Externalsources
Privateinvestorswhoarenotrelatives!friends(angels)
Venturecapitals

Dynamic
group(O/o)

Lessdynamic
group(O/o)
80.3

86.3
82.8
25.1

89.4
87.2
24.1

9.2

10.2

7.3

32.4

34.5

28.4
5.5

74.3
27.1

8.0

9.2

2.8

35

1.4

Banks:Loans

17.8

18.7

16.1

Banks:Overdrafts
Nationalpublicinstitutions:Loans,guarantees
Nationalpublicinstitutions:Grants

12.9

13.0

12.8

1.9

2.1

1.4

O.9

O.9

O.9

O.8

O.9

O.5

1.1

1.4

O.5

61.9

53.2
19.7
27.1
2.81

Localgovernments:Loans,guarantees
Localgovernments:Grants
Othersources
Clients(advances)
Suppliers(tradecredits)

59
19.7

19.6

35.1

39.2

Factoring

4.5

5.4

Postponementoftaxpayment
Postponementofpaymentforservices
Postponementofwagespayment
Buyingsecondhandequipmentinsteadofnew

11.1

11.1

1.0

3.3

3.3

3.2

Others
Source: Same as Table 3-1

3.43

3.3

3.7

O.6

33.6

24.8

3.9

3.8

4.1

OF NEM ENTERPRISES AND
OF EMSTENT ENTERPRISES 45
HOSONO.•CREATIONDEVELOPneNT

a good business plan and no collateral), the score for Latin American countries is generally

lower than in East Asian countries: Brazil 3.4, Argentina 2.9, Mexico 2.4 and Peru 2.0 ascompared to Taiwan 4.3, Singapore 4.2, Japan 3.4 and Korea 3.3. Furthermore, as regards tothe availability of venture capital ("entrepreneurs with innovative but risky projects cangenerally find venture capital"), the score of Latin American countries is considerably lower

than that of East Asian countries: AJrgentina 3.2, Brazil 3.1, Mexico 2.9, and Peru 2.4 ascompared to Korea 5.0, Singapore 4.9, Taiwan 4.8 and Japan 4.0. An important contributionof the Study is that it made clear how the weakness in the financial system affects firms at

the start up and the early development stages. This confirms what many scholars haveargued: "Well functioning banks spur technological innovation by identifying and fUnding

those entrepreneurs with the best chance of successfu11y developing new products andimplementing innovative production processes" (World Bank, 2002: p.75).

3.2

Consequences of theAn evenit clarified the

difficulty ofaccess to financemore important and original contribution of the Study, however, is thefact thatway Latin American entrepreneurs respond to the problem of access toexternal

Table 3-3. East Asia: Where to Get Financing at an

Early Development Stage

Dynamicgroup Lessdynamic
Internalsources

Personalsavingsoffoundingpartners
Relativeslftiends

Personalcreditcards
Externalsources
Privateinvestorswhoarenotrelativeslfriends(angels)
Venturecapitals(O/e)

group(O/o)

60.4
54.3
23.6

65.3

10.0

56.0
25.6
13.6

57.3

44.4

14.8

18.5

10.6

6.1

Banks:Loans

39.9

28.0

Banks:Overdrafts
Nationalpublicinstitutions:Loans,guarantees
Nationalpublicinstitutions:Grants

9.7

4.0

23.5

12.4

8.3

4.5

12.8

6.0

Localgovernments:Loans,guarantees
Localgovernments:Grants
Othersources

5.0

5.2

36.9
10.4

36.7

19.5

23.5

Factoring

5.7

52

Postponementoftaxpayment

4.3

3.2

Postponementofpaymentforservices

3.2

5.2

Postponementofwagespayment
Buyingsecondhandequipmentinsteadofnew

2.7

3.2

17.2

17.6

Others2.8

1.2

Clients(advances)
Suppliers(tradecredits)

Source: Same as Table 3-1

15.1

KOBE ECONO?LflC & BUSINESS REVIEM, 47 (2002), 23-66

46

financing. Frequently, they look for altemative finance sources, and if they cannot get enoughfunding to start up a business, they downsize it. In fact, in addition to personal savings andloans from relatives, a Latin American entrepreneur uses other sources of financing more
frequently than hisfher counterparts in East Asia: suppliers credits (390/o vis-a-vis 160/o),
advances from clients (200/o vis-a-vis 100/o) as well as postponement of tax payments (110/e

vis-a-vis 30/o) at the start up phase. Although in both regions, personal savings is the
predominant source of financing at start up, it is more important in Latin America than in
East Asia (870/o vis-a-vis 670/o). Furthermore, the Study made it clear that in Latin America,

most of the dynamic entrepreneurs who face problems with access to financing at the startup phase begin on a smaller scale than that needed to be competitive (610/o vis-a-vis 480/o in

East Asia). They also ask for support from clientslsuppliers (590/o vis-a-vis 42n/o in East

Asia), start with a lower level of technology (570/o vis-a-vis 220/o in East Asia), andlor
purchase second hand equipment (340/o vis-a-vis 230/o in East Asia). (See Tables 3-4 and 3-5)
Although fttrther research needs to be done to confirm this situation, this unfavorable

scenario for Latin American entrepreneurs compared with their East Asia counterparts seems
to at least partially explain why the time gap between initial motivation and start up issignificantly shorter in East Asia than in Latin America: the average time in the former
Table 3-4. Latin America: Where to Get Financing at an Early Development Stage

Dynamicgroup Lessdynamic
Internalsources

Personalsavingsoffoundingpartners
Relatives!friends

Personalcreditcards
Externalsources
Privateinvestorswhoarenotrelatives!friends(angels)
Venturecapitals(o/o)

group(e/o)

67.9
63.7
21.0

61.2
55.3
14.4

9.1

9.6

37.8

35.1

6.5

1.6

1.3

O.5

Banks:Loans

23.8

21.8

Banks:Overdrafts
Nationalpublicinstitutions:Loans,guarantees

18.1

19.1

Nationalpublicinstitutions:Grants

Localgovernments:Loans,guarantees
Localgovernments:Grants
Othersources
Clients(advances)
Suppliers(tradecredits)

1.1

1.6

1.3

05

1.0

O.5

1.3

O.5

65.0

55.3

19.7

20.7

43.5

35.1

Factoring

9.1

1.6

Postponementoftaxpayment
Postponementofpaymentforservices
Postponementofwagespayment
Buyingsecondhandequipmentinsteadofnew

13.2

11.2

Others
Source: Same as Table 3-1

4.7

1.6

4.4

2.7

27.5

20.7

7.3

3.7

OF EX7[STENT ENTERPRISES 47
CR,EATION OF NEPV ENTERPRISES AND DEVELOPneNT
HOSONO:

region is about half of that of the latter (2.6 years vis-a-vis 4.6 years). And this unfavorable

situation could be closely related to the fact that East Asian dynamic new ventures start withhigher initial sales and they grow faster than Latin American firms do.
In addition to the differences explained above (financial aspects), there are obviously
several other reasons that could explain this significant difference between the two regions.
For example, the difference in industrial stmcture could be one of the most significant causes.

These differences include the different types of goods and services that dynamic new ventures
produce in East Asia and Latin.America; the fact that subcontracting is more intensively andwidely used in East Asia; and the larger share of the manufacturing industry in the economy

in East Asia. In fact, the presence of knowledge-based new firms is higher in East Asia.

However, on the other hand we must recognize that further efforts are also needed inTable 3-5. East Asia: Alternatives if Initial Funding is Insufficient

Dynamicgroup Less
Thenewfirmstartedsmaller

Thenewfirmstartedlater

thanwhat was considereddesirabletobecompetitive
than it shouldhaveforittobecompetitive

Apartnerwasneeded
Thenewfirmstartedwith
Largeclientorsuppliera less thandesirableleveloftechnology
support was needed

Others

Thelimitedaccessdidnot

have any importanteffects

dynamic(o/o)

group (O/e)

47.6
22.9
45.8
21.6
42.0

65.9

300
44.7
28.4
44.9

16.8

13.9

44.6

51.8

Sameas Table 3-1

Source:Funding is Insufficient

Table 3-6. Latin America: Alternatives if Initial

Dynamicgroup Less
Thenewfirmstartedsmallerthanwhat wasconsidereddesirabletobecompetitive

Thenewfirmstartedlaterthanit

Apartnerwasneeded
Thenewfirmstartedwithaless
Largeclientorsuppliersupportshouldhaveforittobecompetitive
thandesirableleveloftechnology

wasneeded

Others

Thelimitedaccessdidnothave
Source:anyimportanteffects

61.4
37.9

56.7
37.5

12.2

8.7

56.5

48.1

59.4

48.6

7.3

9.6

32.3

28.8

since Launchover US$1 million)

Enterprises(Percentages of enterprises with sales
East Asia

year

Third Year
Year 2000
Source:group(O/o)

Sameas Table 3-1

Table 3-7. Evolution of Sales of DynamicFirstdynamic(o/o)

Sameas Table 3-1

23

64
83

(o/o)

Latin

America (o/o)
92536

48 KOBE ECONOmaC&BUSINESS REVIEM, 47 (2002), 23-66

some countries within East Asia in order to improve the business environment for small andmedium enterprises (SMEs) in general, and dynamic fums in particular. A recent study by

the United Nations Conference on Trade and Development (UNCTAD, 1998) mentions that
there is evidence ofa "missing rniddle," refemhg to the core group of dynamic SMEs thattypically employ 20 to 300 employees, growing at average rates which is at least double therate of economic growth, and are more 1ikely to be internationally active. This means that
there is a shortage of the middle sized, growth-oriented SMEs that make an important contribution

to development. The same study concludes that while the Ieading economies in East Asia
(Japan, Korea, Singapore and Taiwan) were able to allow their SME sectors to evolve anddevelop over relatively long periods of time, other countries in the region tend to face a moreurgent need to ensure that they have intemationally competitive and viable SME sectors.7

Given the fmancial constraints in Latin America in comparison with East Asia, at thetime of business start up, among the economic factors that influence the decision to begin,
the level of family incomelassets is more important in Latin America than in East Asia (500/o
vis-a-vis 310/o for dynamic firms). For Latin American dynamic firms the personal savings offounding partners are more important for the start up stage than for their East Asian
counterparts (870/o vis-a-vis 670/o). This stronger presence of families in the entrepreneurial

process in Latin America than in East Asia could be attributed to several factors. Suchfactors may include more restricted access to bank loans, a general lack of financing fromventure capital, angels and other sources, and socio-cultural factors.

Given these differences between the two regions regarding such factors, we could
presume that the possibility of starting a business in Latin America would be considerably
1imited for those potential entrepreneurs who do not have a strong family business traditionor high levels of incomelasset within close family circles. We could safely state that theopportunity to start a business in Latin America is unequally distributed among potential
entrepreneurs.

As a matter of fact, the IDB Study on entrepreneurship found that the presence ofdynamic entrepreneurs from the lower-middle class and lower-class families is much lower in

Latin America than in East Asia (IDB 2002, p.14). ln fact, entrepreneurs from thelower-middle and lower class correspond to 47 percent in East Asia as compared to 30
percent in Latin America. In the latter, 70 percent came from upper-class families, the7 According to the same Study, among the countries studied in Asia, the phenomenon of the missing middle wasmost marked in indonesia and the Philippines. The relatively small dynamic firms (with less than 100 employees)

made up only about 8 percent of the output in Indonesia and 14 percent in the Philippines. This can becontrasted with small farms (those with less than 100 employees) contributing one-third of the output in Japan,
and two-fifths in Taiwan. The Study mentions: "The under-representation of this component of an entrepreneurialengine means that growth opportunities are being foregone." It also states: "This was probably less important to
the leading countries as they developed, but for countries developing now in a more internationally competitive

world, S)vfiis provide an important source of renewing competitive advantage." (UNCTAD, 1998: 17)

HOSONO: CRE]ATIOIV OF NEPV E?VTERPIUSES AND DEVELOPneNT OF EX]ISTE?VT ENTERPRISES 4

upper-middle class or the middle class. Another distinctive feature in East Asia is the lesser

presence of entrepreneurs with parents who were entrepreneurs or self-employed. That meansthat family tradition is less important in East Asia as a determining factor in terms of thedecision to become an entrepreneur.
All these factors seem to suggest that entrepreneurship serves as a stronger channel ofsocial mobility in East Asia than in Latin America. In other words, if potential entrepreneurs

from the lower class families were given an equally supportive enviromnent for starting theirbusinesses, there would be more new enterprises in Latin America and at the same time
greater social mobility could be promoted through them.

4. Expansion of Existing Firms: Their Responses to Economic Reforms and Other New
Factors of 90s
Shallow financial depth affects the structure of the sources of finance that are available

to existing firms. Firstly, this aspect of shallow financial depth as related to sources offinance in Latin America will be compared to East Asia, then the influence of limited sourcesof finance on the expansion of existing fimis in Latin America as compared to East Asia will
be assessed from three different angles. The three angles are:(a) Size of large firms in Latin America as compared with East Asian counterparts;(b) Scale of outgoing FDI by Latin American firms compared with outgoing FDI by
East Asian firms; and(c) Expansion of business by Latin American firms in East Asia compared withbusiness of East Asian firrns in Latin America.
Such evidence suggests that shallow financial depth could be one of the major factors
affecting the expansion of Latin American firrns, even though it may not be the only factor.

(Sections 2 through 4) On the other hand, we can confirm that some Latin American firms
have effectively responded to a new business environment and opportunities produced by reforrns,

globalization and regional integration in 90s. This means that if they and other firms were

given improved availability to financial resources, their expansion could have been more
intensive. (Section 5)

4.1 Shallow financial depth and sources of finance for firms
Obviously, shallow financial depth for companies (domestic credit to private sector) is aconstraint for the finance available to businesses in Latin American countries. The companies
tend to depend on their own savings (retention of profits) andlor sources that are different

50 KOBE ECONOMIC&BUSINESS REVIEM, 47 (2002), 23-66

from financial institutions, such as suppliers' credit. Therefore, as Barajas and Steiner point
out, "it is generally believed that Latin American firms finance most of their investment with

their own resources" (Barajas and Steiner, 2002, p.4)

Although we have no access to reliable comparable data regarding this aspect for thesecountries, as Barajas and Steiner put it, we have some statistics that suggest the generalbelief. For example, a case study for Colombia showed that in the first half of the 1990s
financing of firms came from profit withholding (33 percent), new equity (12 percent) andloans (55 percent). However no differentiations were made as to the origin of these loans,in order to isolate those from financial institutions as opposed to other sources, such as
suppliers. (Steiner and Salazar, 1998 cited by Barajas and Steiner, 2002, p.4) A more recent
study indicates that in 1999 around 19 percent of manufacturing firm's liabilities was withfinancial institutions. Singh made a comparative analysis of the top 100 firms of leading
emerging countries in 1980s. He found that in Brazil and Mexico, the percentage of internalfinance (retained profit) is higher (46.0 percent and 23.1 percent respectively) than thecorresponding figures in Korea, Thailand (15.8 percent and 14.7 percent). In Malaysia, thefigure (29.70/o) was higher than Mexico. In the same study, Singh found that the ratio of debt

compared to net assets in Brazil and Mexico was lower (8.4 percent and 8.6 percent
respectively) than Korea, Thailand and Malaysia (39.7 percent, 55.8 percent and 10.3 percent).

This means that in these Latin American countries large firms depend less on banks thanlarge firms in East Asia. (Singh, 1995, p.51)
A detailed survey regarding sources of finance for firms of different sizes is canied out

every three months in Mexico. We must recognize that the finance that comes from thewithholding of profits of the firm itself is not covered in this suryey. Nevertheless it contains

very relevant information for this study. First of all, it is important to note that in Mexico,72.5 percent of firms surveyed do not use bank credits (in the first trimester of 2002; samefor the following figures unless mentioned otherwise). Although the percentage of firms
which do not use bank credits are higher among smaller firms as is shown in Table 4-1, 66.1
percent of large firms do not use credits of banks.8

Now, as for sources of finance for all firms, 56.4 percent comes from suppliers, 19.7

percent from commercial banks, 3.8 percent from foreign banks, 12.2 percent from otherfirms belonging to the same group, 23.2 percent from development banks, 3.3 percent fromparent companies and the rest (1.4 percent) stem from other liabilities. It should be
mentioned that even for large companies and AAA companies, the largest source of financeis suppliers credit (46.8 percent and 32.5 percent respectively), while they depend more on
8 The classification of enterprises are made on the base of value in 1997. Small firrns are those with sales valuesof 1-100 million pesos, medium firms with 101-500 million pesos, large firms with 501-5,OOO million pesos andAAA (triple A rated) firms with 5,OOO million pesos. The composition of samples are 38.20/o for small firms,
35,40/o for medium-sized firms, 22.50/o for 1arge firms and 3.90/o for AAA firms.

OF IVIEPV ENTERPRI[SES AIVDHOSONO.•CREATIONOF EMSTENT ENTERPRI[SES 51
DEVELOPneNT

domestic and foreign banks than smaller companies. (23.7 percent

and 8.6 percent in thecompanies and 37.5 percent and 7.5 percent in the caseof AAA companies)of largeon the Credit

Table 4-1. Mexico: Results of the Survey
TotalMarket: FirstBy sizeof.enterpnses

s

M

L

case

Quarter 2002 11
Bytypeof enterprises3/

21

AAA Export

Non-Export

55.4

100.0
57.5

19.6

19.9

Sourcesoffinancing

100.0

100.0

100.0

100.0

56.4

62.4

59.1

100.0
32.5
37.5

100.0

Suppliers

Commercialbanks

19.7

14.3

20.7

46.8
23.7

Foreignbanks

3.8

2.9

1.3

8.6

7.5

3.5

4.0

Othersfirrnsincorporation

12.2

12.5

12.5

11.5

10.0

11.4

13.0

Developmentbanks
Parentcompany

3.2

4.3

2.6

2.2

2.5

4.6

1.6

3.3

2.5

3.0

6.5

o.o

4.6

1.9

Otherliabilities

1.4

Ll

O.8

O.7

10.0

O.9

2.1

27.5

21.2

27.8

33.9

55.2

29.6

25.6

Workingcapital

68.7

65.1

81.4

62.3

60.0

66.3

71.3

Liabilityrestructuring

1L8

12.7

10.2

15.0

13.9

9.6

Foreigntradetransactions
Investmentpurposes

7.2

7.9

1.7

1L3
1L3

10.0

7.9

6.4

9.7

11.1

5.1

11.3

15.0

8.9

10.6

Firmsthatusedbankcredit
For

Otherpurposes

2.6

3.2

1.6

3.8

2.1

72.5

78.8

72.2

66.1

o.o
44.8

3.0

Firmsthatdidnotusebankcredit

70.4

74.4

Reasons
Highinterestrates

26.6

28.7

25.2

26.6

1L8

24.7

28.6

Demandproblemsfortheirproducts

4.7

5.4

5.0

3.1

o.o

4.0

5.5

Bank'sunwillingnessto.lend,

19.9

24.2

14.4

17.2

17.6

21.5

182

Economicuncertainty

19.2

14.8

23.0

20.2

18.2

ILI

7.6

15.1

23.4
10.9

29.4

Financialrestmcturingdifficulties
Applicationrejected

23.5

11.7

10.5

8.4

11.3

5.0

7.8

o.o

7.6

9.1

Past-dueloanportfolio
Marketcompetitiondifficulties
Others

4.5

4D

6.5

3.1

o.o

4.9

4.1

4.7

4.0

5.0

6.3

5.9

4.9

4.5

O.9

o.o

O.8

1.6

11.8

O.5

1.3

Firmsthatgrantsometypeoffinancing
To

74.3

76.9

74.6

73.0

55.2

83.5

65.9
83.1

80.4

84.2

79.4

77.9

60.0

78.3

Suppliers

9.1

10.1

10.1

5.8

5.0

12.2

5.1

Otherfirmsincorporation

10.5

5.7

10.5

16.3

9.5

11.8

o.o

o.o

o.o

o.o

35.0
o.o

o.o

o.o

55.0
40.0
69.0

55.0
35.0
80.0

55.0

59.0
55.0
61.0

43.0
45.0
88.0

46.0

40.0

67.0
26.0
80.0

Clients

Other
Averagematurityoffinancinggranted(days)
Clients
Suppliers

Otherfirrnsincorporation

11 Nationwide sample with responses from at least 500 firms. The
2! S: Firms sales in 1997, 1-100 million pesos.
M: Firrns sales in 1997, 101-500 million pesos.
L: Firms sales in 1997, 501-5,OOO million pesos.
AAA: Firms sales jn 1997, over 5,OOO mjJlion pesos.
31 Non export firms are those that do not have any activity withgoods and services.

62.0
reply of thisforeign".o
58.0

survey is voluntary andtrade aswell

as those that

confidential.

only IMPOrt

52 KOBE ECONOMIC&BUSINESS REVIEM, 47 (2002), 23-66

The difficulty of access to the credit provided by banks is confirmed by this survey, as
among firms not using the credit of banks, about 28 percent of them responded that they are
not able to use it because the application of credits are rejected or banks are unwilling tolend. In the case of small companies, the percentage is higher (37 percent). Anothersignificant reason behind the firms'lack of using bank credit is because of high interest rates.

(26.6 percent of firms not using bank credit) All these financial constraints also affect theinvestments of companies. According to the same statistics, Mexican companies use a muchlesser percentage of their credits from banks for their investments. Companies which obtain

credits from banks used the funds mostly for working capital (68.7 percent) and much lessfor investment (9.7 percent). It is worthwhile to note that this tendency is not so different

even in the cases of large and AAA companies. (62.3 percent vs. 11.3 percent for large
companies and 60.0 percent vs. 15.0 percent for AAA companies.) (See Table 4.1)

Although we do not have statistical inforrnation of East Asian countries that can becompared strictly with the above-mentioned survey of Mexico, the credit of banks as a sourceof finance for firms appears to be more important in Korea. The coefficients of banks' credits

to the amount of total assets of large and smalllmedium enterprises were 27.0 percent and31.4 percent respectively in 1987-90. (Cho and Kim, 1995) On the other hand, Table 4.2
shows that Korean firms depend considerably on the capital market for their source of financeand less on interfirm finance.

4.2 Financial depth and size of firms
The constraints of accessibility to finance would affect the expansion of firms. A recent

IDB study on the size of enterprises of different regions seems to be highly relevant fromthis perspective. (IDB 2001, pp.35-42) The largest firms in Latin America are very small incomparison with other regions in the world. Among seven regions, Latin America comes inlast in average size in terms of total assets of the countries' 25 largest companies. The
average size of the assets of Latin American countries is approximately US$1,200 million,

while that of East Asian countries is about US$4,500 million. This IDB study got a very
impressive conclusion. "The financial depth (measured as the ratio between total credit to theprivate sector and the GDP) is a very robust determinant of the size of large companies.
Given the estimated coefficients, an increase of the standard deviation in the financial depthof a country (which equals 46 percent of GDP) is associated with an increase of between 26
percent and 44 percent in the size of its large companies. The magnitude of this effect issurprising because presumably, large companies would have better possibilities of having
access not only to domestic but also to international financial markets. Consequently, it is to

be expected that the effects will be even more pronounced for medium-sized and small companies." (p.40)

HOSONO: CREATION OF NEW E?VTERPRISES AND DEVELOPMENT OF ELUSTEIVT ENTERPRISESIn this regard, the empirical studies on the case of Chile are interesting because Chileis the unique country in Latin America, which experienced a remarkable financial
development in the last two decades. The analysis of Ga!lego, Francisco and Norrnan Loayza(2000) confimis that in the 1990s firm investment has been less constrained than in the
1980s. (p.29) As is well known, the 1990s was a period of significantly higher financial
development than any time before in Chile. They also review literature on the effect offinancial development at the aggregate level on the firms' financial stmcture and access tocredit and equity markets. It is pointed out that to the extent that firms face constraints onor high costs of external financing, their investment depends not only on its profitability but
is limited by both the availability of internal resources and the balance-sheet composition of

the firm. Medina and Valdes (1998) find that in a sample of stock-traded firms in Chile,firms' financial constraints do affect their investment behavior, particularly in firms notregarded as "investment grade".

4.3 Comparison of outgoing FDI by Latin American firms and East Asian firms
4.3.1 Intra-regional FDI in Latin America
The increase of intra-regional foreign direct investment (FDI) by Latin iinierican firms
is a new phenomenon in the 90s. This reflects that Latin American firms are expanding their

Table 4-2. Korea: Source of Finance of Enterprises 2/

Short-termbonds

CPLong-termbonds
Bondsissuedabroad
Corporatebonds

1990

1991

1992

1993

1994

6.4

-2.6
-4.0

9.0

165

4.1

7.9

14.7

20.6

26.4

14.4

20.1

25.4

o.o

o.o

1995

1996

1997

1998

19991/

4.8

14.9

17.5

4.1

-412

19.3

5.0

16.1

175

4.1

-41.2

19.3

20.3

17.6

18.7

19.3

26.7

164.7

21.1

12.5

15.0

14.4

15.3

16,9

22.9

161.9

21.7

o.o

3.8

1.9

2.6

2.1

3.3

O.9

-LO

Shares

1L8

10.0

12.2

14.0

15,O

14.4

11.3

O.8

47.7

55.8

Loans31

40.3

43.7

38.2

32.8

44,8

31.8

31,3

37.9

-52.9

-23.7
24.2

Bankloans

15.6

20.8

16.0

13.7

20,9

15.0

15.7

12.9

O.2

Increaseofcapita1

1.9

3.6

2.1

2.5

1,4

O.2

Ll

l.9

5.1

1.7

Inter-firmfinance

6.9

7.8

8.7

7.4

6,6

2.9

5,8

8.6

6.0

Externaldebts
Others

7.4

4.5

6.8

-2.7

1,7

1.6

3,3

-1.2

-19.2
-28.3

4.8

6.7

8.7

9.2

8.2

15.4

10,4

21.2

24.0

22.2

100.0

100,O

100.0

100.0

100,O

100.0

100.0

100.0

100.0

100.0

460,814 553,449 528,289 615,311 878,775 1,OOI,68 1,182,Ol

1,170,Ol(InlooTotal

millionwon)
283,599 356,028

Source: Murakami, Michiko (2000) based on the data of the Bank of Korea, Economic Statistics Yearbook, Monthly
Bulletin.

If January-June.
2! Includes state-owned enterprises.

3! Includes discount of CP banks.

-2.4

54 KOBE ECONO?vaC&BUSINESS REVIEM, 47 (2002), 23-66

activities across the borders and responding to new business environment and opportunities

created by reforms, globalization and regional integration in the decade. The ratio of
intra-regional FDI to the total inward FDI in Latin American countries increased from lessthan 3 percent in 1990 to more than 5 percent in 1996 and almost 15 percent (exceptionallyhigh) in 1997. The ratio then abruptly decreased to less than 3 percent in 1999. (ECLAC
2001, pp.187-189)

Intra-Latin Arnerican investment amounted approximately US$20.2 billion in 1990-1999
and was 5.5 percent of total FDI entering the region during the period (US$365 billion). This

intra-Latin American investment flow had two major components: participation of Latin

American enterprises in privatization and in M&A. According to the ECLAC 2001
(p.187) "the main investnient took the fomi of purchases of private-sector assets (510/o), withvery active participation on the part of entrepreneurs from Argentina, Brazil, Chile andMexico. Privatization-motivated investment was dominated by Chilean investors (450/o),
followed by those of Argentina, Mexico and Venezuela (410/o, taken as a group). Mercosur(including Chile) turns out to be the most important sub-regional source, accounting for over-- - ef

500/o of total mtra-Latin American mvestment.

Among investor countries, Chile was of foremost importance with the amount of intraregional investment of 6,727 million of dollars during 1990-1999. The second most important

was Mexico with 4,786 million dollars and the third was Argentina with 3,535 million
dollars. Brazil and Venezuela invested approximately same amount: 1,500 million dollars.
(Table VI.7b of ECLAC 2001, p.189) (See Table 4-3 for details)
To increase international business not only in terms of trade but also of investment it isTable 4-3. Latin America and the Caribbean: Intra-regional Foreign Direct Investment (FDI), by
Country of Origin and Destination, 1990-1999(Millions of Dollars)
OriginfDestination

Argentina
Bolivia

Argentina
-4-

Chile

Brazil

534

1,097

---

---

Brazil

48

--i

Chile

176

1,791

Colombia

CostaRica
EcuadorMexicoPeru
Venezuela
Other

LatinAmericaand
theCaribbean
Source: ECLAC, 2000.

-+-

Bolivia

Colombia

400
6
-----

-----

151
1,333

Peru

Venezuela

Other

263

1,129

113

---

151
1,426
18

-t-

---

---

---

+-i

---

---

---

--l

--t

--+

115

---

702
---

118
17
3,335

----t

6
i----

764

---

--+

206

111

700

7
19

IJ-

t--

---

---

15

967

-----

++-

---

3,093

532

3,265

---

31

1,915

Total

3,535
6

---

---

165

32

1,533

209
922

279

6,727

---

45
2,152
100
+----

4,721

---

940

2

2

2

169
4,786
136

897
30

480
737

1,580

2,573

20,198785

HOSONO: CREATION OF NEW ENTERPRI[SES AND DEVELOPMENT OF EiW[STENT ENTERPRISES 55

important for enterprises to get a larger scale of operation to attain economies of scale in thearea of their competence. It is especially tme for Latin American enterprises in a country
with a small domestic market. From this consideration, it is highly relevant to facilitate,allow, or at least not restrict enterprises to invest abroad if they find opportunities. In thisprocess again, financial constraints matter very much. We will discuss this aspect later in
Section 4.4.

