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Morgan Stanley: can mega deals widen the gap with Goldman Sachs?



Within weeks of signing the second-biggest deal of his career, Morgan Stanley boss James Gorman was fighting Covid-19 in his Manhattan apartment and watching the world’s economies lurch towards a coronavirus-driven recession

Some might have fretted about committing to pay $13bn for online brokerage ETrade at such a perilous time. But within months, Mr Gorman was already thinking about another big play, the $7bn acquisition of investment manager Eaton Vance, announced last week. 

“Timing is a funny thing,” says Mr Gorman, who argues that both deals were “strategically obvious over many years” and made just as much sense in the Covid world as before it.

The 62-year-old Australian has a history of crisis-time acquisitions, having wrested control of brokerage Smith Barney from Citigroup in the aftermath of the financial crisis in 2008. It was a $13.5bn deal that would prove transformative, delivering stable income to smooth volatile investment bank earnings and stable funding to Morgan Stanley’s balance sheet. It ultimately laid the foundations for 22 per cent revenue growth from Morgan Stanley’s pre-crisis high to 2019, and a recent string of record results. 

James Gorman, chief executive  of Morgan Stanley, has a history of crisis-time acquisitions
James Gorman, chief executive of Morgan Stanley, has a history of crisis-time acquisitions © Simon Dawson/Bloomberg

With ETrade, an online brokerage popular with millennials, and Eaton Vance, Mr Gorman is doubling down on his original bet that Morgan Stanley’s brightest growth prospects lie in helping individuals and companies to manage their money. 

The decision to go “very deep in the things we understand and know” and avoid the rest further widens the gap between Morgan Stanley and Goldman Sachs, a once-similar Wall Street powerhouse that is now chasing growth in new businesses including cash management and credit cards. 

But ETrade and Eaton Vance will tilt the balance of earnings, and arguably of power, at Morgan Stanley away from the investment bank which has long been described as the “DNA” of the 85-year-old institution but which would have contributed just 42 per cent to 2019’s pre-tax profits, based on the combined accounts of Morgan Stanley, ETrade and Eaton Vance.

“We want to make sure that in very difficult times, Morgan Stanley is steady in the water,” Mr Gorman told analysts on Thursday. “A decade ago, our asset management and wealth management businesses had bright spots in them, but they weren’t big enough . . . [to] provide real stability to the rest of the organisation. This gives us unbelievable balance.” 

Column chart showing Morgan Stanley's revenue by business segment in billions of dollars from 2010 to 2019

Yet, for all their textbook logic the acquisitions have done little to lift Morgan Stanley’s share price, which at around $49 still trades at a slight discount to the value of the firms’ assets. “The market can be really stupid,” Mr Gorman says of the level the stock currently trades at. 

Analysts, however, point out that the fallout from the Covid crisis means interest rates will stay lower for longer, restraining ETrade’s profitability. They also question whether Morgan Stanley can make good on its hopes of converting ETrade clients to its main businesses, and some express frustration at how long the bank will have to wait for a pay-off from its investment. 

As for the Eaton Vance acquisition, the almost 40 per cent premium that Morgan Stanley paid raised eyebrows, despite general appreciation for a deal which takes the bank into the league of $1tn-plus investment managers, adds new product areas and offers a broader distribution network across the US. 

Analysts note that fallout from the Covid crisis means interest rates will stay lower for longer, restraining ETrade’s profitability
Analysts note that fallout from the Covid crisis means interest rates will stay lower for longer, restraining ETrade’s profitability © Brendan McDermid/Reuters

There are broader questions about whether the deals will be enough to maintain the momentum built up by Mr Gorman and his team.

“Morgan Stanley was probably my best stock call of the last decade,” says veteran Wall Street analyst Mike Mayo of Wells Fargo. “But now we actually don’t recommend it. We’re not negative, we’re just trying to figure out what’s left [for them to do], especially since the jury is out on its acquisitions.”

Reforming divisions

It is hard to overstate the impact of the 2008 financial crisis on Morgan Stanley, the corporate finance house spun off from JPMorgan in 1935 to satisfy the Glass Steagall Act’s requirement for a church and state-style separation between banks that dabbled in high finance and those that safeguarded household deposits.

