Why Japan Should Pursue an FTA with China - The Need to Prevent a Hollowing-out of Domestic Industry

Fellow, RIETI

With China-related business booming, Japan's "China threat syndrome" has receded and been replaced by the view that China is actually helping to prop up the Japanese economy. Japanese firms have two ways to access the continuously expanding Chinese market - they can "produce locally and sell locally" in China or "produce in Japan and export to China." Other things being equal, the latter option is less risky and can create more employment opportunities at home. As the present surge of Japanese exports to China clearly shows, Japan still possesses international competitiveness in technology-intensive industries, such as machinery, and it is entirely possible for Japanese companies to profit by producing domestically and exporting to China. If the comparative advantages of both countries can be realized through trade, China's advancement will not be a threat to Japan but rather a win-win game for both sides. In order to ensure this, the various regulations that impede trade between the two nations need to be abolished through such means as a free-trade agreement.

Should Japanese firms view China as a production base or a market?

When considering China's emergence as a business opportunity, Japanese companies need to ascertain whether market advantage and production advantage lie with China or with Japan. The fact that wage levels in China are much lower than those in Japan does not mean that all products can be manufactured more cheaply there. At present, China does not have its own technology or brands, and has no choice but to rely on cheap labor to compete. In contrast, Japan continues to be very competitive in the production of technology-intensive goods. At the same time, while it is true that income levels in China are rapidly rising, it is still a developing country whose per capita GDP has just reached the $1,000 level, and its consumption structure no doubt greatly differs from that of industrialized nations. Therefore, the answer to the question of whether China is a "production base" or a "market" differs from one industry to another.

According to whether China is a production base or a market, the strategies that Japanese companies could pursue can be classified into the following four cases (see diagram). Firstly, in areas where China has the advantage on the production front but Japan has predominance as a market, it is better to manufacture in China and then re-import to Japan. Secondly, in areas where China enjoys advantages both as a production base and as a market, Japanese firms should strive to produce locally and sell locally. Thirdly, in areas where China is superior only as a market and Japan is more competitive on the production front, it would be advantageous to produce in Japan and then export to China. Machinery industries, such as automobiles, fall into this category. Finally, when Japan is dominant both in production and consumption, Japanese companies should concentrate on domestic production and domestic sales.

Diagram: Models of "China Business" for Japanese firms

When considering business operations in China, one should also fully recognize the fact that direct investment and trade are substitutes for each other, and that there are various hybrid forms between the two. In the case of direct investment, the influence a firm wields over management matters increases in proportion to the ratio of its investment, but then so does the risk. In contrast, in the case of trade, which is supposed to be a one-time transaction, the risk is small. Therefore, regardless of whether a firm views China as a production base or a market, it does not necessarily have to set up its own factories in China. As in the first and second cases outlined above, when Japanese companies want to utilize China as a production base, a wide range of options are available, such as (1) direct purchasing from a Chinese firm, (2) signing an original equipment manufacturer contract with a Chinese company and selling products under its own brand, (3) setting up a joint venture with a Chinese firm, and (4) making a 100% direct investment. Even when no investment is made, it is possible to have subcontractors fully accept the management's policies against the backdrop of market dominance, as in the case of Uniqlo. In addition, as in the second and third cases, even when Japanese companies are targeting the Chinese market, it should not be forgotten that this can be achieved not only by manufacturing locally but also by producing in Japan and exporting to China.

Good direct investment versus bad direct investment

While there are firms in Japan that are making use of China's vitality, there are still concerns that increased investment in China will lead to a hollowing-out of industry at home. In essence, if the market mechanism is functioning properly, the overseas expansion of companies should encourage the efficient allocation of resources. If a hollowing-out still occurs despite this, it should be attributed to the high cost structure brought about by excessive regulations at home, and to trade barriers in trading partners.

Japan's foreign direct investment can be broadly categorized into two types - investment that places priority on production costs and exports, and investment that aims to avoid trade barriers and trade friction. The latter is more likely to lead to a hollowing-out of industry. Direct investment that places priority on production costs and exports aims to reduce costs by securing advantageous production factors overseas and improving export competitiveness. For example, many Japanese firms have set up production bases in China to exploit its cheap labor and mainly export what is produced there to Japan and other countries rather than selling locally. Such investment improves the efficiency of resource allocation and both the investing country and the host country have much to gain. In contrast, direct investment that aims to avoid trade barriers and trade friction is made in situations where there is no choice but to produce locally because exports from Japan are blocked by import restrictions. The resulting division of labor distorts resource allocation because it runs counter to the comparative advantages of both the investor and the host.

A typical example of the type of direct investment that aims to avoid trade barriers and trade frictions is that made by Japanese automakers in China. There is no doubt that China's auto market will see rapid expansion. However, local production is not the only way to access the Chinese market - it is also possible to export automobiles from Japan. Although China's import tariff on automobiles will be greatly reduced upon its entry into the World Trade Organization, it will still remain at the high level of 25%, and exporting automobiles to China from Japan could lead to trade frictions. In order to circumvent high import tariffs and avoid trade friction, Japanese automakers have no choice but to produce cars in China despite the fact that they can produce cars of higher quality and more cheaply in Japan.

In terms of the aforementioned business models, automakers would benefit by manufacturing in Japan and exporting to China in order to take advantage of the complementary relationship between the two countries. However, because of the existence of trade barriers, this is replaced with local production and local sales in China. If Japanese automakers could manufacture 1 million cars in Japan and export them to China, it would mean that many employment opportunities, in the form of high-wage "good jobs," could be created in an area in which Japan excels. However, if the same 1 million vehicles are produced in China, even if some parts are still manufactured in Japan, fewer jobs would be created and the opportunity cost would be very large.

In this way, direct investment that places priority on production costs and exports is "good direct investment" that boosts the efficient allocation of resources, while direct investment that aims to avoid trade barriers or friction is "bad direct investment" that leads to a decline in production efficiency and, in the end, a hollowing-out of domestic industry. Unfortunately, however, public opinions regarding the hollowing-out of industry in Japan are arguing for exactly the opposite. In other words, when old factories for industries in which Japan no longer has a comparative advantage are relocated to China, much is made of the matter and it is portrayed as a serious hollowing-out problem because employees lose their jobs. In contrast, when firms in areas such as automobile manufacturing, where Japan still has a comparative advantage, build factories in China, their moves are praised as efforts to open up a new market and so there is no opposition at home. This misunderstanding of the nature of direct investment is leading on the one hand to the protection of declining industries through measures such as import restrictions, while delaying the advancement of industry on the other.

Japan should pursue a free-trade agreement with China to encourage more "good direct investment" and prevent "bad direct investment." If import tariffs are eliminated, trade between the two countries will become increasingly active. Japan's key industries such as automobiles, especially, will no longer have to take the risk of producing in China. In this way, an FTA with China is the ultimate way for Japan to prevent a hollowing-out of its industry.

March 23, 2004

March 23, 2004