Opening Japan - Comparisons with other G20 countries and lessons learned from international experience

Date June 23, 2011
Speaker Dirk PILAT(Head, Structural Policy Division, Directorate for Science, Technology & Industry, OECD)
Speaker Andrea BELTRAMELLO(Policy Analyst, Structural Policy Division, Directorate for Science, Technology & Industry, OECD)
Moderator NAKAO Yasuhisa(Consulting Fellow, RIETI / Director, International Economic Affairs Division, Trade Policy Bureau, METI)


The paper examines three key elements of openness, namely, the role and importance of openness in economic growth; comparisons of openness and how Japan ranks among other G20 countries using indicators such as openness to international knowledge streams and international mobility of people, capital and technology; and available policy measures employed by the Organisation for Economic Co-operation and Development (OECD) countries to promote openness and their results. Given the multi-dimensional nature of openness, it is necessary to examine both inward and outward openness. In the context of foreign direct investment (FDI) one must therefore consider FDI into the country as well as FDI of domestic companies to the global market. The impacts resulting from openness are numerous. Typically, international trade in open economies enables specialization of the economy and allows the economy to reap economies of scale. Exposure to international competition also leads to efficiency and productivity gains and can lead to reallocation within the economy. Sectors which are heavily exposed to international competition will need to improve and increase productivity, while weaker, inefficient competitors will often exit the market. Moreover, openness provides access to knowledge and ideas which in turn drives further innovation, the diffusion of technology and additional productivity gains.

However, openness does entail adjustment costs, particularly when an economy opens quickly and dramatically. This can result in loss of employment as some sectors or companies become unable to compete on a global scale. This effect could be witnessed in the 1990s in Eastern Europe which experienced significant adjustments in the economy. To help minimize these negative impacts, labor markets, social policies and training policies to help retrain the workforce for their employment in other parts of the economy are essential.

In terms of trade openness—taken as a simple indicator of the sum of exports and imports of goods and services compared to GDP—Japan ranks relatively low to other countries. However, this trend is fairly typical of larger economies which tend to trade slightly less than smaller economies. In terms of foreign direct investment as a dimension of openness, Japan's position is mixed. When evaluating both inward investment or liabilities and outward investment or assets, in terms of inward investment, Japan is relatively low, ranking the lowest among countries covered in the paper. There are, however, notable differences between sectors. Taking the example of the transport equipment sector and using a number of indicators (exports as a percentage of production; imports; share of foreign affiliates; turnover of foreign affiliates as a percentage of domestic turnover and two indicators on FDI outflow), close to 50% of foreign affiliate turnover of Japanese automobile makers occurs outside of Japan, indicating a high exposure to international competition. By comparison, the food, beverage and tobacco sector tends to be far less exposed to international competition due to the fact that there are fewer plants outside of the domestic economy and less international trade. This comparison underscores that it is important to be mindful of the differences between sectors.

Global value chains are an additional element of openness. The production of goods in one country which is heavily dependent on the import of intermediates and trade with other countries results in a highly complex and dynamic supply chain. One indicator used to evaluate this chain is intra-industry trade which looks at trade within specific industries. In Japan, intra-industry trade comprises half of all trade. The second indicator is the share of imported intermediate products to the share of total intermediate products, for example, the share of imported parts from abroad used in the production of a Japanese automobile. Using this indicator, large disparities can be observed among countries. For instance, 25% of intermediates are imported from abroad in Mexico's manufacturing sector compared to less than 10% in Japan. And thirdly, the import content of exports, which looks at how much of the production of a certain export is based on imported intermediate goods, can be fairly high in some countries.

