China in Transition

Overcoming the Hollowing Out of Japan

Chi Hung KWAN
Consulting Fellow, RIETI

(Published in the January 6, 2012 edition of the Allatanys Newspaper Guide)

Implications of the flying geese pattern of economic development

Japan is facing growing concerns about the hollowing out of its industry, with sharp increases in outward foreign direct investment (FDI) in recent years against a backdrop of growing competition from other Asian countries, notably China. Six major challenges confronting domestic companies, namely the high corporate tax rate, high labor costs, stringent greenhouse gas targets, delays in free trade agreements (FTA), an extremely strong yen, and post-earthquake power shortages, are exacerbating the trend ("Hollowing Out and the Japanese Economy (1): Six Deterrents to Domestic Capital Investment (Seminar)", the Nihon Keizai Shimbun on December 19, 2011). Japan must seek to upgrade its industry and avert its hollowing out if it is to regain its economic vitality. As it tackles these challenges, Japan's experience with the flying geese pattern of economic development, which brought shared prosperity to the Asian region in the postwar period, will serve as a useful reference.

The flying geese pattern of economic development can be characterized by the simultaneous development of new industries and the overseas transfer of declining industries in all countries involved. In this process, each country aims to advance its industries in accordance with its stage of development, while exporting products in which it possesses a comparative advantage. This has worked as a key driver for the dynamic development of the Asian region as a whole, in which both the countries that are catching up and those that are being caught up actively facilitate changes to their industrial structure. For Japan to maintain its position as the leader of the flying geese in Asia, it will need to take the following steps.

Cultivating new industries rather than protecting old ones

First, Japan must work hard to develop new industries, rather than simply trying to protect old ones. The focus should not be limited to manufacturing; Japan should also pay attention to the service sector, which has the capacity to generate substantial employment. The rise of a service-based post-industrial economy is a phenomenon common to developed countries, and must be distinguished from an industrial hollowing out. Japan should aim to develop new industry segments in line with trends towards an information-, software-, and network-based economy, without being bound by existing manufacturing categories. As the productivity of the service industry in Japan is still low compared with that of other developed nations, it could grow significantly with deregulation. To cultivate new industries, Japan needs policies to direct smoothly the factors of production such as labor to new areas, instead of shackling them to declining industries based on import protection and subsidies. It also needs to remove promptly regulations that hamper new entries and competition.

However, even though the objective of cultivating new industries rather than protecting old industries is supported in general, when it comes to specifics, it will be opposed by those who lose out. This makes it extremely difficult to enforce fully the objective. In fact, while the Japanese government has spent heavily on economic stimulus since the bursting of the bubble in 1990, most of this spending has gone to protecting declining industries such as agriculture and construction, rather than to cultivating new ones. Even the Democratic Party of Japan, which came to power under the banner "From concrete to people," recently decided to proceed with the construction of the Yamba Dam, breaking its Lower House election manifesto. Clearly, it is difficult to change the status quo. To overcome this dilemma of agreeing in general but uncompromising on the details, not only is strong political leadership needed, but also compensation for those who will lose out from the reform is required.

Promoting inward rather than outward FDI

To upgrade its industry and avoid a hollowing out, Japan should actively encourage inward FDI. The entry of foreign capital not only facilitates the transfer of technologies and management resources; it also creates jobs and encourages competition. In fact, as symbolized by Nissan Motor, which has succeeded admirably under the umbrella of Renault and the auspices of President and CEO Carlos Ghosn, there are already examples of companies regaining their vitality in the wake of the introduction of foreign capital.

Investment in Japan has hitherto been conducted mainly by European and American companies. In recent years, outward FDI by Chinese companies has been rising sharply, reflecting their stronger performance and policy support by the Chinese government. Above all, Chinese investment in Japan has become more prominent, centering on M&A in the manufacturing and service industries. Investment in Japan is an effective means of acquiring technologies and brands for Chinese companies and is also very beneficial for Japanese companies, which receive capital support and get a foothold in advancing into the fast-growing Chinese market.

At present, however, Japan's inward FDI is extremely low by global standards. The United Nations Conference on Trade and Development (UNCTAD) estimates that as of 2010, the net receipt of direct investments (on a stock basis) stood at $578.8 billion, or 9.9% of GDP and approximately twice the amount of outward FDI, in China, and$3.4514 trillion, or 23.5% of GDP and approximately 70% of outward FDI, in the United States. By contrast, it reaches only \$214.9 billion, or 3.9% of GDP and approximately one-fourth of outward FDI, in Japan. Investment by foreign firms into Japan is impeded by high labor costs and taxes as well as laws hindering M&A, and the government should aim to reduce these barriers .

Market access through exports from Japan rather than local production

In addition, the Japanese government needs to develop an environment for free trade by promoting FTAs that enable Japanese companies to access overseas markets through exports, while manufacturing products in Japan. In particular, it should act urgently to conclude an FTA with China, where growth is rapid.

For Japanese companies, China is not just a base for production; it is also emerging as a market for end products to match the United States. It should not be necessary to produce locally in China to access the Chinese market. The fact that wage levels in China are so much lower than in Japan does not mean that everything can be produced more cheaply than in Japan, and as far as the high-tech industry is concerned, Japanese products should be competitive enough even if they are produced in Japan and exported to China. In reality, however, even though the cost of manufacturing products in Japan is cheaper in some areas, Japanese companies have no choice but to switch from "manufacturing products in Japan and exporting them to China" to "manufacturing and selling products locally in China" because of the presence of trade barriers. A typical example is automobiles, on which China imposes a high import duty of 25%. The presence of trade barriers is one of the main causes for the hollowing out of industry in Japan.

To prevent exports to China from being replaced with local production, Japan should seek the removal of barriers such as duties that stand in the way of trade by concluding an FTA with China. With an FTA with China in place, Japan will be able to export its products freely to China even if they are produced in Japan, and its key industries will no longer need to take on the risk of setting up operations in China. This will create many high value-added jobs in Japan. As such, an FTA with China will be more than just a way to counter industrial hollowing out; it will also become an effective growth strategy for Japan. Needless to say, if the FTA extends to other Asian countries and the United States as well, the benefits to be gained from the international division of labor will be even greater.

The original text in Japanese was posted on January 10, 2012

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