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Foreign Direct Investment: A Few Home Truths

Kyoji Fukao

December 2001 (Look Japan)

Foreign direct investment in Japan's non-manufacturing industries has escalated dramatically in recent years.
Fukao Kyoji examines the cause of this sudden increase, analyzes its effect on the domestic economyand explains the need for closer governmental analysis of the role of foreign companies in Japan.

SINCE the late 1990s, foreign direct investment in Japan in non-manufacturing industries has increased sharply.

According to the Ministry of Finance (MOF)'s "Inward Direct Investment Statistics," the total cumulative amount of foreign direct investment in Japan's non-manufacturing industries has grown eight-fold in the last 10 years. Recent investment is particularly striking, and investment flow during the three years from fiscal 1998 onward (¥4.8 trillion) exceeds the total amount invested from fiscal 1950 to fiscal 1997.

	BIG NAMES: Foreign-owned companies in Japan employ largely in the fields (non-manufacturing) of, in order, wholesale, food service, finance and insurance, retail, and air transport and transportation-related services; air transport and software development/information services have seen a "remarkable influx" of direct investment compared to the United States
	Both photos LOOK JAPAN

Foreign direct investment in Japan refers to the international capital movement that occurs for the purpose of buying or investing in already existing Japanese companies or that occurs when non-Japanese companies establish or expand companies in Japan. Generally, when foreign companies conduct activities in Japan, they are considered to be at a disadvantage compared to Japanese companies due to differences in languages, systems and so on. The fact that the foreign companies proceed despite this indicates that they have some sort of advantage. The sources of their advantage may be considered to include their "management resources," including their stock of technological knowledge ac-cumulated through research, development and investment, outstanding management systems, and marketing know-how.

Because foreign direct investment is an inflow of production factors (management resources), the effects on the receiving country can be understood through the economic theories on international factor movements. The inflow raises wage rates and capital earnings rates, and on the other hand, reduces the earnings rate of inferior management resources. Ordinarily the profit of the former is considered to be larger than the loss of the latter, which produces a net profit for the receiving country.

Foreign direct investment in the non-manufacturing industries (excluding primary industries) has a characteristic that markedly differentiates it from investment in manufacturing industries. The difference is that almost all of the products of non-manufacturing industries are difficult to ship internationally since they are products such as financial services and retail services, meaning that companies must establish a supply site in the country where the services will be consumed. From the standpoint of Japanese consumers, this means that outstanding products of foreign companies in the manufacturing industry can be obtained by importing them without receiving foreign direct investment, but to obtain the outstanding services produced by foreign companies in the non-manufacturing industries, foreign direct investment is absolutely necessary. Moreover, this difference between the manufacturing and the non-manufacturing industries means that although it is difficult for a wealthy country like Japan with high labor costs to attract the manufacturing plants of foreign companies, Japan can attract foreign direct investment in the non-manufacturing industries that is aimed at its huge domestic market.

FDI BY SCALE OF PRESENCE

Although foreign direct investment in Japan is sharply rising, it has been pointed out that the amount is considerably lower than in other advanced countries, and this has been used to symbolize the closed nature of the Japanese economy. For example, according to statistics, the cumulative total of direct investment in Japan's non-manufacturing industries as of the end of March FY2001 did not exceed one-eighth of the cumulative total of similar direct investment by Japan overseas.

However, since direct investment is considered to be international movement of management resources according to standard economics, judgment on the scale of direct investment should not be based on how much capital has been moved across national borders (cumulative amount of direct investment flow), but rather on the scale of the production activities that the foreign-owned corporations operate in the given country. Due to the following reasons, a large gap is likely to occur between the cumulative investment amount and foreign capital presence. First, until very recently in Japan, establishment of a foreign-owned subsidiary in the banking or insurance industry was strictly regulated, and so foreign companies entered the Japanese market by establishing branches, which require little fund movement, rather than establishing subsidiaries, which require large investments of capital and so on. While this has meant that the cumulative investment has been small, the presence of foreign-owned firms is fairly large when measured in terms of number of employees or operating income.

Second, despite the fact that investment by Japan in foreign real estate industries during Japan's bubble period was mainly of a portfolio investment nature and hiring and sales in the local real estate industries was not that large, the amount of cross-border investment was massive, and moreover the subsequent withdrawals were not subtracted from the MOF's statistics since the statistics are gross data. So, this swelled the ratio of foreign investment by Japan to foreign investment in Japan.

Third, there are cases when foreign-owned companies expand their production scale by borrowing in Japan instead of procuring funds from their home countries.

