Japan Needs to Boost its Inward Foreign Direct Investment

URATA Shujiro
Faculty Fellow, RIETI

In his policy speech to the Diet in January 2003, Prime Minister Junichiro Koizumi unveiled a plan to double inward foreign direct investment (FDI) in five years. This move is based on the belief that FDI can play an important role in revitalizing Japan's lackluster economy. By receiving foreign direct investment, the domestic economy can promote greater economic efficiency by tapping the capital, technology, management know-how, sales, and procurement networks of foreign companies. In addition, the entry of foreign companies leads to greater competition, which in turn spurs improvement in the management efficiency of domestic firms. In fact, various studies show that foreign companies that have entered the Japanese market have a higher degree of management efficiency and productivity than their Japanese counterparts. Thus, the Japanese economy has much to gain by promoting economic revitalization through inward FDI. However, although such investment has increased in recent years, it remains at a low level. In this column, I will attempt to clarify the factors that are obstacles to inward FDI and discuss what measures might be taken to overcome these obstacles and increase such investment.

Inward FDI is increasing, but remains low

Foreign direct investment flows into Japan have surged since the latter half of the 1990s. From 1990 to 1996, direct investment in Japan hovered at an average of $1 billion annually. This figure reached the $3 billion mark in 1997 and came to $12.7 billion in 1999 (on a balance of payments basis). This inflow has since decreased, but is still at a high level compared to past years - around $6 billion to $9 billion per year through 2004. Furthermore, in the first quarter of 2005, inward FDI registered a year-on-year surge of 86%.The recent rise in inward FDI is driven by several factors: deregulation has opened up more sectors to foreign capital; the rise in the number of corporate bankruptcies has encouraged foreign acquisitions of Japanese companies; the establishment of a legal framework has made mergers and acquisitions easier; a decline in cross-shareholding has put more shares on the market; the global push to reorganize industries encourages entry into Japan by foreign firms; and the yen's appreciation makes Japanese assets more attractive.

But while FDI inflows to Japan have risen in recent years, they remain at an extremely low level compared to other large developed countries. According to the latest outstanding stock figures as of 2003, we can see that Japan-bound FDI ($89.7 billion) is considerably lower than countries such as the United States ($1.55 trillion), Britain ($672 billion), Germany ($545 billion) and France ($434 billion). Because differences in the size of national economies makes comparison of absolute investment figures less than meaningful, we can instead use two relative indexes to compare the level of Japan's inward FDI with that of these other nations.

The first index compares inward FDI with outward FDI. Based on figures for 2003, Japan's ratio of inward FDI to outward FDI was 0.27. This compares to ratios for the U.S., Britain, Germany and France of between 0.6 and 0.9. We can thus see that Japan's inward FDI is extremely low compared to its outward FDI. While outflows of FDI can lead to a hollowing-out of industry, inward FDI boosts the domestic economy. When we look at Japan's inward and outward FDI flows from this standpoint, we can see that inward FDI has been unable to offset the hollowing-out of industry brought about by outward FDI.

The second index compares inward FDI in different countries by taking into consideration the state of their economies. We can compare Japan's inward FDI with that of other countries using an index that compares gross domestic product (GDP), which is a measure of economic scale, and a more complex index that is calculated based on various economic factors. The United Nations ranks 140 countries by comparing the ratio of a country's share of global FDI flows to its share of global GDP (the U.N. calls this ratio the Inward FDI Performance Index). In the most recent survey, covering the years 2001 to 2003, Japan ranked near the bottom at 132. In the early 1990s, Japan ranked about 110 and has declined since then.

Let us look at the results of an analysis using a more complex index. The U.N. has calculated the stock of inward FDI that can be expected for the 140 countries above based on an analysis of the relationship between inward FDI and 12 factors that have an important effect on determining inward FDI including GDP growth, percentage of the population that has completed higher education, and the extent of infrastructure development. This is called the Inward FDI Potential Index, and it shows how much inward FDI a country can expect given its economic structure. In the most recent survey, which covered the years 2000 to 2002, Japan ranked 16th, indicating that it has the potential to become a very attractive country for foreigners to invest in: Japan is a market supported by huge consumer purchasing power. It is richly endowed with capable human resources and highly advanced technology. And it enjoys close proximity to other East Asian countries such as China that are the growth centers of the global economy.

Despite these attractions for foreign investors, the level of inward FDI in Japan is very low. This highlights many factors that block the entry of FDI. If we can clarify these factors and reduce or eliminate them, inward FDI will increase and we will see progress in the revitalization of the domestic economy.

The obstacles to inward FDI

A myriad of surveys and studies have been conducted to determine the factors that block inward FDI in Japan. It would be ideal if we could analyze companies that have just made a foray into Japan or abandoned attempts to do so, but such surveys are virtually nonexistent. Therefore, let us use the results of a questionnaire that asked foreign firms already active in Japan about what they felt were the problems hampering their operations so as to probe the obstacles to inward FDI.