4.3.2 Intra-regional EDI in East Asia
Investments abroad of East Asian enterprises have increased much earlier than those of

Latin America. The investmehts by Asian NIEs (Korea, Taiwan, Singapore and Hong Kong)
are, now, the most important source of FDI for both the ASEAN four countries (Malaysia,
Thailand, Indonesia and the Philippines) and the People's Republic of China. The FDI by
Asian NIEs to ASEAN four amounted to 15,900 million dollars (44 percent of total FDI inthese countries) and the FDI by Asian NIEs to China amounted to 25 billion dollars in 1995.
(See Table 4-2 for details)

At the same time, the investments outside of Malaysia and Thailand have been also
increasing. The investments of Malaysian companies in East Asia increased rapidly to 1,800
million dollars in 1994 and those of Thai companies increased to 400 million dollars in thesame year. In the case of Korean companies, their investments abroad began to increase in
the second half of the 80s. The amount of out-going investments of Korea surpassed that ofin-coming FDI to Korea for the first time in 1990. Among the destinations of Korean
companies' investments abroad, the United States was the most important at the beginning,

but from 1991, their investments to Asian countries superseded those to North Americancountries. Among Asian countries, the most important destination of Korean investments was
ASEAN countries until 1993, when their investments to China and Vietnam began to increase
rapidly.

The investments abroad of Taiwanese companies began to increase at the same time withthose of Korean companies. Their investments in China have increased rapidly since 1991

especially by small and medium companies of Taiwan. But the government encouraged
Taiwanese companies' investments in South East Asian countries, to reduce dependence on the

Chinese economy. Hence their investments in Vietnam, Indonesia and the Philippines
increased. Taiwan was the third most important foreign investor in these three countries in
1994.

The investments abroad by companies of Hong Kong started even earlier than those of
Korean and Taiwanese companies. They started as early as the beginning of 80s. More than90 percent of 2000 companies belonging to the Hong Kong Chamber of Commerce andIndustry have invested in Kang Dong province before 1993. Their investments have expanded

56

KOBE ECONOAtffC & BUSINESS REVIEva, 47 (2002), 23-66

from this province to Beijing and Shanghai and other provinces. Although Hong Kong
companies invested in South East Asian countries, the scale has been much smaller than theirinvestments in China.

We should also point out that in the case of East Asia there has been a substantial
increase of investments by SMEs, which is not widely-observed in the Latin American region.

Although statistics related to out-going foreign direct investments (FDI) by SMEs of East
Asian countries are limited, available data elucidate interesting aspects of FDI by SMEs inthis region. For example, the stock of FDI by SMEs of Korea increased from 1,026 million
dollars to 2,054 million dollars between 1993 and 1995. Their stock accounts for around 20
percent of total FDI stocks of Korean enterprises (including large, medium-sized and small
enterprises). The number of cases also increased almost two times from 1,603 to 3,593 casesin this period. These cases of FDI by SMEs of Korea correspond approximately to 70 per
cent of all cases of FDI by companies of this country. Although the SME FDI of Korea islargely concentrated in Asia, North America is gaining importance as a host region. Anothervery important characteristics of the Korean Srvfl] FDI is that more than four-fifths of SME

FDI is invested in manufacturing and although SME FDI from this country is becoming morediversified, the bulk is in the labor-intensive manufacturing industry.9

The study on foreign direct investment in East Asia, especially of SMEs, carried out by

UNCTAD (UNCTAD 1998) summarized its findings as follows: "Firms engaged in FDI form
an important part of the entrepreneurial engine of growth. They typically expect much higher

growth rates than national GDP growth. These high growth rates are more likely to besustainable because of the firms' ability to draw on financial, managerial and technicalresources abroad. Thus, these firms, both in host and home countries, could provide animportant nucleus for development." (pp.31-32)

These dynamic increases of intra-regional investments by East Asian companies in theregion are motivated by the following factors. First, the manufacturing industries of thesecountries are relocated so as to obtain a less expensive work force in ASEAN countries andChina. At the beginning, foreign investments by Korean and Taiwanese firms in labor
intensive manufacturing industries such as textile and shoe industries were started. Many Hong

Kong firms did the same type ofinvestments in China.

Secondly, investments in manufacturing industries by Asian NIEs were much more

9 According to suryeys by UNCTAD, S]Vlli investors in Korea, Singapore and Taiwan Province of China (Taiwan
hereinafter) indicate that, on average, they plan to increase their FDI by about a quarter in 1997 and would
increase it fUnher by one-third per armum if govemments took sigriificant positive steps to address problems thatthey face in investing abroad. Japan also collects some inforrnation on the number of cases of SME investment
abroad. SMEs make up about 50 percent of cases of FDI. The proportion rose to as high as 60 percent in 1988
when the yen was rising steeply (after Plaza Accord), and then dropped to around 40 per cent in 1991, increasing

again to 55 per cent in 1996. (UNCTAD, 1998, p.31)

HOSONO: CRE]ATION OF ?VEW ENTERPRISES AND DEVELOPMEI?VT OF EXISTENT ENTERPRIISES 5

diversified at a later stage. Investments in electric and electronic equipments, automobile

parts and other machinery increased. Thirdly, investments in service sectors in China by

Taiwan, Hong Kong and Singapore increased rapidly. Taiwanese companies invested
intensively in finance, insurance, trade, wholesale and retail in Hong Kong and Singapore.

Taiwan, Hong Kong and Singapore companies increased their investments in China in areasof property development (including industrial parks) and infrastructure. Korean enterprises are

not so active in investments in service sectors. The common language and culture appear tobe the most important factors for increase of investments in this sector by companies of

Taiwan, Hong Kong and Singapore in China.
4.3.3 Comparison of intra-regional investments of Latin America and East Asia

When we compare intra-regional investments of Latin America and East Asia as
discussed above (two previous sections), we find a remarkable difference between the tworegions. First of all, the amount of foreign investments by East Asian countries' enterprises is far

much larger than that of Latin American counterparts as was demonstrated in the previous

sections. In ASEAN countries, investments from Asian NIEs had gotten to be the mostimportant source of FDI in the mid-90s. In Latin America, although the investments byleading countries such as Brazil, Chile and Mexico increased considerably, they are still small

compared with the total FDI inflow (between 3 and 5 percent of total FDI) in most Latin
American countries. Second, in the case of East Asia, manufacturing industries constituted themost important area of intra-regional investments, while in Latin America, this was not thecase. Third, in the case of East Asia, it is also noteworthy that there has been a substantial

increase of investments by SMEs, which is almost not observed in Latin American region.

4.4 Response of Latin American enterprises to improved business environment and new
business opportunities: a more detailed comparative analysis between Latin Americanand East Asian companies
A practical approach to assessing the expansion of existing firms is to see how they
responded to a changing business environrnent and new opportunities created by economic
reforrns, globalization, regional integration and teclmological development, analyzing how they

took advantages of them through increase of exports andlor through increase of investment
abroad (outgoing FDI).'O Regarding the export performance of East Asian and Latin American
10 Reforms (liberalization of international trade and investment, privatization of state owned enterprises andderegulation, especially in areas previously monopolized by the state) would encourage business activities andeconomic growth through two channels: Firstly, improvement of the business environment and secondly,(continued)

58 KOBE ECOIVOMTC&BUSJNESS REVIEM, 47 (2002), 23-66

countries in the global market in the 90s, Bonifaz, Jose Luis, Jorge Duarte de Oliveira andMichael Mortimore (1997) compared changes in the shares of export of East Asia and Latin
America in the world market by major products categories.ii
Professor Horisaka and I tried to analyze in detail, cross-border activities, among others

and outgoing FDI by major Latin American enterprises elaborating our own data base forArgentina, Brazil, Chile and Mexicoi2 and comparing them with those of major East Asianemergmg economles.
The first strategy adopted by existing national enterprises in Latin America in responding
to the above-mentioned challenges (reforms, globaiization, regional integration and technologicalinnovation) is normally to restructure themselves, which in turn leads to "specialization of
production" , as is confirmed by the study by Moguillansky and Bielshowsky (2001, p.53)
Once this first phase of response or adaptation is finished, enterprises start to think globallyand try to expand their business to foreign markets and to invest abroad. In this regard, theabove-cited study found that "with the economy stabilized, firms began to employ a longer
term planning horizon." "With the largest firms this meant taking decisions on several issues,

including strategic partnerships with foreign investors; expansion into new markets; alliancewith firms in other countries; introduction of new technologies in terms of products, processes

and organization; and the sale of the firm to the actors better positioned to exploit its
particular assets."

Specialization in the areas where firms are most competitive was the widely sharedstrategy among national enterprises in Latin America in 90s. For example, in Chile, in thefirst years of economic reform from the mid-70s, Chilean enterprises tried to diversify theiractivities in terrns of sectors and sub-sectors, as was the case of the most dynamic groups ofcompanies like Groups of Javiel Vial and of Cruzat and Larrain. But this strategy wasabandoned by Chilean enterprises when it was increasingly clear that firms should specializein their areas of core competences.
enhancement of business opportunities. However, in order for reforms to produce growth through these channels,

it is important for economic actors, both national and transnational, to be capable and competitive enough to
respond actively to these reforms. They must take advantage of the improved business environment and invest
in new business opportunities. While we are able to analyze the responses of transnational enterprises using thedata of foreign direct investments, it is not easy to assess quantitatively the intensity with which national actors

respond to reforms, globalization, regional integration and other new tendencies mentioned above, Therefore,
Professor Horisaka and myself tried to analyze them by elaborating our own database of cross-border activities

of enterprises of major Latin American countries. (Horisaka, Kotaro and Akio Hosono, 1997)
11 In addition to the cited study (ECLAC 2000), the IDB (2001) also discusses the exports shares and competitivenessof Latin America.
12 Most of the cases identified in this study and included in its database are cross-border activities of private
national enterprises of the four countries (78.0 per cent). A few cases were of state owned enterprises (10 cases)

or of privatized SOEs (18 cases). 14 cases were activities of branches of transnational corporations establishedin these countries.

HOSONO: CREATION OF NEPV ENTERPRISES AND DEVELOPMENT OF EXZSTENT ENTERPRISESThis important change of corporate strategy was clearer after the debt crisis, especiallyfrom the mid-80s. Specialization in competitive areas of each Chilean national company
meant that they should expand their activities beyond their borders, because of the limited
size of their domestic market in the case of Chile. Therefore Chilean companies had to first

expand cross-border activities towards the end of 80s and during 90s, and then thesecompanies, including privatized ex-state-owned enterprises, thus adopted the strategy of
specialization and cross-border activities. This strategy was also adopted later by companiesof other major countries of Latin America.

This process of Latin American national enterprises' response to a changing businessenvironment in the first half of 90s was studied in detail by Professor Horisaka and myself.

We elaborated our own data base of the cross-border activities of the companies of major

Latin American countries such as Argentina, Brazil, Chile and Mexico. (Horisaka andHosono, 1997)
We defined "cross-border activities" as investments for the establishment of subsidiaries(plants and other facilities) as well as joint ventures in foreign countries, alliance andcooperation with foreign companies for marketing and sales in international markets,
technological partnership, OEM production, joint development of products and initiatives toattam concesslons.
We covered almost all the relevant cross-border activities of the enterprises of the four
countries which took place in first five years of the 90s (1991-95, 177 cases), when the major

economic reforms of these countries were implemented. From this data we can confirm
firstly, that cross-border activities increased substantially in these five years. The number of

Figure 4-1. Expansion of Cross-border Activities of Companies of Argentina, Brazil, Chile andMexico in 1991-95.
50
40

en Brazil

NChileptMexico
-ALL

20
10

o :' ••

1991 1992 1993 1994 1995
Source: Horisaka, Kotaro and Akio Hosono (1996), Latin American New Multinationais, Nihon-Hyoron Sha, Tokyo(in Japanese)

60 KOBE ECONOMiC&BUSINESS REVIEM, 47 (2002), 23-66

cases increased 7 times. (See figure 4-1) This finding reflects that reforms, especiallyliberalization of trade and investment, together with regional integration (in case of Argentina

and Brazil) effectively produced better business environments and enhanced business
opportunities as early as the period of the first half of 90s in Latin America. It is also
confirmed by the fact that 85.3 percent of cases are new cross-border activities and not theextension of already existing activities. In other words, they are made possible because ofreforms, globalization and!or integration of 90s.

Secondly, that most of the cross-border activities (83.1 percent) were made inside theLatin American region and of this more than two thirds (60.5 percent of the total) were in

Mercosur. This means that the international activities of Latin American countries aredeveloped inside its own region and they were partly encouraged by the regional integration
process, especially of Mercosur. However, 14.7 percent of cases were activities developed inindustrial countries (mostly in the United States). The activities of Latin American companies
in the United States, Europe (Spain, Portugal and Great Britain) and even in Asia reflect theirimproved competitiveness and effects of globalization.
Thirdly, the number of cases of Chilean companies branching out into international activities(21 percent) is only surpassed by Brazilian companies and is an outstanding accomplislment. This

reflects the competitiveness that they have attained because of the fact that Chile implemented

economic reforms much earlier than other Latin American countries. Chilean companies'
cross-border activities are relatively concentrated in electricity, telecommunication, and financial

sectors (50 per cent of the all cases of Chile) where privatization was canied out muchearlier in this country in comparison with other Latin American countries. The economic
reforms of Chile definitely strengthened the competitiveness of private national companies andprivatized exSOEs of this country.

Now when we compare the Latin American companies' cross-border activities with thoseof East Asian companies, we can find, among others, the following features:(a) In the case of Latin American companies, the most common cross-border activities

are Mergers and Acquisitions (M&A, 71 of 177 cases), while East Asian companies
activities are more diversified. They are more active in establishing branches, joint

ventures and taking initiatives of international alliances in several areas (sales,
technology, management, etc.)(b) While one of the most impomant motivations of cross-border activities in East Asia
is to establish competitive production operations and export bases to third countries,
especially industrial countries as well as to get access to less expensive labor, thecross-border activities motivated by this reason is rare in cases of Latin Americancountries, which tend to be more motivated by other reasons such as getting access to

the local market; and(c) wnile the cross-border activities of companies increased substantially in the 90s in

EMSTENT ENTERPRISES 61
NEPVENTERPRISESCREATION OF
HOSONO:ANDDEVELOPMEINT OF

Latin Americ, they started much earlier in East Asia. This means that the businessenvironment and business opportunities were much better in East Asia in the period
before 90s.

Having analyzed the general tendencies of cross-border activities of Latin Americancompanies summarized above, Professor Horisaka and myself carried out research on casestudies of the process of the internationalization of major Latin American enterprises in the

90s. These case studies confirmed the general tendencies as identified in the following
pattems of their internationalization.

On the basis of this research and other studies, it is possible to distinguish between atleast five types of new dynamism of Latin American national enterprises in 90s. The firstone, of which is widely observed in the above-mentioned analysis of 177 cases, refers to the

expansion of trade and investment in "industrial commodities". Many Latin Americancompanies advance their international development based on the advantages they possess,including: (a) the abundant natural resources of the countries in which they are located, as
well as their expertise in developing and processing these resources; and (b) their superiority

or competitive edge in marketing processed resources or "industrial commodities" in theinternational market.

The second type of new dynamism observed in the 90s in Latin America is related tothe international activities of the companies (mostly of privatized ex-SOEs) in sectors such asenergy, communications, transportation, constmction, finance, insurance, pension funds, etc.

They are pursuing development on a scale that encompasses two or more countries in Latin

America. These sectors could be considered to be "new tradables" which were "nontradable" services in the pre-reform period. Economic reforms, particularly privatization,
deregulation and liberalization carried out very rapidly by Latin American countries facilitatedand encouraged new activities in this "new tradable area" both of national and international
actors. Professor Horisaka and myself carried out research of case studies on privatization ofstate owned enterprises in Latin America, which confirms this new dynamism. (Horisaka,
Kotaro and Akio Hosono 1999) It should be emphasized that privatization in Latin America
was accomplished much more widely than in East Asia in the 90s. The income derived fromprivatization in Latin America is three times as large as that of East Asia in the period of
1990-96.

In this process of economic reform, especially privatization, many Latin Americancompanies expanded their activities both in their home market and in other Latin Americancountries. The most impressive cases are privatized Chilean companies of the electric sector
which extended their business to neighbor countries when they implemented their privatization
process, although some of these major Chilean companies in this sector were later bought by

Spanish companies.

62 KOBE ECONOAtflC &BUSINESS REVIEM, 47 (2002), 23-66

The third type of new dynamism is the renewed wave of development of natural
resources encouraged by liberalization and introduction of new and liberal laws related to themining sector and other natural resources sectors, privatization of state enterprises, concessions

and other forms of private sector's participation in natural resource development.

The new tendency is observed especially in Chile, Peru and Argentina as well as
Mexico. Although national actors' participation in this area is much less than international

actors' involvement, there has been active investment by, among others, Chilean companies
such as Lucsic (copper mining), Soquimich (non-metal minerals), Angelini and Matte (forestry

sector). The privatization of CVRD (Compania Vale do Rio Doce) now in the hand ofnational actors of Brazil would revitalize mineral resource development in Brazil.

Compared vv'ith the above three tyTpes of new dynamism which appear to be considerably
distinct from dynamism observed in Asia, the following two types of new dynamism in Latin
America might be widely witnessed in East Asia too.

The fourth type is the increase of non-traditional exports due to liberalization,
deregulation, globalization, etc. The most representative phenomenon of this type is theincrease in exports of a wide range of products to very diversified markets all over the worldfrom Chile. One of the distinguishing features of this type from the other four types of new

dynamism is the participation of many small and medium industries. The number ofexporting companies of Chile has increased from less than 1,OOO to 6,OOO in the period of

mid 80s and 90s, although a large percentage of export activity is concentrated in large
enterprises of the country. Exports of varieties of products of Chile, among others, wine, fish

and other sea foods, especially salmon, fruits and vegetables (during winter season of theUnited States and Europe), furniture, computer software, etc. have experienced very rapid

increases in the 80s and in the 90s. The same process is now being observed in othercountries of Latin America.

The fifth type is the expansion of trade and investment motivated by special
arrangements of economic integration. The most dynamic example of this type is the case of

the automobile industry in Mercosur and NAFTA. As Mercosur is the fourth largest
automobile market in the world, many multinational enterprises have invested in twin plants

located in Brazil and Argentina. Auto parts enterprises followed them. Although theassembling industries are of multinational enterprises, national auto parts makers of principally

Brazil and Mexico, were able to participate actively in the development of the automobile

industry under the process of integration of Mercosur and NAFTA.

4.5 Development of reciprocal inter-regional economic activities of Latin American
firms and East Asian firms
Generally speaking, the flows of foreign direct investment (FDI) between the Asia-PacificHOSONO: CREATJON OF NEPV EIVTERPRISES AND DEVELOPMENT OF EXISTENT ENTERPIUSES

and Latin American countries have been relatively low compared with the total inflow of FDI

into both regions. However, it should be emphasized that remarkable increase of FDI flows
from some East Asian countries into Latin American countries was observed. They should beconsidered as pioneering cases of new phenomena which is emerging as part of increasingly

dynamic economic relations between the two regions. On the other hand, FDI flows from
Latin America to the Asia-Pacific countries are still very limited, although some mterestmg

cases are taking place. (Hosono 2000)i3

While Japanese involvement in the region of Latin America and the Caribbean has notbeen very dynamic in the 90s compared with other industrial countries, some of the other
East Asian countries strengthened remarkably their relations with the region. For example, theRepublic of Korea "for the first time began to become substantially involved in Latin
America and the Caribbean" since the mid-80s. (Kim, Won-Ho, 1999) An important increaseof FDI flows to Latin America is also observed in some of other East Asian countries suchas China, Taiwan Province of China and Malaysia.
Nevertheless, if we consider East Asian countries' investment in Latin America in the
total amount of their FDI flows to the world, its share is still very small. According to thestatistics presented to the PECC Trade Policy Forum (1997), FDI of North East Asia to Latin
America was O.50 per cent of its total FDI and that of South East Asia to Latin America was
O.12 per cent of its total FDI in 1992.

On the other hand, there has been almost no FDI flows from Latin America to East

Asia. (PECC Trade Policy Forum, 1997) However, we observe some interesting cases of
Latin American firms involvement in East Asia such as investments of CEMEX (a Mexicanfirm) in Thailand, the alliance of Techint Group (Argentina) with Japanese steel makers forseamless steel pipes, investment of CODELCO (Chile) in China, initiatives of some Brazilian
civil engineering companies in China, etc.
Summing up, we observe an asymmetrical evolution in reciprocal interregional investments
and other activities of Latin American and East Asian firms.

5. Policy ImplicationsFirst, the impact of refomis and other factors should be assessed in terms of creation of
new firrns and expansion of existing firms. For this, periodical surveys of creation of new
firms and investment by existing firms (if possible by sectors and regions) should be carriedout. Most of the leading East Asian countries have this kind of surveys. The cost of thesurveys is not very high, because most of Latin American countries have already formal

13 A comprehensive analysis of specific cases of reciprocal inter-regional investments of Latin Americari and East

Asian firms is included in Hosono (2000)

64 KOBE ECONOAtflC&BUSINESS REVIEM, 47 (2002), 23-66

system of registry of firrns. Net rate of creation of firms could be also calculated on the baseof the gross rate of creations of new firms and the rate of closing of firms (entry and exit
rates).

As for activities of existing firms, survey of their activities abroad, both in trade andinvestment would provide reliable indicators in assessing the evolution of their competitiveness.

In Chile, numbers of new exporters, of permanent exporters and of those firms which
discontinued their exports by sectors (or by principle product exported) and by principal
markets of the world are published.
A survey of sources of finance of new and existing enterprises, disaggregating different
sources of intemal financing (founders' own savings, retention of profits, etc.) and external
fmancing (bank loans, interfirm credits such as suppliers' credits, increase of sharcs, issues ofbonds, etc.) as well as by purposes of fmancing (for working capital, liability restmcturing,
foreign trade transactions, especially for export, investment, especially investment abroad, R& D, etc.) is usefu1 to assess the evolution of the role of financial institutions and of capital

markets, as well as the effects of financial reforms and financial policies on development of
new firms and existing firms.
Second, measures to deepen financial intermediation (or the financial system, especiallybanks) as well as capital markets, should be designed having in mind an assessment on therelationship between reforms and development of enterprises, based on the above-mentioned

surveys. These surveys would help policy makers identify obstacles to the creation anddevelopment of enterprises. Discussion on concrete measures for this purpose is beyond thescope of the present paper, but recent several studies, which do not necessarily address theissues of this paper, propose such measures. Among others, OECD (2001), IDB (2001) and
ECLAC (1996) contain interesting analysis and important proposals regarding them.
Third, from a long-term perspective, an integrated approach to strengthen entrepreneurship,

innovation and sustained growth could be formulated on the basis of a more comprehensive
analysis of the interplay between macroeconomic reforms and microeconomic responses, andof the experiences of industrial and emerging countries.

References
Barajas, Adolfo and Roberto Steiner (2002), Credit Stagnation in Latin America (IMIF Working Paper)Beck, Thorsten and Ross Levine (2000), "New Firm Formation and Industry Growth: Does Having aMarket- or Bank-Based System Matter?" (mimeo)
Bekaert, Geert, Campbell R. Harvey and Christian Lundblad (2002), Does Financial Liberalization Spur

Growth2 (mimeo)
Bonifaz, Jose Luis, Jorge Duarte de Oliveira, and Michael Mortimore (1997) La Competitividad
Internacional: Un Andlisis de lay Experiencias de Asia en Desarrollo y America Latina
CEPAL Serie Desarrollo Productivo No.40, Santiago (Chile)

HOSONO.• CR,EATION OF NEPV ENTERPRISES AND DEVELOPneNT OF EXTSTEIVT ENTERPRISES 65

Burki, S. Javed and Gullermo Perry (1998), The Long March; A Refonu Agenda for Latin America andthe Caribbean in the Next Decade (World Bank Latin American and Caribbean Studies)
Clark, George R.G., Fobert Cull, Mariz Soledad Martinez Peria and Susana M. Sanchez (2002) Bank

Lending to Small Businesses in Latin America: Does Bank Origin Matter2, (World Bank
Policy Research Working Paper)

Cobham, Alexander (1999), 77ie Financing and Technology Decisions of SMEs: Finance as a
Determinant of Investment (Oxford Working Paper Series)

De Ferranti, Guillermo Perry, Daniel Lederman and William F.Maloney (2002), From Natural
Resources to the Knowledge Economy: Trade and Job euality (World Bank Latin American
and Caribbean Studies)

De Gregorio, J.and P.Guidotti (1995) "Financial Development and Economic Growth", PVorld
Development, 23(3), 43

Easterly, William and Ross Levine (2002), Tropics, Germs and Crops: How Endowments Influence
Economic Development, (mimeo)
ECLAC (1996) Strengthening Development: The Interplay of Macro-and Microeconomics Santiago(Chile)

ECLAC (2001) Latin America and the Caribbean in the PVorld Economy 1999-2000 Santiago (Chile)
ECLAC (2000) Foreign Investment in Latin America and the Caribbean 2000 Satiago (Chile)

Gallego, Francisco and Norman Loayza (2000), Financial Structure in Chile: Macroeconomic
Developments and Microeconomic Effects (Central Bank of Chile Working Papers)
Global Entrepreneurship Monitor (2001), 200I Executive Report, United Nations Association of theUnited States of America and the Business Council for the United Nations: New York

Gylfason, Thorvaldur and Gylfi Zoega (2001), Natural Resources and Economic Growth: The Role ofinvestment (mimeo)
Horisaka, Kotaro and Akio Hosono (1997), Latin American New Multinationals, Nihon-Hyouron Sha,
Tokyo (in Japanese)
Horisaka, Kotaro and Akio Hosono (1999), Privatization in Latin America, Shin-Hyouron Sha, Tokyo(in Japanese)
Hosono, Akio (2002) "Finance, Social Capital, and Entrepreneurship: Some Relevant Findings from theComparative Study on Entrepreneurship in East Asia and Latin America", in Kantis, Hugo,

Masahiko Ishida and Masahiko Komori (2000)
Hosono, Akio (2000) "Investment Opportunities in Latin America and Asia and the Pacific", ESCAPInterregional Cooperation in Trade and Investment: Asia-Latin America, United Nations(ESCAP), New York and Bankok
IDB (2001) Competitiveness: The Business of Growth Washington
Kantis, Hugo, Masahiko Ishida and Masahiko Komori (2002), Entrepreneurshi in Emerging Economies:
77ie Creation and Development of New Firms in Latin America and East Asia, Washington:

IDB
Kim, Won-Ho (1999), "Post-crisis Korea and Latin America: Searching for a new framework of
economic relations" (mimeo) presented at the "LASAK International Conference on Latin
America and Asia: Financial Crisis and Prospects of Interregional Relations" Seoul, Korea

King R. and R. Levine (1993) "Finance and Growth: Shumpeter Might Be Right", euarterly Journal of

Economics, 153(3),King R. and R. Levine (1993) "Finance, Entrepreneurship, and Growth: Theory and Evidence", lournal

66

KOBEECONOAtflC &BUSINESSREVIEM, 47 (2002),

23-66

of Monetary Economics, 46 (1),
Levine, Ross and Maria Carkovic (2001), "Finance and growth: New evidences and policy analyses for
Chile" paper presented at the Annual Conference of Central Bank of Chile.

Levine R., N.Loayza, and T.Beck (2000) "Financial Interrnediation and Growih: Causality andCauses," Journal of Monetary Economics, 46 (1),
Loayza, N. and Romain Ranciere (2001) "Financial Development, Financial Fragility, and Growth" (mimeo)

OECD (2001), Science, Technology and Industry Outlook: Drivers of Growth: Information Technology,
Innovation and Entrepreneurshi , OECD: Paris
Moguillansky, Graciela and Ricardo Bielschowsky (2001), Investment and Economic Reforms in Latin

America, ECLAC, Santiago (Chile)

PECC Trade Policy Forum (1997), Asia-Paci;t7c and Mestern Hemisphere Regional Initiatives:
Cooperation for Increasing Competition, (mimeo) presented at the International General
Meeting of the Pacific Economic Cooperation Council (PECC), Santiago, Chile

Rajan, Raghuram G. and Luigi Zingales, (1998) "Financial Dependence and Growth", American
Economic Review, June 1998
UNCTAD (1998), Handbook on Foreign Direct Investment by Small and Medium-sized Enterprises:
Lessons from Asia, GeneveREVIEor, 47 (2002), 67-8i
KOBE ECONOMIC & BUSINESSDYNAMIC EXPORT PRICING AND

RATE EXPECTATIONSSURVEY-BASED EXCHANGE

EIICHI TOMIURA' Kobe University

Abstract
This paper constructs a cutomer market model where an exporting firm lowers the price as theexchange rate is expected to depreciate. The instrumenta1 variables method, usually employed in estimating

the Euler equation with expected variables, however, is inappropriate to estimate this model since theorthogonality is not satisfied for real-world exchange rate expectations. This paper instead derives expectedexchange rates from actual survey data. Our estimates suggest that expectations of future exchange rates alter
the current export price in the predicted direction in the case of Japanese machinery and chemical exports.

JEL Ciassilfication: F31, F12, F14
Kaywords: export price, customer market, exchange rate expectations, survey data

1 Introduction'

A rational firm is supposed to maximize her profit taking account of intertemporal
trade-offs. An exporting firm is no exception: she alters her price now when future exchange
rate is anticipated to change. Studies of dynamic aspects of exports have increasingly becomea real necessity beyond pure curiosity because expectations play more critical role incontemporary international economy as differentiated products and durable goods raise their

Corresponding Address:
Eiichi Tomiura
Research lnstitute for Economics and Business Administration (RIEB), Kobe University

2-1 Roklcodai-cho, Nada-ku, Kobe 657-8501 Japan
E-mail: tomiura@rieb.kobe-u.ac.jp

Phonensax: 81-78-803-7008* Seminar participants at the University of Tokyo and Yokohama National University, especially Kazurnasa Iwata

and Ryuhei Wakasugi, gave me helpfu1 comments for revising the paper. Since this paper is a substantiallyrevised version of a part of Chapter Two in my Ph.D. thesis, I acknowledge Paul Krugman, Julio Rotemberg and
Rudiger Dornbusch for their insightfu1 suggestions to the original version. I thank Kenneth Froot for providing

me with the survey data. All remaining errors are mine.

