THE FUTURE OF JAPAN:

REIGNITING PRODUCTIVITY
AND GROWTH
MARCH 2015

HIGHLIGHTS
33 48 61

Demographic headwinds Advanced manufacturing Innovation

A rapidly aging population Revitalizing Japan’s Capturing global market
magnifies the productivity signature industries share for cutting-edge
challenge products
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 THE FUTURE OF JAPAN:
REIGNITING PRODUCTIVITY
AND GROWTH
MARCH 2015

Georges Desvaux | Tokyo

Jonathan Woetzel | Shanghai
Tasuku Kuwabara | Tokyo
Michael Chui | San Francisco
Asta Fjeldsted | Tokyo
Salvador Guzman-Herrera | Jakarta
PREFACE

Two lost decades have taken a toll on Japan’s confidence and

competitiveness, but today there is new resolve to do “whatever it takes” to
revive the nation’s prospects. Beyond its dramatic moves in monetary policy
and fiscal stimulus, Japan is wrestling with a wide array of policy proposals
intended to address long-standing structural barriers that have hampered
productivity. In addition to reigniting growth in the immediate term, Japan
has to prepare for a brave new world of demographic headwinds, fast-paced
technological change, and amplified global competition.

Abenomics speaks to many of these challenges, but Japan needs an even

broader agenda for change—and its fundamental challenges cannot be
solved in the policy arena alone. This report aims to highlight potential avenues
for growth and renewal, with particular emphasis on areas where the private
sector can take the lead.

This report is the result of collaboration between the McKinsey Global

Institute (MGI) and McKinsey’s Japan practice. The project was led by
Georges Desvaux, managing partner of McKinsey’s Japan office, and
Jonathan Woetzel, an MGI director in Shanghai. Tasuku Kuwabara, a
McKinsey partner in Tokyo, and Michael Chui, an MGI partner based
in San Francisco, directed the research. The research team, led by
Salvador Guzman-Herrera and Asta Fjeldsted, comprised Mami Ariie,
Ken Fujimoto, Karen Kawabata, Motonori Kuwana, Andrew Marconi,
Andrey Mironenko, Mika Mizunuma, Miki Sarumaru, Misako Sasayama,
Elizabeth Silliman, and Manae Uchibori. Lisa Renaud provided editorial
support. Thanks go to our colleagues in operations, production, and
external relations, including Tim Beacom, Marisa Carder, Matt Cooke,
Vanessa Gotthainer, Deadra Henderson, Midori Horii, Misayo Iye,
Yoko Matsumoto, Hanako Muto, Tomoko Okayasu, Julie Philpot,
Rebeca Robboy, and Eriko Tsurugaya.

We are grateful for the advice and input of many McKinsey colleagues,
including Ken Kajii, Peter Kenevan, Kenji Nonaka, Sree Ramaswamy,
Yasushi Sawada, Yoshi Takanuki, and Bill Wiseman, all of whom provided
insight on advanced manufacturing. For advice on retail, we relied on
Peter Child, Rimpei Iwata, and Paul McInerney. Vivek Agrawal, Vito Giudici,
Fumiaki Katsuki, Masaaki Tanaka, and Ryoma Yamamoto provided advice on
the financial services industry. For health care, we received valuable guidance
from Axel Baur and Ludwig Kanzler.

We also thank our academic advisers, Martin N. Baily, the Bernard L.

Schwartz Chair in Economic Policy Development at the Brookings Institution,
and Keiko Ito, professor of economics at Senshu University, for insights that
enriched this report.
This report contributes to MGI’s mission to help business and policy leaders
understand the forces transforming the global economy, identify strategic
locations, and prepare for the next wave of growth. As with all MGI research,
this work is independent and has not been commissioned or sponsored in
any way by any business, government, or other institution. We welcome your
comments on the research at [email protected].

Richard Dobbs
Director, McKinsey Global Institute
London

James Manyika
Director, McKinsey Global Institute
San Francisco

Jonathan Woetzel
Director, McKinsey Global Institute
Shanghai

Georges Desvaux
Director, McKinsey & Company
Tokyo

March 2015
© Getty Images
 CONTENTS

HIGHLIGHTS In brief

48 Executive summary  Page 1

1. The origins of Japan’s productivity imperative  Page 21

Japan’s current trajectory and the need to accelerate productivity growth

2. The opportunity for a new path  Page 33

Advanced manufacturing
The private sector’s role in engineering a leaner and more competitive economy

61 3. A sector-level road map  Page 47

Opportunities for revenue growth and efficiency improvements in four key sectors

4. The enablers of growth  Page 103

Human capital, education, entrepreneurship, innovation, competition, and
Retail
infrastructure productivity

78 Appendix: Technical notes  Page 121

Bibliography  Page 125

Financial services

89

Health care
IN BRIEF
THE FUTURE OF JAPAN:
REIGNITING PRODUCTIVITY AND GROWTH
Over the course of two painful “lost decades,” Japan has lost much of its competitive edge. Its economy continues
to operate below its potential. Productivity growth has steadily eroded in almost every sector, including its signature
advanced manufacturing industries. Policy changes can create the right conditions for reigniting growth, but Japan
needs a greater focus on what individual companies can do immediately and on their own. In fact, launching a major
private-sector initiative to transform Japan’s productivity performance can constitute a “fourth arrow” of economic
reform to complement the Abenomics agenda.

ƒƒ A demographic challenge of historic proportions has arrived on Japan’s doorstep. Its working-age population will
decline from 79 million in 2012 to 71 million in 2025, and its dependency ratio is set to soar from 0.60 to 0.73 over the
same period. With its workforce shrinking, Japan has to rely on productivity as its primary catalyst for growth.

ƒƒ Japan’s labor productivity growth has been stalled below 2 percent for much of the past two decades, and today
there is a substantial and widening gap between Japan and other major advanced economies. Capital productivity
has similarly eroded: the return on investment generated by listed non-financial companies in Japan is 23
percentage points below the performance of equivalent US corporations. Japan is on pace for sluggish annual GDP
growth of just 1.3 percent through 2025 if these trends continue. But there is still time to head off this outcome.

ƒƒ If Japan can successfully double its rate of productivity growth, with a sharp focus on increasing value added as
well as reducing costs, it could boost annual GDP growth to approximately 3 percent. This would increase Japan’s
GDP by up to 30 percent over the current trajectory by 2025 and improve its fiscal outlook. Some $1.4 trillion in GDP
growth is at stake in 2025 alone.

ƒƒ Multiple fast-moving forces are realigning the global economy, including immense flows of global trade, the rise
of billions of new urban consumers in the emerging world, and technology breakthroughs. Japan can ride these
trends to gain new momentum.

ƒƒ Companies have multiple avenues for growing revenues and finding deeper operational efficiencies. These
strategies fall into three main categories: adopting global best practices, deploying next-generation technologies,
and organizing for discipline and performance. Japan can reach some 50 to 70 percent of its productivity goal by
applying practices that are already in use elsewhere around the world.

ƒƒ Around one-third of the productivity potential can be captured within four sectors: advanced manufacturing, retail,
financial services, and health care. In the case of health care, we estimate that Japan can slow the rate of annual
expenditure growth from 3.7 percent to just 1.5 percent.

ƒƒ Implementing productivity improvements such as increased automation will affect jobs in many industries. But the
pursuit of new growth markets and a projected 3.7 percent decline in Japan’s labor force by 2025 can cushion the
net impact on employment.

ƒƒ The public and private sectors will have to work together to create the right environment for growth, focusing
on talent and skills development, labor market frameworks, entrepreneurship, innovation, competition, and
infrastructure productivity.

The task of continuously capturing new productivity improvements grows more difficult over time, but it is achievable,
particularly if Japan takes steps to create new competitive dynamics across entire industries. This effort goes
beyond cost cutting; it is about spurring growth and increasing value added by launching business lines, pushing the
boundaries of innovation, and entering new markets. Private-sector initiative and drive will be key to the resurgence
of Japan.
 Japan’s working-age population
is declining

2012
79 million
2025
71 million

With Japan’s labor force shrinking, productivity

will determine its economic outlook for 2025

Productivity Annual GDP

growth GDP growth per capita

2% 1.3% $32,000

4% ~3% $48,000

A private-sector “fourth arrow” could

accelerate productivity and
boost value added by 28%

Global Next-generation Organizing for discipline

best practices technologies and performance
© Alamy
 EXECUTIVE SUMMARY

Despite two painful “lost decades,” Japan remains the third-largest economy and the
fourth-leading exporter in the world. It is a nation with advanced technological know-how,
a formidable manufacturing base, world-class infrastructure, and a large and affluent
consumer market. This is a rare combination of strengths—and yet the world remains
pessimistic about Japan’s prospects for growth and reinvention.

A demographic challenge of historic proportions has arrived on the nation’s doorstep, and
many Japanese themselves regard the future with anxiety. Japan passed the tipping point at
which its population began to decline in 2011. As of 2013, a quarter of its population was age
65 or older; by 2040, that share will rise to more than one-third. The implications of this shift
are already being felt economically and socially.

Japan’s productivity growth has been stalled below 2 percent for much of the past two
decades, reflecting both missed opportunities to grow value added and deteriorating cost
competitiveness. A continuation of this trend would put the economy on pace to grow by
only 1.3 percent annually through 2025. Another decade of sluggish growth would do little to
boost household purchasing power. Even more ominously, it would constrain the resources
available for social security and health care just as demand for them intensifies.

2X
There is still time to head off this outcome. With its working-age population shrinking, Japan
has to focus on productivity as the primary catalyst for economic momentum. If Japan can
successfully double its rate of productivity growth, it could boost annual GDP growth to
Acceleration in
approximately 3 percent. By 2025, this would increase Japan’s GDP by up to 30 percent
productivity
over the current trajectory. The size of the prize is $1.4 trillion in annual GDP growth in that
needed to push
year alone.
Japan’s GDP
growth to Public policy changes can create the right conditions for growth, but most of the outcome
approximately 3% is in the hands of the private sector. Individual companies can do a great deal immediately
and on their own without waiting for government action. Reigniting the Japanese economy
will depend on their willingness to invest and take risks. The good news is that our research
has identified areas within multiple industries that are ripe for revenue growth and efficiency
improvements. This effort is not simply about cost cutting. It is also about spurring growth
by launching business lines, pushing the boundaries of innovation, and entering new
markets. A major private-sector initiative to accelerate productivity growth can constitute a
“fourth arrow” of economic stimulus that complements the Abenomics agenda.

Japan’s productivity growth has been hobbled by inadequate competitive

pressures and a rigid labor market
After making rapid leaps forward in the 1970s and 1980s, productivity growth has steadily
eroded in almost every sector, including Japan’s signature advanced manufacturing
industries. Today there are substantial and widening labor and capital productivity gaps
between Japan and other advanced economies (Exhibits E1 and E2). In 2010, the mean
return on invested capital for large listed Japanese companies was 23 percentage points
lower than that of non-financial institutions in the US S&P 500, a symptom of large-scale
misallocation of capital.1 Japan has been unable to sustain consistent growth in value
added, and the economy continues to operate below its potential.

1
In the first and second sections of the Tokyo Stock Exchange, excluding financial institutions.
Exhibit E1

Japan’s labor productivity gap with the United States has been widening across most industries

Labor productivity gap by sector (%, based on $ 2009 at purchasing power parity) 2000 2005 2011
Index: 0 = United States

United States Japan

more productive more productive

-70 -65 -60 -55 -50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25
Sectors
analyzed
in detail
Post and telecommunication

Health and social work

Wholesale trade

Advanced manufacturing
and consumer electronics

Manufacturing (other)

Construction

Other community, social,

and personal services

Financial intermediation

Retail trade

Electricity, gas, and

water supply

Hotels and restaurants

Transport

Real estate

Business services

Agriculture

NOTE: Education, public administration, and domestic employees not included.

SOURCE: World Input-Output Database; World Bank; McKinsey Global Institute analysis

2 McKinsey Global Institute Executive summary

Exhibit E2

Japanese sectors are also falling behind US sectors in capital productivity

Capital productivity gap by sector (%) 2000 2005 2011

Index: 0 = United States

United States Japan

more productive more productive

-90 -85 -80 -75 -70 -65 -60 -55 -50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10
Sectors
analyzed
in detail
Real estate

Electricity, gas, and

water supply

Manufacturing (other)

Post and telecommunication

Hotels and restaurants

Agriculture

Financial intermediation

Construction

Transport

Retail trade

Health and social work

Wholesale trade

Advanced manufacturing
and consumer electronics

Other community, social,

and personal services

Business services

NOTE: Education, public administration, and domestic employees not included.

SOURCE: World Input-Output Database; World Bank; McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 3
 Competition fuels productivity, as the most nimble and innovative companies win out over
less efficient firms. But in Japan, highly indebted firms and even uncompetitive divisions
of large conglomerates have often been kept alive in the interest of stability.2 As banks
continue to roll over bad loans, and corporate headquarters continue to allocate funds to
underperforming units, resources are diverted that could be put to better use elsewhere
and the process of creative destruction is impeded. In addition, regulatory barriers make it
difficult for new competitors to challenge incumbents in certain sectors. The presence of
multinationals could provide additional competitive intensity, but Japan attracts very little
foreign direct investment (FDI).

Japan’s long-standing lifetime employment model has also contributed to a certain degree
of stasis. Today the legal strictures around lifetime employment have mostly been lifted,
making the labor market more flexible in theory. But downsizing is viewed in a strongly
negative light in practice, producing inefficient bureaucracies that lack agility. Workers, too,
are reluctant to advance their careers by changing employers, which limits their incentive to
develop new skills.

Japan has partially addressed this issue by allowing firms to hire non-regular (temporary)
workers, or haken. By 2013, more than one-third of workers were covered by these
arrangements, which offer limited legal protections and no pensions. At the current rate
of growth, haken could account for 50 percent of the workforce by 2030. Paradoxically,
this has taken a toll on productivity: temporary workers have fewer incentives to excel, and
employers do not invest in their development. At a broader societal level, this situation has
created a two-tiered workforce and contributed to inequality.

A continuation of current trends would have profound consequences,

but Japan can change course
Although unemployment has remained low for the past two decades, deflation has eaten
away at income growth and discouraged consumer spending. Japan has maintained global
market share in automotive and other select industries, but many of its companies are being
outperformed by Korean, Chinese, and US competitors. Few Japanese startups have
broken through on a global scale. Perhaps most worrisome is Japan’s fiscal trajectory; in
2014, its public debt stood at 234 percent of GDP.

Japan has an opportunity to once again outpace the

world in efficiency and quality.

If current trends hold, Japan’s GDP per capita would grow by a mere 1.3 percent annually
over the next decade. Its overall labor productivity gap with the United States is on track to
widen from 29 percent in 2011 to 37 percent in 2025. Japan could face a third decade of
stagnation—one that would collide with an unprecedented demographic shift, creating even
more damaging consequences.

But Japan has a window of opportunity to create a different outcome—to once again
outpace the world in efficiency and quality, emerging as a global leader in fields such as
advanced materials, 3D manufacturing, and the life sciences.

2
Richard C. Koo, The holy grail of macroeconomics: Lessons from Japan’s Great Recession, Wiley, 2009.

4 McKinsey Global Institute Executive summary

 In this scenario, Japan would open the door to greater competition from multinationals, and
its large companies would rise to the challenge. The Japanese education system would
foster experimentation and critical thinking. Entrepreneurship would become rooted in
campus life, with students in Tokyo University dorms cooking up plans for the next Google,
Facebook, or Alibaba.

In this future, Japan proves that it is possible to provide an aging population with top-quality
medical care while containing costs. Improved health allows experienced workers to remain
on the job as they age, as physically demanding tasks are automated. Millions of women join
the workforce, and many rise through the leadership ranks.

This vision is highly aspirational, but Japan can begin to move in this direction. Instead
of settling for 1.3 percent annual GDP growth, Japan could grow by an average of
approximately 3 percent through 2025. This would lift Japan’s projected annual GDP
in 2025 by almost 20 to 30 percent over current trends—for an increase of up to some
$1.4 trillion in that year alone (Exhibit E3).

Exhibit E3

Productivity initiatives in specific industries can help Japan increase value added by up to 28 percent
above the current trajectory

Value added High range

$ billion, 2009
Low range

907 6,290

+28%

544 5,768
120 21
14 +18%
156 96
186 105
4,900 109

4,139

2011 2025 Advanced Retail Financial Health Other 2025

estimated manufac- services care industries1 improved
turing

1 Increases in value added and productivity in the sectors examined in detail were used to extrapolate gains in similar
industries (e.g., gains in advanced manufacturing were applied to all manufacturing).
NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; IHS; McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 5
 To get there, Japan will need to more than double its labor productivity growth rate,
boosting it to approximately 4 percent. This is an ambitious goal for any economy, but
with its labor force shrinking, Japan has to focus on productivity to accelerate growth.
Increased labor force participation will also play a part, as will innovative business models
and social paradigms. Japan’s capital productivity could improve by 25 percent through
better allocation of resources, higher revenues, and a push for greater cost effectiveness in
infrastructure spending.

New efficiency measures such as increased automation will affect jobs in many industries.
But a growing economy combined with a projected 3.7 percent decline in Japan’s labor
force by 2025 can cushion the net impact on employment.

Japan’s productivity challenge ultimately has to be

met by the private sector—and there is a great deal
that individual companies can do immediately and on
their own.

Firing a fourth arrow: Individual companies can transform Japan’s

productivity performance
A nationwide effort to accelerate productivity growth—led by the business community and
spanning every sector of the economy—could amount to a “fourth arrow” for Abenomics.
Many of the barriers and bottlenecks that have constrained growth are not imposed by
regulation; they stem from traditional ways of doing business. Japan can reach some
50 to 70 percent of its productivity goal by adopting practices that are already in use
around the world, while most of the remaining improvement can be captured by deploying
new technologies.

Incorporating global best practices

ƒƒ Become more globally integrated. Rather than relying heavily on the domestic market,
Japanese companies have to become more aggressive about entering the fastest-
growing overseas markets. But rather than just going global, enterprises have to become
truly global, thinking beyond borders with regard to their operational footprint and talent
development. Organizations can retain their Japanese roots while cultivating deeper
connections to global value chains.

ƒƒ Improve capabilities across the value chain. Japanese companies have historically
excelled in manufacturing and product development, but they need to invest in building
world-class capabilities in other functions such as sourcing, supply-chain management,
customer relationship management, marketing, and after-sales service.

ƒƒ Continue the journey of digitization. In most companies, an end-to-end review will

likely reveal areas that have received a lack of IT investment and process innovation.
Replacing outdated IT systems and equipping employees with mobile tools can enable
massive improvements in performance.

ƒƒ Determine the optimal physical footprint. Organizations may need to reconfigure in

a more digital world with changing demographics. In retail, for example, smaller urban
storefronts (or, conversely, big-box stores) offering innovative customer experiences
can help to reduce costs and increase proximity to customers. Health-care providers

6 McKinsey Global Institute Executive summary

 may need to consider whether their locations, scale, and degree of specialization match
the needs of patients by age and geography. Financial institutions may need to close
some of their least profitable branches and incorporate new interactive technologies
into others.

Adopting next-generation technologies

ƒƒ Harness the power of big data. Big data is a powerful tool for pricing, customer
segmentation and marketing, sales forecasting, risk management, and R&D—and many
large Japanese companies have yet to begin using it to transform their operations.

ƒƒ Take automation to the next level. Intelligent software systems and robotics could help
Japanese companies address critical labor shortages in the years ahead.

ƒƒ Deploy advanced technologies in manufacturing processes. Technology can

reinvent the assembly line yet again, from the adoption of low-cost sensors and
big data analytics for better accuracy in production to the use of 3D printing for
mass customization.

Organizing for discipline and performance

ƒƒ Restructure as needed to create a more competitive and fluid industry landscape.
If additional policies that have constrained market forces are removed, companies will
have to adapt to a much more intense level of competition. Some may need to reorganize
or exit unprofitable markets, while others may undertake mergers and acquisitions to
achieve economies of scale.

ƒƒ Create a culture of performance and accountability. Shareholders and top

executives can reinforce that productivity is a top organizational goal by tying
performance goals to incentives. Some of Japan’s largest companies have already
begun shifting away from the traditional seniority-based advancement system in favor
of merit-based pay structures, and other firms can follow their lead. Promoting younger
talent into management ranks and rewarding results can create agile organizations with
fresh ideas.

ƒƒ Draw on all sources to build talent, leadership, and skills for the future. Individual
companies can attract and retain female talent by implementing supportive human
resource policies and making tangible changes in workplace culture (such as relaxing
the demands for long hours that make it difficult for new mothers to return to work). It is
especially critical for companies to invest in programs that develop and mentor female
leaders who can drive growth and productivity in the future. Employers will also need to
retain valuable skills and experience by reengineering the workplace to accommodate
aging workers, perhaps by automating physically demanding tasks, offering flexible
hours, or focusing on ergonomics. Older workers could also transition to mentorship and
training roles.

ƒƒ Focus on the customer to achieve a better return on R&D investments. Instead of

focusing on technology itself, the development process has to start with understanding
what the customer wants and deliver solutions based on that insight. Innovation
has to evolve from closed and tightly managed R&D operations to more fluid, open
processes involving teamwork across the organization and collaboration with customers
and suppliers.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 7
 Box E1. Riding global trends for faster growth
What is different about today’s environment that could support
a fundamental shift in Japan’s direction? The answer is
simple: everything.

This is an era of explosive growth in global trade, yet Japan’s

share of global exports has fallen from 7 percent in 2000 to
4 percent in 2013. But Japan has the manufacturing, export, and
innovation capabilities to make up for lost time and lost market
share. As emerging economies continue to industrialize, they will
become growth markets for vehicles, machinery and equipment,
and electronics, all long-standing areas of strength for Japan.

Much of the developed world is aging—and it will be watching

intently to see if Japan, the nation at the leading edge of this
trend, can pioneer policy responses. The private sector will
also have to develop new business practices and technologies
to alleviate labor shortages, all of which will have positive
implications for productivity. Japan could be well positioned to
export innovative products and services geared to seniors, who
represent a lucrative consumer segment.

The world is undergoing a historic surge of urbanization, a

shift that puts the spotlight on infrastructure. There is a huge
opportunity for Japan to improve capital productivity in its own
infrastructure projects as well as providing project finance and
engineering expertise to the rest of the world.

Today multiple transformative technologies, from artificial

intelligence and 3D printing to the Internet of Things,
have already appeared on the horizon. Japan is already
adopting—and even inventing—some of these breakthroughs.
Now the challenge is to accelerate adoption throughout
entire industries so that technology moves the needle on
productivity performance.

As one of the most rapidly aging, urbanized, globally connected,

and technologically advanced societies on the planet, Japan
stands smack in the forefront of a global wave of disruption.
These trends present both pressures and incentives to
act. Japan can turn the current wave of global disruption
into opportunity.

8 McKinsey Global Institute Executive summary

 Four sectors illustrate Japan’s untapped productivity potential
Around one-third of the estimated productivity potential can be captured within the four
sectors discussed below, which were selected to illustrate differing parts of the Japanese
economy. The strategies outlined here are by no means exhaustive, but they do offer a
starting point for action and an indicator of the size of Japan’s opportunity.

Advanced manufacturing
Advanced manufacturing (which includes automotive, industrial machinery, and electronics)
represents the vanguard of Japan’s industrial capabilities and the source of its signature
exports. But over the past 15 years, this sector’s global market share has eroded in the face
of new competition. Japan’s advanced manufacturers once raised the bar for the rest of
the world in efficiency and quality, but today their labor productivity is 29 percent below that
of the US sector and 32 percent below Germany’s. This gap is not only significant; it has
been widening.

At the firm level, Japanese auto companies have remained excellent performers, but the
biggest names have shifted much of their production outside of Japan to local markets.
The consumer electronics space has not fared as well. Lean players such as Samsung,
LG, Xiaomi, Huawei, and Lenovo have grabbed market share for products such as TVs,
PCs, and smartphones—often at the expense of Japanese firms. The major Japanese
conglomerates have spent the past decade fighting for profitability. In some cases, they
made unfortunate bets on technologies that did not win out in the marketplace. The
Japanese consumer electronics industry includes many subscale companies and plants
focusing on products with declining margins.

Our research has identified multiple industries

that are ripe for revenue growth and
efficiency improvements.

One of the advanced manufacturing sector’s major challenges has been downward
pricing pressure, but this is a worldwide phenomenon that does not fully explain Japan’s
productivity gap. Four other issues have been at play. First and foremost has been an
insufficient focus on fast-growing global markets. Japanese automakers have successfully
tailored their vehicles for emerging markets, but other Japanese products have failed to
resonate in lower-income economies. Second, Japan’s electronics sector remains heavily
weighted toward hardware in an era when the market has shifted toward software, IT
services, mobile applications, and integrated solutions. Third, Japan spends more on
manufacturing R&D than almost any other country, but in recent years, that investment has
not adequately paid off in the form of new hit products. Fourth, Japan has to contend with a
higher non-labor cost base, due in part to inefficiencies in global operations and in functional
areas such as supply chains (Exhibit E4). Japan’s advanced manufacturing industries could
face a future of declining global market share and slow productivity growth. The sector’s
value added is on pace to increase by a mere 1.4 percent annually through 2025.

But Japanese companies can change this outcome by aggressively adopting global best
practices, starting with redirecting their formidable R&D capabilities to higher-value spaces.
In an era of rapid-fire technology breakthroughs, there is enormous potential to create
entirely new goods and services—not to mention applying innovation to management
and production practices. Companies will have to make smart decisions about where to

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 9
 compete globally and which market segments to target; adopting international standards
can broaden their appeal. They will have to strive for operational excellence in areas
such as supply-chain management, product platforms, sourcing, procurement, revenue
management, and support costs. Manufacturers can also create new revenue streams by
adding after-sales services, such as delivery and installation, operation, maintenance, or
systems integration. Mergers and acquisitions would allow companies to reach the critical
size necessary to benefit from economies of scale and better deploy their capital and
human resources.

Exhibit E4

Japan has a high non-labor cost base, particularly in the electrical and
optical equipment industry

Revenue breakdown by subsector, 2011 Value add (includes labor cost)

$ billion, 2009 at purchasing power parity
Non-labor cost of intermediate inputs

Electrical and Transport

optical equipment Machinery equipment

590.7 608.9

133.5

363.5 374.0
353.8
324.4
95.2
122.5
161.4 475.4
188.6
70.7 278.7
231.3 227.1
163.0
117.9

Japan United Japan United Japan United

States States States

Cost as 65 38 63 50 75 78
% of revenue

NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; McKinsey Global Institute analysis

The coming decade will bring an ongoing wave of innovation in manufacturing. Software
is increasingly being integrated into traditional manufactured goods. The coming wave of
connected cars, for example, represents a new competitive challenge—and a major market
opportunity—for Japan’s automakers. Japan can also capitalize on growth in robotics and
3D printing for its own production processes and for export.

By 2025, these combined strategies have the potential to boost the sector’s value added
by more than 50 percent above the current trajectory. If a critical mass of Japanese
manufacturers were to adopt breakthrough technologies, they could virtually close the
productivity gap with the United States.

10 McKinsey Global Institute Executive summary

 Retail
Japan’s retail sector benefits from a large and sophisticated consumer base as well
as excellent logistics. High Internet and mobile penetration has underpinned growth in
online shopping. But small specialty shops, many of them family-owned, account for
approximately half of all retail sales—and because these businesses are less productive,
they create a drag on the overall sector. Segments such as traditional convenience
stores, supermarkets, and drugstores also remain highly fragmented; the relative lack of
large chains has prevented investment in automation and technology. Only 40 percent of
Japanese retailers are among the top ten national players, compared with 75 percent in the
United Kingdom and 76 percent in Germany.

Since the 2000 repeal of the Large Scale Retail Store Law, traditional store formats have
been on the decline. With a greater weighting of modern-format stores, the retail sector
increased its labor productivity by 2.2 percent annually between 2000 and 2011. But Japan
has not kept pace with the US sector in terms of operational innovations. Even those formats
with higher consolidation and revenue growth have struggled to reduce costs and improve
operating margins. Legacy IT systems and overinvestment in floor space have also weighed
on profit margins.

On its current trajectory, the sector’s value added would increase by just 1.1 percent
annually through 2025. By then, the Japanese sector’s productivity would stand at only
71 percent of the US level. In addition, if the industry continues to expand total floor space
at its current rate, sales per square meter would decline by about 1 percent annually
through 2025.

But the retail sector can make a quantum leap in performance by deploying new
technologies, responding to changing demographics, and increasing its efficiency.
We estimate that there is potential to boost labor productivity by anywhere from 22 to
39 percent by 2025.

One element in this formula is achieving smarter store footprints. By introducing innovative
customer experiences and multiple channels, retailers can rationalize floor space, saving
costs and boosting revenues. Retailers also need to adopt global best practices in
operations along the entire value chain, some of which employ cutting-edge technologies.
In addition to managing complex shipments from vendors, the Internet of Things can use
sensors and tags in stores to avoid stock-outs and signal when reorders are necessary.
Becoming fluent in big data and advanced analytics can help retailers better understand
and segment their customers and make both front- and back-end operations (such as
sales forecasting and employee scheduling) more efficient. With the return of some limited
inflation, Japanese retailers may finally have an opening to raise prices. Companies can
capture new value added by implementing pricing strategies built on a deeper level of
marketing insights from big data.

The continuing growth of e-commerce is another important source of retail productivity.

Japan has already developed the world’s third-largest e-commerce market, but sales are
growing more slowly than in the United States (and are well below the dramatic rate of
growth in China). E-tailers such as Rakuten and Amazon are making strides, but there is still
ample room for adoption by brick-and-mortar incumbents—and for disruptive new players
to emerge in this space.

Accelerating consolidation and the transition to more modern-format stores (and perhaps
“leapfrogging” directly to more innovative digital-hybrid formats) will be crucial to improving
the sector’s productivity.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 11
 Financial services
Japan’s financial sector was the third-largest in the world in 2012, with $11 trillion in assets.
But its low-risk, low-margin operating model has produced limited revenue growth. More
than half of personal financial assets are held in cash or cash deposits. Between 2005 and
2011, annual labor productivity growth was 4.5 percent in the US sector and 7.6 percent in
the German sector, while Japan actually experienced a decrease of 2 percent.

During Japan’s long period of muted demand, banks tended to funnel excess cash into
low-risk, low-return government debt. The government’s most recent and most aggressive
program of quantitative easing is meant to reverse this trend and spark new lending and
investment. Jumpstarting the flow of financing and investment is an Abenomics priority, and
the conditions may be coming together for the financial services sector to achieve higher
margins, increase its value added, and create momentum in the broader economy.

Looking specifically at the banking industry, Japanese institutions serve their customers
with fewer branches and fewer employees than US banks. Despite this advantage, their
labor productivity was 22 percent lower than that of US banks in 2011. The major factors
driving this gap include low returns on assets, risk aversion, simpler product offerings, and
intense competition that has driven down pricing. Japan’s persistently low interest rate
environment has limited spreads and depressed returns on investments—and because
loan demand has stagnated, banks have been unable to compensate for declining interest
margins by boosting volumes. A failure to build deeper relationships harms banks’ ability to
increase advisory revenues.

Japan’s insurance sector trailed the US sector in labor productivity by 29 percent in 2011.
There is high market penetration for life insurance products, but policies produce lower
revenues. Product offerings and pricing strategies tend to be relatively basic across all types
of coverage, and there has been little growth in demand for property and casualty coverage.
Insurers, like banks, have struggled with low returns on their investments.

Whatever Japan’s macroeconomic conditions, individual firms still have scope to improve
productivity and growth. Players can rethink their investment strategies to shift toward
higher-yield assets, finding a better balance between risk and reward. They also need to find
new ways to maximize value from customers. Many firms already segment their customers
by wealth and life stage to develop tailored offerings, but new analytics tools can take
this to an entirely new level of detail. There are opportunities to launch a wider variety of
financial products, using big data tools to monitor risk and determine pricing. In particular,
financial firms can create products and advisory services to meet the needs of seniors and
affluent individuals.

Japanese banks are already the world’s largest international lenders, but further emphasis
on foreign lending and foreign expansion (especially into the most promising markets
in emerging Asia) could be an avenue for growth. Insurers have similarly increased their
overseas operations in response to declining revenues at home.

Banks and insurers alike can undertake an end-to-end review of processes and focus
attention on areas that have received little IT investment and digital process transformation.
Financial institutions will have to continue their efforts to deliver a truly seamless online and
offline experience while slimming down or reimagining their branch formats, with more
advisory and sales centers.

By 2025, these initiatives could increase the sector’s value added by up to 44 percent
while reducing the labor required by 9 percent. This would boost labor productivity up to
24 percent over the current trajectory—and provide a lift to the entire economy by putting
cash reserves to work in productive investment.

12 McKinsey Global Institute Executive summary

 Health care
Providing universal access to quality health care is a point of national pride. Japan manages
to achieve good outcomes while holding health-care spending to 8.1 percent of GDP (well
below Germany, at 11.3 percent, or the United States, at 17.7 percent). But there are serious
questions about whether the current trajectory is sustainable. Government estimates
indicate that health-care expenditures could reach some $515 billion by 2025, for average
annual growth of 3.7 percent. If health care swallows an ever-larger share of national
spending, it could crowd out consumption and investment in other parts of the economy
and force painful tax and social security reforms.

The aging population is frequently discussed as the driver of health-care costs, but that is
only part of the story. Utilization rates remain very high by international standards; Japanese
patients consult physicians an average of almost 13 times per year, more than twice the
OECD average. The average hospital stay is three times longer in Japan than in other
advanced economies—partly due to reimbursement formulas, but also because hospitals
often continue to care for patients who might be better served in rehabilitation centers or
nursing homes, which are in short supply. The ongoing process of medical innovation also
contributes to rising expenditures.