The paper employs a variety of indicators to assess the internationalization of knowledge. One indicator where Japan ranks relatively low is in international scientific collaboration such as international co-authorship of papers. While it is notable that the majority of scientific collaboration in Japan occurs among Japanese researchers, similar results can be observed in the U.S. The size of the economy therefore does affect the level of international collaboration. A second indicator of the internationalization of knowledge is the contribution of foreign multi-national corporations (MNC) to research and development (R&D). For example, almost 40% of R&D conducted in the UK is led by foreign MNC. By comparison, R&D by foreign MNC in Japan accounts for only 5%. The third indicator in the internationalization of knowledge looks at patenting, specifically foreign ownership of domestic inventions and conversely, domestic ownership of inventions made abroad, with vast differences among the OECD countries. In Canada for instance, 35% of all patents are held by foreigners. But in Japan, this number drops to less than 5%, highlighting patents as one area where Japan appears to be less open than many other comparable OECD countries.

The internationalization of labor assesses immigration and emigration rates as a share of the total and domestic population. In this area, certain countries such as Canada and Australia stand out where foreigners account for 20%-25% of the total population. In Japan, foreigners comprise only 1% of the total population. Additionally, the share of the Japanese population living abroad is relatively low. This is relevant because people living abroad can serve as a link to foreign sources of knowledge. The second indicator in the internationalization of labor is the share of foreign workers in the labor force. Again, Japan ranks relatively low compared to countries like Germany and France which have high numbers of immigrant workers. Korea, which has been traditionally low in this area has shown an upward trend recently in terms of foreigners working in Korea.

The final indicator looks exclusively at the highly skilled labor force. This segment of the labor force is of particular interest to policy makers as they aim to attract the top entrepreneurs and researchers to their country. Here, again, Japan ranks comparatively low in terms of people coming to Japan and Japanese nationals working abroad, as compared with countries like Australia, Canada and the UK.

Taking into account the above indicators, Japan tends to fair well on some indicators of trade openness in terms of internationalization of exports and imports, and import penetration, as well as indicators of global value chains. However, Japan ranks relatively low in indicators of the internationalization of people, particularly highly skilled people coming to the country, indicators of the internationalization of knowledge, and innovation. Finally, in terms of FDI, particularly inward FDI, Japan has fairly low scores compared to other OECD countries. China and Korea perform relatively similar to Japan, but it is important to note that a significant number of indicators are missing for China. By comparison, a much higher degree of openness can be observed in the UK, which may be influenced by the smaller size of the UK economy and its heavy dependence on relationships with other European countries. The U.S., the world's largest economy, can be regarded as slightly more open than Japan in many dimensions, but like China, some of the indicators are missing.

Important policy implications can be drawn from the indicators of economic openness. One indicator developed at the OECD looks at the overarching set of regulations influencing trade and investment. The OECD conducts a survey on formal barriers to trade and investment from which indicators are developed. From this survey it was concluded that countries outside the OECD area often have much higher trade and investment barriers than the OECD countries. The OECD also looks at policies in place in terms of trade and investment agreements, reporting a wide disparity in the number of investment agreements in place among OECD countries. For instance, Germany has to date 200 bilateral investment treaties or other types of international investment agreements in place whereas Japan as of 2010 only has 33. However, in terms of trade, Japan has a relatively higher number of regional trade agreements in force.

The second area in terms of policy implications addresses knowledge and innovation. As previously stated, the internationalization of knowledge represents an area where Japan traditionally has lagged quite a bit. However, there have been a number of recent reforms in this area. In addition, Sweden and Finland are making efforts to internationalize their innovation system partly driven by the fact that innovation is growing increasingly more collaborative, multi-disciplinary and expensive. Therefore, it is becoming more difficult for one single country or single firm to innovate which is spurring cross-border collaboration. Another important aspect is labor market policies which the OECD evaluates by looking at a country's employment protection legislation to determine the extent to which jobs are protected in a market. In this area Japan ranks relatively low compared to other OECD countries and typically low degrees of employment protection legislation indicate a slightly more flexible labor market. Therefore, when implementing policies to open up the economy, it is important to consider the consequences of such policies on trade and investment, and the labor force.

