ISSN O075-6407

BUSINESS
39th

REPORT
ANNUAL,eg'lt1Åé/s•

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1994

KOBE
ECONOMICBUSINESS&REVIEW
39th

REPORT
ANNUAL

Kl/SIit[UEi3Tg

le,•A

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1994

CONTENTS

Page
Labour Unions and Nominal Prices ••'•"'•••"''"'"""''•• Kazuo SHIMOMURA

1An International Perspective on
Japanese Corporate Finance •••••••''""'•-•••••••••••••••••••••••••• Kenji KoJiMA

11

Measuring Natural Resource Rents andtheir Macroeconomic Significance for Developing Countries,

with Reference to Latin American Sugar Producers••• Robert K.McCleery

61

The Influence of Product Development Strategy on
Inter-Project Learning ••••-•••••••••••'•••••••••••••••••••••••••••• Kentaro NoBEOKA

A Comparison of Japanese•and UK Welfare •••••••••••••••••• Stephen J Davies

87

111

LABOUR UNIONS AND NOMINAL PRICES

Kazuo SHIMOMURA

1. Introduction'

It is widely believed that labour unions tend to inflate nominal
prices. However the reason does not seem to be quite clear. Rational
labour unions may or may not demand high wage, depending on theirobservation of the state of economy. Thus, the above commonsense
belief can be justified from the point of view of econornic analysis only

if we find certain conditions which make unions choose aggresive
behaviour. The purpose of this note is to give a theoretical support toan intuition that one of such conditions is concerned with the
distribution of monetary assets over workers and capitalists.
To attain this purpose, it is necessary to incorporate, in some way
or another, `money' into the union-ridden equilibrium model. One of thestandard ways of doing so is to add the real money balance to thevariables which directly affect the utility of individual households.
Based on this treatment of money, we shall derive here two theoreticalresults.

One of them, which is derived in Section 2, is that if capitalists

exclusively hold money then union behaviour gives rise to nominal
prices higher than those in the economy without labour unions. The
other, which is in Section 3, is that if, on the contrary, workers alone
hold money then there is a theoretical possibility such that unionization

lowers nominal prices. Those results suggest that the uneveness of the
distribution of monetary assets can be one of the causes of so-called
cost-push inflation.

2. The Case in Which Capitalists Exclusively Hold Money

Consider the one-sector economy such as argued in Shimomura(1990a). It is assumed in this section that the utility function of thetypical capitalist is described as follows. .

KAZUO SHIMOMURA

2u"=ur (c,, M/p) (1)where c. is the amount of consumption made by the capitalist, M thenominal (desired) money balance and p the nominal price of theoutput. This utility function is assumed to be increasing, strictly quasi-

concave and homogeneous of degree one in'both independent variables.
Making use of a unit-expenditure function, the budget constraint of thecapitalist is expressed ase' (p, p)u" =M+z (2)wheree" (pi,p2) E min pi c,+p2x subject to 1 < u" (c,, x),C., X
M is the stock of money held by the capitalist and z the profit definedasn! pf (L)-wL (3)where f(.) is the increasing and strictly concave production function, L

the total labour hours demanded by firms and w the nominal wage perhour.

Denote the utility function of each homogeneous worker by

uw= uw (c., 1-q) (4)where the maximum supply of labour hours of each worker ismeasured as one hour.
This utility function is also assumed to be increasing, strictly
quasi-concave and homogeneous of degree one in c. and 1-q. Then,
resorting to the argument made in Shimomura(1990a,b), the union's
utility function is described as

uW=uW(wg/p, 1-q) (5)where q E L/N and N is the nurnber of workers.

LABOUR UNIONS AND NOMINAL PRICES 3
Now let us obtain the union-ridden equilibrium condition. Sincefirms are competitive, we have a familiar equality

w/p -f' (L) =f'(qN) (6)Substituting (6) to (5) and differentiating (5) with q, we have, as theequilibrium condition,Åë (q) i ugy (of' (qN) , 1- g) [ f' (qlV) + qNf" (gN) ] - u: (of' (gN) , 1-q) =O' (7)where u,W (c., h) i 0 uW/ 0 c. and u hW (c., h) i 0 uW/ 0h

In what follows, it is assumed that the equation (7) has aninternal solution at which Åë'(q) < O, which implies that the unionridden equilibrium uniquely exists. Denote the equilibrium hours oflabour by qU. Then we see that the hours of labour per worker in theunion-free equilibrium, say qF, must be greater than qU. For,Åë(q') - u,W (qFf'(qFAI), 1-q")qFIVf"(qFIV) < 0

Now let us consider the monetary aspect in the present model.
Considering the properties of expenditure function, it may be obviousthat the market-clearing condition for the money market ispe2'(p, p)u" =M (8)where e2"(pi, p2) =- ae(pi, p2)/0p2. Considering (2), (3) and (8),together, we havee2'(1, 1) Me" (1, 1) M+ rr
or

p =-[ er(i',,i.)(ilei")(i' i) ] [f(qAD\qNf'(qN)] ' (9)4 KAZUO SHIMOMURA! p(q)
Obviously, p'(q)< O. Therefore, qU < qF implies thatp(qD >p(qD (10)which is the first result in this note.

3. The Case in Which Workers Exclusively Hold Money

In this section we deal with an opposite case. To make theanalysis sharper, the utility function of the typical worker is specified
as follows.

uw=uw(v (c, x), 1-q) (4')
where both uW(v, 1-q) and v (c, x) are assumed to be increasing,strictly quasi-concave and homogeneous of degree one in (v, 1-q) and(c, x), respectively, and x is the real money balance which is to be
formulated in what follows.

Now let us consider in what way real money balance must be
formulated in the present model. Usually, it is defined as the stock ofmoney divided by a price index. To properly accomodate the realmoney balance here into this definition, we have to choose the mostappropriate price index. Obviously, Laspeyres or Paashe price index is
not the best one. It seems that so-called constant-utility price index(See Allen (Chapter 2, 1975).) is better. We shall use this as the
deflater in what follows. Now we can formulate the real money balancein the present model. Consider a system of equations

G(p, Q, 1, h) -Q (11a)oo-h G(p, Q, 1, h)+tv -O (11b)whereG(p, Q, uW, h) iirnin pc + Qx subject to uW $ uW(v(c, x), h) (12)c,xLABOUR UNIONS AND NOMINAL PRICESRegarding Q and h as the unknowns to the system of equations (11),
Q is nothing but the constant-utlity price index. Therefore, the realmoney balance is formulated as M/Q.

We are ready for presenting the union's problem. From thedefinition of G(p, Q, uW, h) and (11), we seeG(p, Q, uW, 1-q) - (1-q)zW(p, Q)6(uW/(1-q)) (13)wherezw(p, Q) iE min pc + Qx subject to 1 S v (c, x)

c,x
and 6(uW/(1-q)), whose shape completely depends on that of aW(. ),has the following properties; 6(O) = O, 6'> O and6"> O, if uW(O, 1)
is assumed to be zero. Considering (13), the union's problem is

max v
subject tohzW(p, Q)6(1/h) -Q (11'a)zw(p, Q) {6(1/h)-6'(1/h)/h}+w - O (11'b)

w/p == f'(qAT) (6)IV(1-q)2to(p, Q)6(uW/(1-q)) = M+wqlV (14)NQZQW(p, Q)(1-q)6(uW/(1-q)) =M (15)where ZQW(p, Q)E0zW(p, Q)/6Q. Notice that (14) is the budget
constraint of workers and (15) describes the market-clearing condition

with respect to money.
In what follows, we draw attention to the special case in which
each of the functions, zW(1, b), 6(1/h) and f(glV), has a constantelasticity, i .e.,e,=-bzQw(1, b)/zw(1, b) ,bE Q/p

5

6 KAZUO SHIMOMURA
e,Eh6(1/h)/6'(1/h)'

and'e i qNf'(qN) /f(qAD'
are all constant and take on some values between zero and one. Since

the purpose of the present section is to exemplify a theoreticalpossibility that the union behaviour lowers nominal prices, thisspecification may be justified in view of this purpose.

Now let us derive the union-ridden equilibrium condition. Denoting
w/p by R, (6) and (12) are rewritten in the form

R- f'(glV) (6')
hzW(1, b)6(1/h) -b (12a")2W(1, b)(1/e,-1)6(1/h) == R (12b")
From (14) and (15), we have(1-q)(1-ebzW(1, b)6(uW/(1-q) = Rq (16)Differentiating (6), (12") and (16) with b, h, R, q and uW and setting
duW equal to zero, we obtain the union-ridden equilibrium condition

q e, {e(1-e,) + e,a-e,)}

1-q = (i-e,)(1-e,e,) (17)which obviously determine a unique q, say qU
On the other hand, the union-free eqilibrium is described by (6'),(12), (16) and(1/e6-1)2W(1, b)6(uw/(1-q)) - R, (18)'which is derived by differentiating (14) with q and u. and setting
du. equal to zero. From these equations, we have

LABOUR UNIONS AND NOMINAL PRICES 7

1-qq=(1-eb) e6 (lg)1-e,

Let us denote by qF the hours of labour per worker satifying (19).
Now let us compare qV with qF. Subtracting (19) from (17), we see(ln-(lg)n(eb) (2o)1-e,e,
wheren(e,)E-e,2e, + (2-O)e,-(1-e)
Since n(O) = -(1-e) <O and n(1) = 1-e6 >, there exists a
unique eb, say eb', between zero and one such that if O < eb <eb'(resp. eb' < eb < 1) then n(eb) < (resp. >) O. It follows that'qU ;qF according as eb;' eb' (21)On the other hand, from (14) and (15), we have-Me,=M + epf(qlV)or

P= ele-ff;M =- pv(q)v,

Since p(q) is a decreasing function of q, we see from (21) that' as eb; eb' (22)pV(qb g- pV(q") according
'

tt

'

--•-Therefore, if eb is greater thaneb', uniomzation gives rise to thenominal price which is lower than the one prevailing at the union-freeequilibrium. Note that from (6') qU > qE means that the real wage
rate R is smaller in the union-ridden equilibrium than in the union-freeequilibrium. Therefore, if eb > eb' then the nominal wage rate must

8 KAZUO SHIMOMURA
be also smaller in the union-ridden equilibrium than in the union-freeequilibrium.

4. A Concluding Remark
The foregoing argument is easiliy extended to see the relationshipbetween union behaviour and the exchange rate in a small open
economy. Let us show here that under the distribution of monetary
assets assumed in the previous section it is theoretically possible thatlabour unions can make the domestic currency more valuable than in
the union-free equilibrium.

Suppose that there are two tradeable goods, the first and second
goods, and that the economy is completely specialized to the productionof the first good. Denoting the international prices measured in theforeign currency and the exchange rate defined to be the price of theforeign currency in terms of the domestic currency by pi, i == 1, 2, andE, respectively, the union's optimal problem is described as follows:

Max uwsubject to

VN= Q
hew(p;, pi VN
Q)6(1/h)S.,'Lew<p7, pi, (?) {6(1/h)-6'(1/h)/h}+R=O

VN - VY

N(1-q)eW(pt, pi, Q)6(uW/(1-q)) == M/E + RqN

vi VN -

IVQeQ"<pr, pi Q)(1-q)6(uW/(1-q)) == M/E
VN
R = p;, f'(qN)

VN VN

where Q='Q/E and R=w/E. Then, from the first-order conditions
with regard to this optimization problem, we can derive the following
relationship.

EV ;-liY' according as eb; eVb'

UNIONSAND NOMINAL PRICESLABOUR

where EU (resp.
free) equilibrium.

then unionizationEF) is theexhange rate in the union-ridden (resp. v
eb is greater (resp. smaller)
than eb'That is, ifenhances (resp. reduces) the value of the domestic

currency.

References

[1]
[2]

Allen, R.G.D., Index Nurnbers in Theory and Practice, Macmillan. 1975.

Shimomura K., A Simple Union-Ridden General Equilibrium Model", Kobe
Econornic & Business Review Vol. 35, 1990a.

[3]

Shimornura K., A Further Note on Union Power in the Long-Run",
Scandinavian Journal of Economics 92, pp. 599-604. 1990b.

9

AN INTERNATIONAL PERSPECTIVE ON JAPANESE CORPORATE FINANCE 'Kenji KOJIMAThis paper presents major characteristics of Japanese corporate
finance in an internationally comparative perspective. The corporate
finance in Japan appears different from those in the United States. The
paper attempts to identify important features of corporate finance inJapan, to provide economic rationale for those, and to develop insights
concerning the effects of such differences on the relationship between
corporate finance and capital market. The different features can be due
to differing institutional and regulatory structures. The ongoing
financial liberalization has caused structural shifts of Japanese
corporate finance over the last decade.

1. Introduction
As capital and product markets have become more integrated,national differences in corporate behaviors have been drawn into sharp
relief. Since behaviors and performances of firms substantially depend

on institutional and regulatory environments where firms operate,
peculiar patterns of behaviors turn out to be the rational economic
responses to those environments. One of the major differences incorporate behaviors among different countries can be financing
patterns, particularly the relationships between the capital market andnon-financial corporations. Corporate financial structures and practices
in Japan appear distinctive, particularly in comparison with those in
the United States. Specifically, it is commonly observed that financial

institutions in Japan tend to have much closer and longer-term
relationships with their industrial clien,ts than do their counterparts in

the United States. In large part, these differences are due to'Financial supports from Ministry of Education in Japan and the Japan Securities
Scholarship Foundation are gratefully acknowledged. This research started when
the author was a visiting, scholar at Department of Economics, Harvard University
in 1993. He is deeply indebted to W. Carl Kester on the subject of this paper.

KENJI KOJIMA

12

institutional and regulatory structures.

To the extent that the institutional and regulatory constraints
vary systematically across countries, so may corporate finance. Whilelegal and historical considerations help to explain why corporate
behaviors in each country have followed distinctive trajectories, we needto explain the difference of patterns across the countries as well as thesimilarity within each country and their sustainability with providing
economic rationale under specific structures of constraints. The key tounlocking answers to these questions is comprehensive understandingof the eorporate finance with a comparative study, identifying theunderlying structure of constraints. Consequently, this paper is as
much an exposition of the economic rationale that underlies thatsystem as it is an explanation of different patterns in corporate
finance.

This paper presents major characteristics of Japanese corporate
finance in an internationally comparative perspectives. This paper

examines the corporate finance in Japan compared with those inGermany and the United States, three of whose manufacturing sectors
are highly competitive each other. The primary purpose of the study isthreefold: to identify important features of corporate finance in Japan, toprovide economic rationale for similarity among firms in Japan and thesedifferences from other countries, particularly Germany and the UnitedStates, and to develop insights concerning the effects of such differenceson the relationship between corporate finance and capital market.
This paper is organized as follows. The next section presents the

major characteristics of financial policie$ of Japanese firms anddiscusses the underlying economic rationale, comparing with thecounterparts in Germany and the United States. Section 3 discusses
reeent structural shifts in corporate financial policies, and capital andcredit markets in Japan. Finally, section 4 presents concluding
remarks.
2. Major Characteristics of Financial Policies

2.1 LoWer Return Standard
Return on investments(hereafter, ROIs) of Japanese firms are
considerably lower than those of the U.S. firms. As shown in Table 1,
returns on assets have been consistently higher in the United StatesAN INTERNATIONAL PERSPECTIVE ON JAPANESE 13
CORPORATE FINANCE
than in Japan since 1960. Brown, Soybel, and Stinckney (1994) compare

the operating performance of Japanese and U.S. firms using financial
statement data restated to a similar reporting basis during the periodof 1985-88. The results show that neither country appears to generate
systematically higher profit margin, but that U.S. firms have higher

turnover assets and therefore higher rates of return on assets.
Although financial statement ratios of Japanese and U.S. firms are notdirectly comparable because of the use of different accounting
principles, their results suggest that alternative accounting principles

do not seriously distort the comparability of financial statement datain both countries. ' Return on assets of U.S. firms are significantly
higher than those of the Japanese for the year 1985 to 1988, primarily
because turnover rate of assets are higher for U.S. firms.

Table 1
Profitability of Manufacturing Firms in Germany, Japan, and the United States

Five-Year Average(Percentage)

Return on Assets

Return on Sales

Germany

Japan

U.S.A

1960-64
1965-69
1970-74
1975-79
1980-84
1985-89
1990-91

3.00
3.07
1.87
1.80
O.97
2.51
2.23

3.19
3.31
2.60
1.39
2.16
2.46
2.56

6.28
6.94
5.92
7.21
5.68
5.24
3.39

1970-74
1975-79

1.49
1.29
O.65
1.82
1.61

2.94
1.37
1.92
2.40
2.63

4.53
5.20
4.34
4.66
3.22

1980-M
1985-89
1990-91

Source: The Bank of Japan, Comparative Economic and Financial

Statistics: Japanand Other Coantries, 1974, 1978, 1986, 1993, 1994,

Source Note: Statistiches Bundesamt, Unternehmen und Arbeitsstdtten,
The Bank ofJapan, Shuyoleigyo Keieibunsehi (Business Analysis on Main Enterprises in Japan),
The U.S. Department of Commerce, Quarterly Financial Report for
Manufacturing,
Mining, and Trade Corporations.
Note: Book values of assets in Japanese firms differs greatly fromcurrent values
because face values are much lower than market values.
1 Brown, Soybel, Stinckney (1993) develop a method to restate financial statement dataof Japanese and U.S. firms to a cornparable reporting basis. Previous studies whichinvestigate the disparity of price-earning ratios (PERs) conclude that different
accounting principles explain substantially the difference between Japanese and U.S.

PERs. In contrast, they show that adjusting for different accounting principles
explains only a small portion of the defference, using samples of Japanese and U.S.
firms for the years 1985 through 19gg.

14

KENJI KOJIMA

These findings suggest that Japanese firms are much lessprofitable than +.heir U.S. counterparts. The relatively low returns ofJapanese firms have been attributed to differences in accounting
practices, corporate tax rates, and exchange rates, capital structure,and cost of capital. 2 Blaine (1993) observes profitability of Japaneseand U.S. Iarge firms in thirteen major industries over the 1985-89
period. He finds a number of interesting observations about the
profitability of Japanese and U.S. firms in the latter half of the 1980s.

The most important of these are that in almost every industry,
Japanese firms are consistently less profitable than their U.S.
counterparts. Even after adjusting for differences in tax rates,
accounting practices, and debt levels between the two countries,
Japanese firms in most industries have consistently lower operating
margin and return on assets than equivalent U.S. firms. The operating
margin provides the most fundamental measure of profitability since it

is not affected by taxes, interest earnings and expenses, andextraordinary gains and losses. Japanese firms appear to beconsistently less profitable than their U.S. counterparts. He also
concludes that it is very unlikely that accounting practices explain morethan a small portion of the observed differences in profitability between

Japanese and U.S. firms. Based on the results of those studies, it canbe concluded that there appears to have been a real difference in the
profitability of firm in both countries.

A lower acceptable return on investment allows Japanese managers
2 The financial statement ratios such as return on assets, return on equity, andoperating margin are a function of the specific legal framework and accounting
standards used to generate the firm's income statement and balance sheet. Amongthe most important are: the tax rate and the presence or absence of specific tax
and investment credits; the accepted method of accounting for income statement
and ba!ance sheet items, particularly depreciation, research and development
spending, minority investrnent, lease, goodwill, and currency translations; and theeffect of capital structure. Thus, each of the three most widely used profitability
ratios is subject to certain limitations that make the accurate assessment of firrn

performance very complex and difficult task. •. 'Blaine (1993) draws several conclusions about the effects of differences inaccounting standards on the measured profitability of Japanese and U.S. firms.
First, Japanese firms should exhibit more consistent operating results due to theirability to control reported income through the use of general reserve funds and bydeterring foreign currency gains and losses, and through transaction with related

firms. Second, the use of accelerated depreciation in Japan should result insomewhat lower reported income and lower assets for Japanese firms relative
identical U.S. firms. As a result, all three profitability measures rnay besomewhat lower for Japanese firm than identical U.S. firms.

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 15
CORPORATE FINANCE

undertake investments that U.S. firms would find unacceptable. Table 2

shows that investments in plants and equipment to gross domestic
products have been consistently higher in Japan than in German andthe U.S. since 1976. The capital structure policies and return objectivesof Japanese firms usually enhance their long-term corporate growth byallowing the savings from lower capital costs and return standards tobe reinvested in cost reduction, capacity expansion, and productdevelopment. U.S. firms are caught between the need to compete
against Japanese firms that are willing to invest capital at lower
returns, and the need to provide returns to shareholders that meet therequired level of return in the capital market. The U.S. managers
impose higher return standards on their investment decisions than theJapanese counterparts. Furthermore, executives of the U.S. firms
finance with much less debt, which produces a serious cost of capital
disadvantage, reduces the growth rate that can be financially sustained,
and creates capital structure that reinforces the disparity in corporate
goals and ROI objectives between U.S. firms and their foreigh rivals.
U.S. firms rely heavily on cost-of-capital calculations to guideinvestment decisions, and those firms that do not earn a sufficient
return on capital to satisfy the investors will fail. But for Japanesefirms, investment decisions are not made on a discounted cash flow
basis. Japanese managers usually view the cost of equity as the firm's
expense to service this source of capital, that is, dividends. With thisview of cost-of-capital, it is easy to see why the market price of theirstock has Iittle impact on investment decisions of Japanese firms.

Rather, barring market-imposed capital constraints, Japanesemanagers' investment decisions are guided by what they believe thecost of capital by what is quite different from prevalent financial
theories in the U.S. Japanese managers care about borrowing costs
and they push their banks and securities firms to get the best terms.
The most important criteria of Japanese firms is long-term goal of
maintaining and enhancing their positions in the Japanese industry.
Serious considerations of ROI and capital costs thus play only a minor

role in investment decisions of Japanese firms. If an investment isnecessary to keep up with a competitors or offers an opportunity togrow, then the investment may be made. While a U.S. managers might
first determine the cost of capital and proceed to look for investmentsthat offer returns in excess of that cost, the Japanese managers may

KENJI KOJIMA

16

first makethe investment decisionand then worry about

how tofinance it.3

Table 2lnvestments in Equipment and Research and Developmentin Germany, Japan, and the United States

Five-Year Average(Percentage)

Germany Japan U.S.A.

1967-69 5.1 7.7 3.8Real lnvestments in Plants 1970-74 5.3 7.5 3.5

and Equipment to GDP 1975-79 4.3 4.7 3.5
in Manufacturing Firms 1980-84 5.3 5.1 3.5

1985-89 5.3 6.0 3.4
1990-92 5.4 7.6 3.5
1967-69 7.7 7.9 6.5
Real lnvestment in Plants 1970-74 8.3 9.7 6.3

and Equipment to GDP in 1975-79 7.4 9.0 5.7
Non-Manufacturing Firms 1980-gn 6.7 8.8 5.7

1985-89 7.2 10.9 6.1
1990-92 8.4 13.1 6.7
1970-74 1.3 1.0 1.7
Real lnvestments in Research 1975-79 1.6 1.1 1.5
and Development to GDP 1980-84 1.6 1.4 1.7
in Private lndustrial Sector 1985-89 1.6 2.0 2.0
1990-92 1.6 2.4 2.0
Source: The Bank of Japan, Cornparative Economic and Financial Statistics: Japanand Other Countries, 1982, 1987, 1994.

Source Notes: Statistishes Bundesarnt, Statistishes Jahrbuch, Economie Planning

Agency in Japan, Minhan Kigyo Shihon Sutohu Sohuhou (Preliminary Issue ofCorporate Capital Stock), Management and Coordination Agency in Japan,
Kagaleugitvutu Kendyu ChoLtsa Houleoleu (Report on the Survey of Research andDevelopment), Science and Technology Agency in Japan, Kagahugitvutu Hahusho,(White Papaer on Science and Technology), Department of Cornmerce in the U.S.,
Survey of Current Business.

3 Evidences are available from eomparative data provided in a questionnaire surveyof Japanese, European and the U.S. firms (Keizai Doyukai, 19gg). The three setsof managers show notable differences when asked to choose the three mostimportant corporate goals they place on twelve preselected ones. The leading goalsof managers in Japan is improving firm's ratios of new products and businesses,

followed by gaining market share and improving ROI. Capital gains forshareholders ranks at the bottorn of the list and is cited by alrnost none of the

managers' in Japan as an irnportant goals for their companies. In the UnitedStates, in contrast, far most important goals is improving ROI, followed bycapital gains for shareholders and gaining market share. European managers
show improving ROI, gaining market share, and reformulation of international
strategies as three irnportant goals. Capital gains for shareholders is placed tenthon their list.

JAPANESE
AN INTERNATIONAL PERSPECTIVEON
CORPORATE FINANCE
Hodder and Tschoegl (1992) suggest that discounted cash flow
techniques such as net present value and internal rate of return are notwidely used within Japanese firms. A more typical approach is toinclude an imputed interest charge in an investment's projected cash
flows. This interest charge is based on the amount of funds the firm
has invested and effectively incorporates the time value of money into

an investment project's evaluation. Managers with considerable
experiences using such a procedure can get a sense of the proposed
project's anticipated profitability. Many investments in research anddevelopment, manufacturing and marketing are characterized by cash

flow estimate which are vague and highly uncertain. Under suchcircumstances, focusing discussion on the underlying cash flow
assumptions may be far more productive than refining the returncalculation. This indeed seems to be the emphasis in investment
evaluation at most Japanese firms. ` Furthermore, they suggest thatthe difference between typical U.S. discount rates and Japanese implicit
interest charges is primarily due to a differing treatment of risk. U.S.

discount rates are generally risk adjusted whereas the Japanese
impl•icit interest charges are not adjusted for risk. Japanese managers

do consider risk but in a qualitative manner rather than attempting
quantitative adjustments to their financial calculations. The Japaneseapproach avoids the potential problem of discount rates which overadjustment for risk and may,'consequently, explain a large part ofJapanese firms' greater willingness to undertake seemingly risky
proJects.

The U.S. investors are less supportive of investment overall
because of its sensitivity to current returns for many established firms'

goals that stress current stock price over long-term corporate value.
4 Hodder and Tschoegl (1992) also point out organizational concerns on ivestment
decisions in Japanese firms. Discussion regarding sales forecasts, production costprojections, possible competitor responses, government actions, and so on involve

managers from a wide range of functional areas. For major investment,competitor actions are a rnajor concern with this aspects of the analysis having adefensive flavor. The emphasis is on verbal discussions rather than building
quantitative models to analyze these issues. Meaningful participation in these

discussions by a wide range of managers essentially requires ana!ytical
calculations to be relatively simple and clearly understood by all. There is often
an inherent tradeoff between the use of sophisticated analytical techniques and theparticipation level of individuals from diverse backgrounds. Japanese firms haveclearly opted for increased participation, except in situation where analyticalprecision is critical.

17

18 KENJI KOJIMAThe U.S. investors favor those forms of investment for which returns
are most readily measurable, reflecting the importance of financial
returns and the valuation methods used by investors and managers.
This explains why the U.S. firms tend to underinvest in intangible
assets, where returns are more difficult to measure. On the other hand,
Japanese firms can make continued investment to upgrade capabilities
and increase productivity in existing businesses, and enter into new
businesses. These qualities, however, also burden on Japan firms. For
example, these systems create their own tendency to overinvest in

capacity, to proliferate products, and to maintain unprofitablebusinesses in the name of corporate long-term growth. They also
exhibit a slow tendency to redeploy capital out of sluggish businesses
and an inability to enter emerging fields rapidly, particularly throughstartups.

2.2 Lower Cost of Capital
The cost of capital is the return investors expect to receive on a
project with uncertain future cash flows. If investors demand this rate,

managers must demand the same rate on a given project if they are toserve the investors' best interests. In general, investors will demand a

return for a given project equal to the return they could receive on analternative set of cash flows that carry the same risk. Because stocks

traded in capital market represent alternative, easily accessible
investment opportunities, prevailing capital market returns are a logicalfoundation on which to construct an estimate of the cost of capital.

Most managers do this by determining how much debt a project can
support and, by implication, how much equity capital must be invested.
Then the yield to be paid on the debt and the required rate of returnon the equity can be combined to estimate the eost of capital.
Although there is a general agreement that the cost of capitalshould be viewed as an opportunity cost, there are still alternative
ways to define it. In general, the proper definition of the cost of capitaldepends on which of a project's expected cash flows are included
among those to be discounted. A common practice in corporate financeis to include all cash flows except tax shields generated by interest
deductions, which are determined not by the project, but by how it isfinanced. The weighted average cost of capital (hereafter, WACC),
calculated using the after-tax cost of debt, is designed to capture theAN INTERNATIONAL PERSPECTIVE ON JAPANESE 19
CORPORATE FINANCE

value of these shields in the discount rate rather than in the cash
flows.

In the structural explanation for lower return standard ofJapanese firms, managers and the stock market in Japan are seen as
facing an abundance of promising investment opportunities and acting
according by funding them. One reason for the relatively low rate of
return has been that Japanese investors enjoy lower costs of capital,
making even less promising investment opportunities viable. Lower
returns ean be accepted because they are still sufficient to coveroriginal capital costs. Since the commonly cited studies employ various
definitions of the costs of capital and alternative estimation procedures,

it is not possible to compare them perfectly. The common observations
indicate that there is less than 2906 to over 6% of difference in cost ofcapital between Japan and the U,S., depending on the definition
adopted and the period examined. 5 Nevertheless, there is no convincing
evidence that cost of capital in the U.S. is significantly higher thanthose in other countries, particularly in Japan during the period 1970
through 1989. Kester and Luehrman (1991) review and evaluate previous
studies of cost of capital differences. They conclude that there is noconvincing evidence that cost of capital is higher in the U.S, thanelsewhere during the 1970s and 80s. More sophisticated studies also
reported differences in average cost of capital across countries, but
5 Those studies include Ando and Auerbach (19gga, 1988b, 1990), Bernheim andShoven (1989), Friend and Tokutsu (1987), Malkiel (1992), McCaully and Zimmer(1989).
Several different approaches are taken to estimate cost of equity. One approachis to capitalize expected future dividends. Friend and Tokutsu (1987) measure andcompare the cost of capital in Japan and the U.S. They concludes that the average
cost of capital for the period 1962-84 is likely to be lower in Japan than in the
U.S., but it is not necessarily the case that the marginal cost differs between them.

The combined tax impact on the average cost of capital does not seem to havebeen markedly different in the two countries.

The other approach bases cost of equity estimate on realized market return,including capital gains as well as dividends. The third approach is to use earnings

to price per share ratios as the basis for their cost of equity estimates. This

includes Ando and Auerbach (1988, 1990), Bernheim and Shoven (1989), andMcCauley and Zimmer (1989).
Ando and Auerbach (1988) use financial statement data for large sample ofJapanese and U.S. firms to estimate the return to capital for the period 1967-83.
Interpreting these as measure of the cost of capital, they find that the before-tax

cost of corporate capital is higher in the U,S. than in Japan. However, market
returns in the two countries are much closer during that period. They rejectcertain factors of explanation for the difference in return, including differences incorporate taxation, differences in borrowing and assets mix.

20 KENJI KOJIMA
most still suffer from the following shortcomings: Failure to recognize

the interdependency among costs of debt, cost of equity, and capital
structure; Inadequate treatment of risk; Country-level measurement
errors; Noisy, heteroscedastic data.

As an alternative to the weighted average cost of capital, firms
can discount expected future nominal cash flows at a rate that reflects
the return on a nominally riskless security and a premium for the
riskiness of the cash flows. The first component of the cost of capital,

the riskless return, can be compared across countries fairly simply.
There is no problem controlling for risk because of comparing risklesssecurities. There is no mismatch problem and no country-levelaccounting differences because corprate data is not needed. The
nominal riskless rate can be decomposed into a real riskless rate plus

a premium for expected inflation. Kester and Luehrman (1989)
demonstrate the tendency for real rates to across countries to equalize

over time. Using monthly observations from 1976 to 1985, they reject
the hypothesis that Japanese rates were consistently lower than the
U.S. rates. In their sample, the difference in real riskless rates favors

one country as often as the other, and by equal order of magnitude.
They conclude that real interest rates and corporate capital cost candiffer across countries. However, differences in real rates, regardless of

their source, have not been nearly persistent enough to explain
consistently lower capital cost in Japan.

