Japan's Growth Strategy—What can be learned from international good practices?

Dirk PILAT

I would like to talk about where Japan stands on productivity growth, and about some drivers of growth performance and productivity. At the Organisation for Economic Co-operation and Development (OECD), we recently studied the role of global value chains, and I will also discuss globalization, the roles of knowledge and upgrading in that context, entrepreneurship and the role of new firms and young firms, and other drivers of performance. Through all of this, I plan to focus on some policy issues.

Looking at where Japan stands in terms of gross domestic product (GDP) per capita, in terms of income levels, there is a gap with countries like the United States, and most of it is explained by low productivity. Japan scores well in terms of its labor input, number of hours worked, and other indicators, but the difference with many other countries is the relatively low productivity in its economy.

Productivity hasn't grown rapidly over recent years which is concerning for a country lagging in it. The potential for Japan to increase productivity also means the potential for it to increase growth into the future.

Japan's international endeavors, for example, its engagement in global industries, are an important factor. This leads to global value chains.

Using the iPhone as an example, if 10 million units are shipped from China, this contributes to a negative trade balance between China and the United States. However, China adds very little value to the price of this product as it is only doing the assembly; most of the components come from other countries. In value-added terms, this therefore leads to a very different picture: the negative balance between China and the United States gets shifted to other countries, for example, Korea. At the OECD, we have worked together with the World Trade Organization (WTO) to turn this case study into a real database which we call Trade in Value-Added. The point is to develop a global input-output model which links national input-output tables together with bilateral trade statistics. We built upon the extensive work of Japan, in particular, the Institute of Developing Economies, Japan External Trade Organization (IDE-JETRO), in this area.

The OECD-WTO Trade in Value-Added database covers 57 countries, 95% of GDP, and 90% of world trade—a large share of the world economy. We can see how countries are participating in the global value chains. We divide this into backward participation and forward participation. Backward participation involves looking at how much of Japanese exports are based on imports coming from elsewhere, i.e., looking backward in the value chain. The ratio for Japan is relatively low at 15%, which indicates that it is not so heavily engaged in the value chain as it does not greatly rely on imports. Forward participation is looking forward in the value chain. This implies looking at how much of Japanese exports feed into the exports of other countries. This ratio, 28%, is much higher because Japan produces many parts, components, and products which feed into the exports of other countries. It is also possible to see what's happening at the sectoral level—in which industries Japan is mostly engaged in the global value chains.

As for services, only 20%-22% of all trade is in services. With our database, how much services are embodied in manufacturing products can be investigated. There are many services which feed into manufacturing production which has an impact on manufacturing exports. In Japan's case, about 30% of the value of manufacturing exports, a substantial number, is actually value created in the services sector. Although some countries show an increase over time, this hasn't changed much since 1995 in Japan. Recently, we have seen many manufacturing companies adding or embodying business services in their exports.

As for Japan's performance over time, in 1995, it accounted for about 10%-12% of total manufacturing exports. In 2009, it was down to around 6%-7%. This is partly because of China's rise, but some other countries, particularly Germany, have done somewhat better in maintaining strong export performance in manufacturing than has Japan.

We also looked at how much employment is dependent on the global value chains. Many jobs rely on the ability to export and benefit from global value chains. Since 2008, the share of jobs in Japan sustained by foreign final demand in the business sector has increased from about 10% to about 15%-17%. There are a few other countries in which more jobs rely on foreign final demand—from 20% to almost 35%.

As for policy vis-à-vis global value chains, in terms of trade policy, the most important is to acknowledge that imports are essential for exports. If there are barriers on imports, that has an impact on the prices of exports. The second point is the role played by trade facilitation and services. These value chains depend on efficient functioning, on time-to-market, thus trade facilitation is quite important.

Moreover, countries are much more specialized in certain activities today, and competitiveness in global value chains is often no longer about whole industries. The part of the value chains in which you are involved determines the amount of value you are creating. Manufacturing is still a very important driver in value chains because it is still the main determinant of trade, but services, which allow product differentiation and creation of more value, are becoming increasingly important.

Next, I would like to talk about the role of innovation for upgrading in global value chains. There is the case study from the former chief executive officer of Acer Inc. and what we call the "smiley curve." He used this to illustrate where one wishes to be in the value chain based on the example of the electronics industry. We also see this somewhat with the iPhone example, where the middle, the point at which assembly is taking place, may be the part of the value chain where the least value is created because assembly can be done in many different countries. Much of the real value creation happens in the early stages of the value chain, where there is research and development (R&D), design, more complex production, etc., or at the end of the value chain, where there is branding, marketing, and other types of services.