68 KOBE ECONOMIC&BUSINESS REJVIEM, 47 (2002), 67-81

share in world trade while exchange rates drastically fluctuate. To formalize the dynamics,

this paper considers the case where a firm prices to a foreign customer market in which
reputation of quality or habit formation persistently affects purchase decisions. In this sense,

this paper could link the pricing-to-market literature in international economics with thecustomer market theory which is one of the important tools in macroeconomics.
In spite of the clear logic based on the rationality assumption, empirical studies ofdynamic export pricing has been relatively scarce. One of the reasons is found in the factthat the rational expectation hypothesis is rejected in the case of expectations of exchange

rates, as shown in many empirical studies including Frankel and Froot (1987). This implies
that instrumental variable estimations of expected variables, which are common in many otherfields of economics, is limited its usefulness in our context because the instrumental variable

estimation requires the orthogonality condition which is satisfied under the rational
expectations. Actually, the introduction of future exchange rates into the models under theassumption of rational expectations has been thus far rarely successfu1. Among many
variables to be forecasted, it is the exchange rate that the expectations most dramatically varydepending on the belief and on the available information of the firm. The difficulty tointegrate realistic forms of exchange rate expectations with the standard structure of dynamic

optimization models has been the obstacle to examine the role of expectations in dynamic
export pricing. One practical approach to overcome it, however, becomes available as surveys
on actual exchange rate expectations have been conducted. In this paper, I estimate the Euler

equation derived from the dynamic optimization of an exporting firm, not with instrumental

variables for expected exchange rates, but with actual survey data of exchange rate
expectations, while assigning instrumental variables to other expected variables. To test thevalidity of this approach, we examine the case of Japanese exports, which attracted
wide-spread attention by the low pass-through.

This paper is organized as follows. Section 2 formalizes the dynamics of an exporting
firm who chooses the price for a foreign customer market. Section 3 explains our estimation

procedure using survey data. Section 4 describes Japanese export data. Section 5 reports
empirical results. Section 6 concludes.

2 Theory
Many researchers have studied export prices by emphasizing demand-side dynamics withslow adjustment of customers. Among them, Froot and Klemperer (1989) introduce themarket-share variable directly into the profit function in their two-period duopoly model.'Dohner (1984) applies the original customer market theory by Phelps and Winter (1970) to
1 Giovannini (1988) examines the effect of "exchange rate surprise" on export pricing. He assumes the specificprice staggering with geometric disuibution and the orthogonality about expectations.

TOvaURA: DV?VAIL(IC EXPORT PRICING AND SURVEY-BASED EXCHAIVGE RATE EXI)ECTATIONS
69

the optimization of an exporter, assuming perfect foresight. Gottfries (1988) explicitly
formalizes the Euler equation of an exporting firm based on the customer market theory in
Gottfries (1986).

ln this section, I present a model which possesses basically the same theoretical stmcture
as Gottfries (1988), although this paper will deviate from it in the estimation techniques later.

First, consider the following standard intertemporal profit maximization of a fimi
exporting in a simple two country framework. To facilitate discussions, let us make the caseconcrete by calling the exporter as the Japanese firm and the export market as the U.S.

oo

<1> MaxV, == Z 6S-`E[(p,-c,)q,19t]s=twhere p is the export price, c is the marginal cost, q is the export quantity, 6 is the discountfactor which is assumed to be constant (O < 6 < 1), and E( l9,) denotes the mathematical
expectation operator conditional on all the inforrnation available at time t(9t) (hereinafter

expressed as Et() for short). Here, both p and c are expressed in terms of yen.

Next, formalize the demand-side, first by decomposing the current demand q into thecutomer stock (x) and the demand per customer (e):<2>qt = etxt

Here, inventories are neglected so that current export supply equals current demand of
consumers to the product. Naturally, factors such as U.S. business cycles affect e over timethrough income effect. On the other hand, the U.S. customer stock of the Japanese firm x
is supposed to be determined as following, assuming that the product is purchased repeatedly,

though not every period, by the buyers:<3> x, = D( Pr,t ), fi, X2-'i

where r denotes the exchange rate (yenldollar). Let Aj>O for allj>O. The dynamic relation<3> means that the current stock of customers is determined by the current price and by thegeometric weighted average of history of customer stocks. The first term D correspond to a

standard downward-sloping demand imction linking demand quantity with current
dollar-denominated price (D'<O).2 On the other hand, the second temi introduces the dynamics
into this model.3
2 Here, the export price (p) is measured in terms of the price compared with foreign competitors,
3 Although the derivations closely follow Gottfties (1988), I allow pricing effect to directly persist more than one
period (theoretically infinitely) even if customers purchase only occasionally. The right-hand side of (3) includes

all x,'s except for t when xt = O.

KOBEECONOMIC & BUSINESS REVIEM, 47 (2002), 67-81

70

The motivation for this formulation comes from the facts that customers tend to respondtb price changes only gradually over time due to habit formation or reputation effect. Thiskind of consumer behavior, which could be formalized by imperfect infomiation, is especiallyevident in purchase decisions of durable goods and differentiated products with unknown
quality since it should be more difficult to compare prices and qualities and more costly toswitch supplier of complex products compared with simple standardized commodities. As
world trade has shifted its share from homogeneous commodity to goods characterized above,
the relevancy of the customer market theory in export pricing must have increased. Let me
assume the following specific functional forms for D in <3> so that the final form of Euler
equation becomes tractable;<4>

D(p, )= (1+n-lli,, )Ao
77-trt

where n > O .4
Then,

the first-orderrespect tocondition for maximization is obtained<1> withby differentiatingx;
 gX, - E,[(p,- c,) gs + ,S, 6kq,., 0gak] - o

Substituting <2>, <3> and <4> into <5> yields the Euler equation. Although

we should be

carefu1 in interpreting the Euler equation as causal relationship, I will present

lt ln

the form

to which we can provide economic interpretations, by multiplying by xtlrt,<6>

E,[B( rt+ ,qt+ip, r ao+ai!L'co
z+

rt il

rt

rgt

)+r,(

Pt+iqt+ ')]
rt qt

where
1+rp

ao : 77(1+Ao)

>o

Ao

>o
al=1+AoB, =8(1+i7)A,
rp(1+2o)<o

4 Further,

we must assume that the term in the bracket on the right-hand side of <4> mustrelevantp and r,be positive for any

TOMIURA: DYrVAvaC EL\PORT PRICING AND SURVEY-BASED EXCHANGE RATE EXI)ECTATIONS 7I

6iAi
> o.
ri = 1+Ao
The equation <6> implies that the current export price is affected not only by production

costs and current exchange rate, but also by future variables including exchange rate
expectations. The fact that the sign of coefficient Bi i's negative for all i (i = 1,2,3,...)
indicates that the current dollar-denominated export price (Ptlrt) is lower when future market

expansion or future yen depreciation is anticipated. In other words, given the current
exchange rate and other parameters including costs, a Japanese exporter sets the price in yen
terms lower now when she expects the exchange rate of yen to depreciate in the future. Thisis the central hypothesis of this paper.

The intuition behind this is simple as following:purchases today depend on all past
prices since customers do not have perfect knowledge of product quality or since they prefergoods which they have a habit to consume. Hence, exporters care about future exchange rate,
which translates yen-denominated prices chosen by an exporter into dollar-denominated ones,
because customers care about the history of past dollar-denominated prices. In other words,
once a firm sets it, the price has a persistent effect on demand just as the investment decision

does. Exporters "invest" today by cutting the price offered to current buyers who will later

form an expanded customer-base for exporters. There exists an intertemporal trade-off
between current costs of offering low price to current buyers and expected gain from charging

high prices to expanded customers in the future. The expected returns from the"investment" change as the exchange rate fluctuates. If they expect the future exchange rate
to become favorable, exporters choose to offer lower price now because the future gains fromtheir locked-in customers dominates the current costs. Put another way, an exporter
agressively prices for foreign market share in the short-run when they expect currency
depreciation. On the other hand, an exporter charges higher price now when the exchange
rate is anticipated to appreciate because the high current demand relative to the future
demands makes it less attractive for an exporter to price down now to increase future profu

by expanding customer-base. Thus, in addition to the current level of exchange rate, thefuture exchange rates affect current pricing decisions of exporters in the direction explained
here.

Besides, this effect (IBil) gets greater as customers respond to past price changes more
persistently, or Ai (i 2-}i 1) is larger. Thus, expected future exchange rates play more crucialrole in the current export pricing as past prices affect customer flows more persistently.

KOBE ECONOvaC & BUSIIVESS REVIEM, 47 (2002), 67-81

72

3 Estimation
As many economists have estimated individual agent's Euler equations which include
expected variables, we could estimate the export pricing equation <6> by instmmenta1
variables without constmcting any arbitrary series of "expected" exchange rates as long as
we can assume that the orthogonality condition is satisfied.5

Since many empirical studies have aiready shown that the rational expectation hypothesis

is often strongly rejected in the case of future exchange rates, however, we cannot employ
the instmmenta1 variable estimation procedure because the othogonality condition is met under

the rational expectations. In other words, the test based on the instrumental variable
estimation is the test of joint hypotheses: the customer market model and the rational
expectations of exchange rates. Gottfries (1988) estimates the export pricing equation for the

Swedish manufactmng by instrumenta1 variables and finds "only limited support" for thecustomer market theory. As he correctly cites, the rational expectation assumption must be
one of the reason for his results.

One practical way to avoid assuming the rational expectations about exchange rate
expectations has been explored in Froot and KIemperer (1989), who draw expected exchange

rate series from survey data to estimate export price differential equations in thepricing-to-market framework. They conclude that "there is no overwhelming evidence that
expected future depreciation influences the degree of pricing to market" tp.649).

Since various surveys about exchange rate expectations have been carried out, we will

be able to contend ourselves with estimating the dynamic export pricing equation <6> byrelying on the "expected" exchange rate derived from other's survey data, while employing
instrurnental varjable estimation for other expected variables in the same Euler equation(P,+i and qt+i)•

Although it is straightforward to estimate <6> without any constraint, imposing thegeometric lag assumption on the coefficients will be appropriate to capture the original
implication of the customer market theory because the impact of past prices on demand tends

to fade uniformly with the passage of time.` Remember that the discount rate 6 isO < 6 < 1 and Zi gets smaller as i grows. Suppose that Ai = Z` (O < A < 1;i = 1,2,...).
Hence, I impose the following constraints on the coefficients:

5 As many note, the forward rate cannot be an unbiased predictor of future exchange rate, for exarnple, becauseof time-varying risk-premium.
6 The constrained regression is preferred econometrically,

unconstrained version.

too, because it avoids the multicollinearity in the

TOMIURA: D}7VAMIC ELPli7}ORT PRICING AND SURVEY-BASED EXCHANGE R,4TE EXPECTATIONS 73,Bi = ,B6iAi<7>ri = r6izi(z = 1,2,3,...)

where

1+n

B--n(1+Zo)
1
r:= 1+Ao
Under the assumption of geometric lag <7>, we can simplify the Euler equation <6>,

which includes theoretically infinite sequence of expected variables, by the following
transformation like Koyck's in the adaptive expectations model. First, multiply by rg, on bothsides of <6>.

oo
<6A> p,q,=aorA,+aicg,+
Z Et[Birt+,qt+i+riPt+,qt+i]i=]Similarly, for t+1,

oo
<6B> Pt+Iqt+1 =aort+lqt+1+alct+lqt+1+
Z Et+1[iBirt+1+st+1+i+7iPt+1+,qt+1+i]i=1Second, take the expected value of <6B>, conditional on the available information at time t.

co<6C> E,(p,+iq,+i) =aoE,(rt+iqt+i)+aiEt(c,+iqt+i)+
Z Et[Birt+,qt+i+riPt+,gt+i]i--2
Next, multiply by 6A on both sides of <6C> and subtract it from <6A>. Thanks to thegeometric constraint <7>, this cancels out the infinite sequence of expected variables on theright-hand side of <6> and leaves only the variables at t+1<8> -{IL' ": #o+peit' +Et[u2C'"r,iqq,"' +u3rt'r,iqq:'i +pt4P"r,iqq,"i]where
pto = aopt1 = alpt2 = -6Aai
pt3 = 6Z (B Nao)

pt4 = 6Z (1+r)

KOBE ECONOAcffC di BUSINESS REVIEM, 47 (2002?, 67-81

74

Thus, by depending on <8>, we can estimate the Euler equation without arbitrarily
truncating the infinite sequence of future variables in <6>. The estimation of <8> still
provides us with the information necessary to regain the sequence of original coefficients{Bi}, which plays the pivotal role in the origjnal model of <6>, by<g> B, - (pt,- "X3)(-k )t

4 Description of data
Data employed in estimation are briefly described in this section. Appendix will provide

additional information about the data used in this paper. Out of the export prices (p) for
various classifications of Japanese products reported monthly by the Bank of Japan, I use thefollowing four: machinery, chemicals, metals, and textiles.' Included as instruments for
estimation of expected varibales other than expected exchange rates are the lagged regressors,

the foreign producers price index (in U. S. and OECD European countries) as a proxy for the
price offered by foreign competitors, and the foreign industrial production (in U.S. and OECD

European countries) as a proxy for income since GDP data are not available on monthly
basis.

For the "expected" exchange rates, this paper exploits the data derived from the monthly

survey conducted by Money Market Service.8 The exchange rate expectation data in thispaper must reflect expectations actually held by market partcipants, although they do notnecessarily coincide with rational expectations." Due to the availability of survey data for theauthor at the time of original research, the sample period is from November 1982 to January
1988.io

7 To avoid troubies caused by unit-value index, the export "quantity" (q) is defmed by the export value reported

in trade statistics divided by the corresponding export price p. In the theory section of this paper, we havemeasured "p" as relative price compared with foreigri competitors'. The observation of drastic exchange ratechanges compared with stable relative domestic prices during the sample period, however, would allow us toconcentrate our attention to the effect of exchange rate on pricing by assuming foreign competitor's price constant.

This simplifying assumption will not critically affect our results as the empirical work by Engel (1993) for
example has found that volatility of domestic prices is much smaller than that of exchange rates.

8 The data was provided by Professor Kenneth Froot. The exchange rate employed in this paper is the yen-dollarrate, not the effective rate of the yen. Although the effectjve rate is more appropriate in the prjcing context, all
the survey data are on the U.S. dollar rate. ln addition to this, Japanese exports are quite often invoiced in dollar
terms, not in yen or in destination country's currency.
9 Those suryeyed are not necessarily exporters, but are rather more often financial traders. Ito (1992) examines theheterogeneity in exchange rate expectations based on a different source of survey data.
10 Since survey data are proprientary, I cannot extend the data set to more recent periods.

TOMTURA; D}7VAWC EXPORT PRICIArG A?VD SURVEY-BASED EXCHANGE RATE EJtPECTATIONS 75

5 Empirical results from Japanese exports
To facilitate the interpretation of the estimation results, let me restate the Euler equationin the form emphasizing the exchange rate expectations as follows:<11> Pt = pto+pt,-gL, +pt,Et(Ct+iqt+1) +pt,trte+iEt(qt+i) +pt,Et(P,+iqt+i)

rt

rt

rtqt

rAt

rgt

where trte+i denotes the exchange rate expectation for the next month at time t. The suffix"e" means that the expectation in this case is supposed to be fotmed by some given, thoughpossibly unlmown, functional forms, not by the rational expectations, or mathematicalconditional expectation Et.ii As I have explained in the previous section, I assign theinstmmental variables for qt+i and P,+i, while actual survey data replaces ,r,"+Jn estimation.

'

Table 1. EXPORT PRICING EQUATION
e +u.a trt+lqt+1 +u4 Pt+lqt+1 +y,-2IL/ = pto+ulg/ +u2ct+lqt+1
rt

rt

pto

pt1

U2
U3
tt4

p
R7tz

rgt

rAt

rgt

MACHINERYCHEMICALSMETALSTEXTILES

O.1175944""

O.1626018"'

O.08118375"'

O.Ol121056(O.02159012)(O.02633849)(O.03983798)(O.04606878)
O.4055639'"'(O.1067528)(O.06901667)(O.02550059)
O.8307409'**(O.04744845)-O.4487525*'-O.3785581'*'-O.5750713"'-O.8364653"'(O.1979604)(O.1159615)(O.08236632)(O.06429718)-O.09041946*'-O.1586841*"-O.06766599"-O.02970228'(O.04030167)(O.04861174)(O.02928028)(O.02128845)

O.731OO03*"

O.9400697"'

O.8793520"'

1.019540"'(O.2801313)(O.1115125)(O.09298253)(O.04864931)

O.6415449"'

O.6387524*"

O.3591062"

O.3991057""

O.1400070-O.08949768(O.1687039)(O.1764075)(O.2369745)(O.3395477)

O.99447540

O.88205300

O.97308041

O.99342478

ovOTES)
1. Figures in the parentheses are estimated standard errors, "p" denotes the estimate of first-order autocorrelation

by Cochrane-Orcutt method.
2. Coefficients of monthly dummies are not shown tQ save space.
3, Instrumenta1 variables for estimation are constant, (ct/r,), iUS,, IUSt-i, IEUt, iEUt-i, PUS,, PUS,-i, PEUt,
PEUt-i, (,rte+i/rgt), (1/rAt), (ct-iqtLi/rt-2qt-2), (rt-iqt-ifrtTgt-2), (Pt-iqt-i/rt-2qt-2), and monthly dummies.
4. The sigriificance of estimate is denoted by asterisks as follows; "' (",'); signifiÅëantly different from zero at
1 (5, 10) O/o level.

11 Here, I compromise to take the expected exchange rate variable out of the conditional expectation operator but

I must note that this manipulation is not necessarily correct mathematically because the argument inside theoperator is nonlinear.

76 KOBE ECONOMIrC &BUSINESS REVIEM. 47 (2002), 67-81

The results of estimation of dynamic export pricing equation <11> are reported in Table
1. In the machinery industry, the estimation yields remarkable results; all the coefficients are

significant, each has the sign predicted by the theory, and the explanatory power is veryhigh.'2

Before discussing the expectation effect, evaluate these coefficient estimates in terms of

the pass-through coefficient. When firms believe that all the future variables remain at thecurrent level permanently, <11> collapses to the following;<12> =(L, = uo+pt 1-gL, +u2 ct qt +u3 rt qt +p4 Ptqt

rtrt

rtqt rt qt rt qt

By rearranging, we obtain the equation on the pass-through relation:

p, -

ct
<13>
--Åëo+ÅëiM
rt
rt- PO+pt3
ÅëO - 1-U4
where
- Xtl+XZ2

Åëi - 1-U4

The estimation results of u's for the machinery exports in Table 1 tell us that thecoeffient of the dollar cost in the above <13> equation (Åëi) is O.72. This implies thatJapanese machinery exporters pass-through only about three-quareter of an increase in theirdollar-denominated costs to the dollar-denominated export price. Although assuming that theeconomy is in the long-run equilibrium during the drastic exchange rate adjustment may not
be realistic, this result is consistent with the often-cited low pass-through of Japanese exports

and can be served as a usefu1 benchmark for interpretation.
Based on these coefficient estimates, Table 2 shows {j8ili = 1,2,3,...} for representative

months (i = 1, 12, 24, 48), of which the graphical presentations are shown in Figure 1.
Examine the results of each case in the foliowing:More than anything else, as shown in Figure 1, the implied {Bili--1,2,3,...} formachinery exports has a quite intuitive feature: the export price has such a persistent impact

on demand that it lasts sjgnificantly for one or two years and totally diminishes only after
about ten years.

The customer market theory is also applicable to the chemical industry as the estimatesin Table 1 look quite similar to those of machinery. To confirm it, negative and declining
12 Although all the estimated coefficients in the Euler equation have the sigris predicted by the theory, one
reservation should follow as the indirectly implied value, which must be positive for downward-sloping demand
curve, ls negatlve.

TOvaURA; D}7VAvaC moORT PRICING AIVD SURPIEY-BASED exCHANGE R4TE EiU?ECTATIONS
77

Table 2. EXCHANGE RATE EFFECTS
Bi = (ue- ptf23)(-iitt )'i(months)
1122448

MACHINERYCHEMICALSMETALSTEXTILES-O.O0816365-O.OOO160126-O.O0690974-O.O0323793-O.OO141627-O.OO027096+O.O0542406+O.OO170846+O.OO0484479-O.O184145-O.O198594-O.0215652-O.0254290-0219695E-05-O.413557E-09+O.389595E--04{i9ili = 1,2,3,...} is presented in Figure 1.

The case of metal industry also shows that all the coefficients are significant in Table

2. The implied {Bi} in Table 2 persists and gradually declines over time, but, contrary to
those in the machinery and chemical industries, the value is always positive, which meansthat future expected appreciation (not depreciation) triggers export price wars. I will briefly
discuss a possible interpretation for this observation later.

In the textile industry, the estimated coefficient {Bili=1,2,3,...} in Table 2 isincreasing, not decreasing, as the lag (i) becomes larger. Since any reasonable explanations
including the customer market theory require converging series of {Biii = 1,2,3,...}, we findno support for dynamic pricing models in the case of textiles.
The result that the customer market theory well explains only some groups of industries

is reasonable rather than disappointing.'3 The assumption that consumers respond slowly toprice changes is not plausible for some products, especially simple standardized products. In
other words, the customer market theory is suitable only to goods which are characterized byoccasional discrete purchases and complex differentiation; that is typically the machinery

Figure 1. PERSISTENCE OF PRICE EFFECT ON EXPORT DEMAND

IB,l(= -B,) [MACHINERY] -B, [CHEMICALS]

.O030
.oo70
.O025 ,O060.O020 .0050

,OO15

.OOIO
.OO05

.oo4e
.oo30
.O020
.OOIO

1 3 5 7 9 11
cyrEAR) 1 3 5 7 9 ll (YEAR)
.oooo
.oooo
13 Campa and Goldberg (2002) also find that the most important deterrninants of OECD pass-through are related

wnh industry composition of a country.

78 KOBE ECO?VOMIC&BUSINESS REVIEM, 47 (2002?, 67-81

industry in our classification.i` On the other hand, since industries are broadly aggregated
here, we should be cautoius in interpreting the industrial differences. The estimations using
disaggregated product-based data will be left for future independent work.

Next, I like to touch upon an alternative model which could explain the dynamic export
pricing from a different perspective. The implicit collusion models such as that by Rotemberg

and Saloner (1986) sharply differ from the customer market model. If we apply the implicit
collusion model to our case, the incentive to undercut the collusive export price should behigh when the future exchange rate is anticipated to appreciate because the current gain fromdeviating from collusion is high compared with future anticipated loss from being punishedin the repeated game.i5 On the other hand, by the customer market model as has been
examined in this paper, the incentive to cut export price should be high when the futureexchange rate is anticipated to depreciate.'6 The export price in the metal industry reported

in this paper, for example, moves in the same direction as is predicted by the implicit
collusion theory, although studies based on disaggregated data are indispensable to check theconsistency with the game theory model. The task left to future work includes the test
explicitly discriminating these two theories by exploiting the sharp contrast.i'

Finally, the estimates of pricing coefficients B enables us to calculate the effect of

exchange rate expectations on export price, although we must note that the discussion
depending on the estimates of Euler equation is based solely on the necesarry condition.i8 I

will examine how much the export price will be changed by the deviation from the rational
expectations (or by the forecast errors implied by survey-based expectations).

Figure 2 shows the percentage export price change caused by exchange rate forecast
errors for chemical exports. The figure indicates that the chemical export price in 1985 waslower by around three percent than would have been under no forecast error at the peak in

14 Besides, the capital market imperfection, as was examined by Chevalier and Scharfstein (1994) in a different

context, may also explain the industrial difference since the share of small firms, who are supposed to berelatively liquidity constrained and forced to abandon lowering the price in response to expected depreciation, islower in the machinery and chemical industries eompared with textiles industry in our sample.

15 Rotemberg and Woodford (1991) reports that negative correlation of markups with output is higher in moreconcentrated industries. Rotemberg and Saloner (1986) refers countercyclical property of cement price.

16 Some of the customer market models, however, predict coimtercyclical pricing, just as the implicit collusion
model does. For example, Bils (1989) focuses on the infiow of potential new cutomers and refers to procyclicaladvertising expenditure as an evidence to support his theory. Chevalier and Scharfstein (1994) introduces theliquidity constraint and provides evidence from regional price data in the supermarket industry.
17 Rotemberg and Woodford (1991), analyzing the effect of anticipated future profitability on aggregate markups, isa pioneering example along this line,
18 In other words, only from the estimates in Euler equations, we cannot find or test directly the mechanisrn bywhich expectations affect export pricing decisions, At the same time, though, since we cam)ot solve expliÅëitly thewhole dynamic optimization program with many state variables like ours, we must contend without the sufficientcondition.

79
TOMIURA; D}7VAvaC EXPORT PRICING AND SUR/EY-BASED EXCHANGE RATE EM?ECTATIONSFORECAST-ERROR EFFECT ON EXPORT PRICE

Figure 2.

dP,/P, (O/,) [CHEMICALS]
1.8

1.2
.6
o.o
.6
-1.2
-1.8
-2.4
-3.0
-3.6

1983 1984 19g5 1986 1987

of machinery is comparable to this magnitude and this
1985. The fall inpriceexport1986 (omitted from Figure 2 to save space).i"
forecast-error effect throughout
persistsof export price change is consistent with the theoretical prediction,
Although the direction

the expectation effect in the customer market model are
the price changes by
explained
small.20
always numericallyquiteTherefore, other dynamics such as the supply-side hysteresis
should also be incorporated'
mto the model
when we discuss the whole impact of expectations
on actual export prices.

relatively small impact of expectations on export prices isOn the otherthis
hand,consistent with theresults
previously
found by Gottfries (1988) from Swedish data, and Froot

U.S. data.
In this sense, by replacing the instrumental variables
and Klemperer (1989)
fromby actual surveyexchange
data of rate expectations, this paper has confirmed that previous

results areirrespective
robust, ' ' of the estimation procedure (the instrumental variables methodthat theor actual survey data),
in customer market theory explains the real-world export
prices correctly in termsof of changes but only marginally in temis of magnimde.
direction

6 Concluding remarks
By making actualuse ofsurvey data, this paper has examined the effect of exchange
pricing
decisions. The case of machinery and chemical exports
rate expectatlons onexport19 The choice of sample period in this paper enables us to examine the Japanese experience, which attracted wide

attention by its low pass-through during the drastic exchange rate adjustment process in the middle of the 1980s.

It is true that we observe equally interesting episodes of drastic exchange rate adjustment during more recent
years. Since survey data are prDprientary, however, I cannot extend the data set to more recent periods,

20 Within the scope of this paper, it is hard to conclude what is the reason for this quantitative magnitude. One
usefu1 experiment, however, wili be to suppose that the economy is in the long-run equilibrium. In this case,<11> collapses to <13>, which simply regresses the curTent price on itself and on the current cost. Since theestimated coefficient is close to unity and R2 is high, we may attribute the high performance of thecustomer-market model in this paper possibly to the high correlation of current price with future price,80 KOBE ECOIVOjvarC&BUSIIVESS REZTEM, 47 (2002?, 67-81

provides evidence suppoting the cutomer market theory as follows. The sequence of pastexport prices over several years persistently affects the current export demand. Future
expected currency depreciationfappreciation with a substantially long time horizon significantly

lowerslraises the current export price. Consistent wjth the existing evidence from various data

sources with the instrumental variable method, our survey-based estimates have confirmed

relatively small numerical impact of the customer-market effect in the export pricedetermination.

Appendix[Export price] (p)FOB price in terrns of yen (Laspeyres index) from WPI by Bank of Japan. Classifications :(1) textiles, (2) metals and related products, (3) chemicals, and (4) machinery (includingtransport equipment).
[Export quantity] (q)Export "quantity" is defined by export value (from custom clearance statistics by the
Ministry of Fjnance) djvided by WPI export price (P). The classifications are the sameas those of export prices.
[Cost of production] (c)lnput price from Input-Output table (wholesale price for domestic input and import CIF
price for imported input). The industry classifications, which most closely correspond to
those in WPI classifications, are as follows:(1) textiles, (2) basic metal products andmetal products, (3) chemicals, and (4) machinery and equipment.
[Exchange rate] (r)The realized current yen-U.S. dollar rate is the monthly closing rate (yen per dollar).

The expected exchange rates in the next month are from the survey data by Money
Market Service. The diskette contained the survey data was provided by Professor
Kenneth Froot.
[Foreign indices] (PUS, PEU; IUS, IEU)

Producer price and total industrial production in the U.S. (PUS, IUS) and in OECD

European countries (PEU, IEU) from OECD (1990) Main Economic Indicators:
Historical Statistics 1969-1988. All are standardized so that values in 1985=100.

References
Bils, M., `Pricing in a Customer Market,' euarterly Journal of Economics CIV, 699-718, 1989.

Campa, J.M. and L.Goldberg, `Exchange Rate Pass-through into lmport Prices: A Macro or Micro

Phenomenon?' NBER Working Paper No.8934, 2002.

TOvaURA: D}7VAvaC EXPORT PRICI?VG AND SURVEY-BASED EiYCHANGE RATE EJU?ECTATIONS 81

Chevalier, J. and D.Scharfstein, `Capital Market Imperfections and Countercyclical Markups: Theory andEvidence,' American Economic Review 86 (4), 703-725, 1996.
Dohner, R. S., `Export Pricing, Flexible Exchange Rates, and Divergence in the Prices of Traded Goods,'

Journal of lnternational Economics 16, 79-101, 1984.
Engel,C. `Real Exchange Rates and Relative Prices: An Empirical Investigation,' Journal of Monetarv

Economics 32, 35-50, 1993.
Frankel, J. and K.Froot, `Using Survey Data to Test Standard Propositions Regarding Exchange Rate
Expectations,' American Economic Review 77, 133-153, 1987.

