Discuss Japan > Back Number > No.9 > WORRY ABOUT HOLLOWING OUT FOR THE RIGHT REASONS – LIQUIDITY OF RESOURCES IS IMPORTANT TO QUICKLY FILL EMPTY SPACES AFTER COMPANIES LEAVE
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No.9 ,Economy  Dec 07, 2011

WORRY ABOUT HOLLOWING OUT FOR THE RIGHT REASONS – LIQUIDITY OF RESOURCES IS IMPORTANT TO QUICKLY FILL EMPTY SPACES AFTER COMPANIES LEAVE

Globalization and foreign direct investment of companies

Photo : Komine Takao

Komine Takao

We can begin to think about this from the first step.

Corporate activities are globalized in two ways: international trade and direct investment. Until the 1970s, the globalization of Japanese companies was overwhelmingly centered on international trade. Japan imported energy and raw materials, which it lacks, and manufactured industrial products and exported them. Production bases were located in Japan, and the imported products centered on those Japan cannot produce domestically. Therefore, hollowing was not a topic of discussion.

Globalization of Japanese companies has continued to deepen since the 1980s as they have come to deploy operating bases across borders for their corporate activities such as production, sales, and research and development. These activities can be understood by looking at the behavior of foreign direct investment. Foreign investment can be divided into direct investment and indirect investment.

Direct investment refers to that to manage foreign companies by acquiring their shares (merger and acquisition [M&A]) and engage in production by constructing plants (Greenfield investment). Indirect investment refers to simple investment in shares and securities with no intent of managing foreign companies. The behavior of direct investment is a main indicator of companies’ economic activities across borders.

Direct investment is increasing worldwide, acting as an underlying trend. The table below shows a comparison of growth in GDP, international trade and direct investment around the world since the latter half of the 1980s. Growth in international trade is seen to generally be higher than that in GDP, and growth in direct investment is even higher than that in international trade. However, growth in direct investment has been slowing or sharply declining since 2000, presumably due to negative factors such as the subprime mortgage loan problem and the Lehman Brothers collapse. The fact that international trade is growing more quickly than GDP means that ties between countries have been further deepened through export and import, and the fact that direct investment is growing even faster still indicates that the globalization of corporate activities themselves has been advancing at an even higher speed than international trade.

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Foreign direct investment from Japan has also been showing high growth (however, since this is a net value after subtracting inward direct investment from outward direct investment, we cannot simply compare this with worldwide values). After the appreciation of the yen following the Plaza Accord in 1985 the growth became particularly high, and the amount of foreign direct investment from Japan increased from 1,400 billion yen in 1985 to a peak of 10,700 billion yen in 2008.

As corporate activities have been expanding across borders as mentioned, the ratio of overseas production of Japanese companies has been trending higher. The Annual Survey of Corporate Behavior conducted every year by the Cabinet Office shows that the ratio of overseas production of the manufacturing industry in Japan (ratio of overseas production to overall production of companies) rose from 4.6% in FY1990 to 11.1% in FY2000 and 18.0% in FY2010. Particularly for the processing industry, the ratio has been climbing up from 6.5% to 15.9% and 25.1%, respectively.

This globalization of corporate activities should be actively promoted. Free movement of human resources, physical assets and capital beyond borders is a global trend. If Japanese companies stay in their country in this environment, they will end up losing chances for their own development. We can clearly see what this will result in if we think what would have happened had Japanese companies not allocated their operating bases overseas. Since the mid-1980s, Japanese companies have been going overseas to survive as the exchange rate of the yen rose. Adhering to the way of manufacturing products in Japan for export without going overseas would by now have lost them their market share to foreign companies across the board.

Direct investment by Japanese companies was also a key in the development of Asia as a whole. Japanese industries that were caught up to by competitors in emerging countries have been transferring the low value-added areas of their production overseas while cultivating high value-added industries in Japan. This helped transfer industries that Japan had been fostering until then to Asia, and Asia resultantly developed. In fact, Asia grew in earnest after the latter half of the 1980s when Japanese companies advanced into Asia. This is a concept of the so-called dynamic international division of labor.

A Japan that leads Asia hands over some of its industries to other Asian countries and shifts itself to higher value-added industries. In Asia, such industry handover has been implemented in the order of Japan then to newly industrializing economies (NIEs) and regions, ASEAN and China. This has resulted in a more sophisticated industrial structure for Asia as a whole.

It is wrong to delay the pace of globalization of corporate activities because of fears of hollowing out.

