BUSINESSREVIEW
43rd

ANNUALVOLUMEliiilille2gz,,ig:ÅéRESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1998

KOBE ECONOMIC & BUSINESS REVIEW
Editor in Chief
Shoji Nishijima

Co-Editors
Komayuki Itho; Masahiro Tomita; Ryuzo Miyao

KOBE
ECONOMICBUSINESS&REVIEW
43rd

ANNUALVOLUME

tigfva:O:,U'"RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1998

CONTENTS
Page'

What South Asia Can Learn from East/Southeast Asia:
International Trade and Foreign Direct Investment•""""""'•'•• Kazuhiro IGAWA 1

Relational Governancein Japanese Vertical Relationships••••••••••••••••••••• Kenji KOJIMA 25

A Comparative Analysis of Pulp, Paper, and Packaging Companies
in Canada, Japan and United States•••••••••••'•" Akira KAJIWARA 65

Non-performing Assets of Banks and Financial Intermediation:
Experiences of Japan in the Inter-war Period••'•'""'•• Munehisa KASUYA 119

KOBE ECOIVOMIC & BUSINESS REVIEVV, 43 (1998), l-23

WHAT SOUTH ASIA CAN LEARN FROM
EAST/SOUTHEAST ASIA: INTERNATIONAL TRADE
AND FOREIGN DIRECT INVESTMENTi

KAZUHIRO
IGAWA Kobe University
Abstracttt

Taking into account the experiences of East and Southeast Asia, we haverecommended South Asia strategic policies. The important role of intra-regional
trade, intra-industry trade, and intra-regional foreign direct investment for East
Asian miracles is stressed.
JEL classification:- F42

Keywords: International division of labor; Intra-industry trade; Intra-regional

FDI; East and Southeast Asia

1. Introduction'

In this paper,Iwould like to argue that both Foreign Trade andForeign Direct Investment are key engines for economic developmentsof South Asian countries. I also want to discuss that the lessons fromexperiences of East and Southeast Asia might be useful for economic
growth and poverty reduction of South Asian countries. It is a very

distinctive feature in East and Southeast Asian countries thatinternational division of labor is extended through international trade
Corresponding Address:

Kazuhiro Igawa
Research Institute for Economic & Business Administratibn, Kobe Univergity
2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501, Japan
E-mail: igawa@rieb.kobe-u.ac.jp
Fax: (81)-78-803-0391

1 This paper depends on the discussion of the conference held by Economic
Development Institute (EDI) of The World Bank, in Colombo, Sri Lanka, from
October 19 to 24, 1998. The topic is Econornic GrouJth and Poverty Reduction:
Theoror, Evidence,, and Implications for South Asia, and the title of rny submitted

paper is, "Internati6nal Trade and Foreign Direct Investment: International
Evidence and the Case of South Asia"

2

KOBE ECONOMIC & BUSINEss REVIEW, 43 (1998), 1-23

and foreign direct investments.

In the following sections, I will show and discuss about economic
evidence in Asian countries and theery of dynamic gains from tradeand foreign direct investment (FDI) and policy recommendation forSouth Asian countries. 'In section 2, I will look at the macro-economic performance ofSouth Asia, comparing to East/Southeast (ESE for abbreviation) Asia.'

There, I would like to suggest a possibility for South Asian to
introduce economic development polieies of ESE Asia.
In Section 3, first, arguments for the gains from foreign trade arerevisited and I would like to stress the importance of dynamic gains
through efficient and intensive division of labor. Then, foreign tradepatterns are investigated in more detail for ESE Asian countries, whereintra-regional trade and thus more intensive international division oflabor has been extended. The trade patterns in South Asian countries
will be mentioned briefly to suggest that the experiences in ESE Asia
might be good references to Sduth Asia.

In Section 4, arguments for gains from foreign direct investment

are summarized and the importance of dynamic gains throughtechnology transfer is stressed. FDI in ESE Asian countries arecompared with those in South Asian countries. Intra-regional crossforeigri direct investments are impressive feature of ESE Asian regions,which shows exte'nsive international divisions of labor in the regions.
This also gives us some implications for South Asian countrieS to invite
foreign direct investment.

In final section, I would like to discuss about possible economie
policy strategies for South Asia in the contemporary world trends ofglobalization and regionah'sm. The regional integration of NAFTA, EU
and ESE Asia will be taken into account for the policy arguments.
2. South Asia and ESE Asia in the world

In spite of the recent economic trouble in many ESE Asian
countries, it is still impressive that their economic performances before

Asian financial crisis were good and many countries completely cleared
hurdles of early stage of economic development. It is said that policies
for liberalization of international trade and foreign direct investmentsin those countries were successful, especially the policies to invite

CA IV LEA RN FR OM EA ST/SOUTHEA ST ASIA 3
IGA VVA; WHAT SOUTH ASIA

foreign direct investments and to promote exports of products wereright. In discussing the problems in South Asia from aspects of tradeand foreign direct investment, I would like to share the argument about
East Asian Miracles by the Wor}d Bank2.
In the interesting paper3 of comparing Africa and East Asia, Peter

Harrold, Malathi Jayawickrama, and Deepak Bhattasali suggest South
Asia to lesson from economic experience of East Asia. In the paper,
there are many tables, which show economic situations of South Asia
relative to those of East and Southeast Asia. In Table 2 of HJB paper,

per capita GDP annual growth rates are shown as follows.

Table 2%perannum

1961-72

1973-80

1981-90

1961-93

Africa

1.3

O.7

-O.9

O.3

EastAsia
SoutheastA
SouthAsia

7.0

7.1

9.4

7.4

32

4.9

4.3

4.3

1.3

1.6

3.3

1.8

East Asia: Korea, Hong Kong, Singapore and Taiwan.
Southeast Asia: Indonesia, Thailand, and Malaysia

This table shows that the economic performances of Southeast Asia
and South Asia are between those of East Asia and Africa, and the oneof South Asia is between those of Southeast Asia and Africa. If thelessons for Africa from East Asia are relevant, the lessons for South
Asia from East Asia will be relevant. In practice, the lessons for South

Asia from Southeast Asia might be more relevant. This is because,

South Asia is more close to East and Southeast Asia not only
geographical and cultural senses but also similarity of economic
development stages.

We can find the economic performances in country base data ofTable A2, which is made from data tables in Asian Development
Outlooh 1998 from Asian Development Bank.
2 The World Bank, The East Asian'Miracles: Econornic Growth and Public Policy,

The World Bank 1993
3 Peter Harrold, Malathi Jayawickrama, and Deepak Bhattasali, "Practical Lessons

for Africa.from East Asia in lndustrial and Trade Policies" World Bank

Discussion Papers 310, The World Bank' 1996. We call the paper as HJB paper for
abbreviation.

43 (1998),
KOBE ECONOMIC ar BUSINEss REVIEI•V,

4

Table A2 Growth Rate of Per Capita

1-23

GDP
US$,1996%perannum

1992

1996

1997

1998

NIEs
Korea

4.7

5.1

4,6

O.9

4.0

6.1

4.5

-1.9

10,610Singapore

4.1

5.1

5.7

O.4

30,550SEAsia

4.4

5.2

1.7

-2.3

Indonesia

5.4

6.2

2.9

-4.4

1,080

Malaysia

3.3

6.1

5.1

1.2

4,370

Thailand

6.8

4.3

-2.8

-4.7

2,960

SAsia

3.4

4.8

3,1

4.5

Bangladesh

2.5

3.5

3.8

4.1

Bhutan

1.3

2.9

2.9

260
390

India

3.3

5.6

3.4

5.0

380

Maldives
Nepal
Pakistan

2.8
2.5

3.9

2.2

1.6

210

4.7

1.3

O.6

2.3

SriLanka

3.3

2.6

5.2

4.5

480
740

l,080

The level of per capita GDP in South Asian country is far below
the level in Southeast Asia, this is far below the one of Asian NIEs. It

is interesting that the rates of growth in per capita GDP of South Asia
are expected to be higher than those in Southeast Asia in both 1997
and 1998. 0ne reason is resent financial crisis in Southeast Asia, but asa long-term trend there are no reasons that the growth rates ofcatching-up countries are lower than those of the preceding countries.
This will be true under conditions that govemment takes appropriate
economic policies and private sector has sound economic incentives. Of

course, political stability of the country and of the world is an
important necessary condition.

Let us look at more data of economic performance in ESE Asia
and South Asian regions or countries. The following data tables will be

helpful to understand the development stages of South Asian countries
relative to East and Southeast Asian countries, in many aspects.

For economic growth or development, a capital accumulation isnecessary and thus the rate of investments relative to GDP (investment

ratio: Investment /GDP) indicates the rate of growth in capacity.
Looking at Table A8, made from data in Asian Developrnent Outlooh
1998 (Asian Development Bank), the gross domestic investment rate per

iGALVA: LVHAT SOUTH ASIA CAIV LEARN FROM EAST/SOUTHEAST ASIA 5

GDP is low in South Asian countries relative to East or Southeast
Asian countries, where economic growth rates are high. In spite offinancial crisis in ESE Asia, expected investment ratio is higher in thoseregions than the one in South Asia.
Table A8 Gross Domestic Investment%ofGDP

1992

1996

1997

1998

Korea

36.6

38.2

34.6

26.4

Singapore

36.0

35.3

37.4

32.0

SEAsiaIndonesia

32.4

30.8

31.6

25.0

Malaysia

35.1

41.5

42.0

40.5

Thailand

40.0

41.7

35.0

26.0
17.2

SAsia
Bangladesh

12.1

17.0

17.4

Bhutan

47.7

48.0

47.0

India

24.0

27.1

26.6

27.1

Maldives
Nepal
Pakistan

21.2

23.2

23.4

24.9

19.9

18.7

18.4

20.0

SriLanka

24.3

24.2

25.8

26.7

A most part of domestic investments is financed by domestic
saving, and thus it is necessary to check saving rate per GDP (saving
ratio: Saving/ GDP) when we investigate why investment ratio is low
in South Asia. We can find the table of saving rate in HJB paper andWe have quoted some parts of its Table3 as follows.
Table 3: Gross Domestic Savings as a Share of GDP
1967-73

1974-80

1981-90SSA
EastAsia

15.7

20.7

12.6

21.1

28.4

33.2

SoutheastAsia

18.9

28.1

31.9

SouthAsia

14.4

17.1

19.1

SSA: all African countries except AIgeria, Egypt, Libya, rVlorocco, Tunisia, and Sout.h Africa

6 KOBE ECONOMIC &BUSIIVESS REVIEW, 43 (1998), 1-23

It is well known that a recent saving ratio is high in East andSoutheast Asian regions. There are many factors to determine saving
ratio, for example higher growth rate of disposable income than
expected rate, consumption adjustment lag to growing income, andoriental ethical behaviors. Higher per capita income and lower inflation

rate will be necessary conditions for higher saving ratio. We can inferthat those conditions are gradually satisfied first in East Asia and thenin Southeast Asia (lower inflation rate will be discussed later). The

performance in saving ratio of Southeast Asia is catching up the one ofEast Asia, and the one of South Asia has started to catch up the oneof Southeast Asia. The saving ratio in South Asia has become higher
than the one of SSA, after 1980s, but is the level of Southeast Asia inearly1970s. 'Another ways to finance domestic investments are inflows offoreign funds and inflows of ODA. Inflows of foreign funds, specificallyof foreign direct investments, will be discussed in Section 4 in detail andhere I will briefly show ODA data as follows.
Table 1. 0DA of Japan and World

ODAtodevelopingcountriesandInternationalorganizations,Topll
1996

Japan

Million$BilateralODAofJapan,Top10
Accumulatedvalueof1992-1996

Per

Receiving

GNP(%)Country

9439
9377

O.20

China

USA

O.12

Indonesia

Germany

7601

O.33

Philippine

Million$6122.725249.72
3211.24

Share(9)
13.53
11.60
7.10

France

7451

O.48

India

England

3199

O.27

Holland

3246
2416

O.81

O.20

Thailand
Pakistan
Bangladesh

2692.95
2478.04
1156.09
1oo5.00

SwedenCanada

1999

O.84

Egypt

908.20

2.01

1795

O.32

Sri'

798.59

1.77

Denmark
Norway1772

1.04

ptlexico

1311

O.85

10total

DACtotal

55465

O.25

Worldtotal

Italy

Lanka

5.95
5.48
2.56
2.22

501.131.1124123.6845242.37

53.32
1oo.ooData from Kaigai Keizai Kyoryoku Binran, Overseas Economic Cooperation Fund 1998

CAIV LEARIV FLROMEAST/SOUTHEAST ASIA 7
IGA WA: WHAT SOUTH ASJA

The table shows that Japan is one of the top donors of ODA, andbilateral ODA of Japan goes to China and Southeast Asia and South
Asia.

'

Economic development accompanies shift of employment inagricultural sector to those in industrial sector. However this structuralchange will be done successfully with the condition that a productivityof agricultural sector increases parallel to the shift of employment.

Therefor it is necessary to check the productivity growth rate of
agricultural sector in Asian countries. For this argument, the following

Table 4 from HJB paper will be useful.
Table 4: Agricultural Income, Labor Force and Productivity
Averageannualgrowthrate

SSA
EastAsia
SouthAsia

Agriculturalincome

AgriculturalLaborForce

Productivity
O.3

1.9

1.6

3.2

1.0

2.2

2.4

1.7

O.6

Increasing agricultural productivity permitted higher agricultural

income and labor movements into manufacturing, that isindustrialization in East Asia. The performance of South Asia is better

than SSA but much worse than East Asia. It is very important forSouth Asian countries to increase the productivity in agricultural
sector.

As I mentioned, sound policy and sound economic environment arenecessary conditions for economic growth and economic development.
Inflation rates show some aspects of macroeconomic stability and thesituation of South Asia is not bad.
Table 9: Average Inflation Rates, 1961-91
Japan

5.6

Korea,Rep.of

l2.2

Alllow-and-middleincomeeconomies
SouthAsia
SSA

61.8

From HJB paper

8.0

20.0

8 • KOBE ECOIVOMJC & BUSINESS REVIEIV, 43 (1998), 1-23

Using data of Asian Development Bank (Asian Devetopment
Outlooh, 1998), we have got the following table of inflation rates andgovernment budget conditions. There, we can find effects of financial
crisis of Asia in 1998, but inflation rates (left-hand side figures) in Asia

NIEs and Southeast Asia were relatively low. The government budget
figures (right-hand side figures) of surplus or deficit were not bad in

those regions. However, the performances of South Asia were not very
bad but unsatisfactory.
Table A9 Changes in Consumer Priees &Table A23 Overall Budget Surplus/Deficit of Central Government
906perannum&%ofGDP

NIEs
Korea

1996

1992

1998

1997

5.2

4.3

3.5

6.1,

6.2,-O.3
2.3,12.6

4.9,O.O
1.4,6.8

4.5,-O.5

9.8,

2.0,3.3

3.2,

SEAsia

7.1

6.6

5.6

12.9,

Indonesia

7.6,-O.4
4.7,-O.8

7.9,O.8
3.5,O.7
5.9,O.9

6.6,-O.2

20.0,

9.3

4.0,-5.9
8.8,-O.6
9.2,-7.0
6.2,-9.9

Singapore

Malaysia
Thailand

4.12.8'SAsia
Bangladesh

Bhutan5.1,-6.4
15.9,-8.5

India

Maldives
Nepal
Pakistan

SriLanka

16.8,-Z.2
21.0,-7.5
9.6,-7.4
11.4,-7.3

8.1-5.6'

10.8,-6.3
15.9,-8.9

4.0,1.8

5.0,

5.6,-O.9

15.0,

7.1

7.4,

3.9,-5.5
7.0,-4.9
6.5,-6.7
8.0,-8.2
7.8,-5.3
11.6,-6.3
9.6,-4.9

5.5,

7.0,

7.5,

10.0,
10.0,

Recognizing the position of South Asia in these tables is a starting poi-nt of myfollowing discussions.

3. International trade of South Asia relative to East Asia, andSoutheast Asia
International trade is an engine of economic growth, but patternsof international trade are changing. As production technologies change,market side becomes large, and competition becomes severe,international division of labor is extended through international trade.

IGA TIrA: WHAT SOUTH .4SJACAIV LEARN FROM EAS7'/SOUTHEAST ASJA 9This is reflected in the trend of trade pattern from inter-industries
trade to intra-industry trade. The pattern of intra-industry trade isalso changing to intra-firms trade or vertical inter-process trade withina same industry.
Typical relation between trade patterns and economic development
stages might be as follows. I will pick up four cases depending on
development stages or per capita income levels. When a per capita
income is very low and an international comparative advantage showsthat raw materials and agricultural products are exportable, interindustry trade will prevail. Most manufactured goods or industrial
products are comparative dis-advantage and will be still importable.
When a per capita income is low and raw materials or agricultural
products are main exports but an industrial sector has some laborintensive exportable goods, inter-industry trade will be still dominant
but some intra-industry trade might exist. When per capita income ishigh and a comparative advantage is in labor-intensive goods, a weightof intra-industry trade will be high. However, the typical intra-industry
trade will be exchanges of labor inteRsive exports and capital intensive

imports. When per capita income is very high, a typical pattern ofinternational trade is intra-industry trade of capital intensive industrial

products, as can be seen among developed countries or foreign
affiliates in developing countries. The intra-industry trade of capitalintensive industrial exports and labor intensive industrial imports will

still be important. These four development stages and trade patterns
are basis of the following discussion of trade policy for South Asia.
Trade is an engine of economic growth and higher growth rates ofexport and import imply higher economic growth. The following Table

All,13 (using data from Asian Development Outlook 1998 of AsianDevelopment Bank) shows that the growth rate of merchandise trade isa little bit higher in Southeast Asia than Asia NIEs in 1990s, and South

Asia is catching up with those regions. However the rates in South Asia
are fluctuating and this implies that trade policies to stabilize export

and import will be helpful for steady economic growth. The effects ofAsian currency crisis will be found in the figure of 1997 and 1998.

KOBE ECONOMIC & BUSINESS REVIEW, 43 (1998), 1-23

10

Table All,13 Growth Rate of Merchandise Exports & Imports
O/operannum

1992

1993

1994

1995

1996

1997

1998

NIEs
Korea

12.1,l3.1

10.7,10.1

15.0,17.4

20.9,22.9

4.5,5.2

3.4,3.0

4.0,-O.4

8.0,1.0

7.7,2.3

15.7,22.4

31.5,32.1

4.112.2'

Singapore

8.5,11.3

17.0,17.8

25.8,19.8
19.3,21.8

21.0,21.6
24.3,29.7

9.9,13.9
23.1,28.1

18.0,26.6
26.6,30.4

7.2,-2.3

5.8,-12.3-3.1,O.1

2.0,2.0

8.7,2.4
11.2,4.8
6.0,7.0

8.2,-1.1
5.0,-5.0

8.0,6.0

3.2,-9.3

5.0,-15.0

5.1,5.6
13.7,3.0

8.0,8.3
15.0,8.0

SAsia

13.7,6.0
8.0,9.2

15.4,14.5

13.0,18.1

20.5,25.7

6.4,5.4
6.0,6.3
5.8,8.1
7.3,l.7-1.9,O.6
5.5,7.7

Bangladesh

16.1O.5,

19.5,15.5

6.0,-7.5

37.2,39.4

12.2,17.8

Bhutan-9.6,14.0

4.9,50.4
20.2,15.1-4.2,-25.7

11.7,22.1

9.3-8.2'

8.5,25.0

18.4,34.3

20.8,28.0
12.7,20.9-9.6,21.9

4.15.1'

5.0,8.2

16.1,18.5
18.7,11.6

7.116.7'-2.7,-5.0

4.0,5.0
6.0,O.5

7.9,2.5

13.0,7.0

9.0,10.0

SEAsia 14.7,8.9

13.3,14.4

Indonesia

14.0,7.8

8.3,6.0

Malaysia
Thailand

18.1,10,1

16.117.8'

13.412.2'

22.7,18.1

24.8,31.9

India

3.3,10.3
Maldives 10.0,18.4
56.1,15.8
Nepal
Pakistan 14.6,7.3
SriLanka 20.6,15.3

19.0,5.9

43.19.7'

25.4,22.2-2,7,14.6

O.3,11.7
16.3,14.6-1.4,-3.6
12.0,18.6

8:O,12.6

1.7,9.0

5.8,12.0
10.3,10.3

7.5,9.9(Left figure is export & right figure is import)

It is interesting to see direction of exports, which shows how aregion or a country depends on other regions or countries. Table A12(from Asian Development Outlooh 1998) indicates that NIEs wasdepending on USA in 1985 but now is depending on Asia (Developing
Member Countries: DMCs) in 1996. Exports to Japan have decreased alittle, and exports to EU have increased a little from 1985 to 1996. The

share and the change of share are different among countries, but
direction of exports of Southeast Asia is also changing to Asia. These
facts imply that East and Southeast, Asia is increasing intra-regional
trade and is increasing intra-regional mutual dependency. North-South
trade (trade between developed and developing countries or regions) is

not main trade pattern in ESE Asia any more. However, the exports ofSouth Asia mostly depend on USA and EU (the roll of Japan is'relatively small) and exports to DMCs fluctuate. Taking into account ofgeographical location of South Asia, it will be natural to have more

intra-regional trade of Asia. If an international trade is more
liberalized and an economy is more developed, the intra-regional trade
will increase. It might be possible to say that with po}icies to increase
intra-regional trades in Asia, South Asia will develop more.

IGA WA: WHAT SOUTH ASIA CAN LEARAr FROM EAST/SOUTHEAST ASIA 11

Table A12 Direction of Exports (% share)

DMCs

To

From

EU

USA

Japan

1985

1996

1985

1996

1985

1996

1985

1996

NIEs
Korea

12.9

12.3

35.6

16.8

10.4

13.3

36.7

38.4
48.4

15.0

Singapore

9.4

8.2

21.2

18.4

10.1

13.4

46.2

28.8

21.7

16.5

6.0

18.3

24.6

13.4

12.8

18.2

13.6

14.8

27.1

31,5
45.9
34.0

13.4

16.8

19.7

18.0

17.8

15.7

14.5

7.6

7.2

3.1

18.1

31.8

13.0

45.0

8.9

24.1

11.1

7.4

18.9

17.3

16.7

29.4

50.8

41.9

10.1

7.0

24.3

8.5

4.0

38.0

41.4
16.0

12.4

O.7

O,6

35.3

34.4

20.3

52.0

21.4

11.3

6.5

10.0

l6.7

20.9

30.1

11.2

8.1

5.1

6.2

22.3

34.1

17.9

34.4

SEAsiaIndonesia

17.2

Malaysia
Thailand

38.1

SAsia
Bangladesh

BhutanIndia
Maldives

Nepal
Pakistan
STiLanka

DMC: Developing Member Countries of ADB'

Expansions of world trade are supported strongly by increases of
intra-regional trade, and this can be seen in Table 1-9, made using data

in White Paper about World Trade by JETRO.4
Table 1-9 Growth rates of Export among regions
ExportWorld

EU15
AsiaNIEs.Import
1990-95

1996
1990-95
1996
1990-95
1996
1990-95

ASEAN41996
USA
Japan

A.NIEs ASEAN4 USA

World

EUI5

8.3

4.3

15.1

19.2

8.9

7.6

3.5

3.0

-1.4

4.5

5.2

5.9

5.1

3.6

15.2

18.2

5.2

6.4

4.8
16.4

3.5

9.0

3.6

7.9

7.1

9.9

21.2

20.4

8.8

10.6

Japan

3.9

2.1

1.0

6.1

-O.1

2.9

17.2

15.4

20.9

24.6

18.4

10.5

4.6

8.9

--

5.8
5.0

6.4

7.3

1.9

23.4

1990-95

8.2

3.6

12.6

17.3

1996

6.9

3.2

1.9

8.0

--

1990-95
1996

9.0

3.7

14.4

19.2

6.0

-7.2

-10.3

-8.3

-4.7

-7.3

(Average annual growth rate 1990-1995 & growth
4 Sehai to Nippon no Bouehi, 1997in Japaneserate

in 1996)---

KOBE ECONOMJC & BUSINESS REVIEW, 43 (1998), 1-23

12

Although growth rate of world trades shift down after 1996,
average annual growth rate in the period of 1990-1995 was high.
Especially growth rates of Asia NIEs and ASEAN 4 were very high.
More interesting features of Asia NIEs and ASEAN 4 are the facts thatthey increase their exports or imports among themselves, that is intraregional trade had increased among Asia NIEs and ASEAN 4. This willbe the causes and results of fast economic expansion of the regions.

From 1990 to 1995, world exports had expanded 44.4%o (annual
average 7.6%) and, among the exports, industrial products had
expanded 52.5% (annual average 8.8%o) and the share of industrial
products had expanded from 70.5%o to 74.4%. Inside the industrial
products, chemicals had expanded 58.3% (annual average 9.6SO)6o) andelectronics machinery5 had expanded 99.5906o (annual average 14.8%o).

The latter fact is surprising and the export share of electronics
machinery among industrial products had expanded from 12.5% (1990)
to 16.3%o (1995). This shows that exports of electronics machinery
pulled world exports in the period, and thus international division oflabor and eeonomic developments.
Now let us look at the trade matrix of the electronic machinery in

the world (using data from Sekai to Nippon no Boueki, 1997). The

exports share to Asia from EU, North America, and Asia had
expanded from 1990 to 1995 and it should be noted that the share of
intra-regional trade had increased from the exports share of 29.7%oTable 11-2 Trade Matrix of Electrenic machinery (Export Share, left & Import Share, right: %)export

World

EU
Asia
NorthAmerica

EU

Asia

NAmerica

1990

100.0

100.0

1oo.O

1995

100.0

100.0

1oo.O

6.59.46.78.48.08.7.Import

World

1990

100.0

1995

1oo.O

1990

1oo.O

1995

100.0

1990

1oo.O

1995

1oo.O

76.456.1
69.155.9
27.328.6
19.729.7
32.614.4
23.913.0

11.59.8

29.761.0 37.968.0
42.867.7 33.066.6
33.729.3 21.416.2
38.822.1 22.716.5(EU: 12 countries in 1990, 15 countries in 1995)

5 EIectronics machinery includes SITC cords 75,76, and 776, office machinery,computer, telecommunication machinery, semi-conductor, integrated circuit, etc.

IGA WA: VVHAT SOUTH ASIA CAN LEARN FROM EAST/SOUTHEAST ASIA 13(1990) to 42.8%o(1995). The import shares of Asia and of North America

from Asia are more than 60 %o, and these are very high. These facts
again give us some suggestions for Asian miracles.
It is well known among economists that there are net gains frominternational trade. However in real world, it is not easy to Iist all thegains and losses and, more importantly, compensations of losers withgainers do not take place in many cases. A typical theoretical way toshow gains from trade is a comparison of the situations between
without trade and with free trade. However, no country is autarky inthe recent world, and practical problems should be net gains fromtrade liberalization.

However, by and large, there is some consensus among economists
and policy makers that there exist net gains from trade liberalization,
at least in the long run. With trade liberalization, supply side, i.e.

production structures and distribution systems, will adjust for newmarket conditions, such as prices, market sizes, and competitions.
Although adjustments take costs, we have many cases, which show
larger benefits in the long run through more efficient division of labor.

Trade liberalization increases competition and changes businessincentives in the larger international market. To compete with domestic
and foreign firms, structural changes of firms will be called for, after

trade liberalization. New investments with new technology willaccompany higher skill of workers. These adjustments will befacilitated with liberalized larger international markets. The increasesof opportunities to access advanced technoiogies and to get highquality machinery will give incentives for profits in many firms. Efforts

to get competitiveness in international markets will improve efficiency
of firms.

When a market become large, firms can enjoy economies of scaleand economies of scope, and more efficient systems of division of Iabor

will be adopted. Horizontal and vertical divisions of production
processes (division of labor) will increase and an international trade
will assist exchanging and combining of products or services of those
processes. I would like to put stress on this benefits or gains ofdivision of labor by trade liberalization as one of important factors ofhigher growth of EST Asian regions. Increases in intra-regional trade
is a result of extensive international division labor in those regions andis a result of trade liberalization

14

KOBE ECONOMIC & BUSINESS REVIEVV, 43 (1998), 1-23

4. FDI of South Asia relative to East and Southeast Asia

The importance of technology transfer for economic developments
is increasing. Without advanced teehnologies, it will be difficult to join

into international division of labor. As a market transaction oftechnologies is not easy and many technologies are enclosed within one
organization, foreign direct investments play an important role for aninternational technology transfer. On the other hand, with decreases oftransportation costs and communication costs through technology
progresses, the costs of foreign direct investments has decreased andmany barriers for international business are becoming lower. These
enable extension of international division of labor. A country will be
included in the international division of labor deeply, if transaction
costs decrease and activities of firms become global.
Developing countries are competing each other to invite foreign
direct investments. In the case of foreign direct investments, foreign
firms bring funds, technologies, and management know-how. Therefore
a country accepting foreign direct investment inflows should only makean offer of investment environments. Favorable treatments of taxes andbusiness regulations will be short-run incentive policy and filling upsocial capitals and providing education for labor will be long-run
incentive policy. There will be a good eycle that inflows of foreign

direct investment help economic development and this in turn help
inflows of foreign direct investment.

The following Table A17 shows Foreign Direct Investments in Asia
NIEs, Southeast Asia and South Asia. We can find that foreign direct

investment in Southeast Asia and NIEs are large and are steadyincreasing in the period of 1991-1996. The one of South Asia is small

but is increasing rapidly, and this implies hopeful economic
development in South Asia in future.

The volume of foreign direct investment is not enough to evaluate
the gains of foreign direct investments, and it is necessary to get dataof several activities of foreign affiliates in developing countries. In thecomprehensive book6 by United Nations, several interesting data about
foreign affiliates are shown.

The importance of activities of foreign affiliates is increasing,
6 World Investment Report 1997 published by United Nations

IGA WA : WHAT SOUTH ASIA CAN LEARAI FROM EAST/SOUTHEAST ASIA 15

Table A17 Foreign Direct Investment (gross •flows)$million

1992

1991

1993

1994

1995

1996

9.664

12,347'-

15,650

NIEs
Korea

7,876

5,861

7,858

1,180

727

588

t8oo

1,776

2,308

Singapore

4,887

2,204

4,os6

5,480

6,912

9,440

SEAsia

8,512

9,899

10,734

10,325

14,31519,804

Indonesia

1,482

1,777

2,oo4

2,109

4,348

7,960

Malaysia

3,998

5,183

5,O06

4,342

4,132

5,3oo

Thailand

2,O14

2,114

1,730

1,322

2,oo3

2,426

SAsia

470

703

1,141

1,922

2,643

3,468

1

4

14

11

2

9

155

233

574

1,314

1,929

2,587

7

7

7

6

5

7

4
347
195

6

5

5

419

639
63

690

Bangladesh

BhutanIndia

Maldives
Nepal
Pakistan

2

1

257

335

SriLanka

48

123

166

170

Data: Asian Developrnent Outlooh 1998 from ADB

especially in developing countries, and this will be found in thefollowing table (Annex table A.4). The ratio of gross product byforeign affiliates to GDP had increased from 5.0S>(of (1982) to 9.0SO)6o(1994) in East, Southeast, and South Asia, and this change is muchlarger than the change in the world (from 5.29(of to 6.0%o) in the same
period.

Annex table A.4. Value of the gross product of foreign affiliates
and their share in GDP, by region, 1982, 1990, 1994

Billion$,&%oGrossProductofForeignAffiliates

RegionDevelopedCountries

l990

1994

1982

1990

1994

403

I098

1099

5.1

6.7

5.4

7.0

9.1

DevelopingCountries
Asia

150

S,E,&SEAsia

553

World
Data:

GPofFAas%oofGDP

1982

283

445

6.0

74

151

248

5.6

5.9

8.6

44

l12

211

5.0

7.0

9.0

1383

1557

5.2

6.7

6.0

World Investment Report 1997 from UN

16 KOBE ECONOMIC&BUSILNEss REVIEVIi, 43 (1998), 1-23

Foreign direct investment is not a simple substitute forinternational trade, and foreigri direct investment usually accompanies

an import of machinery and parts for products and accompanies anexport of products to investing country or to third country. Thisimplies that there exists deeper international division of labor than thecase of only international trades. It will be interesting to seeinternational activities of foreign affiliates, and export activities offoreign affiliates, shown in Annex table A.5 (using data of World
Investment Report 1997 from UN). The exports of foreign affiliates ofEast, Southeast, and South Asia increased more than 4 times from 1982
to 1994, and those of world increased 2.5 times in the same period. The
share of exports of foreign affiliates relative to total sales of foreign
affiliates in East, Southeast, and South Asia is high and increased from
49.3%o (1982) to 52.0SO)6o (1994) and the one of the world decreased from
30.5% (1982) to 27.7SO)6o (1994). The share of exports to affiliated firms

relative to total exports of foreign affiliates is about 509(of. .
Annex table A.5. Value of exports of foreign affiliates, their share in total sales,and exports to affiliated firms, by region, 1982 and 1994

Billion$,&%RegionDevelopedCountries

ExportsofFA

ExofFA/Total

salesofFA(906o)

ExtoFA/Total

exofFA(%)

1982

1994

1982

1994

1982

491

1225

27.7

25.1

44.2

55.1

DevelopingCollntries

242

585

38.1

35.6

49.5

55.8

Asia

110

431

41.3

47.9

46.2

54.2

S,E,&SEAsia

95

408

49.3

52.0

40.2

54.6

World

732

1850

30.5

27.7

46.0

55.3

Here we will look at data of FDI inflows in 1980s and 1990s of theworld and Asian regions. In the period of 1985-1990, large parts of FDI
flowed into developed countries and it was about 5 times of the one
into developing countries. However, the weight to developing countries
is increasing in 1990s and will be more than 1/2 of the FDI inflows indeveloped countries. The share of FDI inflows into East, Southeast andSouth Asia was about a half of the one into developing countries in the
period of 1985-1990, but it is about 2/3 in 1996. These imply the speedof foreign direct investment inflows into East, Southeast, and South

1994

CAN LEARiV 17ROM EAST/SOUTHEAST ASIA 17
IGA WA: WHAT SOUTH ASIA

Asia has been accelerated.
Annex table B.1. FDI inflows,by host region

and economy,1985-96(Million $)HostregionWorld

1985-90

1991

l992

1993

1994

1995

1996,a141930173761218094116744119692138762DevelopingCountries

24736

49625

Asia
S,E,SE-Asia

73045
50924

Korea

13492
12357
705

1180

727

Indonesia

551

1882

1777

2204

47278
588
2oo4
5006
4686

238738142395
90462
57507
55718
809
2109
4342
5480

2114

1730

1322

316524205876
96330
65249
65175
1776
4348
4132
6912
2oo3

349227DevelopedCountries

158936114792

41696
23129
21228

29632
27668

208226128741

84283
81241

2308
7960

Malaysia

1054

Singapore
ThailandBangladesh

2952
1017

3998
4887
2014

2

1

4

14

11

2

9

India

169

155

233

574

1314

1929

2587

Nepal
Pakistan

2

2

1

4

6

5

5

167

257

347

419

639

6se

SriLanka

37

48

335
123

195

166

63

170

1985-90:5183

Annual Average,

1996,a:

53oo
9440
2426

Estimates

It is also noted that the share of FDI inflows into South Asia wasvery low in the period of 1985-1990 (less than a half of the one into
Thailand), but it has increased rapidly and has become 1/5 'v 1/6 ofthe one into Southeast Asia. The one into India was 169 million $ peryear in 1985-1990 and became 2587 million $ in 1996. The one into Sri
Lanka was 37 million $ per year in 1985-1990 and became 170 million$ in 1996.
We are in the position to see cross-foreign direct investment among

East and Southeast countries or intra-regional foreign direct
investment in the regions. FDI flows into NAFTA is about twice of the

one into ASEAN 4, but FDI flows into NAFTA from EU (share of 2/3)
and Japan (share of 13%) dominates. The share of intra-regional FDI
in NAFTA is 159(o(. FDI flows into ASEAN 4 is dominated by those fromJapan (share of 31%o) and Asian NIEs (share of 28906o). The intraregional FDI in ASEAN 4 is 6 %o. The share of FDI flows into Asia
NIEs from NAFTA is 31906o and the one from Japan is 23%o. The one
from ASEAN 4 is 7906o and intra-regional FDI of Asia NIEs is 7906o. It

18 KOBE ECONOMIC &'BUSILNESS REutEV•V, 43 (1998), 1-23'
should be noted that the share of intra-regional FDI in ASEAN4 andAsia NIEs is 32%o, which is much higher than the one of NAFTA.

t tttt t tt tt ttt

Table 1-14 FDI Matrix in APEC Regions (1996, inflow base, Million $)FromTo

NAFTA

Japan

AsiaNIEs

NAFTA

14,028

2,171

3,030

4,651

Japan

12,146

2,190

15,734726
683

14,446

393
7666
508oo

AsiaNIEs

-821

1200

ASEAN4

90

ll

India

281

1

o

EU

62518
91153

1698

l951

6841

9718

World

ASEAN43211

Data: JETROIn the region of East and Southeast Asia intra-regional FDI has
extended and this will imply that international division of labor isextending in those regions.