Froot, A.K.and P.Klemperer, `Exchange Rate Pass-Through when Market Share Matters,' American
Economic Review 79, 637-654, 1989.
Giovannini, A., `Exchange Rates and Traded Goods Prices,' Journal of International Economics 24,
45-68, 1988.
Gottfties, N., `Price Dynamics of Exporting and Import-competing Firms,' Scandinavian Journal of
Economics 88, 417-436, 1986.
Gottfries, N., `Market Shares afid Pricing Behavior in the Tradables Industry: An Examination of
Swedish Manufacturing,' Instimte for International Economic Studies Seminar Paper No.412,
University of Stockholm, 1988.
Ito, T., `Foreigri Exchange Rate Expectations: Micro Survey Data,' American Economic Review 80,

434-449, 1990.
Phelps, E. S. and S. G. Winter, `Optimal Price Policy under Atomistic Competition,' in E. Phelps, (ed),Microeconomic Foundations of Employment and Inllation Theoiy, New York: W.W.Norton,
1970.
Rotemberg, J. and G. Saloner, `A Supergame-theoretic Model of Business Cycles and Price Wars during

Booms,' American Economic Review 76, 390-407, 1986.
Rotemberg, J. and M. Woodford, `Markups and the Business Cycles,' in O. J. Blanchard and S. Fischer,(eds), NBER Macroeconomics Annual 1991, Cambridge: M.I. T. Press, 63-129, 1991.
Tomiura, E., `Dynamic Export Pricing and Exchange Rate Expectations,' Chapter Two in unpublished
Ph.D. dissertation Three Essays on I]b,namic Export Competition, Massachusetts Institute ofTechnology, 1992.

KOBE ECONOMIC & BUSINESS REVIEPV, 47 (2002?, 83-92

TECHNOLOGICAL TRAJECTORIES AND THE ORIGINS OF
NEVV INDUSTRIES: A THEORETICAL MODELJEFFRI{Y L.FUNK Kobe University

Abstract
This paper describes a model of new industry formation that draws heavily on evolutionary theories

of technical change. It represents the origins of new network industries as the interaction between
multiple technological trajectories that are specific to a particular technology or broadly definedtechnological regime. The speed with which these multiple trajectories cause industry formation depends

on their effective application to the most economical applications; this process occurs through theinteraction between design hierarchies and market concepts. Growth in these initial applications causes
sub-trajectories or sub-regimes, where competition in the new industry initially takes place, to emerge
from the main trajectories.

JEL classi;fication: Ml
Keywords: origins, industry, technology, trajectory, design, hierarchy, market, competition, cooperation,

disruptive '1. Introduction
In spite of the recognized importance of new industriest, there are few models (Van deVen and Garud, 1989) that describe the origins and early evolution of new industries.
Instead, the origin of new industries is typically considered as an exogenous variable in othermodels. For example, the product life cycle theory assumes new industries are formed
through the emergence of technological discontinuities. It then attempts to explain such
Corresponding Address
Jeffrey L.Funk
Research Institute for Economics and Business Administration (RIEB), Kobe University

2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501 Japan
E-mail: fUnlc@rose.rokkodai.kobe-u.ac.jp

Phone!Fax: 81-78-803-7009
1 There is an extensive literature on the importance of new industries, Schumpeter (1942) is usually credited withbeing the first with his coRcept of creative destruction,

84

KOBE ECONO?LcflrC & BUSJNESS REVJEM, 47 (2002), 83-92

variables as the frequency of product versus process innovations, the number of new entrants,

the amount of product variety, and the emergence of dominant designs and their effect oncompetition (Abernathy & Utterback, 1978, Tushnan & Anderson, 1986). Further, recent
research suggests that the product life cycle does not effectively explain many of these(Klepper, 1996; Klepper and Simons, 2000) and other variables (Frenken et al, 1999;
Windmm et al, 1998).
This paper proposes a model for the origins of new industries. The model draws heavily

on evolutionary theories of technical change. It represents the origins of new network
industries as the interaction between multiple technological trajectories (Dosi, 1982) that are

specific to a particular technology or broadly defined technological regime (Nelson & Winter,
1982). The speed with which these muitipie trajectories cause industry formation depends ontheir effective application to the most economical applications; this process occurs through theinteraction between design hierarchies and market concepts (Clark, 1985).
For both producers and users, local search, incremental adaptation, and path dependencies
play an important role in identifying and serving these initial applications. Growth in these

initial applications causes sub-trajectories or sub-regimes, where competition in the newindustry initially takes place, to emerge from the main trajectories. The emergence ofmodular designs (Baldwin and Clark, 2000) or dominant designs, facilitate the emergence of

these sub-trajectories. Network effects, increasing returns, first-mover advantages, andirreversibility play important roles in this initial competition.

2. Proposed Model
Figure 1-1. summarizes the proposed model. New network industries are formed by theinteraction between multiple technological trajectories, each representing one component or"regime" (Nelson and Wjnter, 1982) of the new network industry. Progress in a single
trajectory occurs through improvements in the trade-offs between relevant technologicalvariables (Dosi, 1982). Technological trajectories are similar to Sahal's (1985) concept ofjnnovation ayenues and he argues that the combination of multiple innovation avenues is thesource of many industries.
Prior to the formation of the industry, the relevant technological trajectories are primarily

dnven by factors that are independent of the new industry. For example, in the case of theInternet, improvements to the Internet's relevant components including PCs, digital content,
and networks were driven by other applications for these components until the Internet began
to diffuse. But as the Internet began to diffuse, improvements in these components began tobe driven by their use in the Internet and thus these improvements began to become more
applicable to the Internet. In many cases, relevant improvements in the components may notoccur prior to industry formation.

TRAJECTORIES AIVD THE
ORIGINS OF NEM INDUSTRIES85
FUNK: TECHNOLOGICAL

Figure 1-1. The Origi"s ofNew

Industries
Regional environment for identifying andTechnologicalserving initial applications and expanding

Trajectories

the set of applications

1) Characteristics oftechnology(effect on technical and market linkages

ofincumbents)
2) New firm formation!tps!}}E!I>LSIt!d tryGrwth S fiR nInteraction between

Expansion- ofdesign hierarchies

and market concepts

Applications

Emergence of
sub-trajectories

Technological
Sub-trajectories•
Effect on Main Trajectories

Technological trajectories can be represented by the change in component performance or
the distribution of available performance in the component (e.g., as a function of price) andboth of these measures could be for new components or the installed base of components.
For example, the relevant trajectories for the forrnation of the Internet are terminals (PCs,
PDAs, or phones), digital content, software, and network (e.g., speeds) performance2.

2.1

Interaction

between design hierarchies andmarket concepts

The initial rate of industry growth depends on identifying and serving an initial set of

applications. These initial applications are defined by the interaction between desigri
hierarchies and market concepts where every design problem begins with an effort to achieve

fitness between form (solution) and context (definition of problem). The form includes thebasic functional parameters of the product and the context includes the economic and social

environment. In the latter, the way technology is socially constmcted (Bijker, 1987) has alarge effect on when and where these first applications emerge.

2 For exarnple, dataon thediffusion of digital

deviees can be found in (Lohr, 2002).

perforrnance of digita1 devices

can be found in (Woodal, 2000) anddata on the86 KOBE ECONOvaC&BUSINESS REVIEM, 47 (2002), 83-92

Abernathy and Clark's (1985) model of technological development provides us with apartial framework for understanding the challenges of firm's identifying and serving these
initial applications. In their model, innovations can strengthen or overturn existing technicalor market linkages. Innovations that overturn existing technical linkages destroy existing
capabilities (Tushman and Anderson, 1986, Henderson and Clark, 1990) and thus requirg new
capabilities that are often difficult for incumbents to develop. Innovations that overturnexisting market linkages require new marketing or distribution systems that may also be
difficult for incumbents to develop. One type of innovation that overtums existing market
linkages is a disruptive technology (Christensen, 1997). Disruptive technologies improve some

aspects of product performance while sacrificing others, thus making the new technologies

appropriate for a new set of customers. It is important to recognize that customers must
actually use the product in order to generate information about the requirements of thecontext (Arrow, 1962).
Innovations that do not overmm existing technical or market linkages will favor regions3with the capabilities in the old technology. The relevant capabiiities might be found in the

suppliers or the users (von Hippel, 1988) of the new technology. For example, two reasonsfor US dominance of the digital computer market (i.e., mainframe computer) was its strength
in the analog computer market and in the applications for both types of computers including

the scientific and military markets (van den Ende, Kemp, 1999). Similarly, early dominanceof the television industry by US firms can be explained by their strength in the radio industry(Klepper & Simons, 2000).

On the other hand, the more interesting case is when innovations overtum existing
teclmical andlor market linkages since these innovations may not favor regions that are theleaders in the old teclmology. Instead these types of innovations will likely favor regions thathave firms or other institutions (Lynn et al, 1997) with the appropriate capabilities in the
supply and use of the new technology andlor have firms that focus on the relevant customers.

Of course, even if the region does not have such incumbent firms, it may succeed throughinstitutions that support the formation of new firms (Kenney and von Burg, 2000; von Burgand Kenney, 2000; Cohen & Fields, 2000) as long as there are low barriers to entry in the
supply andlor use of the new technology.

Whether the innovation overturns or does not overturn existing linkages, the social
construction of technology (Bijker, 1987) suggests that other factors will also influence theability of the region to identify and serve the initial applications. These include theregion's demand characteristics (Rosenberg, 1982; Porter, 1990, Mowery and Rosenberg,
1998), the establishment of relevant standards, licenses, and regulations (David, 1986; Funk,

3 Regions can be part of a single country (e.g., Silicon Valley), a single country, or contain multiple countries (e.g.,

Europe).

FUNK: TECHNOLOGICAL TRAJECTORIES AND THE ORIGINS OF AI/EWINDUSTRIES 87

2001a; Hughes, 1983; Shapiro and Varian, 2000), and the regions division of labor (BRIE,
2001; Tether, 2002) including the interactions between firms (Van de Ven and Garud, 1989)
Path dependency will play an important role in determining the above factors, including

those related to incumbents, the formation of new firms, and the social constmction oftechnology. We can represent each of the factors with a chain of discrete Markov processes
where the probability funetion in one state is a function of past states (David, 2001). Firrns

will develop capabilities and focus on customers in an evolutionary manner where local
search and adaptation predominate (Holbrook et al, 2000). Similarly, demand characteristics
and institutions that support the creation of new firms and standards, entry barriers, and othergovemment policies will also be created in an evolutionary manner (Mowery and Rosenberg,
1996).

In any case, the region that first identifies and serves the most economical applications

will be rewarded with first mover advantages (Klepper, 1996; Mowery and Rosenberg, 1996,
Mueller, 1997) in that it will begin developing capabilities in the new technology. The extent

of its advantage will depend on the similarities in standards (2001a), the degree of network
effects, increasing returns (Arthur, 1989) and irreversibility all of which have been found toplay a strong role in network industries. As the industry grows, the existence of network
effects will increase customer value while increasing returns will reduce supplier costs. On

the other hand, firms in less successfu1 regions may find it difficult to develop new
capabilities or focus on different customers, which may radically slow regional growthparticularly if there are no new entrants. Local search, incremental adaptation, andcoordination problems may even lead to irreversibility thus preventing the industry fromemerging until long after it has emerged in other regions (David, 1986; Oechssler, 1997).

2.2 The evolution of competition and technological sub-trajectories
Clark's (1985) model of design hierarchies and market concepts tells us something about
how competition in the industry will evolve in the region that first identifies and serves themost economical applications. In his model, the logic of problem solving and the formationof concepts that underlie choice in the marketplace impose a hierarchical structure on theevolution of technology (Nelson & Winter, 1982). On the one hand, as alternative productforrns compete at consecutively more detailed levels problem solving becomes moreinterdependent and incremental. These incremental improvements enhance and extend theunderlying technology and thus reinforce the design at higher levels in the hierarchy; thesereinforcements are often characterized in terrns of a dominant design (Abemathy and
Utterback, 1978). On the other hand, movements up the hierarchy are associated withdepartures from existing approaches and are sometimes called "dematuration" (Clark, 1985).
However, network products differ from the products that have been used to develop and88 KOBE ECONOMTC&BUSINESS REVIEM, 47 (2002), 83-92

test Clark's model (1985); the latter includes automobiles, semiconductors (Clark, 1985),
insulin, and switching equipment (Durand, 1992). Network products comprise an open system
of interdependent components and thus contain multiple design hierarchies. It is likely thatthe interactions between these hierarchies particularly at lower levels in each hierarchy canhave a larger effect on the evolution of the industry than the distinction between movements

up and down a single hierarchy.
The initial applications, which are determined through the interaction between design
hierarchies and market concepts, cause sub-trajectories and regimes to emerge from the main
trajectories and these sub-trajectories represent interactions between design hierarchies. The

relationship between main and sub-trajectories can be seen as a conceptual application of
Leontief's (1986) input-output analysis, applied at u micro-level in the economy. Leontief'smodels represent an economy as a combination of industries where each industry inputs goods

and services from and outputs them to other industries. In our model, although the main
trajectories also represent inputs of technology to the new industry, much of this teclmology

must be modified for the new industry. Thus, the main trajectories are more properly seen

as inputs of ideas and concepts that are used to constmct the new industry while thesub-trajectories represent measures of technical performance for the industry.

The relationship between main and sub-trajectories is also similar to the relationshipbetween Sahal's (1985) concepts of generic and industry specific innovation avenues (Sahal,1985) although our distinction between main and sub-trajectories is much more precise. Sahal
considered tpresumably in the early 1980s) the evolution of microelectronics to be a genericinnovation avenue while we consider specific types of microelectronics to be sub- and main
trajectories. In panicular, specific types of microelectronics begin as sub-trajectories that are

the focus of strategic battles for the creation of standards and platform leadership and someof these sub-trajectories become main trajectories.

For example, the interaction between one component of PC computer hardware (themicroprocessor) and another of PC computer software (the operating system) caused theemergence of two significant sub-trajectories that became the focus of competition for
platform leadership in the PC industry in the 1980s (Gawer & Cusumano, 2002). The victoryof the Wintel standard has caused both operating system and microprocessor performance tobecome main technological trajectories in the inforrnation technology industry and theirtechnological regimes include many types of electronic products (Freeman and Soete, 1997).
In large applications that also have very different requirements from the PC, sub-trajectories
are emerging that represent significantly different designs; one will be discussed shortly in thediscussion of the mobile Internet.

The PC and other examples suggest that there will be synergistic effect between the
sub-trajectories and the product or system's modularity. Many network innovations like thedigital computer (Baldwin and Clark, 2000) only become network products as firms created89
FUNK: TECHNOLOGICAL TRAJECTORIES AND THE ORIGINS 0F NEVV INDUSTRIES

modular designs where multiple firrns can provide various components or modules in an
open-system configuration. In some cases, the sub-trajectories define the performance of thesemodules while in other cases the addition of modules (Baldwin and Clark, 2000) causes the
emergence of new sub-trajectories.

In most cases, technological evolution along these sub-trajectories will expand theapplication space and in turn influence the main technological trajectories. In the long run,the total application space for the teclmological regimes will be determined by both thetechnological trajectories and the ability of suppliers and users of the technology to adapt it

to specific applications. This raises the possibility that a lagging region may catch up andpass the region where the industry originally emerged because of early maturation in theleading region.

3. Discussion
This paper presents a model of new industry formation. It represents the origins of new

network industries as the interaction between multiple technological trajectories that are

specific to a particular technology or broadly defined technological regime. The initial
applications emerge through interactions between design hierarchies and market concepts
where the social construction of technology takes place. Growth in the initial applications
causes sub-trajectories or regimes, where competition in the market initially occurs, to emerge
from the main trajectories.

This model enables us to more fu11y open the "black box" of technology development`
and address a number of economic and managerial questions that cannot be addressed withexisting models like the product life cycle model. One set of relevant questions is: 1) Why
did industry A evolve faster than industry B; and 2) Why did industry A start first in region

C while industry B started in industry D? We can address these questions by analyzing therelevant trajectories and determining both the rates and reasons for the rates at which initial

applications emerged and grew in various regions and industries. While it is possible thatmacro-economic factors drive many of the main technological trajectories, it is very likelythat the effective integration of them to form new industries is a fUnction of factors that are
stressed in evolutionary theories of economics and the social construction of technology.

This model can also be used to address managerial questions about various industry
segments. For example, 1) wny did certain divisions of labor emerge in industry A and not
in industry B; and 2) Why did certain firms win in these industry segments? We can addressthese issues by analyzing the technological sub-trajectories, the emergence of modularity, therelationships between the sub-trajectories and modularity, and the institutional factors

4I am borrowing the terrn from (Rosenberg, 1982)

90

KOBE ECONOMTC & BUSIIVESS REVIEPV, 47 (2002), 83-92

surTounding the sub-trajectories and modularity.

Future research should apply the model to specific industries. In another paper, theauthor has applied the model to the mobile Internet (Funk, 2002). Based on this analysis of

the mobile Internet, we are confident that the model can be applied to other network
industries in particular the PC Internet. But what about assembled products like automobiles

where the product life cycle model is generally accepted? Can our model solve some of therecent problems (Klepper, 1996; Klepper and Simons, 2000: Frenken et al, 1999; Windmm
et al, 1998) found in the product life cycle model? And what about non-assembled products
like pharmaceuticals and chemicals?

Future research should also attempt to simulate industry forrnation. It should be
relatively easy to represent the main and sub-trajectories in a simulation model. The
identification and serving of the initial application is more problematic but recent models of

disruptive technologies may provide sufficient analytical capability (Adner, 2002). Thesemodels can be used to simulate and perhaps even predict the growth of a new industry where
the application space could be modeled as a function of the main and sub-trajectories. We
can represent the evolution of incumbent capabilities, the formation of new firms, and otherinstitutional responses by a chain of discrete Markov processes where the probability function

in one state is a function of past states. Such a model would enable us to further openthe "black box" of technology development and address a much more detailed set ofquestions about existing and even future industries.

References
Abernathy, W. & J. Utterback (1978), "Patterns of Innovation in Technology, Technoiogy Review 80(July) 40--47.

Abernathy, W. and K.Clark (1985), "Innovation: Mapping the Winds of Creative Destmction,"
Research Policy, 14, p.3-22.

Adner, R. (2002). "When Are Technologies Disruptive? A Demand-Based View of the Ernergence ofCompetition," Strategic Management Journal, Vol.23, No.8., pp.667-688.
Anderson, P. & M.Tushman (1990), "Technological Discontinuities and Dominant Designs: A Cyclical
Model of Technological Change," Administrative Science euarterly, Vol.35, No.4 (December),

604-633.
Arrow KJ (1974). The Limits of Organization, NY: Norton.
Arthur, B (1989). Increasing Returns and Path Dependence in the Economy, Ann Atbor: University ofMichigan Press, 1994.
Baldwin, C. and K. Clark (2000). Design Rules, Boston: MIT press.
Bijker, W., T.Hughes, and T.Pinch (Ed) (1987): Tll}e Sociai Constntction of Technological Systems,

MIT Press.
BRIE (2001). Tracking a Transformation: E-Commerce and the Terms of Competition in Industries: theBRIE-IGCC E-Conomy Project, Washington DC: Brookings.

91
FUNK: TECHNOLOGICAL TR,4JECTORIES A?VD THE ORIGINS OI7 NEM I?VDUSTRIES

Christensen, C. (1997), The Innovator's Dilemma, Boston: Harvard Business School Press.
Clark, K. (1985), "The Interaction of Design Hierarchies and market Concepts in Technological Evolution," Research Policy (14), 235-251.
David, P. (2001). "Path dependence, its critics, and the quest for "historical economics," in Evolution

and Path Dependence in Economic Ideas: Past and Present, P.Garrouste and S.Ioannides(Editors).

David, P. (1986). "Historical Economics in the Long Run: Some Implications of Path-Dependence." In
Historical Analysis in Economics, G. D. Snooks (ed), London: Routledge.
Dosi, G., (1982). "A suggested interpretation of the determinants and directions of technical change,"

Research Policy 11, pp.147-162.
Freeman, C. and L. Soete (1997). The Economics of lndustrial Innovation, MIT Press, 1997.
Frenken, K., P. Saviotti, and M. Trommetter (1999). "Variety and niche creation in aircraft, helicopters,

motorcycles and microcomputers," Research policy 28, pp.469-488.
Funk, J. (2002). "Technological trajectories and the origins of new industries: the case of network pro-ducts," Working Paper, http:1!www.rieb.kobe-u.ac.jpl-fimklindex.html

Gawer, A. and M.Cusumano (2002). Platform Leadershi : How Intei, Microsoft, and Cisco Drive
Industry Innovation, Boston: Harvard Business School Press.
Godoe, H. (2000). "Innovation regimes, R & D and radical innovations in telecommunications," Research
Policjv 29, pp.1033-1046.
Henderson, R. and K. Clark (1990). "Architectural Innovation: The Reconfiguration of Existing Product

Technologies and the Failure of Established Firms," Administrative Science euarterly, 35(1990), pp.9-30.
Hughes, T., (1983). Networks of Power, Baltimore: Jolm Hopkins

Kenney M. and U. von Burg (Instimtions and Economies: Creating Silicon Valley, in Understanding

Siiicon Valley: The Anatomy of an Entrepreneurial Region, Kenney, M. (ed), Stanford
University Press, 2000.

Klepper, S. (1996). "Entry, exit, growth, and innovation over the product life cycle," American
Economie Review, Vol.86, No.3,
Klepper, S, and K.Simons (2000). "Dominance by birthright: entry of prior radio producers andcompetitive ramifications in the US television receiver industry," Strategic Management

JournaL 21: 997-1016.
Leontief, W. (1986). Input-Output Economics, Oxford University Press.

Lohr, Steve (2002). "Technology Climate Is Gloomy, but Its Future Still Seems Bright," NY Times,
July 29, 2002. http:11www.nytirnes.coml2002107!291technology129POKE.html)
Lynn, L., N. Reddy, and J. Aram (1997). "Linking technology and institutions: The innovation communities," J. Eng. Technol. Manage. Vol.14, pp,129-145.
Matsunaga, Mari (2000). i-mo-do jiken (The i-rnode Event), Tokyo: Kadokawa Shoten.

Mowery, David and Nathan Rosenberg (1998), Paths ofJnnovation, NY: Cambridge University Press.
Mueller, D. 1997). "First-mover advantages and path dependence, Jnternational lournal of Industrial

Organization, Volume 15, Issue 6, Pages 827-850.
Nelson, Richard (1996). T7e sources ofeconomic growth, Cambridge Mass.: Harvard University Press.
Nelson, R, Winter S (1982). An Evolutionary Theory of the Firrn, Cambridge, MA: Harvard University
Press.
Oechssler, J. (1997). "Decentralization and the coordination problem," Journal of Economic Behavior

KOBE ECONOMIC & BUSINESS REVIEPV, 47 (2002), 83-92

92

and Organization, Vol.32, pp.119-135.
Porter, M. (1990). The Competitive Actvantage of Nations, NY: Free Press.

Porter, M. (1983). "The Technological Dimension of Competitive Strategy," in Richard Rosenbloom,ed., Research on technological innovation, management, andpolicy, Greenwich, CT: JAI Press.

Rosenberg, Nathan (1982), Inside the black box; Technology and Economics, NY: Cambridge University
Press.

Rosenberg, Nathan (1994), Exploring the black box, NY: Cambridge University Press.
Sahal, D., (1985). "Technological guideposts and innovation avenues," Research Policy, 14, pp.61-82.

Schumpeter, J. (l942). Capitalism, Socialism, and Democracy, NY: Harper & Row.
Shapiro, C. and H.Varian (1999), Information Rules, Harvard Business School Press.
Tether, B. (2002). "wno co-operates for innovation, and why. An empirical analysis," Research Policy

31, pp.947-967.

Tushman, M. & P.Anderson (1986), "Technological Discontinuities and Organizational Environment," Administrative Science euarterly, Vol.31, 439-456.
Utterback, J. M. (1994), Mastering the I]lynamics oflnnovation: How Companies Can Seize Opportunities in

the Face of Technological Change, Boston: Harvard Business School Press.

Van den Ende and R.Kemp (1999). "Technological transformations in history: how the computer
regime grew out of existing computing regimes," Research Policy 28, 833-851.

Van de Ven, A. and R.Garud (1989). "A framework for understanding the emergence of new industries," Research on Technological Innovation, Management and Policy, Vol.4, pages 195-225.

Von Burg, U. and M.Kenney, "Venture capita1 and the birth of the local area networking industry,"
Research Policy, pp.1135-1155.
Von Hippel, E. (1988): The sources of innovation, Oxford University Press.
Windmm, P. and C.Birchenhall (1998). "Is product life cycle theory a special case? Dominant designs

and the emergence of market niches through co-evolutionary-learning," Sructural Cange andEconomic Dynamics 9, pp,109-134.
Woodal, Pam, "Untangling e-economics," 77ie Economist, September 21, 2000
(http:11www.economist.comlsurveysfshowsurvey.cfin?issue=20000923).

(2002],& BUSJNESS REVIEM, 47
KOBE ECONOMIrC

93-115

JAPAN'SDEFLATION
AND THEFEASIBILITY OF

INTERESTRATESNEGATIVE

J. DAVIESSTEPHEN

Kobe University

Abstract
Japan's central economic problem is that interest rates are much too high, so that aggregate demand

is too low. "Structural reforms" will increase supply but not deal with the shortage of demand. It is
generally assumed that "interest rates cannot be negative" and that therefore alternative techniques haveto be used to ease monetary policy when interest rates are already close to zero. This paper discusses

three existing ideas for achieving negative interest rates: Gesell's "stamp scrip" and two recent
proposals. It argues that negative interest rates can be achieved without the cost involved in these
existing proposals. All that is needed is to break the link between cash and the unit of account: a

1,OOO-yen note would no longer be worth 1,OOO yen. Alternatively, cash can be replaced withelectronic legal tender, subject to a negative interest rate.

JEL ciassilfication: B59, E21, E31, E42, E50, E52
Keywords: deflation, negative interest rates

Introduction
As economic policy-makers during the 1980s turned back the tide of inflation that had
threatened to overwhelm them in the 1970s, some prescient economists started to wam about
the risks of over-achievement.i In post--war business cycles interest rates in industrial
countries had not infrequently been negative in real terms and policy-makers' scope to makelarge cuts in nominal rates and to set negative real rates in cyclical downtms presumably

contributed to the shallowness of post-war recessions. Achievement of something close to
Corresponding Address:
Stephen J. Davies

Research Institute for Economics and Business Administration (RIEB), Kobe University

2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501 Japan
E-mail: sdavies@rieb,kobe-u.ac.jp

Phonensax: 81-78-803-7030

1 e.g. L.Summers (1991)

94 KOBE ECOIVOMTC&BUSI?VESS REVIEM, 47 (2002?, 93-115

price stability removed the scope for large cuts in nominal interest rates and for substantiallynegative real interest rates in cyclical downturns, given the generally received wisdom that
nominal interest rates cannot be (more than marginally) negative.

By the end of the 1990s zero interest rates had arrived in Japan and the economics

profession was taking a heightened interest in the problems of "monetary policy in a
low-inflation environment",2and even "the retum of depression economics".3 By early 2002

the Federal Reserve Board was discussing the possibility that the US might find itself in therudderless Japanese boat,4 and that risk clearly increased durjng the course of the year.
Policy-makers, while talking about price stability, have generally aimed for something inexcess of zero inflation (though the reason given for this has more often been to allow for
upward biases in measured inflation than to facilitate stabiiisation policy). In the UK, forexample, the govemment has set an inflation target of 2.5 per cent.

Defiation continues in Japan

Consumer prices have been falling in Japan since 1997. In recent years the GDP
deflator has been falling by around 1.5 per cent a year and this rate of decline is forecast

to continue.5 Land prices have been falling for more than eleven years. In the 12-month
period to July 1, 2002, the average price of residential land fell 4.3 percent, compared with
3.3 percent the previous year, while commercial Iand dropped 7.2 percent, after a 6.6 percent
drop the year before.6

The Bank of Japan's published monthly assessments have been pointing to continuing
and perhaps intensifying deflationary pressure:

As for the conditions surrounding price developments, the balance between supply anddemand is expected to keep exerting downward pressure on prices for a while amid
persistently weak domestic demand, although the completion of inventory adjustment and therise in capacity utilization rates will support prices to some degree. Moreover, factors suchas the ongoing technological innovations in machinery, deregulation, and the streamlining of
distribution channels will continue to restrain prices. Under these circumstances, domestic

wholesale prices are projected to continue to be weak for a while. Consumer prices are
expected to stay on a declining trend for the time being at the current gradual pace. While

the slower growth in imports of consumer goods is expected to alleviate the downward
2 The title of a US Federal Reserve sponsored conference held in October 1999. The proceedings were publishedin Journal of Money Credit and Banking November 2000, part, 2.
3 P. Krugman (1999)
4 Relevant Fed staff analysis was later published: A, Aheame, J. Gagnon, J. Haltmaier, S. Kamin (and others) (2002)

5 OECD Economic Outlook, No.71, June 2002.
6 According to the annual Land, Infrastructure and Transport Ministry survey published on September 19, 2002.

