The confirmation on Monday (13 July) that Japan's two largest drinks companies - Kirin and Suntory - are in discussions on merging their operations may have caught the industry by surprise, but the reasons for the move have quickly become apparent. The implications for the global drinks business are equally clear. Julian Ryall reports from Tokyo.

Kirin Holdings and Suntory Holdings have effectively been forced into merger talks - which company officials indicated started very informally several months ago - by the need to survive. Domestic sales of both beer and soft drinks have declined markedly in recent years, due to a falling birthrate and an ageing population in Japan. That situation has been compounded in the last 12 months by the economic crisis.

In 1994, for example, a total of 572.9m cases of beer were shipped within Japan, with a case the equivalent of 20 large bottles. By 2008, that had fallen to 482.7m cases, a trend that is expected to continue. In its heyday, Kirin operated 15 breweries, but that has shrunk to 11 today.

"Drinks makers are facing a very tough time in the domestic market and need to improve their domestic margins and growth," says Yoshiyasu Okihira, an analyst with Credit Suisse in Tokyo. "One way to improve their balance sheets is through cost-cuts, but doing that by themselves will have limited benefits, so a merger is more effective.

"The two companies also hope to expand their overseas businesses, particularly in the Asian and Oceanian markets, and make the most of their brand synergies," he adds. China may be a "difficult" market to crack in the immediate future, he suggests, but the merged entity may have better luck in South East Asia, where both companies already have a presence.

In May, for example, Kirin purchased a stake in San Miguel Brewery, the largest brewer in the Philippines, and in October is expected to complete its takeover of Lion Nathan, a major Australian brewer. Meanwhile, in February, Suntory acquired Frucor Beverages Group, the New Zealand soft drinks firm.

Both Suntory - which is still owned by the Saji family - and Kirin have been reluctant to comment on media reports of the merger, other than to emphasise that their discussions are in their very early stages and that nothing has so far been decided.

Should the deal go through, however, it would create the fifth largest food and drink company in the world by sales, behind such titans as Kraft Foods and PepsiCo. Combined, the two companies had consolidated sales of around JPY3.8 trillion (US$410bn) in 2008, which puts them ahead of Anheuser-Busch InBev and Coca-Cola Co. in the global stakes.

The merger would also trigger a wave of realignments within the industry, experts believe.

The 'big four' of Japan's drinks industry is rounded out by Asahi and Sapporo, but joining forces will permit Kirin and Suntory to reduce costs through joint procurement on everything from aluminium for cans - the single largest cost - to raw materials. Reduced costs will make the merged firm increasingly competitive, while others may have already been encouraged to look around for a new partner.

"If they are able to improve their domestic margins, this could pose a serious threat to other players, who will be forced to take similar steps," says Okihira. "It will promote further consolidation."

The companies have reportedly already approached Japan's competition watchdogs to informally inquire whether the merged company might contravene regulations, although it is likely that the Government will not stand in their way.

Questions will need to be answered over anti-trust issues, however, as the new firm would control about half of the total Japanese beer market and a third of all soft drinks sold here. There is also the matter of holdings in packaged food and liquor.

The merger is likely to be approved in Japan eventually, however, as the authorities generally dislike the cut-throat competition that has marked the industry in recent years as manufacturers try to increase their market share with new products, particularly ones that circumvent taxation rules by having lower malt content and are therefore cheaper.

Even if the new company's cumulative share exceeds 50% of the total domestic market, experts believe the Government may move the goalposts by including all beverages in the equation and permitting the deal to go through.

A bigger concern for Suntory and Kirin will be the attitudes of competition authorities in Europe and the US.

"Any time there is a merger, the companies have to verify whether the concentration falls within the scope of European merger regulations," says Jonathan Todd, a spokesman for competition policies with the European Commission in Brussels.

Under the rules, companies with a combined global turnover of EUR5bn (US$7.06bn) generating a turnover of at least EUR250m within the European Economic Area (EEA) - European Union (EU) states plus Iceland, Norway and Liechtenstein - are covered by these controls.

If so, the Commission usually has 25 working days to decide following a merger or takeover announcement whether the new company would have a negative impact on effective competition within Europe. Whether Brussels will approve this major Japanese merger without attaching strings, such as the sale of certain European drinks industry interests, remains to be seen.

But it is likely that Suntory and Kirin would be flexible to secure key EU and US competition approvals if required, so they can build a new beer and soft drinks behemoth in markets where its products have previously been more expensive and niche. And that might give the new outfit added leverage to snap up some larger players on the global drinks scene.