The Japanese economy continues to underperform on its potential productivity, falling further behind the US over the coming decade without change. Yet according to a recent study from McKinsey & Company, the Japanese have no reason to be disheartened – a drive for best practice productivity in combination with technological advances – something Japan is known for masterminding – could significantly boost GDP growth, and shift the country’s outlook back into rosy waters.
In a recent report (‘The Future of Japan: Reigniting Productivity and Growth’) from McKinsey Global Institute (MGI), McKinsey & Company’s research think tank – the consultancy explores the economic conditions faced by Japan. The consultants find that following its present productivity trend and with the coming changes in demographics, the country will continue to see lacklustre growth over the coming decade to 2025. However, the business advisory too finds considerable potential in the Japanese economy, such that, even with demographic changes – through improvements in productivity – the economy can continue to perform well, jumping from 1.3% GDP growth to ~3% per year.
Japan is facing a medley of downward forces on its economic standing. The countries demographic makeup is set to continue to age over the coming decades. In 2011 it reached the point where its population has started to decline on the back of low birth rates and high life expectancy. As of 2013, a quarter of its population was age 65 or older; by 2040, that share will rise to 36%. With further pressure placed on the labour force as only 59% of Japanese in the 60-to-64-year-old age bracket are employed. The consultancy finds that the labour market will decline 3.7% by 2025.
The Japanese economy has seen two decades of lacklustre growth, often termed ‘the lost decades’. Following the collapse of its stock market and real estate bubble at the beginning of the 1990s, its economic growth between 1992 to 2012 averaged a mere 0.8%. And while the country remains the third largest economy in the world, its productivity has suffered. Productivity – which was for a long time one of the highest in the world at 3.7% increase per annum in the 1970s and 1980s – has plummeted to around 2% over the past decades. This will see the productivity gap with the US increase further, from 29% in 2011 to 37% in 2025.
If productivity stayed at the level and with the current demographic trends, the outcome would see the real term income of its citizens reduced by $1,600 by 2030.
Productivity under pressure
The research reveals there are a number of conditions affecting the competitiveness of Japanese businesses. While the legal basis for a ‘job for life’ that was for a long time enshrined has for the most part been wound back, the consultancy finds that the culture continues making certain parts of the employment market rigid – creating possible inefficiencies and a downward pressure on productivity. One of the examples is the country’s strategy to support companies shift away from the lifetime employment model and begin hiring non-regular (temporary) workers, or haken. The impact has been massive: today more than one-third of workers were covered by ‘haken’ arrangements, and this group is expected to increase to 50% by 2030 following current trends. The downside of haken workers is that they are unproductive, not only do temporary employees have fewer incentives to excel, but employers rarely invest in their development.
Besides inefficiencies in the labour market from flex workers reducing productivity, McKinsey unearthes that the banking system in Japan is creating uncompetitive conditions by not allowing poorly performing companies to exit the market. The banks roll over the bad debt of underperforming companies, however, as the companies continue to struggle they lack the capital to invest in improving themselves or creating the kinds of innovations required to improve their productivity. A further effect of keeping the firms on the books in a competitive market is that resources are tied up and not being distributed toward firms that improve the productivity of the overall market, while new competitors find it difficult to compete against subsidised firms.
A further issue highlighted by the report is that Japan continues to be a poor target for foreign direct investment (FDI), with just 0.06 percent of GDP, compared with 0.60 percent in the United States and 0.24 percent in Germany. This makes international competition or introduction of new – more productive practices – difficult. According to McKinsey this is largely due to regulatory barriers that make it difficult for new competitors to challenge incumbents in certain sectors.
While there are factors inhibiting the productivity potential of Japan, the consultancy on a positive note also highlights that a number of factors create positive conditions for the country to grow, including technological know-how, a formidable manufacturing base, a highly educated labour force, world-class infrastructure, and a large and affluent consumer market.
To support policy makers with returning Japan to a steeper growth track, the authors explore the potential for productivity and capital gains in major sectors of the economy, and the contribution on Japan’s GDP growth. In a ‘low range’ case, McKinsey believes Japan could add 18% in value added above the current trajectory. In the more aspiration view the advisors estimate up to 28% in value added could be unleashed. “This would lift Japan’s annual GDP in 2025 by almost 20% to 30% over current trends – for an increase up to some $1.4 trillion in that year alone,” write the authors.
The key trigger lies in productivity improvements, activated through adopting industry best practices, including those developed in other countries; moving to the frontier of technology; and organising for discipline and performance. For example, in the manufacturing sector, a range of levers could combined boost the value added by up to 53% of the current trajectory, while in the retail sector the value added could reach 61%. Overall, Japan can reach some 50% - 70% of the productivity goal of around 4% if a critical mass of companies adopts practices that are already global standards; technology, such as further automation, accounts for most of the remaining potential.