The second component of the cost of capital is the premium

demanded by investors to compensate them for bearing risk.
Differences in the premium demanded by investors in different
countries is another potential source of sustained capital costdifferences. Studies which have the possibility that the different equity

markets do not represent portfolios of comparable risk are problematic.
Since financial leverage differs quite significantly across countries, theriskiness of the two samples as selected is likely no well matched. The
another factor in capital costs that is reflected in the weighted average

cost of capital is the tax advantage associated with corporate
borrowing. It should be noted that the tax advantage of borrowing
alone could not possibly account for differences in the cost of capital
unless the differences in leverage across countries is significant. The
value of interest tax shields can not be that Iarge when reflected in the

WACC. Hence, even significant differences in eorporate leverage areAN INTERNATIONAL PERSPECTIVE ON JAPANESE 21
CORPORATE FINANCE

unlikely to translate into significant differences in capital costs. Since

there is significant cross-sectional variation in leverage within bothcountries, it is quite misleading to employ highly aggregate estimatesof leverage to compute WACC for entire manufacturing sectors. 6 As aconsequence, consideration on various factors including real rate, risk
premium, and leverage can not support the notion that costs of capitalsystematically and persistently differ between Japan and the U.S.
Hodder (1991) also emphasizes the special characteristics of thefinancing practices in Japan. After concluding his review of cost ofcapital studies by noting the lack of evidence for a consistentsystematic advantage for Japanese firms in their risk-adjusted cost offunds from the capital markets, he discusses the nature of therelationship that exists between capital suppliers and users. Hodder
argues that the extent of risk in leveraged Japanese firms is overstatedbecause Japanese banks are well positioned to monitor and control
their corporate clients as a result of the close and long-term financial

relationships that have evolved over time. Even though firms that areable to finance their investment plans through internal capital may bebetter off in the short run doing so, it can still be sensible over thelong run to build reliable relationships with particular financial
insitutions for those occasions when internal cash flow is no longer
sufficient.

Some aspects of the relationship between Japanese banks and its
clients have the potential to lower borrowing costs. Most Japanese
non-financial firms, maintain main-bank relationships, that is, a long-term relationship with one or two banks characterized by crossshareholding arrangements, board representation, and alert intervention
in the event of financial distress. The bank has extensive, reliable
information about the firms and has the capacity to become actively
involved if problems arise. This makes it safer to provide capital, whichmakes it possible to change less for it. Japanese firms, however,
explicitly pay for the benefits provided by their main banks. They
6 Kester (1986) asserts that it can not be generally supportive that Japanese firms
are substantially more reliant on debt than the U.S. counterparts. Reiiance on

book-value, country-wide average capital structure is a serious source ofmeasurement error. Unadjusted accounting data tends to cause measurement errorthat bias estimate of WACC of Japanese firms downward relative to that of the
U.S. The leverage gap close when debt ratios are adjusted for cash, reserves, anddifferences between market and book values of equity.

22

KENJI KOJIMA

consistently award them the largest share of their banking business,and they pay a premium for the loans and services provided by mainbanks - all of which drives up the cost of what originally appeared to bea cheap loan. In addition to their main-bank relationships, Japanesefirms tend to maintain on-going business relationship with othercommercial stakeholder such as major customers, suppliers, and soforth. They hold shares of business partners each other and can beviewed in the United States as patient investors who supply cheap capital.

In sum, it is not clear whether Japanese firms enjoy a capital
cost advantage over U.S. firms. Several recent trends suggest thatwhatever advantages may have existed are of declining importance.
Financial liberalization, as discussed later, has opened foreign capital

markets to Japanese non-financial firms That many firms are now
availing themselves of these opportunities suggests that financial
markets are now sufficiently global to have at least partially eliminatednational origin as a consideration in direct capital costs. The recent
move by Japanese firms toward diversifying sources of funds is alsodifficult to explain that higher leverage are still a major source ofcapital cost advantage.

2.3 Long-term lnvestment Horizon
The theory of efficient markets indieates that, in the absence ofprivate information, stock prices represent the best available estimate

of its true value. Market prices incorporate all current public
information about future cash flows and the value of individual assets

in an unbiased way. Stock prices change in response to new
information about individual assets. In fact, the stock price change isthe best measure of the managers decision's future impact on thecorporation. Nevertheless, to understand investment horizon of firms,

one must identify relationships between investors and managers interms of behavior and incentives that are not captured by the efficient

market. Many managers would be in the business of maximizing long-term shareholder wealth as an appropriate goal for corporate
management. Yet there seems to be a notable distinction drawn
between the goals of maximizing current as opposed to long-term stock
prices. Such a distinction probably stems from outside investors not

being able to understand certain aspects of the firm as well as
managers. Without asymmetric information between investors andAN INTERNATIONAL PERSPECTIVE ON JAPANESE 23
CORPORATE FINANCE
managers, the efficient markets theory suggests that short-and longterm stock price maximization would be one and the same. Any actionsof manager that are efficient for long-term value would have an
immediate positive effect on the stock price; conversely, any manager's
actions that reduce long-run value would have an immediate negative
effect on the stock price.
Stock prices cannot reflect perfectly the discounted present valueof a firm's estimated future earnings potential because investors mustbase their decisions on information that managers of firms abridge,
fabricate and relay to stock markets. In the presence of informational
asymmetry, the goals of maximizing short-run and long-run stock prices

can be inconsistent with one another. Managers my be able to raisecurrent stock prices by undertaking certain actions that will reduce
long-run value. In such a case, manager faces the dilemma of whichshareholders to serve: those who do not plan to hold the stock for thelong run versus those who do. As shareholder horizons shorten, it canbecome more difficult to focus exclusively on maximizing long-term value.

From their better-informed perspective, the investment increases
long-term value. On the other hand, because investors are not as wellinformed, the investment may lead to a short-run decline in the stock
price. The investment decision will therefore depend on how intensely
manager is concerned with current stock prices as opposed to long-run
value. The conditions can be considered to influence underinvestment

caused by stock prices: Managers place some emphasis on current
stock prices when evaluating investments; The investment expenditurein question suffers from an informational asymmetry - that is,shareholders are less able than manager to distinguish an expenditurethat will yield future returns from one that will not. Stock prices are
sensitive to current measures of profitability that are reduced by theinvestment expenditure in question. When manager is better informed
than outside stockholders, it may be able to increase current stock
prices by reducing certain invisible investments. This is because lessinformed outsiders will interpret the resulting increase in reported
earnings as good news about firm profitability (Froot, Perold, andStein, 1992).

Managers' preferences for short-term vs. Iong-term stock pricemaximization are likely to be shaped directly by the preferences of
their shareholders. One can imagine that if majority of shareholders in

KENJI KOJIMA

24

a given firm are planning to sell their stock in quite short-term, they

will be more concerned with near-term price performance, and will dotheir best to communicate the concern to managers. To the extent

manager is responsive to shareholders, it too will become moreoriented towards the short-term. Because of the agency relationshipbetween money managers and the beneficial owners of the stock, there
can be a distinction between the length of the actual holding period andthe length of the performance horizon. Clearly, if an individual investor

plans on selling his stock in the short period of time, he will be moreinterested in the stock price being maximized over that period. But

money manager who is subject to quarterly performance evaluation
may be much more interested in the stock's movement over the nearer
term, even if he is also planning on holding them for that length ofperiod. Thus, even though money managers do not appear to trademuch more frequently than the average investors, their interests asagents may be more skewed toward short-term stock priceperformance. Hence, agency problems may lead money managers to beparticularly concerned with short-term stock-price performance.

Table 3Major Stock Exchanges in Germany, Japan, and the United States
Frankfurt

New York

Tokyo

Number of Listed Companies

1984
1986
19gg
1990
1992

381
404
457
743
766

1,543
1,575
1,681
1,774
2,089

1,455
1,551
1,683
1,752
1,770

Total Market Value of Stocks

19M(Billion Dollars)

1986
19gg
1990
1992

72
234
222
341
321

1,529
2,129
2,366
2,692
3,877

1,794
3,789
2,822
2,320

Trading Value of Stocks

19M(Billion Dollars)

1986
1988
1990
1992

14
65
71
349
300

1,374
1,356
1,325
1,745

271
955
2,234
1,303
475

Turnover Ratios of Stocks(Percentage)

19ec
1986
1988
1990
1992

50.1
68.5
58.0
47.4
45.1

47.1
67.2
70.2
38.1
18.0

17.2

32.6
32.0
103.7

87.8

M4

764

the
Note: Dollar arnount is computed on basis
respectiveof

foreignof the end of the years.
Source: Tokyo Stock Exchange, Annual Securities Statistics,

1985, 1987, 1989,

exchangerate as
1991 1993'AN INTERNATIONAL PERSPECTIVE ON JAPANESE 25
CORPORATE FINANCE
Institutional investors now dominate the capital market in the U.S.

The investors that make the market are increasingly motivated byshort-term considerations, as the high turnover rate of stock indicates.

Professional portfolio managers and brokers receive severe pressure tooutperform the average and one another in the short term. Motivatedby intense short-term performance pressure and by the uncertainly
associated with long-term projections, many security analysts andmoney managers base their decisions on more predictable short-term
earnings. The high turnover rate for shares in the market shows thegrowing influence of short-term forces on the market. The short-term
focus of many institutional fund managers worsen this problem.
Because of increasing difficulty to predict future corporate performance,

fund managers have an understandable tendency to emphasize shortterm performance in making investment decisions. In this environment,.
the market overvalues short-term
profits and undervalues the cost of
long-term competitive declines. It is difficult to provide statisticalevidences to support the notion that institutional investors in the U.S.
influence more intense short horizon preferences to corporate managers
than do individuals. Probably most relevant for international comparisons,however, is not the distinction between individuals and institutions in the

U.S. but rather the fact that no influential U.S. investors exhibit the'stable shareholding practices in Germany an Japan. As shown in Table
3, turnover ratios of stock in Japan is comparable to that in the U.S.,
while the turnover in Germany is substantially higher in 1990s. But it
does not suggest that managers in Germany and Japan is subject tothe same investors' pressures as the U.S. managers. The distribution ofshare ownership in Japan is highly concentrated on a large group of
stable long-term shareholders like financial institutions and business

firms as shown in Table 4 and 5. The average turnover ratios
encompass a relatively small group of extremely active traders. '7 Germany managers also take a long-term view for several reasons. First, theyshare the German value which emphasize the firm's enduring importance. Also,
they are employed with multi-year contracts usually at the longer end of thelegally allowed spectrum-four or five years. This provides them with the time tomake longer-term investments and to see them pay out. Of course, it helps
managers to be patient when shareholders are also patient. In Germany there are

no quarterly reports of earnings and no security analysts. With owners,
managers, and other employees all committed to the long term, it is hardly
surprising that German directors who represent them also share this time horizon.
Directors use their most important power, that is, to grant management contacts
creating the longest arrangements allowed by law-up to five years.

26 KENJI KOJIMA
Table 4
Stable Shareholding of Public Corporations in Japan

in 1993(Percentage)

Less than lO% 2.2

10.20rdO O.3

20-30%
1.0
30-40%
3.8
40-50%
8.7
50-60% 25.9
60-70% 34.3

70-80% • 17.1

More than 80foO 6.7
Note: Ratio stands numbers of shares owned by stable shareholders divided by total
outstanding shares.

Source: Fuji Research Institute Corporation, Kigyouzaimu Kenzenha-soleushin
Chosahendyu-Meinbanhu-sisutemu ni hansuru Chosa, (Research on Promotion ofSound Corporate Finance: A Survey of Main Bank System), 1993.

Table 5
Share Ownership of Ali Listed Firms by Type of lnvestors in Japan

Five-Year Average(Percentage of Listed Shares)

1970-74 1975-79 1980-en 1985-89 1990-92

Government O.2 O.2 O.2 O.8 O.6

Financial lnstitutions 34.4 37.6 39.0 44.4 44.8

Banks n.a.
n.a.1.4
17.7
21.8
Investment
Trusts
1.8 21.0
1.2 2.5
3.3
Annuity Trusts n.a. n.a. O.4 O.9 1.0Life lnsurance 11.2 12.0 12.6 13.2 13.1
Other lnsurance 4.6 4.8 4.9 4.3 4.0
Other lnstitutions 1.8 1.9 2.2 2.4 1.6

Business Corporations 25.6 26.3 26.0 24.6 24.7

Securities Companies 1.4 1.6 1.8 2.3 1.5
Individual&Others 35.2 31.9 27.7 23.5 23.4

Foreigners 3.2 2.4 5.2 4.4 5.0

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

Another influence on manager's horizons for maximizing stock
prices is the threat of hostile takeover. The incidence of hostile
takeovers differs dramatically between the U.S., and Germany andJapan. The presence of the large groups of stable shareholders is likely

to provide less pressure on managers in Germany and Japan tomaximize short-term stock prices. Even if takeover pressure really havean adverse impact on certain types of investment, one definitely cannot

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 27
CORPORATE FINANCE

conclude that takeovers are harmful on efficiency of firm management.

Seen in a broader context, hostile takeovers are one of possible

mechanisms of corporate governance. It can be argued that theprominence of hostile takeovers in the U.S. reflects a fundamental
failing of other governance mechanisms. Without an active market forcorporate control, there might be few restraints on reduction ofshareholders' value by managers. Similarly, a lack of takeovers inother countries will be beneficial only to the extent that alternative

mechanisms of governance can be effective in exerting a measure of
discipline and control over managers (Kojima, 1993).
Stein (1988) examines the above argument that takeover pressure

can be damaging because it leads managers to sacrifice long-term
wealth in order to boost near-term earnings. If stockholders areimperfectly informed, temporary low earnings may cause the stock to
become undervalued, increasing the likelihood of a takeover at an

unfavorable price. Hence, managers are concerned with current
performance. Takeover pressure and the accompanying threat of beingbought out at an undervalued price leads managers to focus moreheavily on short-term profits rather than on long-term objectives. If

stockholders observe everything that managers do, any policy thatmanagement knows is not in the best long-run interest of the firm
would lower the stock price. If, on the other hand, stockholders cannot

observe management of the firm perfectly and must rely on someimperfect summary statistic such as reported earnings, there is room
for the type of costly signalling. Managers might be able to boost thestock price by selling off productive assets whose value shareholders
are unable to measure properly. If left unsold, the assets may havelittle effect on current earnings and may be undervalued byshareholders. Consequently, their sale, which has an immediate impact
on the earnings, may cause an upward revaluation of the firm's stock.
In the absence of short-term pressure, there is no strong motivation
for managers to devote resources to making sure that their stock isnever undervalued. After all, the productive assets will eventually start
to yield earnings so that the undervaluation will be transient. •If managers attempt to drive up current earnings so as to avoid
takeovers at undervalued prices, one must look not only at the extent
of takeover pressure but also at the factors that may cause stocks to
be undervalued in the first place. Relatively patient stockholders may

28

KENJI KOJIMA

not be discouraged by a low earnings report; they may attribute it toa policy of long-term investment by the firm. If patient shareholders
are prevailing, low earnings will not lead to a large undervaluation of

the stock, and managers will not need to be overly concerned.
Impatient shareholders, on the other hand, may become very distressedby low earnings reports and may try to dispose of stocks as soon as
such a report is released. If such impatience is widespread, managers
will be more fearful of undervaluation and the accompanying possibilityof takeover. Hence manager's efforts to boost current earning will be
more intense (Stein 1988).

Even if there is considerable pressure on managers to maximize
short-term share prices, the view of asymmetric information does not
imply that all types of assets will suffer from an underinvestment
problem. Bubchuk and Stole (1993) show that observable investmentsthat show up cleary on a balance sheet of firm such as expenditures on
new equipment and plants are the least Iikely to be sacrificed in thequest for higher stock prices, In contrast, the unobservable investments

like enhancing human capital and gaining market shares are most
likely to under-investment and do not show up in accounting data.8
Laffont and Tirole (1988) work in optimal incentive contracts forencouraging managers to work diligently over time. They argue that if
investment is invisible, high investment lowering current earnings will
be mistaken for low managerial efforts. In order to encourage both
efforts and investment in invisible assets, managers is entitled to claim

earnings over the period when the outcome of investment realizes inearnings. Hence, it might be optimal to raise barriers to takeovers inorder to encourage managers to be long-term stockholders, thereby
restraining myopic behavior.
Jacobson and Aaker (1993) find that the Japanese stock market
incorporates information earlier than does the U.S. stock market. The
finding supports the hypothesis that Japanese investors, who tend to
8 Paul (1993) shows that the strength of the firm's incentive to behave myopicallydepends on the degree to which the stock market's information about near-term
cash flows is a better predictor of the firm's total payoffs than its information
about the firm's long-term cash flows. The better the market's information about
near-term cash flows is relative to distant cash flows in predicting total firm
payoffs, the stronger the firm's incentive to behave myopically. Sirnilarly, whenthe market's information about the firm's long-term cash flows is better than its
information about short-term cash flows in predicting the firm's total payoffs, thefirm will overemphasize long-term cash flows.

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 29
CORPORATE FINANCE

have close business relationships with the firm they invest in, are better

informed than their U.S. counterparts. Greater asymmetry of
information with respect to long-term performance induce investors in
U.S. stock market to attach greater importance to current performance
than Japanese counterparts. This, in turn, induces incentives for U.S.

managers to have a short horizon. On the other hand, investors inJapan and Germany may be better informed of long-term businessprospects than those in the U.S and, therefore, place less emphasis on

short-term performance.

Stein (1989) shows that in the presence of asymmetric
information, managers can end up having a higher discount rate thanjustified by cost of capital and so unduly lower the value of investmentswith long-term returns. Since stock market uses current performanceas indicators of future ones, managers typically have incentives to
artificially accentuate current-term results in order to enhance current

stock price. An important factor giving rise to short-term horizon on
managers involves the ability of managers to shift earnings from afuture period without being noticed by outside investors. The greater

the information gaps between managers and outside investors, thegreater the opportunity for managers to raise current stock price byartificially accentuating current results at the expense of long-term
performance.
Jacobson and Aaker (1993) find that the ratio of the effect of
future-term to current-term performance on stock returns is greaterfor the Japanese stock market than for the U.S. one. Then, this isconsistent with the hypothesis that Japanese investors are better
informed than their U.S. counterparts. This result may be attributed to
the fact that a significant proportion of investors in Japanese stock

market have close and long-term business relationship with the firm
they invest in, which may facilitate them to access to information thatmakes them more aware of long-term business prospects than their
U.S. counterparts. As a result, Japanese stock prices incorporate
information about long-term performance earlier than do U.S. stock
prices. U.S. stock price tend to react rnore to current results because,

lacking of information about future prospects, this information has notalready been incorporated into the stock price.

KENJI KOJIMA

30

Table 6
Cross-sharehoidings of Major Keiretsu in Japan(Percentage)
1970

Mitsui
Mitsubishi

Sumitomo
Fuyo
Sanwa
Dai-ichi Kangin

1975
21.17
30.26
29.58
18.28
20.30
23.77

21.32
26.78
28.94
16.04
12.50
24.51

1981

1985

1989

1992

23.13
36.93
36.57
18.80
19.95
17.50

21.61
36.94
29.68
17.36
18.03
16.78

19.46
35.45
27.46
16.39
16.45
14.60

19.29
38.21
27.95
16.88
16.68
14.24

Note: Ratio stands average ratio of the group, which is numbers of sharesfirms in the group divided by total outstanding shares.

owned bySource: Fair Trade Comrnission, Kigyo-syudan no Jittai ni tuite, (ASurvey on

Corporate Groups), 1992, 1994.

Table 7
Dispatched Directors of Major Keiretsu in Japan(Percentage)
1977

1981

1987

1989

1992

Mitsui

47.83(47.83)47.83(39.13)45.83(41.66)41.66(37.50)34.62(26.92)

Mitsubishi

92.86(71.43)96.55(85.71)

96.55(86.21)

96.55(75.86)100.0(79.31)

Sumitomo

66.67(52.38)71.43(52.38)50.00(40.00)50.00(35.00)50.00(20.00)

Fuyo

58.62
(51.72)

62.07(55.17)68.97(58.62)44.83(37.93)48.28(37.93)

Sanwa

61.11
(41.67)67.50(50.00)68.18(50.00)68.18(54.54)70.45(52.27)

Dai-ichi Kangin

57.78(51.11)73.33(68.89)76.60(70.21)

72.34(63.83)56.25(31.25)

Note: Ratio stands numbers of firms which have directors dispatched from thebelonged group divided by the total numbers of firms in the group. The ratio in theparenthesis stands numbers of firms which have dispatched directors from the bank in
the group divided by the total numbers of firms in the group.

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

For Japanese firms cross-shareholdings and access to information
is particularly prevalent among firms in leeiretsu. As shown Table 6,
the firms in the six Japanese major keiretsu hold 14SO)6 to 38% of thetotal shares in the group. Table 7 indicates that large proportion ofkeiretsu firms have directors on their board dispatched from thebelonged group, particularly banks. Moreover, they have close trade

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 31
CORPORATE FINANCE

relationships with firms in the group as shown in Table 8. Cross-shareholdings, interlocking directors, and intragroup traderelationships which strengthen the relationships in keiretsu facilitate

the firm in the group to access and exchange information about theperformances of firms. These consideration suggest that Japanesemanagers will be less inclined to undertake myopic behaviors designed
to enhance current performance. Since Japanese investors are moreaware of the long-term implications of current manager's actions,Japanese managers will find it more difficult to take advantage of
information over market investors by inflating current earnings.
Investors in Japan are in a better position to distinguish between
earnings increases coming at the expense of future profits from thosetruly depicting increased future profits. Therefore, Japanese managers

will be more reluctant to take myopic behavior than their U.S.
counterparts.

Table 8lntragroup Trade Relationships of Major Keiretsu in Japan(Percentage)

1989 1992

Mitsui 45.26 44.16

Mitsubishi 51.33 51.67

Sumitomo 64.17 60.83

Fuyo 30.83 29.33
Sanwa 30.91 27.63

Dai-ichi Kangin 34.45 32.84

Note: Ratio stands numbers of firms which have trade relationships with firms in thegroup divided by the total nurnber of firms which are possible to have those in thegroup.

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

The greater conflict between shareholders and debtholders, thehigher may be the required interest payment, and the higher will be thefirm's cost of capital. With a higher cost of capital, total investment
will be less, and the firm's investment horizon will be shorter. Thus, afirm with a greater disparity of shareholder and debtor interests, andtherefore a greater potential equity and debtholder conflict, may be in

32

KENJI KOJIMAa short-term horizon. Debtholder-shareholder conflicts may also affectthe composition of firm's funding, since they will raise the marginal

cost of external funds to the corporation relative to internallygenerated funds. Thus, firms with a greater capacity to generate funds
internally will have a Iower cost of capital and can be expected toinvest more than would firms with less access to internal funds.
Consequently, such firms will also be more willing to undertake longer-term investment projects. In addition, firms that must rely more on

external funds may prefer to obtain these funds from financial
intermediaries: financial intermediaries utilize more efficient methods tomonitor managers, which makes the cost of funds relatively lower. The
relationship between Japanese banks and their client firms have theeffects on investment horizons. Most Japanese industrial firms
maintain main bank relationships.9 The bank has extensive, reliable
information about the client firms and, further, has the capacity to
become actively involved when problems arise. This makes it safer toprovide capital, which makes it possible to change less for it.

In countries with more developed capital markets, like the UnitedStates, sharehplders and debtholders often have even less of a longterm commitment to firms because it is relatively inexpensive for themto dispose of their claims in highly liquid capital asset markets. In the

United States the control costs associated with widely dispersedownership and debtholdings would be expected to be relatively high.
This, together with the existence of highly liquid capital assets markets,

may increase the information asymmetry that exists between
managers, and debtholders and shareholders. This view leads naturally
to the conclusion that corporate myopia would be reduced if ownershipof firms were more concentrated. Huddart (1993) shows that only
concentrated share ownership will be able to induce shareholders tomonitor. Effective monitoring of management by shareholders is a
public good whose costs are privately incurred. Underinvestment inmonitoring results from the inability to locate the costs and benefits ofsupervision in a single individual. A shareholder who owns more thana threshold amount of stock has an incentive to monitor the manager.
Shareholders who owns less than the threshold choose to delegate the
9 The large scale questionnaire survey provide the evidence that more than 98
percents of public corporations in Japan have main bank relationships (Fuji
Research Institute Corporation, 1993).

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 33
CORPORATE FINANCE

tasks of monitoring and setting managerial compensation to the major
shareholder. When the major shareholder controls both the manager's
compensation and the intensity of monitoring, incentives imposed on

the manager increase in the concentration of share ownershipinfluences the value of a corporation. It predicts that stock prices

increase in the concentration of stock ownership. Hence, large
stockholders would have a greater incentive to obtain relevant
information, and the cost of acquiring such information would be less.

The benefits of having better information also would be moreconcentrated. In addition, disposing of large blocks of claims in stock
markets would be more costly, so that there would be tendency towardattempting to influenee management directly, rather than simply sellingthe firm's stock (Edwards and Eisenbeis 1991). The distribution ofshare ownership in Japan is highly concentrated on a large group of
stable long-term shareholders like financial institutions and business
firms as shown previously in Table 4 and 5. Large shareholders have
incentives to collect information about firms they own through closeand on-going business relationships.

2.4 Highly Leveraged Capital Structure
A frequently mentioned characteristic of Japanese firms is a highdegree of financial leverage. This characterization is supported thefigures in Table 9, where the debt-equity ratios for Japanese firms arehigher that those for the U.S. Japanese frims have relied substantiallymore on debt than either U.S. or German counterparts, especiallyduring the rapid growth period of the Japanese economy. Externalfunding of Japanese firms also comes more from short-term credit,
primarily from banks, than does German and U.S. firms. Debt-equity
ratios for Japanese firms are calculated on reported book values forshareholders' equity. Frequently, book values dramatically understate

the true equity value for Japanese firms because of "unrealized
assets." There are also differences in accounting practices between the

U.S. and Japan. In terms of unrealized assets, land as well asshareholdings in other firms are evaluated at acquisition value rather

current market value; for many Japanese firms, the difference is verylarge. Several studies adjusting for the difference, suggest thatJapanese firms have been substantially less levered than indicated bybook value ratios, but remains higher leverage at market vaiue than

34 KENJI KOJIMA
that in the U.S.'O Furthermore, the studies confirm that leverage has
been declining dramatically.

Table 9
Capital Structure: Debt-Equity Ratio of
Manufacturing Firms in Germany, Japan, and the United States

Five-Year Average(Percentage)
1960-64 1965-69 1970-74 1975-79 1980-84 1985-89 1990-91

Germany 139.48 152.84 196.94 226.08 238.41 248.25 259.79

Japan 236.36 309.91 409.74 460.37 310.72 204.70 172.51

U.S.A. 55.76 73.45 88.24 90.56 105.13 133.62 149.08
Source: The Bank of Japan, Cornparative Econornic and Financial Statistics: Japanand Other Countries, 1974, 1978, 1986, 1993, 1994.

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

This highly leveraged capital stucture gives Japanese firms several

important advantages. First, by substituting debt for higher costequity, it lowers the after-tax cost of capital. Second, as financial
leverage grows, a firm's net income spreads over a relatively smaller
equity base, thus increasing the return on equity assuming the returnon total capital is greater than the after-tax interest rate on debt. The
more leveraged a firm is, the lower the return on total capital it needs
to yield a given return on equity. Third, the higher a firm's financial
leverage, the faster the rate of growth it can finance at a given returnon-investment level. More debt not only directly adds to capital but

10 Borio (1990) cornpares leverage and financial patterns for the Group of Seven withseveral ways of estimation. The overall distinction between high and low-leveragecountries is essentially confirmed by estimates of gross leverage at market value.

Leverage at market value is significantly lower than at book value in Japan.
Leverage in Japan remains higher at market value than that in the U.S. Kester(1986) finds no significant country difference in leverage when equity wasmeasured on a market-value basis and company-specific faetors such as growth,
profitability, risk, size, and industry are considered. Significantly higher leverageof Japanese firms are found when equity is measured on a book-value basis.
However, stratifying the sample by industry reveals that even this result isconcentrated among mature, capital-intensive industries.

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 35
CORPORATE FINANCE

also supports a higher rate of sustained growth because each dollar ofincome retained creates a proportionally larger debt capacity. So
Japanese manufacturer can grow faster than its U.S. counterparts atlower operating margins. Of course, these advantages are not without
costs. Increasing financial leverage raises the cyclical volatility ofearnings. And unless management compensates by reducing operatingrisk, the firm's total risk will rise. But Japanese firms reduce the risksof high leverage through close relationships with their banks (Ellsworth1985).

However, financial leverage has changed dramatically for firms inboth the U.S. and Japan over the 1980s. In the U.S., there has been anotable decline in shareholders' equity as a percentage of total assets
largely due to debt-equity substitution through leveraged buy-outs,
mergers and share repurchases. In contrast, the equity-asset ratio forJapanese firms has grown substantially in the late 1980s, the leveragehas decreased. As Japan has moved into a period of slower growth,reliance on external funding sources, particularly bank loans has
declined relative to internal funding. Although loans continued to funda very large fraction of assets growth after the mid-1970s, the dramatic

slowing of that growth meant a weakened demand for bank loans. This
trend toward lessened dependence on the banking loans gained further
momentum during the 1985-1989 period as market-based funding began
to play a larger role in Japanese corporate finance.
Another notable characteristic of Japanese firms can be observed inTable 10 that the relatively heavy reliance on financing by short-term debt
and account payable. The percentage of short-term debt has declined but stillis higher than those of Germany and the U.S. Furthermore, short-term debt

plus trade payable has been more than the long-term debt for Japanesefirms. The situation for U.S. manufactures is basically the reverse, withmuch greater reliance on long-term and a relatively modest dependence on
trade payable. In other words, Japanese firms have not only tended toborrow more but have also relied much more heavily on short-term funding

sources such as bank loans than their U.S. counterparts. German
manufacturing firms depend on account payable and long-term debt thanshort-term debt. Particulary, the percentage of account payable is muchhigher than those in other two countries. Most of the short-term debt ofJapanese firms is supplied by banks in the form of promissory notes withninety to one-hundreds twenty days maturity. These notes are generally

KENJI KOJIMA

36

Table 10
Balance Sheets of Manufacturing Firms in Germany, Japan,and the United States
Five-Year Average(Percentage)

Germany
1965-69 1970-74 1975-79 1980-84 1985-89 1990-91

1960-64
AssetsCash and Equivalents 11.0
Account Receivables 16.4

Inventories 22.6

Tangible Fixed Assets 41.7
Liabilities

Account Payables
Short-Term Debt

Long-Term Debt
Stockholder's Equity

Stock

58,2
22.9
3.3
23.2
41.8
21.6

10.4

10.5
20.2
22.4
32.8
67.2
26.6
4.0
26.3
32.8
16.7

17.6
21.0
39.0
61.0
24.0
4.0
24.7
39.0
20.3

13.5
2113
25.2
26.1
69.3
29.2
2.9
25.7
30.7
14.8

13.3
22.8
26.3
22.7
70.7
30.0
3.6
23.7
29.3
13.3

16.9

24,3
23.6
21.1
71.2
28.6
4.3

20.9
28.8
12.0

13.9
24.8
23.6
20.5
72.2
28.8
4.7
19.9
27.8
11.3

Japan
1965-69 1970-74 1975-79 1980-84 1985-89 1990-91

1960-64
AssetsCash and Equivalents 10.7

Account Receivables 19.3

Inventories 17.7

Tangible Fixed Assets 34.6
Liabilities

Account Payables
Short-Term Debt

Long-Term Debt
Stockholder's Equity
Stock

70.2
16.2
18.5

22.3
29.8
16.8

13.8
23.4
16.7
30.2
80.2
19.0
16.8
28.8
19.8
8.6

12.8
25.3
15.5
37.4
75.5
18.5
18.7
26.0
24.5
13.6

14.8
22.7
18.3
26.8
82.1
18.7
18.0
27.7
17.9
6.7

15.3
23.1
18.9
25.1
75.4
19.7
17.0

21.9
24.6
6.0

19.3
21.7
13.6
25.7
67.0
16.3
14.0
22.0
33.0
7.5

17.7
21.6
12.4
25.7
os.3
15.6
9.7
23.6
36.7
8.5

U.S.A. •1960-64

1965-69 1970-74 1975-79 1980-84 1985-89 1990-91

AssetsCash and Equivalents 10.2

Account Receivables 16.7

Inventories 23.3

Tangible Fixed Assets 38.7
Liabilities

Account Payables
Short-Term Debt

Long-Term Debt
Stockholder's Equity

Stock

35.8
9.2
2.8
14.3
64.2
25.3

7.1
17.6
23.7
39.5
42.3
9.7

3.8
18.3
57.7
20.1

5.8
17.6

22.7
38.1
46.9
9.4
4.3
22.2
53.1
17.5

6.9
16.4
20.9
35.2
47.5
9.1
3.3
22.9
52.5
15.0

5.5
15.5
18.3
38.2
51.2
9.2
3.7
25.1
48.8
12.5

5.7
14.8
15.5
35.1
57.1
8.2
3.8
31.0
42.8
12.0

Source: The Bank of Japan, Contparative Econornic and Financial Statistics: Japanand Other Countries, 1974, 1978, 1986, 1993, 1994.