A level of FDI outflows is one of index of development stage of acountry. The increase of FDI outflows from Asia NIEs implies that thedevelopment stage of Asia NIEs is approaching to the stage ofdeveloped or advanced countries. 'In the Tablel-12, we can find that Singapore has large outflows offoreign direct investments and direction is into Malaysia, Hong Kong,and Indonesia. Taking into account of geographical locations, historical
relations, and a role as an international financial center, this will benatural for Malaysia. Korea is investing into China and Indonesia, andthis is a part of "wild geese flying pattern of FDI" in Asia. Following

Japan, Asia NIEs invests in ASEAN, and the ASEAN invests in otherdeveloping countries in Asia such as China. This can be find in the FDIfrom Taiwan and Malaysia. Taiwan invests into China, Hong Kong, and
ASEAN and this is not only because of historical relations but also
economic incentives and differences of economic development stages.
Malaysia started to invest into other ASEAN countries and also into
China. ASEAN member has increased and this will increase FDI fromold ASEAN members into new ASEAN members. South Asia shouldmake use of this trend of "wild geese flying pattern of FDI". We will
discuss more about this in the following final section.

IGA VVA: WHAT SOUTH ASIA CAN LEARIV FROM EAST/SOUTHEAST ASIA 19

Table 1•-12 FDI from Asia NIEs and Malaysia (Million $)Singapore,Stock

FromTo Endof1995

Korea1996'Taiwan1996

Malaysia1996

3395

2625

World
Korea
Taiwan

32623
404

15

HongKong

4422

112

60

232

71

165

671

6132

6

Singapore36

Malaysia

6855

74

94

Thailand

sw

66

71

50

Indonesia

2844

213

83

157

Philippines

441

86

74

1oo

China

2094
329

1597

1229

179

57

7

41

Japan
England

USA
Australia

2326
1859
1022

847

6

237

1167

271

4oo

47

15

169

Data: JETRO

Efficient international division of labor will be intensified withforeign direct investments. This is the most important effect of foreign

direct investments and is well understood by many economists andpolicy makers.
The formal argument of net gains from foreign direct investments
is again a comparison of the situations with foreign direct investment

and without foreign direct investment. Investigating effects ofinternational capital movements or effects of international labor

migrations captures some important aspects of foreign direct
investment. However one of the important elements of foreign direct
investments is that they not only accompany movements of capital but
also accompany movements of international business management.
The more realistic arguments for foreign direct investments are
OLI theory of foreign direct investments, by Dunning. That is thetheory of Ownership advantage, Locational advantage, andInternalization. In the resent world, competitiveness of firms depends

on know-how or technology of business management, on technology
embodied capitals, and highly educated human capitals. Market
transactions of know-how and technology are difficult and thus

20

KOBE ECOIVOMIC & BUSINEss REVIEW, 43 (1998), 1-23transactions within a same organization dominate arms lengthtransactions in markets.

Liberalization of foreign direct investments produces many gains
both owner and host countries of affiliated firms. Besides net gains ofinternational factor movements there are effects of international use of'know-how and technology. Know-how and technology can easily (withnegligible marginal costs) be duplicated and an increase ofopportunities to use them will produce net gains. A firm with foreignsubsidiaries can use its own know--how and technology within the sameorganization in different countries. As the marginal costs to use theknow-how and technology are small, the firm will get large profits byincreasing foreign affiliates. In receiving countries of foreign direct
investments, local labors can find jobs in the foreign subsidiaries, andwill be combined with the know-how and technology.

Gains from foreign direct investments are not limited to theinternational use of know-how and technology but are found ininternational technology transfers. Foreign direct investment receiving

countries can access new know-how and technology and the know-how
and technology will defuse to outside of the organization. The
incentives of imitation and innovation or modification of the know-how
and technology will become strong in the host countries. Furthermore,vertical and horizontal division of labor will be extended seeking more
efficient systems. This necessitates the foreign subsidiary firms to
exchange their know-how and technology to their local partner firms.
Without jointly owning the know-how and technology, it will be difficult
to have efficient division of labor. A group of firms similar to a single
organization (KEIRETSU in Japanese) will be designed to internalize

the important know-how and technology.
Anyway foreign direct investments will facilitate technology
transfer and this produces big gains in the long run. With dynamic
structural changes with technology transfers, foreign direct investments
bring net gains, and the gains will be larger with intensive international

division of labor. The degree of international division of labor will bereflected in cross-foreign direct investments, and intra-regional foreign
direct investments. It is shown that extension of intra-regional foreign

direct investment in ESE Asia is a possible candidate of determinant ofhigher growth rate in the regions.

CAN LEA.RN FROM EAST/SOUTHEAST ASIA 21
IGA WA: waAT SOUTH ASIA

5. Policy Strategies of South Asia

There are two big trends in economic environments of the world.
One is globalization and the other is localization. The globalization isan increase of economic activities beyond geographical borders. An
increase of international trade and foreign direct investment is
promoted by a decrease of international transaction costs in broader
sense. Technical progress in transportation and telecommunication is
an important factor and a liberalization policy in many countries isanother important factor. New technology of machinery and new knowhow of management, which make optimum scale of a business larger,

are introduced by R&D activities. With economy of scale and/or
economy of scope, business activity of a firm should be extended
beyond its country borders.
Localization is reflected in regionalism or movements for regional
integration. In the case that optimum market size of business firm is

not global and a local accumulation or concentration of businessactivities produces many advantages, localization or regionalism will
prevail. External economies of business concentration and reduction of

network costs by concentration work. Further more, regional
integration improve political power of negotiation to outsiders. So far,there are three regions of economic concentration, NAFTA, EU, andEast/Southeast Asia. In the case of Asia the integration is not strict
and there exist many overlapping regional nets. However those regions
seem to extend in near future and globalization and localization will
converge in some way in future.
South Asia gets effects of globalization and localization. Withoutliberalization of trade and investment, South Asia will get no gains
from trade and from foreign direct investment. Without access to three
regions NAFTA, EC, and ESE Asia, South Asia might be discriminatedas outsider. It is important for South Asia to chose policies toefficiently use the trend of globalization and Iocalization.

It is beyond my scope of analysis in this paper to investigate
economic situations of South Asian countries in detail. Here I would
like to give more broad arguments of world trade and foreign direct
investment, and discuss possible development policies for South A, sia
region in the world economic streams of globalization and localization.

22 KOBE ECOIVOMIC &BUSINESS REVIEVV, 43 (1998), 1-23

As I mentioned, there are two streams in the recent world,
globalization and localizatioh. In these two streams, South Asia region
can take three pure scenarios of foreign polices. The first is generalliberalization of international trade and foreign direct investment,
where the region does not use strategies of specific export promotion
or FDI invitation. The second is regional integration of South Asia,

where the region has strategic policies to be one of the economic
concentrations or blocks. The third is to strategically approach one ofthree regions of economic integration, NAFTA, EC or East/Southeast' and dis-advantages. The first
Each pure scenario has advantages
scenario of liberalization of trade and investment is one of necessary
conditions for economic development for developing countries. The
point is whether to take strategies for promotion of export and of
foreign direct investment inflow. Without strategic policies, South Asia

can develop in a stream of globalization. However it takes time to be
involved in extended international division of labor. Further more, it isambiguous to become one of centers of economic concentration without

help of policies. That is, there is a risk to lose economies ofconcentration, which relate to localization.

The second scenario of regional integration or block economy is
one of strategies to get benefits of economies of concentration. Once
economic concentration is realized in South Asia, it will facilitate
economic development in the region. The point is whether the regional
integration itself can make economic concentration in the region. There

are three centers of regional integration, USA in NAFTA, Germany inEU, and Japap in ESE Asia. The center will expand within their regions
until an optimum degree of concentration. When their region become
too small, the region will be extended outside to include more countries

and/or another center will be constructed in a new region. The
situations now in those three regions are not optimum degree ofconcentrations. NAFTA can be extended to include South America, EU
can be extended to include East Europe, and ESE Asia has China andextended ASEAN. This means that it takes time for South Asia to be aconcentrated region with new center. There also exist some risks tolose gains of globalization, if South Asia makes a protective economic
block.

Let us investigate third scenario. As the three regions, NAFTA, EU,

IGA LVA: W'HAT SOUTH ASIA CAN LEARAr FROM EAST/SOUTHEAST ASIA 23

and ESE Asia, have capacities to expand inside their regions, specific
poJicy strategies should be taken by South Asia to be included in thoseregions. Without extended inter-dependence of South Asia with those
three regions, a speed of economic development in South Asia will be
slow. Therefore it is necessary for South Asia to have strong economic
relations with those three regions. Furthermore, it is necessary forSouth Asia to be competitive with less developed countries or regions in

those three regions, in exports and inflows of FDI. To manage in these

difficulties, Strategic policies in South Asia for extension ofinternational division of labor will be called for.

My final comment is that South Asia should find strategic policy inthe mixture of these three scenarios, taking into account theexperiences of ESE Asia. We already showed the important role ofintra-regional trade, intra-industry trade, and inter-process trade, andintra-regional foreign direct investment for East Asian miracles.
Strategic policies of trade and FDI liberalization, export and FDI
inflow promotion, and access to EU/ESE Asia/NAFTA with favorable
conditions wM be more effieient with South Asian regional integration
and with political stability in the region.

References
Shigeyuki Abe & Kazuhiro Igawa, "South Asia and Japan: Prospects of Further
Cooperation", South Asia Journal, Vol.5 No.4, pp. 431-468, April-June 1992

The World Bank, The East Asian Miraeles: Economic Growth and Public Policy,

The World Bank 1993
OECD, Foreign Direct Investinent, Trade and Employment, OECD 1995
Peter Harrold, Malathi Jayawickrama, and Deepak Bhattasali, Practical Lessons
for Africa from East Asia in Industrial and Trade Policies, World Bank
Discussion Papers 310, The World Bank 1996.
United Nations, VVorld Investrnent Report l997, UN 1997

JERTO, Sehai to Nippon no Bouelei (in Japanese), JETRO 1997

Asian Development Bank, Asian Development Outlooh I998, ADB, Oxford
University Press 1998
JETRO, Sehai to ATippon no Kaigai Tyohusetu Tousi (in Japanese), JETRO 1998
OECF, Kaigai Keizai Korouryoku Binran 1998 (in Japanese), OECF 1998

KOBE ECONOMIC & BUSILIVEss REVIEW, 43 (1998), 25-63

RELATIONAL GOVERNANCE
IN JAPANESE VERTICAL RELATIONSHIPSKENJI KOJIMA Kobe University

Abstract
The primary purpose of the study is to characterize significant features ofrelational governance in Japanese vertical relationships and to provide an economic
rationale. Japanese vertical relationships, particularly in automobile industry, areexamined in comparison with those in the U.S. Both buyers and suppliers haverecognized the need to be interdependent and have responded by developing bonding
mechanisms that build mutual trust. It could reduce transaction costs and enhance
efficiency in trading relationships with relationship-specific investments in longterm relationships.

JEL Classification: L14; L62

Keywords: Incomplete contracts; Japanese firms; Long-term relationships;
Procurement; Relationship-specific investment; Vertical relationships

1 Introduction

Vertical trading relationships are important concerns for firmsthat transact intermediate goods to achieve an efficient production
system. Various systems of vertical relationships have evolved indifferent countries to attain efficient trading relationships. While thediversity within even a single country can be enlarging, broaddifferences do appear to separate the relationships most commonly
found in different countries. Particularly, there are significant
Corresponding Address:
Kenji Kojima
Research Institute for Economics and Business Adrninistration (RIEB)
Kobe University,
2-1 Rokkodai-cho, Nada-ku,

Kobe, 657-8501, Japan 'E-mail: kojima@rieb.kobe-u.ac.jp
Phone/Fax: (81)-78-803-0406

26

KOBE ECONOMJC & BUSJIVESS REVIELV, 43 (1998), 25-63

differences in vertical relationships between ,Japan and the UnitedStates. It is commorily observed that U.S, automobile manufacturers
are more vertically integrated than their Japanese counterparts. Even
though U.S. automakers are more vertically integrated, they contract
directly with more than one thousand suppliers for the parts they do

not make. The Japanese automakers, by eontrast, work withapproximately one-tenth that number, buying more entire subsystems
from each supplier. Product development process in the U.S. is heavily
influenced by the traditiona} system in which suppliers produce parts
under short-term, arm's-length contracts and have little role in designand engineering. In Japanese vertical relationships, in contrast,

suppliers are an integra} part of the product development andmanufacturing processes: they are heavily involved, assume significant
responsibility, and communicate extensively and directly with productand process engineers. Japanese suppliers frequently play a significant
role in development. Vertical relationships in Japan can be identified tohave distinctive characteristics in several aspects eompared with the
U.S. counterpart. What are the major characteristics of vertical trading
relationships in Japan making differences from the U.S.? What factors
determine the differences in institutional arrangements that govern
vertical re}ationships among the two countries? It is important tounderstand how efficiently Japanese vertical relationships work, andwhether the Japanese practice is unique to the peculiar circumstancesof the Japanese social and cultural system.
Japanese vertical relationships can be identified that both buyers
and suppliers have recognized the need to be interdependent and have
responded by developing bonding mechanisms that build trust between
them in the long-run. Japanese firms do not rely on legal contracts toprotect their interests in trading relationships. The impor'tant issue isto understand why and how firms use such flexible arrangements. Why
are many trading relationships governed by flexible and long-term
relationships in Japan? What factors support the long-term trading
relationships in Japan? What determines the structure of long-term
relationships and why are they used instead of simple long-term
contracts? What governance mechanisms will emerge as the parties
negotiate a mutually acceptable trading arrangement in response to
anticipated transaction costs and contractual executiQn difficulties? It

is important to understand the economic rationale of vertical

KOJIMA: RELATJONAL GOVERNANCEIN JAPANESE VERTICAL RELATIOAISHIPS 27

relationships in Japan. Yet many aspects are stiH left unknown about
the process that unfolds between buyers and suppliers in Japan and theu.s.

This paper identifies major characteristics of Japanese vertical
relationship in a comparative perspective. The verticai relationships inJapan, particularly automobile industry, are examined in comparison
with those in the U.S. The primary purpose of the study is to identify
significant features of Japanese vertical relationships and to provide
economic rationale in a transaction cost perspective. In this paper,significant features of Japanese vertical relationships are characterized

as follows: long-term relationships and commitments based on flexible
legal contracts; significant relationship-specific investments in plant,
equipment, and human gapital; building mutual trust in the long-run;supporting mechanisms for trust such as cross-shareholding, extensive

information sharing, and enduring personal networks, which reducetransaction costs and eliminate inefficiencies between buyers andsuppliers.

This paper is organized as follows. Major characteristics ofJapanese vertical relationships are discussed in order. The next section

discusses long-term relationships in relational governance systems.
Section 3 discusses relationship-specific investments with a viewpoint oftransaction cost. Section 4 describes building trust and supporting

mechanisms to sustain trust among trading partners. Finally,
concluding remarks are presented.
2 Long-term Re}ationships
2.1 Relational Governanee

Relational governance systems that facilitate the building andmaintenanÅëe of stable, long-term trading relationships. These, in turn,

foster investment in relationship-specific assets, and enable firm
operating within an relationship to exploit transactional rent not
generally available to arm's length transactions. One should understandthe conditions under which close, long-term trading relationships
among few firms can lead to efficient performance.
Governance of contractual relationships span a continuum boundedat one end by the writing of explicit, detailed contracts, which may
them be enforced by court in the event of breach by one of the parties.

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KOBE ECONOMIC & BUSINEss REVIEVV, 43 (1998), 25-63

At the other end is reliance on implicit, relational governance foundedon enduring trust relationships and reinforced by largely non-legalistic

mechanisms structured to encourage voluntary compliance withinformal agreements. The central problem of governance in trading
relationships is to devise specialized systems of incentives, safeguards,

and dispute-resolution processes that will promote the continuity of
trading relationships that are efficient in the absence of self-interested

opportunism, but which might otherwise break under forces ofunassisted market contracting.

One of the most important practices supporting the preservation of

long-term trading relationships is tendency of members to engage
extensively in highly informal, implicit contracting. The virtue of
implicit contracting as a mechanism for sustaining long-term trading
relationships lies in its intrinsic flexibility. Assuming a foundation ofmutual trust and shared expectations, implicit contracting among
parties better enables firms to make rapid, informal, and highly refinedadjustments in the terms of trade to preserve the spirit and substanceof a trade agreement rather than merely the letter of a written
contracts. This easy mutability allows implicit contracts to withstandgreater stress than formal, explicit contracts, thereby promoting thelongevity of trading relationships. Where implicit contracting is widely
prevalent, the reference point in any discussion regarding a trading
agreement tends to be the ongoing business relationship itself rather
than the agreements per se.

The market may provide a natural deterrent to agents behaving
opportunistically and eliminate the need to rely on either vertical
integration or complex contracts. There is a potential cost to breachesof writing or implied contractual promises: the loss of future businessfrom either this buyer or other buyers. In market where buyers andsellers frequently engage in similar types of transactions, and where it
is possible at low cost to distinguish behaviors, reputation constraints

will mitigate incentives of opportunistic behavior and allow agents tomore comfortably use market transaction, recognizing that the market
provides penalties for inefficient behavior.

The execution and adaptation of trading agreements are madeprimarily by reference to norms and expectations built over a long
history of trading. Thus, relational governance within members is of amore continuous administrative nature and relies less extensively onKOJIMA.• RELATIONAL GOVERNANCEIN JAPANESE VERTICAL RELATIOIVSLIIIPS 29

legal rules, third-party assistance to effect change, or litigation as ameans of resolving disputes. Managers in firms are those who
understand the interests and priorities of the relationships, are alert tothe network of implicit contracts binding the firm to the relationships,

and can be trusted to uphold these contracts over time throughchanging circumstances.
2.2 Cooperation in Long-term Relationships
Repeated trade relationship can serve in place of formal contracts
in developing incentives for cooperative behavior. It states the gametheoretic idea that infinitely repeated interactions permit cooperation to

occur if the players are sufficiently patient (Fudenberg and Tirole,1991). Repetition of a game allows the players to escape the prisoner's

dilemma; each player's pursuing immediate gain leads to an outcomethat can be improved for all of them. The vertical relationships canhave the character of a prisoner's dilemma. One way of overcoming
this is to write contracts, with each party promising to refrain fromthe mutually damaging activity and making himself subject to legal
sanction if he breaks his promise. However, cooperative outcomes are
enforced by the threat that any deviation will trigger switch to an
outcome of a prisoner's dilemma in a repeated game. In consequence,patient parties can implicitly cooperate with any deviation triggeringpunishment. The cooperation is implicit in that the parties would notneed to enter into binding contracts to enforce their cooperation.

Instead, each party is deterred from breaking the agreement bycredible fear of provoking a prisoner's dilemma. If the equilibriumoutcomes are suitably focal among the parties, then cooperation might
be sustainable without even communieation.
In a continuing situation, people cooperate because it is in theirinterests to do so. The point of the repeated-game argument is that
players cooperate now for fear of being cut off from profits in the
future. Suppliers make efforts to produce products on behalf of thebuyers. The resulting consequences depend on an environment as wellas on the suppliers' efforts. The buyers cannot directly observe thesuppliers' efforts. In this situation, the repetition of the game would

give the buyer an opportunity to observe the results of the suppliers'
effort over a number of periods, and use the idea like some statistical
test to infer whether or not the supplier was making appropriate level30

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KOBE ECONOMIC & BUSINESS REVIEW,

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of efforts (Radner, 1985). The cooperative outcomes can be attained bya review that manufacturer periodically evaluates the cumulative
performance of the distributors. If a review results in a satisfactory
evaluation, a new phase is begun in which the outcome is efficient to allof them; otherwise, the players enter a penalty phase in which theoutcome is a prisoner's dilemma. The equilibrium cooperative outcomesare self-enforcing, and thus do not need to rely on any binding

contracts or other precommitments. A suppler is given a rating
according to her performance and cooperation to sell products for aparticular manufacturer in the Japanese vertical relationships. A
supplier that performs well is given a high rating. Then, she ispromoted to be higher status in which she is provided with the various

menu of rebates being rewarded for target achievement, forcooperation in quality and delivery schedule (Economic Planning
Agency, 1991). The manufacturer's policy of maintaining long-term
relationship with suppliers is designed to encourage them in achieving
good supply performance and high cooperation.

Although repetition can induce the incentive for players tocooperate, a repeated game has plethora of equilibria involving
cooperation outcomes as well as non-cooperative ones; each player
rationally pursues either long-term or short-term gains (Fudenberg
and Maskin, 1986). Hence, repetition offers no guarantee that it will
occur. None of the players can be ensured that cooperation occurs as
an equilibrium outcome. The cooperation resulting from repeatedrelationship is not robust, so that it is necessary to have devices tosupport cooperative relation among players. Repeated relationship inJapanese vertical relationship is secured by mutual trust founded upon
unique bonding mechanism. Bonding mechanism to facilitate partners
to exchange and disseminate information and to establish personal ties
among themselves. Information sharing and close personal ties may
ensure every member of the trading relationship to establish andmaintain goodwill and trust among them. These dominant social norms
encourage members of the group to choose cooperation as one of the
focal point equilibria (Schelling, 1960).

2.3 Long-term Relationships in Japanese Firms

One of the most salient and enduring characteristics of theJapanese firms is their tendency to engage in close, long-term businessKOJIMA.• RELATIONAL GOVERIVANCEIIV JAPANESE VERTICAL RELATIOIVSHIPS 31

relationships with other firms.i This particularly characterizes theirtrading relationships, but also their dealing with banks. Many of thesein turn have long-standing relationships with one another, resulting in

an intricate network of firms connected by formal and informal
commitments. This corporate network maintains stable, close
relationships with a network of suppliers, distributors, and creditors.

Sustaining a complex network of business relations within the group
may also require a narrowing of the scope for independent actions andthe occasional subordination of individual corporate interests to that of

the group at large.

In the trading relationships in Japanese firms, a number ofcommon characteristics that contribute to their effectiveness as
systems for controlling and coordinating the performance of membersin the relationships. One of them are heavy reliance on implicit,
relational contracting founded on trust. Among Japanese firms, supply
contracts are established by a basic agreement which is short, written
document that is little more than legal ones stipulating that the
supplier and assembler are entering into a trading relationship, wiIJ
operate on a basis of mutual respect for each other's autonomy, andwill endeavor in goof faith to maintain an atmosphere of mutual trust1

In 1986, the Fair Trade Commission (FTC) surveyed the user-supplier
relationships at 2oo large non-financial firrns, of which 94 firms responded (Fair
Trade Commission, 1987). In regard to production goods as well as capital goods,
the overwhelming response was that they had long-term relationships with all or
the majority of their suppliers with maintaining over more than five years. 63% of
respondents had the trade relationships with their 30 largest suppliers over morethan ten years. The prevalence of those long-term relationships was explained in
the FTC report as follows: a close, long-term relationship with a few suppliers
affords substantial reductions in purchasing management costs as suppliers can beincreasingly relied on to perform product inspections and inventory control, toprotect technical secrets, and to settle transactions smoothly; in a long-term
relationship, communication becomes sirnpler and mutual understanding develops;
this is seen as a major advantage in maintaining existing purchasing relationshipwith trading off raising switching cost. Economic Planning Agency in Japan
conducted the mail-survey on the trade practices in 1990 (Economic Planning
Agency, 1991). It shows that long-term relationships seem to both foreigners andthe Japanese peculiar to Japan. Moreover, it shows it works against newly
entering foreign firms. Respondents are foreign businessmen in Japan and theJapanese in that survey. 82906o of respondents among foreign businessmen agree
that long-term relationships are peculiar to Japan; 720/o of Japanese respondents
agree with that. 700/o of foreign respondents agree thadong-term relationshipS are
working as an entry barrier. On the other hand, 350/o of the Japanese agree withthat. That survey supports the claim of foreign manufacturers trying to enter theJapanese market. It is claimed that they are unfairly excluded because theJapanese distributors purchase only frorn their accustomed manufacturers.

32

KOBE ECONOMIC & BUSINEss REVIEW, 43 (1998), 25-63

in their business dealings. The contracts in Japan often do not evenstate definitely the transactions at stake so as not to restrict theflexibility considered necessary to modify the supply agreement overtlme.

It is shown that suppliers have a close and long-term relationshipwith their largest customer both in Japan and U.S. automobile industry

by Liker, et al (199). They also suggests closer, more long-term
relationships in Japan, though these differences are not as large as

expected. It is observed that Japanese automakers have the mostdedicated relationships with subsystem suppliers and the least
dedicated with lower-tier suppliers. Japanese suppliers are considerably

more dependent on their largest customer. Equity ownership is moreprevalent in Japan. This results suggest U.S. automobile companies are
as likely as Japanese companies to out-source design, given suppliers

early information about product development, and allow them todevelop unique design capabilities the automobile company cannot
replicate.

U.S. automakers are more vertically integrated than their Japanesecounterparts. Even though U.S. automakers are more verticallyintegrated, they contract directly with 1,500 to 3,OOO parts suppliers forthe parts they do not make. Toyota, by contrast, works withapproximately one-tenth that number, buying more entire subsystems
from each supplier. Reducing the total number of direct suppliers canlower costs while increasing quality. Using fewer suppliers can create
value by providing economies of scale and benefits of experience curvethat lower either transaction costs or production costs. Within mostindustries, as cumulative production experience in producing a productor service increases, quality is improved and costs are reduced.
Japanese automakers have consolidated their business with a few
highly efficient suppliers and created conditions that permit the
suppliers to make the investments necessary to accelerate down theexperience curve and to share the full advantage of this volume withthe automakers. When a Japanese supplier wins a contract with Toyota
or Nissan, it is essentially guaranteed four years of business or the lifeof the model. Moreover, if the supplier performs up to expectations, it
can usually renew the business for the next model as well. Naturally,
these practices encourage long-term plans and investments. Suppliers
invest in developing ideas and plans for the next model well in advance.

KOJIMA : RELA TIONAL GO VERNA NCEIN JA PANESE VER TICAL RELA TIONSHIPS 33

Engineers from the limited suppliers have long-term experience working

together, making it easier to rapidly develop designs for the next
model. When the model change occurs, suppliers continue to move down
the experience curve.

In contrast, U.S. automobile manufacturers have attempted to keep

input prices low by maintaining size and bargaining power oversuppliers. By splitting their business among many suppliers androtating them frequently, U.S. manufactures have repeatedly destroyed
the experience curves of suppliers by ensuring that no one supplier
could accelerate down the experience curve to accumulate decisive costadvantage. Thus, the U.S. suppliers typically do not develop long-term

relationships and experiences with automakers. Moreover, they areunable to effectively plan long-term production and investments, whichis reflected in lower average plant capacity utilization. Without longterm commitments, U.S. suppliers can not have incentives enough tomake long-term investments in capita} equipment, Moreover, without
the ability to make long-term forecasts, it is very difficult to makemaximum use of capacity and capital equipment. For example,
manufacturers may involve suppliers to a greater degree in the productdesign process to utilize fully the value of present tools and equipment.
In this way, the risk of tool obsolescence due to unilateral designchanges is lowered. Naturally, the longer the parties work together
under these circumstances the more likely it is for mutual trust to be
developed. Trust in this case comes from reliability demonstrated overrepeated interactions, as well as the shared knowledge that the parties
need one another (Dyer and Ouchi, 1993).
Supplier relations in the U.S. are changing rapidly and are moving
close to the those in Japan. Cusumano and Takeishi (1991) present theresults of a questionnaire survey to a sample of automobile
manufactures in the U.S. and Japan during the spring of 1990. The
survey provides evidence that U.S. automakers aBd suppliers haveadopted at least some practices traditionally associated with theJapanese, thus indicating a possible convergence toward a Japanesemodel of vertical relationship. The evidence shows that U.S. automakers

appeared to move close to the Japanese model during the 1980s inseveral areas. For example, U.S. firms had long, stable histories ofrelations with their suppliers; the average contract lengths they gaveout for components after market introduction were dropping while

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KOBE ECONOItttlC & BUSINESS REVIEW, 43 (1998), 25-63

quality was improving; past relations an financial affiliation, such asuse of internal part divisions, were becoming less important as factors

in choosing suppliers, while pricing accuracy and quality seemed to begaining importance. Where once contracts were short-term, arm'sIength relationships, now contracts have increasingly become long-term.
Helper and Sako (1995) shows that U.S. suppliers must provide buyers

with detailed information about their processes, and buyers talk ofpartnerships with their suppliers. 87 percent of Japanese suppliers,
compared with 68 percent of U.S. firms, thought that their customer'scommitment would last more than four years, the typical duration of amodel cycle. The actual record of trading with the same customer was
significantly Ionger in Japan than in the United States.
3 Relationship-specific investments

3.1 Transaction costs

If perfectly enforceable contracts could be written, theresponsibility of each party to the others in the contracts could bedelineated under all possible future contingencies. Under thesecircumstances, there would be no scope for the opportunistic
exploitation of asymmetric information and unobservable actions by
any one party at the expense of others. Potential conflicts between
parties lie at the transaction costs. Transactions costs include: costs ofnegotiation and writing contingent contracts; cost of monitoring
contractual performance; costs of enforcing contractual promise; andcost associated with breaches of contractual promise.
As a fundamentally self-interested party in its own right, and one
often capable of undertaking actions or exploiting information hiddenfrom other party, one party cannot always be counted upon to act in
the best interests of the other. Recognizing this possibility, rational
parties are induced to develop appropriate incentives and safeguards tomitigate self-interested opportunism by other parties. The costs ofdesigning and running these relationships, and value lost due to theresidual shirking or private consumption of rents accrued in the
trading relationships by one party that ultimately cannot be eliminated,

are the transaction costs borne by one party.
As uncertainty and complexity become more important in a vertical
relationship, the expected costs of writing, administering, and enforcing

KOJJMA : RELA TIONAL GOVERNA NCEIIV JAPA NESE VER TICAL RELA TIONSHIPS 35

full contingent contracts increases. A contract is incomplete in thesense that it does not specify unambiguously the obligations of eachparty in every possible state of nature. Contractual incompleteness sets

the stage for ex post performance problems. When contingencies arisesthat are not fully and unambiguously covered by formal contractual
provisions, one or both parties to the transaction may have incentives
to take opportunistic behaviors that increase the costs or reduce gains

that will be obtained by the other party. The anticipation at thecontract formation stage that the possibility of opportunistic behavior
when certain contingencies arise affects the structure of initial vertical
relationships.

Institutional arrangements emerge to minimize the costs of making
transactions. These costs include both ordinary production costs thatmake up the components of a cost function and certain transaction
costs associated with establishing and administering ongoing trading

relationships. There exists a continuum of potential governancestructures for vertical relationships. Between vertical integration andarm' s length market' transaction, we have a wide array of potential

contracting arrangements that mediate transactions through themarket but involve the use of a variety of specialized contractual
provisions that arise as a consequence of efforts by firm to minimize
the total cost of transaction over time.

Numerous researches focus on how trading partners protect
themselves from the hazards associated with exchange relationships.2

Because contracts are typically incomplete, parties who invest in
relationship-specific assets expose themselves to a hazard: if
circumstances change, their trading partners may try to expropriate
the rents accruing to the specific assets. One can try to understandhow trading partners choose, from the set of feasible institutional
alternatives, the arrangement that offers protection for theirrelationship-specific investment at minimizing costs.

Transactions differ in a variety of ways: the degree to which
relationship-specific assets are involved, the amount of uncertainty
about the future and about other parties' actions, the complexity of the

trading arrangements, and the frequency with which the transaction
2 Shelanski and Klein (1995) summarize and assess the major findings in empiricalresearch in transaction cost approach to trading relationships.

36 KOBE ECONOMIC &BUSINESS REVIEW, 43 (1998), 25-63

occurs. The efficient form of organization for a given economic
relationship is a function of certain properties of the underlying
transaction: asset specificity, uncertainty, complexity, and frequency.
Specifically, the probability of observing vertical integration depends

positively on the amount or value of the relationship-specific assets

involved and on the degree of uncertainty about the future of therelationship, on the complexity of transaction, and on the frequency of
trade.

Long-term contracts ean facilitate trade between two parties who
must make relationship-specific investments. Once the investments havebeen sunk and the parties have become locked-in to each other, outsidecompetition will have little impact on the terms of their trading, and sothese must be governed instead by contractual provision. The difficult
task in writing a contract is to anticipate and deal appropriately withthe many contingencies which may arise during the course of thejr
trading relationships. Since it may be prohibitively costly to specify, ina way that can be enforced, the precise actions that each party shouldtake in every conceivable eventuality, the parties are in practice likely
to end up writing a highly incomplete contract. Hart and Moore (1988)

consider a situation in which two contracting parties are forced towrite an incomplete contract because of their inability to specify thestate of the world in sufficient detail that an outsider can verify
whether it has occurred. They study whether the parties can make up
for this incompleteness to some extent by building into their contract amechanism for revising the terms of trade as each party receives
information about benefits and costs. For the case where the partiesare risk neutral and must undertake relationship-specific investments,
they show that the parties will not generally be able to sustain efficientinvestment levels even if messages are verifiable. They argue that
contractual incompleteness, due to non-verifiability of the relevant stateof the world, combined with the parties' inability to prevent ex post
renegotiation will lead to under-investment in a hold•-up problem.3

3 Tirole (1986) considers the incentive effects of ex post bargaining on the level of ex

ante investment. Contracts are assumed to be incomplete in the sense that agentsare unable to commit to a division of the contractual surplus before making theirunobservable investment decisions. Although the bargaining process is notresource consuming per se, the prospect of such a redistribution distorts agent's
incentives to invest and diminishes the gains from trade.

