Dynamism Returns After Lost Decades: Japan’s Transformation

Japan, long plagued by economic and demographic challenges, is undergoing an eye-catching transformation.  To explain these developments, Citi Institute recently spoke to Robert Nakamura, Citi’s Country Officer and Head of Banking for Japan. 

What changes are you observing in Japan's economic landscape?

Japan’s transformation has been long in the making. For much of the past three decades, the country has grappled with rebuilding balance sheets, near-zero inflation and interest rates, and an aging population. These factors contributed to a prolonged period of economic malaise, often referred to as the "lost decades". A narrative of lack of opportunity in Japan became entrenched.

Now, change is afoot. Factors that had been moving below ground for several years have broken surface and become strikingly visible and dynamic. While aggressive monetary easing began back in 2013 as part of Abenomics, the shift to positive interest rates finally happened in March 2024 and now looks to continue to rise as inflation becomes sustainable. This shift has been partly driven by rising wages, which in turn is underpinned by demographic-driven labor scarcity.

But the real change concerns Japanese companies. Long used to a more stable world, corporates are waking up to the confluence of new pressures and are being forced to act with a dynamism not seen for decades. These pressures include labor scarcity and government initiatives focused on corporate governance and returns to asset holders.

Another key consideration for companies is the increased geopolitical uncertainty over Japan’s relationship with China, its largest trading partner, and the U.S., its second largest trading partner on whom it relies for defense. Smaller companies have started to see a reduction of pandemic era government loan support while labor is becoming more costly and interest rates and inflation are rising. There will increasingly be a shaking out of marginally productive “zombie” companies.

All of this adds up to catalyzing change. And we are likely at an early stage. M&A activity in Japan, already high last year, is at a historic pace for the first half of 2025, despite geopolitical events. Still, nearly 40% of Japanese listed companies continue to trade below book value^[1]. On average, companies are cash rich and have underutilized balance sheets. Labor fluidity is increasing and starting to force the dismantling of rigid systems of seniority-based promotion and better resource allocation. There is more change to come.

What is the government's role in reinvigorating the economy?

The government has been pursuing a multipronged approach to invigorating the economy. While the Bank of Japan has focused on avoiding deflation, the government has been encouraging a shift from savings to investment and ensuring robustness of returns to asset owners.

Government initiatives range from the expansion of tax beneficial investment accounts for individuals, to measures strengthening corporate governance, a more balanced stance on shareholder activism, encouraging the development of the asset management industry, and a lowering of frictions for takeovers and foreign participation.

Many of these initiatives have been years in the making but some significant measures are recent, and a critical mass of momentum has formed. We see this, for example, in the dramatic increase in individual investment accounts since the launch of the NISA investment program in 2024; the increased presence of foreign funds in Japan looking to capitalize on a fertile private equity landscape; and the behavioral shift of CEOs engaging more actively with investors and increasingly incorporating return on invested capital (ROIC) in key metrics.

Japan's leaders and institutions are aligned and well-coordinated on policies and synchronized when encountering new situations. This will be particularly important as the country transitions to the next stage, where its capital markets start to move away from domination by the Bank of Japan (BoJ) to one that relies on the private sector to channel savings to investment. The BoJ has intervened in an extraordinary fashion over the last decade and now owns around 50% of Japanese government bonds (JGBs). The ride to normalization will inevitably be bumpy, and coordination will be key to mitigate risks and maintain momentum.
 

What is Japan’s place regionally and globally, more broadly?

Japan's strategic location, economic size, and strong trade relationships position it as a key player in the Asia-Pacific region. It is the U.S.’s most important strategic partner in the Indo-Pacific. On trade and technology, it plays a balancing role between China and the US, while on key technologies it is a trusted partner to the US.

As multilateralism retreats, it is a stabilizing pro-trade voice and promoter of trade norms. Japan’s companies and banks have built a formidable global presence, and the country is the third largest source of outward FDI globally behind the US and China.^[2] They are not only exporters and importers but carriers of industrial know-how, trade discipline, and financial stability. Built over decades and ranging from advanced manufacturing, infrastructure and energy, pharmaceuticals, and biotech to automobiles, trading and logistics, and financing, many are global leaders and essential nodes in the global economic web, spanning both developed and emerging markets.

Japan is also on the forefront of needing to adjust to demographic challenges and is responding in multiple ways including another important change - immigration, which in coordination with other economic objectives, has increased substantially over the last few years.

Japan tends to prioritize consistency, resilience, and pragmatism - traits perhaps valuable in an uncertain world. What happens here is worth paying attention to, not just for the dynamism that is finally returning, but as an example of how a large, developed country attempts to pragmatically navigate the megatrends of a changing world.
 

^[1] Verdad, Unlocking Shareholder Value in Japanese Balance Sheets, March 2025

^[2] World Population Review, Foreign Direct Investment (FDI) by Country 2025