“On a personal level, lots of people were worried about [survival],” says Clare Woodman, head of Morgan Stanley’s international business. Hedge funds were pulling their balances from Morgan Stanley at an alarming rate, funding markets seized up and the value of the bank’s trading assets plummeted.

A $9bn investment from Japanese bank MUFG in September 2008 bought the bank time. “When we came out of the crisis, it was very clear what we had to fix,” says Jon Pruzan, Morgan Stanley’s finance boss. 

Clare Woodman, head of Morgan Stanley’s international business: ‘On a personal level, lots of people were worried about [survival].’
Clare Woodman, head of Morgan Stanley’s international business: ‘On a personal level, lots of people were worried about [survival].’ © Charlie Bibby/FT

Top of the list was cutting the bank’s leverage. Its assets were more than 30 times its equity in late 2007 — a figure that has been cut to 13 times, it has also exited illiquid positions, almost halved its assets in the two years to mid 2009 and reduced its outsized reliance on market funding due to its lack of ordinary depositors.

Smith Barney, for whom Morgan Stanley struck a joint venture with Citi in 2009 before buying in full four years later, offered the potential to make the wealth management division “big enough and durable and stable enough to meaningfully change the profile of the company”, says Mr Gorman. 

“It gave us the space to tackle the challenges inside the institutional business [the investment bank], some of which was working beautifully and some which clearly needed to be fixed,” he adds. 

Bar chart showing change in wealth client assets from Q1 2010 to Q2 2020 in per cent

Mr Gorman, hired from Merrill Lynch in 2006, had long coveted such an asset. “I didn’t have any doubt,” he says. Investors, however, were less convinced. The memory of Morgan Stanley’s fraught merger with brokerage Dean Witter in the late 1990s that left a legacy of legal issues and internal divisions still smarted. Adding another 40,000 people in the wake of the crisis was “a bridge too far” for some, Mr Gorman says, adding that although he was initially “bewildered” by their scepticism he now understands the “scar tissue” that investors were nursing. 

He was quickly vindicated. Wealth management has grown from less than a third of group revenues pre-crisis to more than 40 per cent and Morgan Stanley has become America’s largest wealth manager by assets under management. That shift has created a general halo around Morgan Stanley, and a perception that it has fared far better than rival Goldman Sachs since the crisis, even though Goldman’s returns have beaten Morgan Stanley’s for six of the past 10 years.

Traders react to the falling market at the New York Mercantile Exchange in 2008
Traders react to the falling market at the New York Mercantile Exchange in 2008 © Seth Wenig/AP

Taming the investment bank, whose pre-crisis profits were often built on big bets with the bank’s own capital, was the other critical part of Morgan Stanley’s post-crisis reinvention and another area where the bank won praise for beating Goldman.

“Fixed income was always a hot mess,” says Glenn Schorr, an analyst at Evercore ISI, describing how it had “kept trying to chase Goldman . . . and be something that they weren’t” in a division that included everything from government bonds to bespoke interest rate derivatives and commodities. 

The bank went through a string of fixed-income trading bosses and other senior executives. Then in 2015 it cut around 25 per cent or 1,200 people from its fixed income staff, exited areas where it did not have the scale to compete, including some global currencies, and slashed a bloated trading balance sheet by cutting exposures and selling some businesses.

The slimmed-down division was set a goal of quarterly revenues of $1bn, 25 per cent less than its 2015 level. By 2016, it was already averaging $1.28bn. Goldman Sachs, meanwhile, was being hammered by investors for its bet that the changes to the fixed income business were temporary rather than permanent, a position it clung to until 2019 when it began cutting back. 

Line chart showing US banks' share prices, rebased
Bump chart showing ranking by global investment banking fees from 2000 to 2020

As the fixed income division’s return on equity improved from around 2 per cent in 2015 to above the 6 per cent to 8 per cent threshold set by the bank, Morgan Stanley began quietly rebuilding. Around half of the 2015 job cuts have been added back since then. In the second quarter of 2020, as banks across Wall Street were buoyed by a mammoth trading period, Morgan Stanley’s fixed income business rose by more than anyone else’s, delivering $3bn in revenues. 

“We were running a profitable business that was meeting our target threshold,” says Mr Gorman. “We’d be stupid not to take advantage of that.”

