Shifting gears

By Norifumi Kawai

Keiretsu corporate networks are innate to the Japanese auto sector, but could this system finally be changing?

The economic miracle of postwar Japan can basically be attributed to its keiretsu system. A traditional Japanese economic and social network system, keiretsu played a crucial role in creating a monopolistic market, which excludes outsiders.

However, recent years have seen the automobile sector in Japan experience a dramatic change in the scale and scope of customer-supplier partnerships, largely due to the rapid development of technology, standardization of parts, globalization and Japan’s long-term economic slump in the 1990s.

Keiretsu ties now vary across the automobile industry. While Toyota tightens the partial equity share ownership of many of its keiretsu group companies, Carlos Ghosn, Nissan’s CEO, is a striking example of a ‘keiretsu breaker.’ He implemented the so-called ‘Nissan Revival Plan,’ restructuring a financially distressed Nissan by dissolving many of the keiretsu partnerships with trusted group suppliers. Now, Japanese car manufacturers and suppliers are under increasing pressure to adopt cost-effective procurement strategies in the changing market environment.

Economically rational?
Keiretsu is understood as the structuring of a complex web of assembler-supplier networks based on partial equity ownership and trust, mutual respect, and common goals over time. In contrast, the structural organization of American-oriented buyer-seller relationships is characterized by strict cost orientation, search for short-term profits and arm’s length market transactions.

For the automobile industry of Japan, most discussions on the advantages and disadvantages of the keiretsu form of industrial organization are controversial. Moreover, there is not yet an ultimate answer of as to how keiretsu membership affects corporate performance in the automobile industry.

One of the greatest benefits of the automotive keiretsu organization is the protection of the firm from market failure and the mitigation of financial risks. The keiretsu alliance of inter-firm agreements also contributes to lowering transaction costs such as co-ordinating costs, risks of broken contracts, searching costs, switching costs and product quality tests in imperfect markets. It has been proven that Japanese automotive chains incur less transaction costs than those in the US. In addition, the endurance of the hierarchical form of keiretsu ties enables the keiretsu car assembler to lower transaction costs through capitalizing on flexibility in its parts suppliers’ production management processes and disseminating its corporate identity to suppliers.

Typically, the keiretsu groups also play critical roles in pooling financial burdens in the face of crisis and in merging the goals of profit maximization within the corporate community.

Within the keiretsu organization, financial resources below market rates are available to group firms. In return for access to financial, material and human resources, the keiretsu leader obtains its suppliers’ organizational transparency and technological development.

At the same time, keiretsu car parts suppliers can also reap various benefits from the vertical corporate arrangements, such as managerial know-how, demand stability and the flow of inter-firm information through “resident engineers.”

In reality, financial and equity relations in the vertical keiretsu structure also exert a strong impact on corporate stability. Strong equity control of the car manufacturer over its suppliers in vertical production networks result in a stable and long-term demand for parts supplies. By and large, these unique features of the keiretsu organization are expected to yield long-term economic prosperity and reciprocal commitments within the network.

Costs
The late 1990s saw a circle of scholars and policy makers beginning to pay more attention to the disadvantages of keiretsu system.

Author of Alliance Capitalism: The Social Organization of Japanese Businesses, Michael Gerlach, argues that the endurance of keiretsu alliances has been interpreted as a formidable impediment to the entry of Western business competitors into Japanese markets. The absence of liberal market competition is attributed to Japan’s closed industrial policy and the persisting keiretsu legacy. These market environments may preclude Japanese firms from practicing more cost-effective sourcing strategies at the global standard.

It is often argued that the decade-long Japanese recession after the bursting of the bubble was further exacerbated by the negative features of the keiretsu form of governance. Suppliers’ interdependence, unproductive cost management and topdown decision making processes based on consensus and continuity, as well as badly needed change and initiative, all contributed to the country’s lost decade.

Many keiretsu car manufacturers tend to improve cost competitiveness by shifting abroad and then establish international production networks with more independent firms capable of producing quality products at a competitive price.

There is rich empirical research on the negative effect of keiretsu on company performance. Research was conducted using a sample of 566 Japanese firms to examine whether keiretsu-affiliated companies under- perform independent firms. Evidence pointed out that “institutional arrangements of keiretsu groups, taken as a whole, do a less effective job of maximizing shareholder wealth than do the arrangements of the independent, market monitoring oriented firms.” An explanation is that many keiretsu car manufacturers tend to improve cost competitiveness by shifting abroad and then establish international production networks with more independent firms capable of producing quality products at a competitive price.

Shifts in keiretsu boundaries
In the late 1990s, changes in industrial conditions such as the introduction of deregulation, the boom of e-commerce and a number of takeovers of Japanese companies by foreign hands have led to significant changes in the nature and scale of keiretsu supply chain networks. Major Japanese automakers’ equity holdings have been overtaken by foreign companies: Suzuki and Subaru by General Motors, Mazda by Ford, Nissan by Renault and Mitsubishi by DaimlerChrysler—only Toyota and Honda subsist as winning keiretsu successors.