Measures such as increasing taxes to shore up the system or adjusting reimbursement rates
are only partial solutions, and repeated rounds will not be feasible. Japan needs to bend the
cost curve in a more fundamental way. The good news is that other nations facing similar
pressures have managed to implement successful reforms, and Japan can draw on their
experiences. One of the most important lessons they offer is that reimbursement changes
drive provider changes.

The current system rewards providers for generating a high volume of procedures. Japan
took a positive step by introducing a diagnosis procedure combination (DPC) payment
system, much like the billing system used by Medicare in the United States (although
Japan’s version includes a length-of-stay component). It shows promise for controlling costs
and standardizing data, but a limited number of institutions participate. Policy makers can
reopen this issue and consider deeper reforms such as mandating DPC adoption across
the entire system, implementing capitation (which pays providers a set amount for each
enrollee, whether or not the individual seeks treatment), or directly linking reimbursement to
performance and outcomes.

Because Japan has some 3,000 private insurers, a crucial part of the health-care landscape
is fragmented. Insurers do not perform a gatekeeping or cost-control function, as they do
in other countries—but Japan could transform them from payors to real players. Instead of
imposing uniform reimbursement rates, Japan could give them greater flexibility to negotiate
with providers and design their own formulas. Germany’s experience indicates that once
insurers are given responsibility for real management, a wave of consolidation could follow.

Reducing the number of visits per capita requires significant changes on both the demand
and supply sides. Requiring continuing medical education and recertification could promote
a greater culture of trust among patients. The clinical data aggregated by electronic medical
records can be used to create a ratings-based system that allows patients to compare
providers (much like the UK National Health Service’s Choices website). On the other side,
steeper co-payments could discourage unnecessary additional visits or repetitive testing.

Japan’s Ministry of Health, Labour and Welfare has made progress in expanding the
use of generic drugs; meeting its goal of achieving a 60 percent penetration rate by 2017
would save some $8 billion annually. But this would still leave Japan below international
benchmarks. Japan can set a more ambitious target and take steps to bring the price of
generics down to international levels.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 13
 Japan has a fragmented provider landscape, with many small generalist hospitals.
Surprisingly few institutions specialize in specific therapeutic areas, with repercussions
for the quality of care. Financial incentives could encourage some hospitals—especially
subscale institutions—to merge or specialize. Mergers could lead to major savings in IT
systems, purchasing, and the allocation of resources. Greater specialization would prevent
high-risk procedures from being performed at low-volume centers. It would also improve
housing and treatment options for elderly patients, particularly those with dementia. There
are major efficiency gains still to be captured from electronic medical records and big
data tools. Most hospitals do have solid technology systems in place, but the key will be
connecting these systems and ensuring interoperability across providers.

This is an age of medical breakthroughs. Already, 3D printers are being used to produce
artificial organs and implants, robots are being deployed in medical settings, and
nanodevices are making more procedures minimally invasive. In addition to adopting
advances in patient care, Japan has the scientific and manufacturing capabilities to pioneer
many of these technologies.

Today Japan’s health-care expenditures are growing faster than GDP and are on track to
swell to 10.7 percent of GDP by 2025. But we estimate that the reforms described above
can slow the annual rate of growth from the anticipated 3.7 percent to just 1.5 percent. By
2025, expenditures could come in some 22 percent below projections, holding the line
at 8.3 percent of GDP, only slightly above the level in 2013 (Exhibit E5). This would free up
resources that could be used to develop a more comprehensive long-term care sector.
Furthermore, if Japan’s productivity initiatives successfully boost GDP growth to 3 percent,
health-care spending would grow more slowly than GDP, putting the system on a more
sustainable path.

Exhibit E5

Reforms could help Japan cut the growth rate of health-care expenditures in half,
potentially even bringing it below the rate of GDP growth

Compound annual growth rate (%) Health-care costs Growth rate (%)
Index: 0 = 2013
GDP

Pessimistic case Optimistic case

Current trajectory Slower growth of Slower growth of

health-care costs health-care costs plus
improved GDP growth
4
3.7

3 3.0

2
1.5
1.5
1.3
1 1.3

0
2013 2025 2013 2025 2013 2025

Health care 8.1 10.7 8.1 8.3 8.1 6.8

% of GDP

SOURCE: Ministry of Economy, Trade and Industry; Ministry of Health, Labour and Welfare; McKinsey Global Institute analysis

14 McKinsey Global Institute Executive summary

 Japan has a road map, and now it needs the political will to start the journey. Reform will be
a process of “continuous improvement” that will require periodic readjustment. It will take a
steady commitment to create a more sustainable system—one based on a vision that looks
decades ahead and is insulated from short-term political pressures.

The right policies and enablers can spur growth

Deregulating and reforming individual sectors can inject new dynamism into the economy.
But Japan also has to create a broader environment that is conducive to growth. While
Abenomics speaks to a number of these priorities, the agenda for change needs to be
even broader.

Tapping new talent sources

ƒƒ Encourage more women to participate in the workforce and create pathways to
success. Many Japanese feel that women should focus on household duties, and this
cultural attitude is exacerbated by a sharp gender gap in pay and a glass ceiling. But
Japan cannot afford to lose so much potential talent. The participation rate drops sharply
when women reach prime childbearing age; they step off the career ladder when they
might otherwise begin moving up into managerial roles (Exhibit E6). The government
has recognized that expanding child care is a critical starting point. Additionally, Japan
can follow through with removing tax policies that encourage married women to opt out
of the workforce or to choose low-paying part-time work. Companies and institutions
have a critical role to play in helping women fulfill their potential as future leaders of
Japan. They need to make gender diversity a top strategic priority, with executive teams
demonstrating visible support for this change.

Exhibit E6

Japanese women step off the career ladder during their prime child-bearing years
ESTIMATES
and occupy few senior leadership roles

University Entry-level Mid- to senior Executive

graduates professionals management committee CEO Board

China 50 55 21 9 1 8

India 42 29 9 3 <1 5

Japan 49 45 11 1 <1 2

South Korea 48 40 6 2 <1 1

Singapore 49 50 20 15 8 7

Malaysia 57 53 11 n/a 5 6

Indonesia 57 47 20 n/a 5 6

Australia 57 45 n/a 12 3 13

Taiwan 49 44 18 9 1 8

Hong Kong 54 52 23 11 2 9

SOURCE: McKinsey proprietary database, 2011; government publications

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 15
 ƒƒ Retain experienced workers as they age. Japan is gradually raising the mandatory
retirement age that companies can impose from 60 to 65 by 2025, requiring employers
to offer continuing employment options to workers who hit retirement age and offering
subsidies to employers that hire and retain older workers. In fact, Japan already has
one of the highest labor force participation rates in the world for older workers. But
since a quarter of the population is expected to be over age 75 by 2055, further policy
adjustments may be needed—and, as mentioned above, individual companies will have
to drive this effort forward by implementing more flexible working models and ergonomic
adjustments that can entice seniors to stay on the job.

ƒƒ Address supply constraints by rethinking immigration policies. Japan will need

to identify critical roles that are being affected by an undersupply of labor and consider
whether foreign workers could provide at least a partial solution. Increasing their
presence would not only fill gaps in specific roles; it could also bring an infusion of
diverse ideas, new energy, and best practices developed in other countries.

Creating a more dynamic labor force with the skills demanded in a fast-
changing environment
ƒƒ Make the workforce more equitable. The greater flexibility afforded by the use of
temporary workers has harmed productivity while creating a two-tiered workforce, as
discussed above. Faster economic growth will not be enough in and of itself to create a
more equitable system. Policy makers may need to take formal steps to provide better
conditions and benefits for temporary workers—both to ensure they are protected and to
increase their motivation to become more productive.

ƒƒ Create ambitious retraining programs to meet new business requirements. Since

multiple industries face wide-ranging technology transformations, the public and private
sectors will have to ensure that well-chosen, well-designed training programs are
available on a large scale. Companies can also collaborate at the industry level to offer
apprenticeships and partner with education providers to design vocational training and
certificate programs.

Reforming the education system to build talent and capabilities over the
longer term
ƒƒ Instill critical thinking skills. The next generation of workers will need critical thinking
skills and an open attitude toward experimentation to enhance Japan’s productivity
and competitiveness. The current educational experience leaves graduates at a
disadvantage in this area compared with their international peers.

ƒƒ Promote a global mindset. Japan could benefit from achieving greater foreign
language fluency and expanding international student exchanges, which lay the
groundwork for future research collaborations and business deals.

ƒƒ Create a true education-to-employment pipeline. In most countries, the education-

to-employment system fails many young people and employers alike. But employers
and educators can bridge this gap by moving more fluidly into each other’s worlds.
Companies can help to design curricula and lend their employees as “faculty,” while
education providers can integrate internships into their programs and secure hiring
guarantees for graduates. Sustaining long-term growth requires careful, ongoing
evaluation of evolving shifts in demand for specific skills.

16 McKinsey Global Institute Executive summary

 Fostering a startup culture
ƒƒ Increase access to funding. Despite favorable regulatory changes, there is little
angel investing in Japan. Information platforms can help to build a community of angel
investors, and large corporations could play a role where individual investors currently
do not. Japan’s venture capital industry is also underdeveloped. Israel offers a useful
template; it rapidly expanded its fledgling VC industry in the 1990s by offering tax
incentives to foreign investors and matching private capital. The Innovation Network
Corporation of Japan is a positive step in this direction, but unlocking private investment
will require sustained effort.

ƒƒ Promote a supportive legal and regulatory framework for startups. Making the
process of setting up a new business more user-friendly could motivate more aspiring
entrepreneurs to take a leap with their ideas. Japan can also revisit the framework
around intellectual property protection and its incentive structure for commercializing
university research.

ƒƒ Create an ecosystem that allows entrepreneurs and innovation to flourish. Japan’s

current network of business incubators has a limited reach, and the public sector may
need to mobilize resources. New York, for example, has undertaken an ambitious
public-private partnership to build Cornell Tech, which will offer an MBA program with a
digital, entrepreneurial focus. University-affiliated business incubators (such as Waseda
University’s) can expose Japanese students to the process and excitement of turning
ideas into profitable realities.

Implementing market-oriented reforms to unleash competition

Reducing government intervention in specific sectors could open the door to a wave of
consolidation that would allow companies to realize economies of scale. A number of
market distortions, such as barriers to entry for startups, protectionist measures that limit
imports, zoning restrictions, and subsidies that keep unproductive firms afloat, could
be removed.

ƒƒ Promote competition by allowing companies to enter and exit the market. The
birth of new firms and the closure of failing companies are akin to a healthy circulatory
system—and the continued support of highly indebted firms as well as uncompetitive
divisions of large conglomerates represents a disorder that hinders that dynamic.
Resolving the continuing overhang would improve the allocation of capital across
the economy.

ƒƒ Deepen global trade ties. New trade agreements would open the door for Japanese
companies to penetrate new markets and grow revenues. Japan is engaged in a number
of bilateral and multilateral negotiations, the largest of which is the proposed Trans-
Pacific Partnership. Bringing these agreements to a successful conclusion could provide
Japan with new sources of growth.

ƒƒ Move toward open standards. Shifting away from proprietary technologies to globally
accepted standards and platforms that allow for interoperability (and participating in the
creation of these standards) will broaden the market for Japanese products.

ƒƒ Promote a culture of performance at the macro level, including increased

shareholder pressure. Proposed new regulatory standards call for at least two
outside directors on each corporate board, but even stronger measures may be
needed to ensure accountability and improved corporate governance. Shareholders
in Japan have traditionally exercised relatively little pressure for performance, but a
more activist approach would push management to increase revenues and achieve
operational efficiencies.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 17
 Improving productivity in infrastructure
Modern infrastructure comes at a high public cost if projects encounter long delays or
if they are underutilized after their completion. While the value of infrastructure stock in
most economies averages around 70 percent of GDP, Japan has the world’s highest
infrastructure stock, at 179 percent of GDP in 2012.3 Given the size of its investment, Japan
needs to maximize every dollar.

ƒƒ Make project selection and project management as rigorous as possible. It is

critical to direct investment to where it can underpin economic growth or societal goals
rather than to “showcase” projects. Proposals should be subjected to a sophisticated
cost-benefit analysis and prioritized using a transparent, fact-based decision-making
process. An important source of savings would come from speeding up the approval
and land acquisition processes and using the latest technology to plan and manage
projects. Advanced 5D building information modeling systems, for example, can ensure
design accuracy and feasibility to prevent substantial changes and delays later in
the process.

ƒƒ Use maintenance, optimization, and demand management to extend the life

of existing infrastructure assets. In many cases, it is more cost-effective to invest
in extending the life span and capacity of existing assets than to build new projects.
Refurbishment and optimization strategies can save approximately 15 percent on
infrastructure investment.

ƒƒ Export world-class infrastructure. Japan can export its engineering expertise to the
rest of the world. Recent MGI research estimated that Southeast Asia alone has some
$3.3 trillion in infrastructure needs through 2030. There are many opportunities to serve
as either financier or provider of infrastructure services in developing economies around
the world, but Japan will have to compete for them.

•••

The next decade offers a window of opportunity for Japan to shift its trajectory, in part by
capitalizing on immense flows of global trade, the rise of billions of new urban consumers
in the emerging world, and technology breakthroughs. But the new global economy is not
simply realigning; it is also accelerating. The time is right for Japan to undertake bolder
moves, bigger investments, and deeper reforms. Decades ago, Japanese manufacturers
famously introduced the world to “lean” practices. Today businesses throughout
the Japanese economy can apply these concepts to new industries and use digital
technologies to take them to the next level. Focusing on the priorities discussed here can
help to address persistent legacy issues and put Japan on a faster track toward recovery
and renewal.

3
Infrastructure productivity: How to save $1 trillion a year, McKinsey Global Institute, January 2013.

18 McKinsey Global Institute Executive summary

© Getty Images
© Alamy
1. THE ORIGINS OF JAPAN’S
PRODUCTIVITY IMPERATIVE
For much of the postwar era, Japan has been synonymous with rapid improvements in
efficiency and quality. It remains widely admired for innovation in both technology and
processes. From the 1950s through the 1980s, it outpaced the United States and Western
Europe in productivity gains—and this advantage led to robust economic growth, producing
one of the world’s highest standards of living.

Over two painful “lost decades,” however, Japan has lost much of its competitive edge.
Growth in both labor and capital productivity has steadily eroded in almost every sector
of the economy. This trend holds true even in Japan’s signature advanced manufacturing
industries, which originally introduced the world to the concept of “lean.” Today there
is a substantial and widening productivity gap between Japan and other leading
advanced economies.

The task of continuously capturing new productivity improvements grows more difficult
over time, but it is achievable, particularly if Japan takes steps to create new competitive
dynamics across entire industries. The good news is that our research has identified areas
within multiple industries that are ripe for efficiency improvements and revenue growth. This
effort goes beyond cost cutting; it is about spurring growth and increasing value added by
launching business lines, pushing the boundaries of innovation, and entering new markets.
(See Box 1, “Why productivity matters.”)

With its working-age population shrinking, Japan will need to focus on productivity as never
before. Overall productivity growth has been stalled below 2 percent for much of the past
two decades, which puts the Japanese economy on pace to grow by only 1.3 percent
annually through 2025.4 This sluggish pace would do little to boost household purchasing
power, and it would intensify the fiscal pressures of providing social security and health-care
benefits to an aging population. But if Japan can successfully double its rate of productivity
growth, returning to the levels it once posted in the 1970s and 1980s, it could boost
annual GDP growth to approximately 3 percent. This would indicate solid momentum and
contribute to an improved fiscal outlook.

While policy changes can create the right environment for growth, the vast majority of this
potential is in the hands of the private sector. There is a great deal that individual companies
can do immediately and on their own without waiting for government action. Multiple
fast-moving forces are realigning the global economy, and Japan can capitalize on these
trends to seek out new growth opportunities. To break out of its slump, the economy needs
broader adoption of global best practices, a wave of investment in new technologies, and a
greater willingness to try bold new business models.

4
Japan’s productivity growth was 1.5 percent in 2013 (the latest year for which OECD data is available).
 Box 1. Why productivity matters
Productivity growth is the result of workers making more—and better—goods
per hour. This may be a simple concept, but at the macroeconomic level, it
becomes a powerful force. Productivity gains are a marker of progress and
higher living standards. Conversely, a loss of momentum in this area can
cause slow-motion damage to an economy over time. As Nobel laureate Paul
Krugman once put it, “Productivity isn’t everything, but in the long run it is
almost everything.”5

At the global level, rising productivity and a steadily growing labor force, the
twin drivers of economic growth, combined to produce 50 years of rapid
economic expansion. Today, however, the prospects for growth are becoming
murkier in the face of demographic headwinds—not only in Japan but in
advanced economies around the world.

MGI has studied the patterns of growth in dozens of industries and across
more than 20 countries. A recent report building on this body of work attempts
to analyze what the decades ahead might bring.6 Given the pressure of aging
trends on the pool of available labor, it finds that the world’s rate of GDP
growth is set to slow by 40 percent from its rate over the past 50 years. As a
result, income growth could decline by 19 percent in developed economies
and by 14 percent in emerging economies. To head off this outcome, the world
needs to accelerate the pace of productivity growth by 80 percent, reaching a
difficult-to-achieve average of 3.3 percent a year.

These global findings clearly resonate for Japan, the first nation confronting the
full magnitude of the world’s demographic shift. As of 2013, a quarter of the
population was age 65 or older. That share is projected to rise to 36 percent by
2040 and to 40 percent by 2060.7 Its shrinking workforce presents Japan with
an urgent imperative to boost productivity—and other advanced economies
will be watching intently to see if Japan can pioneer solutions.

MGI’s work suggests that, at a global level, it is possible to boost productivity

past the point needed to counteract demographic trends. Most of this
potential comes from adopting existing best practices more widely. The
rest would stem from fully deploying the current pipeline of technological,
operational, and business innovations, which could push the boundaries
of what is achievable through today’s best practices. In Japan’s case, it is
important to note that more than half of the productivity gains that MGI’s
analysis finds feasible in advanced economies could come from closing
the gap between less efficient companies and plants and those with
higher productivity.

Productivity allows companies to offer better products and services at more

competitive prices, which leads to increased consumption and higher-value-
adding employment. This virtuous cycle could pave the way to sustainable
growth while addressing the demographic challenge and maintaining the
universal health-care and pension systems that underpin Japanese society.

5
Paul Krugman, The age of diminished expectations, MIT Press, 1994.
6
For a fuller discussion, see Global growth: Can productivity save the day in an aging world?
McKinsey Global Institute, January 2015.
7
Population projections for Japan: 2011 to 2060, National Institute of Population and Social
Security Research, January 2012.

22 McKinsey Global Institute 1. The origins of Japan’s productivity imperative

 Once a two-speed economy, Japan now faces deteriorating productivity
growth across all sectors
When MGI studied Japan in 2000, it found that a “two-speed” economy had developed.8
Export-oriented manufacturing industries (including steel, automotive, consumer
electronics, and machine tools) set the global standard, but these stood in sharp contrast
to low-performing, domestically oriented manufacturing and service sectors that were
protected from both international and local competition by tariffs and regulation. Our
research recommended three types of reforms to unleash growth: ending subsidies for
unproductive firms and allowing them to exit the market, removing laws and regulations
that prevent more productive companies from entering markets or introducing innovative
products, and creating incentives for competition and innovation.

Given its rapidly aging population and the persistently

low labor force participation of women, Japan will
have to focus on productivity as the primary catalyst
for growth.

Japan has taken some steps toward reform, including a bid to improve corporate
governance by requiring the addition of independent directors and the establishment of
special economic zones to showcase deregulation. Deeper reforms of key industries such
as the power sector, health care, and agriculture are part of the “third arrow” of Abenomics,
although many ideas are still in the proposal or legislative stages. In the meantime, structural
issues continue to constrain sectors across the economy. Barriers to entering and exiting
various markets still exist; for example, zoning regulations limit the presence of big-box
retailers, while tax incentives keep smaller, less productive shops afloat. Tariffs and other
protectionist policies shield many domestic industries from global competition. Furthermore,
government subsidies support unprofitable health-care providers and payors, channeling
public resources into maintaining an inefficient system. Without bold new incentives for
innovation and competition in place, the current era of digital and scientific breakthroughs
has not produced a surge in entrepreneurship in Japan on a par with what has been
unleashed in many other countries.

Today, the two-speed characterization of Japan’s economy no longer holds true. Even its
advanced industries have lost their competitive edge; labor productivity in the transport
equipment sector, for instance, is almost half the level in Germany. Today virtually all
sectors of Japan’s economy lag behind the United States in terms of both labor and capital
productivity, even though the United States (like other advanced economies) has itself
posted only weak productivity gains over the past decade (Exhibits 1 and 2). If current
trends are not reversed, Japan’s overall labor productivity gap with the United States is on
track to grow from 29 percent in 2011 to 37 percent in 2025.

These gaps represent the fundamental structural challenge facing Japan. GDP growth can
be generated by an expansion of the labor force and by productivity increases—and given
its rapidly aging population and persistently low labor force participation rate for women,
Japan will have to focus on productivity as the primary catalyst for growth. Its ability to
increase incomes and maintain its standard of living into the future hangs in the balance.

8
Why the Japanese economy is not growing: Micro barriers to productivity growth, McKinsey Global Institute,
July 2000.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 23
Exhibit 1

Japan’s labor productivity gap with the United States has been widening across most industries

Labor productivity gap by sector (%, based on $ 2009 at purchasing power parity) 2000 2005 2011
Index: 0 = United States

United States Japan

more productive more productive

-70 -65 -60 -55 -50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25
Sectors
analyzed
in detail
Post and telecommunication

Health and social work

Wholesale trade

Advanced manufacturing
and consumer electronics

Manufacturing (other)

Construction

Other community, social,

and personal services

Financial intermediation

Retail trade

Electricity, gas, and

water supply

Hotels and restaurants

Transport

Real estate

Business services

Agriculture

NOTE: Education, public administration, and domestic employees not included.

SOURCE: World Input-Output Database; World Bank; McKinsey Global Institute analysis

24 McKinsey Global Institute 1. The origins of Japan’s productivity imperative

Exhibit 2

Japanese sectors are also falling behind US sectors in capital productivity

Capital productivity gap by sector (%) 2000 2005 2011

Index: 0 = United States

United States Japan

more productive more productive

-90 -85 -80 -75 -70 -65 -60 -55 -50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10
Sectors
analyzed
in detail
Real estate

Electricity, gas, and

water supply

Manufacturing (other)

Post and telecommunication

Hotels and restaurants

Agriculture

Financial intermediation

Construction

Transport

Retail trade

Health and social work

Wholesale trade

Advanced manufacturing
and consumer electronics

Other community, social,

and personal services

Business services

NOTE: Education, public administration, and domestic employees not included.

SOURCE: World Input-Output Database; World Bank; McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 25
 The “lost decades” have eroded productivity

0.8%
Following the collapse of its stock market and real estate bubble at the beginning of
the 1990s, Japan went on to post an anemic average annual GDP growth rate of only
0.8 percent from 1992 to 2012. This prolonged slowdown was accompanied by a dramatic
Japan’s average
drop-off in productivity growth.
annual GDP
growth over the Japan once made rapid leaps forward in productivity, averaging 3.5 to 4 percent annual
past 20 years increases in the 1970s and 1980s. But its productivity growth slowed to less than 2 percent
throughout the 1990s and 2000s, a pace that lagged behind even the modest gains posted
by the United States. After the mid-1990s, productivity growth particularly stagnated in
distribution services (retail, wholesale, and transportation) and manufacturing (excluding
electrical machinery). One contributor to this trend was lower IT investment and a failure
to capture the full productivity and innovation potential of new digital technologies.9 While
industry growth and technology innovation have been the primary drivers of US progress,
Japan’s recent productivity gains have been based on holding output steady with a
shrinking workforce rather than growing markets and revenues. With weak demand for both
domestic consumption and exports, Japan has been unable to sustain clear and consistent
growth in value added; the economy continues to operate below its potential.

Structural issues within the Japanese economy, including the factors discussed below, have
increased the challenges of reigniting productivity growth.

Inadequate competitive pressures

Industries with a high level of competition tend to be more productive overall, as the most
nimble and innovative companies win out over less efficient firms. The market pressure
applied by allowing firms to fail offers a bracing effect on overall productivity. But in Japan,
this process of winnowing out does not play out as expected. Since Japan’s asset price
bubble burst in the early 1990s, highly indebted firms have been kept alive by banks that
may have a stake in them and wish to minimize bankruptcies.10 This stabilized employment
during the initial crisis, but the continued operation of unproductive firms today diverts
valuable resources that could be put to far better use elsewhere. The extension of credit
guarantees, particularly for small and medium-sized enterprises in service sectors, limits
the pressure for bank-led workouts and restructuring. With weak balance sheets, these
companies are unable to invest in productivity improvements.

The same tendency to preserve stability even at the expense of competitiveness is also
apparent in large conglomerates, which have typically shied away from radical reallocation
of resources or from restructuring underperforming business units. This phenomenon has
undermined capital productivity.

Given Japan’s relatively limited entrepreneurial activity, it is rare for startups to disrupt
established industries. In addition, regulatory barriers make it difficult for new competitors to
challenge incumbents, particularly in industries such as health care, education, transport,
and utilities.11 The presence of multinationals could provide additional competitive intensity;
in general, these companies tend to be more productive than purely domestic firms (due to

9
Kyoji Fukao and Tsutomu Miyagawa, Productivity in Japan, the US, and the major EU economies: Is Japan
falling behind? Research Institute of Economy, Trade and Industry, July 2007.
10
Richard C. Koo, The holy grail of macroeconomics: Lessons from Japan’s Great Recession, Wiley, 2009. See
also Ricardo J. Caballero, Takeo Hoshi, and Anil K. Kashyap, “Zombie lending and depressed restructuring in
Japan,” American Economic Review, volume 98, number 5, December 2008. For a more recent discussion,
see Noah Smith, “Japan needs more corporate funerals,” Bloomberg View, February 5, 2014, and Atsushi
Kodera, “Zombie firms pressured to act,” Japan Times, June 6, 2014.
11
Japan sustainability report, Group of Twenty, IMF, November 2011; Japan: 2014 Article IV consultation,
concluding statement of the IMF Mission, IMF, May 2014.

26 McKinsey Global Institute 1. The origins of Japan’s productivity imperative

 their ability to shift production functions to lower-cost countries).12 But Japan attracts very
little investment from multinationals. FDI inflows into Japan’s manufacturing sector in 2011
amounted to just 0.06 percent of GDP, compared with 0.60 percent in the United States and
0.24 percent in Germany.13

There is no one reason for Japan’s relative dearth of foreign investment, but rather a
host of smaller factors such as the language barrier, a (frequently mistaken) belief that
Japanese consumers have fundamentally different preferences than consumers in other
developed countries, the proximity of many countries with lower labor costs, and a history of
protectionist policies. Doubling inward foreign investment is part of the Abenomics agenda,
and the public sector will have to make a concerted effort to win over global investors—not
only to capture the jobs and revenue they represent but for the best practices and new
technologies they bring and the competitive dynamics they can unleash.

Relative inflexibility in the labor market

1/3+
Historically, Japanese companies offered a lifetime employment system that emphasized
seniority. This evolved because of cultural and social norms, and it provided a strong
foundation on which to drive postwar growth and nurture a sense of belonging and
Share of non-
cohesiveness among employees. Today the legal strictures around lifetime employment
regular employees
have mostly been lifted, making the labor market more flexible in theory. But in practice,
in Japan’s
downsizing is viewed in a strongly negative light, making it difficult for firms to pare back
workforce where necessary. Workers, too, tend to be reluctant to advance their careers by moving
from company to company.

Inflexibility hurts productivity in a few ways. First, it can result in overstaffed and bloated
workforces, especially in headquarters and office environments. Second, since workers are
not likely to change employers, an important informal channel of sharing best practices is
lost. Third, employees have little incentive to continue developing new skills throughout their
career since they are unlikely find themselves competing for a new job.

Japan has partially addressed this issue by allowing firms to shift away from the lifetime
employment model and begin hiring non-regular (temporary) workers, or haken. Between
2000 and 2013, 6.5 million non-regular workers were added to the workforce, while
4.1 million “regular” employees left the workforce.14 By 2013, more than one-third of workers
were covered by these arrangements (Exhibit 3). Unlike full-time regular employees, these
temporary workers have limited legal protections and earn no pensions. This shift has
afforded firms a greater degree of agility, but paradoxically, it takes a toll on productivity.
Not only do temporary employees have fewer incentives to excel, but employers rarely
invest in their development.15 At a broader societal level, this situation has created a two-
tiered workforce and contributed to inequality. This issue urgently needs to be addressed,
since haken could account for more than 50 percent of the workforce by 2030 if current
trends continue.

12
Eiichi Tomiura, “Foreign outsourcing, exporting, and FDI: A productivity comparison at the firm level,” Journal
of International Economics, volume 72, number 1, May 2007. Multinationals are defined here as companies
that have at least 20 percent ownership stake in a foreign enterprise; domestic companies used for
comparison do not take part in exporting.
13
OECD. StatExtracts, 2014.
14
Statistics Bureau, Ministry of Internal Affairs and Communications, 2014.
15
Multiple international studies have shown that a dual labor market can have a negative effect on productivity
for a variety of reasons, including lower motivation and reduced training for temporary workers. See, for
example, Chie Aoyagi and Giovanni Ganelli, The path to higher growth: Does revamping Japan’s dual labor
market matter? IMF working paper number 13/202, October 2013; Francesca Lotti and Eliana Viviano,
Temporary workers, uncertainty, and productivity, Bank of Italy, October 2012; Juan J. Dolado and Rodolfo
Stucchi, Do temporary contracts affect TFP? Evidence from Spanish manufacturing firms, Institute for the
Study of Labor (IZA) discussion paper number 3832, November 2008. One study focused on Japan suggests
that part-time workers are about 75 percent less productive and receive 70 percent lower wages than full-time
workers; see Kyoji Fukao et al., Deferred compensation: Evidence from employer-employee matched data for
Japan, Hitotsubashi University Research Unit for Statistical Analysis in Social Sciences, October 2006.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 27
 Exhibit 3

Non-regular employment has increased substantially over the past two decades

Change,
1990–2013
% Percentage
points
40 36.7
Non-regular employees +16.5
35 as share of workforce
30
25
20.2
20
15
10
4.0
5 2.1 Unemployment rate +2.0
0
1990 95 2000 05 10 2013

NOTE: Numbers may not sum due to rounding.

SOURCE: Labour Force Survey, Statistics Bureau of Japan; National Livelihood Survey, Ministry of Health, Labour and
Welfare; McKinsey Global Institute analysis

A continuation of current trends would have profound economic and

societal consequences

234%
Slower GDP growth has already had damaging, if subtle, effects in Japan. Although
unemployment has remained low throughout the two lost decades, deflation has eaten
away at income growth. Japan ranks third in the world in terms of GDP, but was only 16th
Japan’s public debt
for GDP per capita in 2013.16 As a result of falling real wages, consumer spending has been
as a share of GDP
virtually stagnant since 1997.
in 2014
While Japan has maintained global market share in automotive and other select industries,
many of its companies are being outperformed by Korean, Chinese, and US competitors.
In 2010, the mean return on invested capital for large Japanese companies17 was 23
percentage points lower than that of non-financial institutions in the US S&P 500. The
struggle for market share and profitability is particularly apparent in categories that were
once Japanese flagships, such as TVs and mobile phones.

Perhaps most worrisome is the unsustainable nature of Japan’s current fiscal trajectory.
Public debt was 234 percent of GDP in 2014, giving Japan the dubious honor of topping
Greece in this category.18 However, more than 90 percent of this public debt was held
by domestic investors (mostly financial institutions) as of 2012; this is in contrast to other
advanced economies, whose debt instruments are mostly held externally. This high level of
domestic purchasing of government bonds has kept borrowing costs low and avoided the
volatility that can accompany foreign capital flows (although it has also limited returns for
financial firms). Yet Japan ranks as the world’s most indebted country.

16
2013 ranking based on 2005 US dollars at 2005 purchasing power parity; figures from OECD
Economic Outlook.
17
In the first and second sections of the Tokyo Stock Exchange, excluding financial institutions.
18
For further discussion, see Debt and (not much) deleveraging, McKinsey Global Institute, February 2015.

28 McKinsey Global Institute 1. The origins of Japan’s productivity imperative

 Fiscal pressures are being exacerbated by Japan’s demographic shift, as deficits continue
to build within the pension and health systems. According to the World Bank, Japan passed
the tipping point at which its population began to decline in 2011. The implications of an
aging society are beginning to make themselves felt both economically and socially. The
number of Japanese citizens over age 65 who live alone has increased by 80 percent over
the past ten years, for example.19 This trend has created a sense of isolation and anxiety as
well as speeding the depopulation of rural areas.

The past two decades have also been marked by political instability. Japan saw 16 prime
ministers come and go between 1989 and the end of 2012. Today, however, the recent
reelection of Shinzo Abe has provided a greater degree of certainty, ensuring a measure
of continuity for at least the next four years. This should allow time to implement a more
systematic growth agenda without abruptly changing course; it should also improve Japan’s
ability to mount a coherent and consistent response to rising geopolitical challenges.

Large Japanese companies are generating

sharply lower returns on invested capital than their
US counterparts.

The Japanese economy can draw on significant strengths to reverse

this situation
Many global commentators have seized on these sobering trends and written off Japan’s
prospects for growth and renewal. But this narrative of doom and gloom tends to obscure
the nation’s remarkable strengths, including technological know-how, a formidable
manufacturing base, a highly educated labor force, world-class infrastructure, and a large
and affluent consumer market.

Despite two decades of sluggish growth, Japan is still the third-largest economy in the
world, and its citizens enjoy a high standard of living. In 2012, real GDP reached $5.6 trillion,
behind only the United States and China.20 Even under an expectation of limited growth (at
just above 1 percent annually), Japan would likely retain this ranking in 2025.