Ambitions scrutinised

Yet Morgan Stanley’s loftiest growth ambitions have in recent years been focused elsewhere: buying investment manager Mesa West for several hundred million dollars; the $900m acquisition of workplace stock plans manager Solium, ETrade and now Eaton Vance. 

The latest acquisition brings $500bn of assets to Morgan Stanley Investment Management, bringing its total assets under management to $1.2tn and putting it in a position to turbocharge growth at a division that traditionally accounts for less than 10 per cent of Morgan Stanley’s revenue. 

“They fill gaps and give us scale in fixed income,” says Dan Simkowitz, MSIM’s head, adding that Eaton Vance also brings a strong business of environmental, social and governance (ESG) investing as well as a broad US distribution network to complement Morgan Stanley’s international reach. 

Mr Schorr believes the rationale for the deal was sound and that while some investors might “think they have overpaid by around $1bn”, that was “the price . . . for a quality growing company and not overly material for a company with a circa $90bn market capitalisation”. 

Bump chart showing ranking by global investment banking fees from 2000 to 2020

As for ETrade, Mr Gorman says investors are much more comfortable with that deal than they were with Smith Barney, recognising the strategic rationale of having a stake in the online-only brokerage world. ETrade has attracted an additional $32bn of retail clients’ funds this year, as individuals piled into the stock market rally. 

“[ETrade] gives us a growth business in the digital space that is extremely complimentary to everything we do,” he says, describing how the deal will accelerate the digitisation of Morgan Stanley’s own wealth business, improve its capital ratios and potentially open doors to 800-plus companies whose stock plans are managed by ETrade.

The deal also brings 5.2m mostly younger clients from ETrade’s main trading business — a potential pipeline for Morgan Stanley’s core wealth management division where the average client age is around 58. In the short term it hopes to offer them mortgages and loans for trading. 

Morgan Stanley’s headquarters in New York. A business mix shift like the one under way at Morgan Stanley can lead to vying factions © Michael Nagle/Bloomberg

Outsiders offer a cooler assessment. Jeff Harte, analyst at Piper Sandler, says it is “not obvious” that Morgan Stanley will succeed in winning much of the $3.2tn of assets that ETrade’s customers hold in other institutions. Another question is “how long earnings will be diluted for” to offset the extra Morgan Stanley shares created to buy ETrade.

Mr Mayo remains sceptical about the $400m of synergies promised from the deal over the next three years and says Morgan Stanley has grown its assets under management by less than its rivals and less than the S&P 500 over the past decade, though the bank argues that their wealthy clients’ sophisticated demands mean they invest in a more diverse range of assets and would not benefit as much from a pure equities rally. Buying the brokerage also makes the bank more vulnerable to low interest rates since ETrade will be making less on its client balances, and some of those who joined ETrade this year may just as easily depart when equities markets turn, he adds. 

Brian Kleinhanzl, analyst at KBW, says JPMorgan, Bank of America, Wells Fargo and Goldman all have strategies to “develop these feeder systems for the wealth management businesses — they are all trying to grow and they’re all doing it in slightly different ways.”

He adds: “It remains to be seen whether any of them will be truly successful.”

Focus on competition

Hours after the ETrade deal closed on October 2, rating agency Moody’s upgraded Morgan Stanley to A2, one of its highest tiers, praising the firm’s “resilient” business mix. “We celebrated with clients, we said, ‘we clawed our way back, thank you for being there with us’,” says Ted Pick, who runs the investment bank. He sees the upgrade as a powerful endorsement from a rating agency that threatened a three-notch downgrade in 2012 before settling on two notches.

He and other executives insist there is plenty of growth to come, especially in investment and wealth management, where clients are looking for solutions and advice to navigate the pandemic’s unpredictable fallout, and also in some parts of its more traditional Wall Street businesses.

A business mix shift like the one under way at Morgan Stanley can lead to vying factions. “People can see who’s in the ascendancy,” says an executive at a rival bank. “At the margin, people do care about these things.” 

There is a general halo around Morgan Stanley and a perception that it has fared far better than rival Goldman Sachs since the crisis
There is a general halo around Morgan Stanley and a perception that it has fared far better than rival Goldman Sachs since the crisis © Richard Drew/AP

The task for Morgan Stanley executives is to make sure their traders, bankers, wealth advisers and investment managers continue to swear allegiance to the bank, not their individual fiefdoms. 