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

4.6
13.6
14.1
33.6
59.9
7.8
4.2
34.4
40.2
12.1

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 37
CORPORATE FINANCE'

rolled over continually for a period of years.

Borio(1990)examinestheeffectsoftaxfactors on capital structure inseveral countries. The relevance of the tax system can in principle bemeasured by considering what is the after-tax income stream that investors

receivesdepending on the form of distribution, that is capital gains,dividends, or interest payments. On the basis of representative statutory
income tax rates, there is not significant differences in ranking of sources offunds among those countries in the period considered Borrowing is superior

to all equity forms and retained earnings dominates new stock issues.
Germany is exceptional, because for income tax reasons alone investors
would be indifferent between borrowing and new issues while retained
earnings would be inferior to both. Neither of these findings is consistent withthe relatively heavy reliance on retained earning in all countries." He

concludes that on balance tax factors alone are not the overriding
element accounting for choice of financial patterns.

The institutional impediments to external financing in countries
with high leverage can be an important factor to explain. Disclosure
standards and insider-trading registration have generally been lessstringent in Japan and Germany than the U.S. Similaly, traditional
institutional investors like pension funds have not been present inGermany. Although it is appealing, this explanation can only be apartial one. The combination of relatively inactive capital markets withthe predominant role of financial institutions in high leverage countries

may go some way towards explaining their comparatively higher debt
capacity. He points out that concentration of debt can favor leverage inat least two ways. First, it may help to resolve financial distress as it

tends to limit free-riding opportunities. Individual bond holders would
have little incentive to accept a reduction in their contractual claims
11 Myer (1984) argues for the pecking order theory of capital structure. He suggeststhat capital structure has a dynamic feature driven by a firm's need for externalfunds and their relative cost. According to this theory, firms prefer to financeinvestment projects with internal funds. When external funds are needed,
additional borrowing is preferred to new equity issues as Iong as the default
premium implicit in interest rates on added debt is not too great. The pecking
order theory treats equity issues as an expensive funding sources because of anasymmetric information problem. One interpretation is that managers view selling
equity as unattractive when they feel shares are underpriced and vice versa when
they feel shares are overpriced. Although an equity issues could be promoted by aneed to fund desirable investment projects, potential purchasers have difficulty
identifying the true motivation for stock issues and will seek to protect themselves

against overpriced issues. Consequently, share which are issued to financedesirable new investment projects will tend to be undervalued and represent a
relatively expensive funding source.

38

KENJI KOJIMA

because the outcome of the negotiations would tend to be perceived as
independent of their individual decisions while organizing joint action
would be costly. Debt concentration may therefore reduce the expected
costs of financial destress. Second, high concentration, particularly in

non-marketable claims, tends to promote longer-term relationships
between borrower and lender which, by enhancing information flows,
can make the financial institutions more tolerant of leverage. Evidence

from Japan suggests that debt concentration has been relatively highwith main bank providing substantial proportion of loans. Debt
concentration and long-term relationships in favoring debt capacity isparticularly notable in the case of smaller firm which are generally
more leveraged. And these are precisely the firm which, as a lack of
information, cannot normally have access to capital markets and tend
to rely on Ioans from financial intermediaries, while well-establishedfirms with good reputation can borrow from bond markets at a lower
cost than from financial institutions.

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

clearly reduces the scope for conflict between stockholders anddebtholders over the choise of policies, particularly in situation offinancial distress. Therefore, it facilitates more leverage. In Germany
and Japan, banks own a significant proportion of client firm's equity.
In Germany banks directly own substantial proportion of non-financial
firm's equity. Moreover, over majority of total shares are held in theircustody and they may exercise proxies at the shareholder's meetingwith the consent of real stockholders. On the other hand, the U.S.
banks are prohibited from owning equity and are almost impossible to
make any coordinating effort to reconcile conflict between stockholders
and debtholders.
It is also instructive to examine figures on funding sources forGermany, Japan, the U.S. Table 11 presents comparative data on net
sources of funds for manufacturing firms in each country during theperiod of 1975 through 1990. Japanese firms relied, on the net, more on

internal funding sources such as depreciation and retained earnings
than their U.S. counterparts during that period. This fact could not be
consistent with the view that Japanese firms depend more on externalfinancing, the most of which has come in the form of bank loans.

ONJAPANESEANINTERNATIONAL PERSPECTIVE

39

CORPORATE FINANCE
Table 11for
Net Sources of Funds
Manufacturing Firms in Germany, Japan, and the United States
Five-Year Average(Percentage)

Germany
Internal Funds
Retained Profits
Depreciation
Stock Issues

Debts

Bonds
Loans
Trade Payable
Others1975-79
80.4

1980-84
92.3

26.5
50.4

31.3
56.3

n.a.
19.6

n.a.
4.9
n.a.
13.2

4.7
7.7
-1.0

4.4
6.3
2.5

1985-89

1990

97.4

78.1

40.3
55.8
1.2
2.6

23,6
51.6

3.0
21.9

O.1
-1.8
-3.0
7.4

-O,1

1985-89
103.3

1990-91
69.0

22.8
58.4

20.0
43.7

O.8
12.3
9.0

Japan
Internal Funds
Retained Profits
Depreciation
Stock Issues

Debts

Bonds
Loans
Trade Payable

1975-79
68.8

1980-84

15.8
44.7

17.7
40.0

8.3
31.2

71.7
11.9
28.3

4.0

6.7
6.3
7.8

9.7
11.5

22.1
-3.3

5.3
31.1

24.8
-18.5
-9.7

19.7
11.5
-1.4

1985-89
53.3

1990-91
73.6

3.1
45.5

2.7
57.3

OthersInternal Funds
Retained Profits
Depreciation
Stock Issues

Debts

Bonds
Loans
Trade Payable
Others1975:79
62.8

25.9
31.8
5.1
37.2

10.1
2.0
7.4
17.7

U.S.A.
1980-84

64.5

16.5
39.6
8.3
35.5

7.6
6.9
3.2
17.7

4.7
46.7

17.2
12.1
2.2
15.2

13.7
26.4

6.6
3.4
2.1
14.4

Source: The Bank of Japan, Cornparative Economic and Financial Statistics: Japanand Other Countries, 1978, 1986, 1990, 1993, 1994,

Source Note: Statistiches Bundesarnt, Unternehrnen und Arbeitsstdtten, The Bank ofJapan, Syuoroleigyo Keieibunselei (Business Analysis on Main Enterprises in Japan),

The U.S. Department of Commerce, Quarterly Financial Report for Manufacturing,
Mining, and Trade Corporations.

KENJI KOJIMA

40

Furthermore, proportion of stock issues for Japanese firms have risen
and is higher than those in Germany and the U.S. These figures areaverage ones and some firms, particularly, large firms with superiormarket access have obtained a substantially larger fraction of theirfunding in recent years from bonds and stock issues as shown in Table 12.
Consequently, these large firms have recently become much less dependent
on bank loans than their smaller counterparts. In contrast, small andmedium size firms rely heavily on bank loans for source of funds.

Table 12External Sources of Funds by Size of Firm in Japan(Percentage)
Loans

1975 1980 1985 1990

Large Firms 73.6 69.8 21.4 67.2

Small and Mediurn Firms 91.2 89.2 97,1 94.2

Bonds

LargeandFirms
16.3
6.3O.1
38.6
13.1
Small
MediumFirms
O.1
O.2 O.3
Stock Issues
Large Firms 10.1 23.9 40.0 19.7

Small and Medium Firms 8.8 IO.8 2.7 5.5
Source: Eeonomic Planning Agency, Kei2ai Hahusho, 1992 (Economic Survey ofJapan, 1992).

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

Note: Size of firms is based on their stocks. Large firms have more than 1 billon yen
value of stocks.

Historical dependence on bank loan for external funding in Japanesefirms has been due to regulatory constrains. During the period of 1970s,

government restrictions on corporate borrowing and equity offerings
abroad were severe. Japanese firms were restricted to domestic funding
sources with limited exceptions. At the same time, the banks tightly
controlled access to the corporate bond market and imposed cumbersome
and relatively expensive insurance procedures. The commercial paper
market did not exist until 1987, and equity issues were not generally
attractive for a variety of reasons. As the government relaxed restrictions

during the 1980s on offshore funding, bond floatation, commercial paper

issuance, and so forth, Japanese firms progressively shifted towards

market funding sourees as shown in Table 13 and 14. Substantial
amount of funds is financed through convertible bonds and warrant
bonds both in domestic and offshore markets through 1985 to 1993.

AN INTERNATIONAL PERSPECTIVE
ON
JAPANESECORPORATE FINANCE

41

Table 13
DirectFinancing of Public Firms inJapan

Five-Year Average(Billion yen)

1960-64 1965-69

1970-74

1975-79

1980-84

1985-89

1990-93

2,342
3,743

1,623
4,463

1,227
6,173

2,le6
18,376

1,356
5,843

1,304
3,598

884

427

171

287

6,152

4,275

3,478

10,721

10
55

155

240
1,M8

455

754

988

5,785

11,775

1,227
23,3605,923

Stock Issues

No. of Cases 3,e14 1,366

Amounts 2,673 1,352

Straight Bonds

Domestic

No. of Cases 1,689 2,172

Amounts' 953 2187
Overseas
No. of Cases 8 8Amounts 17 109

Convertible Bonds

Domestic

No. of Cases 3 3Amounts 1 15

237

153

272

1,106

1,246

2,951

317

Overseas

No. of Cases 15 9Amounts 61 52

9

230

575

529

156

46

1,456

4,364

5,311

1,761

n.a.
n.a.

n.a.
n.a.

16

87

26
544

1,307

n.a.
n.a,

n.a.
n.a.

81

983

704

678

18,934

10,377

1,541

1,037
7,397

715

4,704

7,763

1,424
27,382

17,950

19
101

385

896

2,444

6,890

1,967
30,0301,614
23,913

3,902
8,548

3,045
14,303

2,838
20,826

5,497
75,7883,609
47,705Warrants Bonds
Domestic

No. of Cases n.a. n.a.

Amounts n.a. n.a.

35

Overseas

No. of Cases n.a. n.a.

Amounts n.a. n.a.

Sub-Total of Bonds

Domestic

No. of Casesp} 1692 2175

Amounts 954 2,202
Overseas
No. of Cases 23 17

Amounts 78 160

639

Grand Total

No. of Cases 4,729 3,558

Amounts 3,704 3,715

Sources: Tokyo Stock Exchange,

Annual Securities Statistics

3.

Structural, 1993.

Shifts

3.1 Financial Emancipation

Table 10 indicates t'hat liquidity in the form of cash andmarketable securities for Japanese firms has bee increasing.
Furthermore, Japanese firms have almost 4 times more cash andequivalents than U.S. firms. Historically, a substantial portion of cash

42

KENJI KOJIMA

positions at Japanese firms represented compensation balances oncommereial Ioans. However, the use of compensation balances has
decreased during the 1980s as Japanese lenders have moved towardmarket-rate loans and fee-based services. Much of this liquidity
increase occurred during the second half of the 1980s in parallel withexpansion of money supply, lower interest rates, rising real estates
prices in Japan.
Paralleling the liberalization of Japanese corporate finance has

been'a dramatic buildup of financial slack on Japanese corporate
balance sheets. During the high-growth period, Japanese firms wereconfronted with a volume of attractive investment opportunities that
vastly exceeded their cash flow and the amount of funds most firms
could reasonably expect to raise externally. Throughout this period,
Japanese firms raised the cash necessary to fund the approved projects
securing a sufficient volume of external finance. Minimizing capitalcosts was a distant secondary concern to most of them. For allpractical purposes, there are only two major sources of external funds:
collateralized loans and trade credit. These, in turn, were supplied byessentially the same institutions-banks and major suppliers-stakeholderthat were also major shareholders in their firms. These stakeholder
monitored client firms closely, even to the point of oceasionallyinjecting new management to ensure an efficient deployment of scare

funds. Thus high growth, the rigors of competition at home andabroad, the heavy use of debt and trade credit, and the ownership ofthese claims by institutional shareholders that monitored performanceclosely were sufficient to ensure the deployment of cash in a patternconsistent with the priorities of the suppliers of capital.

Although double-digit real growth in Japan had begun to wane
even prior to 1973, the oil shock produced a sudden and dramatic
reduction in Japanese economic growth. The joint effect of investment
reduction and cost improvement was to lessen gradually the external

capital needs of the firms. Large Japanese firms were using theirenormous cash flow during this period to repay debt and build up
liquid assets on the balance sheet rather than to increase dividends forshareholders. As a consequence, Japanese firms have aceumulated
considerable financial slack in the form of unused debt capacity andtemporary investments in marketable securities. The net debt-equity
ratio of Japanese large firms has declined more or less steadily sinceAN INTERNATIONAL PERSPECTIVE ON JAPANESE 43
CORPORATE FINANCE

1980. The buildup of financial slack on balance sheets, the persistenceof excess cash flow throughout the 1980s, and gradual financial
deregulation have led to a kind of financial emancipation of Japanese
non-financial firms from their traditional lenders.

Close and stable relationships between non-financial firms andbanks have been essential elements of Japanese corporate finance. As
such, they have contributed significantly to the mitigation of takeover
activity in Japanese capital market. Today, however, this stability is
being shaken by two major changes in the world of finance: the buildup

of financial slacks on balance sheets in Japanese firms and theglobalization and deregulation of the Japanese financial system. The
former change is altering the nature of business that banks executewith their major industrial clients and generally weakening bankcontrol over these firms. Concurrently, the latter change is causingbanks and other institutional owners of equity to demand greater
returns on their holdings of client-firm stock. Together these trends are
evoking a creeping instability in close financial relationships (Kester
1991).

Japanese firms, particularly large firms have been in abundanceof Iiquidity found on most of their balance sheets in recent years. It is

no more coincidence that this period of abundance has also beenaccompanied by weakening firm-bank relationships. The increased
availability of internally generated cash to fund projects has reduced

the need to raise funds externally, thus diminishing the financial
dependence of non-financial firms on bank. In addition, the growth andgradual deregulation of capital markets at home and the opening of
capital markets abroad have distanced Japanese non-financial firms
still further from banks. There is a hidden cost to the financial
emancipation of past success, however. In the absence of the discipline

exerted by capital market, Japanese managers now find themselveswith far greater discretion in the allocation of corporate resources
than ever before. Since firms are unwilling to breach long-standing

implicit contracts with key stakeholder, especially long-term
employment relationships, and unable to execute past strategies ofsimply growing themselves out of their current situations, they hold the

direction to sustain marginal businesses and retain unrelated
diversification. Thus, the free cash flow of these corporations may bereallocated from shareholders to other stakeholder, primarily44 KENJI KOJIMA
employees. Despite the low priority traditionally accorded toshareholders in Japan, it is unlikely this trend can continue for long.

One byproduct of the increasingly global market in which Japanesefinancial institutions must compete, and of their weakening relationshipwith industrial clients, has been a growing concern for obtaining higher
direct returns on their equity investments.

Japanese firms moved quickly to raise capital outside Japan assoon as Japan's Foreign Exchange Control Law was relaxed in 1980.
Total funds raised by Japanese firms in overseas markets leaped froman average of about 2 trillion yen per year in the period of 1975
through 1979 to 30 trillion yen per year in that of 1985 through 1989
(see Table 13). Most of the funds raised outside of Japan were used to

repay domestic borrowing. Thus by the late 1980s, Japanese firms had
already dramatically restructured their liabilities, substituting cheaper
foreign capital for local financing. '2 .

Although borrowing continued shrink as a significant proportionof total funds raised, bank loans have continued to dominate security
financing in domestic markets. Moreover, lending practices began tochange in the wake of overseas financing by Japanese firms and thecontinued relaxation of domestic financial market regulation. Continued
growth in the certificate deposits market and the introduction of large-

denomination money market certificated in 1985 contributed to greater
variability in banks' cost of funds. The introduction of a commercial
paper market in 1987 provided another viable alternative for large firms
in search of short-term funds and further reduced the dependence ofcorporation on banks. For all practical purposes, lending to large firms
has ceased to be growth business for Japan's major banks.
Over the past two decades, capital market liberalization in Japan
has made available financial instruments not previously available to

12 Financial regulations in Japan skewed finance into banks, by suppressing a bondmarket through collateralization and insurance standards, holding down depositinterest rates so that banks could lend at low rate and still profit, and suppressing

competing financial sources such as equity issuance, thereby channeling saving
into bank. Today, when firms place debt securities, they usually need banks as
their bond trustees.

Post-war Japan had two offsetting regulatory sets. One set segmented finance,
but not as severely as in the U.S.; bank could be large and active, but could nothave securities, insurance or very large blockholding activities. But another set

channelled finance through banks: depositors had few options other than banks,
and large corporate borrowers had few non-bank financing sources.

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 45
CORPORATE FINANCE
corporate borrowers. Firms are now free to raise investment funds
through a variety of equity, bond, and hybrid instruments, and in both
domestic and overseas markets. Many large Japanese firms have taken
advantage of these opportunities, and the results has been a substantial

decline in the proportion of external corporate capital coming fromtraditional sources such as long-term debt. With the decreasing
proportion of total capital allocation channeled throuth the traditional

prime rate system, the Ministry of Finance and the Bank of Japan are
no longer able to exercise the same degree of control over financial
markets that they once could. It is also true that, with the new relianceon securities-based finance, major securities firms are now more
important in financial markets than in the past. Furthermore, even as
banks and other financial institutions account for an increasing shareof securities-based capital, the ability of highly profitable non-financial

firms to fund their investments through retained earnings has reduced
their overall external capital dependency and shifted the balance of
bargaining power with financial institutions in their direction.

Whereas most non-financial firms indicated that their corporate
plans and investments were closely examined by banks during the 1950-

80 period, none reported being subjected to such scrutiny today.
Although rneeting with banks are still held semiannually or at least
annually to discuss performance, these have apparently evolved intolargely perfunctory presentations of past performance rather thansubstantive discussions of future capital investment. Banks are now
more interested in tracking the overall return earned on their total
investment in client firms rather than monitoring and influencing
managerial decision making. The exchange of information historically
fostered by placing retiring bank officers in senior management
positions at client firms also appears to be waning. Major banks havebegun to experience difficulties in placing retiring employees in second
careers.

As constraints on corporate finance relax and capital andfinancial markets deregulate in Japan, competition among banks has
further weakened traditional firm-bank relationships. The securitizationof Japanese corporate finance had made financing increasingly pricesensitive transactions in which past relationships count for little. A
firm's main bank may win a mandate to lead-manage a deal, but only
if it offers a better idea or a competitive quote. Nonetheless, although

KENJI KOJIMA

46

Japanese non-financial corporations may be distancing themselves frombanks, Japanese banks and other financial institutions still own
considerable fractions of these firms' outstanding shares. However
diminished the need by industrial corporations for a close banking
relationship, Japanese banks will maintain that strong relationships
with their industrial clients which are still central to the success of
their institutions. Even though large industrial firms no longer rely
heavily on intermediated credit to meet financing needs, financial
institutions still look to these firms for access to affiliated middlemarket firms of commercial lending, access to employees for retailbanking and insurance underwriting, and as customers for new
products and service offered on a fee basis (Kester 1991).
3.2 Financial Liberalization and Debt lssuing

It is clear that the ongoing financial liberalization in Japan has

been important effects on corporate financing practices. In somerespects, financial liberalization has been taking place since the 1960s;

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

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

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

markets. However, some regulations and practices which cause
distortions and result in unusual financing patterns still remain. The
elimination of one restrictive regulation results in a "regulatory
arbitrage" opportunity with market participants using their increased
freedom to profitably exploit another, still-existing regulation. This
continues until the consequent pressure on the second restriction forces
its elimination or modification. Consequently, the liberalization process

tends to produce windows of opportunity permitting firms to earn
additional profits by exploiting regulatory differences (Hodder andTschoegl, 1992).

AN INTERNATIONAL PERSPECTIVE
ON
JAPANESECORPORATE FINANCE

47

Table 14
DirectFinancing of Public Firms inJapan

Five-Year Average(Percentage)
1960-64

1965-69 1970-74 1975-79

1980-84

1985-89

1990-93

Stock Issues

No. of Cases

Amounts

63.7
72.2

38.4
36.4

60.0
43.8

53.3
31.2

43.2
29.6

38.3
24.3

37.6

35.7
25.7

61.0
58.9

33.4
42.1

29.0
43.0

15.0
22.7

3,1

4.6

7.9
22.5

O.2
O.4

O.2
2.9

O.3
O.7

5.1
6.9

8,4
8.9

'7.6

20.9
24.7

O.1
O.1

O.1

O.4

6.1
12.9

5.0
8.7

9.6
14.2

22.3
30.8

8.8
12.4

O.2
O.5

7.6
10.2

20.3
21.0

9.6
7.0

4.3
3.7

n.a.

n.a.
n.a.

O.6
O.4

O.5
O.7

1.0
2.7

2.9
3.2

17.9
25.0

19.5
21.8

12.2

Straight Bonds

Domestic
No. of Cases

Amounts
Overseas

No. of Cases

Amounts

8.3

Convertible Bonds

Domestic
No. of Cases

Amounts

Overseas

No. of Cases

Amounts

O.3
1.6

O.3

n.a.
n.a.

n.a.
n.a.

1.4

Warrants Bonds
Dornestic

No. of Cases

Amounts
Overseas

No. of Cases

Amountsna.

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

Sources: Tokyo Stock Exchange, Annual Securities Statistics,

1993.

There have been several dramatic shifts in funding patterns which
can be traced to regulatory changes. It is also important to understandthat the government's own financing needs have been an important
influence on market regulations as well as the general character of thedomestic bond market. Indeed, that market has been dominated bygovernment issues since the mid--1970s with corporate issues
representing a relatively small fraction of the total market. For
example, during the 1985-1989 period, straight corporate debt issues
accounted for just 3%o of total bond issues in Japan. Table 14 indicates

additional data on domestic bond issues by Japanese firms during 1960-

1993. In recent years, other Japanese firms have essentially forsaken
the domestic straight debt market in favor of other funding sources,
including offshore bond issues. This striking aversion to domestic issues
has produced enormous pressure for regulatory and procedural changes.
To a large extent, the underlying problems for domestic corporate

48 KENJI KOJIMA
bond issues have related with who determines issue terms andcollateral requirements. It was only after 1979 that Japanese firms
were allowed to issue unsecured bonds for the first time since the1930s. Initially, only two firms were eligible to make unsecured issues.
This situation continued until 1983, when the restrictions on convertible

bonds were further relaxed so that some 30 firms become eligible toissue such bonds without collateral. Subsequently, restrictions for bothconvertibles and straight bonds were relaxed in stage until several
hundred firms were eligible for unsecured issues as of 1988. The official
logic for a collateral requirement has been the protection of investors.

However, this restriction has also made bond issuance in Japan
relatively unattractive. Not only did corporate issuers have to pay
management fees and underwriting commissions, but they also had tocompensate a trustee for a variety of services which substantially
increased issue costs. Firms also has to obtain approval on the terms
and timing of issues from a committee dominated by a group of largebanks. This procedure is cumbersome and lacks flexibility regarding
issue terms. This bond issuing procedure endowed the Japanese bankswith considerable control over industrial firms' access to debt markets.

Under the main bank lending system, such control was important for
dealing with highly levered clients. In recent years, financially healthyfirms have naturally tended to view this process as an expensive
nuisance. Consequently, offshore issues have been attractive as a way
around cumbersome and expensive procedures in the domestic market.
Table 13 illustrates the rapid growth in offshore bond issues byJapanese firms over the last decade. It was not until the early 1980s
that Japanese firms were no longer required to get a permission of

Ministry of Finance to participate in the offshore market. Total
corporate issues during the 1985-1993 period were greater in theoffshore market than domestically. In the domestic market, convertible
bonds have dominated' straight issues since 1985. There seem to be
several reasons for this. First, collateral requirements have beenrelaxed more rapidly on convertible resulting in lower effective issue
costs for more firms. Second, issuing terms on straight corporate debt

have been tied to government bond yields in ways which made many
corporate issues relatively unattractive for initial purchasers. In contrast,

terms on convertibles were more easily adjusted to make themattractive for purchasers. Third, the lower coupon rate on a convertible

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 49
CORPORATE FINANCE
coupled with the generally low dividend yield on shares after conversion

implies a lower cash flow drain relative to issuing straight debt.
Fourth, historically, a firm could not issue bonds in excess of its paidin capital plus reserves. The revision of the Commercial Code in 1990
roughly doubled the limit; but even this relaxed constraint can be binding

for a rapidly growing firm needing external funds. A convertible issue

provided immediate funding but, as it was converted into shares,enhanced a firm's ability to issue additional bonds in the future.

Overall, the main concern for corporate bond issues during thelast decade has been the shift to issuing overseas. This is clearly due toreduced regulatory constraints on access to offshore markets where
there is greater flexibility and lower costs. The rise of the offshore

primary market has, however, seriously undermined the domestic
primary market. Consequently, efforts are currently underway toreform domestic bond issuance procedures and make them morecompetitive with offshore markets. This will presumably require more
flexibility with regard to pricing and issue terms as well as largely
eliminating the additional costs imposed by the commissioned banksystem (Hodder and Tschoegl, 1992).

Diamond (1984) shows that direct financing from individual
investors is inefficient either because monitoring costs are needlessly
duplicated among individual lenders; or monitoring is a public goodwhich no one has an incentive to provide. Diamond (1991) builds on theidea that banks are the most efficient corporate monitor. His model
predicts that young firms, and older ones that have done poorly,
should borrow from banks, while older, more successful firms should
issue public debt. The reason is that older, successful firms have more
"reputational capital" at stake; bank monitoring is unnecessary because
they have more to lose from being inefficient. By contrast, younger firms

have not yet developed a reputation, and older, less successful firms
have no reputation to lose. These firms need to be monitored.

Hoshi, Kashyap, and Scharfstein (1993) build on the idea thatmanagers and shareholders may not completely agree about whatkinds of investments should be taken. If managers place a lot of weighton shareholder concerns, then they show that firms with more
attractive investment opportunities will be more prone to use public
debt to finance investment. The idea is that the managers of firms withvery attractive investment opportunities will find it very costly to

50

KENJI KOJIMA

forego these oportunities in order to take a pet project. As a result,they do not need to be monitored to ensure efficient project selection.
The model therefore predicts that when managers are closely following
shareholders' wishes, firms with high Tobin's Q will issue public debt,

while those with low Tobin's Q will issue bank debt. The model also
implies that firms with high net worth-those with valuable assets inplace or low leverage-will use the public debt markets. Because theyrisk this net worth when they invest, the managers of these firms havea greater incentive to invest efficiently. Thus, the model predicts thatfirms with good performance, valuable investment opportunities, or
valuable assets are more prone to use public debt, while other firms
will rely more heavily on bank financing. They find that high net worth
firms are more prone to use public debt financing. In addition, firms inkeiretsu have responded to deregulation in different ways: the more
successful firms have accessed the public debt markets, while the lesssuccessful firms continue to rely more heavily on bank loans financing.
As firms reduce their dependence on bank financing, they might lose
some of the benefits of relationship-based borrowing. They may have aless ready source of financing, and creditors may be less willing to help

during the time of financial difficulty. Interestingly, the financing
pattern of large Japanese firms are beginning to resemble the morearms-length financing patterns observed in the U.S.
The securitization and globalization of Japanese corporate financedramatically changed the business of major banks in Japan. Withlending non-financial firms waning, they have aggressively sought tooffer product-oriented, fee-based banking services such as currency andinterest swaps, leveraged lease arrangement, and M & A advisory
work. The rapid growth and low profitability of Japanese banks has
led to concern about their capital adequacy. Foreign banks have sought
protection from the onslaught of Japanese competition by calling forJapanese banks to operate with capital ratios comparable to thoserequired in the United States and Europe. Japanese banks are watching
their financial performance carefully. In contrast to the low-margin,
volume-oriented banking practices, Japanese banks are now restraining
growth and carefully tracking the profitability of their relationships
with industrial clients. Increasingly, clients are being ranked by banks
according to the profitability of the relationship with them. Just as
industrial clients are now short listing the banks with which they doAN INTERNATIONAL PERSPECTIVE ON JAPANESE 51
CORPORATE FINANCE

business, banks are now beginning to identify and terminate
relationships with clients that do not provide them with sufficiently
attractive rates of return. The shifting patterns of Japanese corporate

finance, and the competitive and regulatory pressures on Japanesefinancial institutions to increase their return on assets, are collectively

resulting in a gradual unbundling of claims held against industrial
corpoations. Rather than being key shareholders, lead lenders, andprimary vendors of financial servises in long-term relationships withclients, Japanese banks are now being reduced to the position ofminority shareholders that must compete fiercely for a client's businesson a transaction-by-transaction basis.

Table 15

Profit Performances of Commercial Banks in Germany, Japan, and the United States

Five-Year Average(Percentage)

Germany Japan U.S.A.

Gross Profit Margin 1980-84 2.24 1.75 1.99
1985-89 2.21 1.35 3.47
1990-92 2.06 1.18 3.27
Per-tax Return on Assets 1980-84 O.54 O.53 O.90

1985-89 O.70 O.58 O.78
1990-92 O.54 O.33 O.93

Equity to Assets 1980-84 5.89 3.69 6.19

1985-89 6.84 3.64 6.50
1990-92 8.56 4.15 6.75
Return on Equity 1980-84 14.06 14.43 15.34
1985-89 12.11 16.41 11.13
1990-92 8.87 7.96 12.52

Source: The Bank of Japan, Cornparative Econorrtic and Financial Statistics: Japanand Other Coantries, 1986, 1990, 1992, 1994.

Source Note: Deutsche Bundesbank, Monthly Report of the Deutsche Bundesbanh,Bank of Japan, Economic Statistics Annual, Board of Governors of the Federal
Reserve System, FTederal Reserve Bulletin.

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

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

KENJI KOJIMA52

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

Return on investments of Japanese firms are considerably lower
than those of the U.S. firms. Based on the results of empirical studies,it can be concluded that there appears to have been a real difference inthe profitability of firm in both countries. A lower acceptable return on

investment allows Japanese managers undertake investments that U.S.
firms would find unacceptable. The capital structure policies and returnobjectives of Japanese firms usually enhance their long-term corporate

growth by allowing the savings from lower capital costs and return
standards to be reinvested in cost reduction, capacity expansion, andproduct development.
U.S. firms rely heavily on cost-of-capital calculations to guideinvestment decisions, and those firms that do not earn a sufficient
return on capital to satisfy the investors will fail. But for Japanesefirms, investment decisions are not made on a discounted cash flow
basis. Japanese managers usually view the cost of equity as the firm's
expense to service this source of capital, that is, dividends. With thisview of cost-of-capital, it is easy to see why the market price of theirstock has Iittle impact on investment decisions of Japanese firms.

Rather, barring market-imposed capital constraints, Japanesemanagers' investment decisions are guided by what they believe thecost of capital by what is quite different from prevalent financial

theories in the U.S. 'The U.S. investors are less supportive of investment overall
because of its sensitivity to current returns for many established firms'

goals that stress current stock price over long-term corporate value.
The U.S. investors favor those forms of investment for which returns
are most readily measurable, reflecting the importance of financial

returns and the valuation methods used by investors and managers.
This explains why the U.S. firms tend to underinvest in intangible
assets, where returns are more difficult to measure. On the other hand,
Japanese firms can make continued investment to upgrade capabilities
and increase productivity in existing businesses, and enter into new
businesses. These systems create their own tendency to overinvest in

capacity, to proliferate products, and to maintain unprofitablebusinesses in the name of corporate Iong-term growth. They also
exhibit a slow tendency to redeploy capital out of sluggish businesses.

