J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 17
Friday, February 28, 2003

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Viewpoint: M&A -- NO SILVER BULLET

The Bottom Line:

o From a macro-perspective, there is no denying the crying need
in Japan for more dramatic consolidation, ostensibly through
more M&A, or foreign direct investment. But MoneyWatch
believes that M&A is no silver bullet for what ails Japan. For
one, the global track record for M&A in terms of value-added
to stakeholders is mixed at best. For "in-in" mergers in
Japan, the track record is not just worse, it is atrocious.
Moreover, the global cross-border M&A boom that arose as a
result of the secular bull market in the 1990s has already
passed, and with it, the ability to commit substantial sums of
risk capital.

o Secondly, while the government is calling for a doubling of
direct foreign investment (cross-border M&A) by 2008, they
have been incapable of creating an environment that produces
the kind of ROI that would attract this capital.

o Finally, there is the IRC (Industrial Revitalization
Corp.), which plans to buy up NPLs from "redeemable" Japanese
companies, and thereby eradicate deflation and revitalize
Japan's economy. Here, the government has forgotten to
consider one crucial aspect of the program -- who will buy
these assets from the IRC after the IRC closes operations in
five years?

o If the Japanese government is counting on minimizing
government losses, or hoping that foreign capital will solve
their problems, it is badly mistaken. The problem has simply
gotten too large. MoneyWatch sees no way out of the problem
other than massive amounts of taxpayer funds, nationalizations
in some cases, higher interest rates and eventually a lower

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Auction Them Off to the Highest Bidder
Many people attribute the stubborn economic and financial difficulties
that have afflicted Japan to systemic rigidities in Japan's political
and economic system. Profitability and efficient resource allocation
through more competitive capital markets and more open financial
institutions could make Japan's economy more competitive. The
still-small scale of mergers and acquisitions (M&A) -- not only
cross-border, but within Japan -- is yet another indicator of how hard
it is to change old habits in Japan. From a macro-perspective, there
is no denying the crying need in Japan for more dramatic consolidation
・ deals like Wal-Mart buying a 37 percent stake in retailer Seiyu,
Renault buying Nissan, Ripplewood buying Long Term Credit Bank; deals
that show it can be done and done well; deals that lead to improved
corporate value, increased employment and increased tax payments to
the government. So how does Japan scale up such promising activities
to a level that really makes a significantly positive impact on the
economy as a whole?

In principle, the Koizumi administration and the government are
encouraging direct foreign investment, with prime minister Junichiro
Koizumi himself calling for a doubling of direct foreign investment
into Japan by 2008, which would represent a rise from 6.5 trillion yen
to 13 trillion yen. This is relaxing impediments to foreign M&A. The
Ministry of Economy, Trade and Industry is hoping that company mergers
will reform sagging industries and has its sister organization, Jetro,
encouraging foreign direct investment (FDI). Increasingly, when one
speaks of FDI, one is really talking about M&A. According to the World
Investment Report (WIR2000), almost all of the world's FDI is now in
the form of cross-border M&A.

Naoto Kan, leader of the Democratic Party of Japan, thinks that the 43
trillion yen or so of nonperforming loans held by the nation's banks
should be auctioned off to the highest bidder. He has stated in the
Diet that he admires companies such as Ripplewood, the US
private-equity fund that revitalized Shinsei Bank, and has brought
TV-talk-showlike pasteboards into the Diet to compare Carlos Ghosn's
success in revitalizing Nissan with the failure of Koizumi to make
solid progress in his self-professed "reform" program.

Poor Track Record in Creating Value
Actually, mergers are risky, time-consuming and in the main, do not
have a good track record, especially among Japanese companies. A study
by KPMG found that 83 percent of the mergers it studied did not
improve shareholder value, especially if you owned the stock of the
acquirer. Another KPMG study found that 80 percent of a successful
deal's value came from having a successful integration strategy, but
no one knows whether the integration strategy will be successful until
it is actually tried. More than half (58 percent) of the 115 mergers
completed globally between 1993 and 1996 failed to "add value,"
according to A.T. Kearney. A similar study by Mercer Management
Consulting revealed that 57 percent failed to add value, while
research by J.P. Morgan found that 44 percent did not add value after
three years. Moreover, national politics can greatly complicate an
already tricky process.

The case of Aozora Bank illustrates the schizophrenic attitude being
shown in Japan about foreign bank takeovers. Aozora is the "other" of
the two banks nationalized following the financial crisis in the fall
of 1998 and then sold to a group led by Softbank, which bought a
49-percent stake in the bank from the government. But Softbank has had
its own problems following the collapse of the tech-media-telecom
bubble, and now Aozora is up for sale again, with suitors such as
Sumitomo Mitsui Financial (SMBC), Cerberus, GE Capital and Hypovereins
Bank. The Financial Services Agency, which has to approve any purchase
of Aozora, apparently has a preference for SMBC even though Financial
Services minister Heizo Takenaka has been accused by his opponents of
introducing dramatic bank reforms that would push the major banks into
default, ostensibly so they could be nationalized and sold off to
foreign interests.

