The high and rapidly rising level of Japan's FDI in recent years stands out when compared to those of other major developed countries. While Japanese exposure to FDI is significantly lower than that of other industrial countries.

Theoretical Explanations

With the 6 specific reasons in mind, let us now look at how these reasons can be combined with theories to explain the low inbound FDI to Japan and whether there are other factors contributing to this, thus getting a more thorough understanding.

The Eclectic Paradigm

John Dunning’s Eclectic Paradigm avers that the determinants of a country’s inbound as well as outbound FDI fall into three categories: (a) Ownership (O) Advantage: the competitive advantages of firms in the home country over those in the host countries. Ownership advantage not only includes the possession of tangible and intangible assets (Oa) but also includes organisational competence to coordinate and lower internal transaction cost (Ot); (b) Location-bound (L) Advantage: It includes both natural resources and created resources of the host country, which comprise transportation and telecommunication infrastructure, legal, commercial system, educated labor force and the attitudes and actions of governments. (c) Internalisation (I) Advantage: the extent to which firms choose to exploit their competitive advantages by way of horizontally or vertically extending their domestic value-added activities, or by some form of non-equity cooperative relationship with a foreign firms.

What is worth mentioning here is that the actions taken by the government can affect seriously both the Ownership Advantages and the Location Advantages.

The propensity of a country’s inbound FDI is determined by a function of OLI advantages. According to this theory, he reason why Japan attracted so little FDI must be due to an extremely unfavorable OLI configuration.

1. O-specific Deterrents

1. Industrial Structure: In several sectors, there is a limited Japanese market for foreign goods due to the tastes, customs, established ties with Japanese firms and unfamiliarity with foreign goods. Fhe transaction cost of setting-up a foreign owned subsidiary in Japan is perceived to be unacceptably high.
2. Distribution: the distribution characteristics of Japan and the government’s retail as mentioned by earlier add up to the transaction cost of foreign firms.
3. The Paucity of M&A. Due to Japanese-specific legal, institutional and other impediments, this mode of FDI in Japan is severely limited.
4. Keiretsu Influences: The cross-shareholding and close bonding between Japanese firms offer the participating firms unique competitive advantages including sharing of rishkes and information, mutual financial support, etc. However, Keiretsu networks, pose obstacles to outsider firms wishing to break into this network. In addition, even if foreign firms break into this network, the low profitability of this network is also a major deterrent.

2. L-specific Deterrents

The location deterrents of FDI into Japan are to a large extent imposed by the Japanese Government.

5. M&As: the Japanese government’s highly discriminatory policy towards FDI in the first half of the postwar period is the most obvious one, especially, their attitude towards M&A. In that period, the M& As were completely disallowed by in many industrial and service sectors.
6. Technology Imports: with regard to the Ownership advantages of technology enjoyed by foreign firms, the Japanese government has deliberately stipulated that the proprietary rights of foreign firms should be transferred o Japanese producers only by licensing, which has dramatically reduced the intra-firm payments of royalties and fees.
7. Industrial Policies: though Japan has been much more liberalized in terms of their attitudes toward FDI, the industrial and commercial policies and attitudes they hold are often overtly or covertly partial towards Japanese firms. These include selective protection of domestic markets, the support of search consortia, and all sorts of other non-tariff barriers.
8. Deliberately Conceived Culture: successive Japanese Governments has deliberately cultivated a set of cultural beliefs into its citizens, such as the “ buy Japanese attitude”, alliance capitalism and long-termism, all of which adversely affect the market size and characteristics

Factors other than government intervention also contribute to the unfavourable locational factors.

9. Labour Issues: although Japan has a highly educated labour force, the inability of foreign firms to provide long-term training, life-long employment and other benefits reduces these firms’ attraction to Japanese work force.
10. Factor Price: The appreciation of Japanese Yen and the rising wage rate also reduced Japan’s attraction to FDI.

3.Internalisation Deterrents

As is mentioned above, the paucity of M&A, the high transaction cost of setting up a completely foreign owned subsidiary and the Japanese policy preference towards imports and licensing all work against the high level of internalising activities.