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 53
CORPORATE FINANCE

In the structural explanation for lower return standard ofJapanese firms, managers and the stock market in Japan are seen as
facing an abundance of promising investment opportunities and acting
according by funding them. One reason for the relatively low rate of
return has been that Japanese investors enjoy lower costs of capital,
making even less promising investment opportunities viable. Lower
returns can be accepted because they are still sufficient to coveroriginal capital costs. Since the commonly cited studies employ various
definitions of the costs of capital and alternative estimation procedures,

it is not possible to compare them perfectly. There is no convincing
evidence that cost of capital in the U.S. is significantly higher thanthose in other countries, particularly in Japan during the period 1970
through 1989. As a consequence, consideration on various factors
including real rate, risk premium, and leverage can not support thenotion that costs of capital systematically and persistently differ
between Japan and the U.S.

The extent of risk in leveraged Japanese firms is overstatedbecauce Japanese banks are well positioned to monitor and control
their corporate clients as a result of the close and long-term financial

relationships that have evolved over time. Even though firms that areable to finance their investment plans through internal capital may bebetter off in the short run doing so, it can still be sensible over thelong run to bulid reliable relationships with particular financial
institutions for those occasions when internal cash flow is no longer
sufficient. Some aspects of the relationship between Japanese banks

and its clients have the potential to lower borrowing costs. Most
Japanese non-financial firms maintain main-bank relationships. The
main bank has extensive, reliable information about the firms and has
the capacity to become actively involved if problems arise. In addition
to their main-bank relationships, Japanese firms tend to maintain ongoing business relationship with other commercial stakeholder such as
major customers, suppliers, and so forth. They hold shares of business
partners each other and can be viewed as patient investors who supply
cheap capital. Cross-shareholdings, interlocking directors and intragrouptrade relationships which strengthen the relationships facilitate the firmin the group to access and exchange information about theperformances of firms. These consideration suggest that Japanesemanagers will be less inclined to undertake myopic behaviors designed

54

KENJI KOJIMA

to enhance current performance. Since Japanese investors are moreaware of the long-term implications of current manager's actions,Japanese managers will find it more difficult to take advantage of
information over market investors by inflating current earnings.
Investors in Japan are in a better position to distinguish between
earnings increases coming at the expense of future profits from thosetruly depicting increased future profits. Therefore, Japanese managers

will be more reluctant to take myopic behavior than their U.S.
counterparts.
A frequently mentioned characteristic of Japanese firms is a highdegree of financial leverage. The debt-equity ratios for Japanese firms

are higher that those for the U.S. Japanese firms have relied
substantially more on debt than either U.S. or German counterparts,
especially during the rapid growth period of the Japanese economy.
External funding of Japanese firms also comes more from short-term

credit, primarily from banks, than does German and U.S. firms.
However, financial leverage has changed dramatically for firms in boththe U.S. and Japan over the 1980s. In the U.S. there has been a notabledecline in shareholders' equity as a percentage of total assets largely
due to debt-equity substitution through leveraged buy-outs, mergers
and share repurchases. In contrast, the equity-asset ratio for Japanesefirms has grown substantially in the late 1980s, the leverage has

decreased. As Japan has moved into a period of slower growth,reliance on external funding sources, particularly bank loans has
declined relative to internal funding. Although loans continued to funda very large fraction of assets growth after the mid-1970s, the dramatic

slowing of that growth meant a weakened demand for bank loans. This
trend toward lessened dependence on the banking loans gained further
momentum during the 1985-1989 period as market-based funding began
to play a larger role in Japanese corporate finance.
Paralleling the liberalization of Japanese corporate finance has

been a dramatic buildup of financial slack on Japanese corporate
balance sheets. Although double-digit real growth in Japan had begun

to wane even prior to 1973, the oil shock produced a sudden anddramatic reduction in Japanese economic growth. The joint effect ofinvestment reduction and cost improvement was to lessen gradually theexternal capital needs of the firms. Large Japanese firms were using
their enormous cash flow during this period to repay debt and build up

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 55
CORPORATE FINANCE

liquid assets on the balance sheet rather than to increase dividends forshareholders. As a consequence, Japanese firms have accumulated
considerable financial slack in the form of unused debt capacity andtemporary investments in marketable securities. The net debt-equity
ratio of Japanese large firms has declined more or less steadily since1980. The buildup of financial slack on balance sheets, the persistenceof excess cash flow throughout the 1980s, and gradual financial
deregulation have led to a kind of financial emancipation of Japanese
non-financial firms from their traditional lenders. Close and stable
relationships between non-financial firms and banks have been essential
elements of Japanese corporate finance. As such, they have contributed
significantly to the mitigation of takeover activity in Japanese capital
market. Today, however, this stability is being shaken by two majorchanges in the world of finance: the buildup of financial slacks onbalance sheets in Japanese firms and the globalization and deregulationof the Japanese financial system. The former change is altering thenature of business that banks execute with their major industrial
clients and generally weakening bank control over these firms.
Concurrently, the latter change is causing banks and other institutional

owners of equity to demand greater returns on their holdings of clientfirm stock. Together these trends are evoking a creeping instability inclose financial relationships.

Japanese firms, particularly large firms have been in abundanceof liquidity found on most of their balance sheets in recent years. It is

no mere coincidence that this period of abundance has also beenaccompanied by weakening firm-bank relationships. The increased
availability of internally generated cash to fund projects has reduced

the need to raise funds externally, thus diminishing the financial
dependence of non-financial firms on banks. In addition, the growthand gradual deregulation of capital markets at home and the openingof capital markets abtoad have distanced Japanese non-financial firms
still further from banks. There is a hidden cost to the financial
emancipation of past success, however. In the absence of the discipline

exerted by capital market, Japanese managers now finds themselveswith far greater discretion in the allocation of corporate resources
than ever before. Since firms are unwilling to breach long-standing

implicit contracts with key stakeholder, especially long-term
employment relationships, and unable to execute past strategies of

KENJI KOJIMA

56

simply growing themselves out of their current situations, they hold the

direction to sustain marginal businesses and retain unrelated
diversification. Thus, the free cash flow of these corporations may bereallocated from shareholders to other stakeholder, primarily
employees. Despite the low priority traditionally accorded to shareholders in Japan, it is unlikely this trend can continue for long. One

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

Traditionally, much of corporate finance in Japan have evolved
around the main bank relationship. This is changing for many firms.
Indeed, financial liberalization has created serious difficulties for themain bank system. Nevertheless, that system seems likely to adapt andcontinue to provide valuable supports for growing firms. Exactly how
this will come about is not yet clear; however, there are substantial
incentives for preserving the system's advantages. More generally, theeffects of financial liberalization over roughly the last decades havebeen enormous. The process of change will continue, both because ofcontinuing liberalization and because some financial patterns change
sluggishly. Increasing financial sophistication and capability to exploit
opportunities arising from regulatory changes will also continue toalter corporate finance. It is reasonable to expect that the role ofoffshore financing will not decline.

There is some evidence that the financial systems are converging;that Japanese system is moving toward the U.S. Japanese banks may
be forced to liquidate some of their equity holdings to maintainadequate cash balance. Yet these changes are modest if Japanese
investors are forced to sell their nonpermanent shares that are actively

traded and have little influence on corporate behavior. Although
securitization of debt and retained earnings in Japan unde,rmine bankinfluence as a creditor, it has not yet undermined the equity-based
influence.

AN INTERNATIONAL PERSPECTIVE ON JAPANESE 57
CORPORATE FINANCE

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lndastry in the United States and Japan, Cambridge University Press, 21-50.
Ando, A. and A.J.Auerbach (19gg), "The Cost of Capital in the United States andJapan: A Comparison," Journal of the Japanese and International Econornies,
2 134-158.
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Ando, A. and A.J.Auerbach (1990), "The Cost of Capital in Japan: Evidence andFurther Results," Joural of the Japanese and International Econornies, 4, 323350.

Bank of Japan, Comparative Econornic and Financial Statistics: Japan and OtherCountries, 1974, 1978, 1986, 1993, 1994.

Bebchuk.L.A. and L.A.Stole (1993), "Do Short-Term Objectives Leads to Under-or
Overinvestment in Long-Term Projects?" Journal of Finance, 48, 719-730.

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MyopicMEASURING NATURAL RESOURCE RENTS AND THEIR
MACROECONOMIC SIGNIFICANCE FOR DEVELOPING
COUNTRIES, WITH REFERENCE TO LATIN
AMERICAN SUGAR PRODUCERS

Robert K. MCCLEERyi

1. Introduction

This paper attempts to provide a description and analyticalframework for the estimation of natural resource rents in an economy,

and some evidence of the impact of rents on the macroeconomy ofrent-dependent economies. Some countries have been successful inchanneling rents from abundant natural resources into investment forindustrialization and economic growth, while other countries havefailed. A look at the small, sugar dependent economies of the
Caribbean could prove instructive into the development processes andproblems of resource rich countries in general.

From their initial formulation and usage in seminal works by
Ricardo, Shumpater, and others, modern neoclassical economics haslargely defined rents out of existence. In neoclassical formulations, if

entry is possible, new firms enter the market, bidding away scarce(and mobile) resources, which pushes the supply curve out (lowering
price and marginal revenue) and raising marginal costs. The processproceeds (in the absence of risk) until all profits are dissipated, notjust for the final entrant, but with mobile factors and markets thatclear, for the industry as a whole. Thus empirically observed profits
are inherently transitory, unless some clear market failure is identified,

and thus not a suitable topic for analysis. .
Yet profits do persist, and there are theoretical and empiricalreasons for believing that they affect a country's political economy in
1 Associate Professor, Research Institute for Economics and Business, Kobe
University. Many of the concepts and rnethods of analysis ernployed here arederived from earlier joint work with Professor Clark Reynolds of Stanford
University, to whom I acknowledge a tremendous intellectual debt.

ROBERT K. MCCLEERY

62

a manner distinct from factor payments. Reasons for the persistenceof profits range from the obvious (the use of market power when aresource is largely controlled by a few owners, such as OPEC and the

diamond cartel) to the subtle (limits on land suitable for the
production of certain crops, whether they are real or created byadvertising-induced preferences, such as the demand for Colombian
coffee). Lags between investment and output, such as in citrus andother tree crops, can also lead to rents that persist for some time.

Risk aversion, imperfect capital markets, and other market
imperfections can also lead to the persistence of rents that could
otherwise be diluted by entry. Finally, industries characterized byeconomies of scale or large amounts of "knowledge capital" may earn
profits for as long as the technologies can be kept proprietary or entry
can be forestalled.

The reasons to believe that rents and profits may have economic
impacts distinct from factor payments relate both to the distribution ofrents (normally closely held by a few individuals or the government)
and the observed difference in consumption patterns out of "normal"
and "windfall" income. In certain rare situations, rents are not closely

held by individuals or governments; for instance, considerable rents
accrued to small landholders in Malaysia and Indonesia from palm oiland rubber in the 1970s. These rents may have quite a different impact

on the macroeconomy than did oil rents accruing to governments

during the same period. While rents may boost growth rates,
especially in the short run, a two-part problem emerges in the medium
run, particularly where rents are captured by governments.
Whereas an individual will treat rents as windfall profits, saving alarge percentage either to expand production in the same sector, or
expanding production in other sectors through financial intermediation,

governments tend to expand spending across the board. Furthermore,to the extent that lenders perceive the rents to be permanent (or facea surplus to recycle), available credit will increase. Borrowing heavily

at a time of high rents exacerbates the problems associated with the"Dutch disease," and also inflation, if the limits to domestic absorption
are reached. This leads to a relative if not absolute contraction in the

traded goods sector, and thus the inability to service the growing debt

in the future. Furthermore, if the inerease in rents was indeed
transitory (or is dissipated through rent-seeking or other behavior),

MEASURING NATURAL RESOURCE RENTS AND THEIR 63

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
then the country will be faced simultaneously with a crisis in thebalance of payments and in the fiscal balance. Lastly, rents may spillover into wages, not just in the sector generating the rents, but
throughout the economy, due to linkages between sectors.
Recently a great deal of attention has been focused on rents, inthe form of the burgeoning literature on rent-seeking behavior (alsoknown as directly unproductive profit-seeking behavior, or DUP).2 Yet
this literature and much of the development literature treat rents as abad, with prominent researchers writing about the "Curse of natural
resources," tracing the contrast in development performance between

Asia and Latin America and Africa in the 1980s to the presence orabsence of natural resources.3 Instead, the approach taken here is toacknowledge that natural resource rents increase the "degrees of
freedom" or the "political-economic policy space" of a country, andthat additional "freedom" or "space" can be used either for good orill.

One reason for a negative view toward rents is the so-called"Dutch Disease." The Dutch Disease literature stemmed from theobservation that large resource discoveries set in motion a process ofdeindustrialization in the affected economy. Simply put, the economy isendowed with additional wealth, which translates into an increased
demand for goods and services. A country operating on the frontier of
its production possibilities curve cannot increase its production of all

types of goods in response to demand pressures, so imports grow toservice tradeable good demand, and resources are shifted from theproduction of tradeables to non-tradeable goods and services. In the
short run labor and prices adjust to equilibrate markets, but in thelonger run investment and attendant technological progress areconcentrated in the non-tradeable sector, while the tradeables sector,
including manufacturing, stagnates. In addition to the difference inrates of return to capital that provokes this investment pattern,domestic rates of return may be high by international standard,
inducing capital inflows. These inflows, however, will usually go to
inward-oriented activities which produce for the home market andrepatriate profits abroad.

2 Krueger 1974, Bhagwati 1982, etc. .

3 See Ranis 1987 and 1992, and Urrutia and Yukawa 19gg for the empirical side andMatsuyama 1991 for a theoretical approach.

64

ROBERT K. MCCLEERY

Development policies do have some scope for affecting a resourcerich country's long term equilibrium growth path even in this restrictive

setting. If the country runs a current account surplus over the
adjustment period, reflecting the transitory nature of non-renewable
resource rents, the long term capital stock position and growth path
are higher. But if the country borrows against future rents to prop up
a sagging social pact, using consumption subsidies and supporting an
unrealistic exchange rate, the long term growth rate may actually belower that what would have occurred in the absence of the discovery.
A natural resource discovery in an advanced, industrial country

clearly reduces the size and competitiveness of the country's
manufacturing sector. How serious this effect is depends both on
government policies of taxation and redistribution and on the behaviorof firms and households toward the increase in income. If the increaseis viewed as transitory, we would expect a high proportion of it to be
saved, while if the government convinces itself and its people that a new
age has dawned, the rise might be treated as permanent and eonsumed
like ordinary income.

The above analysis holds for developed countries, but what ofdeveloping countries, where capacity constraints are not so binding?
Might there be more scope for policies designed to expand industrial
production, using the resource rents to ease capital and humanresource development constraints?

This paper estimates the magnitude and analyzes the impact ofsugar rents on economic growth in several sugar dependent countries
in the Caribbean Basin. The wide fluctuations in sugar prices from1960 to 1991 led to large but transitory rents in these small economies,

which may prove to be an interesting empirical test of the theoretical
impact of resource rents on economic growth described above.
The rest of the paper is arranged as follows. Section II provides
a brief introduction to the production process for sugar and the world

sugar market. In section III, estimates of the rents from sugar
production are given for 17 countries for selected years, 1958 through1991. Section IV contains a description of the economies of some of
the more sugar dependent countries in the region and some preliminary
estimates of the impact of sugar rents on their economic development.
Some concluding thoughts are presented in section V.

MEASURING NATURAL RESOURCE RENTS AND THEIR 65

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
2. Sugar Production and the World Sugar Market
Sugar is unique among commodities for two major reasons. It is

produced in all major developing regions and in many developed
countries as well, with cane sugar being produced in the tropics andSouthern Hemisphere countries like South Africa and Australia, while
the United States, France, and other European countries produce a
considerable amount of beet sugar. AIso sugar is notable for having
perhaps the most severely distorted market structure of any producttraded internationally. As a result of restrictions, tariffs, and controls

in both developed and developing countries, the "free" sugar market isthin and subject to wide fluctuation in price.

Production
Any country with sufficient water, sunshine, and low cost labor

can produce sugar. Although the Caribbean basin has an excellent
climate for sugar, it produces only about 12-15 percent of the world's

sugar output, roughly the same fraction as the EC. South America
accounts for another 10-12 percent, with Brazil one of the largest andlowest cost producers. Asia recorded the most rapid production
increase in the 1970s and 80s, and now produces more than 20-25
percent of the world total.

Growing sugar cane is a labor-intensive process. Although
increased use of pesticides and mechanization of the harvesting process
to different degrees in different countries has somewhat reduced thelabor input, the cost advantage from low cost labor is still a significant
factor in international competitiveness. The size of farms is extremely

variable as well. The smaller island economies like Jamaica andTrinidad and Tobago naturally have smaller average farm size thanBrazil, Australia, or South Africa, by 20 times or more. But even
within the island economies there is coBsiderable variance in the size ofplots, with roughly half of production taking place on Latifundios, orlarge farms, and the other half on smaller plots, Although the smallerplots tend to be hillside or other marginal lands, which are tougher tomechanize, they are often more intensively cultivated and may havehigher yields than the big plantations.

In countries that have not mechanized the harvesting process,getting cane cut at the peak of sweetness depends on a supply of

ROBERT K. MCCLEERY

66

unskilled labor. Thus there is a seasonal demand for domestic labor or
possibly migrant labor. For instance, the Dominican Republic relied
for many years on cane cutters from neighboring, lower income Haiti.
Cane loses its sweetness in a day or two after being cut, so mills must

be located close to the fields and/or good transportation systems
must exist. This process is quite capital and energy intensive. The
next stage of the production process is refining, which is even more
capital intensive, but because it does not have the same time pressure
as milling, it is generally done in developed countries.

Factors of sugar production, particularly the field machinery,
milling machinery and the land itself, are quite crop-specifie. Sugar
itself is a perennial, yielding about eight crops before replanting isnecessary (in tropical and sub-tropical conditions). Thus it is quite
costly to switch crops in response to international prices. These

technical problems are compounded by government policies, as
described in the next section.
One final technical point is that considerable substitutability exists

on the consumption side. Both artificial sweeteners and high fructose

corn syrup (HFCS) have made inroads against traditional uses ofsugar, like soft drinks, In developing countries, one can consider raw

sugar and refined sugar (usually exported and reimported) as
substitutes for some purposes.

Market Characteristics

The world sugar market is extremely segmented. The EC, UnitedStates, and Japan all protect domestic producers, while government
intervention in production, distribution, marketing, and trade policies indeveloping countries further distorts markets.

Looking first at developed country protection, the United States as

the world's largest consumer has the largest impact on prices, Sugar's
price is artificially high in the United States as a result of a combinationof tariffs and quotas on sugar and protection to HFCS producers.
HFCS and artificial sweeteners have reduced sugar's share of the U.S.
sweetener market from 79 percent in 1970 to 41 percent in 1988.` The
accompanying decline in U.S. sugar imports has both depressed prices
and increased price variance in the world market. It is estimated that
4 Borrell and Duncan 1992.

MEASURING NATURAL RESOURCE RENTS AND THEIR 67

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
sugar prices were 9 percent lower on average over a 20 year period due
to U.S. sugar policies, with a peak impact of over 40 percent.5 Because

the impact is greatest at low points in the sugar price cycle, thecoefficient of variation is larger as well, by 8-12 percent.6

The EC policies are a complex web of support prices, quotas, andtrade restrictions that were introduced after the 1975 price rise with theexpress purpose of making the EC self-sufficient in sugar.7 Indeed they

have gone well beyond that point. Annual output rose from 9 to 16

million tons between 1974/75 and 1981/82, moving the ratio of
production to consumption from about 80 percent to 150 percent. The
impact of EC policies on world prices is also considerable, with thelong term price depressed by 5-12 percent as a result of intervention.8
Variability is increased, especially as the support prices result in higher

protection at low points in the world price cycle, insulating EC
producers from lower world prices, with peak impacts of 30 to 35
percent.

Japan has a small but highly protected sugar market. It isestimated that Japan's sugar policies reduce domestic demand by 50
percent, which lowers the world price by 2-5 percent on average andraises the coefficient of variation on prices by 11 percent.9

The combined effect of policies in these three developed regions
was estimated to reduce prices by 33 percent on average and increaseprice variation by 28 percent.'O Furthermore, no reliable estimates existof the considerable distortionary impact of the policies of the CMEA
bloc (the Soviet Union and partner countries) during the cold war.
Various sugar price stabilization plans have been attempted by theInternational Sugar Organization (ISO), with no success, possibly
because of the large number and geographical dispersion of sugar
producers.
Developing countries have also contributed to price distortions in
the world sugar market. Sugar producers often have high tariffs onrefined sugar, in an attempt to save foreign exchange by forcing
domestic consumers to use raw sugar rather than reimported white
5 Sudaryanto 1987, and Sturgiss, Field and Young 1990.
6 Borrell, Sturgiss and Wong 1987.

7 For details, see Abbott 1990. •8 Anderson and Tyers 1986, and Bureau of Agricultural Economics (Australia)l985.
9 Sturgiss, Connell, and Tobler 1988.
10 Wong, Sturgiss and Borrell 1989.

68 ROBERT K. MCCLEERY
sugar whenever possible. Other developing countries, particularly in

Africa, started or promoted domestic production through enhanced
protection as a means of saving or generating foreign exchange during
the sugar booms of 1975 and 1980. Now they are stuck with high costproducers who need protection to even cover their variable costs in bad
years. Low sugar prices and high oil prices in 1977-79 and 1981-85 ledsome large producers, most notably Brazil, to start large-scale,subsidized production of gasohol in order to save foreign exchange,rather than cutting back production. Nationalization of production,
milling, or distribution also leads to a dulling of economic incentives

and slower supply responses to market signals, which increases theseverity and duration of cyclical downturns.
The end result of policies in developed and developing countries is
to create a volatile "free" market in which prices are generally too low,

coexisting with segmented, protected markets with prices that are well
above world prices. Analyzing the production incentives in this context
is difficult, even if one ignores the important political dimensions of
production in many Caribbean countries. But it should still be possible

to analyze the impact of those production decisions and pricemovements on individual countries by estimating the "resource rent"
component of sugar export revenues and the impact of these revenues

on the macroeconomy of the countries. •3. Estimating Sugar Rents
Data on export revenues and volumes are taken from two sources,

United Nations Trade Statistics Yearbook and FAO Commodity Trade
Statistics. The UN data have a longer, consistent time series, but the

FAO data are calibrated for "raw sugar equivalent," and thus are
better for countries that do considerable sugar refining for export,such as Nicaragua, Costa Rica, and Panama.

Data on costs are taken from several different sources forselected years. The few hard data points (Conell, Rice and Sugar Co.
Inc. for 1974-75; International Sugar Organization for 1981; Landell
Mills for 1979-80 to 1982-83; and Borrell and Duncan for 1985) are
interpolated and extrapolated to make a time series from 1958 to 1991.

Perez-Lopez (1991) presents a cost breakdown for Cuba in 1984,
indicating that imported inputs (including energy) and capital costs

MEASURING NATURAL RESOURCE RENTS AND THEIR 69

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS(including maintenance and depreciation) are the two most importantelements of mill costs, while labor is a large part of the cost of cane

production. Thus the following three variables are used to proxy forchanges in the costs of production: the index of import unit values, afive year moving average of LIBOR, and industrial wages, or whenunavailable, real gross domestic product as a proxy for real wage
growth (all variables taken from IMF, International Financial Statistics

Yearbook and data tapes).
Rent estimates are presented in Table 1. Note first that rents arenegative for many countries and years. If rents are a surplus, why are
they negative? Does a negative measure of rents mean that production
should not have taken place? Several caveats are presented below, butthere is no basic contradiction inherent in the concept of negative rents,

particularly in a commodity like sugar.

All agricultural markets are characterized by considerable
variability in prices, but the sugar market is particularly volatile.

Market price at harvest is a random variable at the time planting
decisions are made. Thus poor outcomes may easily lead to losses insome years, despite profit maximizing decisions. Secondly, debtor
countries with exchange controls may have an internal "shadow price"of foreign exchange that is well above the official exchange rate, thus

what appear to be losses, when all costs and revenues are expressed indollars, are really profits in the home currency.'i Several of thecountries in the sample have fixed nominal exchange rates in dollar
terms for much of the period, despite bouts of high inflation, indicatingsome form of exchange controls. Third, perhaps most importantly, arethe high fixed costs of sugar production. Variable costs, especially in

low wage countries, are estimated at only 3 to 4 cents per pound,which "helps to provide an answer to one of the great paradoxes of
the recent behavior of the sugar market. This is the willingnessof producers to continue to grow beet or sugar to supply sugar

to the free market, even when prices have fallen to the 3c/lb
11 This point can be easily seen in a simple example. Suppose that l/3 of costs and90 percent of revenues are denominated in dollars. Converting domestic costs todollars at the official (overvalued) exchange rate overstates those costs, and may
indicate losses. Conversely, if the exporter can circumvent exchange controls toconvert most of export revenues into domestic currency at market rates, thosedollars could yield as much as twice the domestic currency units as would conversion
at the official exchange rate, making a profit in domestic currency terms.

K. MCCLEERYROBERT70

range."'2 Fourth, there is a potential source of bias in the costs
estimates used that might bias the rents estimates downward. The
available cost estimates are primarily for years of high prices. Allcompanies, but particularly government owned or controlled firms, tend
to expand costs when output price is high, and cut costs in lean years.

To the extent that good years are overrepresented in the actual costs
data, the projections may overstate actual costs in years of lower

product prices by neglecting the possibility of significant cost
reductions.i3 Finally, sugar production was nationalized in some
Caribbean countries, and nationalized producers pursue multiple goals,

including minimizing the social costs of labor relocation, rather thanmerely profit maximization.i`

There is also one major omission in the rents estimates thatbiases the results downwards. The value of by-products is apparently
not taken into account in formulating the estimates. Sugar production
from cane generates a number of useful by-products. Bagasse (canefibers) are the largest by volume, and can be used for fuel (generally

at the plant, which may be accounted for in the cost estimates),
particle board, paper, animal feed, etc. Molasses can be made into
rum, cattle feed, and fertilizers, as well as other miscellaneous uses.
For reference, the sale of by-products reduced costs for Cuban sugar

producers by 18 percent in 1984.i5 Applying this ratio to 1985 costestimates of 20 cents per pound indicate that net costs are actually
about 16.5 cents per pound, with similar adjustments necessary forother years. A second possibility would be to take into account thefact that Cuba is a low costs producer, with a cost level about threequarters of the world average, and subtract a constant equal to O.75.
12 "3c/lb." is an abbreviation for 3 cents per pound. Landell Mills Commodities Studies,1985.
13 Rising output in years of high prices has an ambiguous effect on costs. One might

expect that marginal lands would be brought into cultivation, which would raise
average costs. But if there are economies of scale at the mill level, a larger crop would
better utilize milling capacity, reducing average costs. To the extent that high prices

and outputs lead to the building of new capacity, the subsequent fail in prices andoutput can lead to a rise in unit costs. Data limitations prevent the consideration of anyof these effects in Table 1.

14 Between 1972 and 1976, the government of Trinidad and Tobago took over 1oo percent
ownership of all cane processing. Jamaica obtained the lands of the three largest sugar

producers in 1971 and turned them into co-ops, an experiment that was abandoned in
1981. Guyana nationalized its sugar industry in 1976. For further details, see Abbott

1990.
15 Perez-Lopez 1991.

Table 1- Rents From Sugar Exports
Year
BrazilDominican Rep.

1958

1959

1960

-724

-11.31-11.04-11,94-18.89-26.43-O.Ol

Guyane

1962

1963

1964

1965

1966

1967

1968

1969

1970

-6.10

39.08

22.23

8,26

-18.16-22.34-40,70-30.08-12.18-10.19-19.66

1,61

16.65

12.87

-2.53

5.39

3,65

8.09

5.72

1.58

-3.74

-5.55

-3.26

-3.19

-14.30-17.02-28.80-40,22-20.53-22.09

1961

1972

1973

1974

-6.44

60.38

130.25884,93

-5.31

-3.05

18.40

145.15-20.46-17.39

-9,54

33.70

1971

Jamaica-17.53-15.53-19.50-21.63-24.38-7.65-12.86-34,58-27.33-28.68-32,43-30.88-36A6-34.53-27.80-24,4244.75

Belize

-7.03

-8.25

-11.28-11,75-12.27

3.19

-6.83

-20.55-17.24-14.65-22,22-17.15-19.33-1.14-12.59-17,55

15.83

Argentina

-O.20

-1.17

-O.16

-O.64

-O.69

-O.05

-O.80

-1.04

-1.97

-2.97

-3.88

-2.35

-3,47

-2,90

-2.50

-2,33

15.15

Trinidady Tobago

-8.63

19.53

•-

10.16

-13.64-16.84-15,OO-13.50-17.11-17,60-14.22-22.02-14.19-22,76-20.90

-6.83

-9.24

-10.47

Barbados-31.98-49.85-49.81-46.84-34.13-31.15-20.16-37.33-44,19-49.22-49.39-25.31-43.18-43.20-38.43-41,47

27.62

GuatemalaHonduras

-2.29

-3.48

-2.66

-3.76

-4.35

-1.26

-3,36

-5.42

-5.14

-7.33

-8.23

-7.13

-8,75

-8.62

-3.78

-6,17

5.61

-o.e2

-O.14

-1.66

-O.34

-2.11

-2A8

-1.83

-O.44

-O.80

-O.91

-e.55

-1.83

-O.43

-2,60

22.44

O.Ol

2.95

20,15

119.91

-1.73

-1.21

-1.58

-O.33

-O.40

LO.06

-O.43

-O,08

-O.15

Mexico

O.25

O.47

O.27

O,06

-O.39

-027

-O.20

-O.22

-O.94

-O,64

-4.22

-5.08

-2.97

-4.43

-8.99

St.Kitts-et-Nevis-17.20

O.23

1.29

5.34

4.09

15.15

16.55

-2.68

-O.18

-O.41

4,83

-14,03

11.73

14.02

17.60

Costa Rica
Nicaregue

-1.50

-2.34

-2.12

-2.35

-2.41

-2.13

-120

-IA9

-O.90

-O.36

-O.97

-1.80

-2.58

-2.78

-2.72

-2.80

-3.05

-3.77

-2.65

9.27

30.99

-4.38

-2.97

-3,54

-2.92

-4.92

-4.56

-1.79

-4.96

-4.65

-Z15

-8.56

-g.12

-12,12-10.46

-8.65

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

-16.79El Salvador

-O.04

-O.46

Panama

1975

1976

1977

8.72

-2.20

711.6057.59-16.91-40.32-22.84468.96206.08-85,87

r99.40-129.09-175.90-157.69-151.52-99.84

64.46

O.04

-15.83-32.6686.76

286.61

35,47

6A6

35.46

-32.49O,20-40.82-33.07

-9.68
8.45

69.12

38a.22

37,90

37.50

GuyanaJamaica

33.00

-3.t3

-2.04

-23.21-50.44

45.01

-3.44

-92.00-74,74-52.48-109.01-70,Ol-18.53-67.21-83.95-99.46-39.13

96.26

11,69

6,84

-1.51

3.35

32,69

-9.19

-17.46-13.57-28.06-10,04

58.28

3.07

18.16

-O.20

10.87

-O.84

3.24

-16.56

73.67

87.00

7.02

12.27
8.85
7.17

79.42

89.15

10.67
19.77
3.41
-O.93

9.54

Belize

11.62

10,08

-15.24-10.38-5,07-10,39BrazilDominican Rep.

