China in Transition

Is FDI in China Hollowing Out Japan's Industry?
- The need to differentiate between good and bad direct investment

Chi Hung KWAN
Consulting Fellow, RIETI

In recent years, the rise in foreign direct investment (FDI) by Japanese firms has been cited as the reason for the hollowing out of Japanese industry, and investment in China, particularly, has been seen as a problem. Normally, if the market mechanism is functioning properly, the entry of firms into overseas markets should enhance the effective allocation of resources. If a hollowing out occurs despite this, we should presume that it is because excessive regulations at home or import barriers of trading partners intervene in the functions of the market.

Japan's foreign direct investment can be broadly classified into two types - one that emphasizes production costs and exporting and another that aims to avoid trade barriers or friction with trading partners. It is usually the latter type that is more likely to lead to a hollowing out of industry. Direct investment that focuses on production costs and exports aims to improve export competitiveness by securing advantageous factors of production overseas and thereby cutting costs. For example, many Japanese firms have set up production bases in China to make use of cheaper labor, and mainly export their goods to Japan or third countries rather than sell them locally. This kind of investment improves resource allocation, and is a win-win game for both the investor country and the host country. In contrast, direct investment that aims to avoid trade barriers or friction is undertaken when companies face import restrictions that hamper exports to the country in question. The division of labor that occurs through such investment tends to distort the allocations of resources because it does not accurately reflect the comparative advantage of the investor and the host.

The rush of Japanese automakers into the Chinese market is a typical example of the latter form of direct investment. While I do not doubt that the Chinese auto market will see rapid growth in the future, automakers must have had the choice of exporting cars made in Japan to China, and not just produce vehicles locally. Even though the automakers can make cars of higher quality and more cheaply in Japan, they were forced to set up production facilities in China so as to circumvent high import tariffs. But these tariffs on imported automobiles will be greatly reduced as China fulfils its WTO commitments, so there should be more room for exporting cars from Japan. Nevertheless, there can be little doubt that behind the "official" reason that they acknowledge the great potential of the Chinese market, the strategy of expanding production facilities in China undertaken by Japanese automakers is to avoid trade friction with China. Furthermore, when we consider the fact that such overseas production is merely a substitute for domestic production, the price paid for such direct investment, such as the loss of job opportunities in Japan, is great indeed.

The above example shows that direct investment that places importance on production costs and exporting is "good investment" that improves the allocation of resources, while direct investment that attempts to avoid trade barriers or friction is "bad investment" that leads to a decline in production efficiency and results in the hollowing out of domestic industries. Unfortunately, the exact opposite perception has become the mainstream in Japan when the issue of the hollowing out of industry is debated. In other words, there is a big fuss when old factories for industries in which Japan no longer has a comparative advantage close and move to China -- workers are made redundant, and it is seen as a serious case of hollowing out. However, there is virtually no objection when companies in sectors where Japan still has a competitive edge, such as automobiles, opt to establish factories in China, because it is perceived as being the result of efforts to open up a new market. This mistaken recognition not only results in the protection of domestic industries that are on the decline through import restrictions, but also delays the advancement of industry as a whole.

The Japanese government needs to promote good direct investment while at the same time make efforts to prevent bad direct investment by securing an environment for free export through utilizing such measures as free trade agreements. During the November summit between the leaders of Japan, China and South Korea in Phnom Penh, Beijing proposed that the three nations study the idea of a trilateral FTA. Regrettably, the Japanese media have only taken up the matter from the trivial viewpoint that "Japan and China are battling for leadership in the economic integration of East Asia," and the response has been a negative one. Japan should not hesitate to conclude an FTA with China if it is to keep its competitive industries at home while preventing any further hollowing out.

November 8, 2002

November 8, 2002