Global M&A Wave Has Peaked
Japan cannot even count on the level of foreign capital inflows that
it saw during the 1990s. Cross border M&A is more associated with
active economic activity, bull markets and open economies. For
example, foreign investment in the US plunged by 60 percent in 2001,
reflecting the US recession and a slump in M&A, following three
straight years of record highs. Thanks to the bull market in Anglo
Saxon countries, the late 1990s saw an unprecedented wave of
cross-border M&A. The 1990s cross-border M&A wave was at least five
times that of its predecessor in the 1980s, even in real dollar terms,
but remained pitifully small with regards to Japan. When the wave was
at its peak in 2000, over $1.1 trillion of cross-border M&A took
place, versus a mere $135 billion during the peak in the 1980s.
However, a study by the World Trade Institute and the Centre for
Economic Policy Research (May 2002) points out that the 1990s
cross-border M&A wave took place in a relatively small number of large
service sectors in the industrialized economies -- and the vast bulk
of that was outside Japan.

As large as the 1990s global M&A wave was, however, it represented
only a fraction of the publicly traded corporate assets in
industrialized economies. Thus "foreigners" were therefore NOT taking
over large chunks of national economies through cross-border M&A, even
at the peak of this wave. While small when compared with the stock
market capitalization of even those countries where M&A activity was
more active, it was infinitesimally small for Japan. The claims of
opponents to more open cross-border capital flows (mainly out-in),
therefore, have no leg to stand on in their claim that "foreign"
capital is taking over Japan.

Foreigners Going Home?
In addition, while M&A specialists continue to hope that 2003 will
finally be the year when a full-fledged M&A boom begins in Japan, that
is not in keeping with global trends. As previously pointed out, the
global M&A wave has already passed, and the consensus within and
without Japan is that the economy has reached a standstill. The
government's inability to implement meaningful reforms that bolster
the economy has led many to predict a woeful economic environment for
2003. In 2002 the value of Japan's M&A market, according to Thomson
Financial, was 29 percent lower than in 2001 at $48.44 billion, down
for the third straight year and the lowest since 1998. The number of
deals was up 8 percent to 1,446, but this represented just 4 percent
of global M&A volume. While Japan appears poised for even more deals
between domestic firms, the drawback for global investment banks is
that "in-in" deals are typically smaller, meaning lower fees. The
global stock market slump is likely to sap the appetite for
cross-border deals -- the specialty of foreign bankers -- and
substantially lower their headquarters' tolerance for bearing the cost
of having an expensive investment-banking presence in Japan with
little to show for it. Indeed, foreign investment banks have trimmed
their M&A operations in Tokyo or switched focus to purchasing
depressed assets with their own money or with investment funds.

In addition, numbers from Recof, an M&A research and consulting firm
in Japan, show that most of the deals since early 2001 have been
mergers or acquisitions within corporate groupings or divestitures.
Strategic M&A has been less than 20 percent of the total volume.
Japanese securities firms have an edge in handling these "in-in"
transactions thanks to their solid client networks. Nomura Securities
is clawing its way back into the league tables amid the rise of
"in-in" deals; it grabbed the biggest market share, 32.9 percent, in
2002 by handling 125 deals with a total value of $20.77 billion,
marking a sea change from the market in 2001 when foreigners mostly
dominated the M&A league table. Citigroup ranked second with a
16.6-percent market share, trailed by Daiwa Securities SMBC, which
moved up from 13th in 2001 with a 12.3-percent share. Goldman slid to
fifth with a 11.8-percent share, following fourth-ranked Morgan

The evidence from overseas is that defensive, mimetic (me too) and
uncertain (i.e., no clear strategy) mergers are doomed to fail. On
April 1 of last year, anyone with a bank account at Mizuho Bank was
having trouble getting their money. The new bank, created through the
merger of Industrial Bank of Japan, Fuji Bank and Dai-Ichi Kangyo, was
spitting out ATM cards, refusing to pay out cash to its own customers
and causing general chaos up and down the country.

It turns out that when the three banks tried to integrate their
operations, they simply couldn't agree on whose computer systems would
survive the merger. Instead, in Japanese fashion, they reached a
compromise, involving a relay system to bridge the Dai-Ichi Kangyo and
Fuji systems. The deal may have saved face internally, but the bank
had lots of public egg on its face after its important first week in
business. The moral of the story? In a 1:1:1 merger, no one can
effectively take charge, and what you get is essentially group-grope.