Japan achieved this status largely on the back of its highly efficient manufacturing and
exporting capabilities, which it built through heavy capital investment and an emphasis
on technology and process innovation. In auto manufacturing, for example, Japanese
companies (led by Toyota) imported US and European mass-production approaches,
procedures, and equipment, and then added their own adaptations (such as the concept
of continual refinements and a greater integration of suppliers into production processes)
to reap even greater benefits from them.21 Thanks to its sophisticated industrial base,
Japan exported more $700 billion worth of goods in 2013, with a heavy weighting toward
knowledge-intensive products such as vehicles, industrial equipment, and electronics.
Although it has begun to run a trade deficit in recent years, Japan ranks as the world’s
fourth-leading exporter.22 Its modern transportation and logistics infrastructure is
considered among the best in the world.23

19
National livelihood survey 2012, Ministry of Health, Labour and Welfare.
20
2010 US dollar values. IHS, real GDP by country.
21
Michael A. Cusumano, “Manufacturing innovation: Lessons from the Japanese auto industry,” MIT Sloan
Management Review, October 1988.
22
2013 values, OECD international trade statistics.
23
Japan ranked sixth globally for the overall quality of its infrastructure in the World Economic Forum’s Global
competitiveness report 2014–2015.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 29
 Although Japanese consumers have, to some degree, shifted away from top-quality luxury
goods and have begun to hold out for bargains, domestic demand continues to be a major
engine of the economy.24 Japan is the second-largest consumer market in the world in many
categories, including packaged goods, over-the-counter drugs, and cosmetics. And the
Japanese consumer still has untapped potential: most households have significant savings
and hold more than half of their assets in cash and deposits.

Japan also remains a powerhouse of technology and innovation. As of the end of 2013, its
Internet penetration exceeded 86 percent, and because of excellent digital infrastructure,
Japan has the second-fastest connection speeds in the world.25 This provides a solid
foundation for technology adoption in multiple fields. Furthermore, Japan accounted for
one-fifth of all patents filed globally in 2012. Japanese players have captured major market
share in multiple fields with long-term growth potential, such as articulated robots, lithium-
ion batteries, carbon fiber products, and vacuum pumps.

Japan can build on a remarkable set of advantages,

including technological know-how, a formidable
manufacturing base, a highly educated labor force,
world-class infrastructure, and a large and affluent
consumer market.

Japan prides itself on having a highly educated population and a deeply held work ethic.
In 2012, 46.6 percent of the workforce had attained tertiary education (the second-highest
share in the world). Educational equity has improved in recent years: women accounted
for only 36 percent of university graduates in 2000 but 42 percent in 2012. Japan has also
begun to attract some top foreign students, a strategy that has served to bolster talent
development and innovation in other countries. The number of visiting Chinese students in
Japan doubled between 2001 and 2011, reaching almost 90,000 (out of some 140,000 total
foreign students at the tertiary level).26

Taken together, these factors constitute an impressive set of advantages. Japan is facing a
daunting economic and demographic challenge, but it has the financial, physical, human,
and social capital at hand to meet them.

•••

The next decade offers a window of opportunity for Japan to shift its trajectory—in part
by taking advantage of some of the broad trends that are reshaping the world economy,
including increased connectivity across borders and disruptive technologies. But the
new global economy is not simply realigning; it is also accelerating, which increases the
imperative to act now. The following chapter takes a closer look at what it will take for Japan
to restore competitiveness and capture a greater share of global growth.

24
Brian Salsberg, “The new Japanese consumer,” McKinsey Quarterly, March 2010.
25
Penetration statistics from Nielsen and the International Telecommunications Union; connection speed
rankings from Akamai’s State of the Internet report, first quarter, 2014.
26
Education at a glance 2014: OECD indicators, OECD, October 2014.

30 McKinsey Global Institute 1. The origins of Japan’s productivity imperative

© Getty Images

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 31
© Getty
SourceImages
2. THE OPPORTUNITY FOR
A NEW PATH
Japan’s efforts to change course are approaching a critical inflection point. After
showing promising signs of growth in the first half of 2014, the economy slid back into
recession. Policy makers are attempting to administer a dose of strong medicine to the
faltering economy, including additional fiscal stimulus and an enormous new round of
quantitative easing.

If current trends hold, Japan’s GDP per capita would grow by a mere 1.3 percent
annually over the next decade, weakening consumer purchasing power. The overall
labor productivity gap with the United States is on track to grow from 29 percent in
2011 to 37 percent in 2025. The nation could face a third decade of stagnation—one
that would collide with an unprecedented demographic shift, creating even more
damaging consequences.

The continued aging of the population is inevitable, and unless Japan can boost workforce
participation and productivity, this trend could overwhelm the economy. Projections from
McKinsey’s Cityscope database indicate that Japan’s working-age population will decline
from 79 million in 2012 to 71 million in 2025 (with effective employment decreasing from
58 million in 2012 to 56 million in 2025). Its dependency ratio is set to soar from 0.60 to 0.73
over the same period, eventually hitting a staggering 0.96 by 2050.27 Persistent sluggish
growth would constrain the resources available for the social security and health-care
benefits that Japanese citizens expect at the very moment when demand for these services
will intensify. Japan’s public debt, already the highest in the world, would continue to mount.
Saddled with snowballing burdens of health care and elder care, Japan’s younger workers
would have diminished hopes for the future.

There is still time to head off this outcome. Japan has the opportunity and the capabilities
to engineer a leaner and more competitive economy. It will take political will to push through
structural reforms—but the private sector can take action in many areas without waiting for
policy changes. Japan can add a “fourth arrow” to the Abenomics agenda by engaging the
business community in a multifaceted, long-term national project to accelerate productivity
growth and innovation in every sector of the economy. In fact, our analysis finds that Japan
can meet some 50 to 70 percent of its productivity challenge if the private sector adopts the
best industry practices already in use by global companies in a variety of industries.28

Japan can change course and reignite growth

If productivity stagnates at 2013 levels while the population continues to age, the average
citizen will see his or her annual income shrink by approximately $1,600 in real terms by
2025. Japan would have to boost labor productivity by some 5 percent by 2025 merely
to maintain the GDP per capita it posted in 2013. Maintaining today’s income level is not
enough, of course—it is just the beginning. To sustain current social security spending, and
to ensure competitiveness and employment opportunities for generations to come, Japan
needs to grow beyond the status quo.

27
The dependency ratio is defined as the ratio of the non-working-age population (those below 14 years of age
and those above age 65) to the working-age population (ages 15–65).
28
This was estimated by calculating the potential impact produced by various industry levers described in detail
in Chapter 3. Most of the remaining improvement can be captured through technology adoption.
 Imagine a future Japan that once again outpaces the world in efficiency and quality—so
much so that experts from overseas flock there to study the best practices developed in its
industries. In this scenario, Japan emerges as a global leader in cutting-edge fields such
as advanced materials, 3D manufacturing, and the life sciences. Several major technology
clusters anchored by research centers and universities serve as the foundation for a newly
revitalized culture of innovation; top researchers and engineers from around the world
gather in these settings to collaborate. Intelligent robots fill the gaps where labor is scarce,
delivering results with high precision and low cost—and Japan exports this technology to
the rest of the world. At home, Japan reserves its human capital for tackling more creative
and knowledge-intensive work, reaping higher returns while working fewer hours.

Achieving a more prosperous future largely boils

down to whether Japan can more than double its
annual rate of productivity growth to generate new
economic momentum.

This future Japan has developed a thriving entrepreneurial ecosystem with easier access to
seed capital. Not only is there is a wave of new startups, but Japan also opens more of its
domestic markets to multinationals and foreign firms, unleashing new competitive dynamics
that force its large companies to rise to the challenge and become more nimble. Japanese
names enjoy market-leading positions in their respective industries globally and are run by a
new generation of innovative executives (some of whom come from outside Japan and all of
whom have international experience). More Japanese companies move to replace traditional
seniority-based pay scales with merit-based incentive structures that reward younger
talent. Corporations cede more responsibility to early-tenure managers with fresh ideas.
Shareholders insist on a new culture of performance, accountability, and agility—one that
transforms the way talent is managed and the way capital is allocated.

Japanese companies play an active role in establishing and implementing international

standards and take a more open-architecture approach to hardware and software
development. Financing and government support is made available to help Japanese firms
expand across all major geographies.

A rigorous focus on resource productivity helps Japan become a global leader in new
technologies for energy efficiency, transportation, and infrastructure management, opening
new possibilities for exporting some of these solutions worldwide. More of the nation’s
energy comes from domestic renewable sources, and “smart cities” deploy intelligent
infrastructure systems to manage demand and increase efficiency. Japan bolsters its energy
security, while efficiency and lower costs support new growth in domestic manufacturing.

The Japanese education system of the future would be retooled to instill a more open
and global mindset. Top students study abroad and undertake international internships
as a core part of their experience. Japanese universities hire more foreign faculty and
welcome the same share of international students as their leading European counterparts.
Entrepreneurship becomes rooted in campus life, with students in Tokyo University dorms
cooking up plans for the next Google, Facebook, Alibaba, or Tencent. Government funding
for education focuses on developing the specialized skills that are needed by employers as
well as the entrepreneurial and creative approaches that spur innovation in the economy
more broadly.

34 McKinsey Global Institute 2. The opportunity for a new path

 Japan remains one of the healthiest nations in the world and leads the way in demonstrating
that aging nations can deliver high-quality medical care while containing costs. The health-
care sector deploys new technologies such as remote health monitoring systems that can
take readings 24/7, alerting patients and doctors when an intervention is needed. Japan
becomes a leader in cutting-edge fields such as regenerative medicine, and it pioneers
the use of intelligent robots for everything from the daily care of elderly patients to the
sterilization of surgical instruments. New incentives encourage the development of more
specialist practices that deliver a higher quality of care, and providers compete on the basis
of outcomes rather than the number of treatments they perform.

Improved health allows experienced workers to remain on the job as they age, with
increased automation to relieve them of more physically demanding tasks. New policies
and practices draw more women into the labor force—and women begin to assert a
much greater presence in all types of leadership roles. Japan also begins to liberalize its
immigration policy to address its labor shortages.

Thanks to the adoption of autonomous vehicles, Japanese society becomes even more
mobile. High-speed connections between industry clusters allow for better deployment of
specialized and high-skilled labor. Mobile payments make for seamless transactions, and
big data analytics help companies offer goods and services that are better tailored to what
consumers really want. The Japan of the future harnesses technology to improve the quality
of life.

In this scenario, the specter of deflation disappears, and Japan’s economy averages
approximately 3 percent annual growth through 2025 (Exhibit 4). GDP per capita increases
by almost 3.5 percent annually, and Japan closes a substantial share of its current
productivity gap with the United States. Economic growth generates revenue that supports
Japan’s commitments to provide health care and social security for the elderly, and the
nation begins to chip away at public debt.

Exhibit 4

Accelerating productivity growth would change the outlook for Japan’s economy over the next decade

2% 4%+
Annual
increase in
Aspiration
1.3%
GDP annual
~3%
productivity, for 2025 growth,
2000–12
2000–11

16th
World ranking
5th $32,000
GDP per
$48,000
in GDP per
capita, 2013
capita, 2013

SOURCE: World Input-Output Database 2011; IHS; OECD GDP statistics; McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 35
 This alternative vision is highly aspirational, but Japan can in fact begin to move in this
direction. Achieving a more prosperous future largely boils down to whether Japan
can more than double its annual rate of productivity growth to generate new economic
momentum. Increased labor force participation will also play a part, as will a greater
willingness to experiment with more innovative business models and social paradigms.

Global trends are creating growth opportunities

After two decades of frustrated attempts to break out of stagnation, it is only natural for an
outside observer to ask what is different about today’s environment that could support a
fundamental shift in Japan’s direction.

The answer is simple: everything. The world outside Japan has been changing radically, and
it’s no longer possible to stand apart.29

As one of the most rapidly aging, urbanized, globally connected, technologically advanced,
and resource-scarce societies on the planet, Japan stands smack in the forefront of a global
wave of disruption. These trends present both pressures and incentives for Japan to make
bold moves. In some cases, they play directly to its strengths—and even where they pose
economic dangers, they will force Japan to adapt. And because Japan will be among the
first nations to face these issues, its responses will be of global relevance.

Global markets are growing more interconnected and fluid

7%
We take it for granted that our world has grown more connected, but it is startling to
contemplate the immense flows of goods, services, finance, people, and data and
communications that now move across the world’s borders. Previous MGI research
Japan’s share of
estimated that $26 trillion worth of goods, services, and finance were traded in 2012 and
global exports in
projected that global flows could triple by 2025.30 Today market forces are “on steroids”—
2000
but Japan has yet to capitalize on these opportunities, as it is not as plugged into the global

4%
Japan’s share in
economy as other developed countries. It ranks 21st on the MGI Connectedness Index
(below the United States, most of Western Europe, Russia, Hong Kong, Malaysia, and
South Korea). Its ratio of exports to GDP is 0.15, in contrast to 0.40 for Germany. Its private
2013 sector has lacked the agility to match the speed of change in this new world, and as a result,
Japan’s share of global exports has fallen from 7 percent in 2000 to 4 percent in 2013.

But Japan has the manufacturing, export, and innovation capabilities to make up for lost
time and lost market share. By 2025, emerging economies will account for half of global
consumption.31 As their incomes rise and as they continue to industrialize, these countries
will be growth markets for more sophisticated, value-added products such as vehicles,
machinery and equipment, and electronics—long-standing areas of strength for Japan. To
take advantage of growing demand, Japanese firms will have to operate in a more genuinely
global fashion. This may include tailoring products and services in new ways and lowering
price points to compete in volume-driven markets. Companies will have to gather detailed
market intelligence to cater to varying consumer preferences and design their products
to fit local definitions of value; consumers everywhere are beginning to expect specificity
and customization.

For Japan, this new era of global connectedness presents a massive opportunity to
overcome sluggish consumption growth at home. Targeted, prioritized international
expansions, especially throughout emerging Asia, can unlock new demand.

29
See Richard Dobbs, James Manyika, and Jonathan Woetzel, No ordinary disruption: The four global forces
breaking all the trends, Public Affairs, 2015, for a book-length discussion of how these forces are transforming
the global economy.
30
Global flows in a digital age, McKinsey Global Institute, April 2014.
31
Urban world: Cities and the rise of the consuming class, McKinsey Global Institute, June 2012.

36 McKinsey Global Institute 2. The opportunity for a new path

 An aging population can spur policy reform and represent a huge new
consumer market
Much of the developed world is aging along with Japan. Many advanced economies
will soon face the prospect of a shrinking labor force. This trend will only intensify in the
future, as 60 percent of world’s population lives in countries with fertility rates below the
replacement threshold. This fundamentally transforms the economic growth equation:
if countries cannot grow through an expansion of the labor force, they have to look to
productivity gains to compensate. Growing dependency ratios will also force countries
to make hard policy choices to maintain their social safety nets in the face of limited
fiscal resources.

No country is more exposed to this demographic headwind than Japan. Further

exacerbating the problem, only 59 percent of Japanese in the 60-to-64-year-old age
bracket are employed (vs. 66 percent in Sweden and 79 percent in Iceland).

As the country at the leading edge of the global demographic challenge, Japan will have
to pioneer policy solutions to increase labor force participation. The private sector will
also have to innovate to develop new business practices and technology solutions to fill
critical shortages and maximize the impact of human capital (such as advanced robotics,
autonomous cars, or intelligent software systems that can perform knowledge work). These
developments can have positive implications for productivity, and some of these solutions
could be exported to other countries.

The graying of the population also represents more than a policy or societal challenge.
Seniors are a potentially lucrative consumer segment. Japan could be well positioned to
export innovative products and services geared to the changing needs and preferences
of aging consumers in other developed markets (as Fujitsu has done with its senior-
friendly smartphone).

Japan—and the rest of the world—is growing more urban

40%
The world is undergoing a historic surge of urbanization that is spurring new economic
growth. As of 2007, more people lived in cities than in rural areas. The global urban
population is growing by 65 million a year, creating legions of new consumers. Nearly half
Potential
of global GDP growth between 2010 and 2025 is expected to come from 440 cities in
improvement in
emerging markets.32 If Japanese companies can develop the necessary market intelligence
infrastructure
and tailor their products to match local cultural preferences and price points at the city level,
productivity they could unlock significant export opportunities.

Although Japan’s total population is expected to decline by 2025, Tokyo is projected to

remain the world’s largest metropolitan area, with 38 million inhabitants.33 Japan is already
one of the world’s more urbanized nations, but now depopulation of the countryside is
accelerating, posing challenges for integrating rural migrants into already-dense urban
areas. This shift also poses important questions about infrastructure investment—both in
growing urban centers and in rural areas with fewer and fewer inhabitants.

While the value of infrastructure stock in most economies averages around 70 percent
of GDP, Japan peaks with the world’s highest level at 179 percent in 2012. Furthermore
Japan’s spending on infrastructure has historically been among the world’s highest,
averaging approximately 5 percent of GDP from 1992 to 2011 (second only to China, at
8.5 percent of GDP). Beyond any new projects it may undertake in the future, Japan’s
recent wave of infrastructure projects locks in the need for substantial ongoing expenditures
for operation, maintenance, renewal, or expansion as existing assets age. Previous

Ibid.
32

Projections from McKinsey Cityscope database.

33

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 37
 MGI research has identified opportunities to improve infrastructure productivity by up to
40 percent through better project selection, streamlined construction and delivery, capacity
management, and optimized maintenance.34

Its modern, world-class infrastructure puts Japan in an excellent position for trade and
digital innovation. In addition, Japan can export its engineering expertise to the rest of the
world—and there is a growing market for infrastructure as the world’s emerging economies
urbanize. Recent MGI research estimated that Southeast Asia alone will need to invest
some $3.3 trillion in infrastructure through 2030, with much of this going to urban transit,
water, and power systems. The region’s infrastructure gaps are growing increasingly
evident: less than two-thirds of Indonesia’s roads are paved, and approximately a quarter
of the population in both Indonesia and the Philippines still lacks access to electricity.35
Japan is already partnering with the region’s governments on a variety of projects. Tokyo
Metro is providing technical assistance to develop urban metro lines in Hanoi, for example,
and Japan is providing capital and expertise for electricity projects in Myanmar and road
projects in the Philippines.36 There are many more opportunities to serve as either financier
or provider of infrastructure services in Southeast Asia and around the world, but Japan will
have to compete for them.37

Disruptive technologies are setting the stage for productivity gains and new
product development
Today a host of potentially transformative innovations have already appeared on the
horizon, from advanced materials and 3D printing to the Internet of Things.38 Japan is
already adopting—and even inventing—some of these breakthroughs. Moving beyond
that first wave of experimentation, the next challenge is to apply these tools and accelerate
adoption throughout entire industries so that technology moves the needle on productivity
performance. If Japan moves quickly, it can seize the initiative to become a global leader in
some of these areas.

Advances in artificial intelligence, machine learning, and human-machine interaction are

making it possible to automate and augment knowledge work. Embedded sensors and
actuators in machines and other physical objects enable remote monitoring of everything
from factory equipment to urban infrastructure and medical devices. Google’s autonomous
cars have driven more than 700,000 miles (as of April 2014) among conventional manual-
driven cars, further illustrating the rollout of the Internet of Things, robotics, and big data.
With its strong capabilities in technology R&D and manufacturing, its depth of specialization
in robotics and hardware, and its great need for automation due to a shrinking labor force,
Japan has a unique combination of “push and pull” factors to become a global leader in
these fields, which could represent tremendous growth markets in the decades ahead.

The Internet is also shaking up the competitive landscape for businesses in profound
ways, as newcomers can scale up with stunning speed and little capital. As a result,
value is shifting between sectors, and entrepreneurs and startups have a new advantage
over large, established businesses. These competitive dynamics will force Japan’s most
tradition-bound companies to evolve and become more agile if they are to survive in this
fast-paced environment.

34
Infrastructure productivity: How to save $1 trillion a year, McKinsey Global Institute, January 2013.
35
Southeast Asia at the crossroads: Three paths to prosperity, McKinsey Global Institute, November 2014.
36
“Tokyo Metro offers assistance to Hanoi Metro,” Voice of Vietnam, February 18, 2014; Yuka Hayashi, “Japan
aids neighbors with ‘high-quality infrastructure,’” The Wall Street Journal, November 12, 2014.
37
“Japan, China competing for construction projects in Asia,” Japan Times, January 28, 2015.
38
See Disruptive technologies: Advances that will transform life, business, and the global economy, McKinsey
Global Institute, May 2013, for a full discussion of the 12 technologies with the largest economic potential on a
global scale.

38 McKinsey Global Institute 2. The opportunity for a new path

 The private sector can pursue three major types of strategies to
boost productivity
Emerging economies have the ability to capture large productivity gains as they undertake
an initial wave of industrialization and modernization. But for a highly advanced economy
such as Japan, it takes a sustained commitment to drill down and find new efficiencies and
to push the boundaries of innovation beyond the current frontier.

That being said, there is ample scope for Japan to improve productivity. While there is plenty
of inefficiency that begs to be addressed in Japan’s state sector, most of the economy—
and therefore most of the opportunity for improvement—lies within the private sector. The
business community will have to provide the leadership for a national productivity project
to succeed.

This is a time for business leaders to think big—in terms of creating innovative products,
penetrating new markets, and making substantial investments in equipment, technology,
and talent—to generate new value added. But they will simultaneously have to put every
aspect of their operations under the microscope to find ways to streamline. In many
cases, the barriers and bottlenecks are not imposed from above via regulation; they stem
from entrenched ways of doing business. Private-sector leaders can dismantle these
practices themselves without waiting for policy directives. In fact, doing so is a matter of
survival. Productivity drives growth at the macroeconomic level, but it also determines
whether individual companies can thrive in a fast-moving, digital, and highly competitive
global economy.

This report explores three sets of industry initiatives: adopting existing industry best
practices, including those developed in other countries; moving to the frontier of technology;
and organizing for discipline and performance. Within each of these areas, companies can
adopt multiple strategies to boost productivity.

Overall, Japan can reach some 50 to 70 percent of the productivity goal discussed here if a
critical mass of companies adopts practices that are already global standards; technology
accounts for most of the remaining potential. Chapter 3 will explore these topics in greater
detail as they apply within advanced manufacturing, retail, financial services, and health
care, but the following list speaks to Japan’s entire private sector more broadly. Chapter 4
will outline the basic enablers that need to be in place to meet the productivity challenge;
these issues depend in large part on public policy, but they can also benefit from private-
sector support and engagement.

Incorporating global best practices

ƒƒ Become more globally integrated. Rather than relying heavily on the domestic market,
Japanese companies have to become more aggressive about entering the fastest-
growing overseas markets. But in addition to going global, enterprises have to become
more truly global, thinking beyond borders with regard to their operational footprint
and talent development. Organizations can retain their Japanese roots while cultivating
deeper connections to global value chains.

ƒƒ Improve capabilities across the value chain. Japanese companies have historically
excelled in manufacturing and product development, but they often lag behind their
global competitors in other corporate functions such as sourcing, supply-chain
management, customer relationship management, marketing, and after-sales service, to
name just a few. Japanese companies need to invest in building capabilities across their
entire organization and the broader value chain.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 39
 ƒƒ Continue the journey of digitization. Many Japanese companies continue to operate
with legacy IT systems and antiquated architecture. In most companies, an end-to-
end review will likely reveal areas that have received little IT investment and process
innovation. Replacing outdated systems and equipping employees with mobile tools
can enable companies to transform their business processes to become more efficient
and effective. It can also open up avenues for creating value, expanding offerings, and
improving the customer experience.

ƒƒ Determine the optimal physical footprint. Organizations may need to reconfigure in

a more digital world with changing demographics. In retail, for example, smaller urban
storefronts (or, conversely, big-box stores) offering innovative customer experiences can
help to reduce costs and increase proximity to affluent customers. Health-care providers
may need to consider whether their locations, scale, and degree of specialization match
the needs of patients by age and geography. Financial institutions may need to close
some of their least profitable branches and incorporate new interactive technologies
into others.

Adopting next-generation technologies

ƒƒ Harness the power of big data and advanced analytics. Big data can be a
powerful tool for pricing, customer segmentation and marketing, sales forecasting, risk
management, and R&D. But a recent Nikkei survey showed that almost half of the major
Japanese companies surveyed were not using it to transform operations.39

ƒƒ Take automation to the next level. Internet technologies have been automating
business processes for years, but now this trend could expand into many additional
roles as intelligent software systems become more adept at performing knowledge
work. These technologies, along with developments in robotics, could help Japanese
companies address critical labor shortages in the years ahead.

ƒƒ Deploy advanced technologies in manufacturing processes. The coming decade

will bring an ongoing wave of innovation in manufacturing that reinvents the assembly line
yet again. Firms will have to embrace these new technologies to keep pace and capture
new sources of value. This could mean adopting low-cost sensors and big data analytics
for better accuracy in production or using 3D printing to achieve mass customization.
New technologies also make it possible to exert much tighter control over supply
chains; the Internet of Things, for example, can help to manage transportation fleets and
distribution networks in real time.

Organizing for discipline and performance

ƒƒ Restructure as needed to create more competitive and fluid industries.
Competition is the greatest driver of productivity, and in some sectors, the government
could spur substantial progress by removing policies that have constrained market
forces. Companies will have to adapt to a much more intense level of competition—
and new winners would likely emerge in a variety of industries. A more fluid industry
structure would allow more up-and-coming startups to enter various markets while
removing protections and subsidies for incumbents. In response to these changes,
some companies may need to reorganize or exit unprofitable markets, while others may
undertake mergers and acquisitions to achieve economies of scale and quickly gain
new capabilities. These dynamics would support more effective capital allocation by
individual firms and across the broader economy.

39
“Majority of Japanese companies mine big data,” Nikkei Asian Review, December 11, 2014.

40 McKinsey Global Institute 2. The opportunity for a new path

 ƒƒ Create a culture of performance and accountability. Shareholders and top
executives have to make it clear that productivity is a top organizational goal. The best
way to spur real change is to tie performance goals to an incentive structure. Companies
such as Hitachi, Sony, and Panasonic have already begun shifting away from the
traditional seniority-based advancement system, and Toyota’s recent announcement
of a merit-based pay structure is likely to create even broader momentum for this
transition.40 Promoting younger talent into the management ranks and rewarding results
have the potential to create more agile organizations and fresh ideas.

ƒƒ Draw on all sources to build talent, leadership, and skills for the future. At a
macroeconomic level, Japan needs to maximize the labor force participation of women
and older workers (see Chapter 4 for a deeper discussion). Some of this effort can be
addressed by public policy, but much of it depends on the willingness of individual
companies to change entrenched norms and attitudes (such as the demands for long
hours that make it difficult for new mothers to return to work). It is especially critical for
companies to invest in programs that develop and mentor female leaders. McKinsey
research indicates that companies with the highest proportions of women in senior
management positions report enhanced organizational and financial performance.41
Companies will also need to find ways to retain valuable skills and experience by
reengineering the workplace to accommodate the needs of aging workers. This could
include increasing automation to reduce physically demanding activities; implementing
flexible hours, part-time arrangements, and work-from-home policies; and redesigning
the physical environment with a greater focus on ergonomic issues. Older workers could
be also reassigned into mentorship and training roles.

ƒƒ Focus on the customer to achieve a better return on R&D investments. Japan

has the sophisticated R&D and manufacturing capabilities to develop new products
and services—whether in traditional industries or at the cutting edge of fields such as
robotics, advanced materials, and genomics. But instead of focusing on the technology
itself, the development process has to focus on understanding what the customer wants
and delivering solutions based on that insight. Innovation is no longer just about creating
products within a closed and tightly managed R&D process; it involves both teamwork
and a more external, customer-centric orientation. A greater willingness to collaborate
with customers and suppliers can yield new ideas for product development and process
refinement based on real end-user insights. New working models (from social media
platforms for collaboration to new arrangements of physical office environments) can
break down hierarchies and department silos to encourage more innovation from across
the organization. Google and 3M have both been noted for policies that encourage
employees to spend some portion of their hours working on personal ideas. Procter
& Gamble and GE have both embraced open innovation, starting programs that
crowdsource ideas from outside the company for solving design conundrums. Tencent
has created an open platform that allows developers to connect with millions of its QQ
users to create mobile apps and other products.42

40
Kana Inagaki, “Japan Inc shuns seniority in favour of merit-based pay,” Financial Times, January 27, 2015;
Craig Trudell and Yukiko Hagiwara, “Toyota plans overhaul to seniority-based pay,” Bloomberg, January
26, 2015.
41
Women matter: An Asian perspective, McKinsey & Company, June 2012.
42
“Tencent open platform heralds a new era,” company press release, October 30, 2014.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 41
 These initiatives can have a remarkable impact on economic growth
and productivity
If the private sector undertakes the initiatives described above, it could lead the way in
putting the economy on a faster track toward recovery and renewal. Instead of settling
for a future with 1.3 percent annual GDP growth, Japan could grow by an average of
approximately 3 percent through 2025—in other words, realizing the alternative scenario
for a more prosperous future described earlier in this chapter. This would increase Japan’s
projected GDP in 2025 by up to 30 percent over current trends (Exhibit 5). In fact, the size of
the prize is $1.4 trillion in GDP in that year alone.

Exhibit 5

Productivity initiatives in specific industries can help Japan increase value added by up to 28 percent
above the current trajectory

Value added High range

$ billion, 2009
Low range

907 6,290

+28%

544 5,768
120 21
14 +18%
156 96
186 105
4,900 109

4,139

2011 2025 Advanced Retail Financial Health Other 2025

estimated manufac- services care industries1 improved
turing

1 Increases in value added and productivity in the sectors examined in detail were used to extrapolate gains in similar
industries (e.g., gains in advanced manufacturing were applied to all manufacturing).
NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; IHS; McKinsey Global Institute analysis

To get there, however, Japan needs to more than double its labor productivity growth rate
over this period, boosting it from approximately 2 percent to approximately 4 percent. This
is a highly ambitious goal, but with its labor force expected to decline by some 3.7 percent
between 2011 and 2025, productivity is Japan’s most important means to accelerate
growth. If this effort is successful, Japan would surpass Germany in productivity by 2025.
Its productivity gap with the United States would persist, but instead of growing from
29 percent in 2011 to 37 percent, it could be reduced to 19 to 26 percent (Exhibit 6).

42 McKinsey Global Institute 2. The opportunity for a new path

Exhibit 6

Japan can shrink its labor productivity gap with the United States and surpass Germany by 2025

Labor productivity (value added per hour worked) High range

$ 2009
Low range

United States

-19%

10 66 -26%

6
Germany
2 <1
2 1
1
52 1

61

40

2011 2025 Advanced Retail Financial Health Other 2025

estimated manufac- services care industries1 improved
turing

1 Increases in value added and productivity in the sectors examined in detail were used to extrapolate gains in similar
industries (e.g., gains in advanced manufacturing were applied to all manufacturing).
NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; IHS; McKinsey Global Institute analysis

Economic growth, along with better allocation of capital and a focus on optimizing
expenditures, could also improve capital productivity in Japan by an average of 25 percent
across all industries by 2025 (Exhibit 7).

The innovations pioneered by one leading company can have an outsized impact on the
productivity of an entire industry as competitors are forced to raise their game. In the 1950s
and 1960s, Toyota introduced more efficient production processes that were soon widely
adopted by the entire Japanese auto industry. Decades later, Wal-Mart had a major direct
and indirect effect on the productivity of the entire US retail sector by introducing new
managerial and supply-chain practices.43

This observation leads to crucial questions: Which Japanese companies will be the ones to
spur industry-wide change? And could the ripple effects on their competitors lead to higher
levels of corporate churn?

A drive for greater productivity can also raise anxiety about the eventual impact on jobs.
Technology often enhances productivity by automating tasks, which can eliminate some
jobs or force existing employees to adapt to new roles and responsibilities that require

43
US productivity growth, 1995–2000, McKinsey Global Institute, October 2001.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 43
 different skill sets. The effect of automation on overall unemployment is likely to be roughly
neutral in Japan, given that the workforce is shrinking. Our estimates suggest that in some
sectors, such as advanced manufacturing and financial services, productivity growth from
automation may displace 6 to 9 percent of the workforce, while labor inputs (total workers
and declining working hours) are on track to decline by 9 percent. Nevertheless, change
does not happen at the same pace across the economy. The need for labor may decline
sharply in some sectors, while other industries may have sudden spikes in demand for
new skills. The public and private sectors will have to be prepared to deal with this issue
by ensuring that adequate support is available to ease the pain of transition for affected
workers as labor is reallocated across the economy. A key component of this will be
providing retraining programs on a large scale so that workers can acquire the new skills
employers need.

Exhibit 7

By 2025, Japanese industries can sharply improve their capital productivity

Gross value added per unit of fixed capital stock— Base case
2025 estimates
% Improved capital productivity

138 54%

90
77 65%

47

30 26%
24
15 54% 17%
12 14
10
0

Advanced Retail Financial Health care All industries

manufacturing services

NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; IHS; McKinsey Global Institute analysis

•••

Industrial policy can enable economic growth (as we will explore more fully in Chapter 4),
but Japan’s productivity imperative will ultimately have to be met by the private sector.
Japanese manufacturers famously invented “lean” practices and exported them to the rest
of the world. Today businesses throughout Japan’s economy—and particularly in service
sectors—can reinvent these concepts, applying them to new industries and extending their
impact with the help of new digital technologies. Businesses will need a greater willingness
to invest and take risks, while managers and workers will have to adapt to fresh ways of
doing business. Achieving the rate of productivity growth needed to drive Japan’s economy
forward will be a long-haul national project that involves every employer and employee.

44 McKinsey Global Institute 2. The opportunity for a new path

© Alamy

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 45
© Getty Images
3. A SECTOR-LEVEL ROAD MAP

With its labor force shrinking, Japan has to focus on productivity as its primary source of
growth—and identifying areas that are ripe for improvement is at the heart of our research.
Unless Japan cracks the productivity challenge, long-term trends of stagnation, eroding
competitiveness, low fertility, and rapid aging will bring about a society with a reduced
quality of life and an unprecedented burden on the working-age population. Boosting
productivity can head off this outcome and inject new dynamism into the economy.