DA VIES: JAPA.MSDEFLATION AND THE FEASIBILITY 0F NEGA TIVE INTEREST RA95
TES

pressure on prices to some extent, the faster pace of decline in wages may possibly reinforce
the ongoing decline in prices, especially for services prices."7

On any reasonable assessment, to achieve price stability Japan needs a substantial easingof monetary policy. Over and above the monetary easing needed to stabilize prices, a further

substantial easing will be needed sooner or later to accompany fiscal consolidation. While
Japan's current public debt burden may be sustainable, no country can allow its public debt
to rise faster than GDP (or fall more slowly than GDP) forever. But just to stabilise the ratioof Japanese public debt to GDP, taxes will have to be raised andlor public expenditure cut
by several percentage points of GDP.8 As "Ricardian equivalence" does not appear to apply
in Japan, the tightening of fiscal poiicy will further deflate the Japanese economy.9
wnile it is certainly beyond the ambitions of this paper to calculate the optimal level ofinterest rates for Japan, we can use the Taylor rule for setting interest rates to give us someidea of the scale of cut that might now be called for in Japan. McCallum has computed a
Taylor rule for Japan up to 1998; this appears to indicate a warranted interest rate of aroundminus 2 per cent at the end of 1998.'O
Attempting a more up-to-date estimate we take the original form and parameters of the
Taylor rule:`ii= (r+p*)+1.5(p-p*)+ .5(y-y*)where i is the nominal interest rate set by the authorities;r is the warranted real interest rate
P* is the target inflation rate
p is the actual inflation rate
7 Monthly Report of Recent Economic and Financial Developments, Bank of Japan, September 19, 2002.
8 The IMF (World Economic Outlook, September 2002) estimate Japan's structural general government deficit as
currently close to 6 per cent of GDP.
9 Horioka finds from his analysis of bequest behaviour that what he calls the "selfish life cycle model" is far more

applicable in Japan than the "altruism" model that would imply "Ricardian equivalence": C.Y. Horioka (2002).
A recent IMF cross-country study also finds against "IUcardian equivalence" in the case of Japan: A Thomas(2001). It may be possible to introduce fiscal policy measures which simultaneously reduce the deficit while
stimulating demand. (l am gratefu1 to Professor Hisashi Harui of Kwansei Gakuin University for making thispoint.) A rise in income tax accompanied by a reduction in consurnption tax might have this effect; as might
regular pre-announced rises in consumption tax (as proposed by Professor Martin Feldstein.) Unfortunately, tax
reform is more likely to go in the opposite direction, inspired by tax reform in couritries where saving is too low

rather than high.

10 BT.McCallum (2002), in a paper prepared for March 2002 workshop sponsored by Economic and Social
Research Institute of the Japanese Govemment. (The collection of papers for the workshop can be found at
http:ffwww.esri.cao.go.jpfenlpri1020320f020320main-e,html.) At the same workshop, Watanabe showed the resultsof a backward and forward looking Taylor rule, computed by Okina and Shiratsuka for the period up to end
1999, The backward looking version indicated interest rates of around minus 2 per cent at the end of 1999 while
the forward looking version indicated interest rates of around minus 3 per cent.
11 JB. Taylor (1993)

47 (2002),
REVIEM,&
KOBEECONOMICBUSINESS

96

93-115y-y* is the output gap.
In the case of Japan:' Japan's demography means that r may be very low (possibly even negative) and almost
certainly not more than+2.i2• P* is a small positive number in most countries that have adopted inflation targets (asnoted earlier, 2.5 in the UK) but perhaps in Japan, the objective of price stability
should perhaps be taken as meaning more or less zero inflation, i.e. P* = Oto 1.

•The GDP deflator has been falling by around 1.5 per cent a year for some time so
I take actual inflation (p) to equal -1.5.

•There is a wide range of estimates for the output gap. The June 2002 OECD
Economic Outlook put it at arottnd -3 in 2002, the latest IMF WEO database puts

it at around -4. A carefu1 study by Kamada and Masudai3 put the output gap atcloser to -10 in 1999 (and of course it would be bigger now); however, the latter
authors seem to define the gap relative to maximum output rather than relative to
mid-cycle output. The highest estimate I am aware of is -30!'`
Ignoring the most extreme estimate of the output gap, these estimates would probably
imply seuing nominal short-term interest rate now at between -2.5 and -5 per cent. Then,as noted earlier, to allow a rebalancing of fiscal and monetary policy (to put government
finances on a sustainable track) a significant further reduction in interest rates would beneeded (makjng the required level of jnterest rates still more negative).
While different interest rate rules, or different parameters for the Taylor rule, might bepreferred, it seems reasonably clear that Japanese interest rates need to be negative, andsubstantially so. But the option of holding wealth in the form of cash apparently rules out
interest rates being more than marginally negative. (The marginal scope for negative interest
rates reflects the cost of storing, safeguarding andf or insuring hoarded cash.) If the Bank ofJapan moved its intervention rate significantly below zero, banks would simply borrow toincrease the cash in their tills, with no necessary effect on interest rates faced by non-banks.

Likewise, depositors would choose to hoard cash rather than pay for the privilege of keeping
their savings in bank deposits.

So interest rates need to be negative but cannot be negative: that is Japan's monetary

policy dilemma. wnat is to be done? The options seem to be:' Do nothing: allow the economy to adjust by itself to cope with the inappropriate levelof interest rates (which is after all what individual countries within the euro zone haveto do);
12 Benjamin Hunt and Douglas Laxton
simulations they report.

13 K. Kamada and K. Masuda (2001)
14 See The Economist, 1 March 2002.

(2001)

adopt an equilibrium reallnterest

rate of 2.2 percentin theDA VIES.• JAPAN'SDEFLA TION AND THE FEASIBILITY OF NEGA TIVE INTEREST RA TES
97' Change forward looking real interest rates by announcing a positive inflation target;' "Structural reforms"' Various forms of "unconventional monetary policy" or "quantitative easing"; i.e.
Iarge-scale BoJ purchases of govemment or corporate bonds, equities, property, foreign
assets;' Getting round the non-negativity constraint by taxing or imposing a negative interest

rate on cash holdings.
The remainder of this paper will consider these options in turnDo nothing: allow the economy to adjust on its own
We should certainly give serious consideration to the option of just doing nothing andletting events take their course. There are self-correcting mechanisms in the economy, which

may on their own return the economy to equilibrium. For regions in a monetary union, thedepression experienced in a region with unduly high interest rates will tend to reduce prices
and costs in that region relative to the rest of the monetary union, and the resulting improved

competitiveness in that region may restore the region's economic health. This is an exampleof negative feedback. This particular mechanism is less relevant in the case of a country

with a floating exchange rate, as the impact of lower domestic prices on competitivenessmight be offset by a movement of the exchange rate.
Unfortunately there may also be positive feedback: the economy may adjust in ways thatmake the original problem worse. It is the possibility of positive feedback that leads to talkof a "deflationary spiral": of deflation feeding on itself. For example, an unexpected fall in
prices may cause expectations of further fall in prices, increasing the perceived real interest

rate, and so further discouraging spending. Falling prices may make banks more cautious
about the value of security on which they lend, so reducing finance for investment. The
increased shortfall of demand relative to supply means prices again fall faster than expected,

and so on.
The relative size of negative and positive feedback effects must depend to some extent
on whether inflation expectations are backward-looking or forward-looking. Some simulations

conducted for the UK economy, using a National Institute's macro-economie model withalternatively backward-looking and forward-looking expectations, showed that, on either
assumption about expectations, the impact of excessively high nominal interest rates would besevere even after the economy had had ten years to adjust. In the case of backward-looking
expectations, the impact of a sustained increase in nominal interest rates on unemployment,
for example, would be greater after ten years than after five years.i5 In this model, at any

15 S, Davies (2000)

KOBE ECOIVOMIC & BUSIIVESS REVIEM, 47 (2002), 93-115

98

rate, the speed of adjustment was too slow for laissez-faire to be an option.

While Japan's current situation may not correspond to an intensifying "defiationary
spiral", as noted earlier there is no sign of Japan's defiation abating of its own accord.

Moreover, the demographic factors that are contributing to weak Japanese domestic demand
will become a still more negative influence over the next decade.

As far as I am aware, the most carefu1 analysis of the relation between Japanesedemographics and domestic demand is that canied out by Smnhers and Co. As this work isdone on a commercial basis for fee--paying clients it is not fu11y available in public, though

Andrew Smithers did give a seminar in February 2002 at the Japanese Research Institute of

Economy, Trade and Industry.'6 He argued there that Japan's "age structure causes theequilibrium savings rate to be 4 per cent of GDP above a steady state. It also causes theequilibrium investment rate to be 3.5 per cent below the steady state equilibrium". The basic
point is that Japan currently has a relatively high proponion of its population at an age whensavings tend to be high, while the prospective low potential low growth associated with afalling labour force is tending to weaken investment demand.

In most countries, people in their fifties have the highest saving rates, as theiremployment income is at or near its peak, and many of their children are financiallyindependent. Saving rates of older age groups are lower, as some people in those age groups
supplement declining income by liquidating assets accumulated earlier in the life cycle. Japan

Japanese population stmcture in 200 1
12,OOO.s'.

.v'i'

10,Ooo/IE'.

ll•//•••
li

g F.

•'

g••

tt

'

l

8 s,ooo

o
9

tt

f'

t;

tF

tt

:

'
'

T

•

s

(

,

j

tt
l'

ff1

Jt

..

tt

tt

l''/

tt

.s

'

;egx.

''

'
../

't.
''

':1tt

l.

.9a 6,Ooo
re

.,-

'
'
s

'

se

'

Sn

tt

'

l

.t/

tt

'

'

tt

P,i2•

'

t. t

,n

t"

'
fltt

'

'

I'.

'

t.'

FF."li

'i

'

'

'

•••

'

'

'

'

t

'

s

;t

t"

fv

l,

8 4,ooo

'

ttt.

\

ltt

'

'

t,

l

t.
tt

ttt

/ifitt

2,ooO

'

'
tt

s

ellt
st
s

'

/ttt

'

tt.

}t
'

'

tt
'

k/ttt

tt
'

tt

-

'

/1•i

tt
"l

l

l'y

'

tt

'

tttxE,

'

/t

ig

I

k tt

tt

tt.t.

,li•

'

'tt

ltLt//..,.

'.'•l
'."

'

'

tt
'
II

.,

Lt't

.,

'
•.

'

;/lt

:

tH't

o

'

tt

tt

si
'htt

,

:.

e
'

25-29 30-34 35--39 40-44 45-49 50--54 55-59 60-64 65--69 70-74
Age ranges

Source: Statistics Bureau Ministry of Public Management, Home Affairs, Post andTelecommunications "Population Census".

16 "Smithers Revisited: The Irrelevance of the Restmcturing Debate" at
http:1!www.rieti.go.jpljpleventsA)bY02020801.html.

tDA VIES: JAPAN'SDEFLATION AND THE FEASJBILITY OF NEGATJVE JNTEREST RA
99 TES

conforms to the general pattern at least to the extent that saving rates rise as people moveinto middle age; but the fall in saving in old age implied by the traditional life-cycle model-- -- --ss- -of consumption is missing. According to Borsch-Supan and Brugiavini, m Japan, savmg
rates increase almost monotonously (sic) with age, such that the effect of population ageing

is similarly monotonou.s. Population ageing puts fewer households in the low-saving age
categories and more households in the high-saving age categories, resulting in higher saving

on an aggregate level"." Just on the basis of demographic stmcture they compute a rise inJapan's household saving ratio of 1.5 percentage points between 1990 and 2020.
Horioka and Watanabe'8 confirm that in Japan desired saving for retirement increases ashousehold heads go through their fifties and into their sixties (and flattens out rather thanfalls thereafter). Nakagawai9 notes that the financial assets of the elderly do not fa11 after
retirement and that their total assets actually increase.

Demographic prospects thus give no reason to expect a spontaneous recovery inconsumer spending. And as Japanese business investment remains high (in relation to GDP)by the standards of other OECD countries,20 while profitability is low, it would be unwise tocount on a rise in Japanese investment from its current rate.

Inflation target

Monetary policies centred on inflation targets have been successfu1 in many countries
since the 1990s. In the decade since an inflation target was first introduced in the UK, theUK has experienced low and stable inflation, jn marked contrast to the experience of theprevious three decades. However, the UK's introduction of infiation targeting was
accompanied by other important changes in the formulation of monetary policy, culminatingsome five years ago in Bank of England independence. And in spite of the introduction oftargets, in spite of the institutional change, and in spite of the actual achievement of low
inflation (in recent years generally below the target) the inflationary expectations of thegeneral public have adjusted only sluggishly to low inflation.2'

Thus the UK's experience with inflation targets provides absolutely no reason to expect

the announcement of a positive infiation target on its own to have a major impact on
inflation expectations and hence on spending, in the absence of other policy changes that

17 A,Borsch-Supan and A.Brugiavini (2001)
l8 C. Y. Horioka and W. Watanabe (1997)

19 S.Nakagawa (1999)
20 For a comparison of business investment rates in the seven largest OECD countries see "Savings and Investment:

Deterrninants and Policy Implications" chapter 4 of OECD EÅëonomic Outlook 70 (December 2001). As of 200e,
Japan still had the highest business investment rate of these seven countries in spite of its low growth rate.

21 See the survey results reported in S Davies and E Harley (2001)

KOBE ECONOAtflC & BUSINESS REVIEM, 47 (2002), 93-115

100

make the target credible. Alan Blinder put it very well in 1999:"I do not see how [a pledge to achieve a moderate inflation target] could possibly workin a country like Japan, where the average inflation rate over the past seven years has been
negligible, where deflation has recently been experienced, and where doubts about the central

bank's ability to stimulate demand have been widely expressed'including at the central
bank! The problem, in a word, is that such a policy pronouncement will not be credible oncea country is already in the soup."22

Structural reforms
There is a long list of factors that are sometimes held responsible for Japan's economic

malaise (male gerontocracy in management, emphasis on rote learning in education, low
standards of English ability, the tradition of arnakudari, the power of the construction lobby,

and so on).2] As these sorts of factors are relevant to the potential output of the Japanese

economy, it is difficult to see what they have got to do with deflation (which reflects
shortage of demand relative to supply). Another candidate for blame is the powerlessness ofthe prime minister and cabinet: this would matter more if it was clear what the cabinet ought
to be doing. Inflation and deflation are essentially monetary phenomena and it is natural tolook for their remedies in monetary policy, not in "structural reforms".

A more promising diagnosis may seem to lie in the weakness of the banking system andthe latent under-capitalisation of banks (if bad debts were properly accounted for). However,while it is clear that the Japanese banking system is in crisis, it is not clear to what extent

the weakness of Japanese banks is currently reducing demand. While bank credit is declining
this does not necessarily mean that credit is supply constrained.

Nakaso2` takes it as read that Japan has experienced a persistent "credit crunch". Someeconomists have found evidence of a credit crunch, related to shortage of bank capital, aroundthe period 1997 to 1998 (though not earlier in the 1990s).25 The obvious way to distinguishbetween supply and demand effects on credit is to look at what has happened to the(risk-adjusted) price of credit. Shortage of capital in the banking industry and barriers to theentry of new capital give banks the power to raise the price of credit and make supra-normal
profits; this excess profitability should continue until bank capital has increased enough tobring credit supply in line with demand. By contrast, low demand for credit (which may becaused by such factors as lack of collateral or shortage of profitable investment projects)
would tend to depress bank profitability, reducing capital in banking until the supply of credit
22 A, Blinder (2000)

23 For a survey onthese lines, see "The Economist", issue of 19th Apri1 2002.

24 H,Nakaso (2001)
25 T. Motonishi and

H. Yoshikawa (1999); D. Woo (1999) G, Hoggarth and J. Thomas (1999)

DAVIES: JAPAN'SDEFLATIONAND THE FEASIBILITY OF IVEGATIVE INTERESTRATES 1Ol

was brought into line with demand. wnile long-term relationships might constrain Japanesebanks' ability to exploit a shortage of capital to increase margins, banks should surely havemanaged to make at least satisfactory profits if credit had really been in short supply for an

extended period.

Recent Senior Loan Officer Lending Surveys imply credit demand remains weak relative

to the supply of credit. Banks report a marked decline in demand for loans from firms(especially small firms)-the main reasons for this fall in demand being a decrease incustomers' sales and a decrease in fixed investment. They indicate an easing of the standards
applied by banks in assessing credit applications (most marked in relation to applications fromsmall firms). And they indicated a marginal reduction in loan spreads for highly rated

borrowers. The main specified reason for easing credit standards is given as "moreaggressive competition from other banks".26

Finally, as noted earlier, business investment remains relatively high in Japan byintemational standards, in spite of low profits. It does not appear to have been constrainedby lack of finance. Whatever micro evidence there may be of failures of credit supply, theoverall picture is surely that there has been too much rather than too little bank lending.

Complete protection of bank deposits (now extended beyond March 2003 for bank sightdeposits) and pressure from the authorities to maintain lending to small firms, together withthe availability of finance from public lending agencies, has generaliy succeeded in preventing

a credit crunch, to the extent that chronically unprofitable firms have remained in businessand banks have been unable to eam an adequate compensation for the risks of lending tothem. Simply re-capitalising the banks now would indeed "be like pouring water into abucket with a hole in the bottom of it".2'"Quantitative easing"
Many economists have argued that even with interest rates at zero the Bank of Japan has

scope for significant monetary easing,2g by buying govemment or corporate bonds, equities,

property, foreign assets, on as large a scale as needed to make an impact. The Bank ofJapan has made some efforts at "quantitative easing" since March 2001, so that the monetarybase actually increased by more than a third in the year to April 2002, but still draws theline at what it describes as "unconventional monetary policy".29

26 This discussion is based mainly on the July 2002 survey, The latest survey can be found at
http:11www.boj,or.jplenlsiryolsiryo-f.htm,

27 The quote is from Japan Center for Economic Research (2002) (Also to be found at
http:1!www.jcer.or.jplenglindex.htm1,)

28 For example, B. Bemanke (2000)
29 See M. Shirokawa (2002)

102 KOBE ECONOIvaC&BUSINESS REVIEM, 47 (2002?, 93-115

Clearly if the Bank of Japan intervened in the foreign exchange market on a massive
scale, at some point the yen would weaken and eventually it would fall a lot. The rest of
the world would require some reward (in the form of future expected appreciation of the yen)

if it was going to hold massively increased amounts of yen at zero interest rates. The yen
would therefore have to fall until it was obviously cheap.

It is not, however, feasible for the Bank of Japan, or for the Japanese government, tofollow this sort of policy. The rest of the world, and particularly America, would not standfor it. Advocates of this policy are simply ignoring the history of "trade frictions" which theJapanese authorities cannot ignore. If a reminder was needed, it was provided when the
recent period of yen weakness quickly led to American calls for Japan to sort out its banking
crisis, rather than rely on a depreciating currency.30 While a weaker yen is likely to be aby-product of any successfu1 policy of monetary easing, it cannot be the main or sole policy
lnstmment.

There would be no such problems of international relations involved in the Bank ofJapan buying a wider range of domestic assets, even on a massive scale. However, the Bankof Japan would argue, quite reasonably, that such a policy would have major fiscal
implications and that it could not undertake it on its own responsibility. The underlying
problem is the risk of potentially massive losses if it acquired land, equities, and bonds on

the scale needed to have a significant impact on the economy. Land, for example, whilecheap by the standards of the bubble era, is still not obviously a bargain in a country facing

a substantial decline in population. Losses on such asset purchases would make the eventual
task of fiscal consolidation all the harder.3i

Getting round the non-negativity constraint on interest rates
As there seems no attractive alternative to cutting interest rates, some way simply has tobe found of getting round the non-negativity constraint. A report issued in March 2002 by
the Japan Center for Economic Research came close to calling for negative interest rates inadvocating a "tax equal to the deflation rate on the financial assets that the government
guarantees... [including] cash...For example, if currency redenomination is carried out with arate of exchange of the new yen being equal to the old 102 yen we can levy a2O/o tax on
cash".32 What is needed to escape from deflation, however, is not a one-off unanticipatedlevy on cash but an anticipated and continuing negative retum on cash.
There is some literature on techniques for making positive interest payments on cash.
30 "O'Neill against relying on weak yen for recovery" The Japan Times, January 24, 2002.

31 When the Bank of Japan announced in September 2002 that it would buy equities from the commercial banks,
it made it clear that this was to reduce risks to financial stability, not to ease monetary policy.

32 Japan Center for Economic Research (2002)

DAVIES: JAPAN'SDEFLATIONAND THE FEASIBILITY OF NEGATIUE INTERESTRATES I03

Following a suggestion by Goodhart,33 there could be an occasional lottery in which somebank note serial numbers attract prizes (rather like the annual lottery in which some of theserial numbers of Japanese New Year greeting cards attract prizes). Winning serial numbers

would be published in the newspapers and winners would present their bank notes at the
local post-office or bank to collect their prize. (The timing of the lottery would have to berandom and unannounced, as a regular or pre-announced lottery would lead to unmanageable

shifts in the demand for cash. For the same reason, ATMs would have to be cleared ofwinning notes immediately after lottery announcements: this would not be impracticable inJapan, as ATMs generally shut down at night.)
A corresponding technique could not, however, be used to impose a negative interest rateon cash. One might, indeed, imagine a lottery in which the bank notes with selected serial

numbers were declared to be void. But those with the unlucky notes would not hand themin and accept their loss. Instead they would try and pass them on to others. Shops could
install technology to detect invalid serial numbers, but this would be expensive, would
prejudice shops' relations with their customers, and in any case there would always remainsome areas of cash transactions where invalid notes could be passed on undetected.

Silvio Gesell and "stamp scrip"
There is, in fact, a scheme for implementing a negative interest rate on cash that was
first proposed in the early years of the last century, attracted the support of two of the mosteminent economists of the century, was put into practice (if only briefly), and judged a great

success. The author of the scheme was Silvio Gesell,3` a successfu1 businessman turned
armchair economist (and, briefiy, Bavarian finance minister, in which capacity he narrowly

escaped execution). He believed a "depreciating currency" would facilitate the economic

management of business cycles, and also bring about what Keynes was later to call the"euthanasia of the rentier". Both Gesell and Keynes regarded this latter state of affairs (inwhich investments with no entrepreneurial input earned no return) as desirable (though

Keynes thought it macro-economically problematic). Gesell believed it was the natural
outcome of capital accumulation and was frustrated only by "non-depreciating currency";
Keynes also saw it as the likely eventual consequence of increasing affluence.

To achieve a negative interest rate on currency, Gesell proposed the introduction of"stamp scrip". The particular feature of scrip was that, to remain legal tender, currency

notes would require to have a stamp attached to it at regular intervals. The note-holder
33 C,Goodhart (1986)
34 An English translation of Gesell's "The Natural Economic Order" can be found at http:lfwww.systemfehler.delenlneol.

Gesell's emphasis on eugenics may be off-putting for the modern reader but was not unusual for the age in which

he wrote.

104

KOBE ECOIVOMZC & BUSINESS REVIEPV, 47 (2002), 93-115

would have to pay for the stamps, thus inctmng in effect a negative interest rate. A good
critique of Gesell's ideas by Hugh Gaitskel135 includes an account of the apparently highly

successfu1 local experiment with stamp scrip in W6rgl, Austria in the early 1930s. Irving

Fisher was impressed by this experiment and by the theory behind it: he became a
propagandist36 for the stamp scrip movement in the US, which flourished briefly before theeconomic recovery ushered in by the New Deal. European scrips were eventually suppressedby central banks as the number of experiments threatened to get out of hand.

Keynes wrote that Gesell's followers had "bombarded" him with copies of the master's
works. For a long time he had treated Gesell's "profoundly original strivings as no better

than those of a crank", but had come to a very different view by the time of writing the"General [[heory".i' By then his verdict on Gesell's proposal for depreciating currency was

one of guarded approval: that it "may carry with it the essence of what is needed". Both
Gaitskeil and Keynes, however, argued that the existence of non-cash fomis of money (bankdeposits etc.) meant that Gesell's proposals (which just covered currency) were inadequate toachieve their purpose. In this they were surely wrong. There is no difficulty in achieving
negative interest rates on bank deposits, provided the interest rate on cash is sufficiently
negative (see further discussion later on).

Finding ways to achieve a "depreciating currency" has hardly been a pressing problem
for most of the post-war period. But the Gesell movement has kept going over the years incontinental Europe and America, and now flourishes on the Internet, along with other"alternative money" movements. In recent years the movement has attracted adherents inJapan: a Japanese Gesell Research Society3g was founded in the late 1990s, and is closely
related to the burgeoning39 Japanese "local currency" movement.

There is actually no necessary connection at all between Gesell's stamp scrip proposal
and local currencies. It is just that no country has tried out the idea with its national

currency; thus all the experience with stamp scrip has perforce been at a local level.
wnatever the spread of local currencies may achieve for individual communities in Japan,
these currencies seem unlikely by themselves to have a significant macro-economic effect. If

people hold a small amount of depreciating currency but still have most of their money ina non-depreciating form, they can spend the depreciating currency quickly without total
35 H. Gaitskell (1933)
36 I.Fisher (1934). US "depression scrips" are now collectors' iterns.

37 J. M. Keynes (1936). Keynes discusses Gesell's ideas in chapter 23 (Notes on Mercantilism, etc.) pp,353-358.
38 Its web site, at http:1/www.grsj.orgl, serves as a sort of alternative economics bulletin board. The site is inJapanese, though there is an automatic translation device on the site, which produces jntelligible English some of

the time.
39 "burgeoning" at least in the number of local currencies, put at 145 in early 2002 by Niklcei Regional Economic
Report, No.385, February 2002 (in Japanese); in many (most?) of these schemes the scale of transactions is verysmall, however.

DAVIES: JAPAN'SDEFLATIONAND THE FEASIBILITY OF NEGATIVE INTERESTRATES 105

spending being affected. To achieve higher aggregate spending, Japan needs negative interest
rates on its national currency.

Is a national version of the sort of stamp scrips issued in the 1930s feasible? If scrip

can be operated in one or two towns, it can in principle be operated in every town. And if
it is feasible to stamp a fraction of the stock of cash, it is in principle feasible to stamp thewhole stock of cash. But clearly regular stamping of all Japanese currency notes would use

up a massive amount of time and resources. There might also be security problems forpeople taking money to and from stamping. Another major issue would be how to secure thetechnique of stamping against forgery.
Of course, even if monthly stamps, say, were required for notes to remain legal tender,

all notes would not be stamped every month. Hoarded notes would need to be brought up
to date only when put back into circulation, and no doubt many businesses would accept
un-stamped notes at an appropriate discount. The negative interest rate on notes would reduce

the amount of notes in circulation, as would the loss of anonymity of cash ownership thatstamping notes might seem to imply. So the scale of the task involved would be very muchless than stamping every month all the current stock of currency notes.

The greatest logistical problem would be the need to convert all of Japan's ATMs,
vending and ticket machines to dispense andror accept the scrip (and to distinguish between

stamped and unstamped notes). This would be a much bigger and more disruptive job thanthe conversion that has just been completed in the euro area. The range of products available

from Japanese vending machines is notoriously wide; while railway and subway tickets arenorrnally purchased from machines in Japan, with the exception of shinkansen ("bullet train")tickets-stations generally do not have the facilities to handle a large volume of manual
ticket sales.

Some modification of legal tender rules would also probably needed to allow banks andperhaps other businesses to discount the value of notes paid to them shortly before stamping

was due. There is also the "problem of small change". Perhaps non-depreciating low

denomination coins could co-exist with depreciating notes; but the higher denomination coins

would need to be replaced by scrip. No doubt there would be other problems with
implementing a stamp scrip in contemporary Japan; but as I intend later to propose analtemative I will leave the list here.

A "modern" version of Gesell
One recent paper sets out a design for a modern version of Gesell's proposal, which
would involve smaller costs than the traditional scheme discussed in the previous section.
The paper comes from an authoritative source: it is the work of Willem Buiter (one of themembers of the Bank of England's Monetary Policy Committee at the time the first version

106 KOBE ECONOMIC&BUSINESS REVIEW, 47 (2002), 93-115

of his paper was written, and currently Chief Economist at the European Bank for
Reconstruction and Development) and Nikolaos Panigirtzoglou, a researcher at the Bank ofEngland.`O

Buiter and Panigirtzoglou analyse cash as a sort of bearer bond that (at present) has azero interest rate and no maturity date. Their idea is that the whole stock of currency would

periodically be replaced by a new issue: the old issue would cease to have any value after
a certain date, indeed after the expiry date old currency might be subject to confiscation

without any compensation. Before expiry, old currency could be changed into new currency
at an exchange rate different from one for one. For example, an old 10,OOO-yen note might

be exchanged for only 9,OOO yen in new notes. If an exchange on such terms were to takeplace every two years, say, the implicit annuai interest rate on currency would be roughly

minus 5.1 per cent. As the whole stock of currency could not be replaced overnight there
would have to be a transitional period prior to each expiry date in which both old and new
currencies were in circulation.

Buiter and Panigirtzoglou's scheme would certainly be less costly to implement than amore traditional scheme that involved physical stamping of notes. But it would still be
costly, involving at each currency replacement the printing and storing of new notes ready forissuance; as well as the reprogramming of all ATMs and vending machines to recognise andaccept the new currency, and to reject (and perhaps confiscate) the old currency after acertain date. Thus at every replacement period there would need to be something like theone-off exercise that has just been conducted in parts of Europe to replace national currency

notes and coin with euro notes and coin (though the educational effort involved would bemuch smaller).

Currency tax via magnetic strip
An alternative proposal, by Marvin Goodfriend, is to impose a tax on currency, using amagnetic strip embedded in each currency note`' to compute the tax due. The strip would
record each time a note was put into circulatjon (issued at a bank counter or via an ATM).

wuen the note was again deposited with the banking system a tax would be levied
proportional to the period the note had been in circulation since its last issuance. Banks
would also be taxed on their holdings of cash.
Suppose the tax was at a rate of 5 per cent a year. If a currency note was in circulation

for two weeks at a time on average, it would attTact a tax of just under O.2 per cent, on
average, each time it was re-deposited. Someone depositing a 1,OOO-yen note that had been

40 W. H. Buiter and N. Panigirtzoglou (2001)

41 M. Goodfriend (2000)

DA VIES: JAPAN'SDEFLATIONAND THE FEASIBILITY OF NEGATIVE I?VTEREST RATES 107

in circulation for two weeks would have his bank account credited with about 998 yen, withthe bank deducting 2 yen to pay on the depositor's behalf to the tax authorities. Goodfriend
suggests that as businesses norrnally deposit cash receipts almost immediately the tax payable

would be small enough for them to ignore. Alternatively they might install machines thatwould read the magnetic strips to calculate the tax due on cash paid to them and charge theircustomers extra to cover the tax due.

