Who Should Take Responsibility for Unexpected Interest Charges?: Lessons from the Privatization of Japanese Railroad Systems

Abstract

Due to inefficient operations exacerbated by political intervention, Japanese National Railways (JNR) was finally dissolved in 1987 after piling up huge debts. Fortunately, a passenger rail service had and has the potential to become viable business because the population density per habitable land is exceptionally high in Japan. Indeed, there have been many profitable non-JNR rail companies mainly in the Tokyo and Osaka metropolitan areas for years. Although Japan’s high population density gives a passenger rail service an advantage over those in other industrialized countries, the density is not even. Therefore, JNR as a passenger rail operator was not only dissolved but also divided into six regional companies, of which three have inherited debts as well as assets from JNR but the other three have inherited only assets and been additionally given extra financial assets. Under these arrangements, the three profitable companies in highly populated areas were expected to earn operating revenues sufficient to service the debts, while the other three unprofitable companies in sparsely populated areas were expected to lose money in rail operations but sufficiently small to be covered by interest income on their financial assets. The mechanism was then considered incentive-compatible because (1) the profitable three would have to pay the debts but amass more profits than expected should they enhance their efficiency, and (2) the unprofitable three could earn profits should they lose less money in rail operations than expected by efficiency gains. Actually, all have done better than expected in a profit (loss) before interest. The profitable three have earned more than expected and got listed on Tokyo and other stock exchanges, while the unprofitable three have lost less than expected. The initial policy goal that the inefficient national rail service be vitalized under the incentive-compatible scheme seems to have been accomplished. However, this apparent success story is not that simple. Japan’s extremely low interest rates, which no one expected to happen when designing the original scheme, have affected the profitable three and unprofitable three in diametrically opposite directions. For the former, a reduced amount of interest payment have increased their profits after interest and taxes, while, for the latter, a reduced amount of interest income has given rise to decreased profits and in some years resulted in net losses after interest. To curb this unexpected income transfer, the Japanese Government has devised a clever but not transparent program. Although it is difficult to decipher from publicly available information, now the profitable three are de facto forced to borrow at artificially high interest rates from the unprofitable three. In short, the former subsidize the latter through the backdoor. Should shareholders allow their companies to help other unrelated companies though there does not seem to be any synergy? But, then, who should take responsibility for unexpected interest changes? What should we have done when devising the initial scheme? We give some thoughts to these important but difficult questions.