The preceding chapter described some cross-cutting strategies for the private sector,
but here we examine more specific opportunities to accelerate productivity growth in four
sectors: advanced manufacturing, retail, financial services, and health care. These were
chosen because they represent significant but diverse parts of the Japanese economy.

Some 30 percent of Japan’s productivity potential

can be captured within four sectors: advanced
manufacturing, retail, financial services, and
health care.

If Japan can more than double its annual rate of productivity growth to approximately
4 percent, the size of the prize would be substantial: up to $1.4 trillion in GDP growth in
2025 alone. Some 30 percent of that potential can be captured within the sectors profiled
here, while the remainder can be achieved in other sectors based on benchmarking against
international peers that have adopted best practices.44 The strategies outlined below are by
no means exhaustive, but they do offer a starting point for action and an indicator of the size
of Japan’s still-untapped productivity opportunity.

We have extrapolated the potential impact from the four industries we analyzed in detail to the remainder of
44

the economy, differentiating by type of industry (e.g., private, public, goods, or services) and industry structure
(e.g., level of consolidation).
 ADVANCED MANUFACTURING

29%
Japanese manufacturing was once viewed as a “two-speed” sector. When MGI examined
the Japanese economy back in 2000, domestically focused industries such as textiles and
food manufacturing lagged in productivity, but more export-oriented industries posted
Japan’s labor
world-class performance.45
productivity gap
with the US in Today, however, even some of the flagship industries within the latter group have grown
advanced less competitive. This report will focus on a subset that is of particular concern. “Advanced
manufacturing manufacturing” is defined here as the aggregate of three industries: electrical and optical
equipment (which includes consumer electronics), industrial machinery, and transport
equipment (which includes automotive). These industries have multiple attributes in
common: high R&D intensity, high value added, a substantial share of output for export, and
a relatively low reliance on labor and energy compared with other manufacturing industries.

Above all, these industries represent the vanguard of Japan’s industrial capabilities and
the source of its signature exports. For years, Toyota, Honda, Nissan, and other Japanese
automakers set the global standard for reliable, well-made cars at affordable prices.
Japanese electronics brands such as Sharp, Sony, and Panasonic were lauded for their
quality. They remained consistently at the forefront of technological innovation, introducing
products such as the PlayStation, Blu-ray, and the flat-panel, high-definition televisions that
are ubiquitous today.

But over the past 15 years, these leading names have seen their market share erode in the
face of new global competition. Even more worrisome, Japan’s advanced manufacturing
sector, which once led the world in productivity, has fallen behind its competitors. Today
Japan’s labor productivity in this sector is 29 percent below that of the United States and
32 percent below that of Germany (Exhibit 8).

Exhibit 8

Labor productivity in Japan’s advanced manufacturing sector lags behind

that of the US and German sectors

Advanced manufacturing labor productivity

(value added per hour)
$ 2009 at purchasing power parity
80 73
69 Germany
United States
70
60 56
52
43 Japan
37 50
40
39
22
20
23
19

0
1995 2000 02 07 2011

SOURCE: IHS; McKinsey Global Institute analysis

45
The 2000 report included the steel industry in this category along with automotive, consumer electronics, and
machine tools.

48 McKinsey Global Institute 3. A sector-level road map

 Japan’s productivity gap vs. the United States is not only significant—it has been widening
(Exhibit 9). Since 1995, US productivity in advanced manufacturing has grown by
218 percent, while Japan’s has grown by 163 percent.46 Technology advances in the years
ahead will naturally continue to improve labor productivity in both nations. But if current
trends continue, Japan’s improvement would still lag behind the pace in the United States.
Unless targeted measures are taken, the productivity gap between the US and Japanese
advanced manufacturing sectors is on pace to grow from 29 percent in 2011 to 34 percent
by 2025.

Exhibit 9

Japan’s productivity gaps with the United States in manufacturing have been widening,
especially in electrical and optical equipment

Advanced manufacturing labor productivity United States

(value added per hour)
$, 2009 at purchasing power parity) Japan

Electrical 100 98
and optical
equipment 80
60
52
40

20

Machinery 70
64
60
50 49
40
30
20
10

Transport 100
equipment
80
60
42
40 49
20

0
1995 96 98 2000 02 04 06 08 10 2011

NOTE: Not to scale.

SOURCE: IHS, World Input-Output Database, McKinsey Global Institute analysis

Adjusted for inflation and price level changes.

46

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 49
 Despite these challenges, advanced manufacturing remains one of Japan’s core sectors,
and its performance is closely tied to the health of the broader economy. These industries
account for 7 percent of Japan’s employment, 6.7 percent of its GDP, and 60 percent of
R&D spending; they also produce more than two-thirds of Japan’s exports. The erosion of
their global market share is a clear cause for concern (Exhibit 10).

Exhibit 10

Japan’s advanced manufacturing industries have relied on the domestic market

while losing ground globally

Share of Japanese market, 2010 Global consumption of

% advanced manufactured goods
%; real 2005 $ trillion

Japanese goods Imported goods Japan Rest of world

6.8 9.8
13 8

67.2

93.6 91.1
100.0
87 92

32.8

6.4 8.9

Autos TVs PCs Mobile 2000 2010

NOTE: Numbers may not sum due to rounding.

SOURCE: IHS World Industry Service; Gartner; iSuppli; IDC; Japan Automobile Importers Association; Japan Automobile
Manufacturers Association; IHS AutoInsight; McKinsey Global Institute analysis

At the firm level, Japanese auto companies have remained excellent performers. Nissan
rebounded strongly after entering its partnership with Renault, and Toyota successfully
pioneered hybrid cars with the Prius, which continues to dominate its category. Toyota’s
Corolla ranked as the number 2 top-selling model globally in 2013, while the Camry came in
sixth; the Honda CRV was the number 9 best seller.47 However, Japanese carmakers have
shifted much of their production outside of Japan to local markets.

The consumer electronics space has not fared as well. The market has shifted toward
a greater emphasis on software and integrated platforms such as Apple’s iOS, which
creates the ecosystem for all of its devices. Fast-following, lean players such as Samsung,
LG, Xiaomi, Huawei, and Lenovo have grabbed market share for products such as TVs,
PCs, and smartphones—often at the expense of Japanese firms. The most recognizable
Japanese conglomerates (Sony, Sharp, Panasonic, Toshiba, and NEC) have spent
the past decade fighting for profitability in the face of stagnant growth. In a number of
cases, Japanese companies made some unfortunate bets on technologies that did not
ultimately win out in the marketplace; they have not developed blockbuster products
that have resonated with global consumers and have largely missed out on the growth of
smartphones. Consumer electronics companies need to achieve truly global scale to stay

47
LMC Automotive data as quoted in Joann Muller, “The world’s most popular cars: Ford Focus and other
surprises,” Forbes, December 23, 2013.

50 McKinsey Global Institute 3. A sector-level road map

 competitive, but Japan’s industry has been hampered by fragmentation and an adherence
to proprietary standards. Many subscale companies and plants are focused on products
with declining margins.

The global market for electronics looks significantly different than it did just 15 years ago.
These products were once considered luxury goods destined for consumers in advanced
economies, but today there is an explosion of demand from emerging economies.
While consumption in Japan is expected to stay flat, consumption throughout all of Asia
(including Japan) has doubled in the past ten years, and it is expected to grow by more than
170 percent in the decade ahead.48 In Southeast Asia alone, MGI estimates that 81 million
households are currently part of the “consuming class,” and this number is forecast to grow
to 163 million households by 2030.49 Similarly, consumer-facing industries in Africa are
expected to grow by more than $400 billion by 2020.50 Emerging economies are not just
sources of low-cost labor. They are now lucrative consumer markets—and multinational
companies from around the world are competing to establish market share.

Many Japanese exports have been slow to gain traction in emerging economies, and
while this is cause for concern, it is also an indicator of opportunity. If Japan’s advanced
manufacturing sector can unlock new sources of revenue growth, in part by taking
advantage of its proximity to many of the world’s fastest-growing centers of demand, it can
reestablish itself as a global leader.

Productivity challenges
Advanced manufacturing industries have experienced downward pricing pressure over
the past decade—and that pressure has been particularly acute in the electronic and
optical equipment sector. This downward pressure has been exacerbated by the industry’s
reliance on cost-based pricing and competition; Japan’s traditional monozukuri spirit places
value on delivering excellent craftsmanship and quality at a “fair price” to the consumer.
Some leading global names have changed the rules of the game by introducing innovative
products for which consumers are willing to pay premium prices, but by and large,
electronics are subject to rapid commoditization and falling prices.

Pricing pressures are a worldwide phenomenon, however, so they do not fully explain the
productivity performance of Japan’s advanced manufacturing sector relative to that of the
United States. The three major challenges described below contributed to today’s gap. They
concern mismatches between the industry’s focus and changing market trends, and they
relate to the broader issues around Japan’s underlying environment for competitiveness and
innovation raised earlier in Chapter 1.

Insufficient focus on fast-growing global markets

Japanese manufacturers have long been able to rely on the spending power of the
Japanese consumer. But today domestic demand is stagnating even as more international
competitors have entered the Japanese market. By contrast, there is booming demand in
emerging economies around the world. Japanese companies face an increasingly urgent
imperative to go global.

The typical global strategy for Japanese companies has been “inward-out”—that is, taking
products that have performed well in the Japanese market and simply selling them abroad.
51
This has worked, to some extent, when entering other developed markets such as the
United States or Western Europe.

48
IHS Global Insight, World Industry Service.
49
Southeast Asia at the crossroads: Three paths to prosperity, McKinsey Global Institute, November 2014.
50
“The rise of the African consumer,” McKinsey Quarterly, November 2012.
51
Some automotive companies have taken a different approach, moving production closer to local end-
user markets.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 51
 But this strategy falls flat when companies attempt to enter emerging markets such as
India, China, or Africa. Japanese products are often overly feature-rich and expensive, and
as a result, they can fail to resonate in lower-income economies. (Japanese automakers
are an exception, however. Toyota, Nissan, and Honda have successfully tailored their
vehicles to appeal to the needs of a growing consumer class in emerging markets. In fact,
Nissan recently revived its Datsun brand for entry-level buyers in India and elsewhere.52
Honda motorcycles are ubiquitous for commuters in markets such as India, Southeast
Asia, and Brazil.) Understanding what drives value for consumers in local markets requires
local intelligence—and many Japanese firms have not made the necessary investments to
develop these insights.53

As a result of insufficient investment and misaligned focus, Japan’s advanced

manufacturing industries have lost ground in growing international markets, resulting in
a decline in net exports since 2010 (Exhibit 11). Japan’s exports of electrical and optical
equipment have fallen behind those of the United States and Germany in terms of both
volume and growth rate.

Language barriers, delayed adoption of global standards, and management culture

have also combined to slow the pace of internationalization. While there is a great deal to
overcome, Japan’s proximity to emerging Asian economies means that there is massive
growth potential at its doorstep.

Exhibit 11

While the global market continues to grow, Japan’s net exports have been on the decline

Consumption of advanced manufacturing products Net exports of R&D-intensive manufactured goods

Index: 100 = 2005 $ billion

318
400 310
300
Asia Electrical 57
350 and optical 63 47
equipment
236
300
22
96 84
250 Machinery 82
World 66
200

150
Transport 169
100 164 165
equipment 148
50

0
2005 2010 2015E 2020E 2025E 2010 2011 2012 2013

NOTE: Numbers may not sum due to rounding.

SOURCE: World Integrated Trade Solutions Database; McKinsey Global Institute analysis

52
Siddharth Vikram Philip, “Datsun leads Nissan’s emerging markets push with Go model,” Bloomberg
Businessweek, July 16, 2013.
53
Andrew Dugan, Randy Kyung-rok Han, and Sagar Pagare, Asia or bust: Why Japanese firms must succeed in
Asia to survive, Knowledge@Wharton, December 2013.

52 McKinsey Global Institute 3. A sector-level road map

 A product mix that is weighted toward lower-value goods
At the industry level, labor productivity is not just affected by how quickly workers can
churn out goods. It is highly influenced by the industry’s overall product mix. In advanced
manufacturing, parts and components tend to generate less value than final goods—a
phenomenon that explains why companies such as Apple and Vizio have “unbundled” their
value chains across geographies, relying on far-flung suppliers to become “factory-less
manufacturers.” By contrast, producers of parts and components are a mainstay of Japan’s
advanced manufacturing sector. Although these players have been successful, the fact
remains that these companies collectively produce less value added per hour of labor than
other types of manufacturing.

Japanese firms have to find a way to play to their strengths in these areas. One possibility
is to maximize value added through better pricing and marketing; another is to concentrate
R&D activity in technology hubs to develop more innovative products.

In the electronics sector, the product mix effect is especially relevant. Japan’s electronics
sector is still heavily weighted toward hardware; its firms hold large market shares in
products such as digital cameras, printers, and TVs. Meanwhile, those same firms have
largely missed out on tapping into growth in software, IT services, and smartphones. They
have been hindered by an adherence to proprietary standards and a lack of interoperability
as well as an environment that does not encourage more fluid innovation. These points are
discussed more fully elsewhere in this section.

Difficulties in commercializing new innovations

Japan has a long-standing global reputation for innovation. It is a leader in patent filings,
holding 50 percent or more of the world’s intellectual property in areas such as lithium-ion
batteries, articulated robots, and copy machines. Japan spends more on manufacturing
R&D than almost any other country in the world: in 2010, its R&D investment in the advanced
manufacturing sector was equivalent to 1.7 percent of GDP, ahead of Germany’s 1.6 percent
and 1.1 percent in the United States. Nevertheless, in recent years Japan has not seen the
payoff in terms of growth or productivity that one would expect from such heavy investment.
It performs well below peers in productivity growth relative to R&D investment (Exhibit 12).

3.7%
This is due in large part to the difficulties entrepreneurs and businesses encounter in
commercializing new ideas and cutting-edge technologies. Japan has fewer entrepreneurs
than the United States; one study found that they constituted 3.7 percent of the labor force
Share of
in Japan in 2013, compared with 12.7 percent of the US labor force.54 Additionally, their odds
entrepreneurs in
of securing early-stage funding are much lower than they would be in the United States and
the Japanese
other developed countries.
labor force
Another driver may be the Japanese approach to R&D. Companies tend to keep their
research operations tightly contained rather than taking a more open approach that allows
ideas to cross-pollinate between different parts of the organization and outside entities
(including suppliers and customers). The new norm of collaborative innovation has been
embraced more fully by companies in other advanced economies. Outside partnerships are
particularly important as companies try to get closer to customers in local markets across
the world and tailor products to meet their preferences.

José Ernesto Amorós and Niels Bosma, 2013 global report, Global Entrepreneurship Monitor, January 2014.
54

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 53
Exhibit 12

Heavy investment in R&D has not produced a large payoff in productivity for Japanese firms

Business investment in R&D vs. total factor productivity, 1986–20081 GDP size, 2013

Total factor productivity annual change

%
2.0

Finland
1.5
Norway
United Kingdom
Germany Sweden
1.0
Austria
Iceland United States
0.5
New Zealand Belgium
Australia Switzerland
France
0 Netherlands
Portugal Japan
Canada
-0.5

Italy Denmark
-1.0

Spain
-1.5

-2.0
0 0.5 1.0 1.5 2.0 2.5
R&D
% of GDP

1 Total factor productivity is a measure of technological progress that measures increases in output after taking labor and capital inputs into account.

SOURCE: Gartner; iSuppli; IDC; Euromonitor; IMF; McKinsey Global Institute analysis

A high cost base

Compared with its international competitors, Japan often has to contend with a higher
non-labor cost base, particularly in the electrical and optical equipment industry (Exhibit 13).
The cost of intermediate inputs in the comparable US sector is equivalent to only
38 percent of revenue, as opposed to 65 percent in Japan. Examining the performance
of key players in both countries reveals that only a small part of this difference is explained
by the cost of goods or by R&D expenditures. Japan’s operational expenses are driven
higher by inefficiencies in global operations and in corporate functions such as supply-
chain management.

54 McKinsey Global Institute 3. A sector-level road map

 Exhibit 13

Japan has a high non-labor cost base, particularly in the electrical and
optical equipment industry

Revenue breakdown by subsector, 2011 Value add (includes labor cost)

$ billion, 2009 at purchasing power parity
Non-labor cost of intermediate inputs

Electrical and Transport

optical equipment Machinery equipment

590.7 608.9

133.5

363.5 374.0
353.8
324.4
95.2
122.5
161.4 475.4
188.6
70.7 278.7
231.3 227.1
163.0
117.9

Japan United Japan United Japan United

States States States

Cost as 65 38 63 50 75 78
% of revenue

NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; McKinsey Global Institute analysis

Japan’s future path: Comparing the current trajectory of advanced

manufacturing with a vision for revitalization
If Japanese manufacturing continues on its current trajectory, it will face limited growth,
continued loss of share in global markets, and widening labor productivity gaps with the
United States. The sector’s value added would increase by a mere 1.4 percent annually
through 2025. Labor productivity would increase by a total of 41 percent over the entire
period from 2011 to 2025. By then, the Japanese sector would generate only $71 per labor
hour vs. $107 per labor hour in the United States, leaving Japanese productivity at just
66 percent of the US level.

But Japan has an opportunity to change this path if companies aggressively pursue the
strategies we outline below, including value optimization, targeted globalization, improved
operational excellence in all corporate functions, and the deployment of next-generation
technologies. By prioritizing the most lucrative global markets and employing the right
pricing strategies, Japan could reestablish a world-leading position in its advanced
manufacturing industries—not only in automotive, but also in areas such as optical and
electrical components and robotics.

Japan has long realized the beauty of keeping things simple and streamlined. Its advanced
manufacturing industries can reap significant productivity gains from adopting international
standards and a modular approach—that is, using an increasing number of interoperable

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 55
 parts and processes to build platforms of components that can be plugged together like
Lego bricks. Taking an open-architecture approach and adopting international standards
can raise quality and lower costs. Automation will play a significant role in this Japan of the
future, with increased use of advanced robotics that are able to work alongside humans and
support labor-intensive tasks.

In this vision, Japanese manufacturers reinvent their world-renowned lean thinking

approach for a new era by integrating the Internet of Things and other next-generation
technology solutions into their processes. These solutions can allow them to add new
business lines such as cost-efficient and high-quality after-sales service and maintenance.
With the right environment in place, entrepreneurship could grow within the industry,
and innovative ideas would more frequently translate into new product lines. This is a
time of tremendous evolution—and tremendous churn—in manufacturing, trade, and
technology. But the current wave of disruption is presenting Japanese manufacturers with
new opportunities.

Challenges and opportunities from global forces

For Japan, a new era of globalization means an opportunity to overcome sluggish demand
at home. Emerging economies represent huge new markets, and not only for consumer
goods. As these nations rapidly urbanize, they are generating new demand for compact
cars and rail technology, which plays directly to Japan’s strengths. Exports of machinery
can also unlock greater demand for services; workers in economies that are just beginning
to industrialize have less experience in operating and maintaining sophisticated equipment.

Japan has the manufacturing, innovation, and

export capabilities to make up for lost time and lost
market share.

Global connectedness is also allowing manufacturers to separate their headquarters from

R&D operations and from actual production. This translates into fierce competition for spots
in global value chains—and because Japan has significantly higher labor costs than many
other countries in the region, its firms have to compete by developing unique capabilities.

At a global level, the manufacturing industry is experiencing a remarkable wave of

innovation—and Japanese firms can capture enormous opportunities by establishing
themselves as global leaders. Some of the most promising areas include nanomaterials,
new production technologies such as additive manufacturing (3D printing), and integration
of the Internet of Things and advanced robotics into production processes.55 Innovative
software is increasingly being integrated into traditional manufactured goods; Apple,
Google, IBM, and Baidu, for example, are developing platforms for “connected cars” and
have engaged with major global automakers. This blending of software and hardware
represents a new competitive challenge—and a major market opportunity—for Japan’s
automakers if they can stay at the forefront as they unveil their own connected car offerings.

Japan is importing a larger share of its energy than at any point in the past decade. This
makes Japanese producers in energy-intensive manufacturing industries more sensitive to
a fluctuating yen. Additionally, consumers are increasingly demanding eco-friendly goods
made by companies that operate sustainably. Despite the recent dip in global energy prices,
the industry has incentives to minimize its energy consumption—and these efforts would

55
Manufacturing the future: The next area of global growth and innovation, McKinsey Global Institute,
November 2012.

56 McKinsey Global Institute 3. A sector-level road map

 support a push toward more efficient processes overall. There is untapped potential for
Japanese firms to use “circular economy” concepts such as recycling and minimizing waste
in production processes. In the same way that Toyota anticipated customer desires and led
the way in the hybrid car market with the Prius, other firms should be deliberate about the
opportunities for growth and efficiency they can achieve by going greener.

Company strategies for boosting productivity and growth

A new era of innovation is under way, and Japan can take decisive action to revitalize its
advanced manufacturing sector. We have identified key strategies that collectively have
the potential to boost value added in Japan’s advanced manufacturing industry by up to
53 percent above the current trajectory by 2025 (Exhibit 14). It should be noted, however,
that Japan would need to adopt breakthrough technologies on a wide scale to achieve the
full potential.

Exhibit 14

Productivity levers can help Japan boost value added in manufacturing by more than 50 percent in 2025

Lever Impact on value added Impact on labor hours

Commercialization of
7.8 1.5
innovation

Internationalization 14.0 6.6

strategies
Global best
practices
Operational excellence
13.2 -6.5
across the value chain

After-sales services 5.2 1.1

and opportunities

New manufacturing
7.2 -7.0
technologies
Next-generation
technologies
Taking the lead in
robotics and 3D 0.8 0.3
manufacturing markets

Organizing for
discipline and Industry consolidation 5.3 -0.4
performance

Total impact 53.4 -4.4

NOTE: Numbers may not sum due to rounding.

SOURCE: McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 57
 Four of these strategies result in more output and will require additional labor, while the
remaining four create value through efficiency gains that will reduce the need for labor. We
project that if current trends hold, the sector’s employment would fall by 14 percent by 2025.
However, our estimates indicate that by fully implementing these initiatives, industry growth
could mitigate the expected decline in employment, reducing it to 10 percent.56

Combining these strategies would produce a significant improvement in labor productivity.

By 2025, this sector’s performance could increase by 26 to 47 percent above the current
trajectory—almost matching projections for US productivity in this area (Exhibit 15).57

Exhibit 15

Japan’s advanced manufacturing sector has the potential to almost close the productivity gap with the US sector

Range Low High

Value added
$ billion, 2009 at purchasing power parity

534

Labor productivity, 2025 +53%

348
(value added per hour worked)
$, 2009 at purchasing power parity 288

United States = 107 457

104
Germany = 97
-34%

71 2011 2025 2025 improved

50 Labor inputs
Million hours worked
89
5,727

335
-10.2%

-5.9%
251
2011 2025 2025 improved 5,140
-4.4%

2011 Decline in Decline 2025

average from levers
hours per
worker1

1 Average hours per worker gradually decrease over time as general technological progress improves productivity.
NOTE: Numbers may not sum due to rounding.

SOURCE: McKinsey Global Institute analysis

56
The expected decline in employment stems from a combination of a roughly 4 percent reduction in labor hours
due to increased productivity and a 6 percent reduction due to the continuing trend in Japan toward shorter
workdays and lower average hours per worker. All in all, the 2025 labor hours required are estimated to be
about 90 percent of 2011 levels. See the technical appendix for more detail on these assumptions.
57
Industry projections from IHS Global Insight, World Industry Service, 2014.

58 McKinsey Global Institute 3. A sector-level road map

 Incorporating global best practices
Shifting R&D to higher-value-added opportunities
Japan, once a world leader in innovation, has seen limited return on its R&D investment in
recent years, and its reputation for cutting-edge creativity has lagged. But it may be able
to reverse this trend by redirecting its formidable R&D capabilities to higher-value spaces
(for example, by shifting away from its traditional focus on hardware and moving more
decisively into software and systems). In an era of rapid-fire technology breakthroughs, there
is enormous potential to increase revenues from creating entirely new categories of goods
and services as well as by creating new value within existing categories—not to mention
the potential to increase margins by applying innovation to management and production
practices to boost labor productivity. The link between productivity and job creation is
particularly strong when efficiencies stem from innovation. Success in high-tech fields could
also improve capital productivity, as it may encourage the formation of new companies and
business models that are more asset-light than other types of heavy industry.

Japan can boost productivity by redirecting its focus

from hardware to software and systems.

Targeted globalization strategies

The need for Japanese firms to expand into international markets has already been
well established. This will require increased output and will likely increase the need for
labor. Japanese firms need extremely targeted and prioritized strategies to capture
this opportunity. It is critical for firms to have a granular understanding of markets and
customers—not only at the national level, but at the city level. In Africa, for example, MGI’s
Cityscope database suggests that 47 cities will account for nearly 50 percent of African GDP
growth by 2025. In China, 250 cities are expected to account for 28 percent of global GDP
growth by 2025.58 The more accurately firms can target city-level pockets of demand and
the more precisely they can tailor products to local preferences, the more successful they
will be. This is not a matter of simply capturing greater market share, but of making smart
decisions about where to compete and in which market segments.59 Adopting international
standards will be key to helping Japanese firms go global.

Operational excellence along the value chain

Companies will have to strive for new standards of performance in every corporate
function—not just in production but also in areas such as sourcing, procurement, pricing,
and marketing, to name just a few. For example, only two of the top 100 supply chains in the
world are owned by Japanese companies (Honda and Toyota).60 But technology is making
it possible for companies to gain much tighter control over this part of their operations.
E-commerce allows manufacturers to tap suppliers from anywhere across the globe. The
Internet of Things can track materials and components as they move through warehouses
and transportation hubs. GPS-enabled telematics can manage fleets and distribution
networks in real time, while big data–enabled demand forecasting systems can avoid stock-
outs and excess inventory. These types of systems can produce significant cost savings.

58
Urban world: Cities and the rise of the consuming class, McKinsey Global Institute, June 2012.
59
Patrick Viguerie, Sven Smit, and Mehrdad Baghai, The granularity of growth, John Wiley & Sons, 2008.
60
2014 Gartner supply chain top 25: Asia/Pacific. This ranking evaluates performance in return on assets,
inventory turns, and revenue growth.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 59
 Manufacturers can also create platforms that make production both flexible and cost-
effective. As companies penetrate new markets and consumers grow to expect more
personalization, demand is becoming increasingly fragmented. Companies could incur high
development, design, and production costs in this type of environment unless there are real
synergies between products. But some manufacturers are able to solve this problem by
developing product platforms that offer the ability to achieve scale while still offering product
diversity (although it imposes some constraints on the ability to individually tailor features).
This approach is particularly well developed in the automotive industry.61

Platforms reuse components, processes, equipment, and even knowledge and teams
to make an entire product family. Modular platforms, in particular, allow manufacturers to
assemble common subsystems to create distinctive products with varying functionalities,
expanding a company’s portfolio of products while minimizing complexity. This is achieved
by increasing the number of compatible parts and components that can be used across
products and applying this up and down the value chain, from quoting through installation
and delivery. Using different levels of modules to appeal to different market segments is key,
along with pricing discipline that charges a premium for additional customization beyond the
standard modular products. This approach dovetails with the adoption of global standards,
as the world has been shifting toward a more open-architecture approach.

After-sales services and opportunities

Manufacturers are creating new revenue streams by adding services that tie into their
products, such as delivery and installation, operation, maintenance, or systems integration.
The market for these types of offerings is growing, especially in emerging economies.
Japanese companies are generally known for providing excellent service but have been
slow to monetize this part of the value chain. To go this route, companies will need to
professionalize their service arms (potentially adding employees) and develop pricing
models in which customers pay different amounts for various agreed-upon service levels.
Some companies may experiment with business model innovations, in some cases going
so far as to transform themselves from product companies to service companies.

Adopting next-generation technologies

New manufacturing technologies
The coming decade will bring an ongoing wave of innovation in manufacturing that reinvents
the assembly line yet again—and new technologies can push the boundaries of what
can be achieved through lean concepts. Firms will have to embrace these developments
to keep pace and capture new sources of value. This could mean adopting ubiquitous
sensor networks and big data analytics for more efficient, higher-quality production or
using 3D printing to achieve mass customization or more accurate product molds. These
and other manufacturing technologies present opportunities for increased revenue from
new product and service offerings as well as cost savings, faster time to market, and
quality improvements.

By implementing these changes, Japanese manufacturers can achieve a long-term

improvement in capital productivity. Since technology continues to evolve at an accelerated
pace, adoption is not a one-time investment; companies have to continuously watch for new
breakthroughs they can integrate into their own business models.

61
Olivier L. de Weck, Eun Suk Suh, and David Change, Product family strategy and platform design
optimization, presented at the 2003 ASME Design Engineering Technical Conference, September 2003; David
Robertson and Karl Ulrich, “Planning for product platforms,” MIT Sloan Management Review, July 1998. See
also Claire Bal, “Toyota wants TGNA platform to close gap with VW, Hyundai,” Automotive News Europe,
December 12, 2013.

60 McKinsey Global Institute 3. A sector-level road map

 The use of industrial robots in production could automate up to a quarter of all industrial
tasks in developed countries by 2025.62 Japan is already leading the way, with the greatest
absolute number of industrial robots deployed in the world. It is second in the world in terms
of robot density, with 323 robots deployed for every 10,000 workers in 2013 (behind only
South Korea, with 437).63 This trend toward automation can smooth the way for adopting the
modular production approaches described above. Perhaps most important, it can mitigate
the impact of Japan’s aging and shrinking workforce, and by reducing the necessary human
labor required for certain functions, it can contribute to higher labor productivity.

Gaining global market share in robotics and 3D printing

Japan is in a strong position to capitalize on growth in robotics—not only for automating
its own operations but for exporting its technology to the world. In fact, it already owns
50 percent of the global industrial robotics market.64 Focusing on exports of additive
manufacturing (3D printing) technology could be another area for rapid growth.

Japan could capture significant growth opportunities by boosting its global market share
for both of these technologies by 5 to 10 percent. To accomplish this, the industry needs to
first target pockets of international demand, such as the rapidly growing market for industrial
robotics in China. The industry can also intensify R&D efforts to continue pushing the frontier
of innovation in these fields, such as the use of robotics in service industries.

Organizing for discipline and performance

The industry landscape is fragmented in a number of Japan’s advanced manufacturing
industries, with many small, inefficient players. Pursuing consolidation through mergers
and acquisitions would allow companies to reach the critical size necessary to benefit from
economies of scale and better optimize their capital and human resources. Larger firms
can improve their cost structure and become more competitive in international markets—in
some cases even regaining their global leadership.

Companies will have to strive for new standards of

performance in every corporate function—not just
in production but also in sourcing, procurement,
pricing, and marketing.

62
“Shaping the future of manufacturing,” McKinsey Quarterly, issue number 1, 2014.
63
International Federation of Robotics statistics.
64
Trends in the market for the robotics industry in 2012, Ministry of Economy, Trade and Industry, July 2013.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 61
 RETAIL

35%
Japan’s retail sector represents a significant part of the economy: it accounts for 9 percent
of total employment and 5 percent of GDP.65 In addition to its large and sophisticated
consumer base, Japanese retail benefits from excellent logistics; many companies routinely
Japan’s
offer same-day delivery or even a one-hour delivery window. High Internet and mobile
productivity gap
penetration has underpinned growth in online shopping.
with the US retail
sector Despite these strengths, Japanese retail is fraught with challenges and inefficiencies.
Forty-seven percent of sales derive from small, often family-owned specialty shops—and
because these businesses are less productive, they create a drag on the overall sector (see
Box 2, “Japan’s retail formats at a glance”). Furthermore, Japan’s persistent deflationary
environment has put a damper on consumer demand; retailers have struggled to maintain
margins and to price products at full value. Finally, in segments such as traditional
convenience stores, supermarkets, and drugstores, the market remains highly fragmented.
Consolidation has been slow, as many retailers that have been family-owned for generations
are hesitant to become part of larger brands. With few large national chains, retailers cannot
achieve the full benefits of purchasing at scale.

Japan has not kept pace with the productivity growth

posted by the US retail sector—but it can close up to
95 percent of the gap.

Recently Japan’s retail sector has begun to change. Since the 2000 repeal of the Large
Scale Retail Store Law, Japan has seen a decline in traditional store formats and an
increase in drugstores, small modern specialty stores, e-commerce, and mail-order/catalog
shopping. This shift has contributed to gains in labor productivity over the past 15 years—
even so, Japan has not kept pace with the productivity growth posted by the US retail
sector. Even large retail chains have not created best-in-class processes and mechanisms
to capture true economies of scale in sourcing and IT systems.

E-commerce is another major source of retail productivity. Japan’s e-commerce market

is already the third largest in the world, with $119 billion in 2014 sales. But it is growing
more slowly (at 7 percent annually) than the US market (12 percent annual growth) or the
Chinese market (which has rocketed ahead to become the largest market in the world,
with 51 percent annual growth).66 Major players such as Rakuten and Amazon are making
strides, but there is still room for brick-and-mortar incumbents to add new channels—and
for disruptive new players to emerge in this space.

New developments could help the Japanese sector gain ground. Retailers can adopt
new technologies to generate consumer insights, forecast demand, and tighten inventory
management; they can also make a more decisive shift to e-commerce and create new
market opportunities by actively catering to seniors. By implementing the specific strategies
outlined later in this section, the retail sector can add $105 billion to $156 billion to its GDP by
2025, an increase of 41 to 61 percent over current 2025 projections.

65
World Input-Output Database, 2014.
66
Ekos Global statistics.

62 McKinsey Global Institute 3. A sector-level road map

 Box 2. Japan’s retail formats at a glance
The retail sector encompasses seven main formats that vary on the basis of
the choices, service, and prices offered to consumers.