KOJIMA .• RELA TIOAIAL GO VERIVA NCEIIV JA PA IVESE VER TICAL ,RELA TIONSHIPS 37

3.2 Long-term Contracts and Vertical Integration
Long-term contracts can be readily enforced by the courts if theterms and conditions of the contracts are clear, the obligations andbehavior of the parties in each state of nature can be verified easily,

and the court can be relied upon to enforce contractual promises
through orders for specific performance and the assessment ofdamages reflecting the economic losses to the party that has beendamaged if a breach of contractual promises occurs.` Since suchcontracts are generally incomplete contingent claims contracts, one cannot expect real long-term contracts to be enforceable by the courts

with certainty or without potential cost to the damaged party.
Contractual provisions may be unclear or ambiguous, obligations andbehavior may be difficult to verify, and the litigation process is costly
and uncertain.5

In what circumstances should a firm proeure its needs in themarket and should it internalize the market by integrating operations
so as to be self-sufficient in its own capacities? Extensive reliance onmarket procurement permits firms to exploit the efficiencies associated4

Crawford (1988) examines the effect of contract duration on the incentive to invest

in relationship-specific assets when its parties have perfect information, andcontract are complete, except that short-term contracts specify only current-period
actions. Then, short-term contract distorts investment only when the efficient plan

involves mainly sunk investment and the relationship plays a consumptionsmoothing role. Thus sunk investments can cause under-investment only whenshort-term contract interferes with consumption smoothing within the relationship.
It is shown that when trading parties do not need their relationship for efficientconsumption smoothing, short-term contracting is equivalent to long-term
contracting, so that the duration of contracts affects neither the efficiency of theirrelationship nor how they share its surplus. Farrell and Shapiro (1989) also
examines the ro!e of incomplete Iong-term Åëontracts in a simple model of ex postlock-in in the presence of non-contractible quality. The ex post bargaining
necessary for a sequence of short-term contracts may be inefficient if information
is incomplete. In particular, buyers' switching costs are often unobservable to theseller. Then, without a long-term contract, the seller may be tempted ex post toraise his price or lower his quality so far that some buyers will inefficiently
switch away: thus spot market interaction would not be fully efficient. A longterm contract that prevents the seller from raising the price ex post might tempt

him to lower the quality instead. Because that would be inefficient, such acontract would be unattractive: buyers would prefer no long-term contract.
Because the cost savings from quality reduction do not fully match the utility loss,a long-term price contracts that prevents the seller from driving away buyers withlow switching costs by raising price may dissuade him from driving them away
at all. Thus long-term contract can be helpful.
5

The motivation for long-term contracting as an alternative to arm's length

exchange has been examined in detail by Williamson (1979, 1985), Klein,
Crawford, and Alchian (1978), Goldberg (1976).

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with specialization in production and the exposure of independent
assets owners to high-powered market incentives. But it also exposes
firms to the risks of self-interested opportunism. Opportunism refers
here both to behavior that does not maximize rents when a particular
contingency arises and also behavior that involves the appropriation of
wealth of one party by the other in some states of contingencies. In
either case, upon realization that opportunistic behavior may occur, thegovernance structure and the terms and conditions of any arrangement
chosen are adjusted ex ante. Contracts that pose more serious hazards
are provided with greater safeguards.
Consider a firm that invests in specialized assets used to support a
particular trading relationship. By virtue of their specialization anddefinition to one or a few specific customers, these assets may behighly efficient and yield lower production costs than alternative
general-purpose assets. But their specialized nature also means thatthey have much lower value in alternative use. This create the danger
that investing firm's counterpart in the trading relationship might
attempt to improve the terms of trade it receives by threatening todefeet from the business relationship. Alternatively, there is thepossibility that the counterpart will simply cease to remain in businessfor any of several reasons, thus saddling the investing firm with
underutilized or even idle assets.

Monteverde and Teece (1982) examine the role of asset specificity
in determining the structure of vertical relationships. They focus on the

choice between vertical integration and market procurement of
automobile components by Ford and General Motors. They use
application-engineering effort as a measure of the degree of asset
specificity. The hypothesis is as follows: the greater is the applications

engineering effort associated,with the development of any given
automobile component, the higher are the expected appropriable quasirent, and therefore, the greater is the likelihood of vertical integrationof production for that component. They find that specific components
will have a higher probability of being vertically integrated. The
empirical result provides support for the view that variations in an
asset specificity affect the choice between vertical integration andmarket procurements as hypothesized.
Masten, Meehan, and Snyder (1989) attempt to distinguish among

type of specific assets, comparing the relative importance ofKOJIMA: RELATIONAL GOVERNAIVCEIN JAPANESE VERTICAL RELATIONSHIPS 39

relationship-specific human and physical capital. They also study
automobile component production finding that engineering effort as aproxy for human asset specificity appears to affect the integration
decision more than physical or site specificity.6 Klein (1988) suggeststhat specific human capital in the form of technical knowledge is amajor determinant of General Motor's decision to buy out Fisher Body.'
To sum up, asset specificity and uncertainty appear to have significant
effects on the vertical relationships in the U.S.

3.3 Relationship-specifie Investments in Japanese Firms

If vertical integration is not economical because of diseconomies

associated with internal production, contractual arrangements togovern exchange between independent agents will emerge to economize
on these transaction costs. The structure of these market contracts willreflect efforts to create incentives and restrictions that reflect
anticipated performance problems so that agents will perform as
initially promised when different contingencies arise. Contractual
arrangements should at least evolve in the shadow of the law, withrecognition that court enforcement remains an option. Opportunities tospecify contractual agreements in a clear and unambiguous way so as
to strengthen the credibility and reduce the costs and uncertainty oflegal sanctions should be taken advantage of. Given contractual

incompleteness due to uncertainty and complexity, as durable
relationship-specific investments become more important, thetransactions costs associated with mediating vertical relationships
using arm's length market increase. Relationship-specific investments
generates a stream of potentially appropriable quasi-rent equal to thedifference between the anticipated value in the use to which theinvestments were committed and the next best use. The presence of
6

Masten (1984) also provides an empirical result of make or buy decision by anaerospace firm for the components of a large system that it had contracted toprovide to the government. He finds that variations in the importance of asset
specificity affect the choice between vertical integration and market procurement.
It suggests that contractual complexity as well as asset specificity leads vertical
integration to be chosen over contracting.

7

Other studies of component procurement in the auto industry find similar support
for transactional explanations of vertical relationships. Walker and Weber (1984)
find that greater uncertainty about production volume raises the probability thata component is made in-house, but that the frequency of changes in productspecification and the probability of technological improvements have little effect.

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relationship-specific investments creates incentives for one party tohold up the other ex post and can lead to costly bargaining. Whenrelationship-specific investments are important, governance structure
will emerge ex ante to reduce the incentives either party has to exploit
them ex post.
Vertical relationships in Japan are characterized long-term andhighly committed, whereas they are more likely to be governed byshort-term, arm's-length relationships in the U.S. One of the major
benefits of the Japanese supplier involvement in design is access tohighly customized design with unique features for a particular buyers'
needs. Japanese automobile suppliers develop more unique parts fortheir customers and make greater investments in specialized assets
than do U.S. suppliers. A supplier typically has contracts with anautomaker both for a variety of components in a single model and forsimilar components in different models. There are usually several

companies within the automaker's supplier group qualified to
manufacture a component. The other qualified suppliers may becurrently producing similar components for other models. Within an
assembler's hierarchical structure of suppliers, there are two basic
types - design approved (DA) and design supplied (DS). DA suppliers

provide both design and production services to the automaker's
specifications, while DS suppliers produce a component from drawings
provided by the automaker. The DA suppliers are usually those withthe close and Iong-term relationships with the automaker. First-tierand the DA suppliers have a greater number and more profitable
contracts with the automaker. The automaker usually has less detailed
knowledge of the DA supplier's production costs which give the supplieran advantage in price negotiation. There are many thousands ofsuppliers in the automaker's supplier hierarchy and only a few hundred
at the first-tier.

The typical production cycle for a car model begins with a lengthy
design and development stage followed by a 4-year production stage.
The automaker usually invites several qualified firms in the suppliergroup to compete for a contract t,o design and produce a component
for a new model cycle. A DA supplier will undertake the design anddevelopment as well as tooling for production with no guarantee of
reimbursement by the automaker. For DS supplier, the automaker will
guarantee reimbursement for specific investments such as tolling.

KOJIMA: RELATIONAL GOVERNANCEIN JAPANESE VERTICAL RELATIONSHIPS 41

Whether DA or DS, the automaker makes a firm commitment to use
the supplier for the 4-years production life of the model. A first-tiersuppliers does not usually receive a separate payment for theinvestment in tools, dies, molds, and jigs that are highly customized
and would need to be scrapped if the automaker cut off orders to the
supplier. The suppliers' specialized capital investments make themhighly dependent on the automakers, with the real possibility of holdup problem. However, automakers are also significantly dependent on
the suppliers. Most DA suppliers' parts are "black box," meaning thatthe automaker provides only very general specifications while thesupplier does all of the detailed functional specifications and blueprints.

Consequently, suppliers have significantly more knowledge about thedesign and manufacture of the part than does the automaker. Because
black-box parts are customized to a specific model, the automaker ishighly dependent on the supplier. If the supplier did not perform as
desired, the automaker would have difficulty simply shifting business toanother supplier, given the product's customized nature. Some DA
suppliers claim that they do not provide the automakers with all of thespecific functional details when they submit their design drawings forapproval, but intentionally leave out certain important details such as

tolerances. Because the automaker does not know the part's exact
design specifications, it is difficult to change suppliers, resulting in theautomaker's dependence on the supplier.S

Under these conditions, each party makes commitment with
substantial relationship-specific investments, which creates quasi-rent

only if the both parties continue working together. According toempirical studies in the U.S., highly relationship-specific investment

should be avoided by buying commodities in the market and making
customized products in-house where the hierarchy can be used toreduce transaction costs. By contrast, Japanese automakers
increasingly pushed responsibility for design and manufacture of more
complex subsystems to a close-tied group of suppliers who are willingto make significant relationship-specific investments in developing
customized parts for the buyers. Moreover, Japanese automakers seemwilling to allow suppliers to development capabilities to receive the

8 Most automakers in Japan restrict suppliers tocompanies (Fair

Trade Commission in Japan,

sale design specification to1993).

other42 KOBE ECONOMIC &BUSILIVESg REVIEW, 43 (1998). 25-63'
long-term advantages of cooperation.
In fact, relationship-specificinvestment increase mutual dependence if they are made equally byboth parties. Since these relationship-specific investments increase theexit costs for a party and reduce the potential for opportunistic
behavior, parties are likely to be comforted and thus may increase
their commitment to each other. This, in turn, creates incentives tocooperate, and the reduction in cost and improvements in quality thatare gained through the cooperation outweigh the risks of opportunistic
behavior from the parties involved. Japanese suppliers dedicated someof capita investments to their primary customer that these customized
physical assets that could not be re--deployed if the customer terminate

to purchase from them.9 It generally requires various types ofinvestments in customized assets by one or both firms in order to makethe production and physical distribution more efficient.

Dyer and Ouchi (1993) identify three types of customized
investments employed in supplier relationship: (1) site-specificinvestment; (2) physical investments; (3) human capital investments.iO(1) Site-specific investments: Site specificity refers to the situation

whereby successive production stages that are immobile in nature arelocated in close proximity to one another to improve coordination andeconomize on inventory and transportation costs. Plants are located sothat they are dedicated largely to a particular customer in order toimprove coordination and economize on inventory and transportation
costs. Vertical relationships in Japan involves building a supplier plantwithin fifteen miles of the customer plant to reduce transportation
costs, improve delivery, and generally improve coordination. It allow
supplier engineers to work daily at customer technical centers withcustomer engineers in designing new products.
(2) Physical investments: Manufacturing equipment such as tools,

dies, molds, jigs, machinery, information system and so on iscustomized. Physical specificity refers to relationship-specific capital

9 Clark and Fujimoto (1991) suggested that dedicated physical assets play animportant role in the improvement of product integrity and thus in overall productquality.

10 Williamson (1983) identifies four different types of relationship-specificinvestments: Site specificity; physical asset specificity; human capital specificity;
dedicated assets. Asanuma (1989) identified that transaction-specific investments
are prevalent in supplier relations in Japan, and developed the notion of "relationspecific skill."KOJIMA .• RELATIONAL GOVERNANCEIN JAPANESE VERTICAL RELA TIONSHJPS 43

investments. Physical asset specialization allows for developing uniquefeature of product and may improve quality by increasing productlntegrlty.

(3) Human capital investments: Dedicated design to manufacturing
requires engineers to develop significant customer-specific knowledge.

Human capital specificity refers to relationship-specific know-how
accumulated by trade partners through long-term trading relationship.

Mutual human capital increases as trade partners develop
experiences working together and accumulates specialized information,
language, and know-how that allows them to communicate efficiently
and effectively. It involves transferring the buyer's executives or
employees to the supplier to work on a temporary or permanent basis,and sending consultants to work with the supplier to improve
production methods, implement just-in-time delivery systems, or assist
in solving other problems. For example, Toyota and Nissan have large

supplier-assistance management consulting groups with specialized
expertise that work full time with suppliers to help them improve theirproduction techniques and solve the problems on quality, cost, anddelivery. Providing assistance to suppliers is a highly effective method

for both helping and forcing suppliers to continuously innovate andimprove to stay ahead of the competition. Each type of relationshipspecific investment is likely to have differential effects on performance.

For example, site-specific investments eeonomize on inventory andtransportation costs but may have little direct effects on quality. On

the other hand, investments in human capital are not likely toeconomize on inventory or transportation costs, but could have asubstantial impact on increasing quality and reducing new model cycle
time. If relationship-specific investments can increase quality, reduce

new model cycle times, and minimize inventory costs, then thesebenefits should translate into higher efficiency.

Dyer (1996) examines the relationship between relationship-specificassets and performance in the automobile industry. The survey consistsof two Japanese automakers and all three U.S. automakers and asample of their suppliers. The unit of analysis is the supplierautomaker relationship. Toyota and Nissan's supplier indicated thatapproximately 21 percent of their capital equipment investments were
not re-deployable, compared with 20 percent for Ford suppliers, 14
percent for GM suppliers. On virtually every assets specificity measure,44

43 (1998),
REVIEW,
KOBE ECOIVOMICBUSIIVESS
&

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JapaRese automakers and their suppliers were more specialized thantheir U.S. counterparts. Moreover, with regard to site and human asset
specificity, Toyota's supplier group was more specialized than Nissan's

supplier group. More specifically, it examines the extent to which
differences in supplier-automaker asset specialization may explain
performance differences between Japanese automaker and the U.S. The
findings indicate a positive relationship between supplier-automakerspecialization and performance. In particular, the data suggest apositive relationship between inter-firm human capital specificity andboth quality and new model cycle time. Moreover, site specialization isfound to be positively associated with lower inventory costs. The
findings suggests that in the automobile industry a tightly integrated

production network characterized by proximity and a high level ofmutual human capital specificity will outperform a loosely integrated
production network characterized by low level of inter-firm specificity.

A firm may choose to seek efficiency advantages by creating
assets, which are specialized in conjunction with the assets of a trading
partner. These relationship-specific assets as the vehicle through which

trading partners are able to generate relational quasi-rent. AIthough
investments in specific assets boost productivity, the incentive to makerelationship-specific investments is tempered. The contingent value of a
specific resource exposes its owner to a greater risk of opportunism
than the owner of generalized resources. According to the transaction
cost economics perspective, if trading partners make relationshipspecific investments, then they must safeguard against the hazards ofopportunism. Source of advantage is contingent on the costs associatedwith safeguarding those investments. Relationship-specific investments
are more likely to result in high performance when trade partners havedeveloped safeguards which can control opportunism at relatively low

cost and task activities are characterized by a highly degree ofinterdependence.
The efficient level of specificity between trade partners is likely to

be contingent on the task activities and degree of interdependence.
Generally speaking, the greater the interdependence, the more bothparties will benefit from investments in specialized assets. The findings

suggest that when working activities are highly interdependent as they

are in the automobile industry, the Japanese automakers are more
efficient than the U.S. These relationship-specific investments create

KOJIMA : RELA TIOIVAL GO VERIVA NCEIIV JA PA IVESE VER TICAL RELA TIONSHIPS 45

substantial buyer and supplier switching costs and, once sunk, makethe two parties highly interdependence. This interdependent relationshipcan create potential contracting problems if the parties do notcompletely trust each other. Toyota's just-in-time (JIT) system is agood example of how customized investments can create value. Just-in-time system was designed to reduce complexity and costs byeliminating inventories and work in process and to ensure that there
were no redundant buffers stocks, distribution facilities, or quality
inspections. However, to implement JIT efficiently, Toyota and its
suppliers had to make customized investments in information systems,

plants, and flexible manufacturing systems that created mutual
dependency.'`

4 Trust in Vertical Relationships
4.1 Building Trust

Trust in trading relationships means assuming that, when facedwith the ability to undertake hidden action or to utilize hiddeR
information, one's counterpart in an ongoing relationships can be
expected to pursue those actions that would be to one's benefit and torefrain from those that would be detrimental. This does not necessarilymean that one's counterpart will always act in one's own benefit.
Rather, it implies merely a sufficiently high likelihood of responsible
behavior over a range of normal circumstances to warrant cooperation

on an informal basis. Although none of the agreements were legally
enforceable, they were not easily broken. The reputation effects andreciprocity provisions embodies in these arrangements evidently work
well and provide strong safeguard for the parties involved; the shortterm gains form opportunism are largely offset by long-term losses
from a damaged reputation in the particular industry community.
Because the future contingencies are hard to describe, complete
contracting is costly. As a result, many of these contracts are implicit,

and the party must be trusted to deliver on the implicit contracts even

without enforcement by courts. To the extent that long-term contracts
reduce costs, such trustworthiness is a valuable asset of the party. The

11 Cremer (1995) provides a model to explain why just-in-time system can improve
the incentive of suppliers.

46 KOBE ECONOMIC&BUSINESS REVIEW, 43 (1998), 25-63

principal reason why long-term contracts between parties are needed isto promote relationship-specific investments by parties. The necessary

arrangement to ensure appropriate investment by parties is a longterm relationship, which allows them to collect some of the rewards of
doing honestly. The expense of writing a complete contingent contract
ensures that these long-term relationship are implicit in nature. The
relationships are beneficial to both parties, as they split the ex ante

gains from trade.

Although both parties benefit ex ante from implicit long-term
contracts, it might pay one party to renege ex post. For example, abuyer might gain from refusing to compensate a supplier for investingin the relationship-specific investment, after investment is done. Breachof implicit contracts can therefore raise one party's gain, and the moreso the greater is the burden of fulfilling past implicit contract.
Conversely, the value of supplier's relationship-specific assets suffers aloss. To take advantage of implicit contracts, potential sellers musttrust buyers. Otherwise, sellers would expect breaeh whenever it raises
the buyer's value and would never enter into implicit contracts. To

convince sellers that implicit contracts are good, buyers must be
trusted not to breach contracts even when it is value maximizing to do
so. A solution to the problem of how implicit contracts are maintained
is reputation formation. Suppliers adhere to implicit contract because

their adherence enables them to develop a reputation fortrustworthiness, and thus to benefit from future implicit contracts. If

violating an implicit contract today would make the suppliers
untrustworthy in the future, they will uphold the contract as long as

the option of entering into future contracts is valuable enough.
Conversely, if it is not important for the supplier to be trusted in the
future, they will violate the implicit contract.

Manufacturer's or supplier's efforts to promote efficient tradingare especially subject to reputation effects. Reputation is defined herethat a trade partner's belief that other trade partner will perform anaction that is trustworthy enough to consider engaging in some formof cooperation with him. Both of parties in channel of distribution may
not be able to observe the efforts directly. In such situation, the long-term relationship enables better monitoring and permits intertemporal
incentives that sustain cooperation. The incentives can take the form of

remuneration that depends in each period on the history ofKOJIMA: RELATIONAL GOVERNANCEIN JAPANESE VERTICAL RELATIONSHIPS 47

observation; trade partners in each period take account of the effect of
his efforts on his current reward and its effect on his subsequent ones.
Reputation plays a key role to provide trade partners with incentives in

the market. To the extent that efforts are unobservable, the long-term

relationship with remuneration contingent on the history of measured
performance provides incentives for the trade partners to invest effort
in building a reputation for a qualified partner. The supplier's
reputation for cooperative dealing is valuable to him: reneging on thiscontract would diminish his ability to make profitable contracts in the
future. Therefore, the new entrants are required to spend time andeffort to establish reputation to set up new trade relationship. It may
burden the newly entering firms as a trade barrier. Once the traderelationship starts, the trading cost of each party reduces substantially

due to simplified procedures. But each party must make efforts tomaintain trustworthy relationship (Economic Planning Agency 1986).
The reputation accounts for strong intertemporal linkages along asequence of otherwise independent situations. The key idea is that one's
reputation is a state variable affecting future opportunities; moreover,the evolution of this state variable depends on the history of one's
actions. Hence, current decisions must optimize the tradeoffs between
short-term consequences and the long-term effects on one's reputation.
In a game, a player's strategy is a function that assigns the action to
be taken in each situation in which he might make a choice. If theplayer has some private information, then the choices of actions may
depend on this information. In this case, other players can interpret his

past actions as signals about what his private information might havebeen. The player's reputation is the history of his previously observed

actions. Furthermore, if the iriformation concerns something thatpersists over time, then these inferences about the private information

can be used to improve predictions of his future behavior. To be
optimal, the player's strategy must take into consideration thefollowing chain of reasoning. First, his current reputation affects
other's predictions of his current behavior and thereby affects theircurrent actions; so he must take account of his own current reputation
to anticipate their current actions and therefore to determine his best
response. Second, if he is likely to have choices to make in the future,then he must realize that whatever are the immediate consequences of
his current decision on his future reputation, and other's anticipatibn

48

KOBE EeONOMIC & BUSINESS REVIEW, 43 (1998), 25-63

that he will take these long-term consequences into account affects
their current actions as well. The key ingredient is that a player canadopt actions that sustain the assessment made by other parties thatyields favorable long-term consequences. Whenever it is feasible toimitate the behavior one would adopt if one's private information weredifferent than it is, and this would affect other's actions favorably,
there is potential role for reputation effects. The operative mechanismis the process of inference by which observed actions are taken as
signals of private information. Behavior can be considered as designed
to affect other's responses by sustaining or altering their beliefs(Wilson 1985).

Wilson (1980) conducts an intensive study of the New England fresh

fish market. He find that underlying the smooth functioning of themarket was a system of mutual dependence created by the particular
trade arrangements there; reputation effects provided an enforcement
mechanism. Acheson(1985) studies the Maine lobster market and findthe lobster market to be characterized by long-term, informal
relationships between fishermen and lobster-pound operators. They

typically crafted agreements designed to reduce the costs of
information and the possibility of opportunistic use of informational
asymmetry. Reputation considerations and interdependencies arisingfrom the sharing of scarce resources reinforced the arrangements.i2
The long-term relationships with remuneration provide incentives
for trade partners to build a reputation for trustworthiness that yields
favorable long-term gains. The concept of reputation, however, has

technical caveat of practical significance like repeated games.
Reputation can explain many behaviors. It is too easy to suppose thatan unobserved state variable is called reputation that explain all that

happens. We should circumscribe the observations that an outside
observer might make. The bonding mechanism to maintaining group
goodwill and trust can reinforce the mechanism of reputation building

by the rational agents.'3 Trade partners do not rely solely on
reputation available from outside parties to judge the trustworthinessof other partner in the Japanese vertical relationship. To ascertain
whether other partner is trustworthy they rely additionally on their

12 Informal agreements and norms in eighteenth- and nineteenth-century whaling
have been studied by Ellickson (1989) and Gifford (1993).

KOJIMA .i RELA TIONAL GO VERIV[A IVCEIN JA PA NESE VER TICAL RELA TJONSHIPS 49

own experiences. A certain periods of time and a number of personal
contacts are required to update the reputation about other partners.
During that period they operate in a testing process. Initially small andshort-term trades are given and further trade depends upon
performances and trade behaviors. Once they are satisfjed with thetrade, on-going trade relationship is ensured. The combination ofcertain types of behavior and personal contracts involving the exchange
of information and giving mutual assurances, and a considerable time
for the consistency of one's behavior to be observed and tested canenhance and maintain a reputation for trustworthiness. The Japanesefirms have recognized the need to be interdependent and have
responded by developing bonding mechanisms that build trust among
them. The Japanese do not rely on legal contracts to protect theirinterests in trading relationships.

One can understand how Japanese firms have developed uniquemechanism of relational governance to facilitate long-term relationshjps

with flexible agreements. It would be misleading to suggest that
relationship-specific investment is the primary factor that contributes

to performance differences among automakers. Undoubtedly numerous
other factors not captured in the modei contribute to performancedifferences. The optimal level of relationship-specific assets will dependon the costs of safeguarding specific investments. If the safeguard
costs are particularly high then the gains from specialization may beoutweighed by the costs. The fact that hanhei gaisha (affiliatedsuppliers) exhibit greater asset specificity than U.S. in-house division is

intriguing. Trust may be a highly effective and low-cost means for
safeguarding relationship-specific investments. One can argue that

constraints on opportunism within the Japanese institutional
environment allow Japanese firms to generate relational quasi-rent
13 In Japan, firms may choose a trade partner within a circumscribed group inwhich reputation about the other contraeting party is readily available and inwhich public sanctions against opportunistic behavior exist. The Japanese are
inclined to introduction. Many Japanese will deal only with parties that can
submit introductions from respected third parties. The introduction verifies boththat the party has acted in ways considered `honorable' within the world of`reputable' firms and that it will be subject to the sanctions of the third party if
it tries to act `dishonorably' in the future (Ramseyer, 1986). The trading groups

which are mentioned beforehand work in a similar way. When members of agroup share the trading information and hold a common code of honorable
behavior and subject to the sanctions of others in the group, monitoring cost canbe substantially mitigated.

50

KOBE ECONOMIC & BUSINEss REVIEW, 43 (1998), 25-63

more effectively.

4.2 Supporting Mechanisms in Japanese Firms
4.2.1 Cross-shareholding

Although they may be substantial, the economic incentives tomaintain long-term trading relationships in Japan are not perfect.
Because one party to an agreement can undertake hidden actions to its
own benefit and to the detriment of the other, or make private use of
hidden information, the risk of self-interested opportunism corrupting
the relationship exists. That is why reciprocal equity ownership isrequired to sustain long-term trading relationships. An exchange ofequity between two trading parties connects their economic interests,
which help mitigate incentives to act opportunistically. The more equity
the trading partner owns in the firm, the less sense it makes to try to
exploit other shareholders' interests. Reciprocal equity ownership
between any two Japanese firms, so called mochiai, is typically small generally in the range of 1-30/o of outstanding shares. By itself, such abilateral exchange of shares constitutes a safeguard against abuse of
the relationship. But embed two transacting firms in a larger cluster ofinteracting firms and multiply the percentage of bilaterally cross-heldshare by a factor of 20 or 30, and the safeguard become potent.M
FIath (1996) shows that cross-shareholding between non-financial

firms that are trading partners does in fact serve the purpose that
deters opportunistic behavior. Holding shares in a trading partner
slants the bargaining over product trading in favor of the trading
partner. Divesting shares accomplishes the reverse. The firm that holds

shares in a trading partner can credibly threaten to divest should the

trading partner behave opportunistically, withdrawing from it thebargaining advantage that the equity position had conferred. In thismanner a firm may establish a partial equity position in a trading
partner to deter opportunism. One trading partner of a firm deters
opportunism towards itself by maintaining equity interests which itthreatens to divest if it is ever deceived.
14 The recent surveys suggests that average ratio of cross-shareholding over total
outstanding share is about 230/o of public corporations (Fuji Research InstituteCorporation, 1993). The firms in the six major keiretsu hold 14% to 380/o of thetotal shares in the group (Fair Trade Cornmission, 1994).

KOJIMA .• RELA TIOIVAL GO VERNA NCEIN JA PA NESE VER TICAL RELA TIONSHIPS 51

Divesting unilateral shares in a trading partner but without ending
trade, reduces the present value of t•he partner's future gains from thepresent trading relationships. Because divesting shares interests in a

trading partner imposes a capital loss on the trading partner, thecredible threat of divesting can be valuab}e in deterring opportunism.
Cross-shareholding strengthens the reputation effects that wiil, if

strong enough, forestall opportunism. The greater the ongoing streamof profits associated with trade, the more costly damage to reputation
with the trading partner is also likely to be. Opportunism refers tomisrepresenting the extent of one's own investment in relationshipspecific assets. The keiretsu shareholding interlocks are to deter
opportunism in Japanese trading relationships. A firm that holds anshare interest in a trading partner weakens its own bargaining position
with regard to the product transactions but precisely for this reason iscapable at any time penalizing the partner by unilaterally divesting. In

this manner cross-shareholding can be to strengthen the penalties forbehaving opportunistically and induce a rational expectation that theother party will in fact not behave opportunistically. Opportunism by asupplier would entail substitution of products having inferior quality towhat is claimed. Opportunism by a buyer would entail promising andthen failing to make investments that reduce the supplier's costs.
Cross-shareholding that is to deter opportunism in the manner detailed
would link trading partners, and would tend to be smaller if growth intrade is expected or if each trade confers greater rent. Flath (1996)

provides the evidence supporting the view that cross-shareholding
deters opportunism in the six major keiretsu in Japan. Equity links are
greater between keiretsu firms that by virtue of the industries to which

they belong are likely to be trading partners. Also equity links are
greater where opportunism would seem to be less deterred by the mere
loss of reputation with the trading partner.

Firms need credible commitments if they are going to be willing to
make relationship-specific investments. Cross-shareholding in Japanese
automobile trading relationships represents commitments that firms
have made to each other, and in many ways, it is an arrangement thatis to deters opportunism. Automobile makers and their suppliers own
significant portions of shares each other. This ownership stake builds

trust and represents a commitment among trading partners that needan incentive to make the relationship-specific investment they require.

52 KOBE ECONOMJC &BUSIIVESS REVIEI?V, 43 (1998), 25-63

The incentive to breach contracts with suppliers and buyers in theinterest of transferring value to shareholders, or to borrow money andthen take extraordinary risks that might benefit shareholders at theexpense of lenders, are reduced when the other stakeholders arethemselves among the firm's principal owners. Many enduring
supplying and distribution relationships throughout the Japaneseindustry exhibit multiple-claim ownership. A benefit derived from thistendency to hold a blend of different financial and other claims against

a firm is an attenuation of frietion that might normally arise among
various stakeholders that each owned a separate and distinct claim.

The incentives to breach contracts with suppliers and buyers ininterests of transferring value to shareholders are reduced when the
injured trading partners are the firm's principal shareholders.

4.2.2 Extensive Information Sharing

Another feature that helps Japanese firms forestall disputes orother problems that might destroy valuable trading relationships isextensive information sharing. The quality of information that trading
partners have at their disposal is clearly different from that available

to outside parties. Trading firms have learned about each otherthrough ongoing trading relationships and through various
collaborative projects and other forms of interaction that provide
information not available in financial statements. If, for example,
product quality begins to decline, the trading firm and other trading
partners are likely to be among the first to know this through theirpurchasing connections. The kind of in-depth information that the
firm's main bank acquires in order to extend loans is utilized as well inits decision as shareholders. How information is understood also
differs. Managers in trading firms who have concrete knowledge about
and experiences in running firms, may be better able to evaluate theperformance of other managers. Monitoring with the relationships
takes place in several ways involving formal and informal information
sharing mechanisms. The practice of temporarily dispatching managers
to other firms is one means by which an informal information sharing
network is established within the relationship at multiple levels of thehierarchy of firm.
The Japanese supplier management suggests suppliers are trusted
enough to be given model information relatively early in the design

KOJIMA: RELATIONAL GOVERNANCEIN JAPANESE VERTICAL RELATJONSHIPS 53

process - often at the concept or pre-concept stage - and suppliers are

expected to participate in the development, beginning at the concept
stage. In the process, Japanese suppliers wield significant influence

over the process of defining customers' requirements so that the

product designs exploit the suppliers' unique manufacturing
capabilities. Liker et al. (1996) indicate that almost all of the subsystem

supplier in Japan receive early vehicle concept information from theircustomers although they do not necessarily have a great deal of
influences over the setting of specifications for their subsystems.
Japanese automakers provide early new model information to first-tiersuppliers as the product concept is forming and issue only theminimum critical product requirements. U.S. firms are thought toprovide much more detailed specifications to their suppliers, allowing
suppliers little latitude on specifying the design. Japanese vertical
relationships involve intense and frequent communication during the
product development cycle, particularly in the early stages when the
product is being defined. This includes the intense and regular sharingof technical information to improve performance and reduce cost.
Because these are long-term buyer--supplier relationships, the quality
and efficiency of information exchange is significantly higher than it
would be in new relationships. Thus mutual human capital investment

enhances information sharing and communication between buyers andsuppliers.

There was considerably more frequent exchange of design
information reported in the U.S. compared to Japan at all tier levels

and all stages of the development process. The frequency ofcommunication does not necessarily reflect the quality ofcommunication. Japanese have a long and continuous history ofworking together with their suppliers on design that they cancommunicate quickly and easily between them. Direct communication
and relationships developed over a long period of time made detailed
and explicit written communications largely unnecessary. The result of
this emphasis on communication is greater efficiency, faster product-development cycles. The greater frequency of information exchange
about product development between buyers and suppliers in the U.S.
may reflect less effective communication and decision making. Japanesesuppliers are given specifications formally, asking to go off and do thedesign and return With a prototype on time. Communication has been

54

43 (1998),
KOBE ECONOMIC & BUSINESS REYIEW,

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streamlined so it is less frequent than in the U.S. The Japanese vertical

relationships in automobiles can be thought to involve intense andfrequent communication during the product development cycle,
particularly in the early stages when the product is being defined. This

includes the intense and regular sharing of technical information to
improve performance and reduce cost. When a supplier gets a noticethat the concept session for a specific vehicle model is being scheduled,there is no ambiguity about what the supplier must bring to thesession; approximately when the first, second, and third prototypes will

be due; and what the buyer's expectations at each of those milestone

events will be. One can find clear and consistent communication
between suppliers and buyers in the Japanese relationships.
The evidence is provided to support that the suppliers' association
continue to exist in Japan not merely out of inertia but because it isserving a useful function in delivering benefits to both the automakerand member supplier (Sako, 1995). Contrary to the bilateralcontracting view, suppliers value mutual learning from other suppliers
just as much as learning from their buyers, and that the majority offirst-tier suppliers do not consider suppliers' associations to be of lessuse now that in the past. There is a considerable variation fromassociation to association with respect to the size of membership, theproportion of members in the total supplier base, and turnover ofmembers over time. However, as a common characteristic, association
membership is much broader than the boundary of heiretsu groupings,
particularly in recent decades when independent suppliers which standoutside the keiretsu have been taking up membership in multiple
assoclatlons.

Toleai Kyohokai has three sectors grouped according to the type ofparts that members produce. Each group meets once a month, typicallyto visit a member supplier's factory, and to learn from the member's
presentation about problems and achievements at his company in thefollowing month. The automakers except Honda which have anassociation continue to retain much control over the activities of theassociation. Although less common today, many of the associations
required the automaker's recommendation as well as the approval of
the association's administrative board to become members. Whether
leading or advisory, providing support for the suppliers' association isexpensive in managerial time, judging from the frequency of meetings.