While there are no formal indicators to assess migration policies, poll data related to the ease of employing foreign labor in different OECD countries show that Korea and Japan are the most difficult countries to employ foreign labor among the countries surveyed. This could be due to formal or informal rules or other related issues, but nevertheless, it is more difficult for foreigners to come and work in Japan than almost any other country included in the poll. In addition, the survey takes into account the attractiveness of the business environment to highly skilled foreign workers. This can include elements such as international schools, language barriers, the working environment, and opportunities for cultural involvement. Countries wishing to attract highly skilled foreign workers must consider all of these elements in addition to competitive salaries. Two notable countries, Denmark and Norway, which traditionally have had low levels of highly skilled foreign workers, are making efforts to raise their levels through the introduction of favorable tax policies, the development of international schools, and wider use of English.

Against the backdrop of an aging population and in order to expand Japan's economic growth prospects, openness in the economy is a timely and important topic. While Japan has been actively involved in opening its economy, particularly at the multilateral level, it continues to lag considerably in areas such as inward FDI, internationalization of science and innovation, and openness to labor, particularly highly skilled foreign workers. The world economy is growing more rapidly than the Japanese economy. Accordingly, the Japanese share of the total GDP is slowly shrinking and, as such, Japan must continue to consider ways in which to effectively increase the openness of the Japanese economy.

Questions and Answers

Q: First, in your presentation, you compare Japan to other OECD countries in terms of openness of the economy. Please also say a few words on the comparative costs to open the economy. Second, the service sector accounts for more than 70% of GDP. In your view, what will happen if Japan opens its service sector?

Dirk PILAT's PhotoDirk PILAT
Responding first to your second question regarding services, typically services are less internationalized than manufacturing. However, this is changing very rapidly as many services become tradable due to advancements in information technology and it is likely that more and more of these services sectors will be exposed to international competition in the future.

Regarding the first question concerning the cost of opening up the Japanese economy, it is true that there are adjustment costs involved. For example, the expansion of English-language education will entail some costs, but it will also provide benefits such as making Japan more attractive to highly skilled foreign workers and providing greater marketability for Japanese nationals wishing to work abroad. Japan can draw upon lessons learned from other countries in order to determine the most cost efficient way to implement policies conducive to economic openness.

As mentioned in the paper, opening the economy can result in adjustment costs. Typically these costs tend to be concentrated on certain categories of workers or industries and, as such, there may be a need for complementary policies to correct these costs in order to ensure that the benefits of liberalization translate to the aggregate economy.

Q: Your presentation did not address the net international investment position (NIIP) indicator, which shows that Japan is relatively open. Is this indicator included in your study?

You are correct that in terms of the NIIP, Japan is relatively open, at least as regards its outward position. Our paper mainly looks at the real economy and therefore this indicator was not included.

Q: Openness of the economy raises concerns regarding the preservation of Japanese culture. Also, opening up the economy may have a negative impact on Japanese agriculture, etc. What are your personal views regarding this?

While there is a wealth of OECD information available on the topic of agriculture, the report does not aim to address this issue. Due to the complexities and sensitivities surrounding the issue of agriculture, particularly in the Japanese context, I would prefer not to touch upon that at this time. In regards to the question on preservation of culture, Japan has been slowly opening up its economy for some time, which has inevitably had an impact on Japanese culture. There are ways of opening an economy while still preserving culture. Our paper makes the point that Japan could face negative consequences to its long-term economic growth if it chooses not to further open its economy.

Q: Please explain the apparent discrepancy concerning Japan's openness. The OECD indicators portray Japan as a relatively open economy. However, the poll data and sentiment of the business community in Japan appears to contradict this. And secondly, if Japan is more open than the poll data suggests, can you please comment on how it can tackle this national branding problem?

You are correct that on some indicators, Japan is relatively open. However, there is not a lot of information available for many countries on non-tariff barriers or informal rules which can also affect openness, and which will influence the business sentiment. There appears to be a growing desire for change or at least a growing awareness of the need for a more open Japan. It remains to be seen what policy mix Japan will take to move ahead on this issue. Certainly discussions on integration with the EU and the TPP are important steps in the right direction.