Argentina

26.05

3.67

3.01

9.15
7,55

7.33

19.20

7.81
3.44
7.41

1.64

-t.28

3.25
1.38

-7.83

5,98
L2.63

Trinidady Tobago

1.82

-6.14

-9.18

-2.55

-10.93

-6.63

-8,25

-19.05-14.39-18.25-12,28-21.14

-O.52
O.09
-5.48
-4.36
O.79

-4,93
e,e2
-7,81

-1.34
-2.10

L028

-2,59

20,65

5.82

-2.56
5.85

1.74

6.66

1S,66

10,19

-50.36-49.63-56.91-177.54-19,13-81,75-15.48-10,31

16,71

-7.84

-12.76

O.83
1.39

-3,83

O.40

-8.81
9.82

-3,04

-12,50-16.11-19.35-49,34-75,19-15.72

40.88-13.14-24.18

Barbados

166.56-O.75-58.10-41.11-43.91

-8.94

-O.05

-45.60-1.54

GuatemalaHonduras

30.21

3.56

O.25

5,87

20.34

7.32

2.93

1.56

73.44

38.54

15.58

2.91
9.34

14.59

13.30

23.83

-6.17

-1.14

El Salvador

4.74

O.72

-O.80

-O.Ol

-1.37

4.99

16.65

-6,31

-6.97

Mexico

49,16

8.40

-8.04

-12.00-17.80

-3,39

-O.88

-3.19

St,Kitts-et-Nevis

89.25

O.16

O.08

1.75

Panama

9.60

-3.25

6.50
3.73
13AO

8.50

-2,71

-2.35

-3.07

-3.35

16.40

16,14

-6.68

-3,21

-3.54

7.10
-3.76

-424

6.03

-22.18-18,72

-6,90

10.30
-2.48

O,89
9.20
1.05

4.94

-5.52

-14.87-12.77

-6.05

2.83

-9.36

-21,29-23.51-12.66-1823-11,05-1225-15.88-83.46-2.07

Costa Rica
Nicaragua
13.88-19.35

29.33

4.00

13.40

N
H

72 ROBERT K. MCCLEERY
O.18.0.20 or 2.7 cents/lb from all cost estimates in 1985, then adjust theadjustment factor for changes in the world average costs for otheryears.

Making any linear adjustment to all years to reflect the value of
by-products would not have a significant impact on the coefficients
estimated in the next section. The problem would be if the adjustment
factor was not constant across countries and time periods. Since all of
the producers in the sample make cane sugar and use relatively similar

technologies, the adjustment should be strietly proportional toproduction levels across countries, but two factors determine theconsistency of the adjustment factor over time. On one hand, supply of
by-products is directly related to sugar supply, thus prices should beclosely related. But on the demand side, many other influences exist,

such as the prices of substitute cattle feeds and other competingproducts. Unfortunately, detailed data on the production, export, andnon-market transactions (such as use of bagasse as fuel in the sugarmill) is not available for any of the countries in the study, so no
adjustment is made to the cost data.
Rents peak in the four years of sugar price peaks (1963, 1975,
1980, and 1990). One might ask, why not just use price or revenue datain the estimations instead? First, as mentioned above, rents as aresidual will be much more volatile than prices or revenues. Second, asa surplus, they may well have quite a different impact on personal andgovernment spending than regular wages or the normal return tocapital. Thirdly, the author has found in earlier work that rents,
measured in this way, do have a strong and differential impact onmacroeconomic variables in the cases of Malaysia, Indonesia, Mexico,and Venezuela.i6 Thus despite the difficulties in properly measuring
rents, the effort has a clear potential payoff in better understanding

macroeconomic adjustments in resource-rich economies.

'
4. The lmpact of Rents on the Macroeconomy of Small,
Latin American Sugar Producers
In this section I look at the impact of rents on a number of
16 McCleery 1989.

MEASURING NATURAL RESOURCE RENTS AND THEIR 73

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
macroeconomic variables in five sugar-dependent Caribbean economies:
Barbados, Belize, the Dominican Republic, Guyana and Jamaica. The
impacts are similar but certainly not identical, indicating that theeconomic structure and policy environment under which rents are
obtained influence how those rents influence rnacroeconomic variables.

In each case the impact of rents on economic growth wasestimated, then various channels by which that impact might be
explained were explored. Monetary (capital inflows, reserves, inflation,and money supply growth), budgetary (revenues, expenditures, and thegovernment deficit), and real (savings, investment, and the balance oftrade) are the three main channels explored (see figure 1).
Estimation Equations

The primary channel of impact of rents on output growth isexpected to be through investment. Consider this simple growth
function for a Cobb-Douglas economy:

Y/Y=a.L/L+b.K/K+c
Let. K=IT (total investment) and 1'==S'(total savings). S'can be
decomposed into SP+Sf+Sg (private, foreign, and government savings).
Thus for each country we will test the impact of changes in rents on
private savings, foreign capital inflows, and government savings(revenues minus expenditures). Investment is not the only way rents
can affect growth, however. Rents may indirectly affect the efficiency
of investment (parameter b above) through government policies oralter the equilibrium wage rate and thus labor force growth (throughparticipation rates) and efficient utilization of labor (a). Increased
imports of foreign capital may even raise the technological level of theeconomy.
One way to proceed would be to try to estimate one sector
production functions for each of the five countries then assume that
rents affect all countries in the same way and have either a crosssectional regression with five observations or attempt to fit the
productions function separately for high and low rent periods. This
does not seem like an efficient way to use the available data, so it was

decided instead to estimate a direct link between rents and growth, tocapture the impact of indirect factors, as well as directly estimating the

74

ROBERT K. MCCLEERY

impact on the components of investment. See figure 1 for a diagram ofpotential channels of impact from rents to growth.
Since the rent series peak in 1974-75 and 1980, it would seem thatsome of the effects attributed to rents, particularly in terms ofincreases in inflation and drops in reserves, might be due instead to theoil price shocks that occurred in those same years. But oil pricedummies were not significant when introduced, and did not
substantively change the estimated coefficients on rents, except in thecase of Barbados as described below.

A number of caveats should be made initially. Data for thesesmall economies are quite limited and of uneven quality. Only

international data are used, to ensure comparability. All
macroeconomic data are drawn from International Financial Statistics
data tapes and International Financial Statistics Yearbook, 1993 andselected years. The number of observations in the estimations below

varies from less than 15 to 30, precluding the specification ofmacroeconomic models relating the variables to each other throughsystems of behavioral equations and identities, or a thoroughinvestigation of lag structures.i' Thus while point estimates andsignificance levels are mentioned throughout the following discussion
the numbers should be viewed as indicative, rather than predictive.
True economic significance rests only with the entire exercise, viewed
as a whole. Below, significant point estimates are denoted in the narrativeby stars, with' indicating significance at the 10 percent level," at the 5

percent level, and"' at the one percent level. All estimates were
derived using ordinary least squares, corrected for autocorrelation
where indicated below by "ARI," utilizing the MICROTSP program.
In all equations below, rents were entered in contemporaneous
fashion and with lags of one, two, and three years. Insignificant lags
were then dropped, unless their presence either significantly altered thevalues of other coefficients or improved the F-statistic or log of thelikelihood function of the regression. . '17 The speed of impact of rents on macroeconornic variables may be different fordifferent variables and countries, and there is little theory to appeal to for

guidance. Thus contemporaneous rents and three lags were tried for each
regression, but insignificant lags were dropped, if their removal increased the
explanatory power of the regression (both the F-statistic and the adjusted R2), in

order to increase the precision of the other estimates. .

MEASURING NATURAL RESOURCE RENTS AND THEIR 75

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
Barbados

Barbados sets the common theme, but in many cases thecoefficients are not significant. Thus the results will be reported morein narrative form than as a list of equations with regression
coefficients. This is somewhat surprising, as Barbados is one of themore sugar-dependent economies in the sample, with a ratio of sugar
exports to total exports that peaked at 44 percent, and sugar exports

peaking a 13 percent of GDP. Barbados is a rather high costproducer, the second highest in the five country sample and about third
in the sample of 17.
The evidence below is interesting but weak, with rents positive but
insignificant in the initial period, and negative'with a two period lag.'B

But notice that the oil dummy is positive and highly significant. We
cannot rule out the possibility that, for an oil importing country like
Barbados, the oil dummy is picking up some effect of the sugar pricerise not captured in the rents estimates.

GROVVTH== O.077 + O.095.R/GDP -O.564.R/GDP(-2)+0.129.0ILDUM(t-stat) (5.5)"" (O.2) (-1.8)' (4.4)"'
R2-O.63, adl'R2-O.56, D.VV.=-1.8, F-=8.98, N=20.

Savings and investment appears to be the main channel for the
impact of rents on growth. Below, one of two alternative formulationsof the relationship between the savings rate (1-consumption) and rents
is shown, the relationship with the rent share of GDP. The pattern issimilar for the basic rents data, but the interpretation of coefficients ismore straightforward in the regression below. The basic pattern of acontemporaneous increase in savings (decrease in consumption) of an
insignificant magnitude, followed by significant declines in savings withlags of two and three years, holds whether rents are specified in dollar

terms or as a share of GDP.

C/GDP= O.813 -O.566.R/GDP+O.930.R/GDP(-2)+1.153.R/GDP(-3)(t-stat) (2LD""(-1.3) (2.5)" (4.0)`"
18 Lags are indicated by the negative number in parenthesis after the variable.

76

ROBERT K. MCCLEERY

R2-O.86, adjR2=O.82, D.VV.-2.0, AR(1)=O.77 (9.8), F==20.00, N==18.

A one percentage point increase in the rent share of GDP would
initially raise the savings rate slightly, but would reduce it by about afull percentage point both two and three years hence. Investment
follows the opposite pattern, falling initially by half a percentage pointin the year of the one percentage point rent increase, but rising thefollowing year to partially offset the decline. This unique patternsuggests that domestic savings may have left the country as capitalflight (or merely financial savings recycled abroad by multinationalbanks) in high rents years, rather than contributing to domestic

investment. Note that both capital inflows and growth figure
prominently in the determination of the investment rate, thus the rents

have secondary impacts to the extent that they influence thosevariables, as detailed above and immediately below.

I/GDP=O.177 -O.528.R/GDP+O.321.R/GDP(-1)+O.21.GROVVTH +O.514eCAP/GDP(t-stat)(16.1)"'(-2.4)' (1.8) (3.1)" (3.6)"'
R2= O. 77, adJ'R 2- O. 66, D. W. == 1.85, F= 7. 43, N= 14.

BelizeBelize is another small, sugar-dependent economy that should be agood test of the impact of rents on the macroeconomy. The peakratios of sugar in total exports and sugar revenues to GDP were 65
percent and 12 percent, respectively. Its ratio of trade to GDP places
it in the middle of the sample.

Growth is impacted somewhat differently by sugar rents in Belize.
The initial impact is strongly positive, and that positive impact isreduced but not reversed by a fall in the following year.

'
GROWTH=
O.098 +O.O08.RENTS -O.O06.RENTS(-1)+O.036.0ILDUM(t-stat) (8.2)"'tt (4.5)"' (-4.0)"' (1.2)
R2 == O. 74, adJ'R 2= O. 68, D. VV. =2. 4, F= 12.97, N= 18.

Two other strong relationships are found in the data, but neither
adequately explains the impact of rents on growth. Rents and laggedMEASURING NATURAL RESOURCE RENTS AND THEIR 77

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
rents both appear to spur import demand, over and above a strong

relationship with the level of GDP. But care must be taken ininterpreting the coefficients, since rents have both a direct impact(given by the estimated coefficients) and an indirect impact, that canbe approximated from the coefficient on growth above and thecoefficient on GDP below, when the mean of the growth and GDP
series are known. In the absence of a consistent model, let us just saythat the true impact of rents on imports is higher contemporaneously

and lower with a lag than the estimates shown here. The highly
significant .coefficient on GDP is interesting, as it indicates that imports

are positively related to the square of GDP. There are two possible
explanations. If imports are largely luxury goods and demand is of
the Stone-Geary type (income above that needed for subsistence levelsof consumption of food, clothing, housing, etc. is spent in fixedproportions on all goods available, including imports), then naturally
the marginal propensity to import out of increases in per capitalincome would be much higher than the average propensity to import,
making the squared income term positive and significant. A second
possibility is that GDP is a proxy for time, technological progress(especially in transportation, making imports relatively cheaper), andopenness (the Caribbean countries, along with the rest of Latin
America, liberalized their trade regimes in the 1980s).

IMP/GDP=16.455+0.456.R/GDP+0.713.R/GDP(-1)+O.573eGDP(t-stat) (1.0) (1.1) (1.D (IL5)"'
R2=O.96, adJ'R2=O.95, D.VV.-1.8, AR(1)=0.71 (3.5), F-83.93, N=-18.

Rents also appear to be anti-inflationary, once the effects ofgrowth, money supply, and reserves are taken into account. Again, thedirect impact in the first period is augmented by a secondary effectthrough growth, which can be estimated at 10 to 15 percent of thedirect effect, making the total impact marginally significant.

CPI=85.66 -O.398.RNTS -O.765.RNTS(-2)+O.111.M2 -56.35.GROVVTH+O.17eRES(t-stat)(41.2)"'(-1.9) (-4.4)"' (4.0)"' (-2.6)" (2.8)"
R2=O.98, adjR2=O.9Z D.VV.=2.0, F=72.28, N=12.

ROBERT K. MCCLEERY

78

Dominican Republic

The Dominican Republic also recorded a high ratio of sugar
exports in total exports (64%), although its peak ratio of sugar
revenues to GDP is a representative 10 per6ent. This reflects the factthat its economy is larger and less open than the previous two, but stillrather dependent on sugar. Few coefficients are significant, and theresults will be presented in narrative form.

Total reserves seem unaffected by rents, and only a slight positive
correlation between consumer prices and rents (with a one period lag)is observed in the data. Capital inflows do increase sharply with rents,

however, with the 64 cent/dollar contemporaneous increase only
slightly eroded by negative lagged•effects, leaving a net increase of 50
cents/dollar.

The strongest contemporaneous correlation between rents andrevenues is found in the Dominican Republic data. Perhaps thegovernment is extremely effective in capturing those rents. The
coefficient is O.92"' to O.98"', indicating that revenues rise virtually

dollar for dollar with rents. Expenditures rise more slowly, allowing
the deficit to fall by about 30 cents on the dollar. A year later, there
is no impact on the deficit.

Investment and savings are not significantly affected by rents,
although the signs of the coefficients are consistent with the evidence
for other countries. Investment rises contemporaneously, then falls in
the two subsequent years. The savings rate increases slightly, thenfalls. There is no indication of a direct impact of rents on GDP or
growth.

GuyanaWith a total GDP of under $400 million, Guyana is the smallest of

the economies studied here. It is an active trader, however, and thesum of its imports and exports varies considerably between one andtwo times its GDP. Guyana is the most sugar-dependent country in thesample in terms of peak ratio of sugar revenue to GDP (35SO>6o). As it

is an extremely small, open economy, even by the standards of thecountries in this sample, the peak ratio of sugar in exports is only
slightly higher, at 48 percent. Sugar rents strongly impact its
macroeconomy, as detailed below, although often with a lag. In fact,
Guyana's economy grew with sugar through 1976, then collapsed with

MEASURING NATURAL RESOURCE RENTS AND THEIR 79

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
the subsequent nationalization and price decline. GDP shrank by 37
percent in real domestic currency terms and by much more in dollar
terms between 1976 and 1990, and inflation skyrocketed after 1980.

Two regression equations showjng the relationship between rents
and economic growth are presented, as the functional form seems toaffect the magnitude of the coefficients, although not the basic pattern.

It is clear that contemporaneous rents have a strong positive relation
to growth, and the impact of lagged rents is negative, although whether

the negative terms are significant and whether the lagged negative
effects are Iarger or smaller than the initial positive relationship cannot

be determined. Note that the nationalization dummy in the second
equation (NDM) is negative and significant; it appears that the impactof nationalization was to reduce the average growth rate by 4.6
percentage points (i.e. from an average of 3.1 percent to -1.5 percent!).

There is also weak evidence that the nationalization made the economy
rnore sensitive to rents; when the second equation is run with a "slope
dummy" (NDM.RNTS), the coefficient is positive but not significant.

GROVVTH==-O.OO4+O.409.R/GDP-O.289.R/GDP(-2) -O.190.R/GDP(-3)(t-stat) (0.2) (3.4)"' (-2.5)" (-1.54)
R2==0.58, adl'R2=O.49, ARI==O.46 (2.3), D.W.=1.8, F=6.87, IV-25.
GROWTH==0.031+O.OOI.RAITS-O.OO025.RNTS(-2)-O.OOO37.RNTS(-3)-O.046.NDM(t-stat) (1.6) (4.4)"' (-0,9) (-L4) (-L8)'
R2- O.63, adJ'R2==O.55, ARI-0.27 (1.4), D.VV.=2.3, F- Z29, N-=25.

Rents, together with GDP growth, are important in explaining both
capital inflows and changes in reserves. Rents boost capital inflows by
about 60 cents"' per dollar of rents contemporaneously, but capital
inflows then fall by about 50 cents"with a three year lag. Lagged
growth is positively related to loan inflows. Reserves increase by 27
cents" per dollar of rents initially, and by another 15 cents with a one

period lag, after correcting for the affects of growth and the exchange
rate.

Another potential channel for the impact of rents on growth ispublic finance. As shown in the three equations below, rents have a

ROBERT K. MCCLEERY

80

strong negative correlation with both expenditures and revenues in
Guyana, but the net effect of rents is a negative correlation with thedeficit. This is consistent with Guyana's strong economic performance

during the period of rising rents and disastrous performance as rents

fell in the 1980s. Note also that nationalization increased both
expenditures and revenues (increased the size of government), but the
net affect was to substantially increase the deficit. The negative partial

correlation between GDP and expenditure is quite rare, indicating astrong countercyclical tendency in spending.
SPND - 423.1-2.07.RNTS-2.07. RNTS(-1) -3. 01 .RNTS(-2) + 68 7. 0.NDM- O.1 78. GDP(t-stat) (1.2) (-6.2)"' (-5.1)"' (-4.2)"' (2.n" (-3.6)•"
R2-0.99, adl'R2=0.99, ARI=0.76 (3.D, D.VV.=1.43, F=479.4, N=26.
RE VEN= -O. 64 .RENTS-1.21 .RENTS(-2) + 22 Z 7. NDM+ O. 1 79. GDP(t-stat) (-8.0)"' (-4.9)"' (4.3)"' (8.8)"'
R2=O.99, adjR2=O.99, D.V[i.-=2.1, F=3601.5, N=27.
DEF= 146-1. 04. RNT-1. 96. RIVT( -1) -2. 43. RNT( -2) -1.38. RAIT( -3) + 588. AllDM- 0.37. GDP(t-stat)(L6)(-5.n"'(-8.D"' (-6.9)"' (-3,8)"' (4.3)"' (-15.4)"'
R2=O.97, adjR2=O.95, ARI==1.06(5.1), AR2-=-O.62(-3), D.VV. :2.0, F==54.4, N=24.

Guyana follows the normal pattern for the impact of rents on
savings, although both the ,contemporaneous savings increase and thelarger lagged decline are statistically insignificant, once the impact ofpublic savings (the deficit) on total savings is taken into account.
Rents first improve then reduce the trade balance, by approximately

equal amounts. GDP has the expected negative sign, as exogenous
increases in income increase the demand for imports and reduce theexportable surplus.

TRADEB=4Z3 + O.44.REAITS - O.41.RENTS(-1) - O.095.GDP(t-stat) (1.8)' (2.8)" (-2.4)" (--3.6)"'
R2=O.60, adjR2=O.51, ARI=-.037 (-1.65) D.W.=2.36, F=6.45, N==22.

MEASURING NATURAL RESOURCE RENTS AND THEIR 81

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
Jamaica
Jamaica is the second largest economy in the sample, with a GDP
of $3.5 billion. As such, its macroeconomic data is more reliable andcomplete that those of the countries with smaller economies. But
unlike the largest economy, the Dominican Republic, it is very open to

trade, with a trade share of GDP [(exports+imports)/GDP] of about
O,75. Sugar is moderately important to the Jamaican economy, withpeak shares of exports of 18 percent and GDP of five percent.
Again, two equations are given for the impact of rehts on growth.

The first covers the period from 1975 to 1985 only, while the second
covers the years from 1966 to 1989. In the first, the positive coefficienton contemporaneous rents is similar in absolute value to the negative
lagged coefficient. But over the entire period, the absolute value of thelagged negative effect is more than twice as large as the initial positive

impact. The other difference between the two equations is that the
government deficit shows a weak positive correlation with growth forthe few years that data are available. The surprising negative partial
correlation coefficient between capital inflows and growth is discussed
below.
GR O WTH= -O. 445+ O. 123.R/ GDP- O. 146.R/ GDP(-3) -O. OO12. CAP+ O. OO05.DEF(t-stat) (-2.0)' (1.2) (-2.2)' (2.9)" (-1.6)
R2= O. 69, adjR 2= 0. 49, D. VV. == 1. 54, F- 3. 36, N= 11.

GROWTH= -O.076+O.036.R/GDP -O.087.R/GDP(-2) -O.OO09.CAP(t-stat) (-1.2) (1.2) (-3.0)"' (-2.8)"
R2=O.40, adJ'R2=O.32, D.W.==1.6, F-4.53, N=24.

The data for Jamaica illustrate an interesting point. Althoughprivate capital flows follow private profitability, official lending forstabilization or balance of payments support ("bail-out" loans that areproportional to the magnitude of the macroeconomic problems) cause
the coefficient of GDP on overall capital inflows to be negative,
although a bit smaller than the coefficient on "other capital flows't(primarily lending) given below. With obvious restrictions on
investment in the rent generating sector due to nationalization, rents

82 ROBERT K. MCCLEERY
are more strongly related to lending as well, as an indicator of
repayment potential.

OTHERCAP-34.7+1.83.RENTS -2.52.RENTS(-3) -367.5.GROVVTH(t-stat) (L3) (2.4)'" (-2.9)"' (-4.0)"'
R2= 0. 50, adJ'R 2 -= O. 43, D. VV. =2. 0, F= 7. 22, N-= 26.

In an exception to the completeness of the data for Jamaica, only
10 years of government finance and spending data are available, notenough to draw even the most tentative conclusions. Partial
correlation coefficients between rents and the consumer price index
indicate a reduction in consumer prices initially" and with a two year
lag', but there is a rise after three years".
CPI-=81.8-O.048.RNTS-0.043eRAITS(-2)+O.055.RNTS(-3)+O.O12.M2-•O.OO34.RGDP(t-stat)(1.3)(-2.5)" (-1.8)' (2.2)" (4.1)"' (-1,nR2=o.gg, adjR2-O.99, ARI-=O.94 (5.8), D.Ui.=-2.3, F=-488.9, N=23.

5. Conclusions
The empirical results presented above are highly suggestive but
clearly incomplete and inconclusive. Lack of data, especially on publicfinance and capital flows, and possibly poor quality data severely
hampers the attempt to measure subtle and often indirect effects. Yeta few consistent patterns are found in the estimates above. Rents
generally drive growth in the short run, by increasing the savings rateand drawing in private and official capital flows. They may also
improve the trade balance initially, further contributing to economic
expansion and/or the accumulation of foreign reserves. The initial
impact on public finances is likely to be positive as well. But with alag of between one and three years, most of the positive impacts ofrents are diminished or even reversed. Consumption, government
expenditure, and imports rise, while capital inflows fall, leading to anegative impact on growth. These findings are consistent with otherwork by the author on Latin American rents, but curiously in many
instances the impacts on these small, sugar dependent economies are
not as strong as those on the larger, resource rich countries of Latin
America. One possible explanation is that their small size and relative

MEASURING NATURAL RESOURCE RENTS AND THEIR 83

MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
openness worked in their favor, making infeasible the inward-looking
import substitution policies to which oil and other resource rents werechannelled in much of Latin America.
Resource rents can be an important source of foreign exchange,savings for public and private sector investment in and outside the rent

generating sector, and DFI, with attendant technology transfers. On

the other hand, they can lead to deindustrialization, improper
sequencing of industrial development, overborrowing, relative expansionof the public sector (especially in spending, but also in terms of its rolein the production of goods and services), inflation, overvaluation of thecurrency, distortions in the relative price of labor to capital, unrealistic

expectations and resultant political pressures from producers andconsumers, social stratification and rigidities, income and wealthinequality, conspicuous consumption, particularly through imports andtravel, etc. In summary I refer again to figure 1 as an attempt totrace some of the important economic linkages from rents to growththrough various macroeconomic variables, as indicated by the
regression results•above, Further research, both in economics andperhaps other fields such as sociology and psychology, is necessary to
fully explain both the formation and impact of government policies inresource-rich countries, and their relatively poor economic performanceover the past two decades.

TABLE 2IMPACT OF RENTS ON GDP GROWTH--SUMMARY

COUNTRY

RENTS RENTS-1 RENTS-2 RENTS-3(R/GDP)BARBADOS+O.095(RENTS)+O.O08GUYANA(R/GDP)(RNTS)+O.409+O.OOI-O.289-O.OO025(1975-85) (R/GDP)(1966-89) (R/GDP)+O.123+O.036-O.087

BELIZE-O.564-O.O06

DOM. REP.

JAMAICA-O.190-O.OO037-O.146

ROBERT K. MCCLEERY

84

RENTS

REVENUE

CAPFLOWS
tMPORTSEXPENDiTURESAVINGS

RESERVES

DEFiCITTRADEBALINVESTMENT

cpl

DEBT

ECONOMICGROWTH
FIGURE 1

MEASURING NATURAL RESOURCE RENTS AND THEIR85
MACROECONOMIC SIGNIFICANCE FOR DEVELOPING COUNTRIES,WITH REFERENCE TO LATIN AMERICAN SUGAR PRODUCERS
References[1]

Abbott, George, Sugar, New York, NY: Routledge, 1990.

[2 ]Anderson, Kym, and Rod Tyers, "Agricultural Policies of Industrial Countries
and Their Effects on Traditional Food Exporters," Economic Record, 62, Dec.

[3 ]Bhagwati, Jagdish, "Directly Unproductive, Profit-seeking (DUP) Activities,"
Journal of Political Economy, 90(5), Oct. 1982.

[4 ]Borrell, Brent and Ronald Duncan, "A Survey of the Costs of World Sugar[5 ]Borrell, Brent, Robert Sturgiss, and Gordon Wong,"Global Effects of the U.S.

1986: pp. 385-99.

Policies," The IVorld Banh Research Observer, 7(2), July 1992: pp. 171-94

Sugar Policy," BAE Discussion Paper 87,3, Canberra: Australian Government
Publishing Service, 1987.

[6 ]Bureau of Agricultural Economics, Agricultural Policies in the European
Comrnunity: Their Origin, IVature and Effects on Production and Trade,
Policy Monograph 2, Canberra: Australian Government Publishing Service,[7]

Connell, Rice and Sugar Co. Inc., World Sugar: Capaeitbl, Cost and Policy,
New Jersey, 1977.

1985.

[8]

Food and Agriculture Organization, "FAO Trade Yearbook," Rome: FAO of
the UN, volumes 16-45, 1963-1992.

[9]

International Monetary Fund, "International Financiai Statistics Yearbook[10]

International Sugar Organization, "Sugar Production Costs: A Sumrnary,"[11]

Mimeo,
London: ISO, (undated). ' 'Krueger, Anne, "The Political Economy of the Rent-seeking Society,"

1993," Washington D.C.: IMF, 1993 and selected years.

American Econornic Review, 64(3), June 1974: pp. 291-303.
[12]

Landell Mills Commodity Studies, Wortd Sugar Trade and U.S. Sugar Policy,'
Washington
D.C.: Congressional Research Service, 1985.

[13]

Matsuyama, Kiminori, "Productivity, Comparative Advantage and Economic
Growth," NBER Working Paper #3606, 1991.

[14]

McCIeery, Robert, "Resource Rents in Economic Development: Boon or[15]

Bane?," Mimeo, East-West Center, Honolulu, HI, 1989.
Perez-Lopez, Jorge, The Econornics ofCubanSugar, Pittsburgh, PA: Universityof Pittsburgh Press, 1991.

[16]

Ranis, Gustav, "Towards a Model of Development for the Natural Resource
Poor Economy," Yale Economic Growth Center Discussion Paper #529, Feb.
1987.

[17]

, "East and Southeast Asia: Comparative Development Experience,"
Bangladesh Development Studies, 20(2-3), June-Sept. 1992: pp. 69-88.

[18]

Sturgiss, Robert, Heather Field, and Linda Young, "1990 and U.S. Sugar

Policy Reform," ABARE Discussion Paper 90.4, Canberra: AustralianGovernment Publishing Service, 1990.

[19], Peter Connell, and Peter Tobler, "Japanese Sugar Policy and its

Effects on World Markets," ABARE Occasional Paper 104, Canberra:[20]Australian Government Publishing Service, 1988.
Sudaryanto, Tahlim, "The Potential Impacts of Liberalized Trade Policies in

86

ROBERT K. MCCLEERY

the United States and the European Community in International Markets for
Sugar," Ph.D. thesis, North Carolina State University, Raleigh, 1987.
[21]

United Nations, "International Trade Statistics Yearbook," New York, NY:[22]

Urrutia, Miguel, and Setsuko Yukawa, eds., Economic Development Policies[23]

Wong, Gordon, Robert Sturgiss, and Brent Borrell, "The EconomieUN, selected years 1960-1992.

in Resource-Rich Countries, Tokyo: United Nations University, 1988.

Consequences of International Sugar Trade Reform," ABARE Discussion
Paper 89.7, Canberra: Australian Government Publishing Service, 1989.

THE INFLUENCESTRATEGYOF PRODUCT DEVELOPMENTON
INTER-PROJECT LEARNING

Kentaro NOBEOKA

1. Introduction
Large manufacturers usually have at least several product lines
and constantly undertake multiple development projects to add new
product Iines or to replace existing products. The ulitmate goal ofthese firms is not only to develop a single product effectively andefficiently, but to develop a successfui stream of new products overmany years. Therefore, it is an important issue for firms to gain

technical knowledge in a new product development project and totransfer and utilize it effectively in other subsequent projects. In orderto facilitate effective learning among multiple projects over time, firms

need the appropriate strategy and organization. This study explores
one aspect of this broad range of issues in inter-project learning byfocusing on two different learning strategies with respect to linkages
between pairs of related product development projects.
This paper explores two different design and knowledge transfer

strategies, each of which provides a unique learning setting:"concurrent design transfer" and "sequential design transfer"strategies. In the concurrent design transfer strategy, a new projecttransfers technical knowledge that is being developed in another ongoing project within the firm, while these two projects coordinate
through actual interactions. On the other hand, in the sequential
design transfer strategy, a new product development project uitilizes

technical knowledge that has already been accumulated in past
projects. This paper discusses the advantages of the first strategy, theconcurrent design transfer strategy, in learning and transferring
technical knowledge within the firm. •There have been many studies focusing on the efficient andeffective management of new product development projects (Cohen, etal., 1979; Quinn and Mueller 1982; Imai et al., 1985; Gold, 1987; Gomory

88

KENTARONOBEOKA

1989; Gupta and Wilemon, 1990; Womack et al., 1990; Clark andFujimoto, 1991; Cusumano, 1991; Cordero, 1991; McDonough III and
Barczak, 1991; von Braun, 1991; Leonald-Barton and Sinha 1991;
Crawford, 1992). Most of these studies have focused on the importanceof cross-fuctional coordination to achieve high productivity, speed, anddesign quality of a development project. One common finding acrossthese studies is that, in order to shorten the development lead time andto achieve high productivity, a relatively project-oriented organization
with strong cross-functional coordination is essential. Even though thisapproach enhances cross-functional learning within a project, it may
not necessarily be appropriate for inter-project learning. There havebeen few studies that have explored the importance of the managementof the inter-project linkages for effective leaning among multiple
development projects.
The management of inter-project knowledge transfer and learning
has become critical for many manufacturers in recent years. Various
studies have reported that leading manufacturers in many industries,
particulary Japanese manufacturers, tend to develop new products
faster and more frequently than competitors. This capability results inshorter product life cycles and a corporate ability to broaden productlines if desired (Abegglen and Stalk, 1985; Dertouzos et al., 1988;
Womack et al., 1990; Stalk and Hout, 1990; Peters, 1992). The primary
focus of these studies has been the speed and the frequency of new
product introductions at the corporate level, rather than the efficiency

and the productivity of individual projects. These studies have argued
that this difference in the frequency and the effectiveness of completing

multiple projects has been one of the major reasons, along with
manufacturing skills, for the growth of Japanese manufacturers inglobal markets. In recent years, however, even Japanesemanufacturers have become more concerned with efficiency indeveloping an accelerating flow of new products. They have faced
severe profitability problems that are reJated at least in part to thehigh costs of developing and manufacturing so many new products or

product variations in markets such as automobiles and consumer
electronics. In most primary markets for these goods, demand has
slowed or even declined. Firms are vigorously trying to improve theirefficiency at developing multiple new products while maintaining both ahigh frequency of new product introductions and high design quality

89
THE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGYON INTER-PROJECT LEARNING

across individual projects. The effective inter-project learning among a
stream of new product projects is essential to achieve this goal.
High levels of engineering productivity in individual projects alone

may contribute to making a firm more effective in productdevelopment. But, effective transfers of technologies and knowledge
from one project to others should increase the efficiency of completing
multiple projects and should decrease component costs for individual
projects through inter-project synergy. The project-oriented approach
alone has not provided insights into the management of the interproject learning within the firm. Research that explicitly focuses on
the effective management of inter-project learning among multiple new

product development projects is needed. Because of increasingly
intense international competition, this perspective has become a criticalissue for competition in many industries (Fujimoto et al., 1992; Meyerand Utterback, 1993).