ƒƒ Small convenience stores primarily sell food and some general

merchandise products such as toiletries and household items. They are
typically located near residential areas. Two types of store formats are
included in this category.67

—— Small, modern convenience stores that are part of larger chains (such
as 7-Eleven or Lawson) represent 10 percent of this category. They are
typically open 24 hours a day.

—— Small, traditional stores. These are generally family-owned and may

employ two or three family members. Since they are not part of larger
chains, they are hard-pressed to offer a wide range of products or low
prices. This category is dominated by specialty stores with a specific
focus on household goods (71 percent of the overall category), food
(11 percent), or apparel (9 percent). These traditional stores are some
25 percent less productive than the modern convenience stores.

ƒƒ Specialty chains focus on a narrow range of products. Some offer a high

level of service in small stores, while others (category killers) offer a broader
selection of brands within each product and compete on price.

ƒƒ Supermarkets are large-scale stores selling primarily food items. In the

United States, this category is dominated by large chains, but in Japan,
supermarkets tend to be part of smaller chains.

ƒƒ Department stores are large-scale stores offering a broad range of general

merchandise. While they have a heavy focus on clothing, accessories, and
cosmetics, Japanese department stores sell some food items; they also
tend to be very high-end.

ƒƒ Drugstores sell over-the-counter drugs and general merchandise; they also

contain pharmacies.

ƒƒ The non-stores category includes mail-order businesses, catalog

businesses, and e-commerce. The mail-order and catalog business is still
strong in Japan, accounting for 43 percent of non-store sales in 2012, while
e-commerce accounted for 57 percent.

ƒƒ Stores that do not fit into the categories above are simply categorized as
“other.”

See other MGI reports for the traditional vs. modern categorization of store formats, such as
67

A tale of two Mexicos: Growth and prosperity in a two-speed economy, McKinsey Global
Institute, March 2014. MGI’s 2000 study of Japan considered the two types of small stores
described here as separate categories, but they have been consolidated in this report to
better reflect the stores’ purpose and access to consumers; this approach is consistent with
retail definitions used in other parts of the world.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 63
 Productivity challenges
MGI’s 2000 report identified the prevalence of traditional stores as a primary driver of
the sector’s low productivity. Structural barriers slowed the sector’s modernization, as
larger retailers often encountered zoning restrictions that prevented their expansion, while
tax incentives and government subsidies kept traditional stores going. The report noted
that removing these barriers would be key to speeding the sector’s transition into more
productive formats.

Since then, Japan has liberalized the sector by repealing the Large Scale Retail Store Law
and making it somewhat easier to open big-box stores and shopping centers in new areas
(although some barriers remain). It also adjusted laws concerning property, capital gains,
and inheritance taxes that discouraged traditional stores from exiting the market and selling
off their land. As a result of these moves, a growing number of large-scale shopping centers
have opened in Japan’s suburbs. Traditional formats have significantly declined in the past
15 years, but they still account for a large share of the sector’s total sales and employment.
While supermarkets and department stores continue to decline, more modern specialty
chains (such as big-box electronics stores) and drugstores have increased. Thanks in part
to these changes, labor productivity in the retail sector grew at a compound annual growth
rate of 2.2 percent between 2000 and 2011. Despite this improvement, growth has not kept
pace with the US sector.

Traditional store formats have significantly declined,

but they still account for a large share of the retail
sector’s total sales and employment.

Over the past 15 years, the US sector has put an intense focus on value-added pricing
and cost savings. US retailers have become more efficient by introducing innovations in
merchandise management, supply-chain management, and store operations. This has
also been a period of tremendous churn among US industry leaders. Today’s leading big-
box retailers (such as Wal-Mart, Target, Costco, and Home Depot) and e-commerce sites
(most notably Amazon) have set a high bar for efficiency and competitive pricing. As the
Internet has increased price transparency, margins have become razor-thin in many product
categories, and many small independent retailers and less efficient chains have shuttered.68
The US sector is characterized by low wages, irregular hours, and few benefits for many
workers, however. A desire to avoid these outcomes does not mean that Japanese retail
should avoid undertaking a push to improve productivity, but rather that it should focus on
innovation and growth as the major drivers.

While the total number of labor hours worked has remained relatively flat in the US sector,
the real value added generated for each hour worked has risen steadily, which translates
into a continuous increase in labor productivity (Exhibit 16). Over the same period, Japanese
retail has averaged 2 percent annual labor productivity growth, only half the average
annual productivity gains in the United States (4 percent). In 2011, the Japanese sector
produced $24.80 in real value added per hour worked, less than the US sector at $38.20
(and slightly below Germany’s performance). Like Japan, Germany has seen relatively flat
labor productivity growth in retail during this period. Its major retailers, such as Aldi and Lidl,
compete heavily on price and maintain a limited number of SKUs (stock keeping units); this
model has resulted in relatively flat real value added over the years.

68
See “How retailers can keep up with consumers,” McKinsey Quarterly, October 2013, and the case study on
retail trade in US productivity growth 1995–2000, McKinsey Global Institute, October 2001.

64 McKinsey Global Institute 3. A sector-level road map

Exhibit 16

Despite its growing share of modern-format stores, Japan’s retail sector has not kept pace with the US sector
in labor productivity

Germany
Value added
United States $ billion, 2009 at purchasing power parity
Japan 1,200

1,000

800

600
Labor productivity
(real value added per hour worked) 400
$, 2009 at purchasing power parity
200
40
35 0
30 1995 2000 05 2011
25
20
Labor inputs
15
Billion hours worked
10
35
5
30
0
1995 2000 05 2011 25
20
15
10
5
0
1995 2000 05 2011

SOURCE: World Input-Output Database; McKinsey Global Institute analysis

Japan has not fully embraced global best practices in retail, such as focusing on key value
items, implementing cutting-edge pricing strategies, benefiting from economies of scale
in purchasing and distribution, using big data for targeting marketing, and creating more
efficient warehousing operations.69 This has led to gaps with the US sector across all store
formats. A lean mindset, long a source of pride for Japanese auto manufacturing, is not
sufficiently applied in retail. Customer buying habits lead to small average transactions,
thus increasing the cost of sales, while wholesalers capture a large share of value through
excessive intermediation.

69
Why the Japanese economy is not growing: Micro barriers to productivity growth, McKinsey Global Institute,
July 2000.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 65
 Above all, growth and productivity have been dampened in recent years mostly due to the
factors described below.

Low consumer spending

Data suggest that compared with other major developed economies, Japan has
significant room for consumer spending to increase. Japan’s retail spending is equivalent
to 8.3 percent of GDP, which is 32 percent lower than the 12.2 percent share in the United
Kingdom (Exhibit 17). If retail spending rises by two percentage points of GDP, it would bring
Japan into line with the share in the United States and close half the gap with the United
Kingdom. It would produce a 23 percent increase in current gross output, equivalent to
unlocking latent demand of just over $116 billion.

Years of deflation have had a pernicious effect on the retail sector. When consumers expect
falling prices and wages, they are more inclined to postpone or even forgo purchases—and
to look for bargains when they do shop. Retailers are often forced to resort to discounting
to lure shoppers, resulting in price wars and eroded margins. Even in these conditions,
however, there is room to spark greater consumer demand through innovation in both
offerings and formats.

Exhibit 17

The Japanese consumer has significant room for increased retail spending

Retail spending
% of GDP1
13

United
12 Kingdom

11
Potential for growth
United -4
10 States equivalent to
2 23%
9 p.p. increase in current
Japan
gross output
8 Germany ▪ Matching the US level
▪ Closing half the gap with
0 the United Kingdom

2005 07 09 2011

1 Retail spending measured as gross output from the retail sector in national GDP.

SOURCE: World Input-Output Database; OECD; McKinsey Global Institute

66 McKinsey Global Institute 3. A sector-level road map

 Prevalence of less productive formats
Traditional stores and small convenience stores have historically dominated the Japanese
retail sector. Although their share of total retail sales has declined slightly, from 65 percent in
1999 to 52 percent in 2012, they continue to account for the largest share of labor hours and
to bring down the sector’s overall labor productivity (Exhibit 18).

Exhibit 18

Japan’s high proportion of small stores decreases overall labor productivity in the retail sector

Store format Growing Declining

Sales by store format Productivity by format and share of labor hours, 2012
%
Compound Japan retail average
annual growth Value added per hour worked
rate, 1999–2012 $
%
32
5 Department
7 -2 Department store
3 store 30
1 Drugstore
6 5 Drugstore 10 Supermarket
28
5 Supermarket -2 Non-store
Non-store -3 26 Specialty chain Small convenience store Other3
16
24
Specialty 22
27 4
chain
20

18

16

14

65 12
Small
10
52 convenience -2
store1 8

2
6 Other n/a2
4
0
1999 2012 0 10 20 30 40 50 60 70 80 90 100
Share of labor hours
%

1 This category includes small, modern-format stores that are part of larger chains as well as traditional stores that are owned and run by families.
2 “Non-store" retail revenue not reported in 1999, including e-commerce.
3 Includes sales from gas station stores that sell food and/or convenience items.
NOTE: Numbers may not sum due to rounding.

SOURCE: Ministry of Economy, Trade and Industry commerce census; annual reports; McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 67
 Traditional independent stores account for 86 percent of this category. Their average size
is 76 square meters, which is roughly 40 percent of the average size of small modern chain
stores, and they employ an average of four workers per store (including part-time workers).
The productivity of these traditional stores is $23.50 per hour; by contrast, small modern
chain stores post labor productivity of $30.70 per hour (Exhibit 19). Many small Japanese
retailers own their stores’ land. Their low property taxes, combined with high capital gains
taxes and land exemptions from high inheritance taxes, discourage these traditional retailers
from selling.

Exhibit 19

Several store formats within the small convenience store category notably lag behind in
labor productivity

Productivity by format and share of labor hours, 2012 Store format Japan
Value added/hour worked ($) retail
Growing
average
Declining
Value added per hour worked
$
Small, modern
chain stores
32
Traditional, Traditional,
28 food apparel Traditional, household goods, and other1
24
20
16
12
8
4
0
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Share of labor hours
%

1 Includes automotive retail, furniture, fuel, health and beauty goods, leisure goods (including sporting goods). Consistent
with our overall definition of the retail sector, sales are for individual/household purposes or, if they are made by
businesses, they are small quantities or values.

SOURCE: Ministry of Economy, Trade and Industry commerce census and interviews; McKinsey Global Institute analysis

68 McKinsey Global Institute 3. A sector-level road map

 Fragmented industry structure in some formats
While there is a growing trend of retail consolidation, the industry structure remains highly
fragmented in many formats, particularly supermarkets, drugstores, and specialty chains
(Exhibit 20). Only 40 percent of Japanese retailers are part of the top ten national players
vs. 75 percent in the United Kingdom and 76 percent in Germany. This has prevented
investment in automation and technology; larger chains can take fuller advantage of
economies of scale that reduce costs and improve operations. A lack of standardization
inflates capital and operating expenses for stores.

Exhibit 20

Japan’s retail landscape is highly fragmented, with relatively few major national chains

Market share, top players, 2012–13 First tier Second tier Other
% of revenue

Less consolidated More consolidated

Department Convenience
Supermarkets Drugstores Specialty chains Non-store stores stores1

Matsumoto
Kiyoshi
Aeon Retail Holdings Yamada
Ito-Yokado Sun Drug Denki
30 Daiei Tsuruha Bic Camera
34 Holdings Edion Rakuten
Uny 38
Cosmos K's Holdings Amazon. Isetan
Don Quijote Pharma- 48 co.jp Mitsukoshi
ceutical Yodobashi Holdings
Camera Yahoo!
Sugi Japan J. Front
6 2 second-tier Holdings Retailing 7-Eleven
players 72 Japan
Takashimaya
Lawson
Sogo &
Seibu Family-
6 second-tier 91 Mart
24 H2O
players 6 second-tier
23 Retailing Ministop
players
Circle K
Sunkus

64

52

41 14 3 second-tier
39 players

14
9

1 Small traditional/family-operated stores are excluded from analysis since no major player exists.
NOTE: Numbers may not sum due to rounding.
SOURCE: Nikkei estimates and convenience store survey; Japan Chain Drugstore Association; Japan Department Stores Association;
McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 69
 A failure to reap scale benefits even when consolidation has occurred
Although Japan’s retail landscape is relatively fragmented, there is a trend toward
consolidation—and one would expect to see higher productivity as larger companies
achieve economies of scale. But this has not been the case in Japan. Exhibit 21 shows
that while revenues have increased from organic growth and industry consolidation across
multiple store formats, industry profitability and costs have improved only marginally.

Exhibit 21

Some top retail players have consolidated and increased revenue,

but profitability has improved only marginally

Revenue growth and profitability of top retailers1

Net revenue
Index: 100 = 2009
140
4.7% p.a.
130

120

110

100

90

80
2009 2010 2011 2012 2013

Cost of goods sold 69.9 69.8 69.8 69.6 69.5

% of revenue

Selling, general, and 26.1 25.6 25.0 25.1 25.6

administrative costs
% of revenue

Operating profit 4.0 4.3 5.0 4.7 4.6

%

1 Includes the top three to five players from each format (supermarkets, drugstores, specialty chains, department stores,
convenience stores, non-store retailers).

SOURCE: Company financial reports; Bloomberg; McKinsey Global Institute analysis

Even those retail formats with higher rates of revenue growth are not necessarily reducing
their costs or improving their operating margins. The top specialty chains, for example,
posted annual revenue growth of some 5 percent between 2009 and 2013 but were not able
to increase profit margins at all. Many retailers have high selling, general, and administrative
(SG&A) costs as they struggle to provide customized offerings to Japanese consumers
across different regions. Consolidation has also had little impact on the cost of goods
sold (Exhibit 22). Retailers with higher revenue growth posted only limited improvement in
merchandising costs; their procurement processes have not captured the benefits of scale.

70 McKinsey Global Institute 3. A sector-level road map

 Exhibit 22

Even Japan’s more consolidated retail formats are not capturing the benefits of scale

Revenue growth and merchandising synergies of top retailers Revenue size

by store format1

Less consolidation Medium consolidation Higher consolidation

Revenue growth, 2009–13

Compound annual growth rate (%)
16

14 Drugstores

12

10
Non-store
8

4 Convenience
Supermarkets
2 Specialty chains stores

0 Department
stores
-2
-4.5 -4.0 -3.5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0 0.5 1.0 1.5 2.0
Growth in cost of goods sold
% of revenue

1 Includes the top three to five players from each format (supermarkets, drugstores, specialty chains, department stores,
convenience stores, non-store retailers).

SOURCE: Company financial reports; Bloomberg; McKinsey Global Institute analysis

High cost of legacy IT infrastructure

Legacy IT infrastructure has been a general problem in Japanese corporations, and the
situation is no different for the retail industry. One survey indicates that 75 percent of IT
spending in Japan goes toward maintenance.70 This leaves very little for investing in newer
technologies. However, for the retail industry, where there are rapidly changing customer
demands, broad product inventory, and complex supply chains to manage, being up to date
in IT is critical to maintaining high productivity.

Overinvestment in floor space

13%
The Japanese retail sector has expanded its physical footprint over the past decade; total
retail space has increased by 13 percent. The average store size has increased across every
format. In particular, from 2007 to 2012, drugstores increased their average floor space
Increase in retail
by 36 percent, while specialty chains (such as consumer electronics retailers) increased
floor space over
by 25 percent. But revenue growth has not kept pace with this expansion, and as a result,
the past decade
sales per square meter have been declining since 1999. Conversely, US stores have been
shrinking their footprints and holding capital expenditures flat.

“METI considers making IT investment disclosure an obligation for corporates,” Nikkei Shimbun, December
70

8, 2014.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 71
 Japan’s future path: Comparing the retail sector’s current trajectory with a
vision for revitalization
If Japanese retail continues on its current trajectory, the industry will be faced with limited
growth and a sustained gap with US labor productivity. The sector’s value added would
increase by only 1.1 percent annually through 2025. Labor productivity would increase by a
total of 60 percent over the entire period from 2011 to 2025. By then, the Japanese sector
would generate only $40 per labor hour vs. $56 per labor hour in the United States, leaving
Japanese productivity at just 71 percent of the US level. In addition, if the industry continues
to expand total floor space at its current rate, retail sales per square meter will decline by
about 1 percent annually through 2025 (Exhibit 23).

Exhibit 23

Retail revenue has not kept pace with expansion of floor space, which has led to
declining sales per square meter

Retail sales Total floor space Retail sales per square meter
¥ trillion Million square meters ¥ million
144 160
1.07 -2% p.a.
142 155
0.97
0.93
140 0.89
150 0.83
138 145

136
140
134
135
132
130

0 0
99 2000 01 02 03 04 05 06 07 08 09 10 11 2012 1999 2002 2004 2007 2012

SOURCE: Ministry of Economy, Trade and Industry commerce census; McKinsey Global Institute analysis

But Japan has an opportunity to carve out a different path if retailers focus on the
opportunities outlined below. By 2025, the retail sector can make a quantum leap in
performance by deploying new technologies, better serving aging consumers, and
increasing its efficiency and sustainability. Applying the strategies discussed here could
boost labor productivity by up to 39 percent over this period, closing up to 95 percent of the
productivity gap with the US sector.

The new world of Japanese retail could conceivably offer a very different experience in
the future—one in which consumers may not need to go to stores at all. A weekly supply
of groceries, based on their typical shopping patterns, could be delivered straight to
their homes, and big data–enabled predictions could tailor promotional offerings to their
preferences. Large automated distribution centers could handle fulfillment with precision
and at low cost, while automated ground and aerial vehicles make delivery fast and cheap.

72 McKinsey Global Institute 3. A sector-level road map

 When consumers do choose to visit brick-and-mortar stores, location-based technology
could be used to send them personalized recommendations and discounts based on their
shopping history. “Endless aisles” and “virtual mirrors” could enable shoppers to tap into
an online and an offline assortment. Friendly robots using the next generation of artificial
intelligence could answer product questions. Retailers can continue to experiment with
creating unique in-store experiences (such as those pioneered by Apple in its stores). Store
operations could become more efficient, with shoppers gaining the ability to scan items as
they go or use mobile self-checkout. Technology will make it possible to adjust prices and
promotions and to track inventory (including the temperature and expiration dates of food
products) and reorder automatically. Supply chains could be dramatically streamlined by
deploying the Internet of Things and using robots to supplement labor in warehouses.

The retail sector’s future potential will be determined in part by whether it is able to respond
to the changes posed by new global trends. Brick-and-mortar stores will have to evolve in
order to survive in a more digital—and increasingly mobile—retail landscape, developing a
more multichannel approach. In general, selling through digital channels can underpin much
higher productivity in the sector. Previous MGI research estimated that selling through digital
channels rather than a traditional store could produce productivity gains of 6 to 15 percent,
based on reduced labor requirements, inventory efficiencies, and lower real estate costs.71
The shift to e-commerce can have other spillover benefits as well: a 2013 MGI study on
China noted that e-tailing spurred growth in supporting industries such as online advertising
and marketing, payment systems, warehousing, express delivery, and IT services. It
also unlocked additional consumer demand by making a wider product set available to
households. Additionally, e-tailing accelerated consolidation and modernization of store
formats.72

It will be critical for Japanese retailers to become fluent in big data and advanced analytics.
These new capabilities will allow retailers to better understand and segment their customers
and to make both front- and back-end operations (such as sales forecasting, employee
scheduling, and merchandising) more efficient and effective. The Internet of Things, too, can
help retailers manage complex shipments from vendors, while sensors and tags in stores
can avoid stock-outs and signal when reorders are necessary.

Demographic trends will have a significant impact both on consumer demand and on the
retail labor force. The elderly population will be an engine of consumption, and retailers that
can meet the needs and preferences of this segment could be poised for growth. Retailers
have already begun shifting their strategies to meet this new reality. Aeon has begun putting
medical clinics inside its locations, while modern chain convenience stores are shifting to
healthier products and offering delivery services that are particularly valuable to shoppers
who cannot carry heavy packages home. Shifting the product mix and offering new services
to cater to the needs of a population that is growing older will be key.

Urban residents tend to shop frequently, value ready-to-eat selections and portability, and
demand more deliveries with a higher level of complexity (although they are increasingly
unwilling to pay more for convenience or expedited delivery). In response to this trend,
retailers will need to rethink their footprints and invest in smaller, more nimble urban
operations and innovative digital strategies as opposed to sprawling suburban shopping
malls. Furthermore, they will need to develop best-in-class logistics and supply-chain
management to manage the costs of complex networks and increased deliveries.

71
Disruptive technologies: Advances that will transform life, business, and the global economy, McKinsey Global
Institute, May 2013.
72
China’s e-tail revolution: Online shopping as a catalyst for growth, McKinsey Global Institute, March 2013.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 73
 Industry initiatives for jumpstarting productivity and growth in retail
We have identified seven strategies that could boost growth for Japanese retailers by 2025
(Exhibit 24). Together they can produce a significant improvement in labor productivity
of anywhere from 22 to 39 percent (Exhibit 25). This is derived from an increase in value
added (ranging from 41 to 61 percent) plus a 15 percent decrease in labor hours thanks
to increased efficiency. Deploying all of these could help Japan potentially close the
productivity gap with the US sector by 52 to 95 percent by 2025.

Exhibit 24

Productivity levers can help Japan’s retail sector boost value added and make more efficient use of labor by 2025

Lever Impact on value added Impact on labor hours

Smarter store
5.9 -0.5
footprints
Global best
practices
Operational/supply
8.6 -1.9
chain excellence

State-of-the-art IT
n/a n/a
systems1

Pricing and
Next-generation
merchandising 18.2 n/a
technologies
excellence

Mobile e-commerce
and omni-channel 13.9 -4.3
retailing

Transition to modern
6.9 -2.3
formats
Organizing for
discipline and
performance
Economies of scale for
7.7 0
sourcing

Total impact 61.3 -9.0

1 This allows retailers to capture additional value added from scale and operational efficiencies. It can improve operations, supply chains, pricing and marketing
strategies, e-commerce, and purchasing.
NOTE: Numbers may not sum due to rounding.

SOURCE: McKinsey Global Institute analysis

74 McKinsey Global Institute 3. A sector-level road map

Exhibit 25

Japanese retailers have the potential to increase labor productivity by almost 40 percent
over the current trajectory by 2025

Range Low High

Value added
$ billion, 2009 at purchasing power parity

411

Labor productivity, 2025 +61%

(value added per hour worked) 255
$, 2009 at purchasing power parity 218
United States = 56 55 359

22–
39%
40
2011 2025 2025 improved

Germany = 30
25 Labor inputs
48 Million hours worked

8,781

530
-15.0%
-6.0%
790
2011 2025 2025 improved
7,461
-9.0%

2011 Decline in Decline 2025

average from levers
hours per
worker1

1 Average hours per worker gradually decrease over time as general technological progress improves productivity.
NOTE: Numbers may not sum due to rounding.

SOURCE: McKinsey Global Institute analysis

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 75
 Incorporating global best practices
Smarter store footprints
Increasing urban density combined with decreasing sales per square meter should serve
as an impetus for Japanese retailers to rethink their current store footprints. By introducing
all-new types of customer experiences and multiple channels, retailers can rationalize floor
space, saving costs and boosting revenues. Store rationalization and consolidation will likely
result in a decrease in required labor, reducing the total retail workforce by approximately
1 percent.

Operational and supply-chain excellence

As networks become more complex and deliveries increase, retailers must keep tighter
control over their supply chains and distribution to manage costs. They also need to fine-
tune store operations, from displays and merchandising to energy usage and employee
scheduling. New technology tools—from the Internet of Things and big data to automated
self-checkout systems—can make major inroads on these fronts. Increasing automation
and efficiency in these areas will reduce the retail workforce by approximately 2 percent.

Big data analytics will allow Japanese retailers to

understand and segment their customers and to
make front- and back-end operations more efficient.

Adopting next-generation technologies

State-of-the-art IT systems
As the industry consolidates, replacing inefficient legacy IT systems with fully integrated,
state-of-the-art IT architecture will be a critical part of capturing synergies and realizing
economies of scale. Technology can now allow retailers to tighten their management of
multiple channels, complex supply chains, and store operations; it also makes them much
more agile in responding to changing market trends. It will take substantial investment (in
both systems and talent) to build big data capabilities that are on a par with the leading
global players. A recent survey of large enterprises in 13 countries found that 48 percent
of Japanese companies had adopted big data, compared with 82 percent in the United
States.73

Pricing and merchandising excellence

Japanese retailers struggled with pricing during the years of persistent deflation, but with the
return of some limited inflation, they may finally have an opening to raise prices. Companies
can capture new value added by implementing new pricing strategies that combine global
best practices with a much deeper level of marketing insight from big data and advanced
analytics. Drawing on a variety of data sources, sophisticated models can examine
historical sales data to determine pricing at the SKU level, including markdown pricing and
scheduling. E-commerce sites can make individual suggestions for cross-selling, while
physical stores can use location-based marketing and analyze customers’ in-store behavior.
Big data tools can also scan social media to glean new insights that lead to products
and promotions that are better targeted to what customers want. With this new level of
segmentation and customer relationship management, sophisticated demand models can
be designed to guide decisions on which products can command a premium and when
promotions would be most effective.

73
Global tech hot spots: A country-level look at big data & analytics, cloud, mobile, and social, IBM Center for
Applied Insights, November 3, 2014.

76 McKinsey Global Institute 3. A sector-level road map

 Big data can also guide the process of determining the right assortment of products to carry
based on factors such as demographics, buyer perceptions, and economic modeling. It can
even help with optimizing the placement of goods and visual design, analyzing down to the
SKU level to maximize sales per square meter (or sales per online visit).74

Mobile e-commerce and omni-channel retailing

Japan is a wired and affluent society, and these are the necessary ingredients for
e-commerce to flourish. With $119 billion in 2014 sales, Japan ranked as the third-largest
e-commerce market in the world. Perhaps the best-known name in this space is Rakuten,
which hosts more than 40,000 small vendors on its marketplace platform. The company
states that 95 percent of Japanese Internet users have registered with it, and now it is
expanding globally.75 But while e-commerce is already well developed in Japan, there is still
room for growth.

Traditional retailers can continue to expand into the digital space, with a particular focus
on mobile e-commerce. To increase their distinctiveness and relevance, they may need
to reconsider their branding and customer engagement strategies, using social media,
customer loyalty data, and remote touch points to create an omni-channel experience that
leads to “stickier” customer relationships.

Because e-commerce is less labor-intensive than other formats, this shift will likely reduce
the overall retail sector labor hours by 4 percent by 2025. It may also allow retailers to avoid
zoning battles altogether.

Organizing for discipline and performance

Modern-format stores
MGI research has found that one of the most powerful ways to improve productivity
in advanced economies is to close the gap between low-productivity companies and
their more efficient counterparts within the same industry. This is particularly relevant
in Japanese retail, where small traditional-format stores still account for 47 percent of
sales. Modern-format stores capture more value per employee, and a greater weighting
of these will thus increase productivity. It will also lower the need for labor by 2 percent.
Beyond a straightforward shift to modern-format stores, Japan also has the potential for
“leapfrogging” directly to more innovative formats (such as “showrooms” where customers
can try out goods that are purchased digitally, for example) and for the entry of disruptive
new players in e-commerce.

Economies of scale for sourcing

One of the most powerful strategies to improve retail margins is to purchase in large volumes
to reduce costs. Small Japanese retailers often struggle with this issue; further consolidation
would enable them to benefit from purchasing at scale. Even large retailers, however, could
benefit from revamping their procurement processes to leverage their size in negotiations
with suppliers and wholesalers.

Big data: The next frontier for innovation, competition, and productivity, McKinsey Global Institute, May 2011.
74

Rakuten corporate website.

75

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 77
 FINANCIAL SERVICES
A healthy financial services sector is a crucial foundation for any economy. The sector
represents 5.3 percent of Japan’s GDP (well above the G20 average of 3.9 percent) but
employs only 2.4 percent of its labor force. By contrast, 4.2 percent of the US labor force
and 3.1 percent of the German labor force work in financial services.

The sector can be split into three major components: banks, insurers, and other financial
firms and institutions (a category that includes asset managers, credit card issuers,
leasing companies, consumer/business lending operations, and the Japan Agricultural
Cooperatives group, a cooperative society offering banking and mutual fund services).
Our discussion of specific mechanisms for boosting productivity will focus solely on the
banking and insurance industries since these two segments represent some 70 percent of
employment and 84 percent of profits generated in the Japanese financial services sector
(Exhibit 26).76

Exhibit 26

Banking and insurance account for the vast majority of employment and profits
in Japan’s financial services sector

Current industry breakdown, 2014

%

1,787 97,596 $74 billion Major players

27 ▪ City ▪ Bank of
31 ▪ Regional Tokyo-
▪ Trust Mitsubishi
51 Banking ▪ Shinkin/shinkumi UFJ
▪ Others, including ▪ Mizuho
2 Japan agricultural ▪ MUFG
3 cooperatives and ▪ SMBC
Japan Post

39

Insurance
30
▪ Life ▪ Dai-ichi Life
Life
64 ▪ Property and ▪ Meiji Yasuda
casualty ▪ Nissay
▪ Agents
Property
33 3 and casualty
Other ▪ Securities ▪ Daiwa
16 financial ▪ Credit card issuers Securities
businesses ▪ Leasing Group Inc.
▪ Asset management ▪ Nikko Asset
Number Number Ordinary ▪ Consumer Management
of players of em- profit business finance ▪ Nomura
ployees

NOTE: Numbers may not sum due to rounding.

SOURCE: Basic survey on wage structure, Ministry of Health, Labour and Welfare; industry associations;
McKinsey Global Institute analysis

76
McKinsey Global Banking Profit Pools database.

78 McKinsey Global Institute 3. A sector-level road map

 Japan has a unique banking structure. The industry includes three giant “megabanks” that
operate nationally, more than 100 regional banks that operate mainly within their home
prefecture, four trust banks that perform both banking and fiduciary functions, and 400-plus
shinkin banks and credit unions (non-commercial banks that serve union members). The
insurance sector consists of life and property/casualty, as well as a small industry share of
mutual insurance.

Japan’s financial sector was the third largest in the world in 2012, with 12 percent of total
worldwide assets ($11 trillion). Thanks to a large base of affluent customers, Japan’s
personal financial assets were equivalent to 309 percent of GDP, also ranking third in the
world—but ironically, this has dampened productivity, since more than half of these personal
assets are held in cash or cash deposits.77

The conditions may be coming together for the

financial services sector to achieve higher margins,
increase value added, and support new momentum
in the broader economy.

Although Japan is one of the top players in global financial markets, the sector has seen
limited revenue growth due to its low-risk operating model, which keeps margins below
those in Western Europe, North America, and emerging markets. During Japan’s long
period of muted demand, banks tended to funnel excess cash into low-risk, low-return
government debt. From 2000 to 2012, government bonds outstanding increased from
$3.3 trillion to $8.2 trillion.78 The government’s most recent and most aggressive program
of quantitative easing is meant to reverse this trend and spark new lending and investment.
During 2013, for instance, commercial banks reduced their $1.8 trillion bond holdings by
$267 billion, while business lending increased by around 5 percent on an annual basis.79

Jumpstarting the flow of financing and investment is an Abenomics priority, and the
conditions may be coming together for the financial services sector to achieve higher
margins, increase its value added, and support new momentum in the broader economy.

Productivity challenges
For years, Japan’s industry landscape has been marked by ultralow interest rates and fierce
price competition—and as a result, a significant labor productivity gap has formed between
the Japanese financial services sector and its US and German counterparts.80 Between
2005 and 2011, annual labor productivity growth was 4.5 percent in the US sector and
7.6 percent in the German sector, but the Japanese sector actually experienced a decrease
of 2 percent (Exhibit 27). By 2011, Japan’s overall labor productivity in the financial services
sector was only about two-thirds of the US level.

77
Ibid.
78
Japan Ministry of Finance.
79
Masashi Saito and Yoshihiko Hogen, Portfolio rebalancing following the Bank of Japan’s government bond
purchases: Empirical analysis using data on bank loans and investment flows, Bank of Japan, June 2014.
80
These figures compare the entire financial sector in each country, including banks, insurers, and others.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 79
Exhibit 27

Labor productivity has risen in the US and German financial services sectors but declined in the Japanese sector

United States Compound annual

growth rate, Value added
Germany 2005–11 (%)1 $ billion, 2009 at purchasing power parity
Japan total 1,400
2.3
Japan banking 1,200
and insurance
1,000
800
Labor productivity 600
(value added per hour worked)
$, 2009 at purchasing power parity 400 -4.8
140 200
7.1
120 4.5 0
100 1995 2000 05 2011
-2.0
80
60 7.6 Labor inputs
40 Billion hours worked

20 14

0 12
-2.1
1995 2000 05 2011 10
8
6
4 -2.9
2
-0.4
0
1995 2000 05 2011

1 The compound annual growth rates are equivalent for Japan’s total and for its banking and insurance industries only (with the exception of value added,
where Japan’s total is -4.8% and the rate for banking and insurance is -4.9%).

SOURCE: World Input-Output Database; McKinsey Global Institute analysis

The period of 2005–11 was, of course, no ordinary moment in the history of finance. It was
marked by an immense bubble and a deep crisis in the global financial system, with the
United States at the center. However, US banks have bounced back from the depths of
2008–09.

Looking at a longer time horizon, the US sector has experienced a gradual but consistent
trend of labor productivity improvements, achieved by creating higher value added
while reducing its workforce. Banks and insurers have responded to shareholder and
management pressure to keep margins high. In addition, as traditional pension plans
disappear, consumers have assumed responsibility for managing their own retirement
assets; banks and insurers alike compete with brokerages and other types of asset
managers in offering retirement products to individuals and employers.81 The US sector
has introduced new digital and mobile channels and has heavily automated back-office
operations, creating substantial cost savings. Once they are in place, these platforms

81
Retirement plan products and services, US Office of the Comptroller of the Currency, February 2014.

80 McKinsey Global Institute 3. A sector-level road map

 can process an unlimited number of transactions at virtually no cost—and the United
States has been a particular beneficiary of this industry trend because of its sheer volume
of transactions.

