January 6, 1999

New York Times

In Japan, Overcapacity in Manufacturing Sector Slows Recovery

By STEPHANIE STROM

IMABARI, Japan -- Some 25 years ago, Itsuhiro Ochi quit his job as a salaryman at a large textile manufacturer and built a factory
here to make towels.

He is now the proprietor of the biggest business in the biggest industry in this quaint seaside town on the northern coast of Shikoku, the
smallest of the four main islands in the Japanese archipelago, presiding over five factories and 600 employees that produced 3,200 metric
tons of towels last year.

Ochi is a hardy survivor in a Japanese towel industry that is a shrunken version of what it once was. Almost 50 percent of Shikoku's towel
companies closed down in the last decade, wrung out of business by more competitive manufacturers in China and Vietnam and by their
own high cost of doing business.

But with so many low-wage countries able to supply consumers with towels, what is one of the most advanced industrial nations in the
world still doing with 250 factories continuing to churn out many more towels than Japan needs?

The question reveals a lot about Japan's current economic distress, which has been exacerbated by a powerful bias against eliminating the
vast amounts of excess production capacity that plague not just towel makers but also producers of cars, steel, semiconductors, consumer
electronics, auto parts and others.

Wasteful and unneeded production facilities are the biggest drag on Japan's vast manufacturing sector, pulling down profits at giants like
Toyota and Hitachi as well as thousands of anonymous mom-and-pop suppliers. "The real problem in Japan is not the credit crunch," said
Kathy Matsui, the chief strategist at Goldman, Sachs (Japan) Ltd. "The real problem is excess capacity."

Japanese companies continued to invest in factories and equipment even after the so-called bubble economy burst in 1989, blindly
continuing to pursue the export-led growth strategy so successfully used to create economic strength after World War II.

As the economy slid into its deepest recession of the post-war years, tangible fixed assets climbed more than 60 percent, according to
Matsui. Now, a huge portion of those assets are unused or underused, making it all but impossible for companies to justify new
investments to spur growth.

"Government officials here and abroad have been mistaken in describing this recession as a consumer-led recession," said Tadashi
Nakamae, a prominent economist. "It's a recession of over-investment."

The auto industry is everyone's favorite illustration of the problem. Japanese automakers collectively can produce 14 million vehicles here,
but this year they will make just 10.4 million -- 8.5 percent fewer cars than they made in 1997. And as auto operations expand abroad,
the need for so much capacity in Japan will probably dwindle even more.

But so far, companies have either ignored the problem or tried to tackle it with chopsticks when they need a battering ram. The closing of
the Nissan Motor Co. factory in Zama, southwest of Tokyo, in 1995 is the only significant effort at tackling the problem that anyone can
remember. Yet the company retained the plant's employees, a traditional and generous move that left it saddled with the bulk of the plant's
costs.

"We have not let the markets work to close inefficient or unprofitable factories and inefficient and unprofitable businesses," said Akio
Mikuni, founder and president of Mikuni & Co., Japan's oldest independent credit rating agency. "Factories have to be closed, but in
most cases, they will keep their factories open and running and producing things for which there is no demand."

There are a few signs of change. The Toyota Motor Corp. and Nissan are considering closing production lines to improve efficiency, and
the Mitsubishi Rayon Co. is closing an acrylic yarn plant in Ogaki and relocating it to Indonesia, reducing capacity at one of its subsidiaries
by 40 percent.

Capital investment is finally in a steep decline, a slump that Nakamae finds encouraging. "Companies are correcting over-investment and at
an accelerating rate," he said.

Imabari has already seen a sharp correction. The Shikoku Towel Industrial Association had more than 400 members a decade ago; it
now has 240. Domestic production of towels fell to 54,397 tons in 1997, from 101,792 tons at the industry's peak in 1991.

Yet supply still exceeds demand by about 30,000 tons, according to Yoshide Yoshihara, the association's chairman, largely because of
cheaper imports, which have more than tripled in the last decade. He insists, however, that the domestic industry is not suffering from too
much output, an opinion echoed by Ochi and other towel makers. He says it is normal to have about 30,000 tons of stock on hand.

"I don't think there is that much over-capacity," Yoshihara said, although he wistfully added that he would not mind seeing some mergers
or acquisitions take place. "I would like to see those kinds of changes, but it's difficult."

Why? Because consolidation aimed at reducing production capacity and costs will almost inevitably involve laying off employees, which is
nearly taboo in Japan where lifetime employment is still a critical component of the tacit social code. In discussing the possibility of Toyota
closing a plant, for instance, Tetsuo Kitagawa, a spokesman, repeatedly stressed such a closure "would not mean direct layoffs or
significant unemployment."