Are overseas investment and domestic investment alternatives?

Moving to step two, discussions on hollowing out implicitly assume that if companies move their production bases overseas by making capital investments there, corporate activities in Japan will decrease by that amount. But this is not necessarily self-evident.

This is a question of whether overseas and domestic investments are alternatives to one another or complementary. Provided this is an alternating relationship between overseas and Japan, domestic investments will decrease if overseas investments increase. This poses the risk of hollowing out. However, if they are in a complementary relationship in which domestic investments increase when overseas investments increase, hollowing out will not arise because corporate activities will increase in parallel.

So then what is the actual situation? Though this can be verified only by actual proof, there appear to be many views that conclude they are complementary, contrary to expectations. For example, the Annual Report on the Japanese Economy and Public Finance 2002 of the Cabinet Office analyzes the relationship between foreign direct investment and business investment in Japan and states that when foreign investment increases, business investment in Japan also increases in many cases (*1 Chapter 3, section 1 – Construing Concern over “Hollowing Out of Industry”).

The Annual Report on the Japanese Economy and Public Finance 2011 published in August 2011 presents its analysis that companies that increase their overseas production ratio have a larger positive value in their employment prospects than those that leave the overseas production ratio unchanged or decrease it (*2 Chapter 2, section 2 – Impact of Globalization on the Domestic Economy).

In other words, companies that actively increase overseas business operations do not necessarily decrease their capital investment and employment in Japan, but instead increase them.

This is in fact convincing. For one thing, companies that actively go overseas tend to be energetic, and domestic activities of energetic companies often also grow. Another reason appears to be that even if companies transfer some of their activities overseas in their move to reallocate corporate activities, they will in many cases strengthen domestic activities in other areas (such as research and development).

The real problem is illiquid domestic resources

Finally is step three. Even if the discussions above are valid from a macro perspective, there may be individual cases in which the overseas transfer of companies will leave complete holes in Japan. Even in such cases, if resources (labor, capital, land, etc.) that have become excessive as a result are used in other areas, the overseas transfer will not result in hollowing out.

Least of all, thinking about the future of Japan, labor will over the long term run short due on the one hand to the lower ratio of the labor force to population, while demand for health care, nursing care and welfare will increase associated with the aging of society on the other. So we could even say that it would in fact be better to transfer economic activities that have been conducted in Japan thus far overseas and divert resulting surplus resources to areas that will newly grow.

The theory of hollowing out assumes a situation where holes in areas out of which corporate activities have gone will not be filled, since domestic resources (particularly labor) in Japan are illiquid. This is a real point of concern. Unfortunately, as the theory of hollowing out assumes, the liquidity of resources in Japan is in fact low. Basically, labor has a strong tendency to stay in companies and occupations where workers first find a job, and the liquidity between regions is also low. This is partly because the metabolism of companies to exit from declining industries is also weak, so that venture companies are not born in growth areas.

In other words, to address such a problem it is important to make the migration of resources more liquid to quickly fill the holes even if companies have left, instead of trying to suppress the overseas operations of companies over fears of hollowing out.

Globalization of corporate activities, and government policies

The above discussion assumes there is no major problem in the environment surrounding companies and that companies that should exit will do so. In practice, however, this is not necessarily the case, because the situation in which even companies that should stay in Japan exit could occur if there are structural problems in the domestic environment.

This is an institutional impediment. A country’s institutional design determines how much burden companies there will be required to shoulder in the tax and social security systems. Restriction of corporate activities by labor laws will also increase costs for companies.

Given these points, it is conceivable that countries around the world are engaged in international institutional competition. Developing a comfortable environment for companies to operate will attract foreign companies and activate the economy. To the contrary, if a country falls behind in institutional framework, companies will leave. In Japan, while Japanese companies make a large amount of foreign direct investment, there is little inward direct investment by foreign companies. This is highly likely to be an indication that Japan lags in international institutional competition.

There are also uncertainties. For example, electricity shortages are a newly added factor for hollowing out. In this regard, if Japan will in fact have regular electricity shortages, companies unavoidably will advance overseas transfer to a certain extent in preparation. However, a real problem is that the appearance of Japan’s energy policy is highly uncertain. Since companies allocate their management resources from a long-term perspective, overseas transfer of corporate activities will accelerate all the more if there are significant uncertainties.

To summarize the discussions here, the following conclusions can be drawn.

First, it is wrong to hinder the globalization movement of corporate activities itself simply because of concerns about hollowing out.