Germany’s sector has experienced even stronger growth, given that it started from a
relatively less saturated market. Between 2005 and 2011, its labor productivity grew by
7.6 percent annually. Most of this was due to a 7.1 percent increase in value added, which
was achieved while keeping labor inputs essentially flat. Not only is the German market
relatively affluent, but there is also a growing market for personal retirement plans to
supplement public pensions. These trends have had a positive effect on labor productivity,
as have automation and industry consolidation.82 As in the United States, the German sector
managed to streamline its use of labor.

The Japanese sector, by contrast, has lagged behind. While firms reduced their headcount
by 3.5 percent per year from 2005 to 2011, their value added declined by almost 5 percent
per year over the same period. The financial services sector as a whole has struggled to
increase revenues—not only because of the challenging macroeconomic environment
but also because of its own difficulties in responding to a changing landscape. To fully
understand the factors behind this erosion, it helps to examine the banking and insurance
industries separately.

Japan’s persistently low interest rates have limited

spreads and depressed returns on investments.

Productivity in the Japanese banking sector

The Japanese banking sector grew more consolidated than the US industry during the late
1990s and into the early 2000s, which confers an advantage in labor productivity. Japanese
banks serve their customers with fewer branches and fewer employees than US banks,
partially due to Japan’s higher population density.

Despite this advantage, labor productivity was 22 percent lower for Japanese banks than
for US banks by 2011 (Exhibit 28). The major factors driving this gap include the difficulty of
obtaining significant return on assets, a limited appetite for risk, simpler product offerings,
and intense competition that has driven down pricing.

While US banks have increased their value added through more diverse trading and
investment strategies, Japanese banks have largely confined themselves to low-risk loans
and government bonds. Japan’s persistently low interest rate environment has limited
spreads and depressed returns on investments—and because loan demand has stagnated
over time, banks have been unable to compensate for declining interest margins by
boosting volumes.

Although customer satisfaction with their primary bank has slightly improved over the course
of McKinsey surveys taken in 2011 and 2014, Japan had the lowest levels of customer
loyalty in Asian banking.83 A failure to build deeper relationships harms banks’ ability to
increase advisory revenues and opens up a considerable opportunity for competitors that
are able to design effective marketing strategies. Banks have not been able to fully capture
opportunities in retirement and estate plans, two of the largest concerns for an aging

Eurostat and Deutsche Bundesbank (German central bank).

82

As measured by the preference for customers to go back to their banks for new services and for their
83

willingness to recommend their bank to others. 2011 McKinsey Personal Financial Services Survey and 2014
McKinsey Personal Financial Services Survey, McKinsey & Company.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 81
 population. In addition, they have not sufficiently targeted younger customers as they build
wealth for retirement.

Furthermore, although Japanese banks have digitized many of their operations, online
banking services tend to be more extensive in the United States than in Japan (where they
are mostly limited to checking balances and making remittances). This type of approach to
online banking has limited the opportunity to reduce labor intensity.

Exhibit 28

Lower revenue is the major factor driving Japan’s productivity gap in banking

Labor productivity, 2011 (real value added/hours worked)

$, 2009 at purchasing power parity

117 10

26 Other income
58
5 Other interest
14 Interest on securities

56
73 Interest on loans
117

1 Fees -22%
91 12

Japan Portfolio mix Return on assets Online Non-labor Labor United States
2011 penetration cost input 2011

NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; Japanese Bankers Association; US Federal Deposit Insurance Corporation; IHS;
McKinsey Global Banking Pools database; McKinsey Global Institute analysis

Productivity in the Japanese insurance sector

Japan’s insurance sector trailed the US sector in labor productivity by 29 percent in 2011
(Exhibit 29). There is high market penetration in Japan for life insurance products, but lower
revenues per policy. This applies to both life insurance and property and casualty (P&C);
product offerings and pricing strategies tend to be relatively basic. In addition, the stagnant
economy has constrained consumption of durable goods, creating little growth in demand
for property and casualty coverage.

Insurers, like banks, have struggled with low returns on their investments. Some firms have
partially offset this issue by serving a larger volume of customers per employee, but this
is difficult to sustain given the already high penetration of life insurance, limited product
offerings, and limited consumer demand.

82 McKinsey Global Institute 3. A sector-level road map

 Exhibit 29

The productivity gap in Japan’s insurance industry stems from low revenue per policy
for both life and property and casualty coverage

Labor productivity, 2011 (real value added/hours worked) Property and casualty
$, 2009 at purchasing power parity
Life

296 -110
34
106
76
-36
3
39 -112

190

-5 113
81 -29%

Japan Revenue Cost Policies Population Hours United

per policy per policy per capita per worked States
employee per
employee

NOTE: Numbers may not sum due to rounding.

SOURCE: World Input-Output Database; Japanese Insurance Association; SNL Financial: Business Intelligence Services;
Ministry of Health, Labour and Welfare; McKinsey Global Institute analysis

Japan’s future path: Comparing the current trajectory of financial services with
a vision for revitalization
Japan’s financial sector is on a path of limited growth. Current trends point to a labor decline
of up to 22 percent by 2025, but the revenue gap with the US and German sectors would
likely widen if margins do not improve. Most important, the sector’s performance would
reflect a lack of productive investment across the wider economy.

But the sector could take a different direction by capitalizing on broad trends. An
aging population requires new types of products and services tailored to its changing
needs; retirement and inheritance products can create new sources of revenue. As the
depopulation of rural areas accelerates, banks will have a greater incentive to reconfigure
their physical footprints, leading to more effective capital allocation. Increased global
connectivity provides an opportunity to expand Japan’s current role as a financier of
international infrastructure projects and businesses in emerging economies. Technology will
lead to even more sophisticated and customer-centric digital models.

In this alternative scenario, customers will have the flexibility to purchase a wider array of
financial products through the channels that are most convenient for them. Younger clients
will primarily be self-serving, conducting all their transactions from their smartphones or
tablets and conversing with customer service through instant chats when necessary. Older
customers will have trusted financial advisers they consult on a regular basis for asset
management and retirement planning. A more competitive market could offer innovative
products that benefit consumers—and it could provide a lift to the entire economy by putting
cash reserves to work.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 83
 Industry initiatives for realizing productivity and growth
Whatever Japan’s macroeconomic conditions, individual financial firms still have scope
to improve productivity and capture new growth opportunities. We have identified key
strategies within banking and insurance.

Together these strategies could increase value added up to 44 percent while reducing
the labor required by 9 percent (Exhibit 30). On its current trajectory, the sector’s labor
productivity would grow to only $137 per hour worked in 2025. But we project that the
industry could boost this to anywhere from $159 to $170 in 2025 by undertaking all of these
initiatives. This would represent an increase of up to 24 percent over the baseline.

Exhibit 30

Japan’s overall financial services sector can improve labor productivity by almost 25 percent
over the current trajectory by 2025

Range Low High

Value added
$ billion, 2009 at purchasing power parity

393
24

Labor productivity, 2025 +44%

273
(value added per hour worked)
$, 2009 at purchasing power parity 206
United States = 211 369

170
10
137 24% 2011 2025 2025 improved

Germany = 98
Labor inputs
81 Million hours worked
159
2,554

147 -9.2%

-6.0%
2011 2025 2025 improved 89
2,318
-3.5%

2011 Decline in Decline 2025

average from levers
hours per
worker1

1 Average hours per worker gradually decrease over time as general technological progress improves productivity.
NOTE: Numbers may not sum due to rounding.

SOURCE: McKinsey Global Institute analysis

84 McKinsey Global Institute 3. A sector-level road map

 Incorporating global best practices
Customer insights and customized value propositions, driven by big data
Financial firms collect a vast amount of customer, transaction, and market data, so it is no
surprise that the financial sector has been one of the first to adopt big data analytics on a
large scale. New analytics tools can allow firms to combine disparate data sets, such as
online transactions, observations on how customers behave in branches, data from partner
companies, and retail purchase histories. Obtaining a more comprehensive view of a
customer’s financial picture can be a valuable tool for deepening relationships (provided, of
course, that appropriate privacy standards and safeguards are in place).84 Japanese banks
and insurers are still at the beginning of this journey, but big data could revolutionize how
they identify and interact with customers.

Many banks already segment their customers by wealth and life stage and develop offerings
tailored to various groups. But technology can now take this to the individual customer level.
This capability will allow firms to focus their efforts on the most promising relationships and
fine-tune their value propositions. Big data analytics tools can help firms accomplish this on
a larger scale and at a level of detail that was not possible just a few short years ago (by, for
example, noting when customers are approaching major life events).

An aging population represents a market

opportunity for offering new retirement products and
advisory services.

On the insurance side, it is rare for customers to switch property and casualty carriers, and
insurers have to seize those opportunities. The same kind of data analytics approaches
can target those elusive consumers at exactly the right moment (for example, when they
are about to buy a car or move) with differentiated and targeted offerings. Insurers can also
analyze their existing policy holders to look for opportunities to up-sell. Big data can offer
much more sophisticated and detailed analysis of the risk behind each policy.85

New pricing strategies

Japanese banks, which lag behind many of their international counterparts in interest
revenue, have a significant opportunity to launch a wider variety of products with
differentiated pricing (for example, risk-adjusted pricing for subprime mortgages or
structured finance products for smaller corporations to expand their options for financing).
But introducing more value-adding fee-based products and risk-based interest rates or
pricing has to be undertaken with an abundance of planning and caution to ensure that
customers will absorb these changes. This process has to involve the frontline sales force to
ensure its buy-in; it also has to feature a solid communications plan.

The insurance industry, too, can benefit significantly from using more sophisticated risk
models based on big data analysis to arrive at pricing. One area of growth for the future
could be low-cost coverage, sold mostly online to younger, more price-sensitive customers.

Big data: The next frontier for innovation, competition, and productivity, McKinsey Global Institute, May 2011.
84

Unleashing the value of advanced analytics in insurance, McKinsey & Company, August 2014.
85

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 85
 Broader product offerings
Seniors represent a potentially lucrative customer segment for the financial services sector.
The 55-and-older segment accounts for almost two-thirds of personal financial assets in
Japan. But the industry will have to take a new approach to cementing relationships with
seniors. Financial firms must quickly develop the expertise and services to specifically
target this group, offering tailored advice on retirement and inheritance issues as well as
investment products. In Sweden, for example, Swedbank designates a specific daily hour
for advisers to dedicate their time to senior customers, and senior-specific products and
communications are offered.86 Targeted approaches can pay off across other age groups as
well. Customers begin to worry about long-term retirement planning as early as their thirties,
and almost half of those in their thirties and forties have indicated they will purchase financial
products in the future. With the right marketing and follow-through, the industry could win
their long-term business and even cultivate new attitudes toward saving and investing.

Japan has a heavy concentration of affluent and high-net-worth customers, but they have
historically had a strong preference for cash deposits. The financial services sector has a
huge opportunity to design and market new investment products that will coax them out
of cash deposits and low-risk certificates of deposit in search of better yields. Financial
firms will need to improve frontline capabilities and tools to provide better advisory services
to customers.

Regional banks can capitalize on their deep ties to small and medium-sized enterprises and
local businesses to provide offerings beyond traditional lending (such as real estate advisory,
introduction of management talent, and financing for international expansion). Pursuing this
advisory business would require regional banks to develop new scale and capabilities.

Japan can expand its current role as a financier of

global infrastructure projects and businesses in
emerging economies.

Increased return on assets

Banks are generating lower revenues from low-interest loans, and both banks and
insurers rely on low-yield investments such as government bonds. Players can rethink their
investment strategies to shift toward higher-yield domestic or international assets, finding a
better balance between risk and reward.

Alternatively, banks can boost return on assets through capital optimization and asset-
light financing products. Instead of traditional “originate-to-hold” lending, they can move
to an “originate-to-distribute” model that involves securitizing loans and selling them to
other investors instead of keeping them on the originators’ own balance sheets. However,
securitization on a large scale requires appropriate internal and regulatory safeguards (such
as requirements for banks to retain a minimum share of the underlying loans or transparency
disclosures) to ensure that outsized risks are not dispersed throughout the financial system.

86
Swedbank company website.

86 McKinsey Global Institute 3. A sector-level road map

 Globalization strategy
A number of global trends offer potential areas of growth for financial services in Japan—
starting with the dramatic rise of emerging economies, many of which still lack well-
developed financial systems.

Megabanks in Japan have already been expanding overseas to compensate for declining
performance in the domestic market. In 2011, Japanese banks surpassed German banks
as the world’s largest international lenders. Their share of consolidated international claims
among all banks that report to the Bank for International Settlements rose from 8 percent
in early 2007 to 13 percent at the end of March 2013.87 Japanese cross-border claims in
Asia have more than doubled since the global financial crisis; they accounted for about
10 percent of total foreign consolidated claims as of March 2013.88 This overseas activity
has contributed to revenue growth, although it has not been enough to compensate for
the overall negative impact of falling returns in the domestic market. Further emphasis on
foreign lending and foreign expansion could be an avenue for Japanese banks to grow,
although it presents risks (and indeed, this strategy resulted in heavy losses in the late 1980s
and 1990s).

The global trend toward urbanization also presents an opportunity for Japanese banks
to utilize their liquidity and expand their role as global financiers of infrastructure projects.
Previous MGI research has estimated that cities will need annual physical capital investment
of more than $20 trillion by 2025.89 Emerging Asia alone has some $8 trillion in infrastructure
needs, and Japanese banks have found opportunities in financing utility, transportation, and
communications projects.90 Mitsubishi UFJ Financial Group, SMBC, and Mizuho Financial
ranked among the top five banks for infrastructure financing in 2013.91

Insurers have similarly increased their foreign operations in response to declining revenues
at home. Targeted, prioritized expansions (especially into the most promising markets in
emerging Asia) will be key to creating value.

Adopting next-generation technologies

Automation of processes
By undertaking an end-to-end review of processes, banks can identify and focus attention
on areas that have received little IT investment and digital process transformation. Research
has found that the top 20 to 30 processes account for approximately 40 to 50 percent of
costs and 80 to 90 percent of activities, suggesting the potential for huge savings still exists
in back offices. Gains could be found in functions such as opening accounts, processing
mortgage applications, lending, customer inquiries, credit card issuance, annual reviews,
customer complaints, and cash handling. Although digitizing additional processes takes
setup time and effort, the chances of success improve with well-thought-out training, quality
management and testing, and a structured rollout plan.92

The insurance sector also has ample potential for capturing operational savings on
processes that remain largely manual, such as processing applications and claims. This will
provide more touch points with customers for cross-selling.

87
Adrian van Rixtel and Jeff Slee, “The return of Japanese banks,” BIS Quarterly Review, September 2013. US
banks followed Japan as the next largest cross-border lenders, with a market share of about 12 percent at the
end of March 2013, followed by German banks at 11 percent.
88
Raphael W. Lam, Cross-border activity of Japanese banks, IMF working paper number 13/235,
November 2013.
89
Urban world: Cities and the rise of the consuming class, McKinsey Global Institute, June 2012.
90
Raphael W. Lam, Cross-border activity of Japanese banks, IMF working paper number 13/235,
November 2013.
91
Project Finance International ranking, 2013.
92
“Accelerating the digitization of business processes,” McKinsey Quarterly, May 2014.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 87
 Superior digital platforms and omni-channel distribution
The initial phase of digitization—including the introduction of online banking and mobile
apps—brought greater convenience to customers. But it has required heavy investment in
systems and talent without always delivering the profits that banks and insurers expected.
Today, however, emerging software solutions can help financial firms continue to push
toward digitizing processes and give them greater agility.

Revenues generated by multichannel banking are 110 percent higher than those generated
by single-channel users. Multichannel users on average use nine products (vs. six products
for customers who use two channels and five for customers with one channel). Accessibility
allows customers to explore their product choices more fully, and because they invest
time in customizing their digital interfaces, digital customers have “stickier” relationships
with their banks. A recent survey targeting “digital high-value” customers in Asia revealed
that customers value experience, flexibility, and customization over pricing.93 The shift to
multichannel banking promises a combination of faster and more automated operations,
cost savings, room to adjust pricing, and customer loyalty—a win-win scenario.

To capture the full benefits of digitization, financial institutions will have to continue their
efforts to deliver a truly seamless online and offline experience—while slimming down
or reimagining their branch formats. Banks will need to rethink their footprints, closing
some of their least profitable branches, transforming others to sales and advisory centers,
and incorporating new automated and interactive technologies into others. Self-service
platforms can be used to provide a presence at minimal cost, while branches can refocus
on advisory services. Taken together, this could result in lower real estate costs and added
operational efficiency.

93
Retail banking in Asia: Actionable insights for new opportunities, McKinsey & Company, March 2013.

88 McKinsey Global Institute 3. A sector-level road map

 HEALTH CARE

8.1%
Japan’s ability to provide universal access to quality health care is a point of national pride.
Indeed, Japan is one of the healthiest societies in the world, with life expectancies that top
the global rankings (although this outcome is also likely influenced by the nature of Japan’s
Health-care
traditional diet).94 The nation manages to deliver good outcomes while holding health-care
spending as a
spending to 8.1 percent of GDP, which is well below the levels in other advanced economies
share of Japan’s
(such as Germany, at 11.3 percent, or the United States, at 17.7 percent).95
GDP in 2013

10.7%
Potential share in
But there are serious questions about whether the current trajectory is sustainable. Health-
care costs are trending sharply upward. In 2012, actual expenditures exceeded projections
by some $40 billion. Government estimates indicate that they could total some $515 billion
2025 if no action is by 2025, for an annual growth rate of 3.7 percent.96 This would drive expenditures to
10.7 percent of GDP (Exhibit 31). If health care continues to swallow an ever-larger share
taken
of national spending, it could crowd out consumption and investment in other parts of the
economy and force painful reforms of the tax and social security system.

Exhibit 31

If no action is taken, Japan’s health-care expenditures are on track to rise

from 8 percent of GDP to almost 11 percent of GDP by 2025

Current trajectory of health-care expense growth

Compound annual growth rate (%)
Index: 0 = 2013

4
Health-care costs 3.7

GDP 1.3
1

0
2013 2025

Health care 8.1 10.7

% of GDP

SOURCE: Ministry of Economy, Trade and Industry; Ministry of Health, Labour and Welfare; McKinsey Global Institute
analysis

The aging population and the growing incidence of chronic diseases are frequently
discussed as the drivers of health-care costs, but in reality, they are only part of the
story. In some ways, the system is a victim of its own success. Japanese citizens have
developed exceedingly high expectations for their health and longevity. Patients tend to
visit doctors frequently and insist on the most sophisticated treatments; there are few caps
or gatekeeping controls to limit the number of procedures or consultations they can seek
out. The ongoing process of medical innovation also contributes to rising expenditures. The

94
OECD data (2012).
95
Health at a glance: OECD indicators, OECD, November 2013.
96
Council for the next generation healthcare industry, Ministry of Economy, Trade and Industry, June 2014.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 89
 latest drugs, diagnostics, and devices carry high price tags, and patients expect to receive
the full benefits of cutting-edge technologies.

Reimbursement models create incentives that reinforce overtreatment. Providers bill for
each procedure, and hospitals are paid for longer patient stays. Japan took a solid step
with the introduction of a diagnosis procedure combination (DPC) payment system, much
like the billing system used by Medicare in the United States (although Japan’s version
includes a length-of-stay component). It shows promise as a means of controlling costs and
standardizing data, but a limited number of institutions participate.97

In recent years, Japan has resorted to cutting reimbursement rates to providers to contain
costs, and today debate is focused on whether the Japanese economy can withstand the
consumption tax increases that were earmarked to shore up the system. But these types
of measures provide only partial solutions, and repeated rounds will not be feasible. Cost-
containment measures alone are not enough. In fact, they could merely exacerbate existing
pressures on the system. Many Japanese public hospitals are unprofitable.98 Patients are
finding it more difficult to access care, particularly if they need to consult with a specialist.

Japan needs to bend the cost curve in a more fundamental way. With funding and
demographic trends on a collision course, there is growing pressure to consider deeper
measures such as redefining the role of payors, encouraging consolidation, changing
incentive structures, and implementing systems to make performance and outcomes
more transparent.

The good news is that other nations facing similar pressures on their health-care systems
have managed to implement bold reforms, and Japan can draw on their experiences.
Germany, for instance, has a universal multipayor system like Japan’s, and it has had
remarkable success in containing the growth of health-care spending as a percentage
of GDP.99 One of the most important lessons demonstrated in other countries is that
reimbursement changes drive provider changes. Specialization, too, makes providers more
efficient while simultaneously elevating the quality of care.

Health-care costs will likely continue to rise in the years ahead, but there is ample scope
to slow the rate of growth simply by implementing strategies that have already proven
successful elsewhere. Revamping the health-care system could free up some of the
resources that are being put to inefficient use today and reallocate them to meet the growing
long-term care needs of the elderly patient population.

Structural challenges
A number of structural issues combine to increase the stresses on Japan’s system. While
simple measures of labor productivity are not always useful in the health-care sector, it is
important to take stock of how the system’s general structure influences efficiency, cost-
effectiveness, and the quality of care (see Box 3, “The limitations of measuring GDP and
productivity in health care”).

97
Gerard Anderson and Naoki Ikegami, How can Japan’s DPC inpatient hospital payment system be
strengthened? Lessons from the US Medicare prospective system, Center for Strategic and International
Studies, October 2011.
98
Central Social Insurance Medical Council report, Ministry of Health, Labour and Welfare, November 2013.
99
OECD Health Statistics database (2014).

90 McKinsey Global Institute 3. A sector-level road map

 Box 3. The limitations of measuring GDP and productivity in health care
Making health-care more efficient and cost-effective can have an outsized impact on the
Japanese economy due to the sheer size of the sector and the ripple effects of having a
healthier and more productive workforce. But cost savings do not directly translate into
GDP gains because of the way GDP is measured for public and quasi-public sectors in the
national accounts.

In private sectors of the economy, such as manufacturing, GDP is measured as the value
added produced within the sector. But the national accounts approach the government and
health-care sectors differently, basing their GDP on expenditures rather than the value of
output. Because cost-saving measures reduce spending, they reduce GDP in the sector.
The benefits of improved health outcomes for workers across the economy are likewise not
measured in health-care GDP.

Because it is directly influenced by efficiency, productivity would seem to be a useful

concept for evaluating the health-care sector. But this measurement has its limitations. At its
most basic, labor productivity is the output produced for every hour workers put in. This is
simple enough in a sector such as manufacturing—but defining exactly what constitutes an
“output” in health care is a much trickier proposition.

Many comparative studies define health “outputs” by looking at the consumption, or

utilization, of health-care services; they may use measures such as in-patient stays or
the number of consultations. But this approach fails to take into account how effective
these units of service are in producing the sector’s real value—that is, health outcomes.
The outcomes that matter are ensuring access to care, improving the quality of care, and
producing the best possible outcomes for patients.

Several national statistics bureaus are engaged in the process of finding a better way to
measure these types of outcomes, and therefore productivity, in health care, but this is no
easy task. “Value” in health care is a multifaceted concept that might encompass survival
rates for various diseases, recovery time after an intervention, or the degree of health that a
patient regains. Health care is delivered in a multitude of settings, and patients may receive
multiple treatments for the same condition or for conditions that appear simultaneously.
Michael Porter has argued for measuring the total costs over a patient’s entire care cycle
and weighing them against outcomes rather than measuring costs that are broken down by
provider, department, or discrete types of procedures or pharmaceuticals.100

Capturing improvements in the quality of care over time is a particular challenge. Cutting
down on waiting times and shifting nurses from administrative tasks to patient care are
obvious improvements that would boost patient satisfaction, but these types of changes are
difficult to capture in statistics.101

Despite the challenges of quantifying productivity in the health-care sector, Japan needs
a broad and standardized push to collect better data on health outcomes. These data
can serve as the basis for clearer metrics on the performance of individual providers, the
efficacy of various treatments, and best practices—all of which go into the formula for
boosting productivity.

100
Michael E. Porter, “What is value in health care?” New England Journal of Medicine, volume 363, number 26,
December 23, 2010.
101
For a fuller discussion of how to measure productivity in health care, see Paul Schreyer, Toward measuring
the volume output of education and health services: A handbook, OECD Statistics Directorate, working
paper number 31, April 2010; P. S. Hussey et al., “Health care efficiency: A systematic review of health care
efficiency measures,” Health Services Research, volume 44, number 3, June 2009; and Shannon Brownlee,
Joseph Colucci, and Thom Walsh, Productivity and the health care workforce, New America Foundation,
October 2013.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 91
 Heavy and growing demands on the system

13
Japan guarantees universal access to care, and carrying health insurance is mandatory.
There is no gatekeeping system; patients may consult any doctor at any time without pre-
authorization. Co-payments were established to curtail demand and provide another stream
Japan’s annual
of funding. Most patients must pay 30 percent of the cost of care, although seniors (who are
outpatient visits per
the heaviest users of the system) pay only 10 percent.
capita, a number
that is twice the Despite these measures, utilization rates remain very high by international standards
OECD average (Exhibit 32). Japanese patients consult physicians an average of 13 times per year, which
is more than twice the OECD average.102 Many crowd into hospitals whenever they need
to see a doctor due to the widespread perception that hospitals provide the best care.
But even then, a certain level of trust is absent; some patients seek out second and third
opinions (sometimes with repetitive diagnostic testing) before deciding on a course of
treatment. Low co-payments for additional visits provide little deterrent to this approach.

Exhibit 32

Japan’s health-care system has very high utilization rates by international standards

Number of outpatient visits Average length of stay, 2013

per capita, 20121 Days

Japan 13.0 17.2

United States 4.0 5.3

United Kingdom 5.0 5.2

France 6.7 5.4

Germany 9.7 7.5

+86% +139%
OECD average 7.0 7.2

1 2011 data for Japan; 2010 data for United States; 2009 data for United Kingdom.

SOURCE: OECD health data; Business Monitor International; McKinsey Global Institute analysis

Furthermore, the average hospital stay is three times longer in Japan than in other advanced
economies for two main reasons. First, hospitals have incentives to keep patients longer
as they are reimbursed by the day. The government moved to address this issue in 2014
by reducing the reimbursement rates for long-term hospitalization of more than 90 days.103
But this change does not affect the many in-patient stays of shorter duration, and it is
a much more limited measure than implementing an outcomes-based reimbursement
system. Second, hospitals often continue to care for patients who might be better served in
rehabilitation centers or nursing homes, as these specialized care facilities have long waiting
lists.104 Creating an adequate number of so-called “step-down” facilities for convalescing
and elderly patients would free up hospital capacity for acute cases. The shortage of

102
OECD data (2012).
103
The revision of the reimbursement 2014 summary, Ministry of Health, Labour and Welfare, April 2014.
104
See, for example, Kiichiro Onishi, “Reduction in the number of hospital beds in a super-aging society: An
upsurge in isolation deaths,” Japan Hospitals, Journal of the Japan Hospital Association, number 33, July
2014, which finds that there are currently more than half a million patients on waiting lists for specialized
nursing homes in Japan, and they must typically wait more than three years after applying to obtain a spot.

92 McKinsey Global Institute 3. A sector-level road map

 long-term care options means that patients often receive treatment in settings that are not
specifically geared to their needs.

Because the long-term care sector remains underdeveloped in Japan, growing demand
is straining other parts of the system. As mentioned earlier in this report, a quarter of the
population has already passed age 65, and by 2060, this share is projected to rise to
40 percent.105 This points to an increasing burden of care for age-related diseases such as
Alzheimer’s. In addition, as Japan adopts a more Western diet, there is a growing incidence
of diabetes and cardiovascular disease. Traditionally, adult children have cared for their
elderly relatives at home, but this custom is breaking down. The government has taken
steps to expand home- and community-based services and to support new nursing home
developments, but there is still an acute undersupply of specialized care facilities (including
assisted living options that could help seniors with more minimal needs enjoy a greater
degree of independence and quality of life). Resources will need to be reallocated in order to
meet these growing needs and create a long-term care sector with the scale and reach to
serve Japan’s population.

A fragmented provider landscape with imbalances, a lack of specialization, and

inadequate quality controls
On a per capita basis, Japan has more than twice as many hospitals and almost three
times as many hospital beds as the OECD average (Exhibit 33). But the system may actually
have too many beds—and this fact, combined with financial incentives to treat on an in-
patient basis, leads to longer lengths of stay. Japan’s reimbursement model is not currently
equipped to deal with this oversupply and drive a reallocation of resources.

Exhibit 33

Japan has an oversupply of generalist hospitals

Number per million population, 2012

Hospitals Hospital beds

Japan 67.2 13.4

United States1 18.6 3.1

United Kingdom n/a 2.8

France 40.6 6.3

Germany 40.2 8.3

OECD average 29.5 5.0

+127% +168%

1 2010 data for United States.

NOTE: Numbers may not sum due to rounding.

SOURCE: OECD health data; McKinsey Global Institute analysis

Population projections for Japan: 2011 to 2060, National Institute of Population and Social Security Research,
105

January 2012.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 93
 Many Japanese hospitals operate at a loss.106 This situation is frequently chalked up to low
reimbursement rates, but there is another factor at work: the sheer number of independent
small-scale providers. There are few integrated providers that operate multiple facilities.
This industry structure reduces hospitals’ purchasing power and limits their opportunities to
capture administrative efficiencies.

This fragmentation also makes it more difficult to share diagnostic information across the
system, so that patients may not receive coordinated care. Small, generalist hospitals
may lack intensive-care units and other specialized facilities. Surprisingly few institutions
specialize in specific therapeutic areas—and this has repercussions for the quality of care.
Research has shown that outcomes tend to improve with the number of times that certain
procedures are repeated, allowing medical professionals to gain experience.107

Japan has no mechanisms for addressing gaps in the system by encouraging physicians to
practice in certain locations or determine which area of medicine they choose. Specialists
are employed by hospitals, usually receiving salaries that are lower than what they could
earn in a primary care practice. As a result, Japan has an acute shortage of specialists, and
these doctors typically carry heavy patient loads to keep up with demand. The system has
also developed geographic imbalances.

Compared with peer countries, Japan also has a relatively weak system for accreditation.108
Medical licenses are granted for life, and no continuing education or recertification is
required. No central body oversees the quality of physician training. Additionally, data
on treatments and outcomes are not collected systematically, so there is no high-level
mechanism for monitoring the performance of individual providers. This information gap
makes it impossible for patients to evaluate providers based on performance—or to create
a compensation structure based on quality. It can also erode confidence, potentially leading
patients to seek out multiple opinions.

A reimbursement model that creates incentives for a higher volume of procedures

Japan uses a highly standardized fee-for-service model rather than paying for performance
(the United States has long had a similar, if less standardized, model, although it is now
attempting to make the transition to value-based payments). The current Japanese system
rewards providers for generating a high volume of procedures, and it can even encourage
medically unnecessary treatment and testing. A physician may bill separately for examining
a patient, writing a prescription for that patient, and then filling the prescription in his
own small pharmacy. In fact, as reimbursement fees are cut, providers face even greater
pressures to increase the number of patients they see or the number of procedures they
perform—a trend that leads to shorter, more impersonal patient interactions that erode the
quality of care.

Low use of generic drugs

Japan has made clear progress in expanding the use of generic drugs. In 2008, for example,
prescription forms were redesigned so that physician authorization of generic substitution
became the default; incentive payments were also established for dispensing pharmacies.109

106
Tesun Oh and Shingo Kawamoto, “Battle for survival among Japan hospitals lures health funds,” Bloomberg
Business, October 21, 2014.
107
John D. Birkmeyer et al., “Hospital volume and surgical mortality in the United States,” New England Journal
of Medicine, volume 346, number 15, April 2002. Also see, for example, a study in the November 2013 issue
of The Annals of Thoracic Surgery that found high-risk patients had better outcomes when undergoing aortic
valve replacement at hospitals that performed the procedure more frequently. Another study published in the
November 2013 issue of Medical Care found similar results for patients undergoing complex endoscopic
procedures, as did a five-year US study on coronary stents published in 2014 by the journal Circulation.
108
Nicolaus Henke, Sonosuke Kadonaga, and Ludwig Kanzler, “Reforming Japan’s health care system,”
McKinsey Quarterly, March 2009.
109
Toshiaki Iizuka and Kensuke Kubo, “The generic drug market in Japan: Will it finally take off?” Health
Economics, Policy and Law, volume 6, issue 3, 2011.

94 McKinsey Global Institute 3. A sector-level road map

 The government has also taken steps to dispel quality concerns about generics among both
physicians and the general public. As a result of these efforts, Japan’s usage of generics has
reached more than half of the total drugs by volume for which there is a generic alternative
available (and more than 35 percent of its total pharmaceutical market).110 However, there is
room for more aggressive adoption, as Japan still has one of the lowest generic usage rates
among OECD countries—and the price of generics is notably higher in Japan than in other
countries. In 2013, generics represented 30 percent of total drugs prescribed by volume
and 12 percent of total drugs by expense. By comparison, generics account for more than
75 percent of drugs by volume and 20 to 25 percent of drugs by expense in the United
States and Germany.111

Japan’s future path: Comparing the current trajectory with a vision for a more
efficient and sustainable health-care system
Given Japan’s demographic and fiscal pressures, inertia is actually the risky course of
action. Without fundamental structural changes, Japan will be left with few options for
containing costs, and additional rounds of co-payment increases or tax increases could be
economically damaging. The system could be swamped with a level of demand it simply
cannot handle as the population ages. Without an infusion of new specialists, patients could
be hard-pressed to obtain the care they need. Heavy demand could degrade the quality of
care that Japanese citizens have come to expect, and resources would not be available to
take advantage of the latest medical breakthroughs. Providers and payors could sink into
deeper financial straits.