In conclusion, although foreign firms do possess ownership advantages in terms of Oa advantages over Japanese firms, the high transaction costs (low Ot advantages) and the low locational attractiveness of Japan, which both significantly affected by the Japanese government, make Japan a much less favourable destination for foreign direct investment, accounting for the minute inbound FDI into Japan by the US and EU.

The Diamond Paradigm

Michael Porter’s Diamond Paradigm was created to explain why particular countries possess a competitive advantaged in particular industries or services. Porter identifies four factors as determining the competitive advantage of an industry, that is, (a) Factor conditions (b) Demand conditions (c) Related and supporting industries (d) Firm strategy, structure and rivalry. In addition, chance events and the government role exert a significant influence in the above four factors.

Now we seek to look into the Diamond of national advantages of Japan, which contributed to Japan miraculous rise in the 1970s and 80s, and find out how particular factors in this paradigm can account for the low inbound FDI to Japan in the last 20 years.

1. Factor Conditions

1. Less attractive factor price: the price: appreciation of Japanese yen and rising wage rate are the part of the Japanese selective disadvantages, leading Japanese companies to feverishly compensate through all means of improving productivity, which are extremely beneficial to the long-term sustainability of Japanese advantage, and which, however, are detrimental to Japan’s attraction to foreign FDI.
2. Labour issues: (as I mentioned in the eclectic paradigm)

2. Demand Conditions

1. Market Saturation: the rates of market penetration and saturation in Japan are very high, and thus the product life cycle is extremely short, which requires firms in the market to constantly push forward new products and make large investments all at once to achieve economies of scale. This proves to be very difficult for western firms, especially in their entry stage, on account of their unfamiliarity of the Japanese market and limited production capacity.
2. Dual Demand Structure: the curious combination of both advanced and backward infrastructure (e.g. poor road, limited living space) results in a dual demand structure and thus leads to interesting combinations of multiple segments, which are too complicated for many western firms to cope with.
3. Sophisticated Buying Behaviour: the sophisticated and demanding Japanese buyer behaviour, such as their demand of high quality and superior service, their visual culture, in which the presentation and the packaging are as important as the products, and their well-known fickleness to the extent of an extreme, would take western firms quite a long time and much cost to grasp.
4. Distribution: in consumer-packaged goods, Japanese demand took off too late, which contributes partly to its backward distribution channels.

3. Related and Supporting Industries

1. Internal Diversification: Japanese firms almost exclusively pursue related diversification through internal diversification instead of M&As, so that they can redeploy people and facilities to ensure the transfer of efficient skills from industry to industry. For example, the typewriter industry grew from sewing machine industry and the copier industry from the camera industry.
2. Trading Industry: in terms of supporting industries, the Japanese trading industry plays a most significant role. It is consisted of huge trading companies with well-developed worldwide networks, which facilitate imports and exports, so that foreign FDI seems less important.

4. The Role of Government (as I referred to in the eclectic paradigm)

To sum up, four factors, that is, factor and demand conditions, related and supporting industries and the government, are identified in the diamond of Japanese national advantage paradigm as particularly relevant to explain the little inward FDI to Japan from western countries. The very “diamond” that deliberately built to achieve the national competitiveness of Japan works against her attraction to foreign direct investment to a significant extent.

Japan FDI in US and EU

Common Objectives

FDI strategies of Japanese companies in the United States and Europe are classified into two categories: Defensive market-seeking investment and Offensive supply oriented investment.

It was found that the majority of Japanese MNE activities in the United States and Europe in the early 1980s were of the Defensive market-seeking investment.

Later, in place of defensive strategies, Japanese firms have increasingly had to adopt offensive strategies in their attempt to secure and advance their foreign markets. Such strategies have been largely driven by the need of Japanese firms to transform themselves from exporters to insiders in the major markets of the world, and to keep in touch with the latest technological and organizational developments, while benefiting from economies of cross-border arbitraging and the gathering and disseminating of information.

This shift from defensive to offensive investment strategies implies a fundamental change in the traditional post-war system of exporting to domestic upgrading and to exporting practiced in Japan. In the move to become successful insiders, Japanese MNEs had to internationalise the upgrading process, with the inevitable result that FDI gradually replaced trade as the mechanism driving the machine.