Indeed, the mergers of the four mega-banking groups were more a
survival tactic in order to achieve "too big to fail" size and make
the government think twice about nationalizing them. Unlike in the
West, where mergers are completed in two or three months, those in
Japan can take two to three years. Witness Sumitomo Chemical and
Mitsui Chemical announcing a merger estimated at two years to
complete. Mergers such as those of the Bank of Tokyo and Mitsubishi,
Yawata Iron and Steel and Fuji Iron and Steel (now Nippon Steel), and
Japan Airlines and Japan Air System, a domestic carrier, face problems
with employee loyalty which has to do with loss of face. From the
Japanese perspective, however, such face-saving mergers remain
preferable. Most Japanese employees would still rather merge with
local competitors than ally themselves with foreign firms that will
impose reform.

But as the Mizuho story shows, such mergers often create more problems
than they solve, beginning with the simple question of who's in
charge. Moreover, battling (or not battling) turf wars, separate
personnel departments, internal rivalries, employee labeling and the
existence of grievance "societies" don't stop with an initial merger.

A study by Deloite, Touche and Tomatsu of 540 companies, 56 of which
were Japanese companies, show a very poor track record for Japanese
company mergers. Only 8 percent of the companies surveyed actually
achieved their M&A goals, and 30 percent had no prospects of achieving
these goals.

Who Is Going to Buy from the IRC?
The situation in Japan is in direct contrast with the ostensible
driver of the massive amount of FDI -- cross-border M&A -- the US was
able to attract in the 1990s. Simply put, the US market offered
economies of scale and potential returns on capital not available in
other parts of the world. Japan offers the lowest return on capital of
the industrialized nations, the lowest potential growth, and Japanese
markets have been notoriously hard to crack.

On the other hand, the Industrial Revival Corp. (IRC), highly touted
by the government as the answer to restructuring Japan, is beginning
to look like another case of "of the banks, by the banks and for the
banks," as the government's strategy appears to be "minimize
government losses, while promoting nonperforming loan (NPL)
disposals." Or in other words, "industrial revitalization on the backs
of bank stockholders and individual depositors with no government
risk." The IRC could merely become a debt-exchange market. The fact is
that the main investors in the IRC could well be the same banks who
will be selling NPLs to the IRC. And if the IRC fails, they will be
the same banks that incur secondary losses. While the 10 trillion yen
in funds used by the IRC to purchase NPLs will have government
guarantees, the entire risk of losses when the IRC is disbanded in
five years will be covered by the IRC's assets, which are essentially
the paid-in capital provided by the banks.

The IRC apparently intends to purchase corporate NPLs at prices above
current market values, as their valuations will be based on a "going
concern" basis that assumes operations will be able to continue
indefinitely. Their intention is to make it easier for banks to sell
their NPLs to the IRC. The IRC's definition of "going concern
valuation" is expected to mean that the IRC will be purchasing NPLs at
prices several times higher than those offered by the Resolution &
Collection Corp. (RCC), which heretofore has been the primary vehicle
for buying NPLs. The RCC in principle buys only those NPLs in danger
of bankruptcy at current market prices, on average paying about 10
percent of the nominal value of the loans. In contrast, the target
market for the IRC is "special attention" loans that ostensibly have a
higher probability of recovery.

But an important aspect of the IRC's whole scheme has heretofore been
left unattended, and that is the final buyer. The IRC is basically
adopting a short-term strategy in order to minimize the probability
that NPLs they purchase will become secondary losses. At the current
juncture, it is assumed that the final buyers of resold credits will
be "private sector revival funds," "corporates" and in certain cases,
"financial institutions." However, how is the IRC going to ensure that
such investors will willingly purchase these credits? There has been
virtually no discussion of the "selling prices" at which these credits
could be profitably liquidated.

Moreover, if the IRC were to seriously try to "revitalize" enough
struggling companies to really make a difference to Japan's economy,
it would need something upwards of 50 trillion yen to do so, a number
that would dwarf the capabilities of Japan's fledgling private
corporate restructuring operators. While increasing a company's value
through a turnaround represents an opportunity for private-equity
funds, the realization of the potential upside requires significant
hands-on management. Thus it is not a high volume business. Recof
estimates the number of takeover deals involving corporate revival
funds totaled 180 billion yen, or only $1.5 billion, in the first 11
months of 2002. The assets of the "Business Revival Fund" managed by
the Development Bank of Japan doubled in 2003, rising to 200 billion
yen. The bank will be expanding its support activities to companies
with "special attention loans," which in turn creates the potential
for two publicly funded institutions to play NPL "catch ball."

Thus if the Japanese government is counting on "minimizing government
losses, while accelerating NPL disposals," or hoping that foreign
capital will solve its problems, it is badly mistaken. The problem has
simply gotten too large. MoneyWatch sees no way out of the problem
other than massive amounts of taxpayer funds, nationalizations in some
cases, higher interest rates (due to crowding out) and eventually a
lower yen.

-- Darrel Whitten

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