The problem with this proposal is that while most notes are returned to the banking
system quickly, not all notes are. At any time there would be some notes in circulation withsignificant amounts of tax due on them. If some businesses install machines to compute thetax payable on notes, those businesses that do not install machines and the customers ofbusinesses that do install such tax-detector machines would find themselves receiving adisproportionate number of the notes that had been in circulation a long time. People paying
cash in good faith to a counterparty who had not installed the necessary machinery might beopen to a subsequent complaint of having passed off a note on which a lot of tax was due(and they would have no way of knowing whether the claim was true).
The underlying point is that, if Goodfriend's proposal was adopted, a 1,OOO-yen notemight really be worth 999 yen, 995 yen, 980 yen or 950 yen, or none of these figures, andthose without a tax-detector machine would not know what the value was. This uncertainty
would greatly reduce the attraction of using cash. Businesses that had installed tax-detector

machines might have an advantage over customers without the machines. But they might alsofind the machines swiftly becoming redundant as cash was displaced as a transactions

medium.
A simpler way of achieving negative interest rates

Buiter and Panigirtzoglou's proposal does not introduce uncertainty about what any
particular note is worth at a given time. One 1,OOO-yen note would always be worth thesame as any other 1,OOO-yen note of the same vintage. However, they do not make clear that
their proposal requires a money unit of account that is distinct from the value of cash. If a

1,OOO-yen note had to be handed in after two years for a new issue of 900 yen, there has
to be a unit of account against which cash would depreciate between issue and conversion.

Supposing a 1,OOO-yen note is worth 1,OOO yen in units of account at time of issue.
With the assumptions used earlier (currency replaced every two years and 1,OOO yen of oldcurrency buying 900 of new currency) a 1,OOO-yen note due to expire in a year's time would

be worth about 949 yen. If at that time I owed you 1,OOO yen in units of account, and weagreed to settle the debt in cash, I would pay you a 1,OOO-yen note, and then another 54 yen

in coins. (A 1,OOO-yen note could obviously no longer be legal tender for 1,OOO yen.) In
other words the proposal severs the link between money in the form of notes (and coins) and108 KOBE ECONOMTC &BUSINESS REVIEM, 47 (2002), 93-115

money as a unit of account.

No less an economist than the late James Tobin has argued that "there must be
store-of-value embodiments of a monetary unit of account".`2 But in fact history records
plenty of examples of monetary units of account that did not have "store-of value embodi-

ments". The Lsd system of money introduced by Charlemagne was originally just a unit ofaccount. In Europe in the Middle Ages units of account ("ghost money") often related tocoins that had disappeared completely from circulation.43 To continue the medieval analogy,
the proposed depreciating currency is a bit like coinage that is subject to continuous clippingand sweating and so is exchanged at an ever increasing discount to its face value.
But if we can live with severing the link between cash and the unit of account, imposing
an interest rate on cash does not actually require all the trouble of having the currency expire

at periodic intervals, or the time and expense of reprogramming every cash and vending
machine to accept the new vintage of currency and reject the old. It is simply necessary forthe government and the central bank to conduct transactions with the rest of the economy onbasis that a 1,OOO-yen note, say, is not worth 1,OOO yen but an amount that changes overtime.

Bank notes and coin are put into circulation when a central bank supplies cash to acommercial bank and are removed from circulation when the cash is returned to the central

bank. When the central bank supplies bank cash to a commercial bank it debits thecommercial bank's account at the central bank, and credits the account when it takes bankcash back.

As the Bank of Japan has a monopoly in supplying new yen bank notes, it has freedom
over the price at which it deals in them (ignoring legal tender rules, which can be changed

to fit the requirements of economic policy). Suppose that the Bank of Japan did not debit
and credit the Japanese commercial banks' accounts with exactly the face value of yen banknotes that it supplied or took back. If accounts were debitedlcredited with less than the facevalue of notes suppliedfreturned, banks would introduce this discount in their dealings with

their own customers. For example, if a bank's account at the Bank of Japan was creditedwith only 950 yen when it returned a 1,OOO-yen note, the bank in turn would be willing tocredit a customer's account with only 950 yen when he deposited a 1,OOO-yen note.

As a supermarket that banked 1 million yen of cash would be credited with only
9SO,OOO yen it would in turn require its customers to pay 1,OOO yen in cash for an item
priced at 950 yen. Customers who settled by credit card (or any form of transfer from abank account) would still pay 950 yen. If the Bank of Japan steadily increased the discountfor cash supplied tolreceived from commercial banks, the gap between shops' accounting

42 J, Tobin (1985)
43 J, F. Chown (1994) pp. 7-19

DA VIES.• JAPAN'SDEFLA TION AND THE FEASIBILITY OF NEGATIVE INTEREST RA TES
109

prices and the cash cost of shop goods would also steadily increase. If accounting prices
were stable, there would, in effect, be infiation in the cash cost of shop goods.

A steady increase in the BoJ's cash discount would be equivalent to a negative interest

rate on cash. Suppose I withdrew money from my account when 1,OOO yen cash was worth
950 yen, hoarded the cash, and then repaid it into my account ten months later when 1,OOO
yen cash was worth 850 yen. I would have lost about 10.50/o, equivalent to an annual interest

rate of around minus 12.5 per cent. I would therefore have been better off keeping themoney in my bank account even if the bank account was subject to an interest rate of, say,minus 10 per cent p.a. I will therefore be willing to accept a minus 10 per cent interest rateon my bank deposit, as long as I need the liquidity the bank account provides.
It might be objected that in this last example it is misleading to talk of a negativeinterest rate on my bank account. Suppose I start the year with 95,OOO yen in my account,and that ifI withdrew all this from my account I would get 100,OOO yen cash. Suppose,
however, I keep it in my bank account,.which is subject to a negative interest rate (minus

10 per cent a year). At the end of the yearIhave 85,500 yen in the account. IfI now
withdraw this from my account I get almost 103,OOO yen cash (if the BoJ's cash discountincreases at the rate assumed in the previous paragraph). So is not the tme interest rate on

my bank account positive (nearly 3 per cent), not minus 10 per cent?

Recall, however what has happened to the cash cost of shop goods while my money
remained in my bank account. Assuming accounting prices were stable, and continuing theassumption about the rate of increase in the BoJ's cash discount, the cash cost of shop goods

has gone up by 12.5 per cent over the year. WhileIcan withdraw almost 3 per cent morecash ifI leave my money on deposit until the end of the year, I wili need 12.5 per centmore cash than ifI had made a cash purchase at the beginning of the year. So my example
implies a negative real interest rate (minus 10 per cent) with zero accounting price inflation,

which would normally be thought of as another way of saying a nominal interest rate ofminus 10 per cent. The trick of increasing the BoJ's cash discount, combined with a negativeinterest rate on bank deposits, would thus succeed in altering the relative cost of current asagainst future consumption, just as it would alter the relative return on equities as against
keeping money in the bank, or on holding dollars relative to holding yen.

A negative interest rate on cash is a necessary condition for a (more than marginally)
negative interest rate on bank deposits, but it is obviously not a sufficient condition. Whatelse would the authorities have to do to cause banks to offer a negative interest rate on

deposits? Even if there were a sharp fall-off in the use of cash, standard central banktechniques of control" would work with negative interest rates, as long as the negativeinterest rate set is smaller (in absolute terms) than the negative return on cash. For example,

44 As discussed in M, Woodford (2000).

110

KOBE ECONOMIC & BUSINESS REVIEM, 47 (2002?, 93-115

if a minus 8 per cent interest rate was applied to commercial banks' balances at the central

bank, with a slightly less negative rate for banks' borrowing from the central bank, theinter-bank market would set very short term market interest rates close to minus 8 per cent,and banks would pay on retail deposits a range of negative interest rates lying between minus
8 per cent and the negative return on cash.

This proposal to sever the Iink between yen cash and the yen as a unit of account may
appear confusing and impractical. How is the Japanese consumer going to react to having to

pay 1,OOO yen, say, for items marked at 950 yen? Actually, the Japanese consumer has
something like this experience most times he goes into a shop, as marked prices (except insome small outlets) are always net of the 5 per cent consumer tax. So for the consumer who
is less than fu11y protNicient at multiplying by 1.05 there is always an element of uncertainty

at the cash till. Of course it cannot be denied that people will initially be confused andperhaps upset by the phenomenon of a 1,OOO-yen note that is not worth 1,OOO yen; but theeducational task required is surely much less than that recently required in the euro area.

Unlike the earlier proposals that involve introducing a new fomi of currency, myproposal would not involve Japanese vending machines etc. all needing to be reprogrammed
simultaneously. As in earlier inflationary times, prices for goods sold in vending machines

would need to be increased from time to time, and this will involve additional costs, butthere would be no reason for disruption to services. Cash registers at checkouts might need

to be programmed to apply an exchange rate between accounting prices and cash prices.
Altematively, in shops where all transactions are carried out in cash, marked prices could besjmply be the cash prices (normally net of consumption tax, as at present).

As with the Buiter and Panigirtzoglou proposal, under my proposal a 1,OOO-yen note,say, could obviously not be legal tender to settle a debt of 1,OOO yen. It might be possjble

simply to do without legal tender: the willingness of the Bank of Japan and the Japanese
government to accept and issue yen notes at advertised rates might be sufficient support forthe currency. (Within the UK, there are no legal tender notes in Scotland,`S but cashtransactions run as smoothly there as in England, where Bank of England bank notes arelegal tender.) If legal tender is required in Japan, then the law would simply have to specify

that a 1,OOO-yen note was legal tender for whatever amount the Bank of Japan wasadvertising at the time as its own rate for yen currency.

Although it involves no insuperable practical difficulty, the proposal made here isundoubtedly controversial and would require protracted debate before implementation. Just theannouncement that the scheme was under consideration would have considerable benefits,
however. There would certainly be an effect on the yen, which would weaken against other
45 Neither Scottish bank notes nor Bank of England bank notes are legal tender in Scotland. Bank of England 1
pound notes were legal tender, but when these notes were removed from circulation, Scotland lost its only legal

tender notes.

DAVJES:JAPA?V'SDEFLATIONANDTHEFEASIBILITYOFNEGATIVEINTEREJSTRATES 11

currencies on the prospect of negative short-term interest rates in Japan. Likewise,
longer-term Japanese interest rates could move into negative territory in advance of the actual
implementation of negative short rates.

Just abolish currency?
If currency is the problem, and the proposal for a depreciating currency seems toocomplicated, then an alternative solution is to do away with cash altogether. James Tobin
once suggested replacing currency with "deposited currency": individuals could hold deposit
accounts in local branches of the central bank, perhaps located in post offices.`6 As Tobinnotes, interest could be paid on such deposits (obviously he would have been thinking interms of a positive interest rate, but if there were no currency but "deposited currency" then anegative interest rate would be equally feasible).

In the seventeen years since Tobin's suggestion, and especially in the last five years,
there has been a considerable literature about whether electronic forms of money are likely

to drive cash to extinction and about the implications of such a development for monetary

policy. The conclusion on the former point seems to be that cash retains advantages overelectronic means of payment in terms of cost, and has further attractions that should ensure
its survival. Krueger, for example, presents data showing the costs per sale for Gerrnan and

US retailers of various payment methods, with cash appearing substantially cheaper thanelectronic measures.`7 ,These comparisons consider the marginal private costs of cash and electronic transactions

methods. Neither they nor the various unsuccessfu1 tests of electronic purses settle whether

it would be optimal for the economy for cash to survive. All they indicate is that cash islikely to survive, assuming that the authorities continue to support it. At least one country
has concluded that it would pay to get rid ofcash entirely. The Singapore Board of Commissionersof Currency, concerned that the total cost of handling cash will reach S$1 billion by 2006,
thinks it "necessary to continue the search for a cheaper medium of exchange". It plans, nodoubt optimistically, to replace cash with Singapore Electronic Legal Tender (SELT) by 2008.`8(One claimed advantage for consumers from the introduction of SELT is that "consumers
could earn interest on unspent SELT". The interest rate could, of course, be negative if
macro-economic conditions required it.)

The Singapore authorities' motives for abolishing cash are not, it seems, related to46 J. Tobin (1985). I am most gratefu1 to Professor Yoichi lwasa of Kansai University for drawing my attention to
the relevance of this article.

47 M. Krueger (2000). . For some further cost comparisons of transactions media, see C. Goodhart and M. Krueger(2001)
48 L. S. Kok, (2002)

112 KOBE ECONOMIC &BUSINESS REVIEPV, 47 (2002), 93-l15

macro-economic policy. But the macro-economic effects of abolishing cash and hence
facilitating negative interest rates would, for a country caught in a liquidity trap, overwhelm
any net savings (or net costs) of replacing cash with electronic legal tender.

Conclusion: not such a 'costly solution for Japan's deflation

To understand Japan's current predicament we can do worse than refer back to Keynes'
prediction of the "euthanasia of the rentier". That prediction was based on some faulty
analysis; in particular, his view of saving-that average saving propensities would rise withincreasing affluence'was sociologically naive. In advanced societies, consumer spending ismostly dictated by competition for social position (children want the same expensjve trainers
as their friends, fathers want a car that is at least as prestigious as their colleagues'). So theease of saving, and the risk of desired saving exceeding desired investment, do not increase
with rising living standards in the way that Keynes supposed.
Japan has, nevertheless, now more or less achieved the stage of "euthanasia of the ren-

-7t -i -- - -+tier , not because of trends m mdividual savmg propensities but because of demographic
change. While all OECD countrjes are facjng some sort of "demographic transition", Japanis exceptional in the rate at which the average age of its population is rising, and possibly
also exceptional in the degree of its citizens' self-reliance.

As shown earlier, there is currently a bulge in the Japanese population in the age group

approaching retirement, and people in this age group tend to have a relatively high saving
rate; at the same time the prospective decline in the labour force is reducing the scope for

profitable investment. In textbook models with "perfect capital mobility" this excess ofdomestic saving would simply be reflected in a current account surplus large enough to fi11

the gap between saving and domestic investment. But Japan's unhappy history of "trade
frictions" is evidence that "perfect capital mobility" is not a very usefu1 characterisation of

the real world."9

It is obviously inefficient for investment with negative returns to go ahead, but there

may be no better altemative, in the absence of an omnipotent planner who could constrain

aggregate Japanese saving to what can be profitably invested at home and harmoniously
invested abroad. Thus far, Japan has partly coped with its excessive private saving byrunning fiscal deficits, including finance for many public investment schemes with large
negative returns. It would be more efficient to crowd in some additional private sector
investment with small (risk-adjusted) negative returns than to continue public investment at its
current rate.
49 There is of course a substantial literature, starting with Feldstein and Horioka (1980), on the "paradox" of thehigh correlation of national saving and national inyestment: this correlation would not be found if capita1 was
perfectly mobile internationally.

DAVIES: JAPAN'SDEF7LATIONAND THE FEASIBILITY OF NEGATIVE J?VTERESTRATES 113

Some may feel that the proposal made here is more drastic than required to deai withwhat may be just a short-terrn, if extreme, cyclical problem. This objection would have force

if it were correct. But Japans demography may require negative real interest rates for a
decade or more. The long-term position may therefore be that if Japan wants to have nearzero inflation it has to have negative nominal interest rates. The implication of not achieving

negative nominal interest rates would be abandoning price stability. Of course, my proposal

would introduce inflation in terms of prices paid for in cash. But it would preserve pricestability in terms of the unit of account.

The proposal made here has some further advantages for Japan. Firstly it would
effectively widen the tax base, by reintroducing a significant contribution from seigniorage.

As average currency outstanding is a little more than the govemment's annual tax revenue, aminus 10 per cent interest rate on cash would be equivalent to more than a 10 per centincrease in tax revenue, if the size of cash holdings was unaffected by the negative interest
rate on cash. Clearly there would, in fact be a substantial reduction in cash holdings, but thecontribution to the public finances would still be important. As Buiter and Panigirtzoglou
note, taxing currency holdings is particularly attractive, as much of the tax will be paid bythose involved in the "hidden economy" and illegal activity.

The proposal may also contribute to restoring the health of the banking system, byfacilitating a widening of margins. At present deposit rates cannot fall below zero and themargins between deposit and loan rates are constrained by the competition banks face from
capital markets (which affects what they can charge their larger borrowers). Put another way,

the liquidity services provided by bank deposits are not being paid for, as they havetraditionally been, through the rnechanism of a deposit rate set well below market rates.
There is a limit to the extent of cross-subsidisation that can be extracted from borrowers,

while banks seem inhibited from making adequate explicit charges to cover the cost of theliquidity services provided by deposits.

The two other recent proposals for achieving a negative interest rate on money (byGoodfriend and by Buiter and Panigirtzoglou) may actually have been counter-productive inthat they have given the impression that a negative interest rate on money, while feasible,

would require expensive and disruptive teclmical change to implement. The latter authors
conclude: "The transactions and administrative costs...would be non-trivial.... These "shoeleather costs" of taxing currency have to be set against the potential benefits of avoiding theliquidity trap. It may take quite a lot of leather to fi11 an output gap." In other words, thecosts of their proposal are high, though the costs of prolonged deflation may be still higher.

My proposal avoids all costs associated with supplying a new currency: no new currency

is required. All that would be needed would be to educate people so that they could
understand the valuation of yen currency under the new arrangement.

KOBE ECONOM]rC & BUSINESS REVIEM, 47 (2002), 93-115

114

References
A.Ahearne, J.Gagnon, J.Haltmaier, S.Kamin (and others) "Preventing DeLfZation: Lessons .fi'om
Japan's Experience in the I990s" FRB lnternational Finance Discussion Paper, Number 729(June 2002)
B.Bemanke "Japanese Monetary Policy: A Case of Self-Induced Paralysis2" in R Mikitani and AS
Posen (eds) "Japan's Financial Crisis and its Parallels to US Euperience" Institute forInternational Economics Special Report 13 (September 2000).
A. Blinder "Monetaty Policy at the Zero Lower Bound: Balancing the Risks" Journal of Money Credit

and Banking (November 2000) part.2 pp.1093-1999

A.Borsch-Supan and A.Brugiavini "Savings: the Policy Debate in Europe" Oxford Review of
Economic Policy Vol.17 No.1 (2001) pp.116-143
W. H. Buiter and N. Panigirtzoglou "Liquidity Traps: Geselrs Solution" in "ReLflections on Economies

and Econometrics, Essays in Honour of Martin Fase", edited by Wim F.V. Vanthoor and Joke

Mooij, (2001) pp.13-58, De Nederlandsche Bank N. V, Amsterdam.
J. F. Chown "A Histo,y of Money" Routledge and the Institute of Economic Affairs (1994) pp.17-19
S.Davies "Business Attitudes to Ene and the Risk to Stability" in M.Baimbridge, B. Burkitt and P.

Whyman (eds) "The Impact of the Euro" Macmillan (2000) pp.177-184
S. Davies and E. Harley "Low InLflation: Implications for the FSA" FSA Occasional Paper No.14 (2001)

M. Feldstein and C. Horioka "Domestic Savings and International Capital Flows" Economic Journal 90(1980) pp.314-329
I. Fisher "Mastering the Crisis: with Additional Chapters on Stamp Scrip" G. Allen and Unwin (1934).

H. Gaitskell "Four Monetary Heretics" in GDH Cole (ed) "PV7;at everyone wants to know about monay"

Gollancz (1933)
M.Goodfriend "Overcoming the Zero Bound on Interest Rate Policy" Journal of Money Credit andBanking, (November 2000) part.2, pp.1007-1035
C. Goodhart "How Can Non-Interest-Bearing Assets Coexist with Safe Interest-Bearing Assets2" British

Review of Economic Issues 8 (autumn): 1-12 (1986)
C. Goodhart and M. Krueger "The impact of Technology on Cash Usage" LSE Financial Markets Group
Discussion Paper 374, (April 2001)

G.Hoggarth and J.Thomas "Mill bank recapitalisation boost domestic demand in Japan2" Bank ofEngland Financial Stability Review, (June 1999) pp.85-93.
C.Y.Horioka "Are the lapanese Sell17sh, Altruistic, or Qynastic.2" The Japanese Economic Review.

Vol.53 No.1 (March 2002) pp.26-54.

C.Y.Horioka and W.Watanabe "MIiy do people save2 A micro-analysis of motives for householdsaving in Japan" Economic Journal 107 (May 1997) pp.537-552
Japan Center for Economic Research "Credibility of Government, Corporate, and Bankt'ng Sectors inJapan" Japan Financial Report No.6 (2002)

B.Hunt and D.Laxton "The Zero Interest Rate Floor and its Implications for Monetary Policy inJapan". IMF Working Paper WPIOII186 (November 2001)
K. Kamada and K. Masuda "Effects ofMeasurement Error on the 0utput Gap in Japan" Bank of Japan
Monetary and Economic Studies (May 2001)
J. M. Keynes "The General Theory of Employment Interest and Money" Macmillan (1936)

DA VIESr JA PAN' SDEFLA TION AND THE FEA SIBILITY OF NEGA TI VE INTEREST RA TES 115

L. S. Kok, Singapore Electronic Legal Tender (SELT) -A Proposed Concept, chapter 6 of The Futureof Money OECD (2002)
M. Krueger "Private Banknote Issue vaithout Free Banking" mimeo September 2000.
Nikl(ei Regional Economic Report, No.385, (February 2002)

P. Krugman "The Return of Depression Economics" Allen Lane (1999)
B. T. McCallum "Monetary Policy Rules and the Japanese DeLf7ation" (paper prepared for March 2002
workshop sponsored by Economic and Social Research Institute of the Japanese Government)
T. Motonishi and H. Yoshikawa "Causes of the Long Stagnation of Japan during the 1990s: Financial

or Real2" University of Tokyo Discussion Paper CIRJE-F-56 (1999);

S.Nakagawa "Mhy has Japan's household savings rate remained high even during the 1990s2" Bankof Japan Research Paper (July 1999)
H.Nakaso "The .financial crisis in Japan during the 1990s: how the Bank ofJapan responded and thelessons learnt." BIS Papers No.6 (October 2001)

M.Shirokawa "One Year Under ` euantitative Easing' "Bank of Japan Institute for Monetary andEconomic Studies Discussion Paper No.2002-E-3 (2002)
L. Summers "How Should Long-Term Monetary Polic7 Be Determined' Journal of Money, Credit andBanking 23 (August 1991) part.2, pp.625-31
J.B.Taylor "Discretion Versus Rules in Practice" Carnegie-Rochester Conference Series on Public
Policy 39: 195-•214 (1993)
A. Thomas "An Exploration of the Private Sector Response to Changes in Government Saving AcrossOECD Cozantries" IMF Working Paper WPIOI169 (2001)
J. Tobin I7inancial Innovation and Deregulation in Perspective Bank of Japan Monetary and Economic
Studies Vol.3 No.2 (September 1985) pp.19-29.
D. Woo "In Search of "Capital Crunch": Supply Factors Behind the Credit Slowdown in Japan" IMF

Working Paper WP19913 (1999)
M. Woodford "Monetaty Policy in a Morld Mithout Money" International Finance 3: 229-260 (2000).

KOBE ECONOMIC & BUSINESS REVIEM, 47 (2002?, 117-141

THE PAST AND PRESENT OF "LOCAL CURRENCIES";
WITH ESPECIAL REFERENCE TO ENGLAND AND JAPAN.

STEPHEN J.DAVIES Kobe University

Abstract
The recent spread of "local currencies" in Japan is considered in the context of earlier local
currencies, particularly in England and Japan, and also of rural Japan's tradition of labour exchange.
The economist can best understand the role for local currencies in relation to the literature on trust and"social capital", using the latter term in the sense now used by Western economists and sociologists
rather than in the sense normally understood in Japan.

JEL CIassiJfication: B59, E42, N13, N15, R51, Z13
Kejywords: local currency, credit, reciprocity, social capital.

Introduction: currency diversity past and present
The years 2000 and, especially, 2001 saw in Japan a remarkable rate of birth of what
are called in Japanese chiiki tsuuka, local currencies. A research report in February 2002i
identified around 150 local currency schemes in operation (mainly on an experimental basis)
with a fimher 50 soon to begin trial. Of those in operation the majority had started since thebeginning of 2001.2

This wave of new local currencies in Japan follows, with a lag of almost a decade, thespread of Local Exchange Trading Systems (LETS) in the UK, Local Energy Trading Systems(LETS) in Australia, SELs in France, and similar schemes with different acronyms in manyother countries, following the original Local Employment and Trading System (LETS) set up
Corresponding Address:
Stephen J. Davies

Research lnstimte for Economics and Business Administration (RIEB), Kobe University

2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501 Japan
E-mail: sdavies@rieb,kobe-u.ac,jp

Phonensax: 81-78-803-7030'
1 Niklcei Regionai Eeonomic Report (2002) (in Japanese)
2 The report did not cover the nurnerous older style `7ureai kippu" types of scheme, discussed later in this paper,

118 KOBE ECOIVOMIC &BUSINESS REVIEM, 47 (2002), 117-141

in British Columbia in the early 1980s. An academic journal (The International Journal ofCommunity Currency Research) was founded in 1997 to cover this subject. In most of thepioneer countries the period of rapid growth in schemes is over, indeed there may be someevidence of decline. For example, perhaps the best-known Australian scheme, Blue Mountain

LETS, which had at one time a membership of over 1000 and covered several hundred
square miles, has effectively collapsed, though efforts are being made to revive it on a muchless ambitious scale.3

In a typical LETSISEL, members perform services for or sell goods to other members
in return not for payment in the national currency but for credits within the scheme that can

only be used to purchase goods and services from other scheme members. Often thecredjtsldebits created in the scheme are measured in a unit of account that has a name withsome local significance; though in some schemes a more generic name is used (such as"green dollars"). The unit of account is normally understood to correspond roughly to aparticular amount of the national currency, though some groups prefer to think of it ascorresponding to an amount of work time. Credits are generally not convertible into nationai

currency though those leaving a scheme may pay off debits in national currency.

At any moment some members in a scheme will have cumulated a net credit, whileothers will have cumulated a net debit. Groups differ in their attitudes to cumulated surplus
and negative balances. The former may be discouraged by some sort of negative interest rate,
the latter, when large and persistent, are sometimes seen as potentially threatening confidence

in the scheme (members who cumulate ever-increasing deficits may be intending to drop outof the scheme without ever repaying the services they have received).

LETS are currently internationally the most widespread form of local currency. (Many
LETS participants would not, incidentally, endorse the use of the term "local currency" or"local money". Some LETS activists see themselves as attempting to make money
redundant, not to add a new money. And economists` also question whether the credits!debitsin these schemes can be regarded as fu1fi11ing the basic roles of money. I shall neverthelesshere use the term "local currency" for convenience, as the term chiiki tsuuka is now sowidespread in Japan.) Apart from LETS schemes there are several other arrangements that
may also be regarded as local currencies, some of which included the circulation of a local

paper money (the best known of these being Ithaca Hours).5 Many accounts of these areavailable, in English6 and Japanese, and I will not attempt a systematic classification, as I am

here more concemed with the general motivation for local currencies than their administrative
details.

3 According to email communications from those attempting the revival.
4 See, for example, the preliminary discussion in M, Fukushige (2002) (in Japanese)

5 See, for example, chapter 5 of D.Boyle (1999)
6 See for example http:/lwww,socsystem.org.uklaesreport/

DAVIES: THE PAST AND PRESENT OF "LOCAL CURRENCIES" I19

Many economists would probably see no attraction in money that can be used within
only a local area, with only a limited number of counter-parties, and to purchase only anarrow range of goods and services. But there are those (mainly sociologists rather thaneconomists) who see monetary history as one of currency diversity, a diversity which has
been suppressed by governments, particularly with the rise of the nation state, but which isconstantly trying to reassert itself. Zelizer argues, for example, that "starting in the nineteenth

century, the American state....taxed thousands of state-issued paper currencies out of existence,

suppressed the private issue of tokens, paper notes, or coins by stores, businesses, churches,and other organisations".' (Rather confusingly for the economist, though, Zelizer also
describes dollars earmarked for different purposes as different currencies: as in the subtitle toher book " pin money, paychecks, poor relief and other currencies".)
Local currencies in medieval Europe.
Cipolla describes an inverse relationship between centralisation of political power andcurrency diversity in medieval Europe:"From the second half of the tenth century onward, in response to a growing demand
for money, ....new mints were built all over Europe. In England, every mint in the kingdom
struck coins in accordance with the standards (fineness and weight) stipulated by the king orby his officers. So although many new mints were founded, this did not result in a plethoraof competing currencies. Things turned out differently on the continent. In Italy andGermany, where the central (imperial) power was conspicuously feeble, each individual town
or prince that possessed the legal right to strike coins proceeded to do so, with the result thatboth countries were quickly swamped with money of all possible weights and alloys. The
situation in France was midway between these two extremes. .... King Louis IX (1266-70)
then proclaimed the principle that "the baron's coin might circulate exclusively within theborders of the barony whereas the king's coin shall circulate throughout the entire
Kingdom."8
While the bill of exchange was developed in this period to finance international trade,

beneath the king's coin and the baron's coin there eventually developed lower level monies
to facilitate small value transactions. Of course, in the medieval village, there would be
limited need for cash, as credit can serve most purposes in a small and stable community, but

in the growing medieval towns, there would be much less trustlcredit between neighbours.

Pastoureau9 distinguishes between counters (in French, jetons) and tokens (Frenchmereaux, Gerrnan Marke). As their name indicates, counters were used (set out on a counting
7 V, A. Zelizer (1997) p.13
8 C. Cipolla (1993)

9 M. Pastoureau (1984)

120 KOBE ECOIVOMTC&BUSINESS I(EVIEM, 47 (2002), 117-141

board) for calculation, before arithnetic using written numbers became widespread in Europe

in the later Middle Ages. Counters were normally made of metal, but stones could be used
(as can be seen by the linguistic connection between the Latin word ealculus (little stone) andcalculate). Counters would obviously have been used, among other things, for counting
credits and debits, so it is not surprising that they occasionally moved from unjt of accountto means of payment, to use as token money; just as coins that were no longer valid asmoney might find use as counters. The counters stmck at Nuremberg were used in Englandfrom about 1328; the fact that they were forbidden from being used as currency by statutein 1335 presumably indicates that they had started to be so used.