In addition, a body of studies have argued that effective
management of a firm's special competencies or resources is one of the

primary sources of a firm's competitiveness (Wernerfelt, 1984;
Prahalad and Hamel, 1990). With respect to new product development,
it is important for a firm to accumulate their unique competencies andquickly leverage these in other development projects. In order toimplement this approach, appropriate inter-project learning strategy
and organization is required.

In this study, we first propose a framework for two types ofinter-project learning strategies. Using this framework, we hypothesize
the relationship between these strategies and the efficiency of inter-

project Iearning. This study measures learning efficiency using a
productivity performance of a project that learns and utilizes technicalknowledge from other projects. After we discuss the sample andmeasurements for the questionnaire survey in Section 3, Section 4
provides an evidence that concurrent design transfer strategy has asignificant advantage in engineering hours, which indicates thesuperiority of the strategy as an inter-project learning setting. Section

5 discusses strategic and organizational implications from the survey
results and from our field study.

90

KENTARO NOBEOKA

2. Framework and Hypotheses
Multiple product development projects within a firm often havetechnological linkages or interdependencies with other past or on-goingprojects. It is important to manage the linkages appropriately to reuseor transfer technical knowledge acquired in one project to otherprojects within the firm. The management of these linkages is closely
related to the inter-project learning capabilities of manufacturers.
There are two types of inter-project linkages that affect the modeof inter-project learning, as shown in Figure 1. In the first type,concurrent design transfer strategor, a new project begins to transfer
technical knowledge and a design from a base project before the baseproject has completed its design engineering. In these two projects, thenew project and the base project, inter-project learning activities could
take place through direct communications and interactions, because thedevelopment efforts overlap chronologically. The second type, sequential
design transfer strategy, transfers a design from a base project to a
new project after the base model's development is finishedi. This typeof project basically reuses an existing design that is "off-the-shelf." Itmay not be efficient or effective, compared to concurrent designtransfer, because direct communications or interactions, design task

sharing and mutual adjustments are not possible between the two
projects2. In addition, when a new project uses the technologies anddesign in this manner the design being transferred is already relatively

old compared to designs which are transferred as a base model isbeing developed, as in concurrent design transfer.

1

The sequential design transfer strategy includes two different types. One is designtransfer from one product line to another, and the other is that between a newgeneration of a product line and its previous generation.
2

This discussion of hypothetical differences between concurrent and sequential
design transfer is partially based on Thompson's distinction between "intensive
technology" and "long-linked technology," where the former also enables mutualadjustments and direct interactions. See Thompson, 1967.

THE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGY 91
ON INTER-PROJECT LEARNING(1) Concurrent Design Transfer Strategy

Base Project

New Project(2) Sequential Design Transfer Strategy

Base Project

New Project

Figure 1 A Framework for Different Modes of lnter-Project Learning

For data analyses, we will focus on the transfer of technicalknowledge and design of new platform design in new vehicle
development projects, because it is a core system centrally located in
automobile design and because it is difficult to transfer. We believethat the same framework can be applied to major components of most
system products. A platform primarily consists of floor panels, asuspension system, a firewall and rocker panels. It defines thearchitecture of the automobile because the platform significantly
affects the basic characteristics of the rest of the vehicle's components
including the body structure, drive-train type and engine/transmission

size. Platform design, from this perspective, is considered to be a"core" sub-system. This notion of the platform as the core sub-systemof the automobile is widely shared by people in the industry, as well as

by researchers studying the industry. The selection of a specificplatform design determines the general level of design functionality andsophistication of the entire product. In addition, platform technology

is one of the key areas in which most automobile manufacturers
compete as they introduce newer designs and a higher level of
performance. Not surprisingly, more financial and engineeringresources are required to develop a new platform design than todevelop most other components. Therefore, it is critically importantfor firms to transfer and utilize a newly developed platform design
among multiple product development projects.
We hypothesize that projects utilizing concurrent design transfer

92

KENTARO NOBEOKA

strategy may require fewer engineering hours than those utilizing
sequential design transfer strategy, We believe that this measurement
is one indicator of effective and efficient inter-project learning. Only

through concurrent design transfer can knowledge be learned andtransferred from a base project to a new project with mutualinteractions and communication between the two on-going projects.
Concurrent design transfer strategy facilitates effective task sharing

and mutual adjustments between a base project and a new project,which we argue enhances an effective inter-project learning.
There are no differences in the effectiveness of design transfer andlearning when the platform design of a base project is re-used without

any modification, when it does not affect any other components within
the new vehicle design. However, even when a new vehicle development
project uses a preceding or an existing platform design as a base, first,
it needs to modify the design to adjust to the requirements of a new
development project. In order to modify the design, engineers in the
new project must know the design processes through which engineers inthe base project have reached the particular platform design, as well as

design outputs such as design drawings. Engineers cannot easily
modify designs through design drawings alone that have been createdby some other people. This type of knowledge can be efficiently
learned only from actual design and engineering activities while thebase project is still active, unless there are comprehensive records ofthe design processes, which are usually not likely or possible.

Second, a new project also needs to develop new proprietarycomponents for other parts of the new product's design. Linking
technologies between the platform design and other components arecomplicated and differ between the base and the new projects.
Therefore, it is likely that many potential problems are only identified

after the new car project starts. Without overlaps among the baseproject and the new project, it is difficult to learn how the new project

can avoid or solve problems that are related to the platform design
being transferred. In the concurrent design transfer strategy, theplatform design for the base project can even be modified according to
the requirements for the new project, so that the design is suited forboth projects and the efficiency of design transfer can be improved.

In addition, transferring and reusing an old design in a new
project may not be efficient, particularly when engineers apply the oldTHE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGY 93
ON INTER-PROJECT LEARNING

design in developing the new project that targets new market
competition and new customer needs. For example, Cusumano (1991)
has argued that reusing existing designs in new software development

without appropriate planning may have a negative impact on
development productivity and quality. When there is a long time lag
between a base project and a new project that transfers a design fromthe base project, it is less likely that there are specific plans for thisdesign transfer during the base project.

Conceptually related to this discussion, numerous studies haveprovided evidence that mutual ajustments and interactions lead togreater efficiency and effectiveness in transferring technology fromupstream functions to downstream functions (e.g., Cohen, et al. 1979;
Quinn and Mueller 1982; Imai, et al., 1985; Leonard-Barton, l988;
Gomory 1989; Leonald-Barton and Sinha 1991; Tyre, 1991; Clark andFujjmoto, 1991). These studies have also argued that mutualadjustments are implemented when there are overlapping and intensive
communications among multiple functions. In this way, the downstream

functions can learn effectively and efficiently what the upstream
functions do. The same concept may be applied to the case of learning
among multiple projects.

3. Sample Characteristics and Measurements
In order to explore the advantages of concurrent design transfer
strategy in inter-project learning, we surveyed 103 project managers of
new car and truck development projects at seven Japanese and three
U.S. firms. This questionnaire survey was conducted in the spring of
1992, and most of the projects surveyed were completed between 1986
and 1992. Among 103 projects we surveyed, 78 projects transferred andutilized a platform design as a base from other projects within thefirm. Among these, we were able to obtain complete answers for 58
new vehicle projects to examine the learning efficiency. Our method for
calculating engineering hours is explained in Appendix. We did not findany systematic differences between the data for the 58 projects and thetotal sample. This sample included 41 Japanese and 17 U.S. projects.
Questionnaires were distributed by one central contact at eachcompany to project managers. The actual number of questionnaires
distributed and the selection of projects were decided primarily by94 KENTARO NOBEOKA
those contact persons. The only guideline for consistency was todistribute the questionnaires to at most 15 project managers in eachfirm who had recently worked on relatively large new product projects.

In the questionnaire, product variations such as different body types
and trim levels which are developed within a distinct project are defined
as a single product. Questionnaires were pre-tested with three project

managers. In particular, we discussed with several project managers
and engineers the definitions and measurements of engineering hours
which are described in Appendix. Throughout our research project,including our data analysis stage, we conducted in-depth interviews
with approximately 130 engineers and 30 project managers at five
Japanese, three U.S., and four European firms between September 1991
and May 19933.

Design Transfer Strategy TypeOne survey question asked whether the platform design eachproject developed was new to the firm or based on a preceding design.

New projects that developed their platform design without any basedesign were eliminated from the sample, because this study focused on
different inter-project learning strategies. New projects based on aplatform design of their direct predecessors, which were to be replacedby these new projects, were automatically categorized as sequential
design transfer. Those projects based on the platform design of otherproduct lines were categorized as either type. The determination ofwhich category depended on the answer to a question that asked if
there were overlaps and interactions between the new project and thebase project with respect to platform design development. Additionally,a project meets the definition of a concurrent design transfer only if

the project managers of the base project and the new project are''
Project Content and Control Variables
It is always critically important to control for differences inproject complexity in order to accurately compare engineering hours''

3 During this research project, the author lived in Boston. The author's field study. included three trips to Japan, one to Europe, and several to Detroit, augmented bynumerous interviews around Boston with MIT's International Motor Vehicle

Program participants. •THE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGY 95
ON INTER-PROJECT LEARNING

across different projects. First, design complexity and newness aremeasured by the ratio of new versus carried-over components in two

separate areas, body/interior and engine/transmission. The
automobile design consists of three primary component groups:
body/interior, engine/transmission, and platform. Therefore, these
new component ratio variables cover the rest of the automobile design
not contained within the platform. Second, many components in new

product projects are completely new yet do not impart any newtechnical features, and should be distinguished from components thatincorporate technology new to the firm. Therefore, in addition to the
new component ratio, we also measured the innovativeness of eachproject by asking whether the technology used in each component area
brought new technical features to the firm (yes==1, no=O). The averageof the answers in these two areas was calculated to create aninnovativeness index, which ranges from O to 1. Third, price in themarket and the number of body types for each new product were alsomeasured, because these may also significantly affect project complexity` .

Finally, a vehicle type variable denotes whether a project is for a car
or a truck, because the other design complexity variables used did not
capture the different design and market characteristics for these twokinds of vehicles. We felt that such differences might potentially havean impact on project performance.

4. Survey Results

Table 1 summarizes the raw data on project content, andengineering hours for each different design transfer strategy type. The
set of projects studied are, in general, relatively major projects as

opposed to minor facelift projects, as indicated by the average
percentage of new design ratio for body and interior components(88fO>6o). In other words, while these projects transferred systemknowledge related to the platform design, they also developed new
proprietary designs to differentiate for and to adjust the new products
to thier own targets.

With respect to design transfer strategy applied to platform
4 Clark and Fujimoto (1991) also used all of these control variables in their study.
Our study intentionally uses their set of variables for product characteristics.

96 KENTARO NOBEOKA
design, 18 of 58 projects (31% of all projects) followed the concurrent

design transfer strategy, in which a platform design was transferredfrom other projeets in progress to the new projects. The remaining 40
projects followed the sequential design transfer strategy. The averagetime lag between the new project and the base project with respect toproject completion was 15.0 months for concurrent design transfer
strategy and 75.7 months for sequential design transfer strategy. The
difference in Iags led us to believe that this question served to
distinguish adequately between these two.
One of the critical characteristics of the sample data that must be
controHed in a regression analysis is the nationality of the projects. As

Clark and Fujimoto (1991) have argued, there are fundamental
differenees in productivity embedded in each region. Fifteen of the 18

projects that utilized concurrent design transfer strategy wereJapanese, and 26 of the 40 projects that utitized the sequential designtransfer strategy were Japanese firms. Engineering hours forconcurrent design transfer projects and sequential design transfer
projects are, on average, O,72 and 1.98 million hours, respectively. Thislarge difference may be partially explained by the differenee in thenationality of the porject. Many more Japanese projects, which weregenerally superior in productivity, were categorized into concurrent
design transfer strategy, There are also some differences in projectcontent between the different design transfer strategies, which we
controlled for to accurately compare the impact of the strategy type on
the project performance or the learning efficiency. For example, theaverage number of body types for a concurrent design transfer project

was 1.7, while that for a sequential design transfer was 1.9. Thisdifferenee may also explain the difference in the engineering hours in
Table 1, so we controlled for it in our regression analysis.

97
THE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGYON INTER-PROJECT LEARNING

Table 1 Data on Project Content and Project Performance
Concurrent

Sequential

Total

DesignTransfer DesignTransfer#ofProjects
Japanese

18

40

58

15

26

41

us

3

14

17

Price($)

16390(7920)

15880(7310)

16030(7430)

1.7(O.5)

1.9(O.9)

1.8(O.8)

4

7

11

Engine/Transmission

63(39)

58(37)

60(37)

Body/Interior

89(22)

87(26)

88(24)

O.33(O.38)

O.14(O.25)

O.20(O.31)

O.72(O.48)

1.98(2.22)

1.58(1.95)#ofBodyTypes
Truck/Van
NewDesignRatio(9(of)InnovativenessIndex(O-1)

EngineeringHours(millionhours)(Standard deviations are in parenthesis.)Table 2 lists the regression analysis for engineering hours as
related to type of design. Model 1 uses only basic control variables,
including nationality, price, and vehicle type. In addition to thesevariables, Model 2 contains task complexity variables, including thenumber of body types, new design ratios for engine/transmission andbody/interior components, and the innovativeness index. Model 1
shows that Japanese projects required far fewer hours, but were notinfluenced by product price or vehicle type. In Model 2, the results
show that in addition to the difference in nationality, projects thatdeveloped more body types required more engineering hours. After
controlling for all of these variables, Model 3 supported our hypothesisthat new projects which use the concurrent design transfer strategy
required significantly fewer engineering hours than did those using
sequential design transfer strategy. We believe that this result, at least

partially, has provided evidence of the efficiency of the concurrent
design transfer strategy with respect to inter-project learning. We will
discuss the potential reasons for this result further in the next section.

KENTARONOBEOKA

98

Table 2 Regression Analyses for Engineering,IndependentVariables

HQurs

Model1 Model2Model3
o.oo

Constnto.oo

o.oo
O,47 l -i
-O.05
O.Ol

Nation(US=1,Japan=O)

O.56' tl

O.55"'

Product'sPrice($intenthousands)

-O.08
-O.04

-O.06
-O.02

VehicleType(Car=O,Truck=1)
ProjectTaskComplexity

NumberofBodyTypes

O.43"'

InnovativenessIndex(O-1)

O.06
O.07
O.11

NewDesignRatio%(Engine/Transmission)
NewDesignRatio%(Body/InteriorComponents)
Inter-projectStrategyTypeofPlatformDesign
1.ConcurrentDesignTransfer
2.SequentialDesignTransfer

AdjustedSquaredMultipleR
SampleSize

O.42 . ll
O,03
O.07
O.20

-O.22 ' .

O.25
58

O.43
58

Coefficients are standardized.
Statistically Significant at: "5906 Level, "'1% Level

Additionally, because the engineering hour data were collected for
only the concurrent design transfer projects, and not for combinations
involving concurrent design transfer projects and their preceding baseprojects, there may be questions regarding negative impacts to the baseproject. If these impacts are severe enough, the usefulness of the
concurrent design transfer strategy might become suspect. In order totest this criticism, a question in the survey asked whether there wasanother following concurrent project with which the respondent's

project shared the platform design, and with which there wassignificant overlap and interaction. The results showed that these
concurrent projects (i.e., other concurrent design transfer projects) did

not significantly add engineering hours to the respondent's projects(see Nobeoka, 1993 for the actual analysis). This leads us to believethat a concurrent design transfer project would not significantly

impedeapreceding base project. '' .
5. Discussions and lmplications'
This section discusses some implications of the survey results on
the two different learning settings. First, we suggest potential reasons

O.46
58

THE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGY 99
ON INTER-PROJECT LEARNING

for advantages of the concurrent design transfer strategy for the inter-

project learning, based on extensive interviews with project managers
and engineers from our field study in Japan, the U.S., and Europe.

Then we discuss appropriate organizational structure to manage
concurrent design transfer projects using some cases from our fieldstudy, which include a strong control above project managers and a
new type of matrix organization.
5-1 Efficient Learning Setting: Concurrent Design Transfer

There are at least several reasons why a concurrent designtransfer strategy provided a more efficient learning setting. This was
supported by its requiring fewer engineering hours than a project using
sequential design transfer strategy5. In a concurrent design transfer,engineers can learn and transfer a design from a preceding baseproject to a new project more efficiently than in a sequential designtransfer. There are two basic factors that may contribute to thisdifference. First, the time lag between the completion of a base project

and that of a new project is much shorter in a concurrent designtransfer project. Second, there are overlaps between the preceding baseproject and the new project only in the concurrent design transfer

strategy. These two factors create specific advantages anddisadvantages in productivity and inter-project !earnig in the two
design transfer strategies. The first factor, the time lag between
completion of a base project and that of a new project, may affect thedifficulty of advanced planning and of learning and incorporating old
designs into a new design architecture. The second factor, the overlap
between a preceding base project and a new project, may influence thefeasibility and the efficiency of inter-project communication. Theseissues are categorized into the following four areas; planned learning

vs. ad hoc learning, learning enhancement through mutual adjustments,
task sharing, and joint design, transfer from a "fresh" project vs.

"dated" project, and role of a general manager for multi-project
management.

5 Prograrn managers and engineers we interviewed basically agreed with ourfollowing interpretations. However, some of these are still only hypotheses thatshould be studied further in detail.

100 KENTARO NOBEOKA
PIanned Learning vs. Ad hoc Learning
When a new project transfers and uses a platform from a -preceding
project, the new project usually needs to modify the base platform
design to adjust it to the new project's proprietary architecture. The
difference in design requirements for the platform design between thetwo projects may be caused by many factors, including differing
customer needs and market segments. In addition, the methods forlinking technologies between the platform and other components of theautomobile design such as the exterior body are often different between
the base product and the new product. Because, in our sample, bodydesigns are different between the two products, as shown earlier inTable 1, this difference alone often requires adjustments to the baseplatform design.
It may be more efficient if advanced plans are made during thebase project regarding the way in which a future project might use thebase project's platform design. The time lag between a base project andconcurrent design transfer project, 15 months on average, was much
shorter than that between a base project and sequential design transfer
project, which was 75.7 months on average. These long time lags may
reflect circumstances in which the base platform was designed without
any plan or consideration for a potential transfer to other future
projects. A question in this survey asked the program managers about
the timing of decisions to make use of the base platform designs in the
new projects. In only 33% of the projects following sequential designtransfer strategy had a decision been made about the usage of theparticular base plarform design before the base project was completed.
Planned learning should be more efficient than ad hoc learning. It is areasonable assumption that the shorter the time lag is, the more likely
planned learning exists.

Learning Enhancement through Mutual Adjustments and Task Sharing
Even when there is an advanced plan during the base project
which describes how a future project will modify and use the baseproject's platform design, there are often unexpected adjustments
required during the new project. It is almost impossible to makeaccurate plans to modify the course of the base platform design totransfer it to the new project when there is such a Iong time lag
between these two projects. It is difficult for engineers in the base

THE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGY 101
ON INTER-PROJECT LEARNING

project to predict problems a future project may encounter in using theold platform design. In particular, many potential problems withrespect to the linking technologies become evident only after the new
project starts, because these problems may become more obvious only
after the design of other components begins. Under this circumstance,
the effectiveness and the efficiency of inter-project learning should be
improved by inter-project overlap.
There are three patterns of inter-project interactions, all of whichshould positively improve learning. First, whether or not there are such

advanced plans, and partly because of interdependencies between
component sub-systems, adjustment and learning processes are socomplicated that they can be more efficiently done through multiple
iterations of feedback between the two projects. Only in concurrent

design transfer projects can the engineers designing components
implement mutual adustments with base projects through an extensive
communication6.
Second, in addition to the mutual adjustments, because of theoverlap and other interactions, these two projects also can effectively
share engineering tasks and resources (task sharing). For example, in

our interviews, some engineers explained that the same testing
prototype can only be shared by multiple interrelated projects for datacollection, when engineers in both projects cooperate closely. Third, inother cases, engineers from the two projects can jointly work on
certain engineering tasks as a group (joint design). Mutual adjustments, task sharing and joint design with a base project, all of which
can be appropriately implemented only in a concurrent design transfer
project, may have contributed to the efficiency of inter-project learning.

In sequential design transfer projects, engineers in a new project

must often learn technical knowhow and design from base projects
through design drawings and specifications, because the base projects
were already completed and the engineers for the base projects may

have already started working on other projects. Some of theseengineers may even have already left the firm. Therefore, it can bedifficult for engineers on the new project to find and communicate with
6 By definition of our categorization scheme for the design transfer strategy types,
explained earlier, only in concurrent design transfer projects did engineers haveoverlap and actual interactions with engineers on other projects from which
platform designs were transferred.

102

KENTARO NOBEOKA

engineers who worked on the old base platform design. It may not be
convenient for engineers who designed the base platform design to help
the engineers on the new project understand the base design. Moreover,engineers for the completed base project may not have enoughmotivation to cooperate with the engineers for the new project,particularly when they have already started working on other projects
that have nothing to do with the new project. From these perspectives,inter-project learning may be difficult in the sequential design transfer
strategy.

These issues are important because face-to-face learning is much
more efficient than learning through specifications and drawings,
particularly regarding some types of knowledge. Some engineers in ourinterviews mentioned that, in order to modify a base design, they often

need more knowledge than that which could be found in standard
drawings or in CAD data. For example, the relationship between
modifications in design and consequent changes in functionality is notshown in the drawings. Only engineers who actually worked on thebase design may have that kind of information in their minds or notes.
Knowledge about the base design that engineers in the new project may
need to modify and adjust the base design to fit the new project may
also include other types of intangible or tacit understanding. It isdifficult for them to learn that kind of knowledge without actual
overlap and interactions with engineers familiar with the base platform
design (Nonaka, 1990 ; von Hippel. 1990).

Transfer from "Fresh" Projects vs. "Dated" Projects

There are also fundamental problems with learning from a"dated" project. As mentioned earlier, in the projects using a platform
design that has already been developed or is being developed as a base,other components such as body and interior components are often
newly developed. This mixture may create some difficulties in linking

the old platform design with new designs in other parts of theautomobile. For example, over the past decade, the usage of CAD in
design has become more extensive each year. The old designs might
have been drawn on paper, instead of using a CAD tool, which has
become common only in the last several years. One other example isthe increasing use of plastic or aluminum materials for the body
panels, which may not fit appropriately with older platform designs.

THE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGY 103
ON INTER-PROJECT LEARNING

Some engineers in our interviews also commented that design
requirements evolving from customer needs, market competition, or
governmental regulations often change after the original design iscompleted, especially when the time lag between the completion of thebase design and its transfer to the new project is long. In other words,

engineers have to learn technical knowhow from relatively new projects
in order to utilize it effectively. The sequential design transfer may nothave been appropriate from this perspective, because the time lag was
too long.

Role of a General Manager for Multi-Project Management

Finally, there is another organizational factor that may
differentiate the learnig effectiveness of concurrent design transferfrom the sequential design transfer. There are usually generalmanagers or vice presidents above the project managers responsible for

product development. These higher-level general managers are
sometimes called platform managers, and have responsibility for multiple

new product projects. They are likely to be responsible for both a baseproject and a concurrent design transfer project, because the time lag
between these projects is short. On the other hand, when the time lag
is long, it is less likely that the same general manager is responsible
for both a base project and a sequential design transfer project. Thisdifference in leadership may affect the efficiency of learning between
the two projects. For example, a general manager is likely to consider

the total productivity of the base project and the concurrent designtransfer project together, while such concern is less likely if he or she

expects to move on before a related follow-on project begins. In otherwords, the shorter the time lag between multiple interrelated projects,

the greater the potential benefit to a single strong general manager
who might lead and manage the inter-project learning'.
As briefly discussed in Section 2, some of the perspectives in thediscussions above about the efficiency of concurrent design transfer are

analogous to efficiency in managing overlaps among different funcions.
Multiple functions, at least to some extent, have a sequential nature in

7 A similar argument could be made not only for general managers, but also forother key functional engineering personnel who are responsible for cornponent

engineering on multiple projects. •104 KENTARO NOBEOKA
terms of tasking. Managing overlaps among multiple functions such as
described by the term "simultaneous engineering" can lead to negative
implications due to the necessarily sequential nature of some tasks. On
the other hand, by managing the overlap among multiple projects, via"concurrent design transfer", a firm may avoid these types of negative
influences, as long as these projects coordinate with each other andmutually adjust their designs. We believe that this lack of negative

implications also at least partially explains why our results
demonstrated a strong gain in project productivity or learning
efficiency through concurrent design transfer.

5-2 Organizational Structure: Multi-Project Management
We have argued that in order to enhance inter-project learning,firms should effectively manage multiple concurrent projects. In orderto achieve this goal, there should be an appropriate organizational
structure. One of the critical issues related to organizations is thatfirms must not decrease the integrity of each project while theyencourage inter-project learning. The importance of the crossfunctional integrity within each project can never be underestimated,because of the system characteristics of the vehicle products. From thisperspective, firms cannot adopt a traditional funcion-orientedorganization to enhance inter-project learning. In our follow-up
interviews, we found that some firms have actually introduced a few
new concepts to their organizations to deal directly or indirectly with
the inter-project learning.

First,.we found that some manufacturers have been shifting theirorientation from the management of a single project to multi-project

management. Toyota's organizational evolution pattern shows anexample of this trend. As Clark and Fujimoto (1991, pp. 276-280)
discussed, by the late 1970s most Japanese companies had shifted fromfunctionally-oriented organizations to project manager-based
structures. By the mid 1980s, a few Japanese firms including Toyota
had already shifted to relatively heavyweight project manager systems,
or the "Shusa" systern, which has been widely discussed (Ikari, 1985;
Shiosawa, 1987). However, in 1992, Toyota created several chiefengineers above shusas. Each of the chief engineers, by managing
several shusas, is responsible for multiple cuncurrent projects. The
person in this position assumes some of the authority that a powerfulTHE INFLUENCE OF PRODUCT DEVELOPMENT STRATEGY 105
ON INTER-PROJECT LEARNING

leader for a single project, a shusa, used to have. One of the primary

purposes of creating a position more powerful than the shusa isfacilitating the inter-project learning, which should enhance the quicktransfer and sharing of new designs among multiple projects.

In the past few years some other manufacturers in Japan, theU.S., and Europe have also introduced this type of organizational
structure, so that multiple projects could also be managed by a strong

control mechanism above project managers. One common mechanism
for control is to divide the whole project portfolio into several groups

and to place general managers above the individual project managers
for individual projects. Although different manufacturers form theirgroupings differently, we were able to identify three categories from
actual examples at nine manufacturers:
1. Design-oriented group (e.g., small vs. medium vs. Iarge cars, frontwheel vs. rear-wheel drives.): Toyota, Ford, Chrysler, Fiat, Renault.

2. Plant-oriented group (e.g., products manufactured at plant A vs.
plant B vs. plant C.): Honda.

3. Customer-oriented group (e.g., luxury vs. economical vs. sporty/leisure market segment.): Nissan, Mazda, Mitsubishi.
These differences may reflect each firm's priority for its interproject learning strategy: either focusing on the efficiency of design,
manufacturing or customer segment, The organizational processes inmanaging multiple projects may also be different. In order to explore

these organizational issues, further studies including intensive
interviews and internal document analyses are needed.
Second, in order to avoid a trade-off between cross-functional
integrity and inter-project learning, some Japanese automobile firms
have employed the idea of extensively differentiated mechanisms withina matrix organization. They are creating a variety of working
structures to manage the development of different design tasks basedon an explicit recognition of the degree of inter-project and cross-functional interdependencies. Figure 2 depicts an example of adifferentiated matrix from one of the Japanese automobile firms.
Depending on the nature of the interdependency and desired learning106 KENTARO NOBEOKA
orientation, there is flexibility in changing task partitioning andorganizational structure.

For some particular components, learning may have to be mostly
enhanced within a function, while knowledge regarding some otherspecific system components may have to be shared by two particularconcurrent projects. In the example depicted in Figure 2, components
like batteries and audio systems in the electronics design division tend

to be developed by a pure component group, while platform
components are developed by a multi-project team. Engineers working

on some body components are totally devoted to a single projectthrough a project-oriented group. The task partitioning strategy
determines the locus of learning. Because the nature of both crossfunctional and inter-project interdependencies, and learning orientation

may change all the time depending on the combination of projects being

developed, the structure should also be quickly and dynamicallychanged. In future research, we plan to study this concept of"dynamic" differentiated matrix structure both empirically andtheoretically in order to explore an appropriate learning organization.

Body Chassis lnterior Engine Electronics
Mixed- Multi-project Multi-Project Component Component

Team Team Team Team Team

Project A

Project B

Project C

Project Deeee

Figure 2 An Example of Differentiated Matrix Organization

THE INFLUENCE OF PRODUCT DEVELOPMENTSTRATEGYON INTER-PROJECT LEARNING

6. Conclusions
This study has discussed, using survey results, the advantage ofconcurrent design transfer strategy in inter-project learning, which
provides a more efficient learning setting than does sequential designtransfer strategy. Based on our interviews with engineers and project

managers, we also suggested several potential reasons for theefficiency of the concurrent design transfer strategy. Only through thisstrategy can knowledge be learned and transferred from a base project
to a new project with actual interactions and communication between
the two projects. In addition, it may often be difficult to learn technicalknowledge from a relatively old project, as is the case with sequential
design transfer. It is difficult to apply what engineers Iearn from an
old project to new architecture and requirements of the new product.
0rganizations at both the management level and the engineering level

cannot strongly support an inter-project learning when two or more
projects are far apart from each other chronologically.

This paper also argued that organizational structures andprocesses that are appropriate for inter-project learning may not be a
traditional functional approach, because of the system characteristicsof the products. Rather, they should be aimed at achieving both corssfunctional coordination and inter-project coordination simultaneously
through the active coordination of multiple projects. This search forbalance requires a multi-project management perspective, rather than asingle-project management perspective. This approach maximizes thedistinctiveness of product components essential to differentiate one
product from another, but also improve the quantity and quality ofinter-project learning. Companies may need either strong control above
the matrix organization, or organizational structures and processes

that enable system-level coordination across multiple projects. In

addition, we also described a concept of a dynamic flexible
differentiated matrix organization, which may deal with both crossfunctional and inter-project learning depending of the nature of projectand component developments at a certain point of time. However,

because this study has primarily focused on the performancedifferences between two learning strategies, further studies need to
examine these organizational issues both theoretically and empirically.

107

KENTARO NOBEOKA

108

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ON INTER-PROJECT LEARNING

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von Hippel, Eric: 1990. "The Impact of Sticky Data" on Innovation and

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KENTARO NOBEOKA

110

Appendix Definitions and Measurements of Engineering Hours
Engineering hours (EH) for each project are estimated as follows.

EH= (FS + PS'PR) 'LT' WH/2
FS : The number of engineers who worked on the project (full time).
PS :The number of engineers who worked on the project (part time).
PR : Average percentage of time part time engineers spent on one project'.

LT : Lead time (months)
WH : Average monthly working hours per engineer'.

('The corporate-level average, obtained from the questionnaire survey of design
engineers, which was conducted in the same research project. The method of thissurvey is described in Nobeoka, 1993)

This estimation scheme is based on our interviews and discussions with engineers
primarily at five Japanese firms. In this equation, the number is divided by two basedon the assumption with respect to a typical pattern of changes in engineering hours
throughout each project, as shown in the figure below. A project defined in this study
contains a time period from the beginning of concept and product planning to job #1.

This period includes primary development tasks including "concept and productplanning", "product engineering and testing", "process engineering", and "pilot
production" .