KOJIMA: RELATIONAL GOVERIVANCEIN JAPANESE VERTICAL RELATIONSHJPS 55

Weighed against this cost are the frequently cited benefits of being able

to communicate about production plans, and of soliciting goodsuggestions for common problems, such as parts standardization andpollution control. The most popular benefits of belonging to an
association is better informational aceess to the buyer. Next, learningfrom other members through exchange of technical information isconsidered the second most important benefit, and more important
than the receipt of technical assistance from the buyer. Many members
apparently regard fellow member suppliers as a more important sourceof technical know-how than their buyer. The type of buyer information

which is valued by members appears to be-about design anddevelopment for the next model, rather than, for instance, about thecertainty of production scheduling.`5

The Japanese supplier management suggests suppliers are trusted
enough to be given model information relatively early in the design
process - often at the concept or pre-concept stage - and suppliers,
particularly the DA, are expected to participate in the development,
beginning at the concept stage. Japanese DA suppliers wield significant
influence over the process of defining customers' requirements so thatthe product designs exploits the suppliers' unique manufacturing
capabilities. Liker et al. (1996) indicate that almost all of the subsystem

supplier in Japan receive early vehicle concept information from theircustomers although they do not necessarily have a great deal of
influences over the setting of specifications for their subsystems.
Contrary to the current literature that suggests Japanese automakers
provide broader specifications that allow the supplier greater freedom
to innovate, there were no Japanese-U.S. differences in the degree of
specificity of the customer requirements. Japanese automakers were as
likely as their U.S. counterparts to include actual dimensions in therequlrements.

Japanese automakers provide early new modei information toprimary suppliers as the product concept is forming and issue only theminimum critical product requirements. U.S. automakers are thought toprovide much more detailed specifications to their suppliers, allowing
suppliers little latitude on specifying the design. Japanese supplier

15 These evidences can be supported by the survey conducted by Fair Trade
Commission in Japan (1993).

56 KOBE ECONOMIC&BUSINEss REVIEW, 43 (1998), 25-63

management involves intense and frequent communication during the
product development cycle, particularly in the early stages when the
product is being defined. This includes the intense and regular sharingof technical information to improve performance and reduce cost.
Because these are Iong-term automaker-supplier relationships, thequality and efficiency of information exchange is significantly higher

than it would be in new relationships. Thus mutual human capital
investment enhances information sharing and communication between
automaker and supplier.

There was eonsiderably more frequent exchange of design
information reported in the U.S. compared to Japan at all tier levels

and all stages of the development process. The frequency ofcommunication does not necessarily reflect the quality ofcommunication. The Japanese relations have a long and continuous
history of working together with their suppliers on design that they

can communicate quickly and easily between them. Directcommunication and relationships developed over a long period of time

have made detailed and explicit written communications largely
unnecessary. The result of this emphasis on communication is greater
efficieney, faster product-development cycles. The greater frequency of

information exchange about product development between automakers
and suppliers in the U.S. may reflect less effective communication anddecision making. Japanese suppliers are given specifications formally,

asking to go off and do the design and return with a prototype on
time. Communication has been streamlined so it is less frequent than in

the U.S. The Japanese supplier relations can be thought to involve
intense and frequent communication during the product development
cycle, particularly in the early stages when the product is being
defined. This includes the intense and regular sharing of technicalinformation to improve quality and reduce cost. When a supplier getsa notice that the concept session for a specific vehicle model is beingscheduled, there is no ambiguity about what the supplier must bring to
the session; approximately when the first, second, and third prototypes

will be due; and what the buyer's expectations at each of thosemilestone events will be. One can find clear and consistentcommunication between suppliers and automakers in the Japaneserelations.

KOJIMA: RELATIONAL GOVERNANCEIN JAPANESE VERTICAL RELATIONSHIPS 57

4.2.3 Enduring Personal Network
The long-term duration of implicit contracts founded upon crossshareholding arrangements depends critically on preserve continuity inthe identity of specific employees interacting at the trading interface.

The rotations and transfers result in the creation of and extensive
network of enduing personal relationships among individual employees
inside and outside the firm. These are crucial to the efficacy of implicit

contracting, for the terms of such agreements are held more between
individual employee interacting at the trading interface than between
the firms as legal entities. It is in this individual employee that mutualobiigations are formed and bonds of trust are forged. It is individual

employees who ultimately adapt contracts to changed circumstances
and, out of consideration for their reputations, can act against any ill-

advised tendencies towards opportunism elsewhere in theirorganizations. Once established, the Japanese practice of long-term
employment serves to preserve these personal relationships for many
years. It also raises the cost to individual managers of untrustworthy,
opportunistic behavior.
The practice of long-term employment within one firm is importantin developing trust among individuals both within the firm as well as
across firms. There is real personal contract between the purchasing

managers of manufactures and the managers or owner of a supplierfirm. Because employees can develop long-term relationships with theircounterparts at the supplier or buyer, it is not surprising that theJapanese have developed significantly greater trust across firms.
Furthermore, management transfers develop effective communicationthat ongoing relationships require. Mid-career managers or engineers
may be temporarily transferred to related firms to help solve specificproblems or to work on joint projects. Such transfers provide extensive

networks of personal relationships between individual managers in

related firms by enhancing trust between the firm's managers.
Reinforcing monitoring and communication at various levels ofmanagers are ties at the level of the board of directors. Among themost prominent features of keiretsu is a layered set of personnel
connections that serve as conduit for information between firms and,occasionally, as a source of extemal djscipljne. Emp]oyees transfers

are common among business partners, particularly among bank andtheir client firms and large manufacturers and their subcontractor. In

58

43 (1998),
BUSINESSREVIEW,
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&

25-63

addition, firms in keiretsu are linked through a variety of intercorporate executive councils that serve as a forum for managers fromdifferent levels of the firms involved, While group interaction takes
place at many levels, undoubtedly the most prominent of these meetings

are the presidents' councils that bring together the chief executive
officers from nucleus firms in 'the group.'6

The way that Japanese firms build trust is by requiring career

paths in which employees transfer from firm to firm. Employeetransfers, both temporary and permanent, are common among business
partners, particularly between large manufacturers and their suppliers.
In addition to permanent and temporary employee exchanges, suppliers
often send guest engineers to work at their customer technical centerson an ongoing basis. Supplier and automaker engineers work jointly
designing the components for a new car model. Not only do thesecareer-path help build trust between firms, but also transferred andguest employees are better able to understand how to enhance theefficiency of the development and production processes because theyknow both buyer and suppjier operations. Direct 'contact is much more

important than other forms of contact in developing ways for
employees to know and trust each other. Both of automakers andsuppliers encourage a considerable amount of face-to-face contact
between supplier salespeople and engineers and between automaker
purchasing agents and supplier engineers.`7
16 The shacho-kai is a kind of informal community council, with membership
limited to a set of core members. It appears that the shacho-kai in praetice is lessa command center to determine the policies and practices of individual firms thana forum for the discussion of mat.ters of mutual concern. It simultaneously (1)establishes an identity for the group and its participants, sigitifying relationships
among firms, and instilling• a sense of coherence; (2) creates a setting in whichissues of group-wide concern may be negotiated, including protection andpromoting the group name and, less often, arranging for assistance for firms introuble, resolving conflicts among members, or discipl'ining deviant firms in thegroup; and (3) enhanees the position of the group in the Japanese businesses
community by presenting the image of a powerful and historically prestigiouS
corporation. More often than not, the,•executive remarked, nothing of particularnote is discussed and the meeting is merely an opportunity to exchange views withother chief eXecutives and to socialize. Nevertheless, the shach6-kai is considerably

more than an'old-fashioned business custdms, for it se'rves bQth to signify
membership in..the grp.up and to provide a common arena for the expression of thestrategic interests group firms' have in one another. As such, it is significant bothfor its symbolism and for what it reveals about.the dynamics of keiretsu
relationship.
17 7eiprOuleatS.g9n9s9) MOdels the idea of group reputation as an aggregate of individualKOJIMA: RELATIONAL GOVERIVAIVCEIIV JAPANESE VERTICAL RELATIONSHIPS 59

5 Conelusion
Various systems of vertical relationships have evolved in different
countries to attain efficient trading relationships. Particularly, there
are significant differences in vertical relationships between Japan andthe United States. It is commonly observed that U.S. automobile
manufacturers are more vertically integrated than their Japanesecounterparts. In Japanese vertical relationships, in contrast, suppliers

are an integral part of the product development and manufacturing
processes: they are heavily involved, assume significant responsibility,

and communicate extensively and directly with product and processengineers. The major characteristics of vertical relationships in Japanmaking differences from the U. S. can be identified that both buyers
and suppliers have recognized the need to be interdependent and have
responded by developing bonding mechanisms that build trust between
them in the long-run. Japanese firms do not rely on legal contracts toprotect their interests in trading relationships.
Japanese vertical relationships are identified as follows: significant
relationship-specific investments in plant, equipment, and human capitalin trading relationships; Iong-term relationships and commitments
based flexible legal contracts to create mutual trust; bonding
mechanisms like cross-shareholding, extensive information sharing, andenduring personal networks, which reduce transaction costs andeliminate inefficiencies between buyer and supplier. Trust founded on

bonding mechanisms among trading partners allows them to adapt
terms of trade as needed in response to changing circumstances basedon high degree of implicit, long-term, relational contracts.
Opportunistic behavior in such relationships can be mitigated, and theirlongevity fostered, by the multiple claims ownership by parties doing

business with each other, and by extensive mutual monitoring. The
relational governance to facilitates building and sustaining stablevertical trading relationships may Iead to investment in relationshipspecific assets to bring appropriable rents.
For most Japanese firms, the long-term trading relationships withfirms in which they invest constitute the chief value of their overall
dealings with those firms. Value comes from the transaction efficiencies
generated by building and maintaining long-term trading re}ationships,
mutually beneficial trust between managers in the trading firms can be43 (1998),
KOBE ECONOMIC & BUSINESS REVIEVV,

60

25-63

nourished and cooperation fostered. Contracting can take place on amuch less formal, more implicit basis, often an advantage when it

becomes necessary to adjust rapidly to a changing environment.
Adjustments in implicit agreements can be made much faster and in
more highly simplified way by managers dealing at the tradinginterface than they can be wrestling over formal written contracts. If
the trading relationship lasts long enough and becomes close enough,the trading firms can become virtual extensions of one another in a
vertical production and distribution system, though without some of the

management control problems that plague large operations integrated
under a single corporate hierarchy. Since the relationship is arm'slength and equity ownership is restricted to minority positions, market

incentives are preserved and bureaucratic disabilities held to a

MMIMUM.
Ultimate safeguard against the emergence of cooperative shirking
in the group is the discipline imposed by vigorous rivalry in the productmarkets in which members compete. Japanese automobile industry
tends to be eharacterized by fairly intense rivalry among vertically-

related groups of firms. Preservation of high-powered market
incentives arising from horizontal product-market rivalry is evident.
Japanese automakers are aware of the need to show consistently theirintent to persist in long-term relationships with their suppliers, thereby

encouraging investments by suppliers in relationship-specific assets,
while stopping well short of granting supplier an outright guarantee oftrades, which would blunt incentives to manage efficiently.
Japanese vertical relationships can be identified that both buyers
and suppliers have recognized the need to be interdependent and have
responded by developing bonding mechanisms that build trust between
them in the long-run. Japanese firms do not rely on legal contracts toprotect their interests in trading relationships. It is important tounderstand why and how flexible trading arrangements sustain in themarket transaction. What governance mechanisms will emerge as theparties negotiate a mutually acceptable trading arrangement inresponse to anticipated transaction costs and contractual executiondifficulties? It is important to identify the economic rationale of flexible

vertical relationships. Yet many interesting issues still remain unknown

about trading relationships between buyers and suppliers in various

countrles. ''KOJIMA: RELATIONAL GOVERIVANCEJN JAPANESE VERTICAL RELATIONSHIPS 61

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

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43 (1998),
KOBE ECOIVOMIC & BUSINEss REVIEW,

65-117A COMPARATIVE ANALYSIS OF PULP, PAPER,
AND PACKAGING COMPANIESIN CANADA, JAPAN AND UNITED STATESAKIRAKAJIWARA Kobe University
Abstract
The United States, Canada, and Japan are the world's top three pr'oducers andconsumers of pulp and paper. This paper is an analysis of the financial
performances and comparative strengths of their publicly owned pulp, paper, andpackaging companies. Seven variables of business activity are examined. The firstarea of investigation is the primary product(s) manufactured by each company.
Next, the study investigates several measures of financial performance, including
annual sales, return on equity, and earnings per share. Liquidity is examined in
calculating each company's debt to equity ratio. Lastly, two business activities,
capital expenditures and international activities, are interpreted and reported.

Relative performance rankings among companies are provided and comparisons are

made between 1996 and 1995 financial data. A concluding discussion suggests
important trends shaping the future direction and performance of Japanese andNorth American pulp and paper companies.
JEL classification: L73, M49
Keywords: pulp and paper industry, financial performance

INTRODUCTION
The 1990's continue to challenge the Japanese and North American
pulp, paper, and packaging industry. Fearful of continued priceincreases and potential supply shortages, many industrial buyers
intentionally accumulated inventories during 1995. However, in the
Corresponding Address
Akira Kajiwara
Research Institute for Economic & Business Administration, Kobe University
2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501, Japan
E-mail: kajiwara@rieb.kobe-u.ac.jp
Fax: (81)-78-803-0412

66

43 (1998),
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65-117

fourth quarter the price of pulp began to move downward. Buyers
curbed hedging activities and instead consumed in production thoseaccumulated inventories. By 1996, a decrease in product demand left
producers with excess supply, sharply declining prices, and lower sales
and profit (Stanley, 1997, p.56). Northern bleached softwood kraft
market pulp, during the first quarter of 1996, fell to $500 per ton froma record high of nearly $1000 in the fourth quarter of 1995. Prices forfine papers and containerboard, which began to slip in the third
quarter of 1995, drifted further downward throughout 1996. Newsprint,
which sustained a record $750 per ton until the second quarter of 1996,
also retreated to a low of $500 per ton by year end. Prices for mostpulp, paper, and packaging grades did stabilize in the third and fourth
quarters of 1996, but did so at Ievels substantially below those seen one

year earlier. •'Such market swings over the past several years have been extreme,even for an industry typically described as cyclical. Recent evidence
suggests that business cycles are not only increasing in magnitude but
in frequency as well. Despite such volatility, industry analysts appear

optimistic about the outlook for the pulp, paper, and packaging
industry over next few years (Koncel, 1997, p.74). Today, the inventory

imbalances experienced in 1996 appear to have been stabilized. Many
producers reduced production in 1997, and prices for all pulp and paper
grades have slowly, but steadily, improved. Efforts directed toward mill

modernization and company consolidation of Japanese and North
American producers are expected to reap returns just as product•ion
capacity growth in other parts of the world begins to slow. One
unknown factor that could challenge this optimism is the recent declineof the Asian economies; the international impact of the•current
financial and economic crises in Korea, Japan, and Indonesia remains

to be seen. .

In 1996, the United' States and Japanese governments met several
times to assess the ongoing implementation of the April ,1992 UnitedStates-Japan Paper Agreement. The objective of the agreement is toopen Japan's US$70-billion paper and paperboard market, which issecond only to the United States. The agreement requires the Japanese
government to encourage Japanese distributors, converters, printers,
and major corporate users to increase substantially their use ofcompetitive foreign paper products, develop long-term buyer/foreign

KAJIWARA.• A COMPARATIVE AAiALYSIS O17PULP, PAPER, AIVD PACKAGiNG COilifPANIES 67

supplier relations, develop company-specific nondiscriminatory
purchasing guidelines, and establish and implement Anti-Monopoly Act
compliance programs.
The bilateral implementation talks in 1996 were held for the second

consecutive year under the umbrella of the United States trade
representative placing the government of Japan on a Super 301 "Watch
List," which allows the United States government to monitor tradeactivities of a foreign country's markets in order to determine whether
discriminatory treatment was being placed against the United Statesand other foreign suppliers. After a year, the United States government
would retain the option of either initiating a full investigation (underSuper 301) or seek to impose some form of trade sanctions to ensurecompliance. After two years of being on the Watch List and after four
years of implementing the agreement, little has changed in terms ofJapan's apparent consumption of foreign paper products. Since theagreement was signed, total Japanese paper imports have increased byonly O.5906o from 3.6906o to a 4.ISO)6 market share (Stanley, 1997, p.56). Thisis mainly because very complicated and inefficient distribution channelsof pulp and paper products remain dominant in Japan. Recent megamergers in the industry are changing this situation.

INDUSTRY OVERVIEW
Pulp and Paper international suggests that in 1996 world
production of paper and paperboard increased 1.3906o, to nearly 282
million tons. The United States and Canada together accounted for 100
million tons (36906o) of this production, maintaining North America's

position as the world's largest producer of paper and paperboard(Table 1). Asia tied Europe for second, and Japan and People's
Republic of China produced almost 80SO)6o of pulp and 68906o of paper andpaperboard of Asian production (Matussek, et al., 1997, pp.20-21).
World production of pulp dropped 11 O/o during 1996, from 181 million
tons to 174 million. With the exception of Latin America, which
reported in 1995 more than an 89 increase in production, every regionof the world showed a decline in pulp production in 1996. Even North
America, where annual pulp production is more than double that ofany other region, reported almost a 30/o decline in production (Koncel,
1997, p.74).

68

43 (1998),
KOBE ECONOMIC & BUSIIVEss REVIEW,

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PulPaerandaerboard

NorthAmerica82,586100,256

Europe39,06080,949

Asia37,57982,081
LatinAmerjca10,13312,719
Australasia2,3083,268
Africa2,3762,694
Worid174,042281,968
Source:PulandPaerlnternational1997

1. 1996 World Pulp and Paper Production (1,OOO tons)

UNITED STATES PULP, PAPER, AND PACKAGING INDUSTRY
United States paper and paperboard production increased byalmost 1%o in 1996 to roughly 82 million tons (Table 2), representing
290/o of world paper and paperboard production. This increase marked

the eleventh straight year of growth in United States paperboard
production, but the rate of growth is down significantly from the 39(ofannual average of the previous ten years. United States pulp production
declined over 4SO)6 in 1996 to 58 million tons (Table 3), but this still
represents 32SO)6o of world pulp production (Lancey, 1997, p.59). As well
as being the largest producer, the United States is the world's largest

eonsumer of paper products. During 1996, the United States consumed
85 million tons of paper and paperboard, a decline of almost 2S>(of from1995, but nearly three times as much as Japan and China, the second
and third largest consumers, respectively. Ninety percent of UnitedStates paper and paperboard production is consumed domestically, but

exports from the United States are growing as a proportion of
shipments. Since 1990, exports of paper and paperboard advanced at a
10% average annual rate and accounted for 469(of of the industry's
growth (American Forest and Paper Association, 1997). In 1996, theUnited States exported 9 miliion tons of paper and paperboard, almosta 1279(of increase over 1995. As for pulp, although exports of paper
grade market pulp were up 3% in 1996, total pulp exports declined fromover 12 to 6 million tons (Koncel, 1997, p.74).

KAJIU(ARA:A COiXfPARATIVEANALYSIS OF PULP, PAPER, AATD PACKAGJNG COMPANIES 69

NewsprintPrintingandwriting

9,0254,689

CanbdaUnitedStatesJapan
Source:Pulp and Paperlnternational1997

6,30422,554
3,14010,811

PackagingTotal paperboard
4,705
52,97916,062

2. 1996 Japanese and North American Paper and Paperboard Production

18.41981,83730,O13(1,Ooo tons)

Mechanicalpulp
ChemicalpulpTotalpulp
10.973
Canada5.372
UnitedStates
1.705
Japan
1997
Paperlnternational
Source:Pulp and13,37924,352
52,86258,234

9.49411,1se

3. 1996 Japanese and North American Pulp Production (1,ooe tons)

The United States is the world's largest producer, with 537 paper
and paperboard mills and 190 pulp mills. The largest manufacturing

areas include the North Central, Northwestern, Northeastern, andSoutheastern regions. The Southeastern United States currently fulfills
72%o of United States pulping capacity and 55%o of primary paper andpaperboard capaeity. The pulp, paper, and packaging industry is thecountry's eleventh largest manufacturing industry and is fully
diversified, producing a wide array of commodity as weH as valueadded products from wood, recovered paper, and cellulosic fibers(Stanley, 1997, p.56).

Pulp, paper, and packaging industry operating rates in 1996
averaged 89%o of production capacity, in stark contrast to the 94%ooperating rates experienced in 1995, and the lowest rate reported sincethe 1980's (Lancey, 1997, p.59). Reflective of the drop in operating rates

is a similar drop in pulp and paper mill shipments. With the exceptionof modest increases in tissue and containerboard, pulp and paper
shipment volumes were down in 1996. Despite a 39(ol increase in export

volumes, a 14%o decrease in domestic shipments drove total shipmentsof chemical paper grade market pulp down in 1995 more than 2%o.
Printing and writing paper volumes declined 2SO)6o as publishers wotked

off 1995 inventories. Containerboard production rose almost 4% in
response to a 35% increase in foreign demand, but domestic shipments43 (1998),
KOBE ECONOMIC & BUSINEss REVIEW,

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65-117

advanced at a less impressive rate of O.4S)(or. Boxboard production
declined ISO)6o in response to decreased demand for domestic milk carton

stock and boxboard exports. A 6%o decline in domestic newsprint
shipments was partly offset by a 460/o increase in exports, but overall

newsprint shipments declined almost 1%. And finally, tissue, where
production and demand tend to be more stable, rose 1 906o (Lancey, 1997,p.59).

United States paper and paperboard production capacity increased
well over 3% in 1996. This represents an increase above the almost 3%oannual average reported for the ten years previous, but growth isprojected to average only between 1 and 2% through the end of thedecade. It is expected that 55%o of the eapacity gains of the next few
years will be realized through efficiency increases in existing machines.

The one industry segment that is projected to see significant growththrough the end of the decade is recovered paper market pulp. UnitedStates mill consumption of recovered paper increased 99(of in 1996 andhas an average annual rate of almost 8906 since 1990. As a result of thisrising demand for recovered fiber, de-inked market pulp production
capacity is slated to increase an average of almost 12906o per year
through 1999 (Lancey, 1997).

CANADIAN PULP, PAPER, AND PACKAGING INDUSTRY
Canada has a relatively large forest resource base, but thecountry's 102 paper and 51 pulp mills represent an industrial base thatis significantly smaller than that of the United States. In 1996, Canada

produced in 1995 more than 18 million tons of paper and paperboard
and 24 million tons of pulp (Tables 2 and 3). However, unlike theUnited States, Canadian fiber production far exceeds the processing
capacity of its domestic paper industry. Canada consumes less than 7
million tons of paper and paperboard annually, which means that
Canada is a large net exporter of pulp (40%) and paper products(73SO)6o). In contrast to the United States, Canadian pulp and paper

production is highly commodity driven with pulp and newsprintcomprising the majority of production. Canada supplies 32906o of theworld's market pulp and 28SO}6o of its newsprint (Industry Canada, 1996).

Paper and newsprint production is concentrated in eastern Canada. The
central region of the country produces primarily hardwood pulp. And

KAJJWARA: A COMPARATIVE AIVALYSJS OFPULP, PAPER, AiVD PACKAGIAIG COMPAIVIES 71

western Canada, British Columbia in particular, has significant
softwood pulping and milling operations.

Worldwide inventory corrections had a substantial impact on
Canadian producers in 1996, resulting in a 2906o drop in pulp and paper
shipments. Inventory corrections were primarily responsible for a 19(ofdrop in pulp and nearly a 5SO)6o decline in newsprint shipments. The two

industry segments that recorded increased deliveries in 1996 were finepapers and paperboard. Strong demand from United States andoverseas markets for boxboard, linerboard, and corrugating medium
caused a 6.5%o increase in paperboard shipments (Canadian Pulp andPaper Industry Association, 1996). As for fine papers, an increase ofover 89(of in shipments of uncoated woodfree papers resulted in a 69(ofcumulative increase (McElhatton, 1997, p.58). As a result of lower
demand and growing inventories during the first half of 1996, Canadianmi}1 operating rates were down 6906o from 1995 to average 88%o of
production capacity. Shipments to domestic markets fell nearly 59(of in1996 as did exports to the United States. At the same time, overseas
shipments of market pulp, newsprint, and paperboard to Asian markets

increased dramatically. Exports to China more than doubled andexports to the other Asian countries, excluding Japan, rose 169(of over1995 (Canadian Pulp and Paper Industry Association, 1996).

It is expected that Canadian paper and paperboard capacity will
average in 1995 more than a 2906 annual growth through 1999 (Industry
Canada, 1996). The industry segments experiencing the largest gains

are printing and writing papers and paperboard, particularly
corrugating medium and linerboard. No major capacity expansions are
expected in pulp or newsprint. As a result, newsprint capacity is
expected to decline slightly and annual growth in pulp capacity is
expected to average only O.3%o. As is the case with the United States,
the expected growth in pulp capacity is significantly lower than theprevious 10 year average of 4906o (Thomson, 1997, p.20).

JAPANESE PULP, PAPER, AND PACKAGING INDUSTRY
Though the Japanese economy seemed to continue its slow recovery
supported by measures introduced to stimulate the economy, it has
actually worsened due to the economic crises in Asian countries. In thepulp and paper industry, the pace of production and shipment growth

KOBE ECONOMIC & BUSIIVESS REVIEW, 43 (1998), 65-117

72

slackened. Nevertheless, in terms of volume, Japan surpassed previous
records and production reached 30 million tons for the first time. The

growth was mainly supported by advertising, and paper demand has
been fairly strong. However, uncoated woodfrees and coated papers which have been two of driving forces in this recent recovery - appear
to be at a turning point and production increases have leveled off.
Paperboard output was flat over 1995, but volumes were still strong.
Paper imports rose again to reach record levels, up to 1.32 million
tons showing a 24.6% increase. The ratio of paper imports to domestic
demand increased by 1.2 points to 7.19(o(. But still, market share ofJapanese imports remains low in spite of the United States-Japan
Paper Agreement.
For paperboard, corrugating medium imports rose 5.2 times thelevels of the previous year, but other grades showed negative growth.
Paper and board exports dropped 21.30/o last year due to slackness inthe southeast Asian markets which form Japan's main export
destinations. This trend has continued since 1993 and all the paper andpaperboard grades declined, except white board (Matussek, et al., 1997,
pp.62).

Pulp production increased slightly last year accompanied by anincrease in the use of recovered paper where consumption hit a record
high. The poor performance of the board sector, which consumes morethan 70%o of wastepaper, meant that the wastepaper utilization rateincreased by just O.2 points to 53.6%o

No new papermills have opened in Japan since 1992, but this year
has seen five become operational. Three of the papermills are forprinting grades, one for newsprint and the other for linerboard. This
helped push expenditure for the last fiscal year up to 49.8%.

The combined sales of the seven major paper companies in fiscal
1996 ending March 1997 increased by 20% over 1995/1996. Pre-tax
earnings were down 9.7% and as a result, the ratio of current profit tosales was down to 5.3% from 6.0906o in 1995.

New Oji Paper and Honshu Paper merged on October, 1996 tobecome Oji Paper. This is now the largest paper company in Japan
with about 1 trillion Yen in annual sales. Oji Paper and Nippon Paper

Industries, into which Jujo Paper and Sanyo Kokusaku Pulp weremerged in 1993, are two major leading pulp and paper companies inJapan. Also, Japan Paper Industry and Jujo Paperboard, both Nippon

KA JIVVARA: A COMPARA TIVE ANALYSIS OF PULP, PAPER, AAJD PA CKA GING COMPA NIES 73

Paper Industries' related and subsidiary companies, merged in October

1997 to become the second largest paperboard producer in Japan,
Japan Paperboard. These five years have seen several big mergers andacquisitions. The Japanese pulp and paper industry is becoming more
and more concentrated in order to struggle along with less advantage
in international cutthroat competition.

RESEARCH OBJECTIVES
Given today's highly competitive world market, understanding therelative financial performance, investments, and liquidity of pulp andpaper companies is essential to a full understanding of the industry.
The first objective of this financial analysis is to analyze financial
information extracted from 1996 annual reports of all publicly owned

United States, Canadian and Japanese pulp, paper, and packaging
companies. Annual sales, return on equity, earnings per share, anddebt to equity ratios are used as measures of performance. Two otherobjectives are to examine the capital expenditures and international
activities undertaken by these companies. The last objective is toprovide a discussion of important trends that are emerging in world
pulp, paper, and packaging markets.

METHODSThis research examines publicly owned Japanese and North
American pulp, paper, and packaging companies, as compared to
privately owned companies. These companies were identified using the1997 Lochtvood Post's Directory of the Pulp and Paper Industry andAllied Trades. Ownership structure of these companies, public versus

private, was determined using the Company Profiles database andMoody's Directory of Intemational Companies. The evaluative criteria
for which companies are in the sample are that the primary product or

output is comprised of a pulp or paper product. That means thatcompanies that use fiber but whose primary product is comprised ofinorganic binders such as Portland Cement are not considered a
primary pulp and paper manufacturer. Two other changes in thesample are noteworthy. First, Specialty Paperboard has undergone aname change and is now known as FiberMark. Second, Weldwood is no74

KOBE ECONOMIC & BUSINEss REVIEW, 43 (1998), 65-117

longer included in this analysis because this formerly publicly owned

Canadian company has since become privately owned. Three recent
mergers and acquisitions have occurred, namely James River and Fort
Howard, Abitibi-Price and Stone Container, and Japan Paper Industry

and Jujo Paperboard, but the actual restructuring to Fort James,
Abitibi-Consolidated, and Japan Paperboard was realized not in 1996

but rather mid-year 1997. Therefore, this 1996 analysis conducts
individua} or pre-consolidation reviews. In total, the number ofqualifying pulp and paper companies is 43 from the United States, 23

from Canada and 30 from Japan, for a total of 96 companies. Upon
request, each of these companies sent 1996 annual reports so that anin-depth analysis could be conducted of 1996 financial performance andbusiness activities.

Seven variables of business activity are examined in this study. The
first area of investigation is the primary product(s) manufactured byeach company. Presenting such a classification makes for a moremeaningful analysis and comparison of financial information among
companies. This study then investigates several measures of financial
performance, including annual sales, return on equity, and earnings per
share. Liquidity is examined in calculating and comparing each firm's
debt to equity ratio. Lastly, two business activities, capital expendituresand international manufacturing and exporting, are interpreted andreported. For each of these variables, an analysis of 1996 data is first

conducted; this is followed by an analysis that compares 1996 and 1995
data on per-firm and industry bases. It should be noted that the 1995
financial information used in this study reflects any restated 1995 data
presented in the 1996 annual reports.

For ease of comparison, all Canadian dollars and Japanese Yenreported in the annual reports are converted to United States dollars

using Moody's International Company Data foreign exchange rate in
1996. For 1996 data, Canadian $1 equals United States $O.7334 andJapanese Yen 1 equals United States $O.O080 while the 1995 data, used
to calculate the percentage change in variables, the exchange rate is
Canadian $1 equals United States $O.7287 and Japanese Yen 1 equals
United States $O.O093.

PA PER, AND PA CKA GING
COMPAAJIES 75
KA JI WARA:A COMPARA TIVE ANALYSIS OF PULP'STUDYFINDINGSPRINCIPLEPRODUCTS PRODUCEDMany pulp, paper, and packaging
product markets with the intent ofcompanies focus on specificdifferentiating to secure acompetitive advantage. For this reason,
categorization of the companies analyzed

in this study according to the

MARKETPULP
UnitedStates

CanadaBoiseCascade

AvenorCantofBowater
BuckeyeCellulose

Table 4 and 5 presents a

PRtNTINGANDWRLTINGPAPERS

CascadesChampion

Crestbrook

ConsolidatedPapers

Doman

George-PacificInternationalPaper

DomtarJamesRiver

FIetcherChallenge

JeffersonSmurtit

HarmacPacificMacM"lanBloedel
NorandaForest
RepapEnterprises

DonohueLouisiana-Pacitic

Pope&Taibot
Potlatch

StoneContainer
Weyerhaeuser

Roiland
SlocanSt.Laurent

Wil[ame{telndustries

TembecRayonier

WestFraser
WestonTISSUEPRODUCTS

NEWSPRINT
UnitedStates

CanadaBoiseCascade

Abitibi-Price

Bowater

AManceChampion

AvenorCanforJeffersonSmurfit
Kimberly-Clark

MediaGeneral
StoneContainer
Weyerhaeuser

UnitedStatesCanada
ChesapeakeCascades
FortHowardPerkinsPapers
George-PacifictnternationalPaper

Donohue

JamesRiver

FIetcherChallenge

KimberlyClark

MacMManBIoedel

MosineePaper
Pope&Talbot

SlocanSpruceFatfs
Stone-Consolidated

Potlatch

Proctor&Gamble

WestFraser

PAPERBOARDANDPACKAGING
CanadaSPECIALTYPAPERPRODUCTS

UnitedStatesCanada

UnitedStates
Bemis

MosineePaper

RepapEnterprises

BoiseCascade

Potlatch

FletcherChallenge

Caraustarlndustries

RepubiicGroup
Rock-Tenn

TembecBemisDomtar
BuckeyeCelluioseRepapEnterprises

WestFraser

Caraustarlndu$triesSlocan

SonocoMacMilianBloedei
St.Laurent

DexterSpruceFalls'

DomtarCascadesGreifBros.
InternationaiPaper
Kimberly-Clark

Champion
Chesapeake
Conso"datedPapefs

StoneContainer

GaylordContainer

Tetnpie-lnland

George-Pacific
GreitBros.
InternatjonalPaper

TennecoUnionCa[npJamesRiver

Westvaco
Weyerhaeuser

JeftersonSmudit
LongviewFibre

WausauPaper
Willamettelndustnes

HberMarkWeston

Lydall,P.H.Glatfelter

RepubHcGroup
SealedAir

TennecoLydailMead
4. Principal

BadgerPaperMillsCascades

WausauPgR9[

products of United States

and Canadian pulp and paper eompanies

76

43 (j998),& BUSJNESS REVIEVV,KOBEECONOMIC

65-IJ7

MARKETPULPPRINTtNGANDWRITINGPAPERS
ChuetsuPulp&PaperChuetsuPulp&Paper

DaioPaper'Chuetsu
DaishowaPaperMfg.DaioPaper

MitsubishiPaperMillsDaishowaPaperMfg.
NipponPaperlndustriesHokuetsuPaperMills

OjiPaperJapanPaperlndustry
TokaiPulpKishuPaper
MishimaPaper

MitsubishiPaperM"ls

NipponKakohSeishi
NipponPaperlndustries
OjiPaperSankoPaperMfg.
TokaiPulp

TokushuPaperMfg.

Totnoeawa

NEWSPRINTTISSUEPRODUCTS
ChuetsuPulp&PaperDaioPaper

DaioPaperMishimaPaper
DaishowaPaperMfg.NipponPaperlndustries
NipponPaperindustriesOjiPaper

OjiPaperTokaiPulp

Reno

PAPERBOARDANDPACKAGINGSPECSALTYPAPERPRODUC

ChuetsuPulp&PaperChuetsuPulp&Paper

ChuoPaperboardChuoPack

ChuoPackGeneral
DainipponShigyoJapanPaperlndustry

DaioPaperMishituaPaper
DaishowaPaperMfg.MitsubishiPaperMiils
FurubayashiShikoNipponHi-Pack

HokuetsuPape'rMillsNipponKakohSeishi
JapanPaperlndustryNipponPaperlndustries
MitsubishiPaperMillsTakasakiPaperMfg,

KishuPaperOjiPaper

NipponHi-PackTaiheiPaperMfg.
NipponPaperlndustriesThePack
OhishiSangyoTokushuPaperMfg.

OjiPaperTomoegawa
Rengo

SankoPaperMfg.

SettsuSuperbagTakasakiPaperMfg.
TaiheiPaperMfg.