Second, we should basically fluidize the migration of resources as much as possible to lead overseas operations of companies toward more efficient allocation of domestic resources.

Third, we should develop an environment for corporate activities to be conducted as smoothly as possible, through structural reforms such as regulatory reform and presentation of a clear energy policy.

References

*1 Column 3-1 Relationship between Foreign Direct Investment and Domestic Business Investment (Annual Report on the Japanese Economy and Public Finance 2002)

It is widely believed that foreign direct investment symbolizes hollowing out of industry in Japan since it may replace domestic business investment and result in declining domestic production capacity. So what is the real relationship between the two forms of investment?

According to the “Foreign Direct Investment Report” by the Ministry of Finance (1), Japanese firms’ outward direct investment expanded substantially in the latter half of the 1980s as manufacturers stepped up investment in Europe, North America and East Asia in response to the rapid appreciation of the yen after the Plaza Agreement in 1985 and Japan-U.S. trade friction, and as banking, insurance, real estate and services sectors increased overseas investment against a backdrop of domestic business expansion. However, such investment peaked in FY1989 and continued a sharp downturn until FY1993 due to the collapse of the bubble economy in Japan. From FY1994 to FY1997, Japanese manufacturers increased outward direct investment, mainly in East Asia, in order to reduce production costs and explore new markets. But the East Asian economic crisis from the latter half of 1997 led to a downturn in Japan’s foreign direct investment in FY1998. Foreign direct investment rose again thanks to large deals reflecting global industrial reorganization, before falling in both FY2000 and FY2001.

The trend of Japan’s outward direct investment has thus been linked to developments in domestic and overseas economies, as well as the exchange rate. A correlation between outward direct investment on the vertical axis and domestic business investment on the horizontal axis, as shown in Figure 1, indicates that domestic business investment and outward direct investment increase or decrease almost simultaneously, though large deals can result in some irregular moves. As such, we can see that they are not necessarily in a “zero-sum” relationship.

The above explanations cover only Japanese parent companies’ outward investment, but their overseas subsidiaries use not only direct investment from their parent companies but also their own final procurement such as borrowing from local banks and profits from local operations (so-called reinvestment) to implement business investment. When examining the relationship between Japanese firms’ outward direct investment and domestic business investment, we have to take account of their overseas subsidiaries’ local borrowings and reinvestment. Looking at the relative size of overseas subsidiaries’ investments, which include investments implemented using self-raised funds, to total domestic business investment (i.e., overseas business investment ratio) for the manufacturing sector, the ratio has been rising slightly (see Figure 2). In other words, Japanese firms’ overseas subsidiaries have been autonomously expanding their business size through business investment using their own internal reserves and overseas-raised funds. This contributes to a raise in the overseas production ratio for Japanese companies.

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*2 Column 2-3: Impact of Intention to Expand Overseas Production on Employment Prospects (Annual Report on the Japanese Economy and Public Finance 2011)

While we focused attention on the relationship among overseas sales ratio (overseas sales ratio = exports + overseas production – reverse imports), expected growth rate and income distribution, here we look into the impact of the overseas production ratio on employment. There is a concern that the expansion of overseas production will result in hollowing out of domestic industries and, in turn, job losses; but is this really true (columns 2-3 in the figure)?

According to the Annual Survey of Corporate Behavior of the Cabinet Office, companies that intended to increase their overseas production ratio had a larger negative value on their employment prospects than those intending to leave unchanged or decrease the overseas production ratio in the FY2003 survey when the sense of excess employment was comparable to the present level. By industry, this trend was noticeable in basic materials industries with the high reverse import ratio (ratio of exports to Japan overseas production). It is conceivable that the fact that companies that were forced to reduce costs transferred their production bases overseas where personnel costs were lower in many cases adversely affected their employment prospects.

In the FY2010 survey, however, companies that intended to increase their overseas production ratio had a larger positive value on their employment prospects than those intending to leave the ratio unchanged or decrease it. By industry, this trend was noticeable in basic materials industries that significantly lowered their reverse import ratio. There is a possibility that, unlike 2003, since companies that establish production bases overseas have been increasing in recent years in response to robust growth in overseas demand, their employment prospects have been more bullish associated with the strengthening of headquarters operations in order to take a complementary role in overseas production bases.

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Translated from “Kudo-ka ha tadashii riyu de kenen shiyo,” Nikkei Business Online, August 24, 2011. (Courtesy of Nikkei Business Publications, Inc.)

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