1i Leed Time t,'+

Concept and Product Planning

1

1
,
,
,

1

1

1

1
1
,

'

Product Engineering and Testing

t
1

,

1

,

'

l

,

1

1

1

l

Process Engineering

'
'

,

r

,

1

r

1

1

,

1

,
,

Pilot Production

and Job #1

'
+

F

t
1
1
1

Engineering

Hours

1

Assumption for Change in Engineering

Hours

1

,
t

A COMPARISON OF JAPANESE AND UK WELFARE

Stephen J DAvlEst

1. Introduction
This paper can be thought of as a contribution to the literature inextended national accounts2. It was in the early 1970s that academic

interest in extending or modifying the statistics for GDP to obtain ameasure of economic welfare was at its peak. That was the age of the"Club of Rome" report, and of widespread worries about theenvironmental effects of economic growth and the sustainability of an
economic lifestyle that was depleting the world's resources. Nowhere
were these concerns more widely felt than in Japan, which had, by theend of the 1960s, experienced a decade and a half of exceptionally fast
growth, accompanied by increasingly grave problems of environmental
pollution. (And perhaps nowhere were these concerns less keenly felt

than in the UK, where the overriding worry was the failure of theeconomy to share adequately in the post-war "catch-up" of the otherdeveloped countries with the United States, rather than any untoward
consequences of the limited growth that was actually achieved.)

The most important type of response by Japanese governments tothese concerns was to implement a range of measures which addressed
the pollution problems that a better off Japanese public was no longer

willing to ignore. Another response was that the Japanese
government's economic policy committee set up, in May 1971, a
committee to develop the measurement of Net National Welfare. This
committee published in March 1973 a report entitled "A new welfare
index: NNW". The proposed index, which was closely related to the
1 Senior Economic Adviser, H.M.Treasury, Currently undertaking research at the
Economics and Business Administration Research Institute, Kobe University. All
views expressed in this paper are personal and do not represent the views of HM

Treasury.
2 A survey of the literature is to be found in Robert Eisner Extended Accounts for

National Inconze and Product The Journal of Economic Literature, Volume 26,
No.4, December 1988.

STEPHEN J DAVIES

112

Measure of Economic Welfare proposed for the United States by
Nordhaus and Tobin3, does not appear to have been subsequently
maintained and published along with the regular national accounts
statistics, however. (In recent years, the Economic Planning Agency
has published annually a range of indicators-New Social Indicators,
People's Life Indicators-relevant to a measure of welfare that goesbeyond GDP, without attempting to combine these indicators with GDP
into a single measure of welfare.)

The NNW index was revisited by Japanese academics in 1977`. In
this later study, which followed with a few modifications the earlier

official work, NNW was computed as the sum of the following
components:- "NNW government consumption",which excluded
from the normal measure of government consumption expenditure on
the law and the police;- "NNW personal consumption", which excluded
spending on consumer durables;-services from the government capital stock;-services from the personal sector's capital stock;-the value of leisure time''-the value of non-market activities i.e. housework't!

-the cost of environmental pollution, obviously
taking a negative value in the summation;- "losses accompanying urbanisation".

The published results of the study were quite striking, andsuggested that NNW grew significantly less fast than GDP over theperiod 1955 to 1970, but much faster than GDP between 1970 and 1975,reflecting a fall in various indicators of environmental pollution, as well

as a sharp increase in leisure time, in the latter period:

3

4

William Nordhaus and James Tobin Econornic Growth. NY:NBER. 1972.

Hisao Kanamori, Yuriko Takase, Kimio Uno, Economic Growth andwelfare.

Japan Economic Research Centre. Research Report No.41, September

1977 (inJapanese)A COMPARISON JAPANESEOFAND UKWELFARE

Growth rates of real GDP and NNW (per cent p.a.)

1955-1960 1960-1965 1965-1970 1970-1975

NNW 5.1 6.6 8.2 9.3
GDP 8.7 9.7 IL6 5.2
The present paper involves a cross-country comparison, rather
than the estimation of a time series for a single country. In general, it

concentrates on figures for 1990. The simplest possible comparison isperhaps to take GDP per capita for Japan and the UK, expressed atcurrent prices and converted into a common currency using market
exchange rates. As shown below, UK GDP per head of population in1990 was only 71.6 per cent of the Japanese figure.
GDP per head of population5 (in US$, market exchange rates)

Japan UK

1990 23734 16922
The first refinement to these figures is to take account of therelative price levels of the two countries. The use of Purchasing Power
Parity statistics is discussed in more detail in the next section of thepaper. At this stage, we just note that using the latest PPP benchmark

estimates for 1990 published by the OECD, the gap between Japaneseand UK GDP per head is narrowed considerably, with UK GDP per
capita some 90 per cent of the Japanese level.
GDP per head of population (in US$, PPPs)

Japan UK

1990 17596 15888
The second type of adjustment that we need to consider is the
exclusion of some components of GDP from the comparison, on the
grounds that they do not contribute directly to welfare. This isdiscussed more fully later in the paper, but here we note theimplication of dropping all investment (both domestic and overseas)from the comparison.

AIthough international comparisons of capital stocks are
5 Source: OECD, National Accounts 1960-1992

113

114

.STEPHEN J DAVIES

hampered by the widely differing assumptions about asset lives thatare adopted in defferent countries' national accounts, it is fairly clearthat the Japanese economy is considerably more capital intensive thanthe UK economy. One set of estimates6 that adjusts published national

figures to a common set of assumptions shows a ratio of the grosscapital stock (of nonresidential structures and machinery andequipment) to GDP of 2.8 in Japan compared with a UK figure of 2.0.

Simply to maintain the existing capital/labour ratio (and thus
maintain output per head in an economy with a growing population) ahigher proportion of GDP needs to be devoted to gross investment inJapan than is the case in the UK. A correspondingly smaller
proportion of GDP is available for consumption.
Some allowance clearly has to be made for this, and an extreme
position'not one that is ultimately defended later in the paper-is totreat all investment spending as intermediate in nature and to consider

only consumption (private consumption and government consumption)
as contributing to welfare. If we look at consumption per head (using

whole economy PPPs to convert to a common currency), we find thatin 1990 while private consumption per head was a little higher in Japan,

government consumption per head in the UK was around twice theJapanese level; and total consumption per head was some 13 per centhigher in the UK than in Japan.
Consumption per head of population (1990, US$, PPPs)

Private Government Total

Japan 10098 1608 11706

UK 9996 3267 13263
At the same time, GDP excludes some elements that may

contribute to welfare. The most important class of these is the use oftime other than in paid employment, principally in leisure activities orin non-marketed activities such as housework. As discussed in section

5, a higher proportion of the Japanese population than the UK
population is in paid employment (labour force participation rates are
similar, but unemployment is higher in the UK); while average annual

hours worked per worker are substantially higher in Japan. Making
6 Angus Maddison Dynamic Forces in Capitalist Developrnent OUP 1991

115
A COMPARISON OF JAPANESE AND UK WELFARE

adjustment for leisure etc. therefore raises the estimate of UK welfare
relative to that of Japan.

2. Comparisons of Japanese and UK prices
The comparisons of price levels in the OECD countries publishedby the OECD is a joint exercise by EUROSTAT (the statistical agencyof the EC, which prepares annual PPP estimates for the EC member
countries and Austria) and the OECD which handles the data for othercountries. OECD benchmarks are calculated every 5 years (mostrecently for 1990) and can be interpolated to intervening years using
time series of national price indices. Comparisons of market exchange
rates and PPP exchange rates show that some countries are expensive

to live in and other countries cheap. The UK has in recent years
generally been a cheap country (as has the United States) while Japanis expensive. This position has been reinforced by the fall in sterlingand rise in the yen over the last two years: in 1993, Japan was around76 per cent more expensive than the UK, on the basis of the 1990 PPP
benchmark, extrapolated using subsequent movements in Japanese andUK price indices.
This enormous estimated difference in prices raises the obvious
question whether we can rely on the statistics; and there seem to be
two ways of considering the answer to that question: firstly we cancheck the calculation against an alternative methodology, and secondly
we can see if we can explain the reasons for the difference.
Checking the PPP estimates against an alternative methodology ismost easily done for a comparison between the Japan and the UnitedStates; if the PPP comparisons pass that test it might be reasonable togive the Japan/UK comparisons the benefit of the doubt. Aggregate
productivity estimates for Japan and the US derived using the 1990 PPP

benchmark and Maddison's data for employment and hours worked areshown below.
Output per hour at current prices and PPPs (US$)

1987 19gg 1989

US
24.49
25.94
27.26
Japan 13.83 15.00 16.26
Japan/US ratio (per cent) 56.5 57.8 59.6

116 STEPHENJDAVIESVan Ark and PilatT, using census of production data and the"industry-of-origin" approach, which is in principle completely
independent of the PPP estimates, estimated relative Japanese/US
prices and productivity for manufacturing industry. After adjusting to

remove the effects of high Japanese food input prices on the output

prices of the food manufacturing industry, they found that theexchange rate needed to equate average Japanese and US
manufacturing prices in 1987 was \173.6= $1, compared with a market
exchange rate of \144.6=$1. The associated estimates of value added
per hour worked put Japanese manufacturing productivity at 67.5 percent of the US level.

Estimates by the McKinsey Global Institute for various service
industriesS show Japanese labour productivity (output per employee) intelecommunications at between 41 and 66 per cent of US levels, using as
the output measure either the total number of calls-which gives thelower figure-or a 50-50 weighting for the number of calls and thenumber of access lines.
The same study puts Japanese productivity in general merchandise
retailing at 44 per cent of the US level; however the measure used is"real value added per employee, using PPPs as deflators" and so
obviously not an independent check on•the validity of the PPP
estimates. Productivity (real sales per full-time equivalent) in Japanese"multicategory stores" is very similar to US levels; but productivity in"single category" stores in Japan is only 31 per cent of US levels. At

the same time there are twice as many employees in wholesaling forevery retail employee as there are in the US.

Although no precise conclusions can be drawn from thecomparison of the PPP estimates (and the productivity comparisonsbased on them) with the alternative estimates (which obviously do notcover the whole economy), the two sets of figures certainly do not lookseriously out of line. The comparison does not establish a presumptionthat there is anything wrong with the PPPs.

7 Bart van Ark and Dirk Pilat, Productivity levels in Germany, Japan and theUnited States: Dtfferences and Causes. Brooking Papers on Economic Activity,
Microeconomics 2, 1993, pp.1-48
8 Reported in Martin Neil Bailey, Competition, Regulation and Efficiency in Service
Industries. Brookings Papers on Economic Activity, Microeconomics 2, 1993, pp.71130

A COMPARISON JAPANESEOFAND UKWELFARE

Quality or price differences?

Before trying to understand the reasons why Japan is more
expensive than the UK (or the US), we need to consider the possibility

that the PPP figures may be picking up not a genuine difference inprice, but a difference in quality (just as a part of what national priceindices record as inflation is in fact an improvement in quality). Casual

observation suggests that supermarket fruit and vegetables, forexample, are of a more uniformly high standard in Japan than in theUK, and that this explains a part of the enormous price discrepancy
between, say, apples which might retail at less than \20 per fruit in
the UK, and at \100 or more in Japan. To take another example thatis very familiar in the UK, Japanese cars are regularly shown in
consumer surveys to be more reliable than cars produced in othercountries. There is no reason to think that high Japanesemanufacturing standards are confined to cars.

More generally, as one Japanese critic of his country's
distribution system conceded: "Few will believe that the quality of

distribution services is no higher in Japan than in the US...For
example, liquor stores deliver beer to doorsteps in Japan. Presaledemonstrations are more common. Courtesy is more prevalent9" . These
remarks would apply a fortiori to a comparison between the UK andJapan. It may be that in some cases the high standards of services inJapan are the consequence of barriers to price competition. But that
does not make them any less a potential source of bias in international
price and output comparisons.
A somewhat different reason for suspecting the PPP comparisons
is that they are almost certainly contaminated by deficiencies in the
coverage of the Japanese retail price survey, which forms the basis of

the Japanese consumer price index. The retail price survey, forexample, specifically excludes special prices, such as those associatedwith "sales". And, although the coverage of the index has been
updated to take more account of imported goods, the fact that such
updating was felt to be necessary at the start of 1992, for example,
suggests that earlier coverage was inadequate. Moreover, prices are
9 Kiyohiko Nishimura, The Distribution System of Japan and the United States: A
Cornparative Study frorn the Viewpoint of Final Buyers, Japan and the World
Economy 5 (1993) No.3, pp.265-2gg

117

118 STEPHENJDAVIES
reported for the survey by designated shops-not by official shoppers,
as in the UK-and the coverage of shops has not been ehange to reflect
the growing importance of "discount stores" which sell at relatively
cheap prices: the official reason given for this inertia is that to include

discounters would cause a break in the CPI series.
At the same time, one source of upward bias in the estimates of
the UK price level used in the PPP estimates should be noted. The data

used in the UK's contribution to the EUROSTAT PPP exercise cover
only London prices'O. As the cost of living is relatively high in London,

the PPP estimates overstate the UK price level and imply acorresponding understatement of real output. To summarise this
discussion, there is certainly something in the view that apparent pricedifferences between Japan and other countries (including the UK) inpart reflect quality differences. But there is no obvious way ofquantifying this component; the point just has to remain as aqualification to be born in mind when using the PPPs.
Explanations for Japan's high prices
We now turn to possible explanations for Japan's relatively highprices. Firstly, it is well known that there is a positive relationshipbetween real exchange rates and GDP per capita (rich countries tend
to be expensive); but since Japan's GDP per capita is only a little

higher than that of the UK (once PPPs rather than market exchange
rates are used in the calculation), this cannot explain very much of thegap between UK and Japanese price levels. Again, the tax system may
be an important influence; but the most striking feature of theJapanese system-the lack of a value added tax and the low rate of thegeneral consumer tax that substitutes for it-should tend to reduce therelative domestic Japanese price level for any given level ofinternational cornpetitiveness.

One more promising explanation may lie in Japan's low
availability of usable land per head of population in comparison with
the UK. The population of Japan (123.5 million in 1990) is some 115
percent larger than the UK's (57.4 millions), while Japanese land area
(377,OOO square kilometres) is only 55 percent larger than the UK's

10 Ian Davis Rich or Poor? Purchasing Power Parities and International
Cornparisons. CSO Eeonomic Trends No.449, July 1994, pp.33-36

A COMPARISON OF JAPANESE AND UK WELFARE 119'(244,157 square kilometres). Moreover, most Japanese land is too
mountainous for residential, industrial or agricultural use: 67 per centof Japan is forest.

The effect of land availability on the real exchange rate has been
considered, in relation to the yen/dollar exchange rate, by Ito'i who

analyses the case where national price indices cover consumer goods(assumed to sell at world prices) and housing services. The intuition
behind the result that countries with a relative shortage of land will
have a high real exchange ratie measured by national price indices as
defined in this model is fairly obvious.

More generally if traded goods in such a country were less Iand
intensive than non-traded goods, a shortage of land would mean ahigher relative price of non-traded goods; so the domestic price level
would be high relative to a country with ample land when compared atmarket exchange rates. It seems likely that non-traded goods would be
relatively land intensive in a country with a shortage of land. That is
because the price elasticity of demand for particular non-traded goods
is likely to be lower than the price elasticity of demand for particulardomestically produced traded goods, as the latter elasticity reflects not
only the sensitivity of domestic demand but also the sensitivity of othercountries' supply. A country with a shortage of land would specialise inparticular traded goods that are not land intensive, but its pattern of
non-traded goods production would be less affected by the shortage ofland.

A further factor may be barriers to imports into Japan. Suppose,for the sake of argument, that in areas where there are no import
restrictions the "law of one price" holds for Japanese exports, imports
and import substitutes. If Japanese regulations restrict the flow ofimported commodities in areas where Japanese domestic supply is notvery elastic, that would tend to raise the domestic price level without
any direct harmful effect on Japanese competitiveness; there would
therefore not necessarily be any forces to bring the Japanese realexchange rate back down to PPP levels.

Another factor may be what might be described as comparative
disadvantage in distribution, as illustrated by the figures for
11 Takatoshi Ito The Land/Housing Problem in Japan: A Macroeconomic Approach.
Journal of the Japanese and International Economies, VOIume 7, No.1, March 1993

120 STEPHENJDAVIES
productivity in retailing given earlier. This low produetivity has at least

something to do with regulation, in particular the Large Retail StoreAct which has allowed small retailers to block the opening of large
stores. Relatively large gross margins in retailing will obviously raise
the real exchange rate, for any given level of competitiveness in traded

goods. Extensive regulation of prices in other areas of the Japanese
economy not exposed to international competition (e.g.domestic airtransport) may also be part of the explanation of the high Japaneseprice level.

Looking at the pattern of relative prices in more detail may give
more of an idea of the factors at work. As a detailed breakdown of the1990 PPP results has not yet been published, movements in componentsof the Japanese CPI and in the UK Consumers Expenditure Deflator
have been used to update some components of the 1985 PPPs in the

results shown below. The figures do not provide any obvious
confirmation of the hypothesis that the shortage of land is the main
factor behind Japan's high relative prices. Japanese housing rents are

not particular high in relative terms-less so than clothing andfootwear which are traded goods. The most striking feature is the highprice of fruit and vegetables, which-while in a closed economy it could
well be attributed to a scarcity of land-in a potentially open economy
must be regarded as reflecting the protection of domestic agriculture.
Components of consumers expenditure:
Japan/UK relative prices in 1990 (\/Åí)

Food, beverages and tobacpo 398.3

Fruit and vegetables 510.2

Gross rent and water charges 330.4

Fuel and power 331.3

Household equipment and operations 291.7

Transport and cornmunications 240.1

Clothes and footwear 418.7

Medical care 263.8

Education, recreation, culture 358.5

Market exchange rate 257.4
The comparison of average housing rents does not, however,really provide a very meaningful indicator of general pressures of land

A COMPARISON OF JAPANESE AND UK WELFARE 121
availability on the price level, because it reflects a mixture of public

sector subsidised rents and controlled private rents as well as freemarket rents. While it has been growing recently under the stimulus of
housing law reform, the uncontrolled rented sector is still relatively

small in the UK. Data on average rents paid in a large number ofJapanese cities and towns can be obtained from the annual reports of
the Japanese retail price surveyi2. Data in this survey is reported inunits crf monthly rent per 3.3 m2. The table below, based on figures for
December 1992, shows the implied rents for a 100m2 house.
Monthly private house rents in selected Japanese cities(December 1992, per 100m2)\ Åí(at Åí1=\155)Tokyo (Ku area) 241394 1557.38

Nagoya 120424 776.93
Kyoto 137818 889.15

Osaka 142424 918.86
Kobe 142121 916.91
Himeji 86727 559.53
Hiroshima 104515 674.29
Sapporo 97727 630.50

Even converted at recent exchange rate levels which make mostJapanese service prices very much higher than UK prices, the sterling
rents shown are not greatly out of line with private uncontrolled rents
that would be paid in the more prosperous parts of the UK. (There is
no official, or reputable private sector, index of house rents for theUK, so this statement is based on personal observation only.) However,the Japanese rent levels shown are to some extent affected by rent
controls.

What is certainly the case is that residential property prices arevery much higher in Japan than in the UK. Just as shareprice/earnings ratios are much higher, so houses trade at a muchlarger multiple of current rents. In Tokyo, the ratio of residential
property prices to annual rents had fallen from a "bubble" peak ofaround 40 to around 25 by mid 1993; but at this level it was still more
12 Published by the Statistics Bureau, Management and Coordination Agency

122 STEPHENJDAVIES
than double the London price/rents ratio. (The latter figure is
generally put by property market experts in the range 10 to 12.5, e.g.
see the Financial Times of 27/28 August 1994'3.) The differences mustreflect some combination of faster expected growth in earnings /rentals in Japan, and a higher savings rate driving down returns in theabsence of perfect capital mobility.

Another analysis of relative prices (in London and Tokyo) is
provided in the Economic Planning Agency's Report on Prices. (Thiswork, which is now an annual exercise, also covers prices in New York,Paris and Berlini`. Data on prices is collected by a private consulting
firm, to specifications drawn up by the EPA. One foreign capital city issurveyed in detail each year-1994 is London's turn-with data for themost recent survey year updated using national consumer price indices.
The project specifically covers consumer prices rather than prices forthe whole of GDP. To produce the overall comparison for each foreign
city, prices of individual items are weighted together using both foreign

consumption weights and Japanese weights. The published figures are
the average of the results obtained with the alternative weightingbases.) The table below shows the EPA's estimates of the ratio ofTokyo to London prices in November 1993, converting prices at the
average 1993 exchange rate of Åí1=\166.87.
The EPA's figures confirm in some interesting respects the earlier
calculations based on the 1985 PPP benchmark. The real cost of houserents (deflated by the respective capital city's general price level)
comes out as lower in Tokyo than in London. And it is food that ismost strikingly more expensive in Tokyo than in London.
Tokyo/London relative prices

Food 2.15 Durable goods 1.07

Clothing and footwear 1.66 Other goods 1.34

Energy/water 1.71 Transport/communication 1.71

Health and medical care 1.83 Education O.81

House rents 1.21 General services 1.28

All items 1.46

13 "London's landlords can srnile again." weekend section, p.XVI
14 Tokyo prices were estimated to 141 per cent higher than prices in New York in
November 1993, 138 per cent higher than prices in Berlin and 136 per cent higher
than prices in Paris.

A COMPARISON OF JAPANESEANDUK WELFARE

123

The report notes some far more remarkable examples of pricedifferences for individual items: for example, lip-stick is more than fivetimes more expensive in Tokyo than in western capital cities. The
impact of regulation is illustrated by the EPA's comparison of some
important prices affected by regulation in Japan with corresponding
UK prices. Based on Tokyo ==100, London prices as of November 1993
were estimated as follows.

.
Electricity(280 kwh monthly bill)

61.8

Gas (550,OOO kilo calories monthly bill)

31.5

Postage: internal letter

67.3

post card

101.8

Railway fare (100 km)

95.7

Bus (one zone)

74.2

Taxi (day rate, 5 km, one person, no luggage)

56.6

Rice (10 kg.)

47.2

Telephone (3 minutes, shortest distance)

240(40km.)(100km.)(500krn.)

67
80
36

ways with the PPP
namely the overall
Japan/Tokyo
estimate of how much more expensiveis than the
UK/London. As shown above, theestlmates
EPA
London to be 46
percent more expensive than Tokyo, while
updating
the latest PPP
While the EPA's statistics correspond m' somedetails, they differ in one very important respect,benchmark to 1993 prices and exchange rates one gets an estimate thatJapan is 76 per cent more expensive thanthe UK.
The EPA argues that
because the PPP estimates are basedmternationalon "'' " weights theyin effect largely represent western demand
whereas their own
patterns,
estimate gives a 50 per cent weight tothe composition '' of Japanesedemand. There may be something in this,althoughas the example ofrice shows, it is not necessarily true that.
Japanese consumption
patterns are skewed towards commodities
at present relatively
that arethere isa risk of (at least
cheap in Japan, At the same time
unconscious) bias in a comparison' thatproJect
is sponsored by anational government agency rather
thatorgamsatlon.

by an international

124 STEPHENJDAVIES' A brief investigation of the EPA's work unearthed two examples

of such bias. Firstly, the comparison of rents was not based on
identical types of location. On the grounds that the typical Tokyo
commuter travels further than the typical London commuter, the Tokyo
rents chosen for the EPA's index relate to locations further out fromthe centre of the city than do the London rents. Secondly, thecomparison of railway fares is based on full-price tickets. However, in
the UK, unlike Japan, discount fares are generally available for travel
outside peak hours and at weekends. Most leisure travel is at half orless than half the full fare. Some account should have been taken of
this.

Another recent international comparison'5 shows Tokyo as 89.5 percent more expensive than London (at an exchange rate of Åí1=\154.9).

This estimate is explicitiy based on the consumption pattern of atypical western executive, and so not as broadly based as the otherstudies. Like them, it highlights food and clothing as particularly costly

in Tokyo; with prices respectively 222 per cent and 462 per cent (formedium price range women's clothing) higher than in London. Unlike
the other studies, it also shows rents as much more expensive in Tokyo-for example, a medium range furnished 4 room apartment is shownas 190 per cent more expensive in Tokyo than in London-but this may
reflect the level of rents in particular areas of Tokyo and of particular

types of apartments favoured by western executives.

3. Consumption and sustainable consumption

This section begins a more detailed consideration of therelationship between GDP and welfare. Section 1 noted the possibilityof arguing that investment is really intermediate spending, and thatinvestment expenditure should be ignored in the comparison ofJapanese and UK welfare. If this position were to be maintained it
would have a significant effect on the welfare ranking of the two

eountries, given the much higher share of GDP that domestic
investment accounts for in Japan, as well as the big difference in thetwo countries' net overseas investment in 1990: a Japanese balance of

payments current account surplus and a UK deficit. In fact the
15 Prices and Earnings Around the Globe Union Bank of Switzerland 1994

A COMPARISON OF JAPANESEANDUK WELFARE

complete discounting of investment is hard to defend. Firstly, it seems

to imply that if an individual decides to invest rather than consume
that reduces his welfare. Secondly, to the extent that one might use
these welfare calculations to make value judgments about the two
economies, it would seem unreasonable to commend the UK economy ifrelatively high consumption were being achieved not through highoutput but by running down the capital stock and borrowing fromforeigners.

It is therefore preferable to focus on sustainable consumption
rather than actual consumption. With a traditional neoclassical growthmodel, any growth in the domestic capital stock above that needed tokeep a constant capital/labour ratio implies increasing output perhead and might reasonably be treated as adding to welfare; any
shortfall below that level would be a deduction from welfare. Nordhaus
and Tobin (op. cit.) did, in fact, make an adjustment of this sort in analternative version of their index.

We have therefore calculated the fixed investment needed in bothcountries to maintain the fixed capital stock at a constant ratio to the

population aged 15 and over. Combining ten years average population
growth centred on 1990 with the net fixed capital stock at the end of
1989, and deducting this "warranted" capital stock growth, as well as
depreciation of the existing capital stock, from actual fixed investment,

we derive an addition to welfare of Åí42.1 billion in the UK, and\41,744 billion in Japan.
Actual and warranted fixed investment

UK Japan
Growth of 15 plus population (per cent) O.19 1.04
End 1989 net capital stock (billion Åí/\) 1457.5 3093109i6

Warranted capital stock increase (bn. Åí/\) 2.8 32168

Capital consumption(..) 61.1 62820
Fixed capital expenditure(..) 106.0 136733
Actual less warranted fixed investment(..) 42.1 41744

A similar adjustment should be made in respect of net foreign
investment. To the extent that the ratio of net foreign assets to
16 includes non-reproducible fixed assets

125

126

STEPHEN J DAVIES

population is increasing, that might count as an addition to welfare; adecline would be a deduction from welfare. There is a need to refine
the calculation to reflect the different demographic structure of the twocountries. A country that is aging fast, like Japan, should save morethan a country whose demographic structure is relatively static, suchas the UK. On the basis that people save primarily for their old age,
we have defined the "warranted" current account as one that allows
growth of net foreign assets in line with growth of the population aged
over 65.

Projections of growth of the population aged 65 years or more
over a ten year period centred in 1990 give a figure of 3.8 per centannual average growth in Japan, and only O.6 per cent in the UK.
Applied to end 1989 stocks of net overseas assets (evaluated at the
average of end 1989 and end 1990 values) we derive a "warranted"
current account surplus of ÅíO.4 billion for the UK and of \1560 billion

for Japan. Comparing these with the actual current account figures in
1990-a deficit of Åí18.3 billion in the UK and a surplus of \5203 billion
in Japan-we calculate a deduction from welfare of Åí18.7 billion in thecase of the UK and an addition to welfare of \3643 billion in the caseof Japan.
Investment in stocks can similarly be included in the welfare total.
Actual stockbuilding in 1990 totalled \2322 billion in Japan, while there

was a rundown in stocks in the UK of Åí1.5 billion. Making an
adjustment of the same form as that used in the case of fixed
investment (calculating the difference between the actual increase instocks and the increase needed for a constant ratio of stocks to the
population aged 15 plus) we find a contribution to welfare of \1566billion in Japan, and a deduction from welfare of Åí1.7 billion in the

UK.
This discussion of investment serves to raise the question of theappropriate denominator to be used in the overall welfare comparison.
Clearly we have to normalise the adjusted GDP figures in some way totake account of the relative population sizes of the two countries: wewould not want to conclude that welfare was higher in Japan justbecause its population was more than twice as large as that of the UK.
In the introductory section, we presented various comparisons in termsof amounts per head of population. However, a comparison based on
adjusted GDP per head of total population would show a country that

A COMPARISON OF JAPANESE AND UK WELFARE 127
had recently experienced a baby boom as on that account enjoying alower level of welfare. The implication that a country can increase its
welfare by not reproducing itself is unacceptable and it seems better toregard the unproductive young as an investment rather than adeduction from welfare. Thus when the final overall comparison of
welfare is made, we normalise the total of adjusted GDP by dividing by
the population of 15 and over, rather than by the whole population.

4. What consumption counts?
Adjustments to the national accounts to make them more closely
related to a measurement of welfare normally include other deductions
and additions to both the personal and government consumption series
published in the national accounts. In the case of personal consumption,

cash spending on consumer durables as recorded in the national
accounts is often replaced by an estimate of the flow of services fromthe stock of consumer durables.

However, the case for making such adjustment is much lesscompelling in the case of a cross-country comparison than it is whenan adjusted time series is being produced for a single country.
Obviously the large cyclical variations in consumer durable spending
give a completely misleading picture of how the consumption of theservices of durable goods is changing over time: a 25 per cent fall in
car sales, for example, might be consistent with an increase in the
consumption of car services. There may well be a large margin of error
over the estimate of the size of the durables capital stock and there
may be considerable uncertainty over the amount of services provided
by any given size of the capital stock; but these problems may have
only a second order effect on the figure of interest in time series
studies, namely the rate of growth in durables services.
For a cross-country comparison, however, these problems may befirst order rather than second order; and a better way to avoid a
distortion to the comparison caused by cyclical variations in durables
goods purchases rnay be to take care to base the comparison on ayear when durables purchases were not at unusual levels, or perhaps totake an average of several years' durables purchases. In neither Japan
nor the UK were durables purchases at either a cyclical peak or acyclical trough in 1990; particularly in view of the "sustainability"

128

STEPHEN J DAVIES

current account adjustment made in the previous section, we havepreferred to include unadjusted consumer durables spending figures inthis study. If we had adjusted the consumer durables figures in some
way we would have had to make some offsetting change to the current

account adjustment, to allow for the impact of consumer durables
purchases on the current account.
Another type of adjustment normally made in "extended national
accounts" exercises is the exclusion of some consumption expenditure

an the grounds that it is really intermediate rather than final
consumption. This issue arises in some areas of personal consumption;
but it arises most keenly in areas of government expenditure such as
crime prevention and law enforcement. It would clearly be odd to ranka crime-ridden country, which consequently spent a lot of money onlaw enforcement, as better off on that account than a country withlittle crime and consequently low spending on law enforcement. The

contribution to welfare comes from the output of the police/lawenforcement system-the level of public safety-not from the input ofpublic spending which is measured in the national accounts, and which
may well be inversely related to the output of public safety.

General government administration expenditures can also be
regarded as intermediate in nature rather than as genuinely final
consumption. In any case, the Japanese national accounts figures do
not separate expenditure on law and order from "general government
services" so if the former is to be deducted from the total of'
consumption that contributes to welfare, it is simplest to take the latterout as well.

Japanese general government final consumption of general
government services, including law and order, came to \10614 billion in1990 (2.5 per cent of Japanese GDP). UK general government current
expenditure on general public services came to Åí6.7 billion, while
spending on public order and safety came to Åí9.7 billion: adding in anallowance for capital consumption, which is not included in thesefigures, final consumption of general public services and public orderand safety is estimated to have come to Åí17 billion (3.1 per cent of UK
GDP). Excluding these items of spending from the total contributing to

the estimate of welfare thus reduces estimated UK welfare somewhat
relative to Japanese welfare.

A similar argument may be advanced in relation to health expen-

A COMPARISON OF JAPANESE AND UK WELFARE 129
diture-that variations in national expenditure levels may be theresponse to more or less healthy lifestyles and eating habits, and thatwhat is relevant to welfare is quality of life and longevity, not thetreatment of illness that is measured in the national accounts. (If thisargument is accepted in respect of government consumption of healthservices, it needs of course to be carried over to personal consumer
spending on health which in Japan accounts for by far the larger partof total health spending.) Japan is clearly a healthier country than theUK, as the following statistics illustrate.