Tatsuya Higaki, the assistant manager of the industry division of the Imabari municipal government, said, "The social aspects of
employment here make it difficult to fire people just because the economy is bad or demand is declining."

So most Japanese companies rely on a slow process of natural attrition to winnow their ranks and pray that the economy will improve
before they are forced to take more drastic action. Despite the efforts to avoid layoffs, unemployment has risen sharply in Japan, actually
matching the United States level of 4.4 percent last month.

Seiichiro Murakami, who represents Imabari in the lower house of Parliament, is sadly convinced that his district's biggest business has no
choice but to consolidate further. "With the higher yen and high labor costs we have in Japan, companies like Toyota and Nissan started
building factories overseas," he said. "In the towel industry, the same thing has happened, and now factories in China and Southeast Asia
are producing towels of the very same quality you find in Imabari but at a fraction of the cost."

Murakami figures there need be no more than 100 companies in Shikoku making towels, noting that Germany makes do with just one
domestic towel manufacturer. The United States has only a handful of highly efficient major towel makers, who also produce a substantial
share in low-wage countries in Latin America and Asia.

But as plainspoken as Murakami is in an interview about the industry's need to shrink, he has yet to breathe a word of his thoughts to his
constituents. "I can't say it to them," he said. "It's too cruel."

So over the last five years the prefectural government has spent upwards of 465 million yen, or about $4.2 million at current exchange
rates, in an effort to put some zip into the local towel business. It has urged manufacturers to cut out wholesalers and streamline
distribution to retain more of the profits.

Meanwhile, Higaki and others have worked hard to steer the towel-making business away from towels as commodities and toward
making high quality, designer towels suitable for gift-giving. In conjunction with the local government, the towel association is developing a
brand name, fuwari, which means soft and light, for the region's towel products. Towel makers are also incorporating design elements into
their products to distinguish them from those made in Southeast Asia and China.

The target? Japanese consumers, who give towels on all sorts of occasions and particularly in return for the traditional cash gifts from
friends to family members of someone who dies.

In a bid to build a high quality image, Yoshiyuki Yano has embraced the effort wholeheartedly. His company, Hisao K.K., is working to
increase specialty towel making, which currently accounts for a little less than 10 percent of its output. Hisao has begun making a gift towel
with threads embedded with porous ceramic filaments filled with an oil extracted from the skins of the mandarin oranges that proliferate on
Shikoku. According to Yano, the extract has antibacterial properties -- and it also imparts a nice scent to the towels.

The company is also exploring the use of natural dyes, and each month it sells about 30,000 highly textured, loofah-like towels made from
unbleached cotton, a small success that has taken Yano by surprise.

Cheap imports from China and Southeast Asia keep chipping away at the prices he can charge for the hotel towels that accounts for 40
percent of Hisao's production. He is unable to reduce costs any further because Hisao's looms are old, operating at one-third the speed of
brand new looms and in need of more maintenance. The company lacks the capital to invest in more modern equipment. But Yano is a bit
thankful for Hisao's limited financial capacity because it has inhibited the company's growth.

"I don't feel the problem of excess capacity that much because we haven't invested in expensive equipment," he said. His older looms have
also perversely allowed him the flexibility needed to take advantage of the woes of the beleaguered hotel industry, which is placing more
orders for small quantities of towels that major producers find unprofitable.

Bigger companies, too, are adjusting their business to the new realities. Ochi built a factory in China in 1984, where he employs 600
people to produce towels at a lower cost and ships them back to Japan to sell to the mass market.

"I saw ahead of time and I thought it might be a good idea," said Ochi, who now owns Japan's fourth-largest textile manufacturing
business.

In his Japanese factories, he produces high-end towels under license to various European design companies like Renoma and Fendi. A
best-seller is a gift set that includes tea and two towels woven with the trademark of Fauchon, the French food retailer that has a
tremendous following in Japan.

Kontex, the second largest towel maker in Shikoku, is also reorienting its business toward higher-margin products, including a towel
woven with silver.

But as these bigger players find better ways of doing business, they will inevitably threaten smaller companies. At Kontex, Kanji Kondo,
who will be the third generation of his family to run the business, is planning to increase production in hopes that higher volume will mean
greater profits.

That will only add to the glut of Japanese-made towels, however. "This isn't like semiconductor chips," Murakami said sadly. "There's not
much value added in towels."