One of the links we have tried to make is to show that much of the value creation in the early and later stages has to do with the use of knowledge. Productivity is also a factor, but in many countries, value creation has become increasingly related with embodying increasingly complex knowledge in the early and later stages. Japan has also worked extensively at looking at intangible capital. We can see from OECD data that nowadays in countries like the United States, Germany, Finland, and Sweden, there is more investment in knowledge capital, software, data, R&D, skills, and organizational capital than there is in fixed capital like machinery, equipment, and buildings. Knowledge-based capital (KBC) can also be used to keep production anchored in Japan.

For KBC, there are three categories at which we typically look. The first is computerized information, both software and data. There is discussion in Japan about the role big data can play, and this is something many companies now see as a real possible driver of growth and productivity. The second is innovative property—everything related to innovation and R&D and particularly intellectual property rights such as copyrights, patents, trademarks, and designs. The third component is economic competencies—branding, skills, networks, and organizational know-how. Measuring these three components properly over time will still require significant work.

A concrete example of KBC is the Nespresso machine. Through very good branding, interesting design, R&D to create capsules of good quality coffee, and substantial marketing, they made a product, which is a simple coffee machine, into something that captures substantial value. Many companies are trying to capture more value by using these types of investments in interesting combinations.

Now, I would like to discuss three especially important factors for discussion on Japan. First, is there a sufficient number of innovative companies? Is there enough change in your value chain? Are you capturing new possibilities sufficiently? The second is the social fabric of society. Can you keep up with the changes in the world economy? And the third is services.

Entrepreneurship is important in this discussion. Most of the job growth over the past 10 years, including in Japan and the United States, has come from young firms that are less than five years old, and most of the job destruction has happened in older companies. We looked at small old and small young firms. Interestingly, small young firms account for only about 12% of total employment in these countries while small old firms account for over 30%, but small young firms have much more job creation than job destruction. It is the same for medium-sized and large firms, and this pattern is repeated across all of the countries for which we have data.

To what extent firms scale over time is the next question, and there are major differences between countries. Firms start small, but what tends to happen in the United States is that they grow significantly over time. On the other hand, looking at data on firms in Italy, once they have started, there is very little growth. We only have manufacturing data for Japan, but there is not much scaling.

What are some of the factors that make a difference here? One is the availability of risk capital particularly for startups. We also need to look at regulation. There are sometimes barriers to competition and regulatory administrative opacity—regulations are quite complex, making it hard to build up a company. One other factor is bankruptcy legislation—if you cannot go bankrupt and try again, you will not necessarily get the entrepreneurs with the right set of skills.

For driving entrepreneurship, a different set of policies is needed than that for small and medium sized enterprises (SMEs), for example, in terms of access to risk capital, types of regulatory policies, and the type of innovation system necessary for these companies. Entrepreneurship is a way of generating new dynamism in an economy and generating new opportunities in the business sector, thus it is very important to consider it in policy.

I will now present some comparisons of indicators of where Japan stands. One is human resources. The people and their skills and education help to drive an economy forward. Japan is particularly low in the participation of women at the doctoral level. Japan also doesn't have many doctorates compared to smaller countries like the United Kingdom and Germany. The recent OECD Programme for International Student Assessment (PISA) and Programme for the International Assessment of Adult Competencies (PIAAC) results show that Japan does well on many of those indicators, but there are areas where improvements could be made. Examples include the high number of people who had no information and communications technology (ICT) experience or failed the test on information technology. This a challenge if you want to make information technology a real driver of growth.

The second is the quality of science in Japan. Japan does extensive research—it is the third-largest investor in the world in R&D, and it publishes an enormous amount. However, looking at the highest-cited publications, Japan scores relatively low. One reason is that international cooperation is relatively low in Japan. High-quality publications often depend on cooperation with other researchers from other universities and other parts of the world. Another factor is that very few researchers in Japan have worked or spent time abroad. The indicator of the international mobility of scientific authors shows Japan's level to be closer to the BRICS economies than to advanced OECD countries. We also see that people who stay in the country have a much lower impact with their research than those who have spent even just a short time abroad. Research mobility accordingly is an important factor.

