The introduction of Japan’s Stewardship Code to institutional investors is central to the Abe government’s corporate governance reform. As part of the broader growth policy, which is the third arrow of Abenomics, this is considered essential to increase the return on equity (ROE) of Japanese companies, which has historically lagged behind US and its European counterparts.
The purpose of the Stewardship Code is to promote stronger corporate governance by calling on shareholders to engage more actively with the companies they invest in. By setting out guidelines on shareholder’s involvement in the firms they own, the government hopes to improve the basic earnings power of Japanese companies with the ultimate goal of executing the Abe government’s growth strategy in a way that is steady and sustainable.
In May this year, institutional investors were asked to monitor and mentor companies for better governance, with 127 institutional investors signed up to the Stewardship Code. Furthermore, the Ministry of Justice has recently changed the Corporate Act and put in place a legal obligation on companies to explain themselves if no external directors are appointed. Subsequently, around 75% of listed companies on the top tier of the Tokyo Stock Exchange have now appointed at least one external director.
Some commentators have expressed concern that Japanese companies will solely increase the number of buybacks and use the subsequent cash to raise ROE. However, this view needs to be considered against the backdrop of the current situation in Japan and its future direction under the Abe government.
The Stewardship Code was the first item of the growth strategy in Abenomics, and the fact that it has already been implemented as planned demonstrates how dedicated the Abe Cabinet is to corporate governance reforms. This is in stark contrast to it successor, with the Democratic Party failing to launch any material measures related to responsible investment whilst in power. In June, the Abe Cabinet also finalised the ‘Japan Revival Plan’, which detailed the intention of the Tokyo Stock Exchange to set a Corporate Governance Code next spring. This will require public companies to comply with the code or explain if they have failed to do so, motivating companies to achieve sustainable growth and good discipline.
Another key development central to Japan’s growth strategy is the reform of the Government Pension Investment Fund (GPIF) by the Ministry of Health, Labour and Welfare. The proposed reform to increase the target return rate will deliver an immediate impact on the stock market, owing to the fund’s reallocation to equities and shift away from low yielding Japanese government bonds.
It is significant that GPIF has decided to adopt JPX-NIKKEI Index400; a new index which focuses on companies’ ROE. The 400 companies of which the index is composed are selected on strict financial criteria, including ROE, and must meet specific requirements around the efficient use of capital and investor-focused management. Money inflow into this new benchmark will therefore stimulate both qualitative and quantitative reform in the Japanese equities market.
This is a unique index which gives companies a strong incentive to raise their ROE and some companies have already taken steps to drastically shift their capital structures. For example, the engineering company Amada, announced in May that they will boost ROE in order to be selected by the new index. We are already seeing some companies using their cash to spend in capital expenditure, research and development and M&A activity.
With the introduction of the Stewardship Code, Japan is taking a crucial step toward real capital market reform in Japan. Read alongside the Abe Government’s broader growth strategy and other key developments, Japanese companies are now well positioned and incentivised to increase ROE and concerns regarding share buybacks are unlikely to materialise.