Q: Is it possible to differentiate between the positive and negative impacts of outward openness and inward openness? For instance, how positive is it for a country to open outward and bring foreigners into the country and conversely, how positive is inward openness where more foreign investment is coming into the country?

As you correctly pointed out the discussion on openness tends to focus heavily on inward openness. But outward investment plays an equally important role, particularly for countries like Australia which is geographically isolated and has a small market. In the case of Australia, for example, it is important to focus also on outward openness, promote the establishment of Australian companies overseas who will then bring that knowledge and experience back to the Australian economy. On the labor side, many countries such as China and India send students abroad with the intention that they will bring their education and entrepreneurial experience back to the country.

There is increasing evidence to refute the conventional wisdom that outward openness is all cost and no benefit. There is a tendency to think that as people leave the country, the country is losing talent. However, there is increasing evidence of brain circulation rather than brain drain as people leave and ultimately come back to the country. Similar effects have been reported for investment. Companies who invest abroad are also more productive and there is no evidence showing a negative impact on local employment.

Q: To what extent can policies change some of the barriers to openness in Japanese society, especially in terms of business practices, social preferences, and institutional setting? Also, you have chosen the nation state as your unit of analysis, but many of the actions actually occur at the sub-national level, which might not be accurately captured by government figures. Please share your thoughts on this.

All cultures evolve over time, but society must be ready and willing to make such changes. That said, there are many ways in which societies change and government is only one player in the evolution of a society or culture that can be influential in relevant policies like education policies, social policies and corporate governance practices. In regards to your comment about the sub-national level, the OECD mainly works with governments at a national level, but there is also work being done at the sub-national level with regions which looks at policy issues at that level.

Q: What are your views on the relationship between the fiscal balance of the national government and openness?

Although the paper does not look at this relationship, I could think of quite a number of countries that are extremely open that have very good fiscal balances so I do not think there is any negative relationship there. The paper argues that opening an economy is good for growth, and growth, in principle, is good for a country's fiscal position.

Q: In your view, what is preventing Japan from becoming open as quickly as some other countries?

My knowledge of the Japanese policy discussion limits my response to this question, but as a general point there are always winners and losers as an economy is opened up. If incumbent companies perceive themselves as the losers, they might effectively oppose structural reform that is not to their advantage. The sequencing of structural reform may also be important in this context. For example, it is important to give consideration to labor market and training policies at an early stage because as the openness of the economy increases, it becomes more exposed to international competition which can lead to reallocation of the economy and job losses in some sector. These policies will play in important role in minimizing the adverse effects of structural reform on unemployment.

Q: This year Japan newly proposed legislation to introduce tax incentives for foreign companies with regional or global headquarters located in Japan. Please share your insight on other countries' efforts to introduce legislation which favors foreign companies and the effects.

One example I can think of is Ireland which used to have a different treatment for foreign and domestic companies. However, there is evidence to support the conclusion that a country's ability to attract foreign investment is more dependent on framework and market conditions, the ease of establishing new companies, and the ability to attract talent while tax incentives, particularly for R&D, play a very marginal role. Therefore, if the framework conditions are not sufficient, tax incentives are not likely to be an effective method to attract foreign investment.

Q: Please elaborate on the soft gains that you mentioned in your slide on regional economic integration in the case of the EU.

Soft gains in the EU context are difficult to measure. The creation of an integrated economic area has increased the EU's clout in terms of trade negotiations and international economic negotiations which we refer to as "soft gains."

Q: Please share your thoughts on why Japan was more successful in the 1970s despite having a less open economy than today.

The stage of economic development is an important factor, but, in addition, the 1970s was a very different period. The global economy today is much larger and Japan's relative share of the global economy is decreasing. The growing need for cooperation on advanced technology is just one reason why openness matters and why it can serve as a driver of future growth for Japan.

*This summary was compiled by RIETI Editorial staff.