According to the results of the Survey of Trends in Business Activities of Foreign Affiliates conducted by the Ministry of Economy, Trade and Industry (36th survey, 2002), the factor most often cited as an obstacle was high costs. Specifically, foreign businesses said items such as personnel costs and office rents were more expensive than in other countries. The next most cited factor was the tough demands of customers. Other obstacles, in order of frequency, were high tax rates, complex distribution channels and anticompetitive business practices that make market entry difficult.

Many of the obstacles pointed out by foreign firms, such as the high cost structure and tough customer demands, cannot be effectively addressed by government policies designed to support foreign businesses. But obstacles such as high tax rates, anticompetitive business practices, problems with information access due to closed industry organizations, lack of infrastructure, intrusive regulations and government guidance, and difficulty in getting preferential treatment can be tackled by the government. Of these, I would like to discuss regulations and government guidance, because they are not only obstacles that can be tackled directly by the government but are, according to some studies, the most serious impediments to FDI.

Business organizations formed by foreign companies such as the European Business Council in Japan (EBC) and the American Chamber of Commerce in Japan (ACCJ) have detailed information concerning specific regulations that are hampering their business activities. For example, a report issued by the EBC cites regulations such as those concerning food additives, moves to ban prepaid mobile phones, and restrictions on cross-border stock exchanges as examples of policies blocking inward FDI.

Amid the sharp increase in mergers and acquisitions driving global FDI in recent years, restrictions on cross-border stock exchanges are hindering mergers and acquisitions and, as a result, are blocking inward FDI. While mergers and acquisitions are also surging in Japan, they are much less common than in other developed countries. In fact, the total value of mergers and acquisitions by foreign companies between 1999 and 2003 came to $73 billion in Japan, much lower than the $950 billion in the U.S. or the $500 billion in Britain during the same period.

We can see that these types of regulations are detrimental to inward FDI given that direct investment in Japan has expanded when regulations have been eased or abolished. The fiscal 2004 edition of the Cabinet Office's "Annual Report on the Japanese Economy and Public Finances'' arrives at a similar conclusion on the relationship between the two conducting statistical analysis. Although Japan is gradually easing regulations concerning inward FDI, the strict regulations of the past and the slow pace at which deregulation is proceeding have made Japan slower to liberalize inward FDI than other countries.

Measures to increase inward FDI

Various efforts to boost inward FDI have been undertaken by both the central and local governments. Among the measures implemented by the central government, support provided by the Japan External Trade Organization (JETRO) and the Development Bank of Japan (DBJ) is important. Not only does JETRO provide information relevant to investment in Japan through symposiums held overseas, it also serves as a matchmaker between companies interested in investing in Japan and local municipalities. Meanwhile, the DBJ is involved in overseas activities to attract direct investment to Japan and offers advice on investment and loans to foreign companies interested in investing in Japan. Some local governments have set up "one-stop'' offices where information can be obtained and the necessary procedures can be carried out quickly and easily. Others are actively soliciting particular industries. For example, the city of Sendai has set up a "Finland Health Center'' and is keen on attracting firms in the health and fitness business. Some municipalities are actively dispatching top officials overseas to directly woo foreign firms.

Among the various steps the government has taken to boost inward FDI, the Japan Investment Council (JIC) is attracting the most attention. The JIC was established in July 1994 as a ministerial-level body with the aim of "collecting opinions regarding improving the investment environment and disseminating information concerning investment promotion measures,'' with the prime minister serving as chairman. The council draws up proposals based on opinions from private-sector members of its expert committee and outlines programs for the promotion of FDI into Japan. For example, in its inward FDI promotion program drawn up in March 2003, the council proposed specific measures such as abolishing certain regulations regarding the dissemination of information at home and abroad, improving the business environment, reviewing administrative procedures, creating favorable employment and living conditions, and improving local and national structures and systems. It was hoped that administrative organizations affected by the proposals would respond swiftly, but it appears that in many instances they have not done so.

Regulations prohibiting or restricting the entry of foreign firms are not being scrapped, despite the obvious need, due to strong opposition from people likely to suffer from deregulation. A similar problem exists for domestic regulatory reform, but strong political leadership and competent and driven administrators to support it are indispensable if such problems are to be resolved. In order to establish strong political leadership, the general public must understand that an increase in inward FDI would be immensely beneficial to Japan's economy and society. The mass media play a huge role in this regard. Many media organizations tend to portray foreign investors as vultures, and present them as enemies of Japan's economy and society. The media have an obligation to convey the facts to the public by also reporting the positive contributions that foreign investors make to the domestic economy and society.

While I have discussed the problems of FDI and measures to increase FDI inflows to Japan, I would like to stress that these problems and measures apply not just to foreign companies but also to domestic firms looking to boost investment. In other words, improving the investment environment is indispensable for the recovery and revitalization of the Japanese economy.

Judging from the trends in inward FDI in recent years, it will be extremely difficult to achieve Prime Minister Koizumi's target of doubling inward FDI in five years' time. If Japan is to attain this target and sharply increase the inward FDI that will contribute to revitalizing the Japanese economy, both the public and private sectors will have to make efforts to eliminate various obstacles, including abolishing regulations and changing the negative opinions of the general public toward such investment.

July 25, 2005

July 25, 2005