Japan provides relatively modest support for business R&D compared to many other OECD countries. This is an area where the R&D tax credit could be improved by adapting it more to young firms.

Information technology is also an important driver of growth for the future. Big data is one area where many countries see opportunities. In Japan, however, there are few enterprises selling online compared to many other countries. Less than 30% of large Japanese companies are selling online compared to over 50% in some European countries. The connection of Japanese companies to broadband networks is also lacking. Also, Japan has very little presence in ICT services.

Human resources is a major concern for the future. At the moment, with Japan's very low women participation level, 50% of its workforce is not necessarily being used very well. It is also confronted with the challenge of very rapid aging. As for science, strong public investment and quality are two things that need further improvement. International collaboration and mobility also can help. Innovation will require strong investment in R&D. The lack of internationalization of innovation should also be improved. Information technology is a future driver of growth, but there likely are still some challenges ahead.

Commentator TANABE Yasuo

Hitachi, Ltd. is one of the largest group companies in Japan. For its productivity target, Hitachi aims at having its operating income to total revenue ratio catch up to the more than 10% recorded by the global major players. Hitachi enjoys 4%-5%, but it is targeting 7% in 2015 and eventually 10%.

Hitachi is also changing its business model, and it was in the manufacturing business. In your smiley curve, we used to be located in the bottom center. However, now we are pursuing what we call a "social innovation" business model. This is Hitachi's catchphrase. The idea is to provide solutions for society by combining products, services, and highly sophisticated IT.

We are also expanding our global business. The majority of Hitachi's revenue comes from the domestic market. Our global business target is an overseas revenue ratio of at least 50% in three years and increasing this figure in later years.

The next point is cost structure reform. Hitachi's "smart transformation project" comprises its cost reduction activities. As for our R&D activities, we now are leveraging R&D capabilities and R&D global networks. We are also leveraging global talent and diversity (human resources). For example, we have modest targets to have our first female executive in 2015 and 1,000 female managers in 2020.

Commentator KAJISA Shunichi

I am the president of Microsoft Development Co., Ltd. and also the chief technology officer of Microsoft Japan Co. Ltd. I would like to comment on Japan's growth strategy. Dr. Pilat mentioned the importance of startups, and I will also talk about that.

First, I will talk about what Microsoft is doing now. We have many programs for startups which provide free software/cloud computing, allow them to engage more with global communities, provide seminars and test facilities, and license intellectual properties for them. Last year, a Japanese team won second place in the Microsoft Imagine Cup, the world premier IT competition for students. We also work with Japanese universities.

Startups are a very critical part of the future economy. According to a recent report by The Boston Consulting Group, SMEs, which comprise two-thirds of Japanese companies, are a critical growth engine for jobs and economies.

Startups contribute to creating jobs more dynamically with more technologies. Japanese companies tend to stay in Japan, but with cloud computing, companies can start global cloud services more easily from the beginning. With more orchestrated effort by the government and private companies like Microsoft, we can accelerate startups.

We need to make sure that startups have world-class IT infrastructure to compete well globally and have access to data and intellectual property (IP). We need to ensure that they also have access to big data, open data. Large companies like Microsoft have big patent pools, but they aren't making effective use of some patents, so we should be able to license IPs to startups with no hurdles. Dr. Pilat also introduced the important concept of KBC. Non-physical assets such as R&D, data, software, and others are exactly what Microsoft can contribute to help startups and people to take advantage of KBC.

We need to manage a good balance in privacy and data security concerns. Regulations that are too strict prevent startups from innovation. Also, the innovation cycle has been getting faster. We need to gear up the international standard process and have good inoperability and good interconnectivity. There should also be better tax incentive programs and funding schemes for innovative startups. Finally, we are part of global value chains, and we should help by bridging startups through opportunities in both consumer and enterprise businesses.

There are many national projects ongoing in Japan associated with open data, covering various segments, which are driving innovation. We must also think about the next thing beyond open data. Currently, we are focusing on how to do data mining and how to create new values.

The rise of KBC will create new challenges for policymakers, business, and the way in which economic activity is measured. In closing, I would like to say that there is no bad data, just bad uses of data.

Dirk PILAT

The transformation described with regard to Hitachi is something we've seen in other countries. In my country, the Netherlands, Philips, which was more of a manufacturing company, is now a company very much focused on solutions and quality of life. In the past, its approach was that it didn't want ideas if they came from outside of the company, i.e. "not invented here." The current approach is "proudly found elsewhere." It changed culturally as well in that the company became more aware of the value of startup companies and of working with others. Making that transformation culturally is important.

