According to standard textbooks on international economics, profits earned by companies through direct investments overseas generally exceed the employee income lost at home, resulting in a net gain for the investor country. Up to now, I have held this view. But there are times when certain adverse conditions may result in a net loss for the investor country. Unfortunately, just such a confluence of circumstances seems to be present in today's Japan, whose leading export industries, including electronics manufacturers, are rapidly moving production and establishing new export bases in China and other East Asian countries. Hereunder, I would like to discuss this issue.
Benefits for the Investor Country: What the Textbooks Say
When manufacturers relocate overseas, the loci into which companies pour their technological knowledge, capital, and other business resources also move beyond the borders of the investor country. According to economics texts on the cross-border movement of production factors, the overseas transfer of a production factor called business resources induces the outflow of other transferable production factors (capital, etc.), while lowering domestic compensation for non-transferable production factors (labor and land). This increases the compensation for business resources (corporate profits). When certain conditions are fulfilled - that is, if an investor country is a "small" economy (with fluctuations and changes in its economic activities having negligible impact on international prices), a state of perfect competition exists, and the domestic accumulation of industries brings no benefits - the benefits of increased compensation for business resources more than offsets the negative effects of reductions in real wages, boosting the overall economic welfare of the investor country.
I would like to illustrate a mechanism that can expand the economy of an investor country, using simple numerical examples. Suppose that a certain machinery industry, which annually generates ¥30 trillion in added value, transfers its operations to China. In the home country, let's say the industry formerly employed 4 million individuals, with each employee earning an average of ¥5 million per year. The total income for all employees is ¥20 trillion. The remaining ¥10 trillion represents industry profits (operating surplus). Now, assume that the same industry is able to maintain the same production in China by employing 8 million Chinese workers (assuming a productivity of 50 percent of their Japanese counterparts) at an average annual wage equivalent to ¥250,000. If the industry's sales and ¥30 trillion in added value are maintained, industry-wide profits rise to ¥28 trillion - a figure derived by subtracting ¥2 trillion in labor cost from ¥30 trillion in added value - for an ¥18 trillion increase in profits. In this case, if the 4 million Japanese displaced workers manage to land new jobs that pay ¥500,000, total lost employee income will remain below ¥18 trillion, resulting in an overall increase in Japan's gross national product (GNP) (gross domestic product (GDP) plus factor income from overseas), the figure that defines the economic welfare of a country.
But from the opposite perspective, this case also clearly points to circumstances under which such relocation may impair the economic welfare of an investor country. Economic welfare begins to deteriorate in an investor country if corporate profits fail to increase in accordance with the labor costs saved following the relocation of operations overseas, or if labor productivity is too low in the industries that absorb the displaced workers.
Characteristics of Japan's Overseas Direct Investment and the Conditions that Lead to Decline
From the 1990s onward, Japan's overseas direct investment has been characterized by the movement among leading export-oriented industries to set up factories as export bases in China and other East Asian countries. This trend encompasses electronics manufacturers, who command high market shares in overseas markets. Such characteristics match the below-listed conditions under which overseas direct investment leads to the decline of an investor country.
(1) High market share, Japanese industry, and fierce competition among companies
The figures given in the above example assume that the production volume for this particular machinery industry remains unchanged following its relocation overseas. However, under conditions of fierce competition among Japanese companies, transfers of operations will take place industry-wide, and price competition occurs as production costs, consequently expanding overall production volume [reword to clarify meaning. If competition takes place only among Japanese companies, reduced production costs cannot produce market share gains. Thus, industry-wide sales fail to expand significantly. In such cases, the parties that benefit are the Chinese workers who obtain jobs created as a result of the relocation and the consumers around the world who gain access to cheaper goods (including secondary manufacturers, in the case of the relocation of a parts industry). But the industry that relocated its operations to China may achieve virtually no profit gains. (In more technical terms, this occurs when the price elasticity of demand is close to 1 while the markup percentage is held constant with companies engaged in monopolistic competition. In the past several years, there have been quite a few cases in which overseas affiliates have outperformed their Japanese parent companies in profitability indicators (for instance, in current profit-to-sale ratios), reflecting the stagnant domestic economy. But even in these cases, the savings in labor costs have not been fully translated into profit gains.
If we set this line of thought against the standard textbook assumption, one could argue that the above-described overseas investment hurts Japan because Japan is not a "small country" in that particular industry. But even in industries in which Japan's market share is not high, Japan would suffer similar negative consequences resulting from a drastic price collapse if competing foreign industries from the U.S. or Europe also moved their operations to developing countries. In such cases, the negative effects would be attributable to an international price collapse (or, in technical terms, a deterioration of the terms of trade), not to the overseas direct investments made by Japanese companies.
(2) Export-oriented direct investment
When companies make overseas direct investment to avoid trade barriers and gain market access, they can increase profits, due to the likely expansion of their markets. But when direct investment is export-oriented and competition occurs only among Japanese companies, industry-wide markets are unlikely to expand significantly. In such cases, as explained in (1), increasing profits is difficult. Overseas direct investment by U.S. companies tends to be more market access-oriented than that of their Japanese counterparts.
(3) Implications of the exodus overseas of export-led industries
When an export-oriented industry relocates its operations overseas, we cannot expect just any industry to absorb the resulting displaced workers. For instance, we cannot say that an overall loss in employees' income would amount to ¥6 trillion (¥20 trillion minus ¥14 trillion) simply because 4 million jobs with an annual income worth ¥3.5 million are to be generated in the medical and healthcare industry. Because Japan must continue to import food and crude oil, when one export industry is lost, another export industry must be found to replace it.
At some point, market forces will force such changes in the export industry. An increase in joblessness pushes down real wages. Meanwhile, if the export industry disappears from Japan and the trade surplus diminishes, the yen is weakened. Given the other conditions, the weaker yen pushes up export prices and reduces real wages further, thus, effectively having the same impact as a wage cut. The lower the productivity of the replacement export industry, the larger the decline in wages.
The question is what level of productivity a new replacement export industry (possibly one in the service sector, as has been the case in the U.S., given the ongoing expansion of services trade) is able to offer. Let's say that the productivity of a new, replacement export industry (the materials industry, for instance) is half that of the machinery industry that was lost. In such cases, adjustments continue until real wages are reduced to half their previous levels. A new export industry with high labor productivity is unlikely to emerge in Japan today. Thus, the potential exists for very large declines in employee income.
Conclusion
I am not asserting at this point that Japan is afflicted by all of the above-listed adverse conditions, or that it is declining as a result of overseas direct investment. The model analysis provided above is based on extreme simplification and certain assumptions, for the purpose of clarifying a perspective. Due caution is required before we apply this analysis to the real world. For instance, it is unlikely for Japan to decline if Japanese consumers and parts-purchasing Japanese companies are the sole beneficiaries of falling prices.
On the other hand, when export industries such as the electronics industry transfer their operations overseas, the eventual impact of such a move must be carefully examined. That is the point I wish to make in this column.
