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Shinzo Abe, who resigned last month as Japan’s Prime Minister for health reasons, leaves behind a mixed legacy on the economy. His administration’s policies, nicknamed ‘Abenomics’, kept the economy afloat in the short term, but largely failed to address its two core problems.  

The first is a plummeting population, set to shrink from 125.7m in 2019 to 88m people by 2065. The second is stagnant productivity. In 2018, Japan’s productivity was the lowest among the G7 members. This has been the case since 1970. Given the imminent demographic crunch, Japan desperately needs to jumpstart its productivity if its economy is to stay afloat.

Fortunately, the appointment of the new Prime Minister, Yoshihide Suga, is an opportunity for a fresh approach to the economy. Don’t expect anything revolutionary in the short term. Since Prime Minister Suga will have to face an election in the next year, he is likely to focus on getting quick wins for now. However, in the longer term, ‘Suganomics’ should prioritise tackling the fundamental drag on Japan’s productivity: unproductive small and medium-sized enterprises (SMEs). 

According to a 2019 paper by the IMF, SMEs in Japan have had significantly lower productivity growth than larger firms. This has crippled Japan’s overall productivity because SMEs represent a significant share of the economy. In 2014, they employed 70.1% of the private sector workforce. Boosting SME productivity is key to lifting overall productivity and preventing the demographic crunch from sinking the economy.

To understand how Suga’s government can raise SME productivity, we must first examine why it is so low.

One reason is that many SMEs face financing constraints. This is because Japanese lending practices put SMEs at a disadvantage. When extending loans to SMEs, Japanese banks rely largely on fixed-assets collateral and personal guarantees, rather than risk-assessments based on business value. This makes it difficult to secure loans for SMEs with good growth prospects but insufficient collateral. Interviews by the Economist Intelligence Unit suggest that these financing constraints are an important reason for many Japanese SMEs spending so little on innovation.

To solve this issue, the government should promote alternative forms of financing for SMEs, such as venture capital. It should also encourage banks to improve their methods of assessing credit-risk, for instance by using IT more and asking prospective borrowers to provide audited financial statements. 

The second reason for low SME productivity is the overly generous Credit Guarantee System for SMEs. Set up in 1950, the system aims to help SMEs access finance and protect them from bankruptcy. Here’s how it works: government-run Credit Guarantee Corporations (CGCs) guarantee many loans made to SMEs by banks. If an SME with a guaranteed loan goes under, the CGCs compensate the lending bank for up to 80% of its losses.

While well-intended, this system’s harmful impact on productivity is a classic example of the law of unintended consequences arising from government intervention in the economy. There are two notable unintended consequences in this instance. 

First, the system creates perverse incentives for banks. While banks are overly cautious when making regular business loans to SMEs, as discussed above, the opposite is true for guaranteed loans. Since the CGCs bear the brunt of the losses when guaranteed loans go sour, banks have a weaker incentive to screen and monitor guaranteed-borrowers. 

This enables non-viable SMEs to secure loans that they would not otherwise have access to. These loans act like life-support, keeping inefficient ‘zombies’ in the market and shielding them from bankruptcy. As a result, an abnormally low percentage of non-viable firms exit the market and the annual rate of firms exiting the market is low compared to other developed countries.

This is disastrous for productivity. Productivity growth hinges on an efficient allocation of resources, which is driven by the dynamic process of firms exiting and entering the market. When zombies continue operating, they hold onto staff who could be employed more productively by more efficient firms. They also drain customers and profits from these firms, making it difficult for efficient SMEs to afford investment. This has reduced investment in Japan, which has harmed productivity. Also, the continued presence of zombies has likely discouraged potential market entrants with higher productivity from entering the market.

A second unintended consequence of the Credit Guarantee System is that it deters SMEs from expanding. Since firm expansion is key to productivity, this equates to discouraging productivity.

In a market economy, firms typically seek to expand in order to increase profits. This entails hiring more staff and investing in extra capacity, which enables them to exploit economies of scale and become more productive.

However, in Japan, many SMEs choose not to grow. This is because growing past a certain threshold in terms of staff headcount or amount of capital means losing the SME status. This entails losing the generous benefits of the Credit Guarantee System. Many SMEs, avid to hold onto these benefits, prefer to simply stay small, even if it means eschewing productive investments. A 2016 study found that this was an important deterrent to Japanese SMEs investing in capital. 

To fix these problems, the government should significantly reduce the loan coverage offered by the Credit Guarantee Corporations. The Abe administration admirably reduced the top coverage rate from 100% to 80% in 2018, but this remains too high. The new government should be more ambitious. 

A reduced rate would make banks bear a greater proportion of the losses when SMEs with guaranteed loans go bankrupt. This would force them to screen guaranteed-borrowers more effectively, monitor them more carefully and perhaps offer struggling borrowers advice on business revitalisation. 

Admittedly, this reform may not be appropriate while the COVID crisis continues to ravage the economy. The pandemic has left many SMEs vulnerable, including productive ones, and the government has rightly stepped in to support them. However, once the crisis abates, the Suga administration should push ahead with this reform.

How likely is this? The precedents are not particularly encouraging – successive Japanese governments have done little to solve this longstanding issue. Moreover, reforms to the Credit Guarantee System will face fierce resistance. SMEs have a strong vested interest in the status quo and do not want to see their benefits cut.

Nonetheless, the chances of SME reform are now better than ever. The new PM has made his eagerness to reform the economy clear. Additionally, one of his closest advisors, David Atkinson, is an ardent proponent of reforming the Credit Guarantee System. If he is to remedy Japan’s chronically low productivity, Suga should put SME reform at the heart of his economic plan.

James is currently undertaking work experience at Bright Blue. Views expressed in this article are those of the author, not necessarily those of Bright Blue.

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