As for your point about data, it is one of those aspects of KBC which is really important, but the policy frameworks for this in place in countries are not entirely there yet, partly because the growth in data has been so rapid and the ability to gather this data has been so quick that our policies haven't kept up with it.

Q1: Please give us your candid assessment of Prime Minister Shinzo Abe's growth strategy. If you were to advise him in coming up with his next growth strategy, what would it be?

Dirk PILAT
First, I think it is very important to have this combination of the arrows, as they are called—a combination of macro and structural reform policies. Japan does need the structural reform side, but it is important to combine it with other types of policies. Structural reform has been discussed in Japan for a long time, but it hasn't moved very far yet. That's why I mentioned services. The big gap in productivity performance in Japan with the rest of the world is not in the manufacturing sector but in the services sector.

I also mentioned internationalization. It's important to be aware that 90% of the world's knowledge is not in Japan; it's outside and being created in other parts of the world. Having access to that knowledge and working with other parts of the world to gain access to it is becoming increasingly important. As for what you can do, I was encouraged by hearing about Hitachi doing more abroad in terms of R&D, but there are also policies you can put in place—for example, in Japan's science system and university system, encouraging more international mobility, trying to bring more people to come to Japan to work and study, etc.

Q2: Dr. Pilat, regarding the issue of foreign workers, which is a global issue, localized solutions to global phenomena sometimes lead to instability. What is the best way to approach this? Mr. Kajisa, I've been working in cyber security for some time, so I would like to ask your opinion about Bitcoin.

Dirk PILAT
As for foreign workers, many OECD countries are currently facing a challenge—how to deal with having an aging population with the knowledge that their workforce is shrinking over time. Some countries believe they can utilize immigration policy. I mentioned it in the context of the international mobility of researchers. For example, the science system of the United States relies to a very large extent on foreign researchers because the system is not developing enough people.

KAJISA Shunichi
I believe Bitcoin is equipped with modern technology and very high security. But there are easier targets than Bitcoin today. Microsoft is being attacked every minute. This is an industry-common issue on which the whole industry should work together.

Q3: My question is about the definition of "internationalization" or the meaning of the word "global." You presented an interesting comparison of participation in global value chains and the international mobility of scientists. However, many of those comparisons are with EU countries. If you have some EU-wide data, it might be more helpful for us to realize the current situation. Second, it is not easy to understand why the scores of Japan in the innovation survey are relatively low. What data were used to make this comparison?

Dirk PILAT
I agree you have to be very careful about the definitions and measurements. However, looking at a whole range of indicators to see where Japan stands on internationalization—foreign direct investment, international trade, international mobility, no matter how you define them, Japan is relatively low. On your question on innovation, we still have difficulty in getting a good handle on the measurement of innovation. What we used here are innovation surveys. The OECD together with Eurostat developed the manual on this. Comparing across countries is always a challenge. I think it is surprising that Japan scores relatively low on this indicator, and I am unable to give a great answer as to why.

MODERATOR
There were some very interesting observations by Dr. Pilat. The quality of science could be improved. This means Japanese science education is lousy, bad.

Dirk PILAT
I didn't say that.

MODERATOR
...And Japanese firms are not yet as active in ICT. Tanabe-san's company is in the ICT business, so you are said to be not active enough. I would like to hear your reactions on these remarks.

TANABE Yasuo
Dr. Pilat, talking about the cultural change for innovation, mentioned "not invented here." Hitachi has a very "not invented here"-minded culture. But we are aware of that, so we are now trying to transform this. Our executives at the headquarters are trying to utilize our many group companies, international companies, to pursue innovation. Our R&D division is often involved in collaboration with local universities and research institutes to interact and bring new research outputs. This can be effective for many Japanese entities.

Q4: Dr. Pilat, you used the term "trade facilitation." Did you mean non-tariff barriers including language barriers, lack of preparedness to cooperate with foreigners, bureaucracy, or tribalism?

Dirk PILAT
I think it is mainly about making it easier to trade. That is, often about things like customs procedures in countries, the ease of shipping, and trading internationally across borders. Considering global value chains, if there is a country where it takes 50-100 days to export because the procedures are very extensive, it is very unlikely that that country will be used in a global value chain where you have a very short time-to-market.