But if Japan can make meaningful changes on both the supply and demand sides, it could
put the system on much firmer and more sustainable footing. It could go beyond meeting
the basic needs of elderly patients and set new global standards for excellent geriatric care
that spans a continuum of needs throughout the aging process.

In this scenario, Japan’s outpatient sector becomes more fully developed and handles
a wider variety of checkups and minor treatments more efficiently. Delivering a greater
share of health-care services in outpatient settings would free up hospital capacity to
focus on acute cases. Drug prescriptions would be renewed online, the price of generic
drugs would fall, and routine checks for many illnesses could be handled remotely. There
are more specialized hospitals, clinics, and nursing homes, and because they belong to
integrated chains, there are able to take advantage of economies of scale and attract the
best management talent. They harness technology to automate non-core tasks, integrate
data, and support clinical decisions. Treatments are based on research into efficacy and
cost-effectiveness. Payor reform leads to better cost controls. With wasteful incentives
removed, fewer unnecessary tests are ordered, and the length of hospital stays goes
down. The emphasis shifts from volume to quality. Patients could be empowered with
better information about the performance of each provider, which would create new
competitive dynamics.

Reforms for boosting efficiency and cost-effectiveness

Today Japan’s health-care expenditures are growing faster than GDP—and if the current
trajectory continues, they will swell to more than 10 percent of GDP by 2025. But we
estimate that the following initiatives can slow the annual rate of growth from the anticipated
3.7 percent to just 1.5 percent. By 2025, expenditures could come in some 22 percent
below projections, holding the line at 8.3 percent of GDP, only slightly above the level in
2013. This would free up resources that could be used to develop a more comprehensive
long-term care sector.

The latest status of pharmaceutical medical costs, Ministry of Health, Labour and Welfare, July 2014.
110

OECD Health Statistics database (2013); Generating value in generics: Finding the next five years of growth,
111

McKinsey & Company, May 2013.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 95
 Furthermore, if Japan implements the productivity initiatives outlined in this report and
successfully boosts GDP growth from 1.3 percent to 3 percent, the growth rate of health-
care expenditures would fall below the rate of GDP growth, putting the system on a much
more sustainable trajectory (Exhibit 34). In this scenario, health-care spending would
decrease to approximately 7 percent of GDP by 2025.

Exhibit 34

Reforms could help Japan cut the growth rate of health-care expenditures in half,
potentially even bringing it below the rate of GDP growth

Compound annual growth rate (%) Health-care costs Growth rate (%)
Index: 0 = 2013
GDP

Pessimistic case Optimistic case

Current trajectory Slower growth of Slower growth of

health-care costs health-care costs plus
improved GDP growth
4
3.7

3 3.0

2
1.5
1.5
1.3
1 1.3

0
2013 2025 2013 2025 2013 2025

Health care 8.1 10.7 8.1 8.3 8.1 6.8

% of GDP

SOURCE: Ministry of Economy, Trade and Industry; Ministry of Health, Labour and Welfare; McKinsey Global Institute analysis

The initiatives below do not represent an exhaustive list of potential reforms. They offer
the broad outlines of reform and are meant to indicate the magnitude of what is possible.
Collectively, they would provide Japan with the flexibility it needs to adopt new medical
technologies in the future and smooth imbalances in the system.

Incorporating global best practices

Changing the reimbursement model
Japan’s current fee-for-service model for reimbursement creates a set of distorted
incentives. Providers are rewarded for ordering additional tests and procedures (even if
they are not considered strictly necessary), prescribing more drugs, and keeping patients in
hospitals for additional nights.

A new payment system (the diagnosis procedure combination, or DPC) was introduced in
2003 in an attempt to shift to a pay-for-performance model. This system of standardized
codes for billing is similar to the diagnosis-related groups, or DRG, system used by Medicare
in the United States. It provides a basic framework for collecting standardized clinical data,
making performance analysis possible; it also represents a step away from the fee-for-
procedure model. There are positive signs that this system is helping to contain costs (DPC
hospitals already post a lower average length of stay than non-participating hospitals, for

96 McKinsey Global Institute 3. A sector-level road map

 example).112 But the system has not been adopted by all hospitals across the country, and it
excludes some procedures and drugs.

Policy makers will need to reopen this issue and consider deeper reforms. One option would
be mandating DPC adoption across the entire health-care system.

A bolder step would be capitation (which pays providers a set amount for each enrollee,
whether or not the individual seeks treatment) or directly linking reimbursement policies
to performance and outcomes. This would remove the current incentives for wasteful
treatments, and more broadly, it could inject more transparency and competition into the
system. Japan could replace across-the-board fee hikes or cuts with pay-for-performance
programs that reward physicians for high-quality care and penalize them for poor-quality or
inefficient care.

To make this shift, Japan needs to complete the transition to a robust electronic medical
records system across all providers and use big data analytics to its fullest potential (see
Box 4, “Concepts that are reshaping health care around the globe,” for additional discussion
on this point). It is also important to note that Japan will have to build up the long-term care
sector in order to achieve a meaningful reduction in the length of hospital stays.

Empowering payors to play a role in containing costs

Japan guarantees universal health care, but its system is not a simple single-payor model.
In fact, there are some 3,000 private insurers, although they are legally prevented from
competing in a meaningful way. This structure keeps another crucial part of the health-care
landscape fragmented.

The government keeps tight control over fees and reimbursement levels but also covers
treatments (such as cold medicines) and services that other systems do not. Insurers do
not perform a gatekeeping or cost-control function, as they do in other countries. They
simply process claims and have very little influence over containing costs. Many of them
are unprofitable and have needed government support. Eliminating that financial support
and removing barriers to competition could potentially have a bracing impact on the
wider sector.

Japan could empower its payors to play a more meaningful role in the system, transforming
them from payors to real players. Instead of imposing uniform reimbursement rates, Japan
could give insurers greater flexibility to negotiate with their contracted providers and adjust
reimbursement formulas (for example, declining to pay for services that are medically
unnecessary or do not meet a certain threshold of cost effectiveness). Payors could also
begin to use more sophisticated predictive modeling tools to direct patients through the
system—steering them toward treatments that are not only more cost-effective but also
higher quality. Payors are in a unique position to demand the provider data on outcomes
that is needed to support the fee-for-performance model discussed above, and as an
added incentive, they could be allowed to benefit financially from successful reforms to the
broader system. Once they are given responsibility for real management, there will likely be
a wave of consolidation in the industry—and as companies gain scale, their operations can
potentially become more efficient.

Japan can draw on Germany’s successful experience in reforming the health insurance
landscape by unleashing competition and giving patients a wider choice of health plans.
Germany also established the principle of lifelong coverage, which creates incentives for
payors to take an integrated and proactive approach to managing a patient’s health for the
long term. The German industry has undergone a dramatic consolidation, with the number

The current status in beds for general patients, Ministry of Health, Labour and Welfare, January 2012.
112

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 97
 of payors falling by 89 percent from 1992 to 2013. These changes have contributed to
slowing the growth of health-care costs—and they have given publicly insured patients a
meaningful choice among different health plans.

Reduce the number of outpatient visits per capita through a combination of

co‑payments and performance transparency
Reducing the number of visits per capita requires significant changes on both the demand
and supply sides. A system that requires continuing medical education and recertification
will improve the quality of care and promote a greater culture of trust among patients.
Furthermore, the health-care system as a whole can build on the clinical data aggregated
by electronic medical records to implement a ratings-based system that allows patients
to compare the quality of service and the outcomes achieved by different health-care
providers (much like the UK National Health Service’s Choices website, which posts detailed
performance indicators and allows visitors to leave their own comments). On the other
side, steeper co-payments could be implemented to discourage patients from undertaking
unnecessary additional visits, and reimbursement could be questioned for repetitive testing.

Increase the use of generic drugs

Another reimbursement change that can help control costs would be limiting prescription
coverage to more affordable generic drugs whenever that alternative is available. Japan’s
Ministry of Health, Labour and Welfare has taken steps to expand the use of generic
drugs; meeting its goal of achieving a 60 percent penetration rate by 2017 would save
some $8 billion annually. But even this increase would still leave Japan below international
benchmarks, as generics account for up to 80 percent of total drug volume in other
countries. Continuing the shift toward generics will involve overcoming perceptions among
doctors and patients alike that brand-name pharmaceuticals offer higher quality. Japan also
has unique requirements for generics that drive up their cost to approximately 40 percent of
the cost of branded drugs, but in other countries, generics can drop to as little as 20 percent
of the cost of branded drugs.113

Professionalize procurement function within individual providers

Japan’s renowned “lean” principles, developed in its auto sector, are attracting new
attention from health-care providers around the globe. Japan has ample scope to apply
more of this approach to its own providers, who will have new incentives to boost efficiency
in an environment of increased performance transparency and competition. McKinsey’s
experience in hospital transformation projects indicates that institutions can achieve up to a
7 percent reduction in non-labor costs through better procurement practices, for example.

Adopting next-generation technologies

Accelerate digitization of medical records and connectivity among providers
There are major efficiency gains still to be captured from electronic medical records and
big data tools. Most hospitals already have solid technology systems in place, but the key
will be connecting these systems and ensuring interoperability across providers. When the
broader system becomes more efficient at sharing information, the number of unnecessary
procedures and treatments can be reduced. This not only relieves the burden on the
system, but it also increases the quality of care as diagnosis and treatment become better
coordinated. Furthermore, health-care providers can eliminate some unnecessary costs,
save time, and reduce errors by digitizing manual processes.

113
“Generic manufacturer of Atorvastatin saves NHS £350 million in first 12 months,” British Generic
Manufacturers Association, May 14, 2013; Facts about generic drugs, US Food and Drug Administration,
July 2013.

98 McKinsey Global Institute 3. A sector-level road map

 Become a global leader in emerging areas of medicine
This is an age of medical breakthroughs. Already, 3D printers are being used to produce
artificial organs and implants, and robots are being deployed in medical settings—not
only to deliver basic daily care but even to assist in complex surgeries. Companies have
developed tiny diagnostic devices (such as capsule endoscopes that contain miniature
cameras), and further developments in nanotechnology will make more procedures
minimally invasive. Genomics researchers are moving the world ever closer to the goal
of personalized medicine. Although new technologies are drivers of health-care costs,
Japan will want to adopt the latest advances for improved patient care. In addition, Japan
has the scientific and manufacturing capabilities to pioneer many of these technologies,
developing treatments and devices that can be exported around the world. Choosing the
right areas of focus and assisting the process of translating basic science through R&D and
commercialization could form an important part of Japan’s agenda.

Organizing for discipline and performance

Financial incentives could encourage some hospitals—especially subscale institutions—
to merge or specialize. Some may abandon acute care and instead become long-term,
rehabilitative, or palliative care providers. Mergers could lead to major savings, allowing
institutions to make better use of IT systems, purchase supplies in greater volume, allocate
resources between facilities, and coordinate the purchasing and location of expensive
medical equipment such as MRI machines. In other words, Japan could aim to reconfigure
the health-care industry’s footprint and services in order to create specialization plus scale.

Reform of the payment system (such as moving to volume targets) would trigger changes
in the industry structure for providers.114 Japan can wield these tools to encourage greater
hospital specialization, which would prevent high-risk procedures from being performed at
low-volume centers.

A key benefit of greater specialization would be improved housing and treatment options
for elderly patients—particularly those with dementia. “Step-down” facilities—whether
rehabilitation centers or home care programs—would become available for patients who
require further treatment after being discharged from the hospital. This shift would not only
improve the quality of the services but would lower costs for the health-care institutions
themselves. The Ministry of Health, Labour and Welfare estimates that more than 2 million
dementia patients are treated in hospitals or in rehabilitation centers (despite lacking
prospects for actual rehabilitation).115 While the patients receive good quality care, the
cost can be more than 50 percent higher than in long-term care facilities that specialize
in dementia patient care. An independent agency that classifies patients according to the
severity of their condition could help ensure the system is providing the right type of care for
each patient.

Increased payments to hospitals may be needed to make specialist hospital practice more
attractive for physicians and address the current shortage. But this type of shift would need
to be undertaken in concert with reform of Japan’s accreditation standards, particularly
board certification in the specialties, to maintain the quality of care throughout the transition.
Japan could also consider exerting more regulatory control over how physicians are trained,
as well as offering incentives to enter certain fields or practice in underserved areas.

114
Volume targets involve reimbursing hospitals only if they perform a given procedure a minimum number of
times during the year.
115
Survey for elderly care payments, Ministry of Health, Labour and Welfare, August 2014.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 99
 Box 4. Concepts that are reshaping health care around the globe
Three interconnected models for delivering health care have been successfully implemented
by other countries in recent years—and they could provide some useful templates for Japan.

The concept of integrated care involves providing seamless treatment and communication
across a patient’s entire contact with the health-care system, coordinating among providers
that may be treating different conditions or picking up the baton at different points in
the patient’s treatment journey. This can involve something as simple as providing full
and complete patient notes and communication during handovers or a more ambitious
model that forms a care team for each patient. This is a more holistic approach that takes
the patient’s overall health into account—and it is especially relevant to treating elderly
patients, who may be coping with multiple ailments. Integrated care can improve the patient
experience, and it can also make the broader system more efficient, as it enables better
allocation of resources, discourages overtreatment, and eliminates room for medical errors
stemming from gaps in communication. Strong integration between payors and providers
can help with implementation. Today the system does include some care managers, but
their role is generally limited to establishing a common system of record keeping.

Standardized care is another concept that shifts the focus of medical decision making
into well-mapped protocols. By studying large clinical data sets, researchers can identify
which treatments produce the best outcomes. Connecting patient records through the
Internet (with the appropriate privacy and data security safeguards) and analyzing them with
the help of big data can enable providers to make use of comparative effective studies; the
same Web-based systems can review prescriptions and detect deviations to ensure that
best practices are being followed. These types of protocols will help to reduce unnecessary
treatments and identify which interventions produce the best outcomes at the lowest cost.

Telemedicine harnesses the power of the Internet to provide clinical services remotely.
This approach is gaining acceptance in a number of countries (including the United States
and China), and it can be a valuable tool for handling routine checks of patients with chronic
conditions and creating a more cost-effective alternative to hospital stays. It can address
some of the geographic gaps in the health-care system by connecting rural patients with
doctors in urban hospitals; they can consult via videoconference, and doctors can make
remote diagnoses using images and pathology reports that are transmitted electronically.
Remote intensive care makes the most of available manpower by using cameras, monitors,
microphones, and alarms to track the condition of patients in critical condition. Although
this technology has been available for some time, the penetration rate of such systems in
Japan was estimated at only 5.7 percent.116 This indicates ample room to deploy remote
monitoring technology as it grows more sophisticated and to capture the associated
efficiency improvements.

These models all depend on having a critical foundation in place: a well-designed

electronic medical records system. Records must follow a standard digital format that
can be used and accessed seamlessly by different providers and payors. Japan has taken
initial steps toward implementing electronic health records, but it needs to complete this
push with interoperability and consistent standards firmly in mind. Japan will need a clear
policy framework to enable data sharing while protecting patient privacy and information
security; this can enable big data analytics to produce insights that form the basis of
efficacy studies and public health interventions. It can also aggregate outcomes and
cost-effectiveness by provider, generating the kind of performance data that can be used
to create competition and inform patient decisions. These data sets can also be used by
pharmaceutical companies and medical device makers to boost R&D.

116
Research on socio-economic benefits from ICT in healthcare treatments, Ministry of Internal Affairs and
Communications, 2012.

100 McKinsey Global Institute 3. A sector-level road map

 Creating the right conditions
Revamping an entire health-care system is a complex and contentious process, as the
recent US experience bears out. Stakeholders are often resistant to change, and patients
are understandably concerned about preserving access to care and containing out-of-
pocket costs. There is growing recognition of the magnitude of Japan’s future funding
problem, but that looming concern has yet to translate into bolder action.

The reforms outlined above are not new ideas. They have been shown to work around
the world, including within the German health-care system, which is configured much
like Japan’s. Germany has rolled out multiple complex reforms during the past decade
(including laws to strengthen competition in the sector, a pharmaceutical savings package,
financial reform of public payors, the introduction of a specialist outpatient care sector, and
long-term care reform). Together these measures have successfully contained health-care
expenditures as a share of GDP despite growing pressures on the system.

The good news is that other nations facing similar

pressures on their health-care systems have
successfully implemented reforms. Japan can draw
on their experiences.

To change the system, Japanese policy makers will need to communicate a clear message
that reform is the best way to ensure its survival and its ability to deliver an even higher
standard of care. But issuing sweeping directives from the top down could reduce
the likelihood of buy-in. Stakeholders will be more likely to rise to the challenge if they
are involved in a consultative process that values and incorporates their perspectives.
Japan could convene leading physicians, nurses, and patient advocates to undertake a
comprehensive, well-funded review of the health system with the aim of creating national
consensus on what needs to be done and setting clear benchmarks for reform.

Japan has a road map. Now it needs the political will to start the journey. Reform will be
a process of “continuous improvement” that will happen in stages and require periodic
readjustment. It will take continuity of leadership to create a more sustainable system—
one that is based on a vision that looks decades ahead and is insulated from short-term
political pressures.

•••

Japan’s companies have a wide menu of options for improving productivity and growing
revenues. For the most part, pursuing these opportunities depends on their own willingness
to invest, innovate, and take new risks. But at a broader level, Japan also needs to make
sure that the fundamentals are in place to fuel growth over the long term; these include
human capital, an education system geared to the needs of the economy, an ecosystem
that supports innovation, and greater competitive dynamics. The next chapter examines
how Japan’s public and private sectors can work together to shore up these basic enablers.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 101
© Getty Images
4. THE ENABLERS OF GROWTH

Japan already has many of the building blocks of future growth at hand: a highly educated
labor force, technology prowess, abundant capital, modern and extensive infrastructure,
and a legacy of industrial innovation. But the economy’s foundations need to be shored
up and reconfigured to withstand demographic headwinds as well as the demands of a
hyperspeed, hypercompetitive global economy.

Since 2012, much of the focus has been on the first two “arrows” of Abenomics: bold moves
in monetary policy and fiscal stimulus. But Japan has been slower to unleash the third arrow
of structural reform, which will shake up the status quo and challenge entrenched interests.

Today it has become clear that hard decisions can no longer be postponed. Substantial
structural change is still needed to lift Japan out of its malaise and inject real dynamism into
the economy. Deregulating and reforming individual sectors will be critical, but Japan also
has to create a broader environment that is conducive to growth, starting by putting the right
set of enablers in place.

Human capital, education and skills development, labor market frameworks,

entrepreneurship, innovation, competition, and infrastructure productivity are among the
core issues that will determine whether the Japanese economy has the ability to adapt and
grow in the decades ahead. Abenomics speaks to a number of these priorities, but the
agenda needs to be extended even further. It will take vision, leadership, and persistence
from the public sector to push through fundamental change in these areas. But it is equally
up to the private sector to speed and scale up these efforts.

Tapping new talent sources to address labor shortages and cultivate the next
generation of business leaders
Economic growth can be generated by expanding the size of the labor force or by increasing
productivity. Given Japan’s shrinking population, much of this research has focused on the
actions individual companies and industries can take to jumpstart productivity growth. But
the other side of the equation begs to be addressed as well. Japanese employers already
report having more difficulty than their international counterparts in filling job openings.96
Japan can take steps to bolster the size of its workforce and minimize its looming
labor shortages.

Encourage more women to participate in the workforce and create pathways

to success
Japan’s female labor force participation rate is only 62.5 percent (compared with 69 percent
in Germany and 72.5 percent in Sweden). Many Japanese feel that women should focus
on household duties, and this cultural attitude is exacerbated by a sharp gender gap in pay,
tax policies that discourage two-income families, and a glass ceiling that limits the number
of women in leadership roles. But Japan cannot afford to lose so much potential talent.
Fully mobilizing its human capital has to be a national priority (see Box 5, “Women in the
workforce: Japan’s most underutilized resource”).

More than 80 percent of Japanese employers reported difficulties filling jobs, far above the 36 percent global
96

average, in the Manpower Group’s latest annual survey, The talent shortage continues: How the ever-
changing role of HR can bridge the gap, May 2014.
Box 5. Women in the workforce: Japan’s most underutilized resource
The Japanese workplace remains a man’s world. The A recent survey found that a clear majority of Japanese
World Economic Forum’s Global Gender Gap Report companies offer parental leave, flexible work programs,
2013 ranked Japan only 105th out of 130 countries for and other programs to facilitate work-life balance. But
gender parity in the economy. It ranks 79th for female the existence of these policies has not yet translated
labor force participation—and more than a third of into broad acceptance—and other types of support
employed women work only part time. systems that could propel women into leadership roles
are in short supply. The same survey found that only
A look behind these numbers reveals multiple policy
16 percent of Japanese corporations have mentoring
issues as well as corporate practices and pervasive
programs for women, and less than a quarter have
societal attitudes that are stubbornly slow to change.
executive training programs designed for women.99
Tax incentives, for example, favor single-income families,
Companies will have to focus on building leadership
leading many married working women to accept
skills as well as removing other types of barriers in the
part-time jobs that keep their earnings just under the
workplace. Long hours and after-work socializing are key
eligible threshold.
elements of Japan’s traditional corporate culture, placing
Young mothers, in particular, are likely to drop out of tremendous strains on all employees, but particularly on
the workforce; just over one-third return to work after women who are already struggling to balance work with
having children. Some are discouraged from working by household responsibilities.
long-held family and societal expectations that women
Creating greater workforce opportunity for women in
should stay at home to raise their children and care for the
Japan is not only a matter of social equity. It has become
household. But equally daunting is the scramble to secure
an issue that can make or break Japan’s future prospects
affordable day care. Prime Minister Abe has pledged to
as aging shrinks the workforce, and Prime Minister Abe
dramatically expand the number of child-care slots, but
has emphasized “womenomics” as a core component of
today young families continue to face an acute shortage
his economic agenda.100 Attitudes and customs will not
of options. Yokohama offers a template for change,
shift overnight, but Japan can change in this regard, just
however. Under the leadership of Mayor Fumiko Hayashi,
as other developed countries have done.
the city privatized the sector, adding dozens of facilities
run by new operators. In just three years, Yokohama went Policy makers can lead by example, implementing
from having the longest day-care wait lists in the country workplace changes within government institutions. They
to having no wait list at all.97 will also need to continue leading a public dialogue that
emphasizes the potential boost to economic growth from
Japan’s salary gap also ranks 79th in the world—not only
mobilizing millions of young, highly educated women.
because of the concentration of women in lower-paying,
part-time work but also due to wage discrimination for One study estimated that raising Japan’s female labor
similar roles. Japanese women account for 49 percent of force participation rate to the G7 average would add
university graduates and fill nearly half of all professional a quarter of a percentage point to annual economic
and technical roles. But they occupy only about one in ten growth and increase GDP per capita by 4 percent.101
management positions and account for only 2 percent of Another has suggested that fully closing the gender
corporate board membership. gap in employment would add more than seven million
workers to the labor force, boosting Japan’s GDP by
McKinsey’s past work on the gender gap identified four
nearly 13 percent.102 Japan clearly has much to gain
critical elements that underpin the success of women in
from tapping into what Prime Minister Abe has called the
the workplace: public policies and a social fabric that lead
nation’s “most underutilized resource.”
to progressive attitudes and pro-family support; personal
commitment from top management to make gender
diversity a strategic priority; leadership programs that help
individual women develop as leaders; and transparent
metrics and human resource policies that create equal
opportunities for recruitment and promotion.98 99
Closing the gender gap in Japan, World Economic Forum,
June 2014.
100
Shinzo Abe, “Unleashing the power of ‘womenomics,’” The Wall
Street Journal, September 25, 2013. See also Laura D’Andrea
Tyson, “Japan’s women to the rescue,” The New York Times,
97
Mami Maruko, “Yokohama day care centers scramble to keep kids August 23, 2013.
off waiting lists,” Japan Times, June 18, 2013. 101
Chad Steinberg and Masato Nakane, Can women save Japan? IMF
98
Women matter 2013: Gender diversity in top management: Moving working paper WP/12/248, October 2012.
corporate culture, moving boundaries, McKinsey & Company, 102
Womenomics 4.0: Time to walk the talk, Goldman Sachs Portfolio
February 2013. Strategy Research, May 2014.

104 McKinsey Global Institute 4. The enablers of growth

 The government has recognized that expanding child care is a critical starting point. The
drop-off in participation rates is particularly steep when women reach prime childbearing
age—and this has the unfortunate side effect of removing them from the career ladder at the
very stage when they might otherwise begin moving up into managerial roles. As Exhibit 35
shows, this problem is not unique to Japan by any means, but it has heightened urgency
in light of the country’s aging workforce. Additionally, Japan can remove tax policies that
encourage married women to opt of the workforce or to choose low-paying part-time work.
For its part, the private sector will need to step up on this issue by changing traditional
corporate cultures that have constrained opportunities for women.103

Exhibit 35

Japanese women step off the career ladder during their prime child-bearing years
ESTIMATES
and occupy few senior leadership roles

University Entry-level Mid- to senior Executive

graduates professionals management committee CEO Board

China 50 55 21 9 1 8

India 42 29 9 3 <1 5

Japan 49 45 11 1 <1 2

South Korea 48 40 6 2 <1 1

Singapore 49 50 20 15 8 7

Malaysia 57 53 11 n/a 5 6

Indonesia 57 47 20 n/a 5 6

Australia 57 45 n/a 12 3 13

Taiwan 49 44 18 9 1 8

Hong Kong 54 52 23 11 2 9

SOURCE: McKinsey proprietary database, 2011; government publications

Retain experienced workers as they age

Encouraging an aging population to remain engaged in productive work is another way for
Japan to increase the size of its labor force—and to ensure that the economy is not drained
of valuable experience and skills as a large cohort nears retirement. Individual companies
can do a great deal to change their policies, create less physically demanding roles, and
adjust the ergonomics of the workplace to accommodate the needs of aging workers. This
would be a great opportunity for Japan to pioneer new workplace approaches. BMW, for
example, redesigned its assembly line to accommodate older workers in one of its German
plants with a host of small changes, including a slightly slower production line, better

See McKinsey’s ongoing “Women matter” series of research reports, including Gender diversity in top
103

management: Moving corporate culture, moving boundaries, November 2013; and Women matter: An Asian
perspective, June 2012.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 105
 lighting, mobile tool carts, ergonomic back supports, and robots to handle some basic
tasks.104

But public policy has to provide the right mandates and incentives to spur these types
of changes on a wider scale. In 2013, Japan began phasing in a gradual increase in the
mandatory retirement age that companies can impose; it was set at age 60 but will rise to
age 65 by 2025. Even before this policy fully takes effect, employers are required to offer
continuing employment options to workers who hit retirement age. The government also
provides subsidies to employers to hire and retain older workers.

As Exhibit 36 shows, Japan already has one of the highest labor force participation rates
in the world for older workers, but since a quarter of the population will be over age 75 by
2055, further policy adjustments and incentives may be needed.105 Many of the new roles
available to older workers after their mandatory retirement age are lower-paid, lower-skilled,
or part time. Improving the options available to those who wish to continue working and
valuing their contributions is not simply a matter of economics. It is also about providing
greater satisfaction, engagement, and autonomy to a large segment of the population
approaching one of life’s big transitions.

Exhibit 36

Japan already has one of the highest labor force participation rates in the world
for seniors

Older workforce, 2012

%

Share of total population age 65+ Share of active

in the labor force labor force age 65+

Japan 19.9 9.5

United States 18.5 5.1

United Kingdom 9.2 3.2

Germany1 4.6 1.9

France 2.3 0.9

1 2011 data for Germany.

SOURCE: OECD; McKinsey Global Institute analysis

104
Ariel Schwartz, “BMW’s new plant built with aging workforce in mind,” Fast Company, February 11, 2011.
105
Ministry of Health, Labour and Welfare.

106 McKinsey Global Institute 4. The enablers of growth

 Address supply constraints by rethinking immigration policies

140K
Even if Japan takes the steps described above, there is a strong likelihood of labor
shortages. Japan will need to identify critical roles that are being affected by an undersupply
of workers (such as the health-care workers needed to care for aging patients, to give just
Foreign students
one example) and consider whether foreign workers could provide at least a partial solution.
studying in Japan
Today foreign workers represent only 1 percent of the Japanese labor force, far below their
in 2011
16 percent share in the United States and 8 percent share in Germany.106

A greater presence of foreign workers would not only fill gaps in specific roles; it could
also bring an infusion of diverse ideas, new energy, and best practices developed in other
countries. One study in the United States, for example, found that every one percentage
point rise in the share of immigrant college graduates in the population increases patents per
capita by 6 percent.107 Forty-four percent of the engineering and technology firms founded in
Silicon Valley between 2006 and 2012 had at least one key founder who was foreign-born.108
Similarly in Ireland, Israel, and India, skilled migrants have played a key role in the growth of
local software clusters.109 In addition, research has found that flows of high-skilled migrants
between countries and other types of cultural ties facilitate cross-border venture capital
deals.110 As of 2011, some 140,000 foreign students were studying in Japan at the tertiary
level.111 They represent a pool of talent that has already begun the process of integrating
into Japanese society. Japan could create programs that build direct connections between
these students and potential employers. It could also re-examine the visa requirements
for obtaining employment after a degree program is completed so that it derives the full
economic benefit from the presence of these students.

While the public sector may need to rethink long-held immigration constraints, Japan’s
private sector can do much more to recruit global talent and create a more inclusive
corporate environment for foreigners. Language barriers, too, would have to be overcome in
order to implement this strategy.

Creating a more dynamic labor force with the skills demanded in a

fast‑changing environment
Japan’s long-standing tradition of lifetime employment has contributed to a certain degree
of economic stasis. Workers who rarely have to compete for new jobs have fewer incentives
to continue acquiring new skills, and an important informal channel of sharing best practices
is lost. But the current wave of disruption sweeping through the global economy means that
some roles are being quickly rendered obsolete while there are sudden spikes in demand for
new skills. Japan can no longer afford to have a rigid labor market; its workforce will have to
evolve quickly to keep pace with changes in global markets and technologies.

106
IMD world competitiveness yearbook executive survey 1995–2014, IMD World Competitiveness Center; US
Bureau of Labor Statistics.
107
Jennifer Hunt and Marjolaine Gauthier-Loiselle, How much does immigration boost innovation? NBER working
paper number 14312, September 2008. See also William R. Kerr, US high-skilled immigration, innovation, and
entrepreneurship: Empirical approaches and evidence, NBER working paper number 19377, August 2013.
108
Vivek Wadhwa, AnnaLee Saxenian, and F. Daniel Siciliano, America’s new immigrant entrepreneurs: Then and
now, Ewing Marion Kauffman Foundation, October 2012.
109
Ashish Arora and Alfonso Gambardella, eds., From underdogs to tigers: The rise and growth of the software
industry in Brazil, China, India, Ireland, and Israel, Oxford University Press, 2006.
110
Sonal Pandya and David Leblang, Deal or no deal: The growth of international venture capital investment,
University of Virginia, November 2011.
111
Education at a glance 2014: OECD indicators, OECD, October 2014.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 107
 Make the workforce more equitable
Japan has taken steps to relax rigid labor laws, but this will need to be an ongoing process
of reform. The greater flexibility afforded by the use of temporary workers has actually
harmed productivity while creating a two-tiered workforce, as discussed earlier in this
report. There is a significant wage gap between regular and non-regular workers; the latter
must also cover all the costs of their own health insurance and pension.

Faster economic growth should allow companies to hire more regular workers, but it will
not be enough in and of itself to create a more equitable system. Policy makers may need
to take formal steps to provide better conditions and benefits for temporary workers—both
to ensure they are protected and to increase their motivation to become more productive.
Public policy can also encourage companies to make the shift to a pay-for-performance
model, which can help to reduce the wage gap between regular and non-regular workers.

Japan will need to create well-chosen, well-designed

training programs on a large scale so that workers
can acquire the skills needed in a fast-changing
digital economy.

Create ambitious retraining programs to meet new business requirements

Effective training programs can help employees acquire the new capabilities needed
to boost productivity, particularly as technology evolves. Recent McKinsey work in the
insurance industry, for example, suggests that a high level of process automation and
digitization could improve productivity and boost sales, but this could require significant
retraining for up to 50 percent of the labor force across the entire value chain.

Since multiple industries face these kinds of transformations, the public and private sectors
will have to work together to ensure that well-chosen, well-designed training programs are
available on a large scale. One possible action would be to build on the e-learning systems
available at many of Japan’s larger companies; with additional funding, these types of
platforms could be expanded to cover emerging technologies and to reach a wider target
group for training. Companies can also be encouraged to collaborate at the industry level
to offer new types of apprenticeships and partner with education providers to design
vocational training and certificate programs that develop specific skills.

Reforming the education system to build talent and capabilities

Instill critical thinking skills
Japan is consistently ranked among the top ten countries in PISA (Programme for
International Student Assessment) test scores for math, science, and reading.112 The system
achieves these outcomes in a relatively cost-efficient manner, with annual costs of $11,000
per student, which is below the OECD average.113 However, Japanese students have the
lowest level of confidence among their peers throughout the OECD when it comes to solving
problems and taking on complex tasks.114 An emphasis on rote memorization can produce
strong results on standardized tests, but new teaching methods, curricula, and real-world
projects can help students learn to problem solve, innovate, and adapt.

112
PISA 2012 results: What students know and can do—student performance in mathematics, reading and
science (volume I, revised edition), OECD, February 2014.
113
Education at a glance 2013: OECD indicators, OECD, September 2013.
114
PISA 2012 results: Ready to learn—students’ engagement, drive and self-beliefs (volume III), OECD,
December 2013.

108 McKinsey Global Institute 4. The enablers of growth

 To support Japan’s goals of enhanced productivity and innovation, students need
to develop industry-specific skills. But critical thinking, an open attitude toward
experimentation, and the ability to collaborate are equally important. These attributes will
prepare Japan’s next generation of workers to adapt to new opportunities and demands
throughout their lives.

