The effect of openness on domestic employment volatility? Evidence from Japan

There is a belief among the general public that employment volatility tends to be greater for firms with higher foreign exposure, but the relationship between the two is ambiguous in theory. This column uses firm-level data for Japan to compare the impact of foreign exposure on employment volatility for multinational, trading, and non-trading firms; for manufacturing and wholesale and retail trade; and for intra-firm and inter-firm trade. In manufacturing, the effect of exports on the volatility of employment varies, depending on the share of intrafirm exports to total sales. In wholesale retail, the effect of exports is generally insignificant.

Increased labour demand elasticities have important labour market consequences. As Rodrik (1997) noted, one of the main concerns is the relationship between foreign exposure and employment volatility—firms that are exposed to foreign demand and/or supply are expected to have higher labour demand elasticities. For example, trade liberalisation could cause greater product market competition, which results in higher labour demand elasticities (e.g. Rodrik 1997). Offshoring could increase the substitution between foreign and domestic workers, which also flattens the labour demand curve (e.g. Senses 2010). Thus, it is widely believed by the general public that the employment of firms with higher foreign exposure tends to be more volatile than that of domestic firms.

If firms are risk neutral, whether employment volatility is high or not does not seem to be a problem, provided that there are no labour adjustment costs. However, when firms face high labour adjustment costs, higher employment volatility will be an issue because it will generate large adjustment costs to the economy as a whole. Indeed, OECD (2005) featured labour adjustment costs as one of the concerns relating to the expansion of international trade and foreign direct investment (FDI). The adjustment of labour in response to foreign exposure is an important concern for policy makers.

Despite this importance, the relationship between foreign exposure and employment volatility is theoretically ambiguous. In the case of exports, on the one hand, employment volatility will be higher for exporters than for non-exporters if the volatility of shocks is significantly higher for the trading partners than for the home country (in this column, Japan), or if the export activity itself is volatile, owing to, for example, changes in the exchange rate. On the other hand, exporters may be able to absorb demand shocks in one country, diversifying their activities in other countries.

Similarly, in the case of imports, a firm that sources inputs from many countries can more easily absorb a shock to a particular input by switching its sources to another country, compared with a firm that sources inputs only from the domestic market. In contrast, importers could have higher employment volatility if imported intermediate inputs are easily substitutable for labour inputs. A similar argument can be applied to the case of FDI. Because the effects of foreign exposure on employment volatility are ambiguous in theory, empirical analysis is needed to clarify which effects appear to be strongest in reality.

A number of studies have examined the causes and effects of employment volatility. To our knowledge, only Kurz and Senses (2016) have examined the relationship between foreign exposure and employment volatility. Using firm- and transaction-level data from US manufacturing firms between 1991 and 2005, they found that the employment of exporters was less volatile than that of domestic firms, whereas that of importers was more volatile. Their study also found a non-monotonic relationship between export status and employment volatility. The effects of exports could be more or less volatile, depending on the share of exports to total sales. They concluded that "as long as a firm's overall exposure is not too large, exporting affords firms the ability to diversify their demand sources across countries and products".

Building upon Kurz and Senses (2016), in a new paper we examine the theoretically ambiguous relationship between the volatility of employment growth and the foreign exposure of a firm (Higuchi et al. 2016). We use unique firm-level data for Japan for the period 1994-2012, which allow us to examine the differences between 1) multinational firms, trading firms, and non-trading firms, 2) manufacturing and wholesale and retail trade, and 3) intra-firm and inter-firm trade.

In our study, following Kurz and Senses (2016), the employment volatility is calculated as the standard deviation of the residual growth rates. The residual growth rates are obtained from the actual employment growth rates minus the firm-specific employment growth rates and industry-year-specific employment growth rates.

Our employment data come from the Basic Survey of Japanese Business Structure and Activities (BSJBSA) compiled by the Ministry of Economy, Trade and Industry (METI), Japan. Employment is measured by the number of permanent workers. In the BSJBSA, permanent workers are defined as workers with a contract period that extends for one month or longer, or an employee who worked for 18 days or more in each of the last two months in the previous fiscal year. The permanent workers comprise regular workers and part-time workers, but daily workers and dispatched workers are excluded.

Other than regular workers and part-time workers, there are two classifications of workers: daily workers and dispatched workers. As noted, daily workers are not included as permanent workers because their contract period is shorter than one month. Dispatched workers are also excluded because they have no direct employment contract but are dispatched from temporary worker agencies.

Using the above employment volatility, we examine the linkage between the firm's foreign exposure and its employment volatility. The major findings of our study are summarised as follows. In manufacturing, the effect of exports on the volatility of employment varies, depending on the share of intrafirm exports to total sales. This result suggests that the effects of foreign demand shocks on domestic employment are transmitted through intrafirm exports. In wholesale and retail trade, the effect of exports is generally insignificant. Unlike manufacturing, there is no significant effect of foreign demand shocks on domestic employment.

In both manufacturing and wholesale and retail trade, the employment volatility tends to become higher as the share of imports to total purchases increases. This result suggests that the effects of foreign supply shocks on domestic employment come from interfirm imports. Moreover, multinational enterprises (MNEs—FDI firms and foreign-owned firms) do not necessarily exhibit higher employment volatility. In manufacturing, therefore, FDI causes higher employment volatility only when the share of intrafirm exports to total sales becomes high. In wholesale and retail trade, FDI does not necessarily result in higher employment volatility.

For manufacturing, our results are similar to those of Kurtz and Senses (2016), who found that, on average, firms that exported were less volatile than non-traders. However, as mentioned above, the story becomes slightly different if we take into account the effects of intrafirm trade and if we extend the analysis to wholesale and retail trade. These results together suggest that foreign supply and demand shocks could be transmitted not only through manufacturing firms but also through wholesale and retail trade firms. Further, a higher share of intrafirm trade could magnify the foreign demand shocks. In identifying the potential risks from foreign demand and supply shocks, it is important for policy makers to be aware of the heterogeneity between manufacturing and wholesale and retail trade, and the possible effects through intrafirm trade.

Editors' note: The main research on which this column is based appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.

This article first appeared on www.VoxEU.org on December 4, 2016. Reproduced with permission.