Summary indicators of health
UK (19gg-90 life table) Japan (1990 life table)

FemaleMale Female
Male
Life expectancy at birth (years) 73.0 78.5 75.9 81.9

UK Japan
Infant mortality (per l,OOO Iive births) 7.9 4.6
Personal and general government final consumption of healthservices, pharmaceuticals etc. in Japan came to \26833 billion in 1990
(6.3 per cent of GDP); in the UK such spending totalled Åí31.5 billion(5.7 per cent of GDP). Since the relative weight of health spending in
GDP at least corresponds qualitatively with the relative healthiness ofthe two countries' populations it seems best to treat this spending as

contributing to welfare; although this is a second best procedurecompared with basing a contribution to welfare on the output of thisspending.

Defence expenditure is another area where a case for omission
can be made. A country that manages to enjoy security without highmilitary expenditures is not obviously worse off on that account thana country with higher military expenditure that does not buy a higher
level of security. Nevertheless, there may be psychic benefits fromhigher defence spending. People seem to get such benefits from theircountry's participation in international peace-keeping efforts, from thecontinued existence of traditional regiments with colourful histories,and so on. Moreover, to the extent that there are more concrete
returns to defence spending (genuinely greater security) the best
available proxy for comparing the amount of this output-in the caseof countries with similar external threats-may the input of defence

130

STEPHEN J DAVIES

expenditure recorded in the national accounts.
Expenditure on education has in general the character of investment

rather than consumption, even though most of it is classed asconsumption in the national accounts. (This applies to spending by bothgovernment and the personal sector; the latter accounts for the larger
part of what is recorded as final consumption of education services inJapan.) In line with the "sustainability" discussion in section 3, someaccount of spending on education should be taken in the measurement ofwelfare. While in principle what should be included is not actual
spending but variations in the human capital stock per capita (on thelines of the treatment of fixed capitai spending) estimation of the size of

the Japanese and UK human capital stock and its depreciation is beyond
the scope of this paper, so we simply include all spending on education.
Within other categories of personal consumption, much spending ontransport can be argued to have the quality of an intermediate
expenditure. This is particularly true of commuter travel, which is itself asource of disutility. Even "travel for pleasure" may be travel in orderto obtain pleasure rather than a pleasurable process. Excluding somepart of travel for pleasure would, however, involve too much of a value
judgment, but travel to work expenditures clearly need to be excluded
from the measurement of welfare. We have proxied such expenditures byexpenditure on rail and subway season tickets. In Japan such
expenditure came to \1371 billion in 1990. In the UK (British Rail for1990 and London Underground for 1990-1991) the total was ÅíO.8 billion.

Personal expenditure on insurance against theft and on lawyers

might also be excluded for much the same reasons as those for
excluding government expenditure on law and order. The low level oflitigation in Japan, and the extent to whieh business relations are basedon trust -rather than on the threat of litigation-is a major structuraldifference between Japan and western eeonomies. According to figures

quoted by van Wolferen, who takes a dim view of Japanese lack oflitigiousness, "the number of civil suits per capita brought before thecourts is roughly between one-twentieth and one-tenth of the figures forcommon-law countries...Japan has one lawyer per 9,294 people, ascompared with one for 360 in the USA, 872 in Britain and 1,486 in West

Germany" n.
17 Karel van Wolferen The enigma of Japanese power. Papermac 1990, pp.213-214

A COMPARISON JAPANESEOFAND UKWELFARE

Most expenditure on Iaw, however, is incurred by companies andso treated as intermediate rather than final expenditure in the national

accounts. Whether the transactions costs of frequent litigation are
greater than the transactions costs involved in the way the Japanese
prefer to do business is an interesting question; but the effect of thesetransactions costs on the relative efficiency of the two systems islargely already reflected in the estimates of output, productivity etc.

derived directly from the national accounts. Some downward
adjustment to personal consumption might be called for in respect oflegal expenditure incurred by households, and this adjustment would begreater in the case of the relatively litigious UK. But the adjustment
would not be large, its size is not readily computable from publisheddata, and so it has been ignored here.

At the same time, some upward adjustment might be made topersonal consumption to take account of business expenditure onsocialising, which is treated as intermediate expenditure in the national

accounts, but which is nevertheless a close substitute for final
consumption: food and drink may taste just as good when consumed in
the course of business entertainment. The Japanese way of doing

business involves a relatively large amount of this form of
consumption. Data published by Japan's National Tax Agency showthat spending by Japanese businesses on entertainment came to around\5630 billion (1.3 per cent of GDP) in the year ending in January 1991.

We have provisionally assumed that UK businesses' spending on
entertainment came to 1/4 per cent of GDP, and added these figures
to the estimate of welfare in the two countries.

There might seem to be a case for other upward adjustments, toreflect the consumption of unpriced services. Television, radio andnewspapers financed at least in part by advertising provide
entertainment and information services that are not included in thenational accounts statistics. In both Japan and the UK there is a public

television and radio service, financed by a licence fee. But given theamount of time that many people spend watching commercial televisionin both countries, there is a potentially significant understatement of
nominal GDP, compared to what it would be if all television broadcasts

were financed by a user fee. However, this understatement of GDP
should be reflected in the relevant deflator-the financing of televisionand newspapers by advertising makes them cheaper than they would be

131

STEPHEN J DAVIES

132

if the consumer had to pay the full cost-so there sould be no net
effect on comparisons of real GDP.
Further examples of unpriced services include admissions to freemuseums and art galleries (many museums and galleries are free in theUK, very few in Japan). If these are government institutions, the freeprovision of services may simply involve a switch between personal andgeneral government final consumption; but if they are private
institutions being financed by government subsidies (or by donations
from businesses or private individuals) the statistics for nominal GDP
will not record the services being provided-though again this should,

in principle, be accompanied by a corresponding reduction in therelevant deflators.

A further area of under-recorded services is the use of public
infrastructure such as roads and bridges. These are, with very few
exceptions, free to the user in the UK, while in Japan high speed roads

are subject to high tolls. Again, if properly accounted for in the GDP
deflator, this should have no effect on the comparison of real GDP.

Moreover, a substantial part of road use is intermediate output(freight transport, commuting, business trips) and so should not be
included in GDP anyway.

5. Welfare from non-marketed time

Extended national accounts estimates generally include someallowance for the value of time not spent in paid work. This can be
split into three categories of use:-time spent in unpaid work
-time spent on getting to work-other time, i.e.leisure (defining study, sleep, eating,washing etc. as leisure activities).

The first and third of these can both be regarded as adding towelfare. The estimate of the value of leisure typically dominates theother adjustments to the national accounts: for example in Nordhaus
and Tobin's study the imputation for leisure accounted for $627 billionof the total $1241 billion of "sustainable MEW".

The Japanese Survey on Time Use and Leisure Activities showedthat in 1986 people with a job spent on average 42 minutes a day

commuting (averaged over a seven day week). Although many

A COMPARISON OF JAPANESE AND UK WELFARE 133
Japanese salarymen have much longer commuting journeys, theaverage commuting time is brought down by the relatively large
number of family workers and self-employed who live at or close to

their place of work. As it has not yet been possible to obtaincomparable data for the UK, no account has been taken here ofcommuting time. Leisure time (broadly defined as above) plus timespent on unpaid work is assumed to be some constant minus time spenton paid work.

The main component of unpaid work is housework, undertaken
primarily by women. Kanamori et al. (op.cit.) take figures for thenumber of women occupied exclusively in housework from labour force
surveys, data on average hours spent on housework from national
surveys of time use, and multiply the product of these by the average
female wage. Thus in 1975, for example, 15.97 million women did anaverage of 53.18 hours of housework per week, and the value of thiswork was estimated at \21.1 trillion, about 14 per cent of GDP. Theseestimates seem to assume that if women go out to work they do not do
any housework. Kanamori et al. then make a separate estimate of thevalue of leisure time.

Starting from the identity that time not spent at work or getting
to work must either be spent in unpaid work or at leisure, and as there

is no basis for assuming that the hourly value of leisure time isdifferent from that of time spent in unpaid work, there seems no gain
in computing separately the value of leisure time and the value of
unpaid work: one global figure can be calculated to cover both items.
This simplification allows us to dispense with the need for survey dataon housework hours; all that is needed is data on hours spent at paid
work.
Clearly, a crucial element in the computation of the contribution
to welfare from non-marketed time is the estimate of the value of aunit of time so used, which we refer to hereafter as the basic hourly
value of leisure. While it is obvious that people are not in general in aposition to maximise over consumption and leisure by making the valueof the marginal hour of leisure equal to the marginal return from anhour's paid work, there seems no better alternative to relating theestimate of the value of leisure to the remuneration from work.
Specifically, we have assumed that for someone working 2000 hours per
week, the value of an extra hour's leisure is equal to the average

134

STEPHEN J DAVIES

hourly wage rate net of income tax (calculated at a marginal rate of
10 per cent in Japan and 25 percent in the UK) plus the average hourly
employers' pension etc. contribution. This calculation produces different

figures for Japan and the UK, which we have taken as alternative
estimates of the true value of marginal hourly leisure, which isassumed to be the same in Japan and the UK for someone working thesame number of hours. The estimates for Japan and the UK (expressedin a common currency, using PPPs) have therefore been averaged, withthe resulting figure used as the basic hourly value of leisure in bothcountrles.

We have further assumed that the marginal value of leisure forsomeone working 3000 hours or more per year is 1 1/2 times the value
at 2000 hours; that the marginal value at 1000 hours is 1/2 the value
at 2000 hours, falling to zero at O hours work per year. This picks up
in a very rough way the premium rates paid for overtime work and the
low average pay of part-time workers.

The other important components of the calculation are theestimates of the numbers in employment and of average hours worked.
Of the UK population aged 15 or over in 1990, 57.4 per cent were atwork. The corresponding figure in Japan was 61.9 per cent. A figure
for average hours worked in Japan has been derived from the Labour
Force Survey, as described in the annex. For the UK, a figure wastaken from Maddison (op.cit.), updated to 1990, as Maddison's data
end in 1989. According to these figures, average annual hours worked

in Japan in 1990 (2108 hours) were 37 per cent more than average
hours in the UK (1538 hours). (Although full-time manual workers inJapan and the UK work a similar number of hours per day, nonmanual workers have a longer working day in Japan; there is moreworking at week-ends in Japan; and annual holiday entitlements aremuch smaller than in the UK. In addition, a higher proportion of thework--force in the UK works part-time.) Estimates of the distribution of

weekly hours were taken from the Labour Force Survey in the case ofJapan and from the New Earning Survey for the UK. These
distributions were then applied to the figures for annual hours

described above. ' •The basic unit-the basic hourly value of leisure time for someone

working 2000 hours per year-came out at Åí6.04 or \1954 whenestimated as described above. The Japanese Annual Report on the135
A COMPARISON OF JAPANESE AND UK WELFARE

Labour Force Survey shows the distribution of weekly hours worked ineight bands, and we grouped the UK data also into eight bands. We
assumed that people working the longest hours in the Japanese survey
enjoyed no leisure; so that the amount of leisure of those in each of

the other bands (for Japan and the UK) was computed as thedifference between the hours worked in that band and the hours
worked in the Japanese band with the longest hours.
The result obtained was that the total value of leisure in Japancame to 157.7 billion times the basic hourly value of leisure, or \308103
billion (72.6 per cent of GDP). For the UK, the total value of leisurecame to 91.3 billion times the basic hourly value, or Åí551.5 billion(100.4 per cent of GDP).

6. Possible further extensions

The "blacle economy"
In both the UK and Japan, a certain amount of economic activity
escapes the attention of the national accountants because it isdeliberately concealed in order, for example, to evade taxes. No
adjustment is made in the Japanese or UK national accounts to allow
for such concealed activity. Although estimates of the size of the UK's

black economy vary widely, a figure of around 5 per cent has beensuggested in one well-respected study'S, Japan, with its relatively low

tax rates and low crime Ievel has traditionally been viewed as acountry with a relatively small black economy, less than 5 per cent of
GDpig.

Illegal immigration, encouraged by the growth of the Japanese
economy, may have made earlier estimates of the size of the black
economy rather dated. But concealed economic activity, if it is being
undertaken by people whose residence is also concealed, may have little
implication for the measure of welfare; as both the numerator and thedenominator of GDP per capita are affected in the same direction by
concealment. Allowing for hidden economic activity would thus add tocomputed UK welfare relative to that of Japan; but there would besome double counting with the estimated value of leisure computed in
18 Stephen Smith Britain's Hidden Econorny, IFS
19 e.g. Vito Tanzi The Underground Econorny World Bank, Finance and Development
Vol. 20, No.4 (December 1983), pp.12ff.

136 STEPHENJDAVIES
the previous section: some "leisure" is in fact used for activity in theblack economy. ' •Pollution and the environment

Twenty-five years ago, Japan had major problems ofenvironmental pollution, as in the high growth period from the mid
1950s to the end of the 1960s little was done to control industries' lethal

discharges into the atmosphere or into Japan's seas and rivers.
Although its environment has been greatly improved since the early
1970s, Japan still has the reputation abroad of a country with serious
pollution problems; just as London still has the reputation of being a
foggy city, some forty years after the passing of the Clean Air Act

which did away with the traditional London winter fog or smog. In
terms of emission of air pollutants, Japanese performance is now
clearly superior to that of the UK, although that does not mean thatJapanese residents enjoy cleaner air than UK residents. As long as theUK's normal weather pattern prevails, UK residents escape the worst
consequences of their country's emissions.
Per capita emission of gases (1991)
Sulphur oxides (kg.) Nitrogen oxides (kg.) Carbon dioxide (tonnes)

Japan 6.9 9.7 8.6
UK 62.1 47.9 10.3
Accidents

Nordhaus and Tobin and the subsequent Japanese work on
welfare included road accidents as a component of the "costs ofurbanisation" that were deducted from the estimate of welfare.
Although Japan has succeeded in reducing the number of persons killed
annually in road accidents by about a third since the early 1970s, inspite of a large increase in road traffic, road accident death rates
remain slightly higher in Japan than in the UK. (The figures for motor

vehicle accident deaths below are taken from both countries' vitalstatistics and are higher than figures sometimes quoted: from police
statistics for Japan-which include only those who die within 24 hoursof an accident-and from transport statistics for the UK-which
include those who die within 30 days of an accident.)

A COMPARISON OF JAPANESE AND UK WELFARE 137
Road accident deaths per ten thousand population (1990)

Japan 1.18
At the same time, deaths from rail accidents are much higher inJapan than in the UK (though the numbers involved are relatively small
in both countries). Over the three years to 1989, deaths from rail
accidents averaged 23 per year in the UK; in Japan they were 436 peryear over the same period. Deaths from industrial injuries are also
higher in Japan; 1872 deaths in Japan in 1990 compared with 433 in the
UK in financial year 1990-91. Another statistic worth noting is therelatively high rate of suicide in Japan: Japanese suicides totalled
20,088 in 1990 compared with 4,643 deaths from suicides and selfinflicted injuries in the UK.

Income distribution
As income and consumption are more equally distributed in Japan

than in the UK, it might be argued that the same level of average
consumption would produce a higher level of welfare in Japan.

7. Results

The results of the calculations described in this paper are
summarised in the following table. Using the PPP statistic to convert

the figures for Japan and the UK into a common currency, Japanese
welfare comes out at 86.6 per cent of the UK level. Clearly the size ofdifference calculated is smaller than the margin of uncertainty over the

PPP statistics, as well as the various other areas of uncertainty
discussed in the paper. Thus the results of this paper must be regarded
as inconclusive in terms of the welfare ranking of the two countries.

138 STEPHENJDAVIES
Summary table of welfare calculations(all figures relate to 1990)

Japan (\ billion) UK ( Åí billion)

Personal consumption 243638 345.65
Governrnent consumption 38807 133.0
Fixed investment (less warranted) 41744 42.1

Overseas investment(..) 3643 -18.7

Stockbuilding(..) 1566 -1.7
Less consumption of general govt.

services and law and order -10614 -17.0
Less expenditure on commuting -1371 -O.8

Business entertainment 5630 1.4

Value of non-marketed time 308103 551.5

Total of above 631146 1035.45
Total population aged 15 and above (OOOs) 100890 46407
Welfare per head of population aged 15 and above \6255783 Åí22312
Japanese welfare (in \)/UK welfare (in Åí) """'••••••••••• 280.4
Purchasing power parity ••••"""''••••"'"'"-'•'""""'"'•••••"'"323.9'• Common currency welfare ratio
86.6 per cent

ANNEX: ANNUAL HOURS OF WORK IN JAPANPublished estimates of Japanese annual hours of work (including
Maddison's20) are generally based on the Monthly Labour Survey, which
is a survey of establishments. Alternative estimates can be derived fromdata in the monthly labour force survey. The LFS asks respondents togive the number of hours they worked in the week covered by thesurvey, in the case that they worked at some time during the week; orto state if they were in regular employment but had not worked in theweek covered by the survey. The published statistics of the employed
20 op.cit.

A COMPARISON OF JAPANESE AND UK WELFARE 139
work force are derived from these responses (which is equal to thenumber of people actually at work plus those in employment but not atwork in the survey week, scaled up to cover the whole population).
An estimate of number of hours worked per year can be derived
from the total of those at work on average during the year in question(i.e. the employed labour force less those employed but not at work

during the survey week) times the average number of hours per weektimes 52 1/7. This should be an accurate estimate of hours worked peryear net of holidays, sickness, strikes etc. if days off work are evenly

distributed throughout the month.
The week covered by the monthly labour force surveys is the last
7 days of each month, except in December when it is the seven days

ending on 26 December. Of the annual fourteen days of national
holidays, only two (Greenery Day on 29 April and the holiday
commemorating the Emperor's birthday on 23 December) will nomallyfall in a week covered by the survey. In addition, the other main times
at which the Japanese take holidays are the first few days of January(following New Year's Day which is an official national holiday), in thefirst week of May (to add to the three national holidays in "goldenweek") and in mid-August at the time of the "bon" festival whenpeople traditionally go back to their home towns on the occasion of thetemporary return to this earth of their ancestors' spirits. None of thesemain holiday periods falls in weeks covered by the survey. There is
therefore a need for some downward adjustment to the calculationsuggested in the previous paragraph.
Using data in the Japanese Labour Ministry's 1993 employment

White Paper on annual holidays of production workers inmanufacturing industry, we have calculated an adjustment based on 87

weekend days off per year, 30 days holiday (including national
holidays) and 3 days off for other reasons. We assume that the days
off for "other" reasons will be reflected in the LFS returns, but that
only 2 of the 30 days holiday will be picked up (a somewhat extreme
assumption which probably causes the resulting adjusted figure forhours worked per year to be an underestimate). These assumptions
lead to a downward adjustment to the simple calculation describedabove of 10.26 per cent. Estimates of hours per year are shown in thetable below.

140 STEPHENJDAVIESLFS based estimates of average annual hours per worker-in Japan

Total employed . Not
at work
Annual hours
Weeklyhours

1989 6128 83 46.4 2141
1990 6249 88 45.7 2108
1991 6369 96 45.0 2074
1992 6436 98 44.1 2032'

The estimate of average annual hours worked in 1989 is some 143
hours higher than Maddison's estimate. It is possible to suggest atleast two reasons why his estimate is biased downwards.
Firstly, Maddison derives his estimate of hours, as noted earlier,from the Monthly Labour Survey rather than the labour force survey.
In the latter survey, respondents who hold more than one job are asked
to give the total number of hours they work in all their jobs. Thus
multiplying the number of respondents who say they have jobs by the
number of hours they say they work should give an unbiased estimateof the total number of hours worked in the economy. The Monthly
Labour Survey's hours figures, by contrast, will obviously be anaverage per job, not an average per person: they will understate
average hours worked per person to the extent that people hold morethan one job. Combining such an estimate of hours with employment
figures that count the number of people with jobs, not the number ofjobs, will obviously lead to some understatement of aggregate man

hours
worked in the economy. 'The labour force survey does not ask people whether they havemore than one job (merely whether they would like to have anadditional job). However, the 1987 Employment Status Survey showedthat of 60,502,OOO workers 3,390,OOO (5.6 per cent) had second jobs.
(And of those with second jobs, 2,198,OOO were working 35 hours per
week or more in their main job.) These are quite large numbers, but

not large enough to explain the main part of the gap between
Maddison's estimates of annual hours and those derived above.
Nevertheless, the, y do mean that using Maddison's estimates of total

Japanese and UK labour inputs would involve some overstatement of
the relative UK labour input. Although his figures for UK average
hours are similarly hours per job, rather than hours per person, theUK employment statisties are bench-marked on the Census of
Employment and so measure the number of jobs not the number ofA COMPARISON OF JAPANESEUKAND
WELFARE

workers: thus it is appropriate to combine them with figures for hours

per job to get an estimate of aggregate man hours.
A more important source of bias in Maddison's figure is a 5.4 percent downward adjustment that he makes to the data for regular
employees' hours over the whole post-war period to allow for selfemployed and temporary workers working shorter hours than regular
employees. While self-employed workers in agriculture work relatively
short hours, outside agriculture the self-employed work longer hours
than employees. Figures for all industries from the 1992 labour force
survey were as shown below.
Average weekly hours by employment status

All workers 44.1
Self-employed 44.2
Family workers 40.3

Employees 44.4
While Maddison's adjustment may have been appropriate in aperiod when the share of agriculture in total employment was muchlarger, it seems clearly too Iarge for recent years.

A further point is that establishment data on overtime seems
likely to include only paid overtime, while labour force survey data
seems likely to include both unpaid and paid overtime. This point
applies to the UK as well, of course; but it might be particularly
important to bear in mind in relation to Japan, given the different
work ethic and the high levels of overtime worked by white collar
workers, a significant amount of which is unpaid- "service overtime".
In this paper we have therefore preferred to use the labour force
survey based estimates of annual hours for Japan.

141

KOBE ECONOMIC & BUSINESS REBIEWCONTENTS

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A Synthetic Analysis of Structuralist and Monetarist

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Stagflation-Causes and Policies- "'"'•••"''••••••'••••••••'"'"•••""'•'• Nobuo 0kishio

A Computable General Equilibrium Model of theJapanese Economy •"'••••••"'••••••'"'••••••'••••••••'••••••-••••••••-••••••••••' Mitsuo Ezaki

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Strategic Corporate Innovation andJapanese Management ••••'""'•••••••••••••••••••-•••••••••••••••••••••••• Hidelei Yoshihara

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Monetary Policy and Foreign Disturbances , •inaSmall Open Economy under Flexible . •Exchange Rates and Rational Expectations •""''••••'"'••••••••••••••• ffideki lzawa
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Increasing Returns to Scale and Optimal
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Some Implications of the Present-ValueBased Depreciation Within the
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Foreign Subsidiaries as Contributors

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The Gains from Free Trade for a Monetary
Economy -•••--•-•----"'•-••"'••••""-•'"'`•-"''•••''"'••••"'••• Murray C. Kemp
On the Optimal Timing of Foreign Aid"'••••••'••••••"••••••••-•j••••••• Murray 0. Kemp

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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? •••••••-••-•••••••••••••••••••••••••••••••••• urillianz E. Janzes

Dynamic Effects of Tax Policies in A q
Model of Investment "-"••••••••••••••••••••••••••-••••••••••-••••••••'••••• Tahao 0hkawa

Kazuo Shimomura
Corporate Governance in Germany, Japan, and theUnited States : A Comparative Study '"•••••••••••••••••••"'''""'"" KenIZ Ko12'ma
Economic Issues in International Debt:A Survey •-•••••••••••"'•••••••'••• Uideki 12awa

A Note on the Estimation of Scale Economies and their
Use in Modeling Free Trade Agreements •••••••••••••••••'•'• Robert K McCleeiyKOBE UNIVERSITY ECONOMIC REVIEW 40, 1994
Effi'o`ebdebt?Ini5earCs"i'ltyY,RfobEe9038111afiS'

CONTENTS
Recent Economic Changes of in
Myanmmer ••••••••••••••••••••••••••••-••••••••••••••••••••••••••••••-••• IVobayoshi?Vishi2awa
Technology Trade of Japan •••••••••••••••••••••••••••••••••••••••••••••••••••••• Tapt' Hagiwara

Alternative Ways to the Harmonization of

the Tax Systems in the EU?
-The ACE System and CBIT- ••••••••••-••••••••••••""••••••••• Mtzsayuki Tamaoha

Turnover of the Landowners in Rural England:
A Case Study of Land Tax Returns ••••'••••••••••••'"""""••••• Kimio Shigetonzi
Toward a Theory of Trade Negotiations ""'•"••••••••••••••••••• ?Vroritsngu iVakanishi

Lrg"(wwrgdTg,krKiLrg(s(scwwrg(},(wwrg(rL(MwwrLsx"dc"'
THE ANNALS OF THE SCHooL
OF BUSINESS ADMINISTRATIONKOBE UNIVERSITY No. 39, 1994 'Edited by the School of Business Administration,
Kobe University, Kobe, JapanCONTENTS
New Forms of Management Organization under New Technology:
Some Empirical Evidence •••••••••••••••••••'""'"'"""""""''•••• ?Vorio Kambayshi

Seven Entrepreneurial Paradoxes and the Taxonomy of Networking:
The Cases of the MIT Enterprise Forum, the Smaller Business Association of
New England and the Yokohama Venture Business Club •••••••••••• Toshihiro Kanai
Uberblick ttber die externe Rechnungslegung der japanischen Unternehmen'"'"'"'"'"""""''""'"""''""""'""'"'""' Masatoshi Kuroda
Coordination and Communication in Vertical Relationships•••••••••••••••••••••••••••''"'"'•••••••••••••""•• Masayoshi Maruyama

Das Japanische Produktionssystem im Kontext des Internationalen Vergleichs"'""'"'"'"""'•-•••••""''""""""'""""" Mtzsayuki Munakata
t71,L7Sxlr-,Lrd-,LTf,L7J)Ni7NrJNL7ShLl-,i7-hLrfN17-LrJ-,L)-,L71t7-LrN7fb-L7fsLrf,L7-kL7KrS)kLrK7f,Ll-LrS-L7f,L71,Lr-L7Jb,L7Sxl7-,L7SNL7-LTfL7-L7-L7J`trf,LY

KOBE UNIVERSITY LAW REVIEW 28, 1994
International Edition No. 28, 1994
Edited by Faculty of Law Kobe University, Kobe, JapanCONTENTS
Legal Issues Facing Japanese Business in Canada"""""""""""""''"""'"""'"""""'•-••••••••••• Yoshio 0hara
Extraterritorial Application of U.S.

Antitrust Law After Hartford:The Exporter's Case

' "'"""'•'•••-•••••••••••••'""""'"'""'••••••• Mlehael Peter uraxman
Recent Development of Trust Law on Occupational Pension

Scheme in U.K.
""'""'""'"""''""""''""""""'""':"""" Kazuhito Yukizawa

ECONOMICS ANDRESEARCH INSTITUTE FOR
KOBE UNIVERSITY
BUSINESS ADMINISTRATION,HISTORICAL SKETCH
In 1919, a research organization named the Institute forCommerce was founded in Kobe Higher Commercial School, one of
the chief predecessors of Kobe University, with a gift made by F.

Kanematsu & Company, a leading mercantile firm in Kobe. The
organization was designed to carry on and facilitate integrated
research on business and commerce and to formulate and publish theresults of those studies and investigations in such form as to makethem available to the business community.
With the founding of Kobe University of Commerce, successor of
Kobe Higher Commercial School, in 1929, the Institute extended its
research activities by adding several divisions. One was the famous
Latin-American Library, which soon became the center of research inthis field in Japan. A room for statistics equipped with various
computing machines was established and began publication of Jtiyo

Keizai T6kei and Sekai B6eki T6kei annually. A filing room was
prepared to deposit press clipping files systematically arranged by
topics and dates. Another room was designed to become the centerof all possible original records and data having to do with the
beginning and progress of Japanese business.

On the campus of Kobe University of Commerce, anotherorganization named the Institute for Business Mechanization was
founded in 1941 utilizing business machines donated by the IBM
Corporation and others. With Professor Yasutaro Hirai as its head abroad and forward-looking plan for business mechanization in Japanwas developed.
In 1944, Kobe University of Commerce changed its name to Kobe
University of Economics. After the War, however, the University was
consolidated with three other colleges in Hyogo Prefecture to become
Kobe University. With this development, the two Institutes were also
amalgamated into the Research Institute for Economics and Business
Administration, Kobe University. At present, the Institute, with its
twenty-one full-time professional staff members, carries on studies

and investigations in international economics, international
environment, international comparative economics, international
business, management information systems and international.
cooperatlon.

ORGANIZATIONThe Institute consists of six sections. Each section and its researchsubjects are as follows:
1. International Economic Studies
International Economics, International Monetary Economics,

Maritime Economics, International Labor Relations
2. International Environmental Studies
Resource Development, International Organizations,International Industrial Adjustment
3. International Comparative Economie Studies
Pacific Basin I (Oceanian Economy)
Pacific Basin ll (Latin American Economy)
Pacific Basin M (North American Economy)
4. International Business Studies
Comparative Business, Multinational Enterprise,International Business Finance

5. Management Information Systems
Business and Accounting Information, Information Processing
System, International Comparative Statistics

6. International Cooperation

In addition to the ordinary work of each section,
several research Groups, whose members are not limited to
the Institute staffs, are regularly held to carry on joint
studies. At present, there are eight standing research groups,

as follows: Group of International Trade, Maritime
Economics, Dynamic International Economic Analysis, Multi-

media Information Systems, International Economic
Comparison, International Comparative Financial Studies, andBusiness Finance and Governmental Rules, and International
Comparative Statistics.
For convenience and greater efficiency in carrying out
its research-activities, the Institute has a general office whichis responsible for 1) the collection and preservation of acomprehensive collection of books, periodicals, pamphlets,and original records and data of finance, trade, commerce,industry and business generally: 2) the classification,
cataloguing, indexing arranging, annotation and compilationof these research materials: and 3) the formulation andpublication of the results of the investigations and studies

accomplished by the professional staff members of theInstitute.

As an affiliated institute, the Documentation Center for
Business Analysis has been established in 1964. It is the firstsystematic information facilities in the field of businessadministration in Japan that has been recognized andauthorized by the Ministry of Education. The purpose is tocollect and to rnake intensive control of all kinds ofmaterials on business administration and to make themavailable to scholars, unjversities, governments, and businessworld with the aid of modern documentation techniques.

RESEARCH INSTITUTE FORECONOMICS & BUSINESS ADMINISTRATIONKOBE UNIVERSITY

Director: Hideki YosHiHARA
Secretary: Koji UNNo

INTERNATIONAL ECONOMIC STUDIESInternational Economics Prof. Kazuhiro lGAwA
Assoc. Prof. Robert Kenneth MccLEERy

International Monetary Economics Assoc. Prof. Hideki lzAwA

Maritime Economics Assoc. Prof. Masahiro ToMiTAInternational Labor Relations Prof. Kazuo SHJMoMuRA
Prof, Kouji SH]NJo

INTERNATIONAL ENVIRONMENTAL STUDIES

Resource Development Prof. Shigeyuki ABEInternational Organizations Prof. Junichi Gcri'oInternational lndustrial Adjustment Prof. Hiroshi SADAMicHi
Research Assoc. Ko MiyAzAKi
Prof. Makoto IoKIBE

INTERNATIONAL COMPARATIVE ECONOMIC STUDIES

Pacific Basin I Prof. Kenichi lsHiGAKi(Oceanian Economy) Research Assoc. Ryuzo MiyAo
Pacific
Basin ll Prof, Shoji NisHIJiMA(Latin Ameriean Economy)
Pacific Basin M Prof. Seiichi KATAyAMA(North American Economy)

INTERNATIONAL BUSINESS

Comparative Business Assoc. Prof, Kenji KcviMA
Multinational Enterprise Prof, Hideki YosmHARA

Assoc. Prof. Kentaro NoBEoKA
International Business Finance Assoc. Prof, Hidetoshi YAMAJi

MANAGEMENT INFORMATION SYSTEMSBusiness and Accounting lnformation Prof. Isao NAKANo

Information Processing Systems Prof. Komayuki lTow

International Comparative Statistics Prof. Yasuo KoNisHi

Prof. Takeyuki TANi

INTERNATIONAL COOPERATION Prof. Chong Yeong LEE
DOCUMENTATION CENTER FOR BUSINESS ANALYSIS
Assoc. Prof. Norio OBATA

OfficeiRESEARCH INSTITUTE FOR ECONOMICS & BUSINESS ADMINISTRATION(TheKa.."geE.;i`g.u,..M,..eilgSl,W.iy,".ai.i)