“I’m not going to be judged based on ETrade or Smith Barney or Solium or Mesa West or restructuring fixed income or selling physical commodities or shutting down our prop businesses,” says Mr Gorman. “All these things are just part of the galaxy of steps you take.

“[The real question is] how did we do relative to our competitors? Better or worse? Did we make the right strategic choices, and did we execute on those?’ That’s how we should be judged.” 

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First unleveraged single-stock ETPs aim to woo retail investors




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Leverage Shares is attempting to tap the boom in retail investing with the launch of the world’s first unleveraged physically backed single-stock exchange traded products. The ETPs provide investors in UK and elsewhere in Europe the rare opportunity to buy fractional shares.

Investors might be forgiven for thinking they are another version of the company’s leveraged or inverse ETPs that amplify gains and losses, reset every day and are generally viewed as unsuitable for retail investors.

However, the products promise no geared returns. Instead, they invest directly in the underlying company and, with their launch at $5 per share, their additional sterling and euro share classes, and their offer of big-name companies such as Tesla, they are being aimed straight at the European retail market.

Oktay Kavrak, product strategist at Leverage Shares, said it was unsurprising that the new products were not well understood at present. “Since we’ve only been making leveraged ETPs until now, I’d say this is expected,” he said.

But they have caught the attention of some industry participants.

Matt Brennan, head of passive portfolios at AJ Bell, one of the UK’s largest investment platforms, said that while no decision had yet been taken to add the products to the platform, AJ Bell was “actively monitoring them”.

“In general I am not usually a fan of ETPs, as they do add extra complexity, but to be fair to these products, they do seem to solve a few different problems,” Brennan said.

The products, which it started to roll out in May, effectively made it possible for UK and some other European investors to buy fractional shares in large overseas companies such as Tesla, Google and Amazon for about $5. That compares to about $600 for a single share in Tesla, $2,500 for Alphabet and nearly $3,500 for Amazon.

Leverage Shares’ latest launches last week added large Chinese companies such as Nio and to the family of unlevered single stock ETPs, which are listed on the London Stock Exchange, Euronext Amsterdam and Euronext Paris.

Kavrak said the ETPs were already available on the Interactive Brokers and Swissquote platforms and that Leverage Shares was in negotiation with other platforms including AJ Bell and Hargreaves Lansdown.

“I can understand the rationale for an unlevered approach to accessing single stocks that acts as a proxy fractional share — though clearly investors will need to pay an ongoing charge for the privilege — something they don’t need to do when owning the standard equity share,” said James McManus, chief investment officer at Nutmeg, a UK investment platform that offers low-cost investment portfolios.

“Clearly this is also an imperfect solution to an existing problem and points to the fact that many platforms have not solved the issue of fractional shares — unlike their US counterparts,” McManus added.

So-called fractional shares allow retail investors to own a part of a share, which can be useful if the share is expensive or if large share price movements result in the need for portfolio rebalancing. Nutmeg has developed a fractional share facility that it uses for its portfolio offerings.

Brennan pointed out that as well as enabling fractional shares the currency share classes eradicated the need for currency conversion charges, which could be high on some platforms.

Investing in the US companies via the Dublin-listed ETPs would also relieve investors of the need to fill in documentation to avoid penal tax rates, Brennan said, although he warned that potential investors should also remember that the European-listed ETPs often trade when the markets on which their underlying stocks are listed are closed.

He also pointed to the potential burden of costs that the ETPs would bring. These included the annual management fee of 0.15 per cent, but also the likelihood of wider bid-ask spreads than a more diversified ETF. He added that the ETPs might not track the underlying stock very efficiently if cash was not fully invested and dividends were not reinvested.

However, Todd Rosenbluth, head of ETF and mutual fund research at CFRA said the products looked interesting and were relatively inexpensive for what they offered.

“I think a 0.15 per cent fee for the stock trackers is modest, given the access these provide, and we would expect trading costs will likely improve as more investors discover them. Most new exchange traded products incur limited volume initially,” he said.