Especially, Carlos Ghosn, CEO of Nissan Corp., initiated the dismantling of the top-down keiretsu configuration. His revolutionary management reforms, so-called ‘Turning Nissan around’ or ‘Revival Plan,’ have exposed Nissan keiretsu to daunting challenges of enormous reduction in costs by 20 percent and in the number of its suppliers by 40 percent.

Ghosn completely dismissed the idea of ‘relational contracting’ by selling off its equity holding shares of 1,394 firms except for four companies such as Calsonic Cansei and Jatco. Its group members are requested to strengthen the product quality and technology independently of, rather than dependently on, Nissan. Nissan’s radical case seems to suggest ‘the end of keiretsu.’ Taking a completely different path from that of Nissan, Toyota strengthened financial control over its affiliated companies. Christina Ahmadjian and James Lincoln, authors of Keiretsu, governance, and learning: Case studies in change from the Japanese automotive industry argue that “Toyota’s rationale is that tighter coordination of Toyota Group companies is essential for success in the more harshly competitive environment of today’s world auto industry.”

There is a clear divide between Toyota and Nissan. The former indicates the maintenance of group-centred inter-firm relations, while the latter is characterized by the advancement of de-keiretsu-ization. Honda’s keiretsu group and Isuzu’s keiretsu group on the other hand, show an increase in the equity share between 1993 and 2008.

Former Nissan companies became independent suppliers, serving various car manufacturers. Independence enables keiretsu companies to create new customer relationships with other car assemblers more easily. At the same time, there are automobile suppliers who switched their keiretsu parents.

The case of the Toyota keiretsu group
Toyota firmly holds onto its group suppliers at the domestic level. Despite the fact that the internal ties of the Toyota keiretsu group have increased, Toyota has tried to reduce its dependencies on Denso in high-end electronic components through advancing its in-house capability. Taking a close look at a coordinated Toyota keiretsu formation abroad, Toyota actively encourages its group companies to compete and cooperate within and beyond keiretsu organization.

For example, Toyota and its group suppliers actively establish new partnerships with Western firms in Europe. Toyota initiated a joint venture project with PSA Peugeot/Citroen group as its strategic partner. Toyota’s strategic alliance with PSA is derived from Toyota’s desire to pull up its market share to more than five percent in Europe, where consumers are demand advanced design and technology. To achieve this goal, the 50/50 joint venture serves as an inevitable instrument for Toyota in upgrading its positive product image and reputation in Europe by the virtue of the ‘French effect.’ Another aim of Toyota is to build an extensive network with PSA’s suppliers in order to procure automobile components at lower costs because competitive cost reduction is a prerequisite to win the European automobile market.

Toyota’s group companies are also exposed to intensified global competition as well as pressure from the Toyota parent company, urging their group suppliers to improve ownership advantages in product quality and technology. Toyota keiretsu suppliers strive to achieve a high degree of customer diversification, while supplying car parts to the Toyota factories in Europe. For example Denso, Toyota’s main group supplier, makes efforts to reduce the degree of its interdependence on Toyota through reinforcing relations with various foreign customers and aggressively embarking upon offshore production.

Toyota group companies intend to maintain financial independence and not rely on the parent, become real global suppliers and accumulate management skills and market-based knowledge at the global level. According to a Nikkei article, Toyota group’s top officials believe that competition and cooperation within and beyond keiretsu actually enhances Toyota’s competitiveness and solidarity as a whole. It can be considered that Toyota reinforces rather than undermines the keiretsu ties.

And in the end?
There is debate as to whether the hierarchical form of keiretsu is an economically rational mode of corporate governance. Japanese automobile parts suppliers often resort to using single keiretsu customers for a long period of time due to financial and personnel ties, improved monitoring systems, technological diffusion, demand stability and managerial guidance. Equity control by the group leader in vertical integration also protects its affiliated firms from foreign takeovers and competition. However, the post-bubble economy period witnessed that the vertical keiretsu system is withering due to Japan’s long-term economic slump, standardization of parts, speedy improvement of technology, growing cross-border merger and acquisition transactions. Given these market environments, keiretsu firms tend to place more reliance on arm’s-length business transactions with various customers. The benefits of the keiretsu network are rather vague and less promising with the exception of the Toyota keiretsu group.

The intensity of inter-firm ties within the vertical keiretsu system differs dramatically by group. While Toyota has strengthened its control over its group members to mitigate risks from hostile takeovers by foreign firms, Nissan group members have been less under the reign of its leader company. Also, with many keiretsu group members likely to develop relationships with domestic and foreign companies beyond the boundary of keiretsu, it indicates that they are more motivated to undertake a strategy of customer diversification. Post-bubble era and the keiretsu ties have been shifted towards arm’s length for many of its members, and many companies are tending to form new ventures beyond their existing keiretsu structures. This shift is a reflection of their requisite to meet ‘shareholder interests’ rather than ‘stakeholder interests.’

Drawing lessons from the recent economic depression and subprime loan crisis, we now know the importance of customer diversification, collaboration with multiple firms for new technology and innovation, and being cost-effective, flexible and the need to update the procurement system of car parts. JI

Norifumi Kawai is from the Mercator School of Management, University of Duisburg-Essen, Germany norifumi.kawai@uni-duisburg-essen.de