ThePack
TokaiPulp

Tomoku5. Principal

Products ofJapanese pulp and paper companies

KAJIl•l'ARA.• A COMPARA TTIVEANALYSIS OFPULP, PAPER, A,NTD PACKAGJNG COMPANIES 77

primary products produced. Following convention, principal paper
products are divided into six categories: market pulp, newsprint,
printing and writing papers, tissue, paperboard and packaging, andspecialty papers.
Market pulp includes all cellulose derived pulps. It is classified by

the method of manufacture and the wood species used. These factors
determine the nature and condition of the fibers which effect end use
properties. Companies may sell market pulp to papermaking companies
or to businesses that chemically convert the pulp into non-paper
products. De-inked pulp is included in this category.

Newsprint is a low grade commodity paper used for high volume,
low cost publications. Newsprint producers use high yield, low costmechanical pulps with only a small percentage of more costly chemical
pulp. Newsprint sheets are characterized by printability, low cost, andability to run on high speed printing presses. Newsprint comprises
about 80906o of the total United States uncoated groundwood production(Biermann, 1996).
Printing and writing papers is a general class of papers made frommechanical and purely chemical (wood free) pulps, and includes
uncoated groundwood (non-newsprint), coated groundwood, uncoatedwood-free, and coated wood free, that. Uncoated groundwood is usedin directory paper and catalogs whereas the coated groundwood grades
are typically used in magazines and newspaper inserts. The uncoatedwood free papers are mainly used for writing grades, photocopy, bond,and tablet papers. The coated wood free papers are supercalendered to
produce a smooth, shiny surface. This premium grade can be used forbooks, advertising, and annual reports.

Tissue products are lighter than other paper grades and arecharacterized by absorbency. Products in this class include facial
tissue, sanitary tissue, toweling, napkins, etc. Due to the relatively
steady demand for tissue products, the market for these items tends tobe less volatile than markets for other paper products.

Paperboard and packaging is a fairly general class that includes
linerboard, corrugating medium, folding carton, boxboard, and sackpaper. The term paperboard stems from the boardlike characteristicsof the sheet. Sheets that are greater than O.3 mm thick are typicallyreferred to as paperboard; however, the distinction is somewhat vague.
This class also includes molded fiber products (e.g. egg cartons, drink

78 KOBE ECONOMIC &BUSJNESS REVIEVV, 43 (1998), 65-117

holders), roll cores and tubes.

Specialty papers include tobacco paper, postage stamps, filter
paper, glassine, etc. Companies that manufacture such specialty papers
generally serve niche markets and are able to command a higher pricethat reflects the value added to the product.
United States
Nineteen (44S)(of) of the United States companies report pulp andpaper products as a sole source of income. Other companies, such as
Weyerhaeuser and George-Pacific, also produÅëe other solid wood forest

products like lumber and engineered wood products. Tenneco andProctor & Gamble diversify beyond forest products producing
automobile parts and a wide range of consumer goods like the fat
substitute Olestra.

CanadaSeven (30SO)6) of the Canadian companies manufacture exclusively
pulp and paper products. The remaining companies produce non-paper
forest products. Weston is the only Canadian company that reports
producing products outside the forest products industry. It appears
that Canadian companies are more involved in the sale of market pulp
and newsprint, two relatively volatile markets. Only Cascades andPerkins Papers report involvement in the more stable tissue market
while only six Canadian companies manufacture specialty papers.

Japan
Ten (33%o) of the Japanese companies report pulp and paper
products as their sole source of income. Oji is the Japan's largest

general pulp and paper company and "land owner". Nippon Paper
Industries and Daishowa are Japan's second and third largest generalpulp and paper manufacturers and they produce other solid woodforest products such as lumber and engineered wood products. Several
Japanese companies have developed product specialty markets: Japan
Paper Industry, Japanese paper; Mishima, tobacco paper; Mitsubishi,

photosensitive material; Tomoegawa, insulated papers. Chuo
Paperboard, Ohishi, Rengo, Sanko, Settsu are specialized for
paperboard and packaging.

ANNUAL SALES
The first financial measure examined in this study is annual sales,

KAJAVARA:A COMPARATIVEANALYSJS OFPULP, PAPER,AND PACKAGING COMPAIVIES 79

commonly referred to as net annual sales. This number represents theamount of total annual sales revenue received by a company lessdiscounts, returns, and allowances.
United States
As Table 6 shows, average total net annual sales decreased 6%o for
United States companies, to $3.9 billion in 1996 from $4.2 billion in
1995. The median value of net annual sales is less than half of the mean
1996Sales

Companylnternational Paper
Kimberly-Clark"

Proctor & Gamble
James Rivera
George-Pacilic
Stone ContaineraChampion
Weyerhaeuser
TennecoJefferson Smurfita

Sonocoa
Westvaco
Union Camp

Mead
W"lamette lndustries
Temple-lnland

Boi$e Cascade
BemisaBowater:O,rt,,",O,,g.a,r,ddap,,.,,aChesapeake'
Potlatch

Crown Vantage"
Gaylord Containera
Sealed Aira

Longview Fibre
Rayonier
Caraustarlndustrie$
P.H. GIatfeltera

Wausau Paper"
Buckeye Cet[ulosea

Mosinee Papera

Rock-Tenn
DexterLyda""
Greit Bros.

Pope & Talbot
Louisiana-Pacitic

Media GeneraT
FiberMarka
Republic Group
Badger Paper Mmsa

MeanMedianTotal

PulpXpaper Pulp/paper

annualannualsales as. elo

sales

annualsales

total sale$sales$t4,060
13,149tO,196$20,143
13,14935,284

7001e

5,691
5,609
5,142
4,962
4,648
3,602
3,410
2,788
2,753
2,716

5,691
13,024

43

5,t42
5,880
",114
6,572
3.41e
2,788
3,045
4,O13
4.707
3,425
3,460
5,108
1.655

100

2,623
2,344
2,082
1,873
1.655
1,610
1,581
1,545
1,159
1,079

925
922
790
636
602
584
566
543
471
314
281
270
253
246
216
177
128
t25

1OO

$13,825
13,373

29

9,291

1OO

6,800
6,962
7,351
6,O07
5,682
2,752
4,093
2,706
2,998
3,230
2,672
2,810
2,198
2,5t8
1,523
1,884
1,621
1.579
1,234
1,099
1,077
1,051

84
42
55
too
100

90
68
56
68
60
37
1OO

1,718

94

1,5Bl

IOO
1OO
1OO

t,545
1,159
1,554

925
922
790
823

69
1OO
100
1OO

77

1,178

51

603
566
543
47t
314
876

97

1,100

253
637
447

2,486

86
76

2r430
1,159

765
125
la8

annuatele Change
Total
Pulptpaper PvlpXpaper
asnan/eusal
sales as O/aannuatI995 Sales

Pulp/paper

1OO
1OO
100
1OO

32
25
1OO

39
48
7
17

100

723
778
540
528
623
516
409
306
329
282
252

327
259
334

Total

$ales

sales

totat sates$19,797
13,37333,482

70ole

2"lo

1OO

-2

2e

10

.g

6,800

1OO

14,313

49

.sg

7,351

1OO

-16
-19
-30

6,972

86
48

"7

-16,

-18
31
-17

[i9

3

-;

11,788

8r899
4,093
2,706
3,272
4,212
5,179
3,874
3,495
5,074
1,523
2,OOI
4,621
1,579
1,234
1,605
1,077
1,051

31

723
9B6
1,261

545
623
516
409
306
903

1,089

252
719
524

2,843

140
118

708
96
93

118

IOO
1OO

92
77
52
73
63
50
100

`2iie

-8

-16

15g

-2

-I7

`12,

6

6

-26

9

94

-15

1OO
1OO
100

68

-2
-2
-6
-2

-I3,

1OO
100

-14
-12

ng

1OO

9

79
43
97

-18

100
100
1OO
1OO

-9

36
26

-15

45
49
12
20

-25
-17
-47

-9

66

37

1QO

1OO

'14,

IZ

"g

11
11

i.g

5

1:

3

g
8

1 5'

-4

o

ilg
-1

:

6

,g

76

1OO

63
93

1OO

-18

-18

3,935

75

2,627

4rT65

76

-8

-6

1,554

90

1,234

1,579

92 •

-6

-2

73

Pufp, paper, and packaging sales not reported separately from total annual sales

6. Annual sales (millions ofUS$) of United States pulp and paper compan]es.

80 KOBE ECONOMIO & BUSINESS REVIEVIJ, 43 (1998), 65-117

or $1.6 billion in 1996. The range in net annual sales is $20 billion toalow of $76 million. ' 'Many pulp and paper firms sell a multitude of forest products,
both paper and solid wood, as well as nonwood products, so revenues
generated by pulp, paper, and packaging sales in the table are reported
separately from overall sales. Analyzing pulp and paper annual sales
provides a more accurate picture of firm productivity and position in
the industry. In this year of price declines, average pulp and paper
annual sales fell 8%o, to $2.4 billion in 1996 from $2.6 billion in 1995.

The median value of pulp and paper annual sales is less than half ofthe mean value or $1.2 billion in 1996. The range in pulp and paper

annual sales is $14 billion to $76 million. .
As the largest paper company in the world, International Paper's
pulp and paper sales were over $14 billion, followed closely by
Kimberly-Clark at $13.1 billion. Proctor & Gamble, James River, andGeorge-Pacific rounded out the top five pulp and paper manufacturer's
with pulp and paper sales of $10.2, $5.7, and $5.6 billion, respectively.

James River replaces Stone Container as a top five company. This may
be because James River concentrates on tissue products while Stone
Container focuses on the more volatile pulp and packaging markets.
During industry downturns, a tissue producer is expected to fare betterin terms of sales due to more stable demand than other types of pulp
and paper.

Although many United States pulp and paper companies
experienced record sales in 1995, 28 of the 43 companies (65%o) reported

a decline in pulp and paper sales in 1996. This can be attributed tolower foreign and domestic demand, lower prices driven by
overcapacity, and inventory drawdowns (Stanley, 1997, p.57).
Companies that had pulp and paper sales decline the most in 1996
include Louisiana-Pacific, Stone Container, Boise Cascade, Greif Bros.,and George-Pacific with decreases of -47%o, -30%o, -26%o, -250/o, and -19906o

respectively. On the other hand, Republic Group, Tenneco, Buckeye
Cellulose, Rayonier, and Caraustar Industries experienced the largest
gains in pulp and paper annual sales in 1996 with increases of 37%,
31SO>6o, 15%, 11 9(ol, and 11 % respectively. Most of the sales increases

appear to be due to acquisitions; for example, Buckeye and RepublicGroup acquired additional capacity in 1996.

KAJJUJARA: A COiX4PARATIVEANALYSIS OFPULP, PAPER, AND PACKAGING COMPAAilES 81

CanadaAverage net annual sales for Canad
US$ 1.4 billion in 1996 from US$ 1.5

lan companles decreased 4%, to(Table 7). The
billion in 1995

range in net annual sales is over US$

1.7 billion to a

low of US$ 301

million.

1 995SalesC

1996Sates

Company
Stone-Consolidated

CascadesDomtar"FletcherChallenge"
Avenor
MacMitlanBloedel
Abitibi-Price

Pulplpaper
annualsales$1,561
1541'

1,450
1,364
1,215
1192'

1151,

WestFraser

950
875
853
656
423
355
322

St.Laufenta

311

SpruceFalls

239
t89
178
158
155
145
137
126
676
423

NorandaForest

Donohue
RepapEntefprisesa

WestonTembecCantorAiliance

PerkinsPapers

Doman
HarmacPacitica
Crestbrook
Stocan
RoLtand

Mean
MedianPuiptpaper Pulplpaper
annualsales asOlo annual
Totalsalestotalsates$1,6779301o$1,850

1,541

100
1OO
1OO
80
32

1,654
1,607

1,450
1,364
1,512
3,699
1,900
1,684
1,201

61

853

56
73
1OO

9,321

7

631

67
27
27
1OO
94

1313
1,204
311

255
311
178

61

1OO
32
1OO

saies

Total

annuaSsa+esasOlosalestotal sales$1,960
1,654
1,607

1160,

1160,

1,629
1,423
1,313

1,904
3r828
2027'

1,754

1125'

596

819

1,092

1,092
9,448

675
450
559
400
326

o!oChange
Pulp/paper

636
1,408
1,OB7

326
183
295
108
596

180
211
108

PulplpaperTotalannualannualsa{essales

94el.

-160!o

1OO
100
too
86
37
65
64
73
1OO

-7

-7

-10

-10

7
71

-140,t

18

18

-25
-16
-12
-16

-21

47

47

-22

-22

-3

t6
-4

-3

-1

-6

-1

40
37
100
9B
72
100

-37
-20

11

-7

-5

-5

33

39

-10

5

65

65
-16

51

-48

263
392
628
318

1OO
70
23
49

-41

.41

-47

-27

-4

-7

-20

T5

1,456
1,401
559
f,20I
67
sales
reportedseparatelyfromtotalannual

71

-fl
.24

-11

499
155

286
584
301

51

306
263
273

23
42
66

143
157
761

I087'

72

-4

Putp,paper,andpackagingsalesnot
b1996exchangerate C$1=US$O.7334
e1995exchangerate C$1=US$O.7287

7. Annual sales (millions of US$)of Canadian pulp and paper eompanies

The Canadian pulp and paper industry is oriented more towards
commodity products. One-half of the Canadian companies produce
newsprint and three-quarters produce market pulp. This focus on lower

margin, volatile commodity grades could explain why Canada fared
worse than the United States companies in terms of pulp and paper
annual sales relative to average net annual sales. Canadian pulp andpaper annual sales fell 11 SO)6o, to US$ 676 million in 1996 from US$ 761

million in 1995. The median value of pulp and paper annual sale'

about 63%o of the mean value, or US$ 423 million. Pulp and paper
annual sales ranges from a high of US$ 1.6 billion to US$ 126 million.

s is

82 KOBE ECONOMIC &BUSINESS REVJEW, 43 (1998), 65-117

Canada's largest grossing company, Stone-Consolidated, earned
US$ 1.6 billion in paper sales, follow by Cascades at US$ 1.5 billion.

Domtar, Fletcher Challenge, and Avenor followed with reported pulp
and paper sales of US$ 1.5, US$ 1.4, and US$ 1.2 billion respectively.
'Canada's pulp and paper industry also faced a difficult year in
1996, and of the 23 publicly owned companies, only 4 (17SO)6o) reported

increased pulp and paper sales. The companies with the largest
decreases in pulp and paper sales are Doman (-48%o), Crestbrook
Forest Industries (-47906o), Harmac Pacific (-41fO)6o), Canfor (-37%o), andAvenor (-259(of). This is compared to increases in pulp and paper sales

as experienced by only four companies, Perkins Papers, Donohue,
Spruce Falls, and Fletcher Challenge, with increases of 65%o, 47%, 33SO)6o,

and 18%o respectively. The increase in sales for these companies is
primarily due to an increase in capacity, similar to United Statescompanies. For example, Perkins Papers acquired some of Cascades
assets in late 1995. Spruce Falls restarted an idle paper machine andDonohue bought two newsprint mills and two sawmills.

Japan
Average net annual sales for Japanese companies decreased 13%,
to US$ 1 billion in 1996 from US$ 1.1 billion in 1995 calculated interms of US dollar value (Table 8). Based on Japanese Yen calculation,

however, the average net annual sales for Japanese companies
increased 2%o to JPY 125 billion in 1996 from JPY 123 billion in 1995
(Table 8-2). This difference in the two assessments comes from the factthat there was a 16%o depreciation of the Japanese Yen against the US
dollar during this period. Therefore, calculated against the US dollar

this depreciation makes the companies' performances look worse thanthey actually were, when in fact, the Japanese pulp and paper
companies were experiencing slow recovery of their production mainly
due to fairly strong demand for advertising and paper in Japanese

domestic
market.' • ''' '' . •'Japanese pulp and paper annual sales also fell 13 % to US$ 855
million in 1996 from US$ 1,O06 million in 1995 while they increased 2%
to JPY 97 billion in 1996 from JPY 96 in 1995. The median value of pulp

and paper annual sales is about 39% of the mean value, or US$ 331
million. Pulp and paper annual sales ranges from a high of US$ 6.2

billion to US$ 11 million. 'Japan's largest pulp and paper company, Oji Paper, earned US$

KAJIWARA: A COilfPARA TIVE ANALYSIS OF PULP, PAPER, AAiD PACKA GING COMPAIVIES 83

1996Selesb

Company

OjiPaperNipponPaperlndustries

DaioPaper
DaishowaPaperMfg.
Renq.eMitsubishiPaperMills

ChvetsvPulp&Paper
HokuetsuPaperMills
SettsuTomokuJapanPaperlndustry
NipponKakohSeishi
TokaiPvtp

ThePack
KishuPaper
SankoPaperMfg.
ChuoPaperboard
TokushvPaperMfg.
TakasakiPaperMfg.
MishimaPapere
NipponHi-PackFurubayashiShlkoa

SuperbagTomoegawa
DainipponShigyo
OhishiSangyo

ChuoPack
Chuetsu
TaiheiPaperMtg.
GeneralMean

1995Saleec

PulpXpaperTotaSPulp/paper Pulp/paperTotalPulpXpaper

okChanePulrVpaperTotal

annvatannualsalesas"loannualannualsalesaselo

annualannuat

salessalestotalsales$alessalestotalsales

salessates$6.282$7,85280% $8,051$9,ou689%

4.9755,71987
2,5162,516100
2,5152,ou795
1•723lr85393
1,1141,48575

5r6776,52587
2,8842.884100
2,8243,O04sc
2,O192.14794
1,310t,67978

41t46289
40541398
39949880

481Me8945048992

914914100
8688g497
539539100
51961784
4244241oo

969969100
9821.01397
628628100
56264687
491491tOO

44456379
41847588
3M41488297297100
346346100
188188100

16220579
15722769
128128tOO

127199M
123123100
11431736

9430231931516272122596072834211836224224100

lg223881
18427168
143143100
14722665
147147100
13434439
1123733e
105t7361-12-12-13-13-11-12-15-14-15-12-6-6-12-12-14-14-8-4-13-13-14-14-10-15-10-11-13-13-14-14-16-16-16-14-15-16-11-11-13-12-16-16-15-8-17-19-11-13-12-13-11-11-32-178214t586781836214244 -7-12
286742307640-7-7111338 1.0061.13978
111448 -13-t3
85599778
33136586

3B242488

MedianPutp,paper,andpackagingsalesnotrepdrtedseparatelyfromtotalannualsalest-22%-13%-13-13b1996exchangerateJPYen1=US$O.O080

c1995exchanerateJP Yee1=US$O.O093

8. Annual sales (millions of US$) of Japanese pulp and paper companies

6.3 billion in paper sales, follow by Nippon Paper Industries at US$ 5billion. Daio and Daishowa, the third and fourth largest pulp and paper

companies, followed with reported pulp and paper sales of US$ 2.5
billion each. It can be said that these four companies dominate theJapanese general pulp and paper market. Rengo, the fifth largest, is
specialized for paperboard and packaging material, and Mitsubishi

Paper Mills, the sixth ranked, focuses on their production ofphotosensitive materials. Chuetsu Pulp & Paper increased its sales 109(ofby acquiring a new newsprint factory.

84

43 (1998),
KOBE ECONOMIC & BUSINESS REVIEW,

CompanyOji Paper
Nippon Paper lndustries

Daio Paper
Dajshowa Paper Mfg.

Rengo
Mitsubishi Paper Mills

Chuetsu Pulp & Paper
Hokuetsu Paper Mills
SettsuTomokuJapan Paper lndustry
Nippon Kakoh Seishi

1996

1995

O/e Change

Total

Total

Total

annualannualannual

sales

sales

sates

981,561

973,167

10/o

714,857
314r533

701 ,9572

310,2741

330,913323,2012

231,626
185,660
114,243
111r803
67,345
77,180231,O18
180,639104,288o10

108.938

3

67,592
69,457
52,772

11

58,083-1

52,571-2

60,525

3

51,07337,26924,07025,55529,175
15,41724.28915r79537,02640,1691

53,04157,75751,67062r29851,74637,09423,54025,63828,386
15,98324,897

Tokai Pulp

The Pack
Kishu Paper
Sanko Paper Mfg.
Chuo Paperboard
Tokushu Paper Mfg.
Takasaki Paper Mfg.
MiShima Papera

Nippon Hi-PackFurubayashi Shikoa

65-117

3

o
1

o
-2

o
-3

4
3

Dainippon Shigyo
Ohishi Sangyo

15,33439,61837,71018,81818,571

15,271

15,1471

Chuo Pack

9,OOO

8,732

3

Chuetsu

14,727

15,256-3

Taihei Paper Mfg.

8,401

8,174

3

General16,622

15,442

8

Mean

124r576

122.521

2

Me dian

45,64445.621

1SuperbagTomoegawa

8-2. Annual sales(millions of JPY)

-3
7
-6
1

of Japanese pulp and paper companles

KAJJIVARA: A COMPARATIVE ANALYSJS OFPULP, PAPER, AND PACKAGIAiG COMPANIES 85

RETURN ON EQUITY'
Return on equity (ROE), which compares net income to averagestockholders' equity, measures how much an "investment" is earning

for a stoekholder based on the growth in the company's equity.
Average ROE for United States pulp, paper, and packaging companies
fell M9(of between 1996 and 1995, while the Canadian average fell 63%
and the Japanese average fell 21%.
United States
During 1996, the United States pulp and paper industry experienced
a dramatic decline (-64fO)6o) in average ROE to 10.4%o in 1996 from 28.7906

in 1995 (Table 9). It should be noted that the decline in ROE is less(-43SO)6o) when the three companies with the largest 1995 ROE (Gaylord

Container 300906, Crown Vantage 100%o, and Sealed Air 90%) areexcluded from the mean. This is also reflected in the median, where theROE decline is negative 41 %o, to 11.1 9(of in 1996 from 18.89(o( in 1995.

Return on equity ranges from a high of 45906 to a low of -719(of. Thirty-six (84906) of the 43 United States pulp, paper, and packaging
companies report a positive ROE.
The most successful United States company, in terms of 1996 ROE,

is Sealed Air, at 45.4%o. This company's income was generated
primarily from strong earnings in international sales of specialty
packaging materials. Sealed Air also reported the largest ROE in 1995
when the pulp and paper industry experienced outstanding profitability.
The diversity of Seaied Air products, many of which do not originate

from pulp or paper, appear to ensure substantial profits in bothoutstanding and poor plllp and paper cycles. Buckeye Cellulose is thecompany with the second largest ROE (38.2906o) and produces wood andcotton liner-based specialty cellulose products. In 1996, Buckeyemanagement attributed it's company's near doubled income to its
specialty products emphasis; another buffer that may have helped
Buckeye's ROE in 1996 is that most of this company's sales (70}O)6o) are

obtained in markets outside of the United States. Caraustar
Industries, which manufactures, converts, and markets paperboard
products, enjoyed the third largest ROE (37.4SO)6o) in 1996. KimberlyClark with a 34.50/o ROE, operates three major businesses worldwide
including personal care products, consumer tissue products, and away-

from-home products. Successful reorganization after a 1995 merger43 (1998),& BUSINESS REVIEW,
KOBE ECONOMIC

86

Com an65-1171996

1995

e/e Chan e

ROE

ROE

ROE

45.40/o89.90/o-490/e

38.2
37.4
34.5
28,O
27.3
23.9
22.5

29.4
35.6

30
5

O.9

3,735

Sealed Air
Buckeye Cellulose
Cairaustar lndustries
Kirnberly-Clark

Rep'ublic

Procter & Gamble
Mosinee Paper
Lydall

Bemis

18.7
18.7
18,6
17,7
17.3
16.4
I6.2
15.6
G4.8
t3.7

P. H. Glatfelter

SonocoBowaterMedia General

Wausau Paper
FiberMarkRock-Tenn
Consolidated Papers

Tenneco

20.6

36

272

O.4

16.0
25.2
t8.3
21.5
18.8
24.9
15.0
13.8
21.7
14.0

49
-11

2
-13
-1
-29

15
19
-25

11

21.5
13.6

-31

o

DexterLongview Fibre

13.1

".4

15

12.3
11.1

Weyerhaeuser

1O,2
1O.O

t7.8
17.2
18.2
31.8
14.2

-31

Greif Bros.

WMamette lndustries

Westvaco

Chesapeake

9.9
8.9
7.6
6.9
6.7
6.4

Potlatch

6.1

George-Pacific

4.4
4,O
3,8

Mead
Gaylord Container

James River
Temple-lnland

Union CampChampion35

lnternational Paper

16.1

300.2
5.7
15.0
21.7
11.7
33.2
22.8
23.4
16.1

-36
-44
-68
-30
-45
-97
21
-56
-70

-48
-87
-82
-84
-78
118
-99
-I81
-334
-171

Pope & Talbot

2.1

-" .9

BoiSe Cascade

O.2

Badger Paper Mills-1 1.0Louisiana-Pacific-13.0

Rayonier
Stone Container

-14.1

-f4.9
-70.9

23.0
13.5
-3.0
20.0
31.0

-1 48

1OO.1

-171

NMa
NMa

NMa
NMa

NMa
NMa

1O.4
11.1

28. 7

-64
-41

Crown Vantage
Jefferson Smurtit

Fort Howard

Mean
MedianNM = not meanin tul due to ne

18.8

ative shareholders' e uit

9. Return on equity ofUnited States pulp and paper companles.

KAJJW'ARA: A COMPARATIVE ANALYSIS OFPULP, PAPER, AAJD PACKAGING COMPANIES 87with Scott Paper resulted in a strong ROE for Kimberly-Clark in 1996,
increasing from less than a 1%o ROE in 1995 to a 34.50/o ROE in 1996.

However, the low ROE in 1995 result.ed from Kimberly-Clark's taking
substantial charges against income in 1995 for the merger with Scott. The Republic Group has the fifth largest ROE or 27.3906o. This
Paper.
company specializes in production of gypsum wallboard and recycled
paperboard as well as the collection and sale of recovered paper fiber.
Kimberly-Clark experienced the largest percent increase (3,735SO)6o) in

ROE, but such an extraordinary increase would not have occurred
without the reductions taken in 1995 for restructuring associated withacquiring Scott Paper. The remaining four companies with the largest

pereent increase in ROE are Pope & Talbot (1189(of), Mosinee Paper(49%o), Buckeye Cellulose (30S06), and Wausau Paper (1199(of).

The five poorest United States performers in 1996, in terms of ROE,

are Crown Vantage (-70.9%o), Stone Contajner (-14.9%), Rayonier(-14.19(or), Louisiana-Pacific (-13906), and Badger Paper Mills (-11906o) andall report that negative ROE resulted from losses due to declining
prices aggravated by weak demand for pulp and paper commodities.
For Badger, Louisiana-Pacific, and Rayonier, such losses were further
intensified by charges against earnings resulting from plant closuresand legal actions. Louisiana-Pacific suffered the double impacts of theclosure of Ketchikan Pulp operations and the settlement of a classaction lawsuit over oriented strandboard. Two United Statescompanies, Fort Howard and Jefferson Smurfit, are shown in Table 9
as having a ROE that is not meaningful (NM) because of negative
stockholders' equity. Both companies attribute a deficit in stockholders'equity to circumstances associated with reorganization of indebtedness.

The company with the largest decrease in percent change ROE isLouisiana-Pacific (-3349(or), 'followed by Badger Paper Mills (-181%),Rayonier and Crown Vantage (both -171SO)6o), and. Stone Container(-148%).

CanadaEffective in 1996, the Canadian Institute of Chartered Accountants
issued a recommendation that convertible debentures be segregated andreported in both the liability and equity sections of the balance sheet.
However, this reporting change makes it difficult to compare UnitedStates, Canadian and Japanese companies in terms of a ratio analysis
involving equity because United States and Japanese companies report

KOBE ECONOMIC & BUSINESS REVIEW, 43 (1998), 65-117

88

debentures in the liability section only. Therefore, it was decided that

the ROE calculation for this analysis would subtract the value ofdebentures reported in the Canadian stockholders' equity section formeaningful comparative evaluation of ROE for Unites States, Canadianand Japanese companies. The calculation for ROE is net income divided
by average stockholders' equity (without debentures).

During 1996, the Canadian pulp and paper industry experienced aserious decline (-639(ol) in average ROE, to 8.2SO)6o in 1996 from 22%o in

1995 (Table 10). For median values, the decline in ROE is negative 60%o,
to a ROE in 1996 of 8906o from 20.29(of in 1995. Return on equity ranges
from a high of 53%o to a low of -16%o. Sixteen (70906o) of the 23 Canadianpulp and paper companies report a positive ROE.
1996

l995

Com anROE

ROE

Spruce Falls

52.701o57.oe/.

-801o

Perkins Papers

34.9
22.3
17.9
17.3
15.3

267

".8
",8

9.5
38.0
23.9
31.2
12.9
15.3
18.8

Abitibi-Price

99

29.1

Slocan9,8

21.6

Fletcher Challenge

8.1

6.6

23

Domtar

7,8
7.4
2.5
1.9

32.2
iO.7
15.4

-76

TembecO.6
o.o

St. Laurent

Donohue
CascadesAlliance

WestonWest Fraser
Rolland

Stone-Consolidated
MacMillan Bloedel
Noranda Forest

el. Chan e

ROE
-41

-25
-44

19
-23
-37
-66
-55

-31

-2.0

32.0
21.6
44.0

Canfor

-8.0

6.3

Doman

-t2.1

12.8

-84
-89
-98
-IOO
-105
-227
-195

Harmac PacificCrestbrook
Repap Enterprises-1 2.5

23.1

-1 54

-16.2

8.5

-291

NMa

NMa

NMa

8.2
8.0

22.0
20.2

-63
-60

AvenorMeanMedian169

NM = not meaningful due to negative shareholders' equity

10. Return on equity of Canadian pulp and paper companies

KAJJWARA: A COi14PARATIVE ANALYSJS OF PULP, PAPER, AND PACKAGING COMPANIES 89

The most successful Canadian performer, both in 1996 and 1995, is
Spruce Falls with a ROE of 52.7SO)6o. This is an integrated company that

produces lumber, newsprint, and specialty papers. Spruce Falls
employees own 48906o of the outstanding common shares and reflects thecompany's philosophy that shared ownership insures profitability.
Perkins Papers, a new participant in the top five, has a 34.99(of ROE andattributes its success to gains in productivity and efficiency augmented
by strong newsprint sales. Donohue (22.3906o), is a consistent performer

with the third largest Canadian ROE in 1996 and fourth largest ROE in

1995. Donohue reported that strong lumber prices offset the weak
performance of pulp in 1996 while in 1995 Donohue reported that record
pulp prices made the eompany profitable in the face of disappointing
Iumber sales. Cascades was second in 1995 and is fourth in 1996 with a
17.99(of ROE. Cascades management credits a mixture of diversified
markets, specialty products, and recycling for its success. Alliance

Forest Product earned a 17.3%o ROE and offers a product mix ofnewsprint, publishing paper and lumber products.

Only three Canadian companies experienced an increase in thepercent in ROE, and these are Perkins Papers (267%o), Fletcher
Challenge (23SO)6), and Weston (19%o).

The three poorest performing Canadian companies, in terms ofreported ROE, are Crestbrook Forest Industries (-16.2%o), Harmac(-12.5906o), Doman (-12.1%o). Each of these companies attributed poor
earnings to soft pulp prices and reduced order volumes. Canfor's -8.0SO)6o

ROE means another year as a bottom five performer. Canfor's annual
report suggests that its lackluster performance is because of poor
market conditions and losses due to foreign exchange fluctuations. St.
Laurent, with a reported ROE of -2.0%, cites soft prices in container
board products and production problems as the source of decline in
ROE. Four of the five companies shown as reporting poor ROE arereliant on the sale of market pulp for substantial portions of sales.
Repap Enterprises is reported as having an ROE that is not meaningful(NM) because of a negative stockholders' value which Repap
Enterprises attributes to a large one time net loss to income fromdiscontinued operations.

The company with the largest decrease in percent in ROE is
Crestbrook Forest Industries (-291%o), followed by Canfor (-227SO)6o),
Doman (-195%); Harmac Pacific (-154%o), and St. Laurent (-105%o).

90 KOBE ECOIVOMIC & BUSINEss REVIEW, 43 (1998), 65-117

Japan
Table 11 shows remarkable characteristics of Japanese pulp andpaper industry; ROE of Japanese pulp and paper industry is really low

compared to US and Canadian counterparts. Furthermore, Japanesepulp and paper industry faced a serious decline (-21906o) in average ROE

to O% in 1996 from 1.6% in 1995.

The most successful Japanese company, in terms of 1996 ROE, is
Daishowa, at 14.5SO)6o. This company has been struggling to survive
1995

ofo Change

Com an

ROE

ROE

ROE

Daishowa Paper Mtg.
Sanko Paper Mfg.

14.5%

-10.9%

2ss%

12.8

21.1

-39

8.6
8.3
7.0
7.0
6.7
6.3
5.4
5.0
4.8

7,5
7.6
8.2
6.6
9.9
5.6

15
9

t996

The Pack
Ohishi Sangyo
Hokuetsu Paper Mills
Nippon Paper lndustries

Chuetsu Pulp & Paper
Kishu Paper
Oji Paper

Daio Paper
Tokushu Paper Mfg.
Nippon Kakoh Seishi

5.t

7.2
5.3

-15

6
-32

13
6
-31

-9
os

Generat

4.5
3.5
3.4
3.3
3.2
3.2
3.0
2.7
2.6
2.3
2.0

Takasaki Paper Mfg.

1.1

-5.7

119

Mishima Paper
Superbag

O.9
O.6

50
o

Tokai Pulp

Nippon Hi-Pack

Rengo
Chuo Pack
Mitsubishi Paper Mills

Dainippon Shigyo

ChuetsuJapan Paper lndvstry

Tomoku

12.2

2.9
3.4
1.3
1.8
5.0
2.4
2.1

21

o
154

78
-36

25
29

7.6
1.0
1.0

-66
130
1oo

Furubayashi Shiko

-2.3

O.6
e.6
2.2

Settsu

-28.9

-3.0

863

Tomoegawa

-33.7

-9.9

-240

Taihei Paper Mfg.

-57.3

-53.2

Chuo Pa erboard

NM.

NM.

NM

-204

8

Mean

o.o

t.6

-21

MedianaNM=not meanin ful due to ne

3.3

2.9

6

11. Return

ative shareholders' e uit

on equityof Japanese pulp

and paper companles.

KAJIWARA:A COMPARATIVEANALYSIS OF PULP, PAPER, AND PACKAGING COMPANIES 91

cutthroat competition among Japanese pulp and paper companies byimplementing financial reconstruction. This dramatic recovery of its
ROE came •-from sales of lands and stocks to settle its debt. Sanko
Paper, one of Oji Paper's affiliated companies, is the company with thesecond largest ROE (12.8%o) and produces pulp and crude paper for
paperboard. ROE of other large companies such as Oji Paper, Nippon

Paper and Daio is not so outstanding compared to other small to
medium-sized pulp and paper companies.