He said they should not be confused with Leverage Shares’ other offerings. “There are leveraged versions, but the ones we’re talking about are as risky as owning Tesla or Amazon outright.”

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Will China become the centre of the world economy?




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China’s economy has developed at an extraordinary rate.

In Europe and the US, the mood has been shifting sharply and quickly.

China is so huge that it comprises different realities at the same time.

The global economy itself is starting to somewhat fragment.

China’s economy has developed at an extraordinary rate over the last 40 years across so many areas. The size of its domestic market, the technical prowess of its leading companies, even the feats of exploration in space and its growing military might have astounded the rest of the world. But Martin, the key question now is will China become the centre of the global economy?

There is no doubt that China’s growth up to this point and its continuing growth mean that it will be a major player in the global economy forever more. But there are reasons to doubt that it will be the centre, the unique centre of a global economy, partly because other parts of the world will not be keen to let it and partly because the global economy itself is starting to somewhat fragment into a more regionalised rather than a globalised economy.

I went to China as a student nearly 40 years ago. And it was a place completely different from the high-tech economic superpower that we see today. There was rationing of grain, cotton, and several other basic commodities. And a train from Hong Kong to Beijing took over four days to arrive. The same journey today would take about nine hours.

The best statistic I think to put this extraordinary change into context is average GDP growth. And since 1979 to the end of 2018, China’s GDP growth averaged 9.5 per cent a year. Martin, is this unique as far as you know in history?

I think it is unique in the following sense. There have been other countries that have racked up higher growth rates for a little bit of time. But you’ve never seen anything of this size.

Go back 2,000 years when everyone was equally poor. The point of gravity, the centre of gravity of the global economy basically followed population size. And then with the Renaissance and the Industrial Revolution, you saw Europe and then later North America forge ahead.

In the last 40 years, it’s been moving back towards Asia, into Asia and towards China. But in a sense, it’s really just getting back to what used to be the normal state. Still kind of extraordinary that they’ve done it so fast, even if it’s a return to normality, as I call it. But James, how did they do it?

To start with, in the late ’70s, they began a programme of market reforms that really overhauled the entire communist command economy. By the early to mid ’90s, they began to really put an accent on attracting foreign direct investment. But I think the really key change in China came, again, probably in the mid ’90s, when China began to allow the sons and daughters of farmers to migrate from the village to these big factory towns.

I would say that the Chinese Communist Party has sort of proved that capitalism works, capitalism and freeing up the movement of labour. But let me add one other aspect of this, which is how the western high-income countries were pursuing globalisation at the time, because in the ’80s and the ’90s, you saw a big push for more liberalised global trade. So globalisation was taking place at the behest and led by the high-income countries. But China could just slot straight into that.

A big part of the answer to the question we’re asking, whether China will become the centre of the global economy, is whether that development model can continue to work, because what strikes me is that with all of this success, China is still a relatively poor country. Isn’t that right?

Absolutely. In fact, China currently ranks 61st and the world in terms of countries by their average per-capita incomes. On an aggregate basis, China is still very much a developing nation. But it’s a very anomalous country as well, because it’s got all of this high-tech prowess. It’s got this amazing infrastructure. It’s a very different type of economic beast, I think, from the type of developed country that we can see elsewhere in the world.

Let’s look at Chinese average income compared to the world leader, the US. And we can see that while it was very poor before this whole economic revolution happened, it’s still not rich.

China is so huge that it comprises different realities at the same time. The Chinese middle class numbers these days about 400m people. That is, obviously, greater than the entire population of the United States. But there’s also about a billion Chinese that are much less well-off.

Economists call this the middle income trap. You get to a certain point, fast growth. And then you kind of stagnate before you’ve pulled everyone into the middle class. I mean, one reason why people think that happens is because getting from poor to middle income is a very different process from getting to middle income to high income.

Chinese consumers last year spent about $7.3tn. That, by the way, is greater than the entire GDP of the Japanese economy. But now I think we’re entering a very different phase. And that one is characterised by China’s emergence as a technological power.

I think that’s crucial, James, because one thing that economics and economic history show is that if there’s a way out of the middle income trap, it’s by changing from a growth model based on accumulating labour and capital to a growth model led by technological development and technological progress.