So, what is the probable scale of activities of foreign-owned companies? In Japan, the statistics on this matter are markedly inferior to those in the United States. The representative government statistics on the role of foreign-owned companies are the Ministry of Economy, Trade and Industry (METI)'s "Survey on Trends of Business Activities by Japanese subsidiaries of Foreign Firms." However, this study has several flaws, one being that the survey is not mandatory and the response rate is a low 50% to 60%. Other problems include the fact that the banking, insurance and real estate industries in which there is very active direct investment in Japan are excluded from the survey, and the fact that because statistics are collected only at the corporate level, branches and offices directly owned by foreign companies are also excluded.

In the "Survey on Trends of Business Activities by Japanese Subsidiaries of Foreign Firms," foreign-owned companies whose foreign capital exceeds one-third and who are involved in non-manufacturing industries are reported to number 1,050 and have 85,000 employees as of March 2000. This most likely greatly underestimates the actual role of foreign-owned companies.

OFFICE AND CORPORATE STATISTICS

The most accurate statistics for grasping the presence of foreign-owned companies are probably the "Establishment and Enterprise Census," which is conducted by the Management and Coordination Agency, currently the Ministry of Public Management, Home Affairs, Posts and Telecommunications). These statistics are the most basic statistics on all the establishments in Japan. It is superior to the above-mentioned METI's statistics because response to it is obligatory, the response rate is very high, and it covers all business sectors. However, statistics on foreign-owned establishments is not included in the report by the Management and Coordination Agency. Working jointly with Ito Keiko of Hitotsubashi University, the author compiled new statistics on the employment of Japanese affiliates of foreign firms (JAFF) in Japan based on micro data of the Establishment and Enterprise Census of Japan. What we did with the Japanese data was almost the same as the job done jointly by the Department of Commerce and the Census Bureau in the United States. Below is a discussion based on our statistics.

According to the statistics, in October 1996 the number of employees in offices of foreign-owned companies (foreign ownership 33.4% or more) and in branches and offices directly owned by foreign companies was 308,000 people in the non-manufacturing industries overall (excluding primary industry) and 176,000 people in the manufacturing industry overall. The number of employees at Japanese-owned foreign subsidiaries as of 1996 as reported in Toyo Keizai Shinposha's "General Survey of Foreign-owned Companies" was 724,000 people in the non-manufacturing industries and 2,344,000 in the manufacturing industries. Thus, it can be seen that the imbalance between overseas investment by Japanese parties and investment in Japan by foreign parties is approximately 1 to 2.5 in the case of non-manufacturing industries if viewed in terms of employment figures. Moreover, if the definition of "foreign-owned company" is broadened to include companies with more than 10% of their capital subscription composed of foreign capital, then the number of employees in foreign-owned companies in Japan expands to 1,133,000 people in non-manufacturing and 1,025,000 in manufacturing.

The table compares the presence of foreign-owned companies in Japan with that in the United States at detailed industry level.

The cumulative amount of direct foreign investment (in all industries) as a percentage of GDP, on an international balance of payments basis, as of 1997 is 9.5% in the United States as compared to only 0.7% in Japan. However, when compared based on employment figures, the difference between Japan and the United States is not that striking. Particularly in non-manufacturing, the ratio of the number of workers employed by majority-owned foreign affiliates to the total number of workers in Japan is over one-fifth of that in the United States.

According to the table, in the manufacturing industry, the presence of foreign-owned companies is markedly lower in Japan than in the United States. However, it is possible that this is not due to Japan's closed nature with regard to investment in Japan, but rather reflects the closed nature of the United States with regard to the import of goods. If the trade barriers are low, it is rational for multinational companies to produce in developing countries where the production cost is cheap and to export to countries like Japan and the United States. U.S. operations set up by foreign-owned manufacturing companies, including those from Japan, are in many cases conducted for the purpose of jumping over trade barriers such as anti-dumping policies and demands for self-regulation of automobile exports.

FDI DISTRIBUTION

Let us consider what sorts of characteristics exist in foreign direct investment in Japan's non-manufacturing industries using data (calculation was conducted on 58 types of manufacturing businesses and 55 types of non-manufacturing businesses in the paper by Ito and Fukao referred to in the table) on business sectors at the three-digit level from 1996.

