Japan’s changing narrative: investment risks and opportunities

Over the past decade, Japan fell from its position as the world’s second largest economy to the world’s fourth largest. As the post-war growth boom receded, the country’s narrative has been tethered to the so-called Lost Decades of stagnation.

However, since Covid, Japan has been experiencing something of a growth spurt. Capital markets have led activity, with foreign investment in Japanese stocks hitting a 10-year high in 2023, buoyed by the cheap yen and ongoing share buybacks. Prices, wages and land values in some parts of Tokyo rose for the first time in decades in 2023. In February 2024, the Nikkei 225 stock index broke a record set 34 years earlier. In March 2024, the Bank of Japan lifted interest rates for the first time in 17 years. This signaled the end of Japan’s deflation era, which had commenced in the early 1990s after the asset bubble collapse.

Meanwhile, we have seen an uptick in private equity activity – supported by Japan’s deep pool of target companies with performance improvement potential and a stable regulatory environment – as well as still-low interest rates. Buoyed by large exits in 2023, it was the only Asia-Pacific private equity market that grew in 2023 in terms of deal activity, according to Bain & Company’s 2024 Asia-Pacific Private Equity survey. Prequin’s 2023 investor survey ranked Japan as one of the top three investment opportunities over the next 12 months.

Despite this positive market sentiment, Japan is a highly complex dealmaking environment, and investors are operating against a backdrop of four existential risks: geopolitical tensions, population decline, lagging corporate governance and bureaucracy. To some extent the country’s resurgence has taken off despite these risks. It has also been driven by them. For investors who are paying attention, each risk offers opportunity.

Geopolitical tensions

Broadly, Japan is a beneficiary of geopolitical tensions with China, North Korea and Russia. The country has also benefited from uncertainty over trade restrictions, as Western investors have started moving strategic industries and supply chains to friendly countries.

Japan started de-risking its critical supply chains in 2010 after its rare earth imports from China were blocked following an escalation of tensions over the disputed Senkaku/Diaoyu Islands. A decade later it has emerged as a strategic friend of the West, with Taiwan chip firms flocking to Japan as they increasingly decouple from China. Nonetheless, many of Japan’s large businesses have heavily invested in China via manufacturing and production. As a result, the Japan economy has real exposure to China risk through business assets and employees in mainland China.

Domestically, the Japan that welcomes the arrival of these new investors is a changed one: Abenomics has created a more investor- friendly foundation, while the first Trump presidency was a wake-up call for Japan’s leaders, spurring them into action on self-defense and sectors deemed of national interest – key among them: energy and semi-conductors.

Japan Inc has shown some anxiety over the possibility of a second Trump presidency. A Harris administration would likely continue the global status quo on Russia and China. While that looks more attractive, a second Trump term may not bring an end to the favourable de-risking trend for Japan. A Trump return would likely push Japan further towards military build-up and industrial policy, which are creating a set of genuinely sustainable growth-driving industries, supported by serious and accessible state subsidies.

Demographics

Japan’s population is expected to halve to 63 million people by 2100, due to a declining birthrate and changing lifestyles. The population is already aging, and the economy is facing labour shortages. For private businesses, there is also a shortage of successors. A study by Japan’s Ministry of Economic, Trade and Industry (METI) previously estimated that over 600,000 profitable small- to medium-sized Enterprises (SMEs) in Japan have CEO’s older than 70 and are facing closure over a lack of successor.

Private equity investors have responded to these challenges and the market is seeing a growing willingness among businesses and families to accept investment as a succession solution.

Additionally, labour shortages are forcing companies to innovate and increase productivity. Investors into Japan would be wise to draft a labour strategy assessing both the obstacles to transferring employees into Japan and also where they can source skilled workers. Some sectors – like pharmaceuticals and construction – have experienced consolidation mergers and acquisitions where larger firms have bought smaller ones to absorb their workforce.

In Japan there often remains resistance to foreign ownership, partly due to fear of how the workforce may react. Aged founders typically want to preserve their legacy and may be hesitant to sell to private buyers who plan to break up the company or implement drastic changes. In many cases, careful negotiation skills and cultural sensitivity are more important in Japan than having a war-chest of funds. Investors acquiring family businesses need to carefully map the family’s influence in the business and understand how to work with key decision-makers who will steer the business post-acquisition.

Corporate governance

There is a perception that Japan’s large listed conglomerates – the “trading houses” – are lagging behind their G7 counterparts in implementing corporate governance change. This perception is reinforced by lack of female participation on company boards and top management, as well as opaque annual reports that are short on carbon reduction goals, among others. This perception is not helped by a high level of protectionism and anti-takeover methods at listed companies that routinely rebuff takeover bids or shareholder proposals.

But this is gradually changing. Japan is implementing an increasingly sophisticated corporate governance regime benchmarked with global best practices. The reforms – which started with Abenomics and were reinforced by governance codes, including by the Tokyo Stock Exchange – are remarkably pro-shareholder activism. Top among the governance measures is the Tokyo Stock Exchange’s name and shame approach to expose listed companies that are not complying with value-adding reforms. And outside pressure has started to move boards in a new direction – while shareholder resolutions are influencing pro-investor corporate finance strategies.

There is also growing pressure on leadership teams to dispose of non-core assets, encouraging spin-offs and divestitures. Hedge funds and other activist investors are active in lobbying for change, and unlike in previous years, they are making progress. Japan’s stock exchange has been instrumental in lifting corporate value. The improved governance is expected to trickle down to the private sector.

Policy navigation

Along with red tape (regulatory restrictions and onerous administrative processes for government approvals), the disconnect between national and local government policy is often cited as a Japan-specific risk. But the national government and Ministry of Trade (Economy and Industry in particular) have been cutting away at policy obstructions for foreign investment and expatriate employment. Policies supporting economic security are seeing new sectors – like Taiwan Semiconductor’s (TSMC) chip plant in Ibaraki prefecture – being set up at China speed.

The gap between local and central policy take-up, however, remains big and real. In the renewables sector, which has been benefiting from favourable national-level policies, we have mapped local ordinances that are obstructing renewable energy investment. Miyagi Prefecture, for example, has the highest amount of ordinances including a recent tax on solar developments exceeding a size restriction. This move was in part a response to residents complaining about renewable projects defacing mountains, causing deforestation and leading to landslides.

Approaching Japan risk and opportunity 

Japan has long been perceived as a low-risk market, with stable government and pro-business policies. However, the risks impacting business and the macro environment are nuanced and distinct from other, emerging, markets in the region.  

Control Risks can help you consider and temper each of these risks. We have over 30 years of experience in Japan, offering a deep bench of in-country experts with local sectoral, commercial and regulatory expertise. Through valuable country and policy context that complements our standard due diligence assessments, we can help you mitigate Japan risk and seize opportunity. 

Interested in finding out how our services can inform your investment strategy into developed Asia?