China is likely to be and really already is a middle-income country that leads the world in many areas of technology. Let me just put some flesh on those bones. Let’s just count the sectors in which China is either a global leader or at least close to the cutting edge, wind and solar power, online payment systems, digital currencies, aspects of artificial intelligence, such as facial recognition, quantum computing, satellites and space exploration, 5G telecoms, drones, ultra-high-voltage power transmission. China really is kind of at the cutting edge of a lot of important technologies in the world.

So maybe I can ask you, James, if you agree that there’s a very conscious strategy here among Chinese policymakers to make the world more Sinocentric?

China is driving its standards-setting processes around the world precisely to do as you describe, to try to ensure that the latest technologies around the world are at least partly or largely dependent on Chinese technologies.

It looks to me like the intention is there to be the unique global centre. The big question, though, is whether the rest of the world is going to play ball and let that happen. It’s not often fully appreciated that the globalisation we’ve seen in the last few decades, it’s still quite regionally organised.

In this chart that look, it looks at different economies, weight in the global trading system and the main trading relationship, what we really see is three hubs, one centred on Germany, one centred on China, one centred on the US. And if we look at the more complex kind of trade relationships, global value chains where inputs cross borders many times, it looks even more regional. So I think that this is actually the direction we’re going, that we’re probably going to see even more intensification of trade relationships at regional level, but not necessarily that much more deep trade or deepening of trade happening between the three big blocs, the EU, the US, and China.

It’s certainly true that China is putting a big accent on expanding its trade and investment relationship with southeast Asia, which, I think, it increasingly sees as a backyard market as it were. Also, China would be very reluctant to in any way give up its US market or the European market. I mean, these are huge drivers of China’s export growth.

So we’ll see what sort of choice China is given about this, because it’s very clear that in Europe and the US, the mood has been shifting sharply and quickly. And I think the fact that global trade in itself is moving to more, towards more complex value chains and more services trade and digital trade, that also is going to strengthen the political aversion to integrating with China. So this is why I think that while China will, as I said, forever more be a major part of the global economy, we are probably looking more at regional dominance than becoming the unique centre of one homogeneous global economy.

I think the scenario that the world splits into three or more regional trading blocs is certainly not conventional wisdom at the moment. And if the world was to move into that direction, it would suffer huge disruptions. There would be protectionism, the decoupling of supply chains, and several other reversals as well. However, sitting here in Hong Kong, I can see the pressures that might lead to such an outcome building up. So I think the key point right now is that unless the EU, the US, and China can sort out their differences, we could see the regionalisation of global trade becoming a reality in several years’ time.

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Covid gives Japan ‘last chance’ to reverse digital defeat




Each day, dozens of residents in Tokyo’s Setagaya district visit an office to sign up for a My Number identification card. Officials take each visitor’s photo, make copies of their existing ID documents and ask them to write down four passwords. The information is sent back to the local government and it can take months before the card is issued.

The process has been slow because of Covid-related restrictions. Residents are asked to book appointments in advance and slots are limited to prevent overcrowding. One resident received a notice in May but her nearest office did not have a slot open until July.

The 12-digit My Number card, which can be used for making online applications for administrative procedures as well as for opening bank accounts and other services that require ID verification, could have flourished during Covid-19. Instead, it has become a symbol of a digitally ill-prepared Japan. The government launched the project in 2015 and spent ¥880bn ($8bn) to make and distribute the cards. But only 15 per cent of the population had received a card by the time the outbreak began.

That meant Japan had no choice but to rely on paper and manual labour, a system that has been largely unchanged for decades and has proved to be extremely inefficient during the pandemic.

My Number card
Only 15 per cent of Japan’s population had a My Number card by the time the Covid-19 outbreak began © Ken Kobayashi

Last year’s emergency cash handout programme required residents to fill in applications and send them by post. Municipalities had to print and mail the applications to households, set up call centres to respond to inquiries and manually process each application sent back to them. Residents had to make copies of ID documents, creating queues in convenience stores with printers. The policy was announced in April 2020 but municipalities could not start delivering the checks until June. “I called the help desk 200 times but couldn’t get through,” reads one complaint from an Osaka resident.

