Japan's Mittelstand Under pressure

Japan's Mittelstand (德文 中小企業 )

Under pressure

Mar 6th 2008 | TOKYO
From The Economist print edition

Small firms, the bedrock of Japanese industrial might, face hard times

THE bouquet of flowers at Densho, a 150-person company one hour's drive from Tokyo, is the pride of Iwao Sumoge, the shacho, 社長 or president. The firm specialises in cleaning parts of machines that make semiconductors, in which a speck of dust is intolerable. It also thins the glass displays for mobile phones by using a special chemical process, rather than grinding. It provides these intricate services to some of Japan's biggest corporate behemoths.

behemoth Hide phonetics
noun [C] FORMAL
something that is extremely large and often extremely powerful:
a grocery chain behemoth

The flowers were sent by a business partner to congratulate Densho after it registered to be treated as a medium-sized enterprise, rather than a small business. The company, founded two decades ago, is toying with the idea of a public listing—not to raise money, but because it is often done in Japan to symbolise a firm's maturity.

The success of Densho, and of hundreds of small businesses like it across Japan, is underappreciated. Japan's big companies—Toyota, Canon, Sony and so on—are well known. But their success rests on the foundation provided by Japan's small and medium-sized firms (those known in Germany as the Mittelstand).

Small and medium-sized enterprises (SMEs), defined in the manufacturing sector as those having capital below ¥300m ($3m) or fewer than 300 employees, represent 99.7% of companies in Japan. They employ around 70% of the workforce and account for half of manufacturing by value. Many of them are found in clusters, in areas such as Tokyo's Ota ward and the city of Higashi-osaka. They specialise in fields such as electronics manufacturing, precision engineering and fine chemicals. A few date back centuries.

As in Germany, many of these anonymous, often family-run small companies boast world-class technology that enables big firms to succeed. But in Japan, firms like Densho are becoming the exception rather than the rule. There is a huge spectrum of small firms, notes Atsushi Seike, an economist at Keio University. Though some are thriving, many are miserable, he says. Indeed, business sentiment among SMEs is at a five-year low, for a number of reasons.

In recent years big firms have put pressure on their suppliers, forcing them to cut prices and accept lower margins. Most small firms find it difficult to refuse, because they rely on a single, anchor company for much of their business, observes Takatoshi Miura of the SME Agency at Japan's Ministry of Economy, Trade and Industry (METI). Much of the profit made by Japan's big exporters since the economy rebounded in 2002 has come from squeezing their smaller brethren.

Wages at big companies increased slightly last year but dipped at small firms. And the productivity of SMEs in the manufacturing sector (defined as value added per employee) is half that of large companies—and even worse in non-manufacturing industries. Overall, Japanese firms are 30% less productive than their American counterparts, notes Hiroko Ota, the minister of economy. Meanwhile, Japan's manufacturing industry is under increasing pressure from Chinese firms offering improving quality, large volumes and low prices. Rising energy and transport costs and the fragility of the Japanese economy only add to the pain.

Accordingly, Japan's Mittelstand is struggling. Only about one-third of firms with less than ¥100m in capital are profitable, according to the tax agency, compared with half of larger firms (see chart). Admittedly, creative accounting—padding expenses, and generous tax deductions for research and development—exaggerates the bad news somewhat. But it is still bad.

Weak companies tend to have been sustained by easy bank loans. Politicians put huge pressure on small and regional banks to lend money on generous terms. Around 70% of SMEs applied for loans without any collateral or guarantee, according to a survey carried out in 2003 by the Tokyo Chamber of Commerce and Industry. Things have been tightened up a bit since then, but loans are still considered an acceptable substitute for providing unemployment assistance, says a government economist. Because the bankruptcy rate in Japan is low and takeovers are rare, bad companies do not go away and good companies can only grow organically. The resulting overcapacity hurts everyone, says Laurent Halmos of CLSA, a brokerage.

The government has recently implemented a number of measures to help small firms. In December it said it would provide subsidies to compensate for rising energy prices, and would make it even easier for small firms to get loans. In the same month METI proposed spending $20m to help SMEs become more efficient by adopting software for accounting, human resources and supply-chain management.

None of this will magically transform the fortunes of Japan's ailing small firms, however. The success stories are those, like Densho, that combine technical acumen with innovative business practices to carve out niches. Another example is Nabeya Bi-tech Kaisha (NBK), a medium-sized firm in Gifu, central Japan, which makes high-precision machine parts, from large pulleys to tiny shaft-couplings.

Instead of churning out standardised products in high volumes and at low prices, it concentrates on expensive, customised components made in small quantities—a natural evolution from its origins in 1560 as a foundry making pots, temple bells and lanterns for the imperial family. “We want to do business like a sushi bar: the customer is right in front of you, orders different things, and a highly skilled artisan makes it right away,” says Masahide Satoh, a senior manager at the firm.

Many small firms now face the looming problem of succession. Though some are much older, a lot of Japan's SMEs sprung up in the post-war period, following the breakdown of the former business order. Their bosses, now in their 70s, are ready to hand over the reins. The strongest firms are selling up—once their owners find buyers willing to guarantee the welfare of their staff. As for the laggards, some business leaders are unsympathetic. “If they are not very good, they deserve to go away,” says Mr Sumoge of Densho, revealing a flash of his samurai ancestry. Eventually the weaker firms will go bust or be taken over. But like everything in Japan, it will happen slowly.