The non-manufacturing field with the most employees at foreign-owned companies (those with over 33.4% foreign capital) is wholesale with 117,000, followed by the food service industry (65,000), finance and insurance (31,000), retail (27,000), air transport and transportation-related services (15,000), followed by software development and information services (12,000). These industries account for approximately 87% of the total. Among these, in wholesale, food service, finance and insurance, and retail, it's not the case that the share of foreign-owned companies is particularly large because the scale of domestic industry is large. Also, in other advanced countries such as the United States, the number of employees is large at foreign-owned companies in wholesale as well as in finance and insurance. In contrast, the influx of foreign-owned companies in Japan in air transport and software development/information services is remarkable compared to the United States. Consequently, the first characteristic of direct investment in Japan that may be noted is the strong presence of foreign-owned companies in air transport and software development/information service.

Moreover, since the latter half of the 1990s, direct investment in Japan has been rapidly growing in the communication and finance/insurance fields, reflecting industrial reorganization in Japan domestically and extensive deregulation, including abolishment of restrictions on investment in the type one telecommunications industry.

According to MOF's statistics, 65% of the direct investment in non-manufacturing industries during the three years starting in FY98 went into these industries. There is a strong likelihood that the foreign-owned presence in these two fields is increasing significantly today.

A second characteristic is noticeable when the distribution of the business sectors that receive investment in Japanese non-manufacturing industries is compared with those in the United States. In Japan, direct investment by foreign parties is concentrated in certain industries, and there remain many fields where there is absolutely no foreign investment, including healthcare, education, and utilities. In contrast, in the United States, those types of fields also receive investment, although it is small. We can say that in Japan's non-manufacturing industries, there still firmly exist "sacred areas" that are not exposed to international competition.

FACTORS IMPEDING FDI

As causes of the recent sharp increase in Japan's non-manufacturing industry, the following can be cited: (1) The fact that Japanese companies are considered to be in a fire sale condition by other countries because of numerous business failures, mainly in the finance/insurance industry and because of the drop in stock prices, land prices and the value of the yen; (2) Global corporate restructuring is occurring in fields such as finance and communications as each company plans for its own survival in a global marketplace; and (3) The fact that the Japanese Government is implementing bold deregulation in the fields of finance, insurance, communications, broadcasting and so on. Factors that have often been noted up until now as impediments to investment, including keiretsu (affiliated company) relationships and the low mobility in the labor market, are starting to be erased by such factors as the ending of interlocking stock ownership, construction of an open supplier system and a high unemployment rate. The foreign-owned share in the non-manufacturing industry viewed in terms of employment figures has already reached approximately one-fifth of that in the United States in 1996, and during the next seven or eight years, it may reach a level not so different from that of the United States.

In order to remove government impediments to direct investment by foreign companies, not only should the principle of equal treatment irrespective of nationality be applied, but restrictions on market access should also be eased. In the "sacred" sectors, restrictions on market access, which take precedence over equal treatment, impede direct investment by foreign companies. In fact, even Japanese corporations are sometimes prohibited from participating in those markets because of legal restrictions. The very existence of public entities also impedes participation by private companies. In order to encourage market participation by foreign companies in areas in which governmental involvement is high, there is a need to solve difficult issues such as how to introduce competitive principles without violating the public interest.

PROVISION OF DESIRED STATISTICS

In the United States, statistics on foreign direct investment were substantially improved in the 1980s when foreign direct investment increased sharply, making it possible to accurately grasp the activities of foreign-owned companies in the United States today. In comparison, the provision of statistics in Japan lags far behind. The lack of statistics may be damaging Japan's national interests in the following ways.

First, despite the fact that the Japanese government has adopted a policy of promoting foreign investment, no one accurately knows in what business sectors and to what extent the entry of foreign companies has progressed. This is like treating an illness without taking the patient's temperature and pulse.

Second, the Japanese Government's policy of promoting foreign investment is premised on the entry of foreign companies contributing to Japan's structural reforms. However, foreign-owned companies are not always necessarily superior to Japanese companies. Just as most Japanese investments in the U.S. real estate and financial industry during the days of the so-called bubble economy ended in failure, some foreign direct investment may be revealed as inefficient at a later point in time. It is a known fact that foreign-owned companies' rates of return are high overall, but almost nothing is known, particularly with regard to the non-manufacturing industry, about how much higher the productivity of foreign-owned companies is when compared to Japanese companies or how much management efficiency improves when Japanese companies are bought by foreign-owned companies. A detailed analysis of these issues is desirable.

Third, because the Japanese government has only incomplete statistics, it has continued to transmit mistaken information overseas that the presence of foreign-owned companies in Japan is extremely low and that the Japanese economy is a closed economy.

To resolve issues like those above, it is necessary to accurately understand the role of foreign-owned companies by making a response to the "Survey on Trends of Business Activities by Japanese Subsidiaries of Foreign Firms" obligatory like in the United States, in addition to adding the finance, insurance and real estate industries to the survey.