A year later, Japan is struggling with similar bottlenecks. Many countries operate online vaccine booking systems using residents’ IDs or mobile phone numbers. But Japan began its vaccination programme by having local municipalities send out physical vaccination tickets to eligible residents. The operation was both costly and slow, resulting in fewer than three doses administered per 100 people at the end of April. Frustrated, prime minister Yoshihide Suga instructed the Self-Defense Forces to operate large inoculation centres in Tokyo and Osaka. The SDF began doing so on May 24 and the number of daily vaccinations has since surged.

These are just some of the many policies that have since been summed up as Japan’s “digital defeat”.

This article is from Nikkei Asia, a global publication with a uniquely Asian perspective on politics, the economy, business and international affairs. Our own correspondents and outside commentators from around the world share their views on Asia, while our Asia300 section provides in-depth coverage of 300 of the biggest and fastest-growing listed companies from 11 economies outside Japan.

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The recent embarrassments have renewed a sense of urgency and prompted Suga to launch an all-out effort to go digital. He is setting up a powerful digital agency that is expected eventually to control the government’s entire IT system budget, which was worth about ¥800bn in the fiscal year 2020. By streamlining the software and standards across all ministries and local governments, he plans to expedite a digital overhaul of administrative procedures as well as of key sectors such as healthcare and education.

Suga has moved swiftly. He tapped Takuya Hirai, an IT expert within the ruling Liberal Democratic party, to set up the digital agency and appointed Taro Kono, known for his social media savvy, as the minister for administrative reform. Sweeping legal changes to enable the transfer of authority from each ministry and municipality were approved in May, paving the way for the agency’s scheduled launch in September.

The ingredients for a modern digital economy are already there. Japan was an early mover in building internet infrastructure and was on the cutting edge of mobile telephony until the introduction of smartphones. The country’s rapidly ageing population means there is strong demand to increase productivity through technology. Making bold moves to boost the digital competitiveness of the public and private sectors could add up to ¥79tn to Japan’s gross domestic product by 2030, estimates McKinsey Global Institute.

Takuya Hirai
Takuya Hirai, an IT expert within the Liberal Democratic party, is in charge of setting up the digital agency © Tetsuya Kitayama

Some experts say Suga faces an uphill battle in creating a competent digital organisation. The endeavour will require attracting talent from Japan’s tech sector, which is already making up for an engineer shortage by hiring foreign talent. Hirai has ruled out this solution. The digital agency, he said, “will not hire foreign nationals as civil servants”.

Unifying systems across ministries also means busting the sectionalism, or walls, built up within each bureau over decades, known as tatewari gyosei.

And a digital push in areas such as healthcare is already being met with hesitancy from the private sector. “This is asking for a fight,” said Timothy Langley, chief executive of consultancy Langley Esquire. “The set-up of a digital agency means: I’m going to take power from all of you ministries. You can’t hide any more.”

The idea is for the agency to combine top-down decision-making with the private sector’s tech expertise. It will be placed directly under the cabinet office and will be led by the prime minister, with the digital minister running the day-to-day operations. A digital expert will advise the minister, a post that Hirai said could go to a private sector hire. The agency plans for 120 of its 500 employees to come from the private sector and universities.

A chart showing Japan’s working-age and senior populations

Hirai has taken his “government as a start-up” slogan on a media blitz to promote the agency’s tech friendliness, appearing on talk shows on YouTube and social media apps such as Clubhouse. He has not minced his words in calling Japan’s past digital policies a failure. “This digital defeat is our last chance,” he declared during an online forum last year.

Hiring is being conducted by the information technology strategy office, a division of Japan’s Cabinet Secretariat. When the project was launched in September, Hirai tapped a group of young officials to lead on-the-ground operations. He also brought in tech industry executives as advisers. Discussions led to the IT strategy office awarding a contract to Tokyo-based start-up Herp to provide online software that manages the remote hiring process.

One adviser called this a symbolic move: the IT strategy office had previously told applicants to send in their documents by post.

“We are really a venture,” said Herp’s chief executive Ichiro Shoda, “so we have never done a government project. I think there was a credibility risk but I think we were chosen because [the officials] sympathised with our ideas.”

Shoda said his team was surprised by how quickly the members involved in the recruitment process were able to grasp its software. “Officials from ministries, external advisers and aides were all using our service. We didn’t spend much time explaining how to use it.”