Promote a global mindset

A global marketplace also demands foreign language fluency. Japan has long required
six years of English language instruction, yet it posts the lowest English-proficiency levels
among OECD countries (as measured by scores on the Test of English as a Foreign
Language).115 More recently, it has introduced English classes in earlier grades and brought
in assistant language teachers from English-speaking countries. But it remains to be seen
whether these strategies will shift the traditional emphasis away from grammar and written
English, producing better ease with practical spoken English. Policy makers will need
to monitor progress—and to consider emphasizing other foreign languages in addition
to English.

The post-secondary level represents an ideal time to expose students to more global
perspectives. But only 34,000 Japanese tertiary students were studying abroad in 2012,
down from 64,000 in 2002, indicating a drop in the number of young people actively seeking
out international experiences. Japan could benefit from sending more students to study
abroad and welcoming more foreign students to its own universities. Student exchanges
not only build personal connections and the transfer of skills over time, but they also set the
stage for future research collaborations.

The next generation of Japanese workers will need

to develop critical thinking skills, a willingness to take
risks, and a more global mindset—and the education
system has to evolve accordingly.

Create a true education-to-employment pipeline

Previous McKinsey work highlighted the fact that the education-to-employment system in
most countries often fails young people and employers alike. But some programs manage
to bridge this gap, ensuring that students are working to acquire the tangible skills that
employers need. The most effective invite education providers and employers to move
more fluidly into each other’s worlds. Companies can help to design curricula and lend their
employees as “faculty,” while education providers can integrate internships on job sites into
their programs and work to secure hiring guarantees for graduates.116

Japan is unlikely to experience the high levels of youth unemployment seen in other
countries, but the education system still needs to align its curricula to match the economy’s
needs. Sustaining long-term growth requires careful, ongoing evaluation of evolving shifts
in demand for specific skills. One study estimated that service sectors such as health care
and construction face a combined shortage of 2.6 million people, while there are almost
1.9 million surplus manufacturing and office workers.117

115
Test and score data summary for TOEFL iBT tests, Educational Testing Service, 2013.
116
Education to employment: Designing a system that works, McKinsey Center for Government,
December 2012.
117
Japan economic analysis, issue number 44, Estimating potential excess demand for labor, Credit Suisse,
September 2013.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 109
 The Australian Workforce and Productivity Agency could provide a useful template. It
was established in 2012 to facilitate greater collaboration among industry, educators,
and government. The agency administers a National Workforce Development Fund to
deliver training for high-priority industries and occupations. It also develops and monitors
workforce development plans in conjunction with industry skills councils, researches
current and emerging skill requirements across all sectors, and offers independent advice to
government and other entities.118

Fostering a startup culture

Japan does not have a strong track record for disruptive entrepreneurship in recent
decades; few up-and-coming Japanese companies have broken through on a global
scale. Only 3.7 percent of the country’s labor force is engaged in entrepreneurial activity,
compared with 4.5 percent in France, 5.1 percent in Germany, 7.2 percent in the United
Kingdom, and 12.9 percent in the United States (Exhibit 37).119

Exhibit 37

Japan has fallen behind other advanced economies in enterprise creation and growth

Share of labor force engaged in entrepreneurial activity, 20131

%

12.9

Nascent entrepreneurship
9.2 Setting up a new business
7.2

5.1 3.6
4.5
3.7
3.1
2.7
2.2 Early stage
3.6 3.7 Managing a business for
1.5 1.8 2.0 less than 42 months

Japan France Germany United United

Kingdom States

1 Labor force defined as individuals 18 to 64 years old.

NOTE: Numbers may not sum due to rounding.

SOURCE: Global Entrepreneurship Monitor; World Bank; McKinsey Global Institute analysis

This low level of entrepreneurial activity is perhaps unsurprising in a county that regards
cohesion as important and seniority in employment as a sign of success. Individualistic
entrepreneurs may be celebrated as cultural heroes in the United States, but in Japan they
tend to be countercultural figures—or even regarded as self-serving or greedy. Reversing
this perception and igniting Japanese entrepreneurship could enhance job creation,
innovation, and economic vitality.

118
Ibid.
119
José Ernesto Amorós and Niels Bosma, 2013 global report, Global Entrepreneurship Monitor, January 2014.

110 McKinsey Global Institute 4. The enablers of growth

 Increase access to funding
The major hurdle for most startups is access to funding. In the earliest stages, US
entrepreneurs can acquire seed capital from an active community of angel investors—one
that made more than $24 billion available to fledgling enterprises in 2013.120 But in Japan,
angel investing does not exist on the same kind of scale. Regulatory changes undertaken
in 1997 were intended to spur growth in this area, but only $113 million has been invested in
the intervening years.121

Regulators have continued to make changes to try to induce more investment, and Japan
certainly has many individual investors with capital on hand. The issues seem to be a culture
of risk aversion and a lack of information about specific opportunities. One-third of potential
investors in one survey by the Ministry of Economy, Trade and Industry cited not knowing
how to make angel investments and a lack of professional advisers in this area. Japan can
actively try to build a community of angel investors by creating information platforms, and
large corporations could play a role in funding innovative ideas where individual investors
currently do not.

Even if entrepreneurs manage to launch a business and reach the point at which they are
ready to scale up, they face later-stage funding gaps. One study ranked Japan only 39th
in the world for the availability of venture capital, and private equity funding is also minimal
compared with the US industry (at $6 billion in Japan vs. $159 billion in the United States).122
Venture funding grew by 20 percent from 2009 to 2013, with particularly strong momentum
in companies that are going global. But this growth is starting from a low base, and less
than a third of ventures are able to secure further rounds of investment needed to sustain
growth.123

Israel’s success story could provide a useful template. Its Yozma program rapidly expanded
the country’s fledgling VC industry in the 1990s by offering tax incentives to attract
foreign VC investment and matching private capital with government funding. Japan has
established the Innovation Network Corporation of Japan, a major public-private VC fund
that combines government funding and guarantees with private capital from more than two
dozen corporate investors. But it may take even bolder steps to unlock private investment
and expand Japan’s VC industry.

Japan’s finance sector can also expand the mechanisms available to entrepreneurs in the
exit phase. Although initial public offerings are the preferred choice, Japan’s IPO market has
not produced the same volume of successful offerings as the United States. Furthermore,
Japanese companies rely more heavily on senior debt rather than a strategy of IPO or
acquisition, and there is low utilization of options such as mezzanine or project finance.
Regulations have paved the way for a greater and more flexible use of stock options, but
this, too, has been slow to catch on. (Classified stock options have been permitted since
2008, for instance, but Cyberdyne was the first to use this approach in 2014—and the
company was able to succeed in going public as a result.) Promoting a wider variety of
funding options, with appropriate education for both investors and investees, could also
spur the growth of new ventures.

120
Center for Venture Research.
121
Yoshiaki Ishii, “Support from individuals energizes startups,” Toyo Keizai, August 2014.
122
Beñat Bilbao-Osorio, Soumitra Dutta, and Bruno Lanvin, eds., The global information technology report 2014,
World Economic Forum, April 2014; Capital IQ; Asian Venture Capital Journal; IHS.
123
Venture Enterprise Center.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 111
 Promote a supportive legal and regulatory framework for startups
The time and number of procedures that it takes to set up and register a new business
in Japan is just above the OECD average, and only 2 percent of entrepreneurs find
procedures to be a hurdle during startup. However, aspiring entrepreneurs who have not
actually been through the process have a very different perception of how difficult it will be;
a significant number have cited seemingly complicated processes as one of the largest
reasons for not starting a new business.124 Increasing awareness of what is actually involved
in starting a business and making the process even more user-friendly could motivate
greater numbers of potential entrepreneurs to take a leap with their ideas. Japan can also
revisit the framework around intellectual property protection and its incentive structure for
commercializing university research to spur more entrepreneurial activity.

Create an ecosystem that allows entrepreneurs and innovation to flourish

Japan lacks a robust network that connects entrepreneurs, financial institutions, investors,
the educational system, and business mentors. These connections are the key to turning
innovative ideas into startups and startups into successful businesses.

Japan needs to build stronger networks linking

entrepreneurs, investors, educators, and
business mentors.

Business incubators can help pockets of startup activity reach critical mass, and a number
have been launched in Japan. More established entrepreneurs are beginning to see the
importance of providing mentorship for those who are following in their footsteps, emulating
the model developed in Silicon Valley and practiced in high-tech hubs around the world. In
some cases, incubators provide physical communities that offer entrepreneurs the chance
to collaborate (such as Tokyo’s Samurai Startup Island). However, Japan’s current network
of business incubators has limited reach. Most young entrepreneurs turn to family and
friends for advice; few connect with fellow entrepreneurs and successful pioneers.125

The public sector can find ways to mobilize resources and excitement around these kinds
of efforts so hubs will grow and other communities will follow suit. In the United States, for
example, New York has undertaken an ambitious public-private partnership to build the
new Cornell Tech campus, which will offer graduate students an MBA program specifically
designed with a digital, entrepreneurial focus and a collaborative ethos centered on making
products rather than learning theory.126 University-affiliated business incubators (such as
the program established by Waseda University and Tokyo University) that engage with
established mentors and investors can expose students to the process and excitement of
turning ideas into profitable realities. Universities can also grant faculty members stakes in
the intellectual property they develop, allow flexible leaves of absence to start companies,
and offer support for commercializing research.

124
Small and Medium Enterprise Agency, Ministry of Economy, Trade, and Industry.
125
Ibid.
126
Steve Lohr, “MBA programs start to follow Silicon Valley into the data age,” The New York Times, December
25, 2014; Ruth Reader, “Here’s why Cornell Tech is so important to building NYC’s startup ecosystem,”
Venture Beat, December 3, 2014.

112 McKinsey Global Institute 4. The enablers of growth

 Promote an entrepreneurial mindset
A recent survey showed that while Japan has greater confidence that it produces innovative
products and services than other OECD countries, a greater share of the labor force that
perceives positive opportunities hesitates to pursue them by setting up a business due to
the fear of failure.127 Countries that pride themselves on having more entrepreneurial DNA,
such as the United States or Israel, tend to view business failures as noble attempts or
exciting learning experiences to be accepted in stride, but failure is viewed in a dire light by
the Japanese.

The Japanese education system equips students with a strong tool kit of hard knowledge,
particularly in math and science. But as mentioned above, there is little if any emphasis
placed on experimentation. The education system can create a new outlook over the longer
term through classroom activities and startup competitions that encourage risk-taking.
Presenting the stories of successful entrepreneurs can create new aspirations for students
and help them consider starting their own businesses as a promising and desirable career
opportunity. Exploring real-life business challenges in the classroom can provide students
with a framework for the future.

Implementing market-oriented reforms to unleash competition

Competition, both domestic and foreign, fuels productivity. Japan has a number of market
distortions that could be removed, such as barriers to entry for startups, protectionist
measures that limit imports, zoning restrictions, and subsidies that keep unproductive firms
afloat. Japan is already engaged in an ongoing effort to reform the power sector in hopes
that greater competition in the residential electricity market will bring down high prices.
Reducing government intervention in other sectors (such as health care and manufacturing)
would likely lead to a wave of consolidation, allowing companies to realize economies of
scale. Unleashing market forces may lead to greater corporate churn and disruption for
incumbent companies (and workers), but it would ultimately provide a bracing effect on the
economy’s resilience and overall health.

Competition fuels productivity. The birth of new firms

and the closure of failing companies are signs of a
healthy economy.

Promote competition by allowing companies to enter and exit the market

During the 1990s recession, the Japanese government made it a priority to protect
companies and workers during a time of turbulence. Although banks were saddled with
an increasing number of bad loans, additional financing was extended to struggling
companies, which minimized corporate downsizing. While this stabilized the immediate
situation at hand, it has left a legacy of indebted companies that should have folded under
normal circumstances but remain in operation to this day. The same tendency to preserve
stability even at the expense of competitiveness is also apparent in large conglomerates,
which have typically shied away from radical reallocation of resources and from restructuring
underperforming business units.

José Ernesto Amorós and Niels Bosma, 2013 global report, Global Entrepreneurship Monitor, January 2014.
127

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 113
 The birth of new firms and the closure of failing companies is akin to a healthy circulatory
system. The continued operation of highly indebted firms (as well as uncompetitive divisions
of large conglomerates) represents a disorder that hinders that dynamic, constraining
innovation and productivity. Over the past decade, steps have been taken to prevent a
repeat of this issue, including new policies on loan information disclosure, but resolving the
continuing overhang would improve the overall allocation of capital across the economy.

Deepen global trade ties

New trade agreements with fast-growing economies (especially those across emerging
Asia) would open the door for Japanese companies to penetrate new markets and grow
revenues. A new trade pact with Australia went into effect at the beginning of 2015. Trilateral
talks with China and South Korea are ongoing, while bilateral talks with Turkey were just
opened. Negotiations are also ongoing with the European Union. Bringing the Trans-
Pacific Partnership negotiations to a successful conclusion has been a top priority of the
Abe administration. The TPP has the potential to increase trade volumes (most notably
with the United States) and to spur productivity by exposing domestic industries to greater
competition from imports. The cabinet office has predicted that a successful agreement
would boost real GDP by $23 billion over the next ten years, with the automotive industry
reaping the greatest benefits from the removal of tariffs.128

Move toward open standards

Over the years, Japanese industry has often created and maintained its own proprietary
technologies and standards. But this approach has undercut global demand for Japanese
products; it has also slowed innovation and added risk by necessitating complex in-
house development. Shifting to global accepted standards and platforms that allow for
interoperability (such as Linux and Android), and even participating in the creation of these
standards, would be especially critical in software development. It could allow Japan to
draw on an agile open-source community for improved support, bug fixes, updates, and
quality enhancements. Productivity could also improve as developers follow structured
development practices and documentation.

Promote a culture of performance and accountability, including increased

shareholder pressure
Chapter 2 discussed the importance of individual companies changing their incentive
structures to promote talent and reward results. But market and regulatory reforms can
support a culture of performance at an even broader level. Proposed new regulatory
standards call for at least two outside directors on each corporate board, but even stronger
measures may be needed to ensure accountability and improved corporate governance.
One interesting approach has been the creation of a new stock index, the JPX-Nikkei 400,
which includes only the 400 top-performing companies on the Tokyo Stock Exchange
as measured by return on equity. With Japan’s Government Pension Investment Fund
adopting this index as a benchmark, companies now have an incentive to compete on this
critical metric. Further empowering shareholders and improving corporate governance can
create the necessary pressures for companies to invest excess cash holdings and address
profit margins.

Shareholders in Japan have traditionally exercised relatively little pressure for performance,
partially due to limited alternative investment opportunities and partially because of a sense
that stability takes precedence over profitability. But a more activist approach has the
potential to push management to increase revenues and achieve operational efficiencies—
ultimately creating more competitive industries and better allocation of capital across the
entire economy.

128
“Cabinet office estimates TTP agreement will boost $23 billion,” Nikkei Shimbun, October 25, 2014.

114 McKinsey Global Institute 4. The enablers of growth

 Improving productivity in infrastructure
Modern infrastructure underpins Japan’s mobility, trade, and connectivity. But world-
class infrastructure comes at a high public cost, particularly if projects encounter long
delays in planning and delivery or if they are underutilized after their completion. Japan’s
labor productivity in infrastructure is 32 percent below the level in the United States and
25 percent below the level in Germany.

Maintaining one of the highest levels of infrastructure investment in the world, at

approximately 5 percent of GDP, has helped to sustain the Japanese economy.129 The
infrastructure and construction industry accounts for 9 percent of employment.130 Years of
heavy investment have resulted in the world’s largest infrastructure stock (Exhibit 38). Japan
was also confronted with a major rebuilding task in the aftermath of the Great East Japan
Earthquake of 2011, and it is pioneering the incorporation of disaster-resilient features into
major public works.

Exhibit 38

Japan has accumulated the world’s largest infrastructure stock

Total infrastructure stock, 2012

% of GDP

Roads 179
Rail
Ports
Airports
Power
Water
Telecom

85 87
80 82
76
Average excluding Japan = 70 71 73
64
57 58 58
~53

Brazil1 United Canada India United Ger- Spain China Poland Italy Switzer- South Japan
King- States many land Africa
dom

1 For Brazil, road data contain all of transport. Brazil stock revised significantly upward to 46–54% from an earlier published version based on longer time
series showing investment rates in the 1970s and 1980s two to three times as high as those in the 1990s and 2000s. The estimate shown is based on data
provided courtesy of Armando Castelar.

SOURCE: ITF; GWI; IHS; national statistics; McKinsey Global Institute analysis

IHS.
129

World Input-Output Database, 2014.

130

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 115
 This level of funding poses a tremendous challenge for a nation with the world’s highest
public debt burden. Furthermore, by 2032, more than half of Japan’s infrastructure assets
will be more than five decades old, and it will require significant expenditure to keep them
functioning efficiently and safely.131 Japan will need to ensure that every dollar is used as
productively as possible. Based on previous McKinsey research, we estimate that the
strategies described below can help Japan can reduce its annual infrastructure spending by
almost 40 percent.132

Make project selection and project management as rigorous as possible

In the past, Japan has built projects that turned out to be underutilized, but it is critical to
direct investment to where it can underpin economic growth or provide important social
infrastructure, resisting the pressure to create “showcase” projects. Proposals should
be subject to a sophisticated cost-benefit analysis and prioritized using a transparent,
fact-based decision-making process that considers how each project fits into other
policy priorities.

Costs can easily spiral on a major infrastructure build, but more timely and efficient project
delivery can reduce costs by up to 15 percent. An important source of savings would come
from speeding up the approval and land acquisition processes and using big data–related
technologies to plan and manage projects. Advanced 5D building information modeling
(BIM) systems can cut costs by enabling value engineering and ensuring design accuracy.
Actual construction time can be streamlined by monitoring real-time updates on all the
complex aspects of a large-scale project in a central command center. Contracts can be
structured around cost-saving approaches such as design-to-cost principles and the use of
prefabrication and modular techniques.

Use maintenance, optimization, and demand management to extend the life of

existing infrastructure assets
In many cases, it is more cost-effective to invest in extending the life span and capacity
of existing assets than to build new projects. Japan could save approximately 15 percent
on infrastructure investment through the right refurbishment and optimization strategies.
A total cost of ownership approach allows for maintenance planning across the entire
life of the asset, for instance. Japan already has an extensive system of toll roads, which
generate revenue streams and tend to deter heavier usage, but more aggressive and
comprehensive demand-management measures may need to be considered. The Internet
of Things now makes it possible to take these concepts to a sophisticated new level, using
networks of sensors to transmit streams of data regarding maintenance, capacity, and
usage. This allows for much tighter management of transit systems, traffic, air control, and
water systems.

Export world-class infrastructure capabilities and financing

Japan can export its engineering expertise to the rest of the world. Recent MGI research
estimated that Southeast Asia alone has some $3.3 trillion in infrastructure needs through
2030. There are many opportunities to serve as either financier or provider of infrastructure
services in developing economies around the world, but Japan will have to compete
for them.

131
White paper on land, infrastructure, transport, and tourism in Japan, Ministry of Land, Infrastructure, Transport
and Tourism, 2012.
132
For a more in-depth discussion of this issue, see Infrastructure productivity: How to save $1 trillion a year,
McKinsey Global Institute, January 2013.

116 McKinsey Global Institute 4. The enablers of growth

 Japan’s challenge will be transforming ideas into action
The parallels between the current Japanese economy and the Germany economy of
2000 are striking. The reunification of East and West Germany was heralded as a time of
great opportunity, but it was followed by a prolonged slump during the 1990s. Despite its
strong technology and industrial base, Germany found itself mired in an extended period
of weak GDP growth, worsening productivity performance, and limited capital investment
and consumer spending. The nation’s ratio of public debt to GDP rose rapidly, a trend that
seemed destined to worsen given the demographic challenges of its low fertility rate. But
Germany embarked on a pro-growth agenda that included monetary and fiscal policy
moves and broad labor market reforms. Its companies also began to globalize, taking
advantage of the new trade frameworks created by the formation of the European Union,
favorable exchange rates, and low interest rates. These moves paid off in the form of a solid
foundation for competitiveness, and they helped Germany weather the global financial
crisis and the subsequent Eurozone crisis in better shape than most of its peer economies.
Germany has surmounted some of the same challenges facing Japan today, and its
success offers some reason for optimism.

Reform is beginning to percolate through Japan’s economy, although these efforts need to
gain traction, scale, and scope. The “third arrow” has always been the most ambitious—
and the most ambiguous—part of Abenomics. The government has proposed a number
of structural reforms, but much of the heavy lifting of passing legislation and ensuring
implementation still remains to be done. In many areas, even bigger issues have yet to make
their way into the public debate.

The government is moving to create an additional 200,000 child-care slots this year,
for example. New labor regulations have been proposed, including a move to evaluate
employees on their productivity performance rather than the number of hours they put
in and a slight increase in the number of foreign workers in certain fields. Tax incentives
have been created to improve capital access for startups, and within key areas such as
agriculture and the power sector, regulatory reform is being debated or phased in. But the
growing inequality created by a two-tiered workforce, the need for large-scale retraining
programs, and a realignment of the education system are looming issues that Japan will
have to address.

Japan is taking steps in the right direction, but its demographic shift is already under way—
and other countries are not sitting still in the battle for global market share and competitive
advantage. In addition to reigniting growth in the immediate term, Japan has to prepare
for a brave new world of demographic headwinds, fast-paced technological change, and
amplified global competition. The global economy is being radically transformed, and it will
take big ideas and bold moves to ride this wave of change successfully.

There is a narrow window of opportunity for turning the general drive for structural
reform into action. To meet these challenges, Japan has to engage the corporate sector,
government, and even the broader public simultaneously. Structural reform of industry
cannot work without the right policy frameworks. Nor can it work without a new vision for
what it means to be a productive Japanese citizen.

If Japan can successfully mobilize new talent, design effective retraining programs, and
retool its education system, its future workforce will have a distinctly different face. Perhaps
the most dramatic change would be the addition of millions of working women, whose
presence could launch a new wave of female leaders into the ranks of Japan’s corporations
and government institutions. Seniors would remain engaged in productive work, passing

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 117
 their skills and experience on to the next generation, while more immigrants would fill critical
roles, bringing in new energy and new best practices. Japanese workers will be forced
to adapt as the lifetime employment model gives way to a more dynamic and fluid labor
market. They will have to rise to the challenge of competing for jobs multiple times during
their careers, keeping their skills continually refreshed, and understanding that every job
carries a mandate for efficiency and ingenuity. All of this would require a sea change in long-
held attitudes and expectations.

There is a narrow window of opportunity for

turning the general drive for structural reform into
concrete action.

Companies can launch a “fourth arrow” of growth and productivity. Japan’s revitalization
depends on their willingness to invest and innovate. But the business community also
has an obligation to engage on the broader aspects of transforming the economy. Japan
cannot mobilize all of its human capital, for instance, unless individual companies take the
lead in hiring more women and seniors or designing training programs. Long-established
companies can take a more entrepreneurial approach to their business lines—and refrain
from fighting measures to open markets and spur competition in the interest of creating
more expansive economic benefits. Last but not least, helping the government become
more productive and entering into public-private partnerships to advance some of Japan’s
social and economic goals could represent more than just good corporate citizenship; it
could be a significant market opportunity.

•••

Japan will have to pursue an ambitious agenda to break free from a protracted period of
stagnation while simultaneously preparing for a demographic shift of historic proportions.
Focusing on the priorities discussed here can help to address persistent legacy issues and
put Japan in a stronger position to meet its looming challenges. They can also help Japan
look to the future, capitalizing on immense flows of global trade, the rise of billions of new
urban consumers in the emerging world, and technology breakthroughs. With a stronger
emphasis on human capital, agility, innovation, and productivity, Japan can turn the current
wave of global disruption into opportunity.

118 McKinsey Global Institute 4. The enablers of growth

© Alamy

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 119
© Getty Images
APPENDIX: TECHNICAL NOTES

This report analyzes the productivity of Japan with a special focus on four of its main
industries. It tracks how their performance has changed over time, how they are likely to
perform in the decade ahead if current trends continue, and the potential for improvement
if various productivity measures are undertaken. It also measures Japan’s performance at
both the country and the sector level vs. two benchmark advanced economies: the United
States and Germany.

There is a limited amount of comparable data available at the industry level. Therefore,
as detailed below, we have based our analysis on global databases whenever possible
to ensure data consistency. We filled data gaps by turning to national sources, including
government ministries and industry associations. In addition, we used base-case growth
projections for 2025 from IHS Global Insight.

This appendix describes the data and methodology we employed for assessing labor
productivity at both the national and industry levels and for estimating the potential for
productivity improvement by 2025.

1. Analyzing productivity at the country and industry level

We define labor productivity as the value added generated per each hour worked. To
estimate labor productivity and to benchmark Japan vs. the United States and Germany, we
analyzed data from the World Input-Output Database (WIOD).

At the country level, we first looked at value added from 1995 to 2011, which is reported in
nominal prices using local currency by WIOD. We then adjusted all nominal figures to 2009
constant values using annual value added deflators from WIOD. Finally, to make figures
comparable across countries, we then converted national currencies to US dollars using the
purchasing power parity (PPP) conversion rate from the World Bank (World Development
Indicators). Once we obtained figures in 2009 USD PPP values for all three countries for the
period 1995 to 2011, we divided the annual value added by the number of hours worked
during each of those years as reported by WIOD.

At an industry level, we followed a similar methodology as described above, adjusting

nominal value added reported by industry to 2009 US dollars at PPP, using industry-specific
deflators for 1995 to 2011 and 2009 PPP conversion rates at the country level, then dividing
resulting value added by labor hours reported by industry in each of those years.

For the four industries we analyzed, we used the following data:

ƒƒ Advanced manufacturing: We used WIOD data that corresponds to sector ISIC

classifications 30t33 (electrical and optical equipment), 34t35 (transport equipment), and
29 (machinery).

ƒƒ Retail: We used WIOD data that corresponds to sector ISIC classifications 52 (retail
trade, except of motor vehicles and motorcycles; repair of household goods) and 50
(sale, maintenance, and repair of motor vehicles and motorcycles; retail sale of fuel).
 ƒƒ Financial services: We used WIOD data that corresponds to sector ISIC classification
J (financial intermediation) for productivity at the industry level. We further break down
the value added as reported by WIOD at an industry level into three subsectors (banking,
insurance, and other financial services). For Japan we used the breakdown of value
added data as reported by IHS; revenues from the Ministry of Economy, Trade, and
Industry’s Economic Census; and labor inputs as reported by the Ministry of Health,
Labor, and Welfare. To break down data for the United States, we used data from
the Bureau of Economic Analysis for value added and data from the Bureau of Labor
Statistics for labor inputs.

ƒƒ Health care: We used WIOD data that corresponds to sector ISIC classification N
(health and social work).

We also estimated capital productivity, defined as value added generated per unit of gross
fixed capital, at both the country and industry level. For this, we divided value added figures
(in 2009 US dollars at PPP values), obtained as described above, by the annual gross fixed
capital stock of each industry (also in 2009 US dollars at PPP values). These were obtained
following a similar methodology as used to derive value added: we adjusted annual reported
gross fixed capital in nominal national currency to 2009 constant values (using industry-
specific deflators for capital formation as reported by WIOD), and converted all figures into
US dollars using each country’s 2009 PPP values as reported by the World Bank.

2. Calculating the potential for productivity improvements within

specific industries
To estimate the potential for productivity improvements at the industry level, we applied the
following methodology.

First, we projected labor productivity in 2025 under current trends:

ƒƒ We used projections for growth in value added by 2025 at the industry level from IHS.

ƒƒ We then estimated the likely decline in labor hours within the sector by 2025, taking two
factors into consideration: 1) a total decline of approximately 3.7 percent in the workforce
by 2025, based on projections from METI that show the labor force falling from
66.3 million in 2010 to 65.0 million in 2020 and then to 62.6 million in 2030; and 2) a total
decline of approximately 5.8 percent in hours worked per employee by 2025, following
historic trends of declining labor hours as reported by WIOD.

ƒƒ Combining the projections for both value added and labor hours, we estimated the
expected labor productivity of these industries (and for the Japanese economy as a
whole) by 2025.

ƒƒ Similarly, we estimated projected labor productivity at both the country level and at the
industry level for the United States and Germany in 2025 for benchmarking purposes.
These were calculated using industry growth expectations from IHS and historic trends
for labor inputs from WIOD.

Second, we calculated the potential for improved productivity performance if a specific set
of levers is deployed within each of the industries analyzed:

ƒƒ We sized the potential benefit of each one of the individual industry initiatives described
in Chapter 3 of this report, focusing on their impact on revenue increases, the reduction
of non-labor costs, and/or the reduction of labor inputs resulting from efficiency gains.

122 McKinsey Global Institute Appendix: Technical notes

 ƒƒ Our estimate for each lever is based on industry benchmarks, global best practices,
and case studies from McKinsey’s own industry experience. Because the benchmark
usually suggests the performance of the “best-in-class” player within a given industry,
we estimated different rates of success and adoption across different players within a
given industry based on the characteristics of that industry. For example, in retail, large
chain retailers with modern store formats are much more likely than small traditional
retailers to be able to take advantage of economies of scale and to have the capabilities
to improve operations using next-generation digital tools. Our estimated impact for this
lever was therefore adjusted proportionally to reflect the share of the industry that is ripe
for adoption of these strategies. Similarly, in banking, megabanks are more likely to be
able to expand their globalization strategies than small regional banks.

ƒƒ We then adjusted the estimated value added by 2025 for each sector based on expected
improvements in revenue or reductions in non-labor costs.

ƒƒ A similar process was performed on the labor side. We estimated a reduction in the
labor inputs needed within each sector by 2025, using a combination of two factors:
1) a decline in working hours per employee, based on historic trends of technological
progress, as previously described; and 2) a decline in employment numbers as result of
efficiency initiatives that require less labor. Although the labor inputs estimated under this
methodology closely track the labor decline already projected under current trends, it is
worth noting that these outcomes do point to a scenario in which operational efficiencies
result in the elimination of some jobs. However, this trend is partially offset by other
industry initiatives that involve pursuing higher revenues and creating new markets;
capturing this growth will likely require additional labor.

In the case of the health-care industry, the system reforms and industry initiatives described
in this report are mostly focused on containing the growth rate of health-care expense
while maintaining high-quality services and freeing up resources to develop a more
comprehensive long-term care sector:

ƒƒ We arrived at base-case estimates of growth in health-care expenditures by 2025 by

relying on projections from the Ministry of Economy, Trade, and Industry. These were
combined from GDP growth forecasts from IHS to estimate health-care expenses as a
percentage of GDP by 2025.

ƒƒ We then sized individual initiatives to control health-care expenditures and create

operational efficiencies within providers and payors, based on a combination of
international best practices and estimates from Japan’s Ministry of Health, Labour
and Welfare.

ƒƒ As with the other industries, we estimated the labor hours required by 2025 considering
both the general trend of decline in hours per worker and more specific declines in labor
produced by implementing both demand-control initiatives and operational efficiencies.

ƒƒ Although this previous step allows us to estimate labor productivity in the health-
care sector by 2025, we have opted to consider this outcome as an improvement in
controlling health-care costs (and therefore on the ratio of health-care expenditures as
a share of GDP). This metric better reflects the effort to continue delivering high-quality
services and the fact that Japan may opt to reallocate these resources in other areas,
such as the development of a comprehensive long-term care system.

McKinsey Global Institute The future of Japan: Reigniting productivity and growth 123
 3. Estimating potential productivity improvement at the country level by 2025
Once we produced estimates for potential acceleration in productivity growth at the industry
level for the four industries we examined in detail, we extrapolated those improvements to
the rest of the economy using the following methodology:

ƒƒ We began with a base case for value added by 2025 for the remaining industries across
the Japanese economy using country-level growth estimates from IHS.

ƒƒ We then linked each of the remaining industries across the economy to one of the four
analyzed in detail based on their similarities. For example, advanced manufacturing
was linked to other manufacturing industries such as textiles, food and beverage, wood
products, and chemicals; health care was linked to other industries that are heavily
influenced by the public sector, such as education, public administration and defense,
and water transportation.

ƒƒ We broke down the potential value added improvement, expressed in percentage terms,
of the four industries analyzed into the three categories of initiatives: 1) incorporating
global best practices; 2) adoption of next-generation technologies; and 3) organizing for
discipline and performance. We assumed that the benefits of the latter category mostly
apply to industries with higher levels of consolidation (i.e., those in which the top 10
players account for more than 40 percent of their industry’s revenues).

ƒƒ Having identified the potential improvement for the rest of the industries across the
economy in percentage terms, we then used the base case for value added to estimate
the potential improvement to value added, and thus to labor productivity, by 2025 for the
rest of the economy.

ƒƒ On the labor input side, we assumed current trends of labor force reduction continue.
As mentioned above, the estimates under current trends and the estimates based on
industry initiatives that involve pursuing higher growth with more efficient use of labor
show very similar declines.

ƒƒ Adding the estimates for the four industries profiled in this report to estimates for the
rest of the economy, we then arrived at estimated value added and labor inputs for
Japan under a potential scenario for growth by 2025. This produced an 18 to 28 percent
increase in value added over the 2025 base case and an absolute reduction of some
9.5 percent in labor hours between 2011 and 2025.

Finally, our estimates of GDP per capita by 2025 are based on a base case that combines
OECD projections of GDP per capita (from $31,900 in 2011 to $37,100 in 2025) with
estimates on population decline from our proprietary Cityscope 2.55 database (showing a
drop from 127 million in 2012 to 123 million in 2025). Assuming that GDP in 2025 improves
by a similar rate as value added (i.e., by approximately 28 percent), and that population
estimates remain constant at 123 million, GDP per capita has the potential to increase to
$47,700 by 2025 under the best-case scenario for higher growth.

124 McKinsey Global Institute Appendix: Technical notes

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