EARNINGS PER SHARE
Earnings per share (EPS) compares net income to the weighted
average number of outstanding common shares of stock, resulting in adollar amount earned by each common share. This ratio is watchedclosely by investors and changes can have substantial impacts on acompany's stock price. The average EPS for United States pulp andpaper companies fell 500/o between 1996 and 1995, while the Canadian
average fell 749(or and the Japanese average fell 122SO)6 (126%o in Japanese

Yen basis).
United States

United States pulp, paper, and packaging companies saw average
EPS decline substantially (-50%o) to $1.52 in 1996 from $3.05 in 1995
(Table 12). In terms of median values, the decline in EPS is less at-22SO)6o, to $1.72 from $2.19. 1996 EPS values range from a high of$4.98 to a low of -$3.28. Due to weak markets, 660/o of US companies
report a decline in 1996 EPS as compared to 1995. The range of EPS isnarrower and with more negative values than the previous year. In 1996
the range is a total of $8.26, from a high of $4.98 to a Iow of -$3.28;
the range in 1995 is a total of $13.15, from a high of $11.29 to a low

Kimberly-Clark reports the largest 1996 EPS of $4.98. It isinteresting to note that Kimberly-Clark and Procter & Gamble ($4.29),

two consumer products companies, enjoy the first and third largest
EPS in the industry. The other three most successful companies include
Bowater ($4.63), Consolidated Papbrs ($4.01), and Mead ($3.67).

Between 1996 and 1995 there is a major change in the companies
appearing in the top five most successful category. Of the top fivecompanies in 1995, only Mead returns in 1996.

92

43 (1998),& BUSINEss REVIEW,
KOBE ECOIVOMIC

65-1171996

1995

o/o Chan e

Com anEPS

EPS

Kimberly-Clark

EPS

$4.98
4,63
4.29

$O.i2

4,0500A

4.01

Bowater
Procter & Gamble
Consolidated Papers

Mead
Willamette lndustries

Media General

Mosinee Paper
Temple-Inland

Weyerhaeuser
TennecoFort Howard
Caraustar lndustries

Westvaco
Dexter
Buckeye Cellulose

3.67
3.48
2.65
2.56
2.39
2.34
2.33
2.32
2.28
2.09
2.06

5.33

-13

3.71

16

5.16
6.33
9.34

-22
-42
-63

2.01

32
78

1.44
5.01

3.93
4.16
O,25
1,66
2.78
1.67

-52
-40
-44

828

37
-25

23
NMb

2.04

NRa

Potlatch

2.01

1.90
1.87
1.81
1.79

3.72
S.63
2.49
1.72
1.97
" .29
1.25
1.21
8.01
1.49

-46

Bemis

1.10
1.23
3.88
6.45

27

Greif Bros.

SonocoFiberMark
George-PacificSealed Air

Rock-Tenn

Champion
P.H. Glatfe[terRepublic
LydallChesapeake
Union CampJames River

Wausau Paper
Longview Fibre

1.72
1.63
t.50
1.48
1.41
1.40
t.37
1.27
l.23
1.15
1.12

1.09
l.04

lnternational Paper
Jefferson Smurfit

1.01

Pope & Talbot
Gaylord Container

O.29
O.16

Boise Cascade

Crown Vantage

-O.63
-t.14
-1.35
-1.B7
-2.B7

Rayonier

Badger Paper Mills
Stone Container
Louisiana-Pacific

O.81

O.85
l.47
4.50
2.19

17
-25

5
-9
-85

30
24
-82
-5
11

-67
-81

42
32
-26
-77
-54

-1.86

"6

2.44
5.93

-93

2.63

-111
-181
-151

-O.48

-290

1.41

NRa

NTvtb

-3.28

4.75

Mean

1.52

3.05

Median

1. 72

2. 19

-169
-50
-22

NR = not reported because not a publicly traded company in 1 995
bNM = not meaningful due to no financial reporting in 1 995

12. Earnings

per share(US$) of United States pulp and paper companies

KAJILVARA.• A COMPARATIVEANALYSJS OFPULP, PAPER, AND PACKAGING COMPANIES 93

Kimberly-Clark experienced the largest percent increase (4,050%o) in
EPS, but Kimberly-CIark's dramatic increase would ndt have occurred
without the reduction of $3.74 in EPS in 1995 due to restructuringassociated with acquiring Scott Paper. Restating EPS to remove
restructuring results in a more modest increase of 29%o. The remaining

four companies with the largest percent increase in EPS are Fort
Howard (828%), Pope & Talbot (116%), Mosinee Paper (78%o), andJames River (42%o). These four companies all attribute increasing EPS

to better productivity and efficiency due to concentrating on corecompetencies. It is interesting, however, that Fort Howard has anegative shareholder's equity, as reported in the previous section, but
had a positive increase in EPS. This positive change is due to a $2oo
million reduction in cost of goods sold.

The company with the lowest 1996 EPS is Rayonier at -$3.81,
representing a decrease of 169%o. Rayonier experienced weak earnings
arising from one time charges attributable to mill closures and achange in accounting practices. The remaining four poorest performing

EPS companies in 1996 include Crown Vantage (-$2.87), LouisianaPacific (-$1.87), Stone Container (-$1.35), and Badger Paper Mills(-$1.14). Crown Vantage reports weak earning as a result of interest
expense related to their spin-off in 1995. Louisiana-Pacific and Badger

both suffered one time charges because of mill closures andrestructuring fees. Pulp producing Stone Container did poorly becauseof weak pulp markets. The company with the largest decrease inpercent in EPS is Louisiana-Pacific (-290S)(or), followed by Badger Paper

Mills (-181%o), Rayonier (-169%), Stone Container (-1519(of), and Boise

Cascade (-111%o). Badger, Rayonier, and Boise Cascade attribute thedecrease primarily to expenses associated with mill closures andrestructuring costs. Stone Container is effected by the weak pulp
market and refinancing charges associated with long term debt.

CanadaOnly two Canadian companies report EPS using both Canadian andUnited States GAAP, so direct comparison of the EPS values between
the two countries is not possible due to the differences between UnitedStates and Canadian GAAP.
Canadian pulp, paper, and packaging companies average EPS 'wasoff sharply (-74%o) to US$ O.47 in 1996 from US$ 1.78 in 1995 (Table
13). In terms of median values, the decline in EPS is 69%, to an EPS inKOBE ECONOMIC & BUSINEss REVIEW, 43 (1998), 65-117

94

1996a

1995

o/o Chan e

Com an

EPS

EPS

EPS

Weston

$3.81

3oel.

Alliance

2.35
2.32
1.81
1.66
1.16
1.00
O.91
O.89
O.86
O.71
O.50
O.42

$2.93
3.32
2.58

West Fraser
Spruce Falls

Donohue
Stone-Consolidated 'CascadesFletcher Challenge

RoHand.
Abitibi-Price

1.11

63

2.24
1.89
1.34

-26
-39
-25

071

29

1.46

-39
-64

Crestbrook
Repap Enterprises

-O.98
-1.12
-1.72
-2.95

2.36
O.14
1.69
1.17
1.60
1.06
3.73
2.16
3.99
O.58
2.16
O.96
O.94
O.83

Mean

O.47

1. 78

Median

O.50-

1.60

Perkins Papers

DomtarSlocanMacMillan Bloedel
Noranda Forest

AvenorTembecSt. Laurent

CanforHarmac Pacific

Doman

026
O.07
O.07
-O.14
-O.42
-O.71

-29
-10

408
-71

-64
-84
-93
-98
-1 07

-1 "

-224
-1 45

-217
-283
-455
-74
:69

1996 exchange rate C$ t =.US$ O.7334
b 1995 exchange rate C$ 1 = US$ O.7287
13. Earnings per share (US$) of Canada pulp and paper companies

1996 of US$ O.50 from US$ 1.60 in 1995. 1996 EPS range from a highof US$ 3.81 to a low of -US$ 2.95. 83SO)6o of Canadian companies reporta decline in 1996 EPS over 1995. The range of EPS in 1996 for Canadiancompanies is broader and more negative than in 1995. In 1996 the range
is US$ 3.81 to US$ -295 (a difference of $6.76), while the range in1995 was US$ 3.99 to US$ O.14 (a difference of US$•3.85).
Weston earned the largest 1996 EPS or US$ 3.81, reflecting a gainof 309(of and one of only three Canadian companies to report anKAJIWARA: A eOMPARATIVE ANALYSIS OFPULP, PAPER, AIVD PACKAGING COMPANIES 95

increase in EPS. Weston is a diversified company that manufactures
many non-forest products, thus lowering its vulnerability in a weak
year in the-pulp and paper markets, The other four most successful
Canadian companies include AIIiance Forest Products (US$ 2.35), West

Fraser Timber (US$ 2.32), Spruce Falls (US$ 1.81), and Donohue(US$ 1.66). Alliance Forest Products and West Fraser Timber bothreport an increase in EPS due to a strong lumber market as well as
productivity progress in mills and plants. Spruce Falls attributes its
higher EPS to the increased capacity of paper mills. Three Canadiancompanies, Weston, Alliance Forest Products, and West Fraser, returnin 1996 to the top five category.

The Canadian company with the largest percent increase in EPS is
Perkins Papers with a change of 408%. Perkins explains this large

increase as being due to productivity and efficiency increases
throughout the corporation. The remaining companies with an increase
in EPS are Spruce Falls (63SO)6o), Weston Industries (30%o), and Fletcher

Challenge (29%o). As stated earlier, Spruce Falls attributes increased

earnings to higher capacity, Weston is a large diversified firm, andFletcher Challenge experienced strong sales early in their financial
year. All other Canadian companies (83906) experienced decreasing EPS

in 1996, which will be discussed shortly, 'The company with the lowest EPS is Repap Enterprises, at US$-2.95. The other four companies suffering from a comparatively Iow

EPS are Crestbrook Forest Industries (US$ -1.72), Doman (US$-1.12), Harmac (US$ -O.98), and Cantor (US$ -O.71). Each of thesecompanies say decreases in order volumes and weak pulp markets werea major influence on decreased earnings. Canfor also says fluctuations

in exchange rates were responsible for a negative EPS. •The company with the largest decrease in percent in EPS is Repap
Enterprises with a decrease of 455%e, followed by Crestbrook Forest
Industries (-283906o), Canfor (-224SO)6o), Doman (-217%o), and Harmac
Pacific (-145SO)6o). Each of these companies attributes decreased earnings

to the weak pulp market in 1996.

No Japanese company reports EPS using both Japanese and UnitedStates GAAP; therefore, due to the differences between Japanese and
US GAAP, direct comparison of the EPS values between these countries
is not possible.

43 (1998),
REVIEW,&
KOBEECONOMICBUSINEss

96

65-117As Table 14 and Table 14-2 show, average EPS decreased to
US$O.03 (JPY 3.40) in 1996 from US$O.14 (JPY 15.38) in 1995. The
median value of EPS is US$O.09 (JPY 11.87) in 1996 and US$O.15 (JPY15.76) in 1995. In spite of weak markets, 50%o of the companies reportan increase in 1996 EPS as compared to 1995 in terms of Japanese Yenbasis. The range of EPS is broader than the previous year. In 1996, therange is a total of US$2.14 (JPY 267.51), from a high of US$O.44(JPY 55.21) to a low of -US$1.70 (-JPY 212.3); the range in 1995 is a
1996g

t995b

%Chan eEPS

EPS

Ohishi Sangyo

EPS
O.M

o.an

The Pack

o%

O.40

O.38

Daio Paper
Daishowa Paper Mfg.
Tokushu PaPer Mfg.
Hokuetsu Paper Mills
Chuetsu Pulp & Paper

O.37

O.65

5
as

O.34

-O.29

O.27

O.34

O.25

O.29

O.23

O.36

Chuo Pack

e.22

O.14

M

Oji Paper

eA9

O.19

Kishu Paper

O.19

O.18

-1
1'

Nippon Paper lndustries

OA9
OA8

O.20

-5

O.16

8

O.14

O.18

-19
os
116

Com anDainippon Shigyo
Nippon Hi-Pack
General

217
-19
-14
-38

O.12

O.07

Rengo

O.10

O.05

Mitsubishi Paper Mills

O.09

O.15

Tokai Pulp

O.07

O.07

Tomokuo.os

o.os

Japan Paper lndustry

O.06

O.21

Nippon Kakoh Seishi
Sanko Paper Mfg.

O.06

O.17

O.05

o.oa

1oo
-70
-65
-38

Chuetsu
Mishima Paper
Supetoag

O.02

O.02

11

O.02

O.02

O.Ol

O.02

q8

Takasaki Paper Mfg.
Furubayashi Shiko
Taihei Paper Mfg.

O.Ol

-O.05

26
-27
116

e.os

o.os

-187

O.21

O.40

-153

Tomoegawa

-O.39

-O.17

-i38

Settsu

-O.89

-O.12

-612

Chuo Pa erboard

-1.70

o.(x;

-2914

Mean

O.CM3

O.14

-122

Median

O.09

O.15

-10

•-

a 1996 exchange rate JP Yen 1 =US$O.O080

bt995 exchan e rate JP Yen1=US$O.O093

14. Earnings

per share(US$) of Japanese pulp and paper companles.

KAJIWARA:A COMPARATIVEANALYSIS OFPULP, PAPER, AND PACKAGIIVG COMPANIES 97

1996

Com anOhishi Sangyo
The Pack
Daio Paper
Daishowa Paper Mfg.
Tokushu Paper Mfg.

EPS

1995

O/o Change

EPS

EPS

55.21

47.49

160/o

40.74

30.83

22
-34
217
-6
o

39.17

-•27

15.12

79
15
18
10
25
-6
90

Taihei Paper Mfg.

49.55
45.86
42.25
34.37
30.81
28.43
26.99
23.49
23.33
23.32
22.09
17.79
14.46
13.02
1O.71
8.88
7.92
7.88
7.24
6.1
3.1
2.69
1.62
O.97
-6.98
-26.5

Hokuetsu Paper Mills

Chuetsu Pulp & Paper

Chuo Pack
Oji Paper

Kishu Paper
Nippon Paper lndustries
Dainippon Shlgyo
Nippon Hi-Pack
GeneralRengo
Mitsubishi Paper Mills

Tokai Pulp

TomokuJapan Paper lndustry
Nippon Kakoh Seishi
Sanko Paper Mfg.

Chuetsu
Mishima Paper
SuperbagTakasaki Paper Mfg.
Furubayashi Shiko

69.63-31.11

36.53

20.48
19.85

21.14
17.63
18.96

7.61
5.19
16.4
7.1
3.41
22.74
17.91

8.51
2.41
1.83
1.9
-5.26

151

-35
25
132
-65
-60
-28
29
47
-15
116

6.87
43.1

-161

Tomoegawa-49.28-17.78-138

Settsu-111.07-13.42-612

Chuo Pa erboard-212.3

6.49

-3371

Mean

3.40

15.38

-126

Median

t1r87

15.76

5

14-2. Earnings per share

total

-202

(JPY) of Japanese pulp and paper companlesof US$O.94 (JPY 100.74), from a high of US$O.65 (JPY 69.63) toa low of -US$O.29 (-JPY 31.11). It is interesting to note, however, thatwhen compared to US and Canadian pulp and paper companies,

98 KOBE ECONO.YIC & BUSINESS REVIEW, 43 (1998), 65-117

Japanese companies have a narrower range and smaller number of
EPS.

DEBT TO EQUITY RATIO'
Debt to equity is a measure of a company's liabilities compared toits stockholders' equity, This ratio measures the relationship between
debt and equity financing. In general, most investors prefer companies

with a debt to equity ratio of 1 or less; a ratio of 2 or greatersuggests that a company has a fair amount of debt payments(principle and interest) to cover which could be difficult if the company

or industry endures a downturn (Fisher, 1990). However, a company's
debt to equity ratio should be high enough to receive a good return but
not so high as to put the company at risk. Average 1996 debt to equity

for United States pulp, paper, and packaging companies is 1.8 while
Canadian counterparts average 1.7 and Japanese average 3.2. .'
'
''
'
'
''

The pulp and paper industry is highly leveraged, in part areflection of its capital intensive nature. Table 15 shows average debt toequity for United States companies in 1996 is 1.8, down 14SO)6o from 2.1 in

1995. Crown Vantage, with almost 32 times more debt than equity in
1996 and 23 times more in 1995, is viewed as an outlier and exeluded
from mean calculations. If this company had been included, averagedebt to equity would be 2.6 in 1996 and 1995. The range in debt to'equity is from 31.5 to O.3. The percent
of change in average debt toequity from 1995 to 1996 ranges from a high of 312 to a low of -53.
That mean debt to equity fell for United States companies in 1996
suggests that United States pulp and paper companies may be taking amore conservative stance toward increasing liquidity and decreasing
expansions. This is impressive given that it was achieved when prices
were at an all time high, which is usually characterized by major

capitalexpansions. • ' •Again, Crown Vantage, spun off from James River in late 1995, has
the largest debt to equity ratio of 31.5. 0ther highly leveraged
companies include Gaylord Container (7.1), Stone Container (7.0),
Temple-inland (5.4), and Fibermark (3.4). The largest percent increasein leverage in 1996 are Fibermark (312%), Willamette Industries (74%),

KAJIWARA:A COMPARATIVEANALYSIS OFPULP, PAPER,AND PACKAGING COMPANIES 99

Com an1996

1995

Ole Chan e

Debt to E uit

Debt to E uit
23.1

Debt to E uit

Crown Vantage

31.5

Gaylord Container
Stone Container
Temple-lnland
FiberMark
George-Pacific
Buckeye Cellulose

7.1

lnternational Paper

2.0
2.0
1.9
1.8
1.8
t-8
1.8
1.8
1.6
1.6

7.0
5,4
3.4
2.6

22

Weyerhaeuser
TennecoJames River
Boise Cascade
Caraustar industries
Badger Paper Mills

Chesapeake
Kimberly-Clark

Champion
Sonoco

1.6
1.6
1.5
1.5
1.5
1.4
t.4
1.4
1.4
1.4
1.3
1.3

Rayonier
DexterLongview Fibre
Sealed Air

Union Camp
Bowater
Willamette lndustries
Potlatch

7,7
5.4
5.5
O.83
2.5
3.5
2.I

2.0
1.4
2.2
1.8
1.3
1.5
1.5
2.1

1.6
1.2
1.2
1.5
1.6
3.2
l.3
1.7

1,2
1.2

1.1

Bemis
Westvaco
Louisiana-PacificWausau Paper
Republic

Rock-Tenn
LydallGreif Bros.

MeanMedianratios of

6
37
21
21
-23

1

32
37
-2
-5
-53

10'
-18

-I9
-24
-24
-18

-5
-22
-16
-17
-7

1.8

2.1

-14

NMb
NMb
NMb

1.5
1.5
Not included in reported means ('if included, mean is 2.6 tor both 1996 and 1995b
NM = not meanin ful due to ne ative shareholders' e uit

15. Debt to equlty
.

-16

1.0
1.0
O.7
O.7
O.8
O.9
O.B
O.6
O.3

NMb
NMb
NMb

Fort Howard
Jefferson Smurtit
Jefferson Smurfit

-3
o
34

1.0
1.0
O.8
O.8
O.7
O.7
O.5
O.3

1.1

Consofidated Papers

-39

20
5
6
1
41
16

12

Mead
P.H. Glatfelter

-1

312
5

13.5

Pope & Talbot

Mosinee Paper

-8
30

74
-2

O.9
1.4
1.7
1.7
1.7
1.5

Procter & Gamble
Media General

37e/e

o

United States pulp and paper companies

100 KOBE ECONOMIC &BUSINEss REVIEVV, 43 (1998), 65-117

Rayonier (37SO)6), Consolidated Papers (41906o), and Caraustar Industries(37S)(or). In 1996 Fibermark had two major acquisitions, Customs Paper

Group and Arcon Coating Mills. These acquisitions required thecompany to assume an additional $100 million in debt.
In terms of the least leveraged companies, Greif Bros. has thelowest debt to equity ratio at O.3. Four other low debt to equity
companies are Lydall (O.5), Rock-Tenn (O.7), Republic Group (O.7), andWausau Paper (O.8). The largest decrease in percent leverage in 1996
for Unites States companies are Sealed Air (-53%), Buckeye Cellulose(-399(or), Media General (-2410)6), Mosinee Paper (-24SO)6o), and Kimberly-

Clark (-23906). Debt to equity ratios can decrease by either increasing

shareholder equity or decreasing debt. A good example of the former
is Sealed Air Corporation, which decreased the debt to equity ratio
from 3.2 in 1995 to 1.5 in 1996 by increasing shareholder equity from$106 million to $187 million. On the other hand, Kimberly-Clark, which

reduced debt to equity from 2.1 in 1995 to 1.6 in 1996, used funds
generated from divesting several businesses and 1995 earnings toprematurely retire debt and finance stock buybacks.

CanadaAs discussed in the previous return on equity section, Canadianaccounting practices dictate that convertible debentures be reported inboth the liability and equity sections, making it difficult to compare

Canadian companies with US and Japanese companies. In the debt toequity calculation, debentures are subtracted from stockholders' equity
and then added to liabilities for Canadian companies. The calculation

for debt to equity, then, is total liabilities (including
debentures)/stockholders' equity (without debentures).
Table 16 reports that both mean and median debt to equity fell for

Canadian companies in 1996. Average debt to equity for Canadiancompanies in 1996 is 1.7, down 15%o from 2.0 in 1995. The median is
identical to the median for United States companies or 1.5, which isdown 12SO)6o from 1.7 in 1995. The range in debt to equity is from 4.2 toO.5. The percent of change in average debt to equity from 1995 to 1996
ranges from a high of 89 to -41. The top five Canadian companies interms of debt to equity are Slocan (4.2), Crestbrook Forest Industries(3.7), Cascades (2.6), Doman (2.4), and Weston (2.4). Canadiancompanies having the largest percent increase in leverage in 1996 are
Donohue (89%o), Canfor (65SO)6o), St. Laurent (60%o), Alliance Forest

KA JJ}VARA: A COilfPARA TIVE ANALYSIS OF PULP, PA PER, AiNTD PA CKA GIATG COiMPANIES 101

Com anSlocanCrestbrook

Cascades

Doman
WestonSt Laurent

Tembec1996

1995

Debt to E uit
4.2
3.7
2.6
2.4
2.4
2.2
2.0

Debt to E

ele Chan euit

Debt to E uit

4.6

-70/o

3.1

12

3.2

-IB

2.0
2.4
4.4

-1

20

1.7

59
19

Avenor

1.9

1.9

-1

Canfor
MacMillan Bloedel

1.8

1.1

1.6

i.6

Donohue

1.5

O.8

65
-3
89

West Fraser

1.4

1.7

-19

RollandSpruce Falls

1.3

1.4

2

1.3

2.2

-41

-34
-38
-40

Abitjbi-Price

1.3

I.9

Domtarl.t

1.7

Perkins Papers

1.0
1.0
O.7
O.6
O.6
O.5

Noranda Forest
Stone-Consolidated

1,6

O.9

12

NMa

O.7
O.4
O.6
8.3

Mean

1.7

2.0

Median15

L7

Harmac Pacific
Alliance

FletcherChallenge
Repap Enterprises

6
-4
7
45
-17

NMa
-15
-12

NM = not meaningful due to negative sharehoiders' equity

16. Debt to equity

ratiosof Canadian pulp and paper companies

Products (45%o), and Doman (20%o). Donohue's large increase is due tothe debt financed acquisition of QUNO Corporation, about $900 million
of debt.

The least leveraged companies are' Noranda Forest (1.0), StoneConsolidated (O.7), Harmac Pacific (O.6), Allianee Forest Products(O.6), and Fletcher Challenge (O.5). Those companies having the largest
percent decrease in debt to equity ratios are Spruce Falls (-41SO)6o),
Perkins Papers (-40%o), Domtar (-38SO>6o), Abitibi-Price (-34906o), and West

Fraser Timber (-19%o). Spruce Falls took aggressive measures toreduce debt, prepaying US$ 64 million and retiring US$ 2.3 million.

& BUSIIVESS REVIEVV,43 (1998),'
KOBE ECONOMIC

102

65-117Japan
Table 17 shows that mean debt to equity increased for Japanesecompanies in 1996. Average debt to equity for Japanese companies in1996 is 3.2, up 4%o from 3.1 in 1995. The median is 2.1, which is gained

from 2.0 in 1995. The range in debt to equity is from 21 to O.2. The
percent of change in average debt to equity from 1995 to 1996 ranges
from a high of 91 to -33. The top four Japanese companies in terms ofdebt to equity are Taihei (21.0), Tomoegawa (8.3), Daishowa (7.8),
Sanko (6.9), and their names always appear in the list of the large

Com an

1996

1995

Debt to E uit

Debt to E uit

o!eCha e
Debt to E uit

Taihei Paper Mfg.

21

11

91 %

Tomoegawa

8.3
7.8
6.9
4.6
3.5
3.4
3.4
3.3
3.2
3.2
2.4
2.3

5.6

ng

9.8

-20

8.1

-15

4.8

4
B
8

Daishowa Paper Mfg.
Sanko Paper Mfg.
Nippon Kakoh Seishi

The Pack
Chuetsu
Tokai Pulp

Superbag
Daio Paper
Takasaki Paper Mfg.
Furubayashi Shiko
Japan Paper tndustry
Chuetsu Pulp & Paper
Oji Paper

3.8
3.7

3.6

-6

3.2

3

3.5

-9

3.7

-14

2.1

14

1.8

28

2.1

2.0

5

2.1

1.9

11

Rengo

2

2

Nippon Paper endustries

1.9
1.7
1.6
1.5
1.3
1.3

1.9

o
o
o
o

Hokuetsu Paper Mills
Mitsubishi Paper Milts

SettsuOhishi Sangyo

Tomoku

1.7
1.6
1.1

36

1.3

o
o
o
o

1.3

1.1

1.1

O.8

Dainippon Shigyo
GeneralTokushu Paper Mfg.

O.8
O.6
O.5
O.5
O.5
O.2

Chuo Pa erboard

NMe

7.9

Mean

3.2

3.1

4

MedianeNM=not meanin ful due to ne

2.1

2.0

o

Mishima Paper
Kishu Paper
Nippon Hi-Pack

Chuo Pack

17. Debt to equlty
.

O.5

20

O.5
O.5

o
o

O.6

-17

O.3

-33

ative shareholders' e uit

ratios of.
Japanese pulp and paper companles

KAJIWARA: A COMPARA TIVE ANALYSIS OF PULP, PAPER, AND PA CKAGING COMPAAIIES 103"financially-risky" companies in Japan (Suzuki and Takeda, 1998, p.33)

CAPITAL EXPENDITURES 'Capital expenditures involve the acquisition of new assets,
improvements to plant, property, or equipment, and technology andregulatory upgrades. Historically, capital expenditures have driven
production capacity and, therefore, contributed to pricing cyclicality.
Expenditures related to manufacturing efficiencies and production
capacity are of particular interest to industry analysts in assessing
forthcoming increases in industry production capacity.

United States 'In the United States pulp, paper, and packaging industry, capitalintensity (pulp and paper capital expenditures divided by net annual

pulp and paper sales) varies by year, but overall has been
approximately double that of any major manufacturing sector (Butner
and Stapley, 1997, p.55). Currently, the industry seems to be adjusting
the focus of expenditures from new technology to modernizing eXisting

technology and environmental compliance. As shown in Table 18, pulp
and paper capital expenditures ranges between a low of $4 million anda high of $1,081 million, averaging $213 million. This average incapital spending is up slightly (5906o) from 1995 when the averageamount spent on capital expenditures was 203 million. Capital intensity
ranges from 29(of to 309(or, with an average of 100%.

International Paper ranks first with more than $1 billion in capital

expenditures. Kimberly-Clark is second at $884 million, followed by
Procter & Gamble ($804 million), Boise Cascade ($470 million), andGeorge-Pacific ($452 million). The five largest investors in pulp andpaper capital expenditures remain unchanged as in 1995 with the
exception of Boise Caseade, new to the top five in 1996, and theexclusion of Weyerhaeuser, which now ranks seventh after reducing
capital expenditures by 26SO)6o. Besides Boise Cascade, the four largest

spenders are also in the top five for sales. Boise Cascade reports thelarge increase in spending in 1996 prima'rily due to a paper machine
expansion project, with a cost expected to be $4oo million. The fivecompanies reporting the largest percentage increase are Badger Paper
Mills (153%), Boise Cascade (94%o), Media General (92S>(of), Consolidated

Papers (81%), and FiberMark (74SO)6o).

104

43 (1998),& BUSINESS REVIEW,
KOBE ECOIVOMIC

1996
Pulp andCompany

Mead
Witlamette lndustries

TennecoaChampion
Union Camp
Consolidated Papers
Stone Container

SonocoPotlatch

Chesapeake
Temple-lnland
Jefferson Smurfit

Longview Fibre

BemiseBowater
Crown Vantage
Fort Howard

-701e

801e

801o

8i8

8

7
8

6
8

296
288
251
232
196
175
t48
146
123
tlO
107
Bl

Rock-Tenn
Rayonier

71

Wausau Paper

63
55
37
36
35
32
21
17
11

Gaylord Container
P.H, Glatfetter

Louisiana-Pacific

Buckeye Cellulose
Caraustar lndustries

Mosinee Paper
Sealed Aira
LydallDexteraPo e & Tatbot

8
7
7
7
4
4

Mean

2I3

Median110

FiberMark
Republic
Badger Paper MillsMedia Generaldintensity

paper capitalex enditures

73
73
72

Greif Bros.

intensityd

paper capital

884
804
470
452
438
415
411
396
342
341
339

James River

1995
Capitalex endituresC$1,157$1,081

Westvaco
Weyerhaeuser

1996
Capitalpaper capital

Kimberly-Clark

Georgia-Pacific

Ole Chan e

Pulp andex enditures
lnternational Paper

Procter & Gamble
Boise Cascade

1995
Pulp and65-117

731

243
599
274
562
440
239
300
316
314
197
159

10
94

25

10

-25

8

9
9

60

16

-26
-7

9
7

66
l4

8
8

387
S81

5

81
-35

19
5
8
18
15
7
4

6
10
5
7
12
18
l4
4

19
7
7
9
5
30

17
6
5
4
3
18

25
12
t2
6
7
20
7
5
7

29
12
13
6
4
14

-23

154
t35

-5
-9
18

-51

96
47
47
60
95
65
66
59
26
47
25
28
17
21

11

12
5
30
3
3
4
24

-9
74

72
55
21
-25

9
-4
-7
45
-23

40
14
26

"9

-75

153

92
10
-85

203
96

11
11

11

227
299

93

6
9

15
15
9
7

50

28
52

129

10

2
4
7
9
9
5

6
5
5
3
5
4
47
3

2
1

2
2

9

5

10

9

15

8

7

Pulp and paper sales not reported separately from totai annual sales

bCa italintensit isannTml ul and a erca italex enditures/ ul and a
18. Capital

expenditures (mi 11ion of US$) ofer sales.
United States pulp and paper companles

in 1996
The smallest investors in pulp andpaper capital expenditures
are Republic Group, Badger Paper Mills, and Media General at $7

KA JILYARA.• A COMPARA TIVE ANALYSIS OF PULP, PA PER, AND PA CKAGING COMPAIVIES 1O5

million each, followed by Dexter and Pope & Talbot at $4 million.
Although all five companies spent less than the 10% industry averageof pulp and paper sales, the small spending leveis for the most partbased on the smaH size of the company. Only Media General andBadger Paper Mills remain the smallest spenders in 1996 as in 1995. In
terms of decreasing the total amount of capital expenditures in 1996,
the five companies reporting the largest percentage decrease are Pope
& Talbot (-85%o), Republic Group (-75906o), Temple-Inland (-51SO)6o), Stone, (-269(of).
Container (-35%), and Weyerhaeuser

Many United States companies, such as Weyerhaeuser,
International Paper, and Union Camp, report spending 8 to 10SO)6o of thetotal capital spent on environment-related projects. In some cases,
spending was in preparation of implementing the Cluster Rule. Two of
the most noticeable changes in capital spending in 1996 and 1995 havebeen lack of spending on new technology and extremely modest growth
in total industry capital expenditures in 1996. 1995 was a very profitable

year for the pulp and paper industry, but there was only a 59(or increasein capital spending by United States eompanies. Compared to the lesseffective capital investments made in the late 1980's, companies areshowing much more caution in capital spending.

CanadaTable 19 presents capital expenditures for Canadian companies in
1996. Capital expenditures range from a low of US$ 7 million to a highof US$ 254 million, averaging US$ 81 million. Average spending for
capital expenditures is down 11 %o. Capital intensity ranges from 4%o to
530/o, with an average of 12906o. Companies in the United States, on
average, spent 2.6 times more than Canadians. However, it should be
noted that in terms of capital intensity, Canadian companies invest 20%

more.

In 1996, the top five Canadian companies for total capital
expenditures include Abitibi-Price (US$ 254 million), Domtar (US$ 246

million), Stone-Consolidated (US$ 215 million), Avenor (US$ 191
million), and Noranda Forest (US$ 157 million). Abitibi-Price, Dormar,

and Stone-Consolidated remain as the top five spenders compared to
1995. In terms of increasing the total amount of pulp and paper capital

expenditures in 1996, the five companies reporting the largest
percentage increase are Harmac Pacific (529%o), Alliance (325%),
Perkins Papers (252906o), Tembec (62SO)6o), and Rolland (56SO)6o). Harmac43 (1998),
BUSINESSREVIEW,
KOBE ECONOMIC&

106

Company

4996

1995

PulpandPulpand

OloChane
Pulpand

1996

1995

Capitatintensityd

Capitatintensity

22e/e

18ele

15
10

34
10

17
14
16
17

-53

11

20

39
325

8

7

53

11

5
7

papercapital
papercapital papercapitalex endituresbex endituresCex enditures
$254
$238
6%
246
246
o

Abitibi-Price

DomtaraStone-Consolidated

215

AvenorNorandaForest
MacMillanBloedel

191

FletcherChallenge
AHiance

CascadesWestonSt.Laurent

Donohue
RepapEnterprises

WestFraser

157
132
115
101

86
62
48
48
39
34

187
143
142
282
83
24
83
50
157
74
60
129

15

6
9

-69
-36
-36
-73

16
5
5

48

tl

32

7
17
12

29

7

18

4
6
7

19

31

l9

62

23

42

-45

3

529'

33

-52
-18
-83

Doman
Rolland

9

6

PerkinsPapers

9

18

59

Crestbrook

7

3
8

Mean

81

gl

Median48
Pulpandpapersalesnot reportedseparately

b1g96exchangerateC$1=US$O.7334
C1995exchangerateC$1toUS$O.7287

60
fromtotalannual

94

SlocanHarmacPacific
SpruceFalls
Canfor

56
252

5

-lf

5
12

-20

9

-7

12
6
4
I

3
4
2
3
I3
10

sales

dCaitatintensiisannual

19. Capita]

d

13

23

Tembec

18
16
15
10

65-117ulandaerca italexendituresX ulandaer sales
expenditures (million of US$) of Canadian pulp and paper companies

Pacific increased spending for cost reduction projects that are expected

to have returns greater than 20SO)6o. In both years, however, Harmac
Pacific is still at or below the Canadian average of expenditures as apercent of pulp and paper sales. Alliance's large increase of 325% isdue to a modification for a product conversion at two of the company's

paper
mills. 'Canadian companies reporting the smallest investments in pulp andpaper capital expenditures in 1996 are Canfor (US$ 15 million), Doman(US$ 10 million), Rolland (US$ 9 million), Perkins Papers (US$ 9
million), and Crestbreok Forest Industries (US$ 7 million). In terms ofdecreasing the total amount of capital expenditures in 1996, the fivecompanies reporting the largest percentage decrease are Doman(-83SO)6o), West Fraser Timber (-73%o), St. Laurent (-699(of), MacMillan
Bloedel (-53906o), and Spruce Falls (-52%o).