Whether bureaucrats and engineers from the private sector can work in harmony will have big implications for Japan’s digital policies. A string of new laws recently passed by parliament defines the digital agency’s role as an “overall co-ordinator” and gives the digital minister authority to make recommendations to the heads of other government ministries and agencies. The agency also has the power to build core systems on its own.

Japanese citizens wearing masks in a subway
Mask use in Tokyo is close to 100% as citizens battle a pandemic that has left their government flustered © Ken Kobayashi

The projects it will oversee include having the entire population obtain a My Number card by March 2023, bringing 98 per cent of administrative procedures online by 2025, transferring data kept in each municipality to the cloud and creating a new digital category for civil servant exams.

The targets seem ambitious. In reality, they are goals that Japan’s peers have already been tackling for years. India launched its national identification system, Aadhaar, in 2010, and nearly all of its 1.3bn people have since registered. Singapore plans to make all government services available online by 2023. Only 7.5 per cent of Japan’s 55,765 administrative procedures could be completed online as of 2019, according to the Japan Research Institute.

Japan ranked 27th in the IMD World Digital Competitiveness Ranking 2020, down from 23rd in 2015. The fall contrasted with China’s rise from 33rd in 2015 to 16th and with South Korea, which jumped from 18th to eighth.

Japan was not always a laggard in digital technology. It built out its internet infrastructure by 2000, when it had the second most internet users in the world, just behind the US. In 2001, then prime minister Yoshiro Mori had a plan drafted for Japan to become a global IT leader within five years.

The country reached some goals, such as laying fibre-optic cables across the nation. But targets such as streamlining government IT systems were largely abandoned. That left each ministry and municipality to manage its own systems. Most organisations lacked technical expertise and outsourced the projects to system integrators such as NTT, Fujitsu and NEC, creating a fragmented environment in which data cannot be shared.

A chart showing digital competitiveness ranking of selected countries

One early IT adviser to the economy ministry said he was surprised by how new contracts were being awarded without much being completed. “It was like constructing a building without a door and then starting a door construction project,” the person recalled. “There was always an excuse for not being able to finish the original plan.”

The lack of change came to haunt the country during the pandemic. In February, the health ministry said it had found a glitch in its contact tracing app for Android users. The app failed to notify users when they came in close contact with another user who had tested positive for Covid-19. Health minister Norihisa Tamura shocked the public by admitting the app “essentially had not been functioning since September”.

Why did the ministry fail to notice the glitch for more than four months? In May 2020 the ministry awarded the contract to Persol Process & Technology, a subsidiary of staffing firm Persol Holdings. In turn, Persol subcontracted the project to five companies, a move it said was due to the short timeframe given to complete the project. Because the responsibilities were sliced up and spread across different companies, “there was no shared understanding over who was actually performing the final quality control”, the ministry concluded after investigating the issue.

Japan’s contact tracing app for Android users
The health ministry said in February it had found a glitch in its contact tracing app for Android users © Ken Kobayashi

Langley says the digital agency should shoot for some quick victories to gain the public’s trust. Those would include abolishing the hanko stamps that the Japanese use instead of signatures and shedding a reliance on fax machines, especially at local government offices.

Bigger reforms such as in the healthcare system are more challenging and cracks are already starting to appear. Plans to enable the My Number card to be used as an insurance card at hospitals, dentists and drugstores were delayed from the initial target date in late March. The health ministry blamed errors in some of the insurance data registered in the system. But many hospitals are also wary of the additional system costs. The ministry had planned to start trials at 500 hospitals and pharmacies but only 54 joined.

The use of overseas cloud services to store and analyse data is another potential landmine. Japan has no local equivalent to services provided by US tech giants Amazon and Microsoft. Some parts of the government already use cloud services such as Amazon Web Services. But “will the prime minister allow his own medical records to be stored on AWS?” wondered a health ministry adviser. “The debate is just starting.”

Hirai believes that starting the debate is an important step forward. “Gathering the authority of each ministry and agency in one place, including the budget . . . consensus building for such a move will not be possible unless it is an emergency,” he said earlier this year. “The sense of speed is unprecedented but it is probably the only way to do it.”

A version of this article was first published by Nikkei Asia on June 15 2021. ©2021 Nikkei Inc. All rights reserved.

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