Foreign Direct Investment in Japan: A Catalyst for Growth and Reform

Robert C. Fauver (President, Fauver Associates)

The following is a summary of Mr. Fauver's presentation at a GLOCOM Platform seminar on November 7, 2001.

I would like to talk about foreign direct investment into Japan and what potential value it can have for the Japanese economy. It is clear to everybody that the last decade has been a lost decade for the Japanese economy. We have seen ten years of very unfortunate performance, despite significant efforts by the Japanese government to increase budget spending. Regarding monetary policy in the last decade, it is clear that at least the effort by the Bank of Japan has been to ease monetary conditions.

But even as we sit here today, there are new signs of weakness in the Japanese economy. Prices have declined and consumer confidence is very low and declining. Even the government has now admitted that this year will be negative and the outlook is for continued deflation. The worst, perhaps, is that fact that we are now facing the first synchronized downturn in the world economy since the second oil crisis in 1979.

It is clear that both monetary and fiscal policies in Japan are not succeeding. But they have also run their course. Further easing of monetary policy will have very marginal effects and further fiscal spending may have negative effects, if not only marginal positive effects. I have come to the conclusion that what Japan needs at this point in time is a "shock." We want a positive shock. It is possible that a shock could reinstill consumer and business confidence, if it were carefully designed. And a shock could be either internal or external.

In the classic situations, an economy is shocked from a major exchange rate change, a major global recession, a financial market crisis, etc. These are all endogenous shocks that can change economic conditions. But what I am looking for is a positive "structural" shock. That is something that will change the foundation of Japan and change the outlook for growth. One such structural shock could be a new trade relationship such as a "structural FTA" with the U.S. I think the odds are slim of negotiating such a structural FTA, but it is worth thinking about over time.

Another way to look at it would be to find a way to bring new economic players into Japan. That is when I turn to foreign direct investors as a potential positive shock for the Japanese economy. As all of you know, the economic literature for a hundred years has talked about the macro value of foreign investment. It is a way to maximize the efficiency of the use of global capital. It can be a stimulus in the near term for economic growth and for change. But is has only been the last decade or so that the literature has turned to looking at foreign direct investment as a way to change potential growth rates and to change productivity. I think the literature has begun to discuss some of the ideas in which new managerial techniques and innovative technologies can alter growth directly and also indirectly via spillover effects to other industries. So it is a question that is worth empirical analysis to see whether a foreign investor can not only increase productivity in that particular sector, but also through spillover effects increase productivity in the rest of the economy. If that is the case, then there is justification for governmental expenditures to improve the environment for foreign investment.

I think that the government has a range of policies it could utilize to improve the investment climate in Japan. Actually, I have noticed that both Japanese and American business people want the same changes, and fundamentally there is equal support for the kinds of environment changes that make investment more attractive, both domestic and foreign investment. Those policies include tax policies, effective corporate governance, labor market flexibility, land use reforms, stock market reforms, commercial code revision, etc.

The question becomes: Why foreign direct investment? What can it do? The studies in the literature are beginning to prove that foreign direct investors bring new managerial techniques and innovative technologies into the host country. This is not to say that they are necessarily better techniques. They are different techniques and they can foster change. The studies have shown in the case of the U.K. and Germany that foreign direct investors have higher labor productivity than domestic investors have. Foreign firms can also increase competition and lower cost, and bring new forms of corporate governance. They have different labor practices, and they can bring new financial products into the market.

All of you know how much direct investment into Japan has been increasing in the past ten years or so. It is still staggering to realize that within the decade of the 90s, you look at Japan as being the 18th recipient of foreign direct investment within the OECD members. Even in 1999, Japan was only the ninth as a recipient, and still the magnitude was fairly small. While foreign direct investment in Japan has risen significantly in recent years, it is still far from international norms. This indicates that there is a lot of room for growth in Japan of foreign direct investment as a share of total activity.

The question has really become how foreign direct investment can increase growth and productivity. Hubert and Pain in their OECD working paper concluded for the U.K. that there are important firm specific advantages over and above scale and mix of inputs that account for higher productivity. This means that there are real potential spillover effects by foreign direct investors into the host country. Their study pointed to three basic areas, where foreign direct investment can increase productivity: (1) managerial techniques and organizational structure, including corporate governance, (2) international competition experience, and (3) knowledge based assets.

Some recent study has shown that since the late 1990s there has been a broad, consistent spread between the asset prices of those Japanese firms that have adopted U.S. style corporate governance and those firms that have not. Competition has encouraged changes in Japan's distribution system, and has led to "good deflation." More experience with international competition will help convince Japanese managers that they must use some of the new information technology and also new labor market practices.

Finally, it is worth noting one of the conclusions that came out of the U.K. study by Hubert and Pain. That is that foreign direct investment is important and significant in explaining the improved productivity in the manufacturing sector. Evidence in their study also points to significant externalities. Inward investment brings ideas that can be applied across a wide range of industries. Policies designed to facilitate dissemination of new business practices across a wide range of industries and improve the attractiveness of the U.K. are likely to be of greater benefit than policies targeted to selective industries. This means that we need government support for improving the investment environment. Japanese and foreign investors will all gain from an improved climate in which it is easier, cheaper, more transparent and more flexible to undertake economic activity.