Tokens were put into circulation by towns, guilds, charitable bodies, and religious

communities. The most important category was church tokens. These existed from the
beginning of the 13th century. Originally they were paid to canons for panicipation in church
services and were exchangeable for food and clothing. Some canons distributed the tokens to
the poor. Increasingly parishes paid tokens directly to the poor who attended services, or toworkman in retum for services. When the recipients had enough tokens they could convert

then into bread, wme, clothing etc or into coms. Sargent and Velde note that sometimes

redemption was made in cash, and sometimes not by the issuer directly, but by anintermediary who provided the food and then returned the token to the issuer for cash".iO
Towns and other bodies started to issue tokens in imitation of churches. While, originally,

most medieval tokens had a charitable purpose, their usage became more general in the
16th century.

The spread in use was primariiy due to a iack of small change. The reasons for thisincluded the apparent unprofitability of small coin production, and the reluctance of at least

some sovereigns to be associated with base metal. Small silver coins might disappear fromcirculation at times as the market value of silver fluctuated relative to gold. Shortage ofsmall change persisted until the nineteenth century. Cipolla saw the problem as essentially afailure of the authorities to understand or implement the formula for "a sound system offractional money: to issue....small coins having a commodity value lower than their monetary
value; to limit the quantity of these small coins in circulation; to provide convertibility withunit money.... In England it was not applied until 1816, and in the United States it was not
accepted before 1853".i'

One particular class of late medieval "local currency" was siege money. The maineconomic problem experienced in a besieged city would obviously normally not be a shortageof money, but an increasing shortage of goods and consequent inflation. Nevertheless, on
numerous occasions, token siege moneys were issued, primarily to pay troops. Leather and

10 T. Sargent and F, Velde (2002), p,2I7, I have drawn other information from this book for this part of this paper.

11 Quoted by Sargent and Velde, from C. Cipolla (1956)

!r PRESENT OI7 LOCAL CURRENCIES 121
it
DAVIES: THE PASTAND

paper money was used as well as base metal tokens. These were to be redeemed for gold andsilver money once the siege was relieved-if it was.

Monetary shortage and monetary diversity in England

As the use of token moneys becarne widespread they provoked varying degrees ofrepression from the authorities. In England policy fluctuated but was generally less repressive

than elsewhere. According to Craig,i2 shortages of coin had been exacerbated in the second
half of the sixteenth as "the tiny farthing had ceased entirely, and the halfpenny virtually, tobe struck after Edward VI. Scarcity of change bred private substitutes of lead, brass, copperor even of `paper or stuff'. In London alone unauthorised tokens for farthings were reckoned

to be issued by 3,OOO tradespeople to an average yearly amount of5 pounds apiece." In 1582,
Elizabeth I allowed Bristol to issue Iead tokens to be current within 10 miles of the city.

Elizabeth's successor, James I in a proclamation of 19 May 1613 referred to the use of
token currencies and the reasons for them:"Whereas there hath been in times past some toleration in this Our Realm of Tokens
of Lead....to pass between Vintners, Tapsters, Chandlers, Bakers and other the like Tradesmen

and their Customers, whereby such small portions and quantities of things vendible as thenecessity and use specially of the poorer sort of people doth oftentimes require may be
conveniently bought and sold without enforcing men to buy more ware than will serve for
their use and occasions; inasmuch therefore as the use of Farthing Tokens hath itself a good

end, tending to parsimony and to the avoiding of waste in petty contracts and pennyworths;
in which respect it cannot be but aa great comfort to the poorer sort of the People."
James made an issue of official farthing tokens to replace the private tokens. These were
specifically not legal tender; no one was required to accept them in settlement `otherwise thanwith their own good liking'. Craig notes that in 1624 the Council had to issue a reminder thatthe tokens were not legal tender and prohibit even their offer for more than two pence at atime.

It was the English Civil War of the 1640s that ushered in the great age of the private
token. The Puritan revolutionaries disapproved on principle of base coin and prohibited thefarthings in 1644. With the execution of the king in 1649, there was for more than a decadeno sovereign to worry about any impiied derogation from his sovereignty.

One English city where much token issuance was seen was Oxford; according to
Leeds,'3 there were in total 70 Oxford issuers in about two decades starting in 1652. Minutes

12 J, Craig (1953)

13 ET.Leeds (1923)

I22

KOBE ECONOMirC & BUSINESS REVIEM, 47 (2002), 117-141of the Oxford City Council for 10 August 1652 record the initial decision to issue tokens:"At this Council it is agreed and desired that there may be tokens made with the City

Arms upon them and that the same tokens shall be delivered out after the rate of one andtwenty shillings in tokens for twenty shillings in silver. And that hereafter when commandshall be given for calling them in again that the City shall receive them back at the same rateof one and twenty shillings in tokens for twenty shillings in silver. And that Mr Mayor andthe Thirteen be desired to make such Quantity as they in their Discretion shall think fit forthe benefit ofthe City." (note that I have modernised the spelling of the originaZ document)

Minutes of 14 August recorded spending 20 pounds on making tokens; eventually 12
varieties of City token were struck. It was a cheap way of obtaining credit for the City as

they would (according to Leeds) have been able to strike around 100,OOO farthing tokens(i.e. about 104 pounds worth) for 20 pounds.

LocaJ tradesmen quickly followed the City Council into the issuance of tokens. Fivemonths later the City reacted: Council minutes recorded for 24 January 1652 (1653 in the
Gregorian Calendar, not adopted in England until a hundred years later) that it was "agreed

that no tokens shall be passable in this City from party to party, or in exchange of money
within this City, but such only as shall be set forth by thjs City. Except only as shall be set
forth at any time by the Keepers of the Liberty ofEngland by Authority ofParliament". The City
Council did not succeed in establishing a monopoly on token issuance within Oxford, however.

The restoration of the monarchy at the beginning of the 1660s eventually led to the
curbing of token issuance, with private tokens banned in 1672 by royal proclamation. The
diarist John Evelyn wrote: "The tokens which every tavern and tippling-house in the days ofanarchy amongst us presumed to stamp and utter for immediate exchange as they werepassable through the neighbourhood, which, though seldom reaching further than the nextstreet or two, may happily in after-time come to exercise and busy the learned critic what
they should signify, and fili whole volumes with their conjectures.".i`

Production of tokens resumed on a substantial scale in the eighteenth century. Craig

mentions an issue by the Anglesey Copper Company in 1787 of a penny, with the head ofa druid for effigy, which bore their name and could be exchanged for reai money at any of
their offices. The variety, like the quantity, of traders' tokens was immense. One commercial

traveller who worked Chester carried fifty designs in his sample box. The final surge of
token issuance was around 1809. Tokens for copper money were again prohibited by statutein 1817, with some years' grace for those issued by Sheffield from 1812 to 1817 and by the

Birmingham Poor Law Authority from 1811 to 1815.
Meanwhile the eighteenth century in England had seen the widespread use of anotherform of (much higher valued) local currency. Between roughly the 1750s and 1840s, private

l4 Quoted in G, Williamson (l970)

{t AND PREISENT}}DAVIES: THE ,PAST
OF LOCAL CURRENCJES

bank notes issued by English country banks became an important means of payment inEngland, generally useable only in the locality where they were issued.i5

There are various reasons why local bank note issuance developed as it did in Englandin the eighteenth century. First was that in 1708 the Bank of England was given by law amonopoly ofjoint stock banking in England and Wales; the monopoly continued until it was
abolished by legislation in 1826 and 1833. In this period English banks could be owned by

no more than six partners, which precluded the development of nation-wide banks. (Bycontrast the Bank of Scotland had no such monopoly in Scotland, and national note-issuingbanks emerged.)

Meanwhile the Bank of England was content to remain in many respects just the"Bank of London". Its notes did not circulate in substantial amounts far beyond the London-according to Pressnell "a radius of about thirty miles was sometimes cited....They were, inany case, of too high denomination for many purposes until the Revolutionary wars, and they

had the further disadvantage that they were payable only in London".

An anonymous Proposals for National Banks issued in 1696 had suggested a "truly
National Bank" in London with a network of branches. But there was no interest in branches

in the Bank of England's Court. The Bank of England's historiani6 notes that the Bank of
Scotland, established in 1695-6, had opened four branches; but two closed by end of 1696

and the other two by 1698. In 1719 Law's banque royale opened branches in the chief
French cities and got its notes circulated in every province of the kingdom. But its
subsequent collapse and Law's disgrace would have discredited all aspects of its organisation.

According to Pressnell, significant growth in the number of country banks started fromaround 1750. Growth in country banks became really marked from the 1780s. One source
records 119 banks in England outside London in 1784; this almost trebled over the following

decade and showed further rapid growth in the early 1800s. The 1844 Bank Charter Act
forbade any further increase in volume of private issues. The last private issue ceased in
i921, when the last issuing bank taken over by Lloyds Bank.
Pressnell puts great emphasis on shortage of alternative means of payment as the driving

force behind local note issuance. The "first group of bankers consisted of entrepreneurs

whose approach to banking was strongly influenced by need to provide a local means of
payment.... The industrial bankers would have been of smaller importance if the Mint and....
government had met their responsibilities for providing the country with an adequate currency.

Silver issued was undervalued and driven out of circulation.... During the whole of theeighteenth century the quantity of sliver coined was less than 6 per cent of that struck
between 1558 and 1694.... Copper coinage was so unsatisfactory....that practically none was

15 The classic source on this subject, which I quote extensively in this section, is L. Pressnell (1956)

16 J. Clapham (1944)

123

124

KOBE ECONOMIC & BUSINESS REVIEM, 47 (2002), 117-141

issued after 1754.... For larger payments, currency provided officially was hardly moresatisfactory. More by accident than design the country was effectively on a gold standard
from 1717, but fluctuations in market ratios, especially during war-time, drove the metal tothe melting-pots, or subjected the coins to sweating and clipping; before and during theSuspension of Cash Payments the divergence of mint and market prices of gold was so great
as to drive it largely out of circulation and out of the country.... A solution to the shortageof currency by the provision of a nationally controlled note-issue was rejected, practicallyfrom its foundation, by the Bank of England, which confined its activities to the London
market.... Until the French wars (1793-1815) the smallest note was for 10 pounds; even whenthe Bank began to issue smaller denominations-5 pounds in 1793 and 1 and 2 pounds in
1797-the country's needs were not really met, because Bank of England notes were very
easily forged and treated with great suspicion.

Thus the currency was in an unsatisfactory, even lamentable condition throughout theIndustrial Revolution. Entrepreneurs were gravely handicapped; they required means of
payment ....above all for workers' wages; but the monthly (or longer) settlements and bills of

exchange that would do for other traders would not suit most workers, who required regular+ -- p)payment in readily acceptable money of low denomination .

According to Pressnell, at their peak the country bankers provided about as much of
England and Wales' currency as did the Bank of England and the Mint. In 1805 the Earl ofLiverpool was complaining that "if a traveller passes from one district to another, he must

provide himself with the Notes of other Bankers which have credit within the district onwhich he is entering; and an inconvenience to which travellers have hitherto been subject, in
passing from one small independent state on the continent to another, is experienced by those
who travel through Your Majesty's dominions, in passing from one district to another".i'

The local bank notes were, of course, fu11y convertible into gold sovereigns by theissuing bank. But that did not make them acceptable outside the area of operation of theissuing bank. People were not willing to accept the notes of an unfamiliar bank, whosesoundness they would not be in a position to judge and whose genuine notes they would inany case be unable to distinguish from forgeries.

One other feature of monetary diversity in England, although it is not an example ofa " local currency", was the widespread use of foreign coin. Isaac Newton in a letter of 1717

records that "foreign coins abounded in England" including "dollars of Scotland", "lewidors

of France" , and "Portugal Moydores". A contemporary noted that in 1713 there was nomoney in Exeter and the other cities of Devon and Cornwall other than Portuguese gold.i8
17 lst Earl of Liverpool A Treatise on the Coins of the Realm (1805) reprinted in John R. McCulloch, ed. A SelectCollection of Scarce and Valuable Tracts on Money New York, Augustus M. Kelley (1966 [1856]); the quote isfound in M. Rowlinson (1999)
18 Referred to in M. Rowlinson (op cit)

is
DAVIES: THE PAST
AND7}PRESEIVT OF LOCAL CURRENCIES 125

This simultaneous circulation of a number of currencies was quite normal in Europe. Braudel
records that "In 1614, 400 different currencies were circulating in the Netherlands; in France,at the same time there were 82."i"The historical privatellocal currencies in Engtand that we have discussed so far havebeen in the main responses to shortage of money. A final historical example is a purely
political or idealistic construction, and a forerunner of the modern "time-dollar".

Robert Owen argued in his Report to the County of Lanark for the creation of a new
standard of value and basis for credit - foreshadowing the system introduced later in his
Equitable Labour Exchanges.20 "The natural standard of value," he wrote, "is in principle--r} powers of men called into action. He
human labour, or the combined manual and mental
called for the practical application of this principle. "The average physical power of humanlabour can be ascertained; and, as it forms the essence of all wealth, its value in every articleof produce may also be ascertained, and its exchangeable value with all other values be fixedaccordingly; the whole to be permanent for a given period." ...."That which can create wealthis, of course, worth the wealth it creates. The producer should have a fair and fixedproportion of all the wealth which he creates." All articles must be exchanged at "cost" , in which Owen apparently includes interest on capital, through a "convenient medium

for expressing labour value".... The new standard would "benefit the landholder and capitalist

as well as the labourer" by eliminating the risks due to commercial fluctuation and the evil

system of "buying cheap and selling dear".

These ideas were finally put into practice when in September 1832 the National
Equitable Labour Exchange began business in large premises in Gray's Inn Road. The new
currency of "Labour Notes", which he issued from the Exchange, was the expression of the

new measure of value. For a time the Exchange seemed a success, despite a tendency toaccumulate an excess of goods that were overvalued in the labour standard relative to normal

market value. In December 1832 a branch was opened for South London. A similar
establishment in Liverpool followed soon after, and other branches and independent exchanges

sprang up elsewhere. The "Labour Notes" for a time vvere fairly widely accepted in London,
not only by supporters of the new system, but even by ordinary tradesmen.
In 1833 a branch was set up in Birmingham, and for a time this too was successfu1. But
by the middle of 1834 business at both centres had considerably fallen off. The Birmingham
branch wound itself up, paying all its debts in fu11, and sending a small surplus to the local

hospital. The London body was a rnore serious failure, and Owen lost all the money he had
spent on its development.

19 F.Braudel (1982) p.196
20 I have taken the account of Owen's ideas and the labour exchange experiment from G. Cole (1966) p.223ff

prime

126

KOBE ECONOMIC & BUSINESS REVIEPV, 47 (2002), 117-141

Monetary shortage and monetary diversity in JapanThe currency arrangements that developed in Japan during the Tokugawa Shogunate(1600 to 1868) had some superficial resemblance to those in England in the country-banking
period of the late 18th and early l9'" centuries. That is to say, a national (but inadequate) goldand silver coinage coexisted with local paper currencies (which were in principle fu11yconvertible into the national coinage but were not generally useable outside their area of
issuance), and with copper coins used for small local transactions.

There were also some major differences, however, starting with the political context.
Japan was not fu11y unified in this period: the local rulers had a considerable amount ofautonomy. Thus Morishima2i can even write as if the Meiji restoration was on par with theunification of Germany: "The unification of Germany was achieved in 1871, but that ofJapan came earlier, in 1868". The local paper moneys were issued not on the initiative ofprivate banks but (after some initial private issuance) by the rulers of local domains (hans)
who forced the use of paper money (hansatsu) on their subjects. In rural villages (mura) rice

was also used as a general means of payment in this period. (Samurai salaries were paid in
rice; and taxes were payable in rice until the Meiji restoration. Indeed in the more remoterural areas, rice was still used as an intra-village means of payment until around the middleof the twentieth century.) In the feudal villages of the Tokugawa period, direct payment forservices and local products was less common and reciprocity much more important than in
England at the same period.

In medieval Japan, rice and fabrics had been commonly used as a medium of exchange
after the government ceased the mjntage of coins in 958 A.D.22 Durjng the 12th and 13`hcenturies, with no domestic currency, a large amount of Chinese coins were imported bywealthy merchants and samurai groups. These imported Chinese coins came to be used as a
medjum of exchange throughout the country, and constituted the mainstay of the Japanesecurrency for a long time to come. It remained practically unaltered for the next 500 years,
until the early 17th century, which was the beginning of the Edo period.

On taking power in 1600, Ieyasu, the first Tokugawa Shogun, monopolized the right toissue coinage; he started to issue gold and silver coins in 1601. From 1636 copper coins
were minted in large amounts. Nevertheless in the early years of the Tokugawa Shogunate
there was a chronic shortage of transactions media. Shimbo23 notes that while there were an

increasing number of transactions that were too small for the use of gold coins, more thanfour-fifths of the silver coinage minted in the seventeenth century flowed abroad.

The first paper currency issuance was private notes. Japan's oldest paper currency was
21 M. Morishima (2000), pp.121-122
22 According to M, Senoo (1996)
23 H. Shimbo (1972) pp,1-37 (in Japanese)tt PRESENT OF LOCAL CURRENCIES 127
DAVIES: THE {{PASTAND

the Yamada Hagaki, issued from around the end of the 16`h or beginning of the 17`h century
in the Ise area, the site of Japan's major Shinto shrine, and hence of much pilgrimage andassociated commerce. Shimbo lists sevefi examples of further private note issues in the period

up to around 1640, all in different parts of the Kinki region, which was then the commercial

centre of Japan. In all these issues the largest denomination note was equal to 1 momme (asilver coin whose weight, 3.75 grams, was roughly half that of a contemporary English
shilling); several of the issues also included smaller denomination notes, as low as 1 fun(one-tenth of a momme). The private note issues were backed by silver.
The first hansatsu note issues were in Fukui in 1661 (near the area where private paper

money issuance had developed, but on the north-facing side of the country, where commerce

was less advanced). Shimbo notes as a general feature of 20 hansatsu issues over the two
decades from 1661 that use of paper money in this period spread out from the economicallymore advanced areas into other parts of Japan. Another feature was the issuance of muchhigher denomination notes. The largest denomination note in the Fukui issue was 100
momme (100 times the largest denomination note of the earlier private issues), while a

Tottori issue in the following decade included a 2000 momme note. Although very small
denomination notes were also issued, there were thus already signs that the motivation fornote issuance had shifted from just making good a shortfall in small value transactions media.

Use of the hansatsu was soon generally made obligatory within the issuing hans. For
example, in Tokushima a decree of 1681 made the local notes, first issued in the previous
year, compulsory in all transactions for more than 2 fun. Travellers from other parts of Japan

were also required to use the local notes within Tokushima. Gold and silver coins were used
for payments between different hans. Thus rather than local notes used together with specie(the situation in England under country banking) the arrangement was, as Senoo points out,
more analogous to separate "national" currencies (the various hansatsu) with specie held inreserves used to settle "international" transactions between hans.
The hansatsu continued in use until the Meiji restoration, apart from a period starting in

1707, when the central Tokugawa government barmed them and required the han rulers toconvert the paper notes back into specie. While some han rulers had fu11y backed their noteissuance and were able to meet this requirement, the 1707 ban exposed others who had
over-issued. For example, the Hiroshima han, which had first issued hansatsu in 1704, wasable to convert only 400/o of the stock of paper notes back into silver when the ban on

hansatsu was announced in 1707.
The ban on hansatsu issuance was revoked in 1730-at least partly in response to severe
deflation: the silver price of rice had fallen by almost half in the second half of the 1720s.
Subsequently, and especially as the economic difficulties of Japan's feudal system mounted in
the first half of the nineteenth century, over-issuance and consequent depreciation of hansatsu

was widespread, although in some areas issuance was restrained and the local notes held

128 KOBE ECONOA`flrC & BUSIIVESS REVIEva, 47 (2002), 117-141'
their value. At the time of the Meiji restoration the total value of hansatsu in Japan was
equal to about a third of the value of gold coins in circulation. They were finally withdrawn

as part of national currency reforms in 1871. (However, in 1877, the eight month Satsuma

rebellion in South West Japan led by Takamori Saigo saw the renewed issuance of local
notes: a sort of "siege currency". Special currencies were also issued for use by Japanese
armed forces in subsequent military campaigns in the nineteenth and twentieth centuries, forexample in wars agajnst Chjna and Russia.)"Shortage of money" and the new local currencies
When one diagnoses a country or region as suffering from a "shortage of money", one
can be referring to two (almost) distinct problems. There may be a shortage of the meansof payment; in a similar sense, a millionaire who has left his wallet at home can be "shortof money". Or there may be a shortage of credit: governments, fimis or individuals being

unable to spend because they do not have realizable assets and cannot borrow. (These
categories of shortage are not completely unrelated: the availability of one-to-one credit

disposes of the need for means of payment.) Shortage of small change is a very clear
example of shortage of money in the means of payment sense. One can see paper money inJapan under the Tokugawa Shogunate as originally addressing a shortage of money in thesense of shortage of means of payment, but later and increasingly addressing the hans' needfor credit.

When a country's means of payment consists only of specie there may be situations inwhich the authorities can do to little to ensure an adequate supply of means of payment; butwith modern fiduciary currency there is really no reason why there should ever be a shortageof money (in the sense of shortage of means of payment) in an otherwise sound economy.
In the UK, Ithaca (and elsewhere in the United States), France and Japan, to mention justfour of the countries where many local currencies have been set up, central banks may affectdemand for cash by changing official interest rates, but they supply all the cash that the
public demands (and also adjust the composition of the supply of cash to demand), so thatshortage of the transactions medium should not arise. (Shortage of small change was,however, a significant problem in Italy less than thirty years ago: telephone tokens, andsometimes sweets or cigarettes, were used to supplement the inadequate supply of low value
coins.)

Thus if local currencies are to alleviate a shortage of money it must now be in the senseof creating additiona! credit, not of creating a transactions medium. It is quite clear that

LETS systems do, in fact, create credit. wnen X performs a service for Y, paid for by anegative entry in Y's LETS account and a corresponding positive entry in X's account, thatis credit creation. Likewise Ithaca Hours and other schemes that use local paper money)1
ti AND PRESENTDAVIES: THE PAST
OF LOCAL CURRENCIES

create credit when that money is put into circulation. Not only do LETS groups create credit
but they may also be better than the established credit institutions at assessing who is worthyof access to credit (through membership of the LETS group).
However, the need for micro-credit cannot it itself warrant the creation of local moneys.
Locally based micro-credit provision is feasible without local currencies; and credit provided

would generally be more usefu1 to the recipient if in the form of national currency than ina currency whose use is limited. Moreover LETS schemes are not generally able todifferentiate in the amount of credit available to different members, and the amount of credit

actually extended to members is a consequence of the transactions those members undertake,not a consequence of an assessment of what amount of credit each member is good for.
Locally based micro-credit provision may thus be done more efficiently by micro-credit
institutions, rather than through a LETS scheme, (Schemes such as Ithaca Hours are more
flexible than LETS in this respect, as the local money can be created by the extension ofdifferent amounts of credit to selected participants.)

The increase in credit provision with some forms of local money, however, is not
micro-credit extended to individuals, but credit extended to local government. This wasclearly the case with the hansatsu, and with some of the stamp scrips of the 1930s. LETS
schemes do not create credit for local government, but some of the types of local currencies

seen in Japan (where NPOs pay for volunteer services by issuing a local currency, forexample) do in effect create extra finance for local govemment sponsored activities.

LETS in the UK
In the UK the number of LETS schemes increased rapidly in the early to mid 1990s; but

there is little evidence of their having a significant direct economic impact. The most
up-to-date and comprehensive evaluation of LETS in the UK is provided by Aldridge, Lee,
Leyshon, Thrift, Tooke and Williams2` (all members of university geography departments in

the UK). Based on replies to a postal questionnaire, they estimated UK LETS membershipat a little under 22,OOO (out of a total UK population of almost 60 million), and annual LETS

turnover in the whole of the UK as 1.4 million pounds (compared with GDP running at close
to 1,OOO billion pounds).

AImost a half of survey respondents (49.4 per cent) said they had joined LETS for
economic reasons (to trade); 22.9 per cent for social reasons (to make new contacts, toimprove their local community etc.) 25.2 per cent for ideological reasons, and 2.5 per centto improve their employability. Thus the most common reason for joining LETS is strictly

24 T. Aldridge, R, Lee, A, Leyshon, N, Thrift, J, Tooke and CC. Williams (2001); available at
http:!!www.geog.le.ac.uklijccr!vo14-6!5toc.htm

I29

130

KOBE ECONOMTC & BUSINESS REVIEM, 47 (2002), 117-141

economic, notwithstanding the evidence that the actual scale of resulting economic activity issmall.

Since the change of government in 1997, considerable policy interest has focused in the

UK on the problems of social exclusion and financial exclusion. (While the "sociallyexcluded" are those who have dropped out of norrnal sociai life,2S the "financially excluded"

are those who do not use the most basic financial products.) The incoming government
created a "social exclusion unit" within the cabinet office to co-ordinate policies affecting

social exclusion across govemment departments. The newly created Financial Services
Authority commissioned research into financial exclusion in relation to its consumer protection

and consumer education objectives.
The research on financial exclusion concluded that while the interest-free credit provided

by LETS was potentially of benefit to those on low incomes, in practice the benefits hadturned out to be small. Many of the most basic goods and services were not available
through LETS, while the most marginalized groups were generally not panicipating in LETS.26

Aldridge et al.2' were more positive about the contribution LETS can make to reducing
social exclusion. They found that LETS membership is "heavily skewed towards the sociallyexcluded". And they note that, while only 5 per cent of their respondents said that LETS had

directly helped them gain formal employment, many more had seen their employability
improved by participation in LETS. 27 per cent of respondents (33.3 per cent of unemployed
respondents) said that LETS participation had boosted their self-confidence, while 15 per centof respondents (24.3 per cent of unemployed respondents) had acquired new skills. On thebasis of this, and fttrther interviews, they concluded that "LETS....provide a usefu1
springboard into employment and self-employment for a small but significant proportion ofmembers".
While there is something in what Aldridge et aL argue they are probably overstating

their case. Peacock notes that LETS membership (in UK and Germany) is biased "towards
those in gainfu1 employment and those who are well educated and well off'. In Germany"less than 50/o of members in over half of the 25 LETS which responded to [his] request
for information were unemployed".28 Research in the UK shows that many of the unemployed
members of LETS schemes are well-educated dropouts.

Local currency arrangements other than LETS are not very common in the UK. Edgar
Cahn, the America originator of Time Dollars,29 hints at some hostility to his variety of local
25 The UK govemment explains that "social exclusion is a shonhand terrn for what can happen when people ofareas suffer from a combination oflinked problems such as unemployment, poor skills, low incomes, poor housing, highcrime environments, bad health, poverty and family breakdown'1 http:!lwww.socialexclusionunit.gov.ukl

26 In or out2 FSA (2000) p.82
27 op. cit,

28 MS. Peacock (2000)
29 See, for example, D.Boyle (op. cit) passim

{c AND PRESELNT}}DAVIES: THE PAST
OF LOCAL CURRENCJES

currency: "On my visits to the UK, proponents and organizers of LETS have been cordial
but guardedly ambivalent. They challenged the intrusion of Time Doltars into their world,

asking: "Why do we need still another currency? What can `your currency' do that ours

can' t do as well or better?"30 Thus conclusions about the significance of all types of local

currency in the UK would not be materially different from conclusions about the impact of

LETS.
Modern local currencies in Japanwnereas in the UK the local currency scene is now almost monopolised by LETS, incontemporary Japan there are three distinct local currency "schools", and within these also

considerable variety. Numerically the most important, and by far the longest established,though not acknowledged by some Japanese writers on local currencies, is what Lietaefi calls"Japanese Healthcare Currency" and Fukushige]2 calls "network-style local currency". In
these schemes, volunteers earn credits in proportion to time spent helping the elderly or
disabled. They can save these credits for eventual use when they themselves need help, orthey can transfer them to someone else. There is also often some limited scope forconverting credits into yen. Where schemes have branches in different regions of Japan, those
who have moved from rural areas to the cities may be able to look after their ageing parents
by proxy: i.e. doing voluntary work and transfening their credits to their parents.

This type of arrangement, also known as the "Exchange Ticket System" Urureai kippu
seido), dates back to at least 1973 in Japan, when Teruko Mizushima founded the Volunteer
Labour Bank. Fukushige identifies 535 localities in Japan where this type of currency is operating.

The two other local currency "schools" are much more recent, and have both contributed
to the upsurge in new currencies since tparticularly) 2001. 0ne of these is the "ecomoney"

movement associated with Toshiharu Kato, a former senior MITI official who became
interested in local currencies during a posting at the Japanese consulate in San Francisco.

wrile acknowledging the influence of LETS on his ideas, Kato has presented ecomoney as
his own distinct invention. He has seen it as primarily a way of rewarding voluntary work,and has argued for keeping a distance between the "volunteer economy" (using ecomoney)

and the monetary economy (using normal money), It is not, he has said, the purpose of
ecomoney to stimulate the local economy (in contrast with LETS, which should at least in
principle provide the means for stimulating transactions in goods and services that are also

traded in the normal cash economy).33
30 E, S. Cahn (2001); http:1/www.geog.le.ac.ukfijccrlvo14-615toc.htm

31 B.Lietaer (2001)
32 op. eit.

33 T. Kato (2000) (in Japanese) pp.57-8

131

132

KOBE ECONOMTC & BUSI?VESS REVIEM, 47 (2002), 117-141

In practice, some of the local currencies involved in the ecomoney movement cover arange of transactions that go well beyond volunteer activities.3` And Kato himself has

recently published a paper35 under the auspices of the Japan Productivity Center for
Socio-Economic Development that argues for using ecomoney as a means of escape fromJapan's deflation. (Though, in fact, the mechanisms for economic revival that he describes in
the paper relate more to micro-credit than ecomoney.)
The third local currency school (which Kato recognises in his recent paper as "ecomoneyin the broad sense") is more obviously inspired by local money movements in Europe andAmerica.36 It is also intellectually related to the Gesell Research Society Japan.3' It was givena great boost by "Ende no yuigon" (Ende's Last Message), an NHK television programme
first broadcast in May 1999, in which interviews with the dying German writer about thenature and significance of money were interspersed with discussion of the ideas of Gesell andother "alternative" thinkers, the history of stamp scrip and other modern local currencies.
Much of Ende's message was essentially an ethical argument against usury, a way of thinking

that goes back to Europe's Middle Ages, when usury was regarded as a mortal sin. Indeed,

one of Ende's parables about the theft of time echoes a medieval attack on usurers.38(Incidentally, as the interest rate on a savings account in Japan at present is unlikely to bemuch in excess of O.Ol per cent a year, concern about usury does seem rather anachronistic.)