KA JI ;•VARA: A COMPARA TIVE ANALYSIS OF PULP, PA PER, AND PA CKA GING COiifPA IVIES 107

Japan
and Table 20-2 show capital expenditures for Japanese
1996. Capital expenditures range from a low of US$ O.4

Table 20compames m
million (JPY

49 million) to a high of US$ 832 million (JPY 104 billion),

Company

l996

1995

o!.Chane

t996

t995

PulpandPulpandPulpand

CapitalCapitalpapercapital

papercapital

papercapitalintensityd

intensityd

4%

ex endituresbex

OiiPaperNipponPaperlndustries
HokuetsuPaperMills

exenditures

endituresc

$832

$296

181%

13%

380

272

40

8

5

255

116

120

29

12

MitsubishiPaperMills

182

222

-18

16

17

DaioPaper
DaishowaPaperMfg.

150

121

24

6

4

140

159

-12

6

6

ChuetsuPutp&Paper
SankoPaperMfg.
Rengo
JapanPaperlndustry
NipponKakohSeishi

78

40

97

9

4

60

21

1ee

2e

6

59

89

-34

3

4

51

21

140

12

4

40

27

ng

10

6

TokushuPaperMfg.
KishuPaper

39

t5

157

24

8

sa

13

200

10

3

Tomoku

24

53

-56

5

10

TakasakiPaperMfg.
TokaiPulp

23

16

42

15

9

14

18

-23

3

4

Settsu

13

15

-11

2

2

OhishiSangyo

11

11

-5

15

14

Tomoegawa

8

9

-9

9

8

General

7

5

53

69

42

ChuoPaperboard

6

20

-68

3

9

NipponHi-Pack
DainipponShigyo

6

2

179

5

2

6

5

25

6

5

ChuoPack
ThePack

5

3

92

9

4

5

4

22

1

1

5

5

15

5

3

Superbag
MishimaPaper
TaiheiPaperMfg.
Chuetsu
FurubaashiShiko

5

6

-22

4

4

3

5

-40

10

15

2

1

277

6

1

o

2

-76

o

1

Mean

82

53

51

11

7

24

8

4

19
16
MedianPulp,paper,andpackagingsalesnotreportedseparatelyafromtotalannualsalesb1996exchangerateJPYen1=US$O.O080
c1995exchangerateJPYen1=US$O.O093
dCaitalintensitisannuai
20. Capitalulandaerca italex

enditures/uland

aersalesexpenditures (million of US$ ) of Japanese pulp and paper companies

108

REVIEV[J,43 (1998),
KOBE ECOAIOMICBUSINESS&

Company

65-117

1996
Pulp and1995

e!o Chan e

1996

1995

Pulp and

Pulp and

CapitalCapitalpaper capital

paper capital

paper capitalintensity

intensity

ex enditures

ex enditures

ex enditures

4%

Oji Paper
Nippon Paper Industries

104,028

31,8412270/o13%

47,55529,19663

8

5

Hokuetsu Paper Mills

31,86912,456

156

29

12

Mitsubishi Paper Mills

22,73523,85717

18,772

13,0276

4

17,50117,1ng

-5
44
2

16

Daio Paper
Daishowa Paper Mfg.
Chuetsu Pulp & Paper
Sanko Paper Mfg.

6

6

9,801

4,283

129

9

4

7,5ng

2,251

235

20

6

7,327
6,384
4,997
4,828
4,721
2,9ss
2,895
1,770
1,677
1,347
1,OOO

9,576

-23

3

4

2,290

179

12

4

2,907

72

10

6

1,617

199

24

8

1,353

249

10

3

5,742

49

5

10

1,751

65

15

9

1,978

-11

3

4

1,222

3

2

2

1,219

11

15

14

Rengo
Japan Paper Industry
Nippon Kakoh Seishi
Tokushu Paper Mfg.
Kishu Paper

TomokuTakasaki Paper Mfg.
Tokai Pulp
SettsuOhishi Sangyo

Tomoegawa

su

6

9

8

516

78

69

42

2,715

-63

3

9

237
514

224

5

2

45

6

5

301
471
4se
631
494
67

t24

9

4

177

75
45

Furuba ashi Shiko

920
7ss
7os
747
673
666
662
574
347
2sc
49

Mean

ro,2os

5.705

Median

2.333

1.687

20-2. Capital expenditures(million of JPY)

GeneralChuo Paperboard
Nippon Hi-Pack
Dainippon Shigyo

Chuo Pack
The Pack
Superbag
Mishima Paper
Taihei Paper Mfg.

Chuetsu

41

1

1

ss
-9

5

3

4

4

-30

10

15

339

6

1

-72

o

1

tt

7

8

4

of Japanese pulp and paper companles.

averaging US$ 82 million (JPY 10.2 billion). Average spending for
capital expenditures increased 519/o (75%o in JP Yen basis). Capitalintensity ranges from O.3%o to 69%, with an average of 119(or.

In 1996, Japanese companies invested a lot to adjust the focus of
expenditures from new technology to modernizing existing technology
and environmental compliance like US and Canadian industry. Hokuetsu

KA JIVI•'ARA .• A COMPA RA TIVE ANAL YSIS OF' PULP, PA PER, AJVD PA CKA GING eOt}fPA NIES 1O9(US$ 255 million), Sanko (US$60 million), Kishu (US$38 million),
Nippon Hi-Pack (US$6 million) and Chuetsu (US$ 2 million) are thecompanies which drastically increased their investment in pulp andpaper factories and equipment. Oji and Nippon paper also madeconsiderable investments in order to eomplete their reorganization by
merging other companies and factories.

INTERNATIONAL ACTIVITY
The last variable investigated in this study is international business.

As is the case with many other industries, pulp and paper faces thedual challenges of rising global demand and competition. Foreigncompanies with a lower cost of capital, faster-growing supply sources,
and lower targets for return on investment pose threats to Japaneseand North American companies. Theoretically, a good balance between
foreign and domestic sales protects companies from cyclical market
downturns. 1996 provided an excellent opportunity to test that logic,
and it did hold true. Both global companies with extensive product linesand distribution networks as well as smaller companies focusing onhigh margin, specialty products performed well, while companies
dependent on market pulp or other commodity products saw a decline
in foreign sales in 1996.

United States

Table 21 highlights the 35 (81%) United States pulp, paper, andpackaging companies reporting foreign sales or foreign manufacturing
operations in their annual reports. The average foreign net annual
sales for United States pulp and paper companies decreased 2%, to$1.54 billion in 1996 from $1.57 billion in 1995. The median foreign net

annua} sales is about the same as in 1995 or $285 million. On average,

pulp, paper, and packaging companies report that 24% of net annual
saies are from foreign sources.

Proctor & Gamble ranks first in foreign sales at $17.7 billion.
International Paper, a distant runner up at $6 billion, and Kimberly-

Clark, at $5.8 billion, formed the next tier of pulp and paper
companies with extensive international business. Weyerhaeuser, with
$3 billion in foreign sales, and Tenneco, with $2 billion, round out the

top five United States pulp and paper companies. Proctor & Gamble
and Kimberly-Clark have been successfu! due to extensive global

KOBE ECONOMIC & BUSINESS REVIEVV, 43 (1998), 65-117

110

Company

1996

Foreignas %ottotal
sales
sales'

Procter&Gamblea $17,682

50of.

tnternationalPaper
Kimberly-Clark

6,032
5,796
3,074
2,032
1,693
1,388
1,042

•30
44

Weyerhaeuser
TennecoJamesRiver
Stone-Container
Georq.ia-PacMct

UnionCampChampion
Westvaco
Rayonier
DexteraBuckeyeCeitulese
SealedAir
Sono6o'Louisiana-PacMc
Bowater

Bemis
FortHowardb
Pope&Talbot?
LongviewFibre
Chesapeake
P.H.GlatfelterRock-Tenn
LydallConsotidatedPapersC
Boise,CascadeC

Meen

5ele

8

o%

60countries
31countries
33countries

Global

-2
11

c

A

21countries

Giobal5-13C,E

EuropeGlobalC,E

2

Global•1,•400

897
874
700
648
499
325
2B5
283
268
259
250
176
168

22

922

15

1,060

23

695
694
496
286
258
276
457
285
234

154

t9
10
8

230
138
114

-37

7•

71

-6.

•1

10
6

55

o

1

51
17

4

7

12

15

6
o

NA
NA
NA
NA
NA
NA

NA
NA
NA

NA
NA
NA

NA
NA'

c
:R

E,A
A.E,LA
c
C.E

.NA

c

Global

NA
•NA

NA
NA
NA

c

Glotsal

ts

LA'

NA
NA

TernIe-lnlandC

salesetExpertForeignproductiond

8

NA

MeadC

Changein
foreignsatesas

30
27

NA
NA
NA

'WillamO' ttelndustriesC

Changeintoreign

1,702
1,655
2,952

tB
15

FiberMark"
GreifBros.C

Foreign
9aies$16,812
5,550
5,455
3,518

6
-13
19
2
-53
-26

115
72
68
55
53

GaylordContainer
Crownvaritageb

•1995

28
31

55

45
69
36
10
11

15
15
11

38

164
172

NA
NA
NA

3

GIobal-2cGlobal-3

1

Globat

-17

o

C,B

A,LA
C,B

1

2

•B,C

-7
1

o
o

14

-1

C,G.IR

E.A

ll

o
o

GlobaS
GlobalGlobalGlobal-5

C.UK.M

A.E

'3

-41

-9

1

77

o1

NZ,A'
E,C,A

c
C,E

GiobalGlobal
GtobalGlobal

C,E,SA

UK
-2

5

c

-33

=5

-17/t

A

-1•

C,F,M

NA

E,A

AE'
E,C,A

-3

1.

o
,1

s,•
C,AU

c•

'FJ'

E

c

'AU,UK,C.

t,549
t,577
-2
24
3
/'f
Median
'285
-4
t9
286
Foreignsale$received outsideofNorth America
bSalesfiguresreportedCForeignsalestigures
Unit6.dStatesexportvaiuesnot
availeble
ftomfereignmanutacturingoperetionsonly;
arenotavaiiabte
dA=Asia,AU=Austra-a, B=Brazil,C=Canade,E=Eurepe,F=France, G=Germeny,IR=lreland.J=Japan,
LA=Latin America,
M=Mexico,NZ=New
Zealand,S=Scotland,SA=South America,UK=EnIand''

21. International actiyities (i . illions of US$) of United.States pu}p and paper companies

' '
'
t/
distribution systems for consumer products. International Papers
strength in international markets comes from its high-margin specialty
products and a captive distribution system. Weyerhaeuser is ran•ked
fourth but is the only company in the top five to report a decrease inforeign sales, which the company attrib•utes to market pulp operations.

Tenneco successfully pursued a dual strategy of $elling non-core
operations and focusing on the global development of its automotive
and packaging divisions. StQne Container is notable for its absence inthis gro'up, having dropped from fifth in 1995 ranking to seventh in
1996, with a decrease of 530/o in foreign.•sales, but this reflects Stone's

divestiture of Stone-Consolidated and other low-margin Canadian

KAJIWARA: A COMPARATIVE ANALYSIS OF PULP, PAPER, AND PACKAGI,VG COMPANIES111

operatlons.

Proctor & Gamble's foreign sales rose by almost one billion
dollars, a proportionally small increase (5906o) relative to its total
annual sales, but one that dwarfs the foreign sales of all but the top

nine companies. Other companies that increased foreign sales are
Tenneco (19%o), Buckeye Cellulose (14%o), Sealed Air (11%o), andInternational Paper (89(of). While Tenneco and International Paper
focused on economies of scale, Buckeye and Sealed Air are fairly small
companies that aggressively market high-margin, specialty products in
Iucrative markets such as Western Europe.
Among those companies experiencing the most dramatic decline inforeign sales, Stone Container experienced the largest drop (-539(of),primarily due to changes in corporate structure. LouisianaPacific(-41%) and George-Pacific (-26SO)6) suffered losses in foreign sales
because of market pulp operations. Gaylord Container cited changes inthe selling prices for linerboard and unbleached kraft paper as thereason for its 370/o drop in foreign sales. Exports of paper andpaperboard hurt Longview Fibre's foreign sales as well (-33SO}6o). •Table 22 shows corresponding information for the 23 Canadian pulp
and paper companies. All of these companies depend on foreign sales
because of relatively low domestic demand in comparison to production
capacity. The average foreign net annual sales for Canadian pulp andpaper companies decreased 16%o, to US$ 712 million in 1996 from US$

844. Since Canadian companies are dependent on the market pulp andnewsprint export markets, it stands to reason that the collapse in
prices during 1996 had a substantial negative impact on the industry.
Median foreign sales of US$ 516 in 1996 are down 18%o from 1995
foreign sales of US$ 626. 0n average, these companies report that 60%
of total net sales are from foreign sources, almost triple that of their

United States counterparts.

MacMillan Bloedel retained its first place position with foreign
sales of US$ 2.7 billion. This company continues to lead Canadiancompanies in global expansion. Because it is more adventurous in newly

emerging markets, such as Latin America and Southeast, Asia,
MacMillan Bloedel has hedged effectively against market share losses
and the volatility of the market. AbitibiPrice, Avenor, and Weston,ranked second, fourth, and fifth, respectively, also maintained the same112

43 (1998),& BUSINEss REVJEW,
KOBE ECONOMIC

Company

1996Foreign sates
Foreignas% oftotal

MacMillanBloedei
Abitibi-Price

FletcherChallenge

AvenorWestonCanforsales$2,737
1,674

sates

1,371
t,221
I,076

9g5
953
900
747

Oonohue
NorandaFerest
WestFraser
Domtar721

Tembec

74%
88
79
8S
12

76
79
53
62
50
82

Stone-Con$olldated

5I8
513

Cascades461

SlocanPerkinsPapers

439
359
345
238
215
157
113
63
59

Crestbrook'

NA

NA

Mean

7t2

60

Doman
RepapEnterprises
Alliance

SpruceFalts
St.Laurent
HarrrtacPacificb

RoHand

3I

30
75
72
40
77

88
47
73
2t

33

Mectian
73
5t6
1996toteignsatesfiguresarenetavailable
bForeignselesreceived outsldeofNorthAmerica

1995
Foreignsales$2,795
1,826
1,047
1,659
1.5t8

Changeintoreign

Changein
foreignsalesas

salese!.

65-117

ottotalsales-2.0%-1.oe!.

GlobalGlobal

-8.3

-1.3

17.6
-26.4

us
us
us
us

US,A,LA,E
US,J.A
US.E,A
US.E,A
US,E,A
A,LA.E,US

-29.1

4.3
-6.3
-4.5

1126

-7.8

-l.O

626

52.2
-49,O

2.9
s.o

US,E,A

102

-O.4

us

-4.6
-32.2

-2.7
-5.4

F

108.5
-18,7
-24.9
-21,8
-26.9
3.5
28.0

ILI

1.765

678
756
764
246
567
598
459
472
230
168
155
t96
74

Expertmarkets'

Foreignproduction'

US.E,

UK,US
US,E

-4.4

-20.2
-5,O

US,E,A

92
-1.5
-3.8

1.3

-11.9

-42.3
-14.9

-1.6
-2.1

NA
NA

NA
NA

NA
NA

844
626

-t6
-t8

-2
-2

us

US,EA
us

US,A,t,E

UK,US
US.E
A,US,O
A,E.O,US
A,E,O.US
us
o,us
o,us
A,E,USus
A,E,USus

C1996exchengerateC$1!US$O,7334
dt9g5exchangerateC$ 1=US$O.7287'A=Asia,AU=Australia,

B=Brazil.E=Europe. F=France, G=Germany,1=lndia,IR=lreland,J=Japan,
NZ=NewZeatend,O=Other.S=Scotland,SA=SouthAmerica.UK=En tand.US=USA

LA=LatinAmerice,M=Mexico.

22. International activities (millions of US$ ) of Canadian pGlp and paper companies'
position as in 1995 despite decreases in foreign sales (-8.3906o, -26.4%o,and -29.1%o). Fletcher Challenge moved from seventh to third as its
foreign sales increased 17.60/o, to US$ 1.4 billion in 1996 from US$ 1.1
billion. Abitibi-Price, Avenor, and Weston all lost foreign sales in 1996
due to the collapse of the pulp market, but have taken effective strides

to maintain a strong industry presence. Abitibi-Price and Avenor aredeveloping stronger economies of scale. Abitibi-Price has merged with
Stone-Consolidated, and Avenor has purchased much of Repap's assets.
Weston produces lumber and specialty papers that hedge against drops
in the pulp market. It is important to note that Weston's decrease inforeign sales primarily reflects its divestiture of United Statessupermarkets, a business unit completely independent of the pulp andpaper industry. Its foreign sales of forest products actually only
decreased by $19 million.
Stone-Consolidated, Donohue, Spruce Falls, Fletcher Challenge, andWest Fraser Timber have the largest increases in foreign sales in 1996.
Stone-Consolidated leads the group, increasing foreign sales by 108.59(ol,KAJItVARA: A COMPA RA TIVE AiVAL YSIS OIF' PULP, ,PAPER, AIVD PA CKA GING eOMPA NIES1l3

primarily because of record earnings from the company's United
Kingdom facility. A delay in price erosion in Europe coupled with lower

waste paper costs led to this success. Donohue's export sales rose
52.2% in 1996 with the purchase of QUNO, and this advaneed Donohue's

market share jn the United States newsprint market. Three othercompanies that experienced an increase in foreign sales, but lessdramatically so, are Spruce Falls (28%o), Fletcher Challenge (17.6%o),and West Fraser (10.2%o).

Noranda, Harmac Pacific, Weston, Repap Enterprises, and Avenor
experienced the largest decreases in foreign sales in 1996. With the
exception of Weston, these companies had lower foreign sales due tonewsprint and market pulp price declines. While Weston can potentiallyweather a poor year because of its size and product diversity, the otherfour eompanies are actively taking steps to improve their positions.
Repap Enterprises sold non-core operations and is focusing on coatedpaper to protect its market share. Harmac Pacific has expanded into

Korea in order to supply the fine paper market in China and other
Asian countries.

Japan
Table 23 shows that 3 (109(or) Japanese pulp, paper, and packaging

companies report specific information on foreign sales or foreign
manufacturing operations in their annual reports. This fact implies thatJapanese pulp and paper industry is less internationally diversified
especially in terms of sales, and the companies mainly focus on thesmall domestic market inside Japan. Even Oji and Nippon Paper, thefirst and second largest pulp and paper manufacturers in Japan, sellless than 10% of their total pulp and paper products outside of Japan.

It can be said that the Japanese pulp and paper industry has beenprotected from foreign markets such as the US and Canada by arather high entry barrier into the Japanese market. The industry has
indulged itself by enjoying surplus gain in domestic market at the costof Japanese consumers. This is why Japanese pulp and paper
companies do not have to consider too seriously international
diversification of their sales market.

114

KOBE ECONOMIC & BUSINEss REVIEW, 43 (1998). 65-117

Company

Settsv

DaisbowaPaperMfg.
General

ChuetsuPutp&Paper
Chuetsu
ChuoPapertx)ard

ChuoPack
DainipponShigyo

DaioPaper
FurubayashiShiko
HokuetsuPaperMills
JapanPaper1ndustry
KishuPaper

MishimaPaper
MitsubishiPaperMills

NipponHi-Pack
NipponKakohSeishi
NipponPaperlndustries
OhishiSangyo
OIfiPaper

Rengo
SankoPaperMig.
SuperbagTakasakiPaperMfg.
TaiheiPaperMfg.

ThePack
TokaiPulp
TokushuPaperMtg.
Tornoegavva

TomokuMeanMedianChanget996

Foreignsaies

1995

Foreignas"/eoftotal

Foreign

inforeign

sales

sales

sales

salas

$6t2

ss%

$572

318

10

ww

7%
lf

Changein

Foreign

Exportforeignsalesas
Veottotalsa1es

pto(Suctionc

marketsc

4S

us.

-1

c.us

c,us
c.us

A,E,O,US

us

A

A
NA

19

t4

16

21

3

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA

NA
NA
NA
NA
NA

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA

3fe
318

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA

NA
NA
NA
NA
NA
NA
NA

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA

os

315

e

2

14

an

7

3

NA
NA

c
c,us

NA

A

A

NA

NA

NA

A,G,USA

A

AU.E,O.US

NA
NA

A

AAU.C.NZ,US A.C,G,US

A
us

us

NA

E,US

C,E.VSusn1996exchangerateJPYenltUS$O.O080
b1995exchangerateJP Yen1sUS$O.Ooo3
G=Germsny,ltlndia ,IR=lretand,
LAsLatinAmerica,M.Mexloo,NZsNewZealand,O=Other,StSootland,SA.Sovth America,UKtEntand,UStUSAcA=Asia.AUtAustrafia,B=Brazil,C=Canada,E=Europe,F.France.

23. International activities (millions of US$ ) of Japanese pulp and paper companies

DISCUSSION'''

Over the past decade, only two pulp and paper companies haveoutperformed the stock market average (Flicker, 1998, p.142). It is
often argued that such unfavorable returns are inevitable because pulp

and paper markets are mature, the products sold are commodities,
capacity is chronically overbuilt, and ownership is highly fragmented. If

the industry is to reverse its 20-year streak of poor stock market
performance, it must overcome these obstacles. A willingness to
implement innovative business strategies will enable the pulp and paperindustry to earn rates of return that reward existing shareholders andKA JI WARA:A COMPARA TIVE ANALYSJS OF PULP, PA PER, AND PA CKA GING COMPA NJES115

attractlve new mvestors.

Of paramount importance to improving stock market performanceis for the pulp, paper, and packaging industry to grow capacity derived

from demand and not in response to amp}e cash flows generated bycost-driven price increases. Many industry watchers are optimistic
because capacity additions have receded from traditional levels over the

past few years. Even though the strong United States economy
continues to increase the demand for paper, capital expenditures in theindustry remain conservative. 'International demand for paper has been expected to grow, withmuch of the new demand anticipated from Asia, but the recent financial

crisis in the region has slowed consumption. North Americancompanies exporting to Asia are experiencing a decrease in sales. In
addition, weak Asian demand means that paper produced in Southeast
Asian mills, primarily Indonesia, will be redirected to North American
markets. The production costs for many Asian mills, including long
distance transportation, is so low that they can easily compete with

United States eompanies in their domestic markets. Market pulp,
especially hardwood, and printing and writing papers industry
segments in the United States will be most negatively effected by Asian
excess capacity production. The financial crisis, however, is restricting
capital in Asia, making it more difficult to realize planned capacity

expansions. This has slowed eapacity growth, which may serve to push
up paper prices in the future. To compete in the Asian market over the

long-term, North American companies need to exploit strategic
advantages like producing paper grades for which they posses a
superior fiber supply, as compared to cost competition based on low
wages and supply costs. For example, due to relatively ample supplies
of softwood fiber, North American companies possess a competitive
advantage in producing high quality packaging grades of paper.
Japanese companies face very serious hardships domestically andinternationally. Japanese pulp and paper industry has been enjoying a
profitable isolated protected market protected from outside competitors

by rather high entry barriers. This has enabled a large number of pulp
and paper companies, from large to small, to survive at the consumers'cost. Now that this sjtuation is drastically changing and the market
they enjoyed is about to open to the competitors. In order for theJapanese pulp and paper industry to survive cutthroat competition in a

43 (1998),
KOBE ECONOMIC & BUSINESS REVIEW,

116

65-117

market which is now connecting to the global markets, some companies
should merge to be larger and stronger players positioning themselves
to move into global markets. Some companies should further develop
their specialized fields which they dominate by outstanding technology
with competitive prices; otherwise, they are only waiting to be weededout.

The pulp, paper, and packaging industry must remain focused on
improving capital effectiveness. The slow capacity growth modelprohibits spending cash for new pulp mills and paper machines in the
traditional way. Part of these funds will be used for implementing
Cluster Rule requirements. It is estimated that $2.6 billion will be
required to comply with the new environmental regulation, which isconsiderably less than the estimated compliance cost of $11.5 billion in

1993 for the original Cluster Rule proposal. Since the Cluster Rule was

first suggested, many United States firms have already madeimprovements facilitating compliance. Capital might also be better

spent debottlenecking or enhancing those activities devoted tocontinuous gains in productivity and quality. Debottlenecking provides

incremental capacity increases on existing equipment that can be
implemented with strategic timing.
A major expenditure of capital will be for acquisitions, individual

mills or entire companies, and mergers between companies. Recent
examples, include the domestic merging of James River and Fort
Howard to form Fort James, New Oji and Honshu to form Oji, and,internationally, the alliance between UPM-Kymmene and Asia PacificResources International. Such consolidations enable firms to achieve
greater economies of scale, increase market share, and access newmarkets, immediately and without an undesired increase in worldwide
capacltles.

References
American Forest and Paper Association. The United States Paper Industry. A
Decode of Growth; A VVorld of Opportunity, Press Release, March 10,

1997.
Biermann, C. Handbooh of Pulping and Paperinahing, Academic Press, New York,

1996.
Butner, R., and Stapley, C. Capital effectiveness of the paper industries. TAPPI 80(10), 1997.

KA JIIVARA:A eOMPA RA TiVE ANALYSJS OF PULP, PA PER, A,NiD PA CKA GIiVG COMPA NIES117

Canadian Pu}p and Paper Industry Association. Economic News, On line,
www.open.doors.cppa.ca/english/cppWrev96/pg24e.htm, 1996.
Fisher, K. Super Stochs, Irwin Publishers, New York, 1990.
Flicker, J. Structural impediments to profitability. Pulp and Paper 72(1), 1998.

Industry Canada. Forest Products: Kay Points About the Industry, On line,
http://strategis.ic.gc.ca, 1996.
Koncel, J. There's light at the end of the tunnel. PIMA'S Papermaher 79(6), 1997.
Lancey, S. USA: Eleven in a row for the USA. Pulp and Paper International 39(7),1997.
Matussek, H., Pappens, R., Lockie, M., and Kenny, J. Record run unbroken as

Asia overtake European output; Annual review. Putp and Paper
International 39(7), 1997.

McElhatton, K. Canada: Looking forward to a year of steady recovery. Pulp andPaper International 39(7), 1997.

Stanley, G. L. Paperboard, imports, and exports to fuel 1997 growth. TAPPIJournal 80(1), 1997.
Suzuki, T and Takeda, T. Tokushu tosan kikendo ranking Shuhan Diamond (VVeelely

Diamond) 86(46), 1998.
Thomson, G. All quiet on the Western Front as things heat up in Asia. PIMA's
Papermaher 7(11), 1997.

KOBE ECONOMIC & BUSIIVEss REVIEW, 43 (1998), i19-146

NON-PERFORMING ASSETS OF BANKS AND
FINANCIAL INTERMEDIATION:

EXPERIENCES OF JAPAN IN THE INTER-WAR PERIODMUNEHISAKASUYA Kobe University
Abstract
The Japanese banks are now holding a lot of noR-performing assets as asset

prices fall. The Japanese banks were also holding a large amount of nonperforming assets in the inter-war period. The experiences of Japan in the interwar period may provide useful lessons for the problem of today's Japanese banks.
In this paper, we consider what effects the non-performing assets of the Japanesebanks had on the financial intermediation in the inter-war period. In addition, we

analyze economic meanings of those effects.

we can infer from several evidences that- there were the deterioration offinancial intermediation in the inter-war period. According to the experiences in

the inter-war period, we can also infer that the prompt action in requiredeollection and required redemption of non-performing assets might be effective inthe recovery of financial intermediation.

JEL Classification: E51, G21, G28, N15

Keywords: asymmetric information; monetary policy; transmission mechanism;agency costs; credit channel; deposit channel; financial intermediation;

Japanese banks

1 Introduction

The Japanese banks are now holding a lot of non-performing
assets as asset prices fall. We are anxious about the deterioration of
Corresponding Address:

Munehisa Kasuya
Research Institute for Economic and Business Administration (RIEB)
Kobe University,
2-1 Rokkodai-cho, Nada-ku, Kobe, 657-8501, Japan
E-mail: kasuya@rieb.kobe-u.ac.jp
Fax: (81)-78-803-0407

120 KOBE ECONOMIC & BUSINESS REVIEVV, 43 (1998). 119-146

the financial intermediation. The period between World War I and theJapan-China War (the Nichu War, started in 1937) is calledt the inter-war period. The Japanese banks were also holding a large amount of
non-performing assets in the inter-war period. As a result, theJapanese banks faced a difficult situation as well as today's Japanesebanks. The Japanese banks actively lent out for fixed capital
investment in the period of World War I. Sales and the sales price ofthe borrowing firms dropped sharply immediately after World War I.
Earnings of the borrowing firms have dropped, too. Consequently, alarge amount of non-performing assets were generated in the banks.
The amount of the bad loans was too huge. Therefore, a long term was
required for the collection and the redemption of the bad loans. The

huge non-performing assets caused various problems in financial
intermediation: high interest rates, new loan decrease, deposit shift,
and bank failures. Therefore, the financial intermediation function of
the banks hasdeteriorated.

The experiences of Japan in 'the inter-war period may provide
useful lessons for the problem of today's Japanese banks. In thispaper, we consider what effects the non-performing assets of theJapanese banks had on the financial intermediation in the inter-war
period.

In addition, we analyze economic meanings of those effects.
Although both of a quantitative approach and a historical approach
are tried in our analyses, we mainly use a historical approach becauseof the problem of data availability. In section 1, we describe the non-performing assets and the economic development in the inter-war
period. In section 2, we analyze what effects performing assets ofbanks had on financial intermediation. In section 3, we consider
possible lessons for the problem of today's Japanese economy.

2 Economie development after World War I
We take a general view of the economic development of the interwar period first.

The outbreak of World War Ii raised overseas prices (Figure 1).
Moreover, the war has lifted up exports (Figure 2). The Japanese
1 1914-1918

KASUYA: IVON-PERFORMING ASSETS OF BAIVKS

121

Figure 1: Importing and exporting prices (dollar basis)
CY1914=1. 00
R.

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Figure 2: Current

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122 KOBE ECONOMIC &BUSINESS REVIEW, 43 (1998), 119-146

economy enjoyed an unprecedented boom by the external shock ofwartime demand (figure 3 and 4). However, the World War I ended'
Figure 3: Real GNP

the

and

'

Change from a year ago, percent

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Figure 4: Contribution to changes of real GNP)

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KA SU YA ; NOIV-PERFORMILIVG ASSETS OF BA NKS

123

the reactionary crisis, occurred. Thereafter, Japanese economy was
generally sluggish until the deflationary fiscal policy (since 1932) by the

Minister of Finance Takahashi. It also experienced several crises in the
period.

The foHowing two are considered to be the background of suchlong-term depression. The first is excessive fixed capital investment

during World War I. A great expansion of the private equipment
investment in this period (Figure 5) was brought by the rapid increaseof exports during the War. At that time, there were a lot of industries
with low productivity. The low productivity equipment pay only under

the war special procurements and high prices of exports. The
equipment became a non-performing asset since the reactionary panicin 1920. It became a big load of Japanese economy afterwards. The
seÅëond is deflationary policies, by which the Japanese government tried

to go back to the gold standard system. The Japanese government
Figure 5: Gross domestic fixed capital formation (real, at the 1934-36 average price)

Billion yen

3-

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Dwellings-- Government non'mjlitary affairs--- Government militaiJv affairs

KOBE ECONOMIC & BUSINESS REVIEVV, 43 (1998), 119-146

124

renounced the gold standard system at World War I. After the War,the government was planning to return to the gold standard system. In
preparation for this return, the government tried to maintain the yendollar exchange rate, which tended to depreciate under trade deficit.

That is, the government executed the tightening economic policy
intermittently by selling gold specie to the private sector, which
alsomeans buying yen bills from the private sector (Figure 6 andFigure 7). We describe in detail a little more. After the ehd of WorldWar I, the boom continued for a while due to the special demand forthe reconstruction in Europe. In 1920, the tightening fiscal policy inEurope caused the recession of Europe and America2. At the same time,the exports of Japan dropped sharply and the reactionary crisis
occurred3.

This crisis was settled by an expansionary economic policy. thispolicy caused not only a boom but also the problem of trade deficit.
The government adopted a tightening policy to deal with the problem of
Figure 6: Exchange rates (yen per dollar)

[

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ri.!..

t"P-

A"/

I

I

2,

3I
1

2,

21
1
1

I

:

I

i

1

l

1

IX

:

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l

1

:

1

2-

19

i-•W.'

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:

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,

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:

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,

1912 19a6 192e 1924 1928 1932 1936 194e23'

. • c\The boom of the United States in and just after World War I depended on exports
for Europe.
Actually, the slump of export was becoming remarkable before the reactionary
crisis occurred on March 15, 1920.

KASU YA: NON-PERFORMING AssETS OF BA NKS 125

Figure 7: Money supply (M2)
Change from a year ago, percent

5S
4e
:I

3e
2e
le
e
-10

11I--11111----19121916192e1924192819321936194S
cy

trade deficit in September, 1920. In September, 1923, the government

was forced to suspend the tightening policy by the Kanto greatearthquake. The damage of the Kanto great earthquake was huge.
However, the earthquake measures with an expansionary economic
policy caused a boom in 1924. The problem of trade deficit also
returned. To deal with this problem, the government adopted thetightening economic policy of the second times of the inter-war periodin October, 1925. Bankruptcies and bank failures increased gradually
due to this tightening policy gradually. After about two years ,thefinancial crisis occurred in March, 1927. The Diet speech of the Ministerof Finance concerning the Tokyo Watanabe bank failure triggered thefinancial crisis. In the financial crisis, the credit and payment networks
collapsed in the chain. Bank runs occurred frequently. The government

was again forced to suspend its tightening economic policyby thiscrisis. Th financial crisis is settled by this policy change, which caused

a boom. In the mean time, trade deficit increased. Therefore, thegovernment started the tightening economic policy in July, 1929, which
was the third and the most severe policy of the inter-war period. This

tightening policy brought the Showa crisis (1930-1931). The Shotva
crisis is called the fiercest crisis in the history of Japan`. The ShoLva

126 KOBE ECONOMIC & BUSINESg REVIEW, 43 (1998), 119-146

crisis was worsened by the world depression, which triggered by thecrash of the New York stock exchange market on October 24, 1929.
These three deflationary policies made a large amount of potential non-performing assets exposed intermittently. At the end of 1931, thegovernment adopted the expansionary policy called "the Takahashi
fiscal policy". The Tahahashi fiscal policy caused a boom with thesupports of the colonia] policy in the continent of Asia and thegovernment control of economic system.
Now, we trace the transition of main economic indicators in thisperiod. Domestic prices greatly rose during World War I. Afterwards,

domestic prices showed the decrease tendency because of thereactionary crisis and the several deflationary policies (Figure 8). The

figure 8 shows that the decrease tendency becomes strong at thetightening policy period of three times (192Q,1925-1926, 1930-1931).
Figure 8: General prices and assets prices
CY1914=1. 00

3

ll:

2,8
2,S

.. .., .i, ,],,/7/tZ X <>"'fXl :lrr:t::"){ '"r'` -k, ..... .. >xN -... .. !. / / l/. Itlli

2,4

2,2

2
a,s
1,6
1.4

1,2

1
e,s

e,6
1912

)1 t 1928ti
1916 192e 1924
1932 1936'''-WPI "" CPI -- Prices of rice fields' Stock prices of Tokyo stock exchange

4 Takahashi (1993)

ig4z
CY

KASUYA: IVON-PERFORMILIVG ASSETS OF BA NKS 127

The land prices show the decrease tendency, which became strongat the tightening period of three times as well as domestic prices5.
Stock prices rose during World War I (1916) and just after World War
I (1919) from the expectation for the wartime special demand and thereconstruction demand. However, stock prices kept sluggish over a long
period of time since the reactionary crisis. In the mean time, the figure

also shows that the rise and the fall of stock prices are observed justbefore and at the financial crisis (1927) as well as just before and at
the Syowa erisis (1930-1931).
From the latter half of 1980's to the first half of 1990's, the asset

prices changed greatly while general prices are stable in Japan. The
movements of assets prices and general prices in the inter-war period
are greatly different from the situation at the present age.
That is, the change of the wholesale prices was larger than theasset price movements. This means that investing in products andproduction facilities was more profitable than investing in land andstocks. Actually, "upstarts by Ship" and "upstarts by Iron" weretypical example of persons who had raised big profits at that time.
Many industrial corporations found in financial difficulties undersuch a situation. The number of bankruptcy stayed in the high level
since the reactionary crisis (Figure 9).