The timing of the upsurge of new local currencies in Japan seems more clearly related

to this television programme than to any other factor. Some local currency groups holdregular screenings of the video of the programme, particularly for the benefit of new

members. A book based on it was published in early 2000,39 and there has also been asequel television programme, as well as many repeats of the original.
It is too early to get any idea of the eventual economic impact of these new currencies.
While in a few cases they are financing quite large value transactions (such as purchases ofsecond-hand cars and computers) and creating significant amounts of credit (up to \400,OOO
34 A list of local currencies (tota11ing around 60 as of mid-September 2002) is available (in Japanese) on Kato's
website http:!lwww.ecomoney.neti (Some of the site is in English, but not the list of local currencies)
35 "Local currency (ecomoney) as a means of escape from Japan's economic predicament (deflation and so on)" July
2002. Available (in Japanese) at http:!/www.jpc-sed.or,jpl

36 A list of local currencies in this "school" can be found (in English and Spanish as well as Japanese) at
http:1!www3.plala.or.jplmig(japan-uk.html, The site also has sections on Gesell and Ende, As far as I can see,as of mid-September 2002, there was no overlap between the 31 local currencies listed on this site and those on
the ecomoney website. This site, but not the ecomoney site, is widely included in lists of international local

currency! LETS Internet links.
37 http:11ww.grsj.orgt
38 "Since they sell nothing but the expectation of money, which is time, they sell the day and the night. But the
day is the time of light and the night of rest, and so consequently they sell light and rest'1 Stephen of Bourbon(d. 1261). Quoted in J. Munro (2001)
39 A, Kawamura, E. Morino, J, Murayama, H. Kamanaka (2000) (in Japanese)((tr
DAVIES: THE PASTANDPRESEIVT
OF LOCAL CURRENCIES

133

per head in one case`O) many of the schemes are going through a series of experimental
stages, and the range of goods and (mainly) services available through the schemes isnormally very limited.

Local currencies as an instrument of local economic financeI have earlier discussed the potential role of local currencies in providing micro-credit.

Many accounts of the effects of local currencies (including "Ende no yuigon") do not
distinguish between schemes that involve micro-credit and the stamp scrip schemes of the
1930s that provided credit to local govemments. Likewise, Maruyama`r jumps from describing
the role of hansatsu in financing local govemment to the potential role of LETS schemes inJapan without acknowledging that the latter do not normally create credit for local
government.

Much of the current interest in local currencies among financially pressed local
authorities in Japan derives from European and American experience with stamp scrips in the
1930s.`2 These scrips were issued by, for example, town halls; they were, in effect, subject

to a negative interest rate, not (immediately) convertible into national currency and onlyuseable within a limited geographical area.
The attraction of such scrips for local authorities is that, as they depreciate and can only

be used locally, they may both raise total spending and change the composition of spendingin favour of locally provided goods and services. Scrip circulates more quickly than national
currency (because it loses its value if not spent) and does not leak from the local economy.
Thus if the local authority puts a local scrip into circulation (e.g. by paying its employees

and local suppliers in scrip) that spending may have a larger local multiplier effect thanequivalent spending in national currency. Moreover, as local taxes can be paid in the scrip,

taxes are paid more quickly (again to avoid the loss incurred in holding on to the scrip),bringing an additional benefit to the local authority's cash flow.

However, for the enhanced local multiplier to be observed the local scrip has to be a
sufficiently large share of money in local circulation to affect people's budget constraints: if

people can spend all the scrip they receive without spending more locally than they would
have chosen to spend anyway, the use of scrip will lead to no additional multiplier effect.
If people spend, say, 40 per cent of their income locally every month (the remaining 60 per

40 Information gained in discussion with members of the "yu" currency scheme in Hara Village, Suwa, Nagano

Prefecture.

41 M. Maruyama (1999)
42 For a description of many of these schemes see Irving Fisher Stamp Scrip (1933). The book is difficult to obtain(at least in Japan), but the entire text can be downloaded from the Internet at
http:!luserpage,fu-berlin,del-•roehrigw!fisher! stampl. html

134 KOBE ECONOAcffC (St BUSINESS REVIEM, 47 (2002), 117-141

cent being spent elsewhere or saved) then it should make no difference to their spending
whether scrip accounts for 30 per cent of their monthly income, or 20 per cent, or whether
all their income is in national currency. Only when scrip exceeds 40 per cent of their income
would the timing and location of their spending be affected.

With a steady issuance of local scrip, however, the share of the local money stock
accounted for by scrip would steadily increase, simply because the national currency part ofpeople's incomes would tend to flow out of the locality while the scrip would accumulate
locally (unless the constant inflow of scrip could all be taken out of circulation by thepayment of local taxes). If businesses accepted the serip but their customers were not willingto accept it in change (or forced by legal tender rules to accept it), the scrip would
accumulate with businesses, which would eventually be unable to pay non-local suppliers. To
the extent that this led to a diversion of orders to local suppliers, there would be a boost to

the local economy.
Local authority employees would certainly be constrained by the properties of scrip ifthey received a large proponion of their salaries in scrip. But it is hard to see why regular
employees or suppliers would (other than in desperate circumstances, such as those currently
prevailing in Argentina) accept a large proportion of payment in scrip rather than national
currency. Thus local monies issued by local authorities are, in normal circumstances, likely

to be most usefu1 in rewarding workers who are not primarily working for the financial
return, i.e. as a form of payment for voluntary work.

This form of payment would probably not be possible in the UK (where remunerationof volunteers, above rejmbursement of expenses, is illegal unless they are paid the minimumwage); but it is used in Japan. In addition to the "fureai kippu" type of currency, some of

the more recent currencies-for example Oumi in southern Shiga-are issued by an NPO in
return for voluntary work, and can be spent on services provided by or in association withthe local authority. Rewarding volunteers in this way will obviously benefit local authority

finances as compared to paying the equivalent compensation in yen, but is unlikely to havethe large economic impact that was apparently seen with sorrie of the 1930s scrip
experlments.

ts
Atatakai okanelwarm
money

{s

This account of the ratjonale for local currency is so far missing an important element,

perhaps the most important element. Kato is really referring to it when he describes
ecomoney as "atatakai okane" (warm money)."3 Here we have to leave the normal realm of
economics and enter that of sociology and psychology.

43 In the title of the first chapter of Kato (2000)

J! PRESENT OF LOCAL CURRENCIES 135{{
DAVIEIS: THE PASTAND

Money, in the words of Simmel, "is conducive to the removal of the personal elementfrom human relationships through its indifferent and objective nature".`4 Simmel also
compared the effect of the use of money to that of the typewriter (for him, a recent
innovation) that displaced hand-written, and hence personalised, communication. Simmel
welcomed money's role in liberating the individual from group-based life. A more negative
way of looking at it is that it has dissolved the glue that bound traditional communities
together. The use of money (national currency) to finance exchanges is not the same (in theimplication for the level of trust in society, for example) as the use of reciprocity. Reciprocationis almost never immediate and reciprocity therefore inevitably involves credititrust.

Anthropologists record that primitive societies often have a variety of moneys, withparticular moneys only being acceptable for particular purposes. In modem societies money
is in many circumstances not acceptable as a gift, even when it would be apparently be themost efficient gift.`S (Japan is something of an exception to this rule, presumably because thetradition of money gifts has developed from what used to be the exchange of gifts of rice.)

A gift of money is too "cold", too impersonal.

Still more significant is the finding that money is often unacceptable as a payment forservices between friends and neighbours.`6 These are the very transactions that LETS schemes

facilitate. Thus there is, after all, a sense in which LETS schemes may be making good ashortfall of transactions media, even in countries where the central bank issues cash on

demand: the central bauk is simply not competent to supply the sort of money that can beused to finance transactions between friends and neighbours.

In Japan (in contrast to Western Europe and North America) much of the replacementof reciprocity by monetary transactions has occurred relatively recently in rural areas, within

the lifetimes of older village inhabitants. Such people may also remember the use of rice asa means of payment. Western sociologists and anthropologists noted the persistence oftraditional forms of exchange in Japan both before and just after the Second World War.
Embree, on the basis of fieldwork carried out in rural Kyushu in the mid-1930s estimatedthat "about 50 per cent of an ordinary farmer's living expenses are in money and about 50

per cent in kind. The increasing importance of the near-by towns as shopping centers has

increased the money expense.... Formerly a farmer's living costs would probably haveincluded less than 10 per cent of money expense".`' A subsequent stimulus to the use of cash

came when the 1946-47 Land Reforrn forbade the practice "until then general"`8 of payingof rents in kind.

44 G. Simmel (1990) p.297
45 See e.g, P. Webley, SEG, Lea and R. Portalska (1983)

46 P. Webley and SEG. Lea (1993)
47 J. F. Embree (1939)

48 T.Fukutake (1967)

136

KOBE ECONOMIC & BUSINESS REVIEW, 47 (2002), 117-141

Robert Smith, retuming in the mid-1970s to the site of his doctoral fieldwork (in rural

Shikoku), was stmck by the decline in reciprocal and co--operative activity: "If asked tosingle out the one feature that best exemplified the character of rural communities in theearly 1950's, most observers would have pointed to the complex patterns of cooperation andmutual aid....In the case of Kumsu, there were many such groups....The joint planting of riceseedbeds, transplanting, and harvesting were all occasions for organizing work on the basis oflabor-exchange (temagae)..... Repayment of labor received was expected to be made inprecise equivalents, even though no forrnal records were kept.... It was widely remarked inthose days that with the introduction of cash and machines, the exchange system was introuble and would fade rapidly. It did just that.... Since [the 1950's] Kurusu has come partly

unstuck....there has been a partial disintegration of links between the households of theCOrnmunity."49

Labour exchange, which went under different names according to the region (temagae,
yui, moyai), now survives mainly as a tourist attraction: every Apri1, thousands flock to

Shirakawago in Gifu Prefecture to see the whole village re-thatching a proportion of thevillage houses. (Minor forms of more or less compulsory collective activity-communal

weeding or cleaning, often veiy early on a Sunday morning-together with rotating
responsibilities for clearing up after rubbish disposal, or for collecting contributions to the
local community association, still persist, however, sometirnes even in city suburbs.)

Many members of Japan's new community currencies are very aware of the still recent
tradition of reciprocity and see the local currencies as partly restoring the tradition (eventhough the members of the currencies in rural areas are overwhelmingly incomers from thecities, and have not personally experienced tiaditional Japanese village life). Members of a

local currency in Nagano prefecture told me about the traditional use in that area of "chou" (reciprocal labour accounts), which they described as the Japanese precursor of LETS
accounts.

Golfing Alone? (Social Capital in Japan)
The second half of the 1990s saw a massive in increase of interest among economists
in the economic effect of communities and social networks, or what has become known as"social capital". While the concept was originally set out by Bourdieu in 1983,5e its mostpopularly known exponent is Robert Putnam. His Bowling Alone5' documents in great detaila collapse in various forms of social interaction in the United States since the 1960s,
implying a significant decline in America's "social capita1" over the last thirty years. In an
49 R. J. Smith (1978)

50 The article can be conveniently found as chapter 4 of M. Granovetter and R. Swedberg (eds) (2000)

51 R. Putnam (2000)

yuirl PRESENT OF LOCAL CURREIVCIES 137
DAVIES.- THE tlPAST AND

earlier and highly influential study he had explained the contrasting perfomiance of southernand northern Italian regional govemments by reference to their very different traditions ofcommunity activity.52

While the term "social capital" was used increasingly by economists, especiallydevelopment economists,53 during the 1990s, it seems to have almost as many definitions as

it has users. Most definitions are, however, related to Putnam's own relatively clear
explanation of the terrn: "By analogy with notions of physical capital and human capital....thecore idea of social capital theory is that social networks have value. Just as a screwdriver(physical capital) or a college education (human capital) can increase productivity (bothindividual and collective), so too social contacts affect the productivity of individuals andlsgroups.

The OECD GIossary tells us that: "social capital is defined as the norms and social
relations embedded in the social stmctures of societies that enable people to co-ordinate
action to achieve desired goals". According to Sobel in a recent JEL survey5` "social capital

describes circumstances in which individuals can use membership in groups and networks tosecure benefits".

Some economists are dismissive of the concept: SolowS5 calls it "an attempt to gain
conviction from a bad analogy". Bowles and Gintis see some possible merit in the concept
but suggest a change of name: "social capital.... may even be a good idea. A good term it
is not. Capital refers to a thing that can be owned-even a social isolate like Robinson Crusoe

had an axe and a fishing net. By contrast, the attributes said to make up social capital

describe relationships among people....we think it better to drop the term in favor ofsomething more precise. "Community" better captures the aspects of good govemance that
explain social capital's popularity, as it focuses attention on what groups do rather than what

people own."56
Over and above the imprecision of the English definition, there is a fUrther difficultywhen talking about "social capital" in Japanese. The obvious translation of "social capital"in Japanese is "shakai shihon". "shakai" was established during the 1870s, after somecompetition, as the standard Japanese translation for "society", coming into widespread use intranslations of the works of Herbert Spencer.5' (It would not be quite correct to say that there

had been "no such thing as shakai" before the 1870s; the word had previously meant a

52 R. Putnam with R. Leonardi and R, Nanetti (1993)
53 See for example the extensive section of the World Bank's website which is devoted to the subject: http:1!www.
worldbank.orgtpovertyfscapitaY. This provides an introduction to the subject and a comprehensive bibliography.
54 J. Sobel (2002)
55 quoted in Sobel (op. cit,)

56 S, Bowles and H. Gintis (forthcoming). Available at http:1!www-unix.oit,umass.edul--bowles/index.htm
57 Douglas Howland (2002) is the source for all this information about the origins of the word "shakai'1

138 KOBE ECONOM]rC&BUSINESS REVIEPV, 47 (2002), 117-I41

religious group, and had been used by Dutch-leaming scholars to refer to places of assembly.)

However, the translation of "social capital" as "shakai shihon" creates some risk ofconfusion and misunderstanding for Japanese economists. "shakai shihon" has been used in
the past as an abbreviated translation for the very different concept of "social overhead
capital",58

whose fu11 translation is "shakaiteki koutsuu shihon". The importance of social

overhead capital has perhaps attracted more long-lasting attention in Japan than elsewhere,

mainly because of the writings of Professor Hirofumi Uzawa.
In his overview contribution to a volume on Social Overhead Capital published in 1994,S9

Uzawa used the shorter term "shakai shihon" to cover "embankments, roads, harbours, gas

and electricity supply, water supply and drainage, etc." (my translation). A Japanesedictionary of economics published the same year gives a very similar definition under theheading "shakoi shihon [English: social capital]". Obviously shakai shihonfsocial capital thus

defined is a form of physical capital, and is not at all what Putnam et al. mean.

To avoid the risk of confusion for Japanese readers, Yamagishi6i uses the term "kankei
shihon" (literally, "relationship capital") to refer to social capital a la Putnam. However,there is probably little future in Japanese scholars attempting to resist the use of "shakai
shihon" in the sense (s) that social capital is now used by non-Japanese economists.62

It seems almost certain that Japan has experienced a decline in social capital in thissense over the second half of the last century, not only because of the decline of co-operative
activity within rural villages but also because of the shift of population from the villages tothe cities of Japan. Participation rates in voluntary social activities are much lower in thecities than in the villages of Japan. In the villages, in 1996, 33.1 per cent of the population

aged 10 years and over took part in voluntary social activities (26.6 per cent took part in

activities for the local community and neighbourhood). In medium-sized conurbations, thecorresponding participation rates were 23.2 per cent and 16.7 per cent; in the large
conurbatjons the participation rates were just 18.1 per cent and 11.3 per cent.63
58 Hirsclman (1958) discusses the "recent distinction between Social Overhead Capital (SOC) and Directly
Productive Activities (DPA)'1 He describes the logic of the distinction as "far from compelling" but theoreticallyand practically usefu1. As far as I can see, Hirsclman uses the terms "Social Overhead Caphal" and "Overhead
Capital" but not the abbreviation "Social Capita1'1 However a Japanese book on the subject published nine years
later (by Miyamoto) was entitled simply "shakoi shihon ron" (social capita1 theory)

59 H,Uzawa and A.Mogi (editors) (1994) (in Japanese). The Japanese title uses the non-abbreviated form"shakaitela' koutsuu shihon'1

60 Iwanami Small Economics Dictionary, 3rd Edition (1994)
61 T. Yamagishi (1998) (in Japanese)

62 Of three papers presented at an "Economic Analysis of Social Capital" session at the autumn 2002 meeting of
the Japan Economics Society, two were about infrastmcture investment (social capital a la Uzawa) but the third
was about optimal club size and volunteer activity (evidently more related to social capital a la Putnam)

63 Govemment of Japan Statistics Bureau 1996 Survay on Time Use and Leisure Activities Volume 6 Table 31-1,
p.296 (details in Japanese)

DAVIES: THE PAST AND PLRESENT OF "LOCAL CURRENCIES"

The time series of results from the quinquermial Time Use surveys do not go back far
enough to pick up the main effects of the post-war exodus from villages to the cities, buteven so, they show a 13 per cent fall in average •time spent nation-wide in activities under

the heading kousai/tsukiai (socialising and fellowship) between 1976 and 1981; since then,however, the amount of time spent in this way has been more or less stable. A rise in timespent on sport participation (some forms of which might contribute positively to social
capital) more or less equalled the fall in socialising and fellowship between 1976 and 1981;
this has also been quite stable in subsequent surveys. (As it happens, participation in bowlingincreased enormously between 1976 and 1996, from 1.6 per cent of respondents to 29.1 percent of respondents, but only O.1 per cent of respondents were "bowling alone" in 1996.

Golfing alone was much more common-2.3 per cent of respondents-presumably mainly inthe ubiquitous golf drive practice nets.)

Japan is often thought of as a "high-trust society"6` and thus perhaps in no need ofadditional social capital. However, successive World Values Surveys show the level of trustin Japan lower than in the United States and even slightly lower than in the United Kingdom.
Yamagishi6S argues that a group-oriented society (such as in Japan) creates peace of mind but
destroys tmst: the rare stranger in the mura will be assumed to be a threat. (This is a logicalextension of Fukuyama's argument that countries with family-oriented societies-such as
China-have low levels of trust outside the family.) To create a higher degree of generalised
trust, he argues, it is necessary not just to strengthen relationships (kankei kyouka) but also

to expand relationships (kankei kakuchou).

Yamagishi presents the results of various questionnaire-based tests that showedAmericans displaying a much higher level of generalised trust than Japanese. He also argues,

and supports the argument with experimental evidence, that people who are ready to trust
others are not in fact the gullible but those who are good at discriminating between those

who are trustworthy and those who are not. Within the mura, there was not the chance tobecome skilled in such discrimination.
The creation of new networks •through local currencies, the creation of trust relationships

between scheme members, including the occasional experiences when tmst is betrayed, canthus be seen as having a role to play in raising the level of generalised tmst among theJapanese, or, in other words, in increasing Japanese "social capital".

Concluding remark
The extensive media coverage of local currencies in Japan over the last two years may

64 It is so categorised, for example, in F. Fukuyama (1995)

65 Yamagishi (1998)139

140 KOBE ECONOMTC &BUSINESS REVIEM, 47 (2002), 117-141

imply some risk of exaggerating the potential role of local currencies in modern Japan.

Suggestions that local currencies may make a major contribution to Japan escaping fromdeflation (as recently argued by Kato), or that they can make a big contribution to solving
local authorities' financial difficulties are likely to prove overoptimistic. Their main role willprobably be in:' financing voluntary work;'contributing to building networks and trust in Japan; that is to say in adding toJapan's social capital.

Further research is needed before we will have a clear idea of how important suchcontributions will be.

Referenees
T. Aldridge, R. Lee, A. Leyshon, N. Thnft, J. Tooke and CC. Williams The Role of the Third Sector in

Paving a Third JVay,' Some Lessons ufrom Local Exchange and Trading Schemes in the United
Kingdom. Journal of Community Currency Research (2001) Vol.5
S. Bowles and H. Gintjs Social Capital and Community Governance Economic Journal (forthcoming)

D.Boyle Funny Money Harper Collins (1999)
F.Braudel The PViieels of Commerce (English translation) Harpers and Row (1982)
C.Cipolla Money Prices and Civilisation in the Mediterranean Morld Gordian Press (1956)
C. Cipolla Before the Industrial Revolution Routledge (1993)

J. Clapham The Bank of England CUP (1944)
GDH. Cole The LiJfe of Robert Owen 3'd edition Archon Books (1966)
J. Craig Zhe Mint Cambridge (1953)
J. F. Embree Saye Mura A Japanese Village University of Chicago Press (1939)

In or out.2 FSA Consumer Research Report No.3 (July 2000)
I. Fisher Stamp Scrip (1933).

M. Fukushige Factors InLf7uencing the Emergenee of Community Currencies The Nonprofit Review Vol.2
No.1, (2002) pp.23-24
T. Fukutake (trans R. Dore) 1apanese Rural Society OUP (1967)

F. Fulqiyama Trust Hamish Hamilton (1995)
E. Gilbert and E. Helleiner (eds) ?Vation-States and Money Routledge (1999)

M. Granovetter and R. Swedberg (eds) The Sociology of Economic Life, 2"" edition, Westview Press(2000)
A. Hirschman The Strategy of Economic Development Yale University Press (1958)

D.Howland Translating the Mest, Language and Political Reason in Nineteenth-Century Japan.
University of Hawaii Press (2002)
Iwanami Small Economics Dictionary. 3'` Edition (1994)

T. Kato The Morld of Ecomoney Begins Kodansha (2000) .
A. Kawamura, E. Morino, J. Murayama, H. Kamanaka Ende's Last Message NHK Publications (2000)
ET. Leeds Oxford Tokens pp.358-443 of Surveys and Tokens Ed. H. E. Salter Oxford Historical Society(1923)

s{ AND PRESEIVT!t
DA VIES: THE PAST
OF LOCAL CURRENCIES

B. Lietaer The Future of Money Century (2001)
M.Maruyama Local currencies in pre-industrial Japan, chapter 4 of E.Gilbert and E.Helleiner (eds)(1999)
M. Morishima Japan at a Deadlock Macmillan (2000)
J. Munro The Origins of the Modern Financial Revolution: Responses to Impediments .from Church andState in Mestern Europe, 1200-1600 University of Toronto Working Paper UT-ECIPA-Ol-02 (2001)
Nikkei Regional Economic Report no 385 (February 2002)
M. Pastoureau Jetons, mereaux et medailles Brepols Tumhout-Belgium (1984)

MS.Peacock Local Exchange Trading Systems: a Solution to the Employment Dilemma2 Annals of
public and co-operative economics (2000) Vol.71 No.1
L. Pressnell Countty Banking in the Industrial Revolution Clarendon Press (1956)

R. Putnam Bowling Alone Touchstone (2000)
R. Putnam with R. Leonardi and R. Nanetti Making Democracy Mork: Civic Tradition in Modern Italy
Princeton University Press (1993)
M. Rowlinson The Scotch hate gold, chapter 3 of E.Gilbert and E. Helleiner (eds) (1999)

T. Sargent and F. Velde The Big Problem of SmaU Change (2002), Princeton University Press

M.Senoo Yamada Hagaki and the Histoiv of Paper Currency in Japan Bank of Japan Institute for
Monetary and Economic Studies Discussion Paper 96-E-25 (1996)
H. Shimbo A Stucly on Paper Money (Hansatsu) in Tokugewa Era The Annals of Economic Studies
Kobe University No.19 (1972) pp.l-37
G. Simmel (trans T. Bottomore and D. Frisby) The Philosophy of Money Routledge (l990) p.297
R. J. Smith Kurusu. The Price of Progress in a Japanese Village 1951-1975 Stanford (1978)

J.Sobel Can PVe Trust Social Capital Journal of Economic Literature (March 2002) Vol.XL No.1
pp.139-154
H. Uzawa and A. Mogi, (editors) Social Overhead Capital. Cities and the Commons. Economic Affairs,

Volume 4. University of Tokyo Press (1994)
P. Webley and SEG. Lea The partial unacceptability of money as a repayment for neighbourly heip
Human Relations, 46 (1993), pp.65-76.

P.Webley, SEG.Lea and R.Portalska 77)e Unacceptability of Money as a Gift Journal of Economic
Psychology 4 (1983) pp.223-238
G. Williamson Trade Tokens Issued in the Seventeenth Century A New and Revised Edition of MilliamBoyne's Mork Burt Franklin NY (1970) (reprint of 1889-1891 edition)

T.Yamagishi The Structure of Trust. The Evolutionary Games of Mind and Society. University ofTokyo Press (1998)
V. A. Zelizer The Social Meaning of Money Princeton University Press (1997)

141

KOBEECONOMIC & BUSINESS REVIEWCONTENTS

No.46 (2eel)
Economic Theory: Past and Future""'''""""""'-""'''''''''"''''""""'••••••''"''"'""'"--••"""'''Murray C. Kemp
Long-Term Cooperation in Japanese Venical Relationships "''"t"••••"--i•••••`""'•••••"'-••-•••••••••""'"Kenj'i Kojima

Experiences of Technological Partnership of Japan with Overseas:

The Case of Steel Industry "'""""""""""""""""""''"b""''"'-"-"''"Akio Hosono/Nobuaki Hamaguchi
Analysis of Adoption of Forest Cenification in Japan
From Perspective of Organizational Theory''''"'"'''"'''''"'"''''"''"'"''"'"''""'"'"'''''"'"'''Akira Kojiwara
Sensitivity of Domestic Production to Import Competition:

Evaluation at Different Levels of Aggregation "'""'"'''''''""""''''•-•""'''"''"'"''""""''"`Eiichi Tomiura
Japan-Korea Free Trade Area and Structural Reforms'''''"'''""'''""'"'''''•"'"''"'''Bonggil Kim/Kazuhiro Igawa

No.45 (2000)
Imperfect Substitutes and Strategic Trade Policies under Cournot Duopoly:

Mathematical Note '"'"'"''"''''"'''''''"""''"'"""'""''"''''""'"""''"'"'-''Seiichi Katayama/Hiroshi Ohta
Shifts in the Japanese Corporate Governance"'""'"'''''"'"'''''"""''"-'"'"''"-"'''"""''''""'"'""'Keny'i Kojima
FSC Certification in Japan: An Uncertain Future '''""'"''''''"'""'''"''"'"""''"''"'-'"'"'"''"''"Akira KaJ'iwara

The Long-Run Impact of APEC Trade Liberalization on Real GDP and Sectoral Adjustments'"'"'''''"""'"""Hiro Lee/David Roiand-Holst/Dominique Van Der Mensbrugghe
Monetary Cooperation in East Asian Countries:
A Possibility from Macro Economic Indexes and Intra-Regional Trade Dependency••••••.••••••••••••••••••••••-•••••••••••-••••••••--••••••••••t•-•••••''Bonggil Kim/Kazuhiro Igawa

Discretionary Accrual Models and the Accounting Process'"'''''''''""""""""""'Xavier Garza-Gomez/Masashi Okumura/Michio Kunimura

No.44 (1999)
A Note on Possibilities about Japan-Korea Free Trade Area:

A Strategic Approach ''''"'"'"'""''"''''''''''""''"""""''"'''''"'"'"''"'""''Kazuhiro Igawa/Bonggil Kim
Crise Cambial Brasileira-Fundamentos vs. Ataque auto-realizavel-"""""''""""'""'''""""Shoji Nishi'ima/Eduardo Kiyoshi Tonooka
Japanese Supplier Relations:

A Comparative Perspective ''""''"""""''-"'"'"'""'''"''"""''""'""''"'''"'''""'"'"""''""Keoji Kojima
Development of the Forest Stewardship Council
Certification Program '"''"'"'"''''''''-'"""''"'""''"""'"-'"'''""'"'"-'"'""'Akira Kojiwara/Todd A41alinickNo.43 (1998)
What South Asia Can Learn from EastiSoutheast Asia:

International Trade and Foreign Direct Investment """"""""""""'"'"'"'"'""''"''""""''Kazuhiro Igawa
Relational Govemance in Japanese Vertical Relationships """""""''•""""•""""'"'"""'""""'"'KenJ'i Kojima
A Comparative Analysis of Pulp, Paper, and Packaging Companies

in Canada, Japan and United States""""""""'""""""""""'""'""'•ny"'"'""''"'•"'""""'Akira Kojiwara
Non-performing Assets of Banks and Financial Intermediation:

Experiences of Japan in the Inter-war Period'""""""""''"""""'"""'"''''"'"'"""'"""'Munehisa Kasuya

No.42 (1997)
A Simple Model of Technology Transfers in the North and South Economies:

Technology as Intermediary Goods '"""""""""''""""""""""'-""""'"""""""''"'''""'Kazuhiro Igawa
Trade and Investment Relations of Japan and ASEAN

in a Changing Global Economic Environment ''"""'"'"""""'"""""'"""""""""''"'""'""Shigeyuki Abe
Japanese Financial Relationships in Transition '""""""'""`""""""""""'""""""""""""""'"'KenJ'i Kojima
Organizational Coordination for Project Interdependency

in New Product Development""'""""'"'"""""""""""""""""""'""""'"'"""""'"`"Kentaro Nobeoka
A Regime Shift in Long-Run Money Demand in the United States """''"""'""""""'"'""""'"'"Ryuzo Mi ao
The Competition between Regional Standards and the Success and Failure ofFirrns in the World-Wide Mobile Communication Market"""'""-"""""-"""'"''"'""-""'"'Veffrey L. Funk

Published on February 2003

byResearch Institute for Economics &Business

Administration (RIEB)

Kobe University
2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501 Japan
Phone : 81-78-803-7036

F a x:81-78-803-7059
Home Page at http:flwww.rieb.kobe-u.ac.jpl
Printed inJapan