As for the banking section, bank lending financed many of private
equipment investments during World War I (Figure 10). Moreover, thebanks often indirectly help firms to issue stocks by making stock
collateral loans to the stockholder6. Under such the structure of thefunds flow, the increase of the non-performing assets of industrial
corporations necessarily led to the increase of bad loans of banks. One

reason of much money flow to industrial corporations was theexistence of the special type of banks, "Kikan banks", which had
intimate relations with specific industrial corporations. These Kihan'
5 Generai land prices are not available. Therefore, we use the land prices of rice
fields. However, the share of "lending secured by fields and forests" in the lendingof all banks reached 41 percent at the end of 1926. This means land prices of rice
fields was considered to reflect land prices used for collateral approximately.

6 "Fixed equipment investments of big firms (excluding financial clique Zaibatsu
firms) were financed mostly by stocks. However, it is proved that the bank often
1:gig9gtikYh.hieag.e.d ,itftC.kt.f(iirglg8)B?362gue stocks by making stock coiiaterai ioans to43 (1998),
KOBE ECONOMIC & BUSINESS REVIEIPV,

128

119-146

Figure 9: Bankruptcy<The share of dishonored bills in all

Percent

bills )

9

8
7
6

:

:

:

:

:

:

:

:

4

:

:

:

:

:

:

:

:

:

:

:

:

:

:

192e

i
1924

t
1928

1932

1936

:

:

I

:

:

gi
1916

:

:

:

]

1912

:
:

:

e

:

:

1

:
:

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:

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:

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l.

:

:

:

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:

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2

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5

3

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:

:

:

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:

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:

194e
CY

BillionFigure 10:

Industrial

1
l
1

1
1
l
i

yen

5
4

1

:

i

:

l

:
:

l

:

l

:

l

:

1

:

3
2

l

1•

l

1

-1

1

1

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1
1

e

funds supply

,

/
FN.=.
- - -t--

l

1
1
1
i
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Ix

nv
/
IN
/ 1

:

:

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1912

a916

t - -t - lt -

:
:

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192e

Ax'
''

-4.- "•-,
dt

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'

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ii

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l'/

:

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-t-

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-itd: d:IK xv
lx

:
:

l
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1

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,

1928

1932

1936

194e
CY

Ei!

- Bank lending

Stocks••Corporate bonds

dustrial corporatlons asbanks supplied lnvestment funds to allied inthose banks often made "fiduciary loans",
they demanded. In addition'

KASUYA: NON-PERFORMIIVG AssETS OF BANKS

129

that is, loans with no collateral'.

After World War I, earnings of banks decreased and bad loans ofbanks increased (Figure 11 and Figure 12). The share of real estates inbank assets rose because of the increase in attached real estates(Figure 13).

We describe the banking management in detail. The growth rate ofdeposits and loans tended to decrease in the inter-war period (Figure14). The reason was basically the depression of the real economy. In
addition, the growth rate of deposits was influenced by the shift torisk-less assets like the postal savings. Moreover, the growth rate oflending was influenced by the shift to safer securities like government
bonds. In the mean time, the deposit-loan ratio (loans/deposits) rose
temporarily immediately after the reactionary crisis. This is because

banks made additional loans to defective borrowers to whom loans
were non-performing loans. After about 1927, the deposit-loan ratio
decreased almost consistently. The reasons are (i) funds demand
decline due to economic stagnation, (ii) the shift from Ioans to bonds,(iii) redemption of bad loans, (iv) liquidation and merger of defective
Figure 11: Total net loss of all bankas (deflated by GNP def.)
CY1914=1. 00

14
13
12
11
le
9

8
7

:
:
:
:

:

:

:

:

:

:

:

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5
4
3

:

:

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:

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6

:

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:

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:

2

:

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1

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e

,

,

1912

1916

:

:

:

I•

;
-

192e

1924

:

'

1928

1932

1936

"194e

cY
7 The share of fiduciary loans in all bank loans reached about 30 percent at the endof 1926.

BUSINEss
RE VIE W,43 (1998),
KOBE ECONOMIC&

130

banks and so on (Figure15) .

Ratio ofFigure 12:119-146

nen-dividend in allbankas with less orbanks

Percent
36

/

l

l

34
i

32

l

3Z

:

l

2g
26

1

Z4

l

:

22

vv

2e
18

l

lxeq
:

ix

:
:

16

l

i'

14
,

,

12

+1
1916

I/
1912

tÅ}l

192e

1924

' 1928
tbl

:
,

,

,

1932

i''
1936

ili

1940
CY

Figure 13: Ratio ofreal eatatesin bank assets

Percent
3
2 g

l
l

1

,

]

2 6
,

1

2 4
,

:

,

:

/NX

:

2 2

:

1

2

L-v/sN

1 8
1 6

:

4

:

1 2

xi.

8

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xl•

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e 6

1912

'i1916

x

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:

li

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l

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x'

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t
192g

11

l
1924

:

:
:

:

:

:

:

,

't1928

1932

l
1936

194e

er

KASU YA : NOIV-PERFORMIIVG ASSETS OF BA NKTS

131

Figure 14: Deposits and loans
Change from a vear ago, percen[

se

:

:

46

:

x":, •

3e

-N,,

2Z

vl,1 .; :,:[:IJI' fi

:

;'1

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+

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k:...

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1

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1912

1916

dl
192Z

,

,

1924 1928 1932

1936

f
194Z

CY

-Deposits•-•- Loans

Figure 15: Deposit-loan ratio

Percent

12e
,

,

:

:

110

:
:

lge

:

:

:

:

:
:

:

:
:
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L

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1932

1936

ag4z
CY

132 KOBE ECONOMIC & BUSINESS REVIEVV, 43 (1998), 119-146'
Next we describe the movements of interest rates. The inter-bank'money market interest rates (call rates) maintained the high level fromthe reactionary crisis (1919) to the Kanto great earthquake(1923)(Figure 16). The reasons are (i) the increase of thecall money
demand due to the increase of bad loans, (ii) the increase of risk

premiums and so on. Moreover, the interest rates of lending toindustrial corporations also maintained the high level (Figure 17).
However, the interest rates traced the decrease tendency as a whole.

The reasons are (i) the decline of funds demand of industrial
corporations due to business contraction, (ii) the increase of special

lending by Bank of Japan, (iii) progress of Iiquidation andreconstruction of defective banks that borrowed much call money andso on.
Figure 16: Interest rates I
Annual rates, percent
le
9
8
7
l.li.

97o

6
5

II
E••
:--t +
---4
-td
--s
tdd
tt
---+
-+4-s:tt
d--1-lq-L-k--t-.-,
i-::- - t.- -:-.
.

is-- i-t-iq-dtlti
,

:
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:
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--dt-d
#d
--Jit
d
--d
-t
t
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tii
----+--ii
il.s
--at
-i
-t
t--dt
---d',
il
-1-d
-+
-t
l:
-t
dl
-t
-1
1.
q-1
-i
--i
192e 1924 1928:

i-tt -i
--t
"---l

:
:

:

:

i- l
.;, 1

:
:

i ;s-

:
:
:

'
-: :.l--.--t----tit-

4

1

3

I
,

'

2

1912

1916

E
- Official discount rates"'- Call rates

:

:

:

:

:

:

:

:,l

-)-

N--ti--'+'------'

1
1932

:

:

:

:

]1

:-s-it---...-tl---t--

1936

1S4Z
cy

KASU YA : NON-PERFORMING ASSETS OF BA IVKS

133

Figure 17: lnterest rates ll
Annual rates,11
lepercent

:

:

:

:

l li-

:

-i.
.-

:

ir;•,

:

-I-

9

8

i..

l -,...
76
5

4:-i----.

1

1-l--

,

1

.--N- t
xl
'
N:

. ,
tt

'"St,il't'-'----N-

1 -.-i.

-t

'i

dt

-I.

1

1

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-i
qd

.t'

1h.

1

-s

-tttd
li
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:,.

1,
I.
I•-

X',. ,!•:•1, if' '""'t---"'`'"-.-...

:

I
1

tt

N.
+. II
i•
1 -,..-.
.

il

Lt----

lrx--"-l1912 1916 192Z 1924 1928 1932 1936 194e
3

i

ll

-......-."CY- Discount bills( 2S ) rfi zP gij 4I "-' Loans on deeds'- Time deposits for six months

3 The deterioration of financial intermediation

As we described, non-performing assets of banks increased
intermittently after the reactionary crisis. In this section, we analyze

the influence of the non-performing asset on the financial
intermediation.

3.1 Eeonomic meanings of the deterioration of financial intermediation

First of all, we analyze the economic meanings of the financial
intermediation and the deterioration of it from the viewpoint of thecontemporary economic and financial theory8.
The financial institutions have the role to intermediate funds from
ultimate lenders to ultimate borrowers smoothly and efficiently. Then,
8 In the contemporary economic theory, various concepts are developed. However,those are developed in mathematical forms.
Therefore, those are not digested enough in usual finance theories. Re'fer toBernanke (1983) and so on.

134

43 (1998),
KOBE ECONOMIC & BUSINESS REVIEW,

119-146

the financial institutions can be regarded as institutions for minimizing"the cost of financial intermediation". Here, "the cost of financial
intermediation" can be defined as the cost of channeling funds from theultimate lenders into the hands of good borrowers.
Banks usually minimizes "the cost of financial intermediation"
between banks and borrowers by using several special things: the good
customer's relationship with customers, the ability of screening andmonitoring, and the collateral system and so on. The good customer's
relationship and the screening and monitoring ability are, so to speak,invisible assets. The collateral system is, so to speak, a kind of
financial technology. On the other hand, banks minimize "the cost offinancial intermediation" between banks and depositors by the invisible
asset of "reputation". As a result, the total amount of "the cost offinancial intermediation" by banks can be smaller than that bY directchannel from ultimate lenders to ultimate borrowers. The deteriorationof financial intermediation can be defined as the condition that

financial institution cannot minimize "the cost of financial
intermediation". Under the condition, the entire cost of financial
intermediation rises as a result. The deterioration of financial
intermediation can be considered as productivity decrease of invisible
assets (the ability of screening, monitoring and so on) and financial
technology (collateral system and $o on). It also means the waste ofresources of the entire real economy. Moreover, it distorts the microallocation of resources. On the other hand, the decrease in money

supply causes imperfect use for economic resources, From thisviewpoint, the effect of the money supply decrease on the real economy
is different from that of the rise of "cost of financial intermediation".
The decrease in money supply is known well as a negative effect of thefinancial sector on the real economy. The effect is called the monetary
effects. Friedman and Schwarzt (1963) pointed out that the decrease ofmoney supply, that is, the monetary effects, made the Great Depression

moresevere and prolonged. .
On the other hand, Bernanke (1983) emphasized the negative effectsof the deterioration of financial intermediation on the real economy.
The deterioration was caused by the financial panic of 1929. He called
the effects "the non-monetary effects."

If the financial market is imperfect and there are no wellfunctioning banks, the required cost of financial intermediation between

KASUYA: NON-PERFORMING ASSETS OF BANKS

lenders and borrowers is supposed to be so large that we cannot
lgnore lt.

Collapse of credit system like the financial panic of 1929 means theincrease the cost of financiaj intermediation. He regressed the real

output on the monetary effects and the non-monetary effects. His
empirical results suggest that the non-monetary effects improve theexplanation of the movement of the real output.
As already described, a large amount of defeetive }ending claims
were generated in the inter-war period. This means the productivity
decrease of invisible assets like the screening and monitoring ability,
and the risk diversifying ability. It also means the deterioration offinancial technology like the collateral system. If bad loans weregenerated by firm-specific factors unrelated to the movement of thereal economy, the collateral system would be effective to save "the costof financial intermediation". However, if bad loans were generated by
the fluctuations of the real macro-economy and the collateral prices
were highly correlated with the real economy, collateral system would
not be effective to save the cost. This is because the collateral prices
would fall if the bad loans were generated by a recession.
In a depression of the real economy, the ability of screening,monitoring and diversifying risks would deteriorate. As a result, thecost of financial intermediation between banks and industrial
corporations would rise. The deterioration of financial intermediation is

also considered as the deterioration of the banking function as the
incentive compatible scheme under asymmetric information.
In addition, although Bernanke (1983) is not pointed out, the nonperforming assets had also a negative effect on the real economy
through the delay of required collection and required redemption of
non-performing assets.

First, the delay would work as a restriction on the cost
minimization behavior in the portfolio selection by banks. It means therise of the cost of financial intermediation. Second, the delay of
required collection and required redemption of non-performing assets
would deteriorate the invisible assets of the bank reputation because
depositors would have the anxiety about the safety of deposits.
It also means the rise of the cost. However, we can not observe
directly the deterioration of financial intermediation: changes of theability of screening, monitoring and the financial technology of the

135

136

KOBE ECONOMIC & BUSINESS REVIEW, 43 (1998), 119-146

collateral system. Then, in this section, we verify indirectly the change

in the lending market and the deposit market. First, in the lending
market, if the ability of screening, monitoring and the financial
technology of the collateral system deteriorated, then lending supply
curve would shift upward. In other words, banks would supply fewer
loans at higher interest rates. However, we could not observed thedecrease of lending precisely because the total amount of loans would
include the non-performing assets, which often grow due to the accrued
interest. Second, in the depositmarket, the increase of liquidity demand

due to the non-performing assets would have an effect of an upper
shift of deposit demand (the acceptance of deposits by banks).
However, the productivity decrease in the financial intermediation
would have an effect of a lower shift of deposit demand. That is, themovement of the deposit demand would be ambiguous. On the other
hand, as already described, the deterioration of the bank reputation
would make the deposit supply (depositors' depositing) curve shift
upward. As a result, the movement of the amount of deposits would be
ambiguous without any special assumptions. However, the agreement of
the deposit rates was made between banks at that time. In a word, thedeposit rate is considered to be maintained under the equilibrium levelthat would clear the deposit market. As a result, the amount of thedeposit can be assumed to be decided by the deposit supply function.
The deterioration of financial intermediation would cause the decreaseof deposits by an upward shift of deposit supply curve even if thedeposit demand curve shifted upward.
Moreover, when the outflow of deposits is extremely large, it would
Iead to bank failure. Based on such a framework, we analyze the four
indicators of the deterioration of financial intermediation: the rise of
Iending interest rates, the decrease of new loans, the shift of deposits,

and bank failures.
3.2 The rise of lending rates

The deterioration of financial intermediation would cause the riseof interest rates by an upper shift of the supply function of new loans.
In general, the rise of the lending rates would have a negative effect on
the real economy through the increase of production costs. Such a riseof the lending rates is caused by the rise of risk premiums requested
by lenders and the under liquidity of borrowers with bad loans.

KASUYA: NON-PERFORMING ASSETS OF BA NKS 137

In the following, we consider the movement of the risk premium. It
is not easy to extract only the risk premium from the level of interest
rates observed in the lending market. Some are considered as methodsof extracting the risk premium of the interest rate. First, if there were
two loans that had the same conditions except the expected loss byborrower's default, the interest rate spread of them would reflect thedifference of risk premiums9. Moreover, if one borrower could beassumed to be free from default, the interest rate spread of two would

mean the level of the risk premium of the lending to the otherborrower. However, the problem of this method is that obtaining of thedata with the conditions as described is very difficult in general'O.

Actually, the data required for such a method did not exist in theinter-war period. Therefore, the risk premium in the period cannot be
extracted by this method. Second, the risk premium is guessed from the
movements of the interest rates. It is assumed that the interest rate iscomposed of three parts: the real interest rate, the expected inflation
rate, and the risk premium. Then, the change of the interest rate canbe decomposed in the change in the real interest rate, the expected
inflation rates, and the risk premium.

Therefore, the movement of the risk premium can be guessed fromthe movements of the actual interest rates, the real interestrates, andthe expected inflation rate if there is no substantial influences ofregulations and control by the government on interest rates. Of course,
the change in the real interest rates and the expected inflation rates
cannot be observed directly. Therefore, it is also difficult to guess the

movement of the risk premium by this method in general. However, thetransition immediately after the reactionary crisis can be guessed bythis method to some degree. The interest rate stayed in the high levelat a while after the reactionary crisis as shown in Figure !6 andFigure 17. At that time, the real economic growth rate and prices havedecreased greatly. Therefore, the potential growth rates, the realinterest rate, and the expected inflation rate cannot be considered to go
up just after the reactionary crisis. In other words, it is natural for us
to consider those rates to fall after the crisis''.

9 The conditions are the amount of money, maturity, collateral, lenders, and so on.
10 Even if the observed conditions, which should be the same, were different, thetheoretical conditions could be estimated by using related information. However,such a method cannot be used if there is no related information.

KOBE ECONOMIC & BUSINEss REVIEW, 43 (1998),
119-146

138

Moreover, there was substantially neither interest rate control
policy nor financial regulationi2.

Based on these facts, we can infer that the high lending rates

immediately after the reactionary panic should mean high-risk
premiums that lenders requested. Such a guess is indirectly proven by
there are the following deseriptions about the financial conditions of
the period.

"Although the demand for lending declines and the liquidityof banh became abundance, the lending rates hept in the highlevel." (BoJ(1958)p.675).
That is, the interest rate kept in the high level though the liquidity

held by banks became abundant. It can be interpreted that the lenders
requested larger risk premiums due to the anxiety about borrower's
default. The interest rates showed the decrease tendency after the
Kanto great earthquake.

However, this does not mean a decrease of the default risk ofborrowers. It should rather mean that the high-risk borrowers were
excluded from the money market. That is, the great earthquake and the
deflationary policies made industrial corporations get in more serious
financial difficulties.

As a result, the risk premium rose so high that borrowers andlenders could not agree to any lending contracts.

As Stiglitz and Weiss (1981) discussed, under asymmetric
information, high-risk borrowers are willing to borrow the higher
interest money. Because lenders cannot distinguish safe borrowers
from high-risk borrowers, even safe borrowers can not help borrowing
at higher interest rates. If the asymmetric information problem weresolved, that is, lenders could tell which borrowers were safe borrowers,
the interest rate would fall. The call market in the inter-war period wasa typical example.

At the financial crisis, as the call money to the Taiwan bank, atypical bank of high risk, was called back by lender banks, the callrates fell.

The real interest rate is considered to take a value close to therate in the future if general economic structures are assumed
12 At that time, the policy operation in the period was basically11

system type. In a word, the monetary authority did not control
unlike today's policy operation.

economic growth
the gold standard
the interest rates

KA SU YA: NON-PERFORMING ASSETS OF BA IVKS 139'
3.3 The decrease of new }oans
Another effect of an upper shift of the lending supply function due
to the deterioration of financial intermediation is a decrease of the newloans. The upper shift of lending supply function would make theamount of the new loans fewer than that of the normal case without
the deterioration of financial intermediation. If the upper shift were dueto the rise of risk premium, thelending refusal might also happen. Sucha decrease or refusal of new loans would have a negative effect on thereal economy in the respect of the availability of the capital. However,the decrease of lending demand was also considered to cause thedecrease of the amount of lending. Moreover, the additional lending to
defective borrowers was considered to cause the increase of lending.

Consequently, we cannot observe directly the decrease of new loanscompared with the normal case without the deterioration of financial
intermediation.

Here, we examine several methods to extract the decrease of newloans compared with the normal case without the deterioration offinancial intermediation. First, we consider the estimation of thelending supply function and the lending demand function. In this case,

we assume that the change in the lending supply function due to thedeterioration of financial intermediation is a structural change, that is,the change of parameters. After we estimate the structural change, we
evaluate the influence of the structural change on new loans'3.

Such a method has the problem that we cannot exclude theinfluence of the bad loans and the additional loans to defective

borrowers unless we can use the data of the bad loans and the
additional loans.

Actually, such a data in the inter-war period is not available sofar. In addition, some of the basic data required for the estimation in
the inter-war period are not available. As a result, this method ispractically very difficult. The second method is consideration of the
13 Additionally, there is a method of assuming the deterioration of financial
intermediation to be an omitted variable in estimation. That is, it is a method ofcomparing "the estimated amount of the equilibrium lending" with "the actual

amount of the lending (errors + effects by the omitted variable)" and ofevaluating the effect of deterioration. However, this method suffers from afundamental contradiction in its procedure. That is, if the influence of the omitted
variable is large, the estimate becomes difficult. On the other hand, if the influenceof the omitted variable is small, identifying the influence of the omitted variabie
to the influence of the errors becomes very difficult.

140 KOBE ECONOMIC &BUSINESS REVIEW, 43 (1998), 119-146

description concerning the individual matter of new loans. If theamount of the new loans decreased compared to that of the usual caseor the new loans did not happen, it would become the evidence of the
new loan decrease. The merits of this method are (i) that a lot of data
is not needed, and (ii) that the exclusion of the influence of bad loans
and the additional loans is relatively easy'n. Now, it was also difficult

for most persons in the period to identify the decrease of the amountof new loans compared with the normal case without the deteriorationof financial intermediation. However, it can be relatively easy forobservers to identify that the }oan that would be done in the normalcase is not done, that is, a refusal of lending. In his method, we can
not necessarily grasp the perspective of the market. At least, however,

we could examine whether there existed some evidences of thedeterioration of financial intermediation or nor. We look somedescriptions about "refusing new loans in the period. The following
descriptions can be interpreted as the data that proves the decrease of
new loans compared to that of the normal case.
At the reactionary crisis, lenders were reluctant to offer not
only long-terin lending but also call rnoney. "'Banhs were notwilling to lend to the borrowers who have good customers'
relationship and to whom the banks would have lent in theusual case (BoJ(1958)p.536.)
3.4 The deposit shift

3.4.1 Economie meanings of the deposit shift
If "the cost of financial intermediation" between depositors andbank, or, the risk premiums requested by deposits, rose greatlY,
depositors would refuse to deposit. This can explain the deposit shift
from small and unsound banks in rural areas to large and sound banks
in city areas. It had following effects on the real economy. First, it
caused the availability problem of credit in specific regions, especiallyrural areas. Especially, the degree of the segmentation of financial
markets was higher at that time t,han that of today. The deposit shiftmeant the decrease of credit availability in the area from which
14 In many cases, it is clear whether loans are new or not. Moreover, it also usuallyclears whether loans are bad loans or not.

KA SU YA: NON-PERFORMING A,SSETS OJ7 BA NKS 141

deposits flowed. Second, it caused an additionaj increase of "the cost offinancial intermediation".

Now, we assume that sound firms borrowed from the defective
banks from which deposits flowed. Besides, we a]so assume that thosedefective banks could not continue to lend to those sound firms. Evenif borrowers were sound, it would be very difficult for them to borrow
newly from other banks. Because, without additional costs of screening,other banks could not tell whether those sound firms were really soundor not.

The additional cost of financial intermediation would be required if

new combinations of banks and industrial corporations started.
3.4.2 Examples of the deposit shift
Actually, the deposit shift from small and defective banks in rural
areas to safe and large banks in city areas happened intermittently in
the inter-war period. Figure 18 shows the share of the deposits of thefive major banks (Mitsui, Mitsubishi, Yasuda, Sumitomo, and Daiichi)
in the total deposits of all banks. The share rises rapidly from 1922 to
1923, and from 1926 to 1927. The first rise corresponds to the period of

the first deflationary policy and the Kanto great earthquake. The
second rise corresponds to the period of the second deflationary policy
Figure 18: The share of the five major bank deposits in the total deposits of all banks

Percent
45

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35

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25

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194e
cy

KOBE ECONOMIC & BUSINESS REVIEW, 43 (1998), 119-146

142

and the financial crisis. In addition, the share rises gradually from 1927

to 1932. Thus, the share of the five major banks which were about 20
percent at 1912 to about 40 percent in 1933]5.

The deposit flowed not only to the major banks but also to thepostal savings. As a result, the deposit ratio of the postal savings tothat of all banks rose rapidly from 1927, the year of the financial
crisis, to 1931 (Figure 19).
Figure 19: The ratio of the postal savings to total deposits of all banks

Percent
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15 Whenever any bank crisis happened since the rapid increase of the number ofbanks in the period of the Japan-China War (the Nisshin War, 1884-1885), thegovernment tried to rationalize the banking industry. That is, the government
established several laws; the Bank Merger Law (1896), the limitation policy ofbank establishment (1901), the reinforcement of bank branch regulation 'and the
Banking Law (1923). However, it is after 1927 that the number of banks decreased
remarkably. On the other hand, It was before 1927 that the deposit shift happened
remarkably. Based on these facts, we can infer that, even if there had been nobank-elimination policy of the government, the deposit shift due to the increase of
the cost of financial intermediation would have been supposed to be a size so that
we won't ignored it.

KA SU YA: NON-PERFOR MING ASSETS OF BA NKS 143

3.5 Bank failures

3.5.1 Economie meanings of bank failures
It is bank failures that the deterioration of financial intermediation

appears most remarkably. The bank failures remarkably deteriorate
financial intermediation. That is, the rapid rise of "the cost of financial

intermediation" between banks and depositors could cause bank runs.
The rapid rise of the cost between banks in the inter-bank market also
could cause the callback of call money from lender banks. Those could
lead to bank failures at last. At this stage, the banks would stop thefunction of financial intermediation. The bank failures would make thechannel of funds from ultimate Ienders (household) to ultimate
borrowers (industrial corporations) narrow. As a result, bank failures

would have a negative effect of the fund availability on the real
economy. Moreover, as already described in the section of the deposit
shift, bank failures would also cause the additional cost of financial

intermediation. Because, due to bank failures, the industrial
corporations that borrowed from failing banks would have to findother banks.

Bank failures would cause such a rise of the cost of financial
intermediation in the short run. In the long run, however, bank failures
would have a positive effect on the efficiency of financial intermediation

as a whole. It is because unsound banks would be eliminated.
'
3.5.2 The data of bank failures

Figure 20 shows the situation of bank failures in the inter-war

period. The number of bank failures has increased as the nonperforming assets of banks increases. The number of banks that gaveup their business, went bankrupt, and dissolved reached to the firstpeak at the financial crisis of 1927. It reached to the second peak in
1932. The reason for the second peak, however, is that the government
made the small-scale banks with less capital than the regulated capitallevel, called "unqualified bank", give up their business according to the

Banking Law promulgated in 1927. Therefore, this is, so to speak, anorderly elirnination of banks based on the law. That is, it is considered
to be at the financial crisis that the number of bank failure related to

the rise of the cost of financial intermediation reached to the peak

substantially. .

KOBE ECOIVOMIC & BUSINESS REVIEW, 43 (1998), 119-146

144

Figure 20: The number of failing banks
l umber of failing banks

11e

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lee
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The number of banks that gave up their business, went bankrupt, and dissolved+

Afterwards, Japanese economy was faced to the serious crisis, called "Showa crisis" (1930-1931) due to the return to the gold standard andthe world depression. At the end of 1931, the government shifted fromthe gold standard system to the managed currency system. Moreover,it also adopted the expansionary fiscal policy, called "the Takahashi
fiscal policy." The Tahahashi fiscal policy caused a boom with supportsof the colonial policy in the continent of Asia and the government
control of economic system.
4 Implieations

As already described, we can infer from several evidences that
there were the deterioration of financial intermediation in the inter-war

period. According to the number of bank failures and the deposit shift,
the deterioration of financial intermediation started gradually at theearly stage of the inter-war period, reached to the peak at the financial

crisis. Then, after the crisis, financial intermediation of Japan
recovered gradually. As Bernanke (1983) suggested, the deterioration offinancial intermediation is considered to be caused by the deteriorationof abilities of screening, monitoring, and the financial technology of the,KA SUYA: NON-PERFORMIIVG ASSETS OF BA NKS 145

collateral system and so on. Those things are supposed to solve the
incentive problem in the normal case under asymmetric information.
In addition, we pointed out that the delay of required collection andrequired redemption of non-performing assets would cause (i) the riseof the cost of financial intermediation between banks and depositors,and (ii) the inefficiency of portfolio selection by the existence of
uncollected funds of collectible part of non-performing assets.

Then, we consider the situation in the inter-war period from sucha viewpoint. The required collection and required redemption of nonperforming assets did not progress easily. It is at the financial crisis(1927) after all that it progressed remarkably.

On the other hand, we cannot find any evidence that there wereany economic factors that could improve the screening ability, themonitoring ability, and the financial technology of the collateral systemat the crisis. Therefore, we can infer that the rise of the cost by thedelay of required collection and required redemption should be a size
so that we could not ignore it as a factor to explain the peak of thedeterioration of financial intermediation at the financial crisis.

Next, we consider the relation between the financial intermediationand macroeconomics.
The real economy became the worst at the Showa crisis (1930-1931)
unlike the peak of the deterioration of financial interme-diation. As aresult, it might not have been the main factor of the real economy
depression in the inter-war period even though the deterioration offinancial intermediation have had negative effects on the real economy
as Bernanke (1983) pointed out. This inference is consistent with theempirical result of Shikano (1993).

Now, what implication does the experiences of Japan in the interwar period have for the present financial crisis?

It seems that the deterioration of the financial intermediation,
which could be observed indirectly in the inter-war period, has also
occurred at the present age. That is, not only deposit shift but alsobank failures have happened in the 1990s.
According to the experiences in the inter-war period, we can inferthat the prompt action in required collection and required redemptionof non-performing assets might be effective in the recovery of financial
intermediation.

KOBE ECONOMIC & BUSINESS REVIEW, 43 (1998), 119-146

146

References
Bernanke, Ben, 1983,"Non-monetary effects of the financial crisis in the
propagation of the Great Depression," American Economic Review.
Bank of Japan, 1958, The Data of Japanese financial History: Taisblo Era,(inJapanese).
Bank of Japan, 1966,The Hundred Year Economic Statistics of Japan
Bank of Japan, 1982, The HuRdred Year History of the Bank of Japan: Volume 16.
Friedman, M. and Anna Schwartz, 1963, A monetary History of the United States,
1867-1960, Princeton: Princeton University Press.
Kato, Toshihiko,1983,Nihon Kinyuuron no Shit,eki Kenkyu (Hi.qtorical Sutudies ofJapanese Financial Theory), (in japanese) Tokyo:Todai Syuppannkai.

Ministry of Finance, 1912-1940, Ginko-Kyoku Houkoku(the Annual Report of
Departmeent of Banking) ,(in apanese).
Ministry of Finance, 1912-1940, Kinyu Jiko Sankosyo (Annual Financial Statistics),(in Japanese).

Okawa, Kazushi, Miyohei Shinohara, and Mataji Umemura, 1965, The Long Term
Economic Statistics, Tokyo: Toyo Keizai Shinpo Sya.
Stiglitz, J. E. and A. Weiss, 1981, "Credit Rationing with Imperfect Information,"

American Economic Review, Vol.71, pp.393-410.
Takahashi, Kamekichi, 1993, "Showa Kinyu Koroho-shi," (in Japanese), Tokyo:

Kodansya.

& BUSINESSREVIEWKOBE ECONOMIC
CONTENTS
NO. 38 (1993)
Generalized Lower-of-Cost-or-Market Rule for Inventory
Valuation for Quasi-rational Managers """••••'••'•"""'••••""""" Isao Nahano
Effects of Financial Deregulation on Australian Financial
System •••••••t•••tt•ttttt••••-•-••--•-•••••----•••-•••••••••J••-••••••••• Kenichi Isigafei

NAFTA and Asia-Pacific Economic Relations ••••-••"'""""'••"""""""' Seiji Naya
The Asian Development Experience and Its Relavance to .
African Development Problems '"""""•••••••'•""••""""•••""""""'' Seiji Naya

Robert K.McCleery
A Qualitative Assessment of the Effects of NAFTA on Japan'sForeign Investment and Trade with East Asia and Mexico:
Opportunity or Diversion? "••••••""'"'•-•••••••"""""""•••••• VVilliam E. James
Dynamic Effects of Tax Policies in A q
Model of Investment '•••••-"'•""""""'•-•••••••••'•""""'••••""" Tahao Ohhawa

Kazuo Shimomura
Corporate Governance in Germany, Japan, and theUnited States : A Comparative Study ••'•'•""""""""""""""" Kenji Kojima
Economic Issues in International Debt:A Survey """""""•••••••••••" Hideki leawa
A Note on the Estimation of Scale Economies and their

Use in Modeling Free Trade Agreements """"""""""' Robert K. McCleery

NO. 39 (1994)
Labour Unions and Nominal Prices """""•"""""""""""••"" Kazuo Shimomura
An International Perspective on Japanese Corporate Finance """"' Kenii Kojima
Measuring Natural Resource Rents and their
Macroeconomic Significance for Developing Countries,
with Reference to Latin American Suger Producers """"' Robert K.McCleery
The Influence of Product Development Strategy on
Inter-Project Learning '•••••••••••""""""•••'""""""""""""" Kentaro Nobeoha

A Comparison of Japanese and UK Welfare "'"'"""'""""""" Stephen J Davies

NO. 40 (1995)
Financial Relationships in Japan:

An International Perspective "'"""""•""""""""""""""""" Kenji Kojorrza
Structual Adjustment and Economic Growth in Mexico:With Comparisons to Indonesia •""""""""""""""'`"•t• Robert K. McCleery
Reorganizing for Multi-Project Management:
Toyota's New Structure of ProductDevelopment Centers '•••-••••••'•'••••••""••••••""""""""'••••"' Kentaro Nobeoha

Production Subsidies, Local Content Requirements
and Foreign Direct Investment:

A Theoretical Analysis •••••••"""""""'""""""""""""""' Roger N. Strange

NO. 41 (1996)
Implications of the Asia-Europe Meeting for the World Trading System:

An Issue-Oriented Review """"""''"'""""""""""""""""""' Shigayuhi Abe
Michael G. Plummer
Reconsideration of Averch-Johnson Argument """""""""""" Seiichi Katayama
Fumio Abe
Supplier Relations in Japan:

An International Perspective '"'"""""""""""""""""""""" Kenji Kojima
Alternative Component Sourcing Strategies
within the Manufacturer-Supplier Network:
Benefits of Quasi-Market Strategy

in the Japanese Automobile Industry ''"""""""""""""" Kentaro Noneoka
Value Networks, Industry Standards, and Firm Performancein the World-Wide Mobile

Communication Industries """"""'"""""""""""""""""' Jeffray L. Funh
The Effects of Transport Infrastructure and Urban Development Investment
in London's Docklands with Particular Reference

to Leisure and Tourism 1970-1997 """""'""""""""""" T. S. Mervyn Jones

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 """""""""""" Shigeyuhi Abe
Japanese Financial Relationships in Transition """"""""""""""" Kenji Kojirna
Organizational Coordination for Project Interdependency

in New Product Development """"""""""""""""""""" Kentaro Nobeoha
A Regime Shift in Long-Run Money Demand in the United States"""""""""""""""""""""""'"""' Rptu2o Miyao
The Competition between Regional Standards and the Success and Failure ofFirms in the World-Wide Mobile Communication Market "' Jeffrey L. Funh

Published on February 1999

byResearch Institute for Economics &Business

Administration(RIEB)
Kobe University
2-1 Rokkodai-cho, Nada-ku Kobe 657-8501, Japan
Phone: 81-78-803-0383
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Home page at http:// www.rieb.kobe-u.ac.jp/]'rinted inJapan