The United States and Europe were important export markets of Japan. From a demand perspective, the two markets, while admittedly different in their size and rates of growth, were also structurally comparable. In the mid-1970s, both had started to clamp down on Japanese imports, this has led the underlying motives for Japanese investments in the two locations to be similar, that was primarily market-seeking, export-substituting FDI, with little or no rationalized investments. However, it was mainly in the area of production economics where the greatest variances were found, although even these reflected not structural, qualitative differences, but rather different regulatory environments.

Japanese FDI in USA

From a viewpoint of the Japanese investor seeking to evolve a transnational strategy, then, the two regions were very similar. The United States and Europe represented overseas concentrations of wealth and technology which were the necessary ‘pull’ factors in the upgrading of domestic Japanese economic activity. However, the table above clearly indicates that the United States did have a far stronger attraction for Japanese FDI than did Western Europe up to and during the early 1980s.

The reasons mainly reflect the larger size and growth of the US market for products in which Japanese companies had O-specific advantages, coupled with the combination of lag inward investment and tight trade-protectionist policies. This policy configuration, reversed in Europe, helped tip the balance of choice facing Japanese MNEs, to engage in FDI in the United States but to continue to export to Europe. Put another way, the absence of restrictions on foreign-owned production-both in manufacturing and in services, meant that Japanese firms could internalize the markets for their O advantages more easily in the United States, while arms-length transactions remained the norm into Europe. Together with the changes in the relative real wage costs of Japanese and US workers have been an important determinant of the growth of Japanese FDI in the US, while there was a statistically significant negative correlation between real labor costs and the geographical distribution of Japanese FDI in Europe.

Japanese FDI in Europe

More importantly, Europe was a collection of fragmented, relatively protected national markets, the size and growth of which were considerably smaller than that of the United States. The fragmentation of the European economy meant that not only were economies of scale difficult to achieve along the value chain, but that economies of scope were constrained in a marketplace which was a patchwork of differing technical, safety and fiscal standards. These production constraints were compounded by prohibitively high cross-border transaction costs, due to part to administrative delays at customs borders. Finally, real wages in most European countries were uncompetitive with those in the United States, a crucial consideration for Japanese companies whose O advantages depended on maintaining lower price/quality ratios than their local competitors. These factors, coupled with the much larger sunk investment already in the United States, made that country a more attractive location for Japanese market-seeking investment in the first part of the 1980s.

Europe’s L advantages in innovatory activities, though strong, were inferior to those of the United States, particularly in the sectors in which Japan was seeking to establish a global presence. In particular, the United States possessed much stronger L advantages for information and technology seeking. Finally, a lower cost of entry favored the United States over Europe for all types of FDI, given cumulated experience gained though previous investments, and a more relaxed policy environment towards the acquisition of corporate asses through takeovers.

Therefore more investment was directed to the United States than to Europe. It was a reflection of the former’s more pronounced L advantages, and the fact that because of differing regulatory environments, Japanese firms could internalize the market for their O advantages more easily in the United States than they could in Europe.

Critics Over Japan’s Market whether it is closed

Japanese market is quite open is based on several factors. First, an international comparison of tariff rates, the number of goods subject to import quotas, and the number of voluntary export restraints requested of trading partners indicates that Japan’s market is at least as open as, and probably more open than the U.S. and European markets in terms of these indices. Second, since around 1975 the Japanese government has continuously and strenuously implemented market-opening, barrier-reducing measures. Third, as a result of the sharp appreciation of the yen since the autumn of 1985, imports, particularly of manufactured goods, have increased substantially over the past few years. Fourth, during the postwar period there have been vigorous new entries into many industries in Japan. As a result, there are generally a large number of powerful firms in an industry in Japan than in the United States or West European countries. This attests to the fact that the Japanese economy is open and highly competitive.

Japan has strong comparative advantage in products produced by advanced technologies and intensive in high-quality labor, in particular differentiated products requiring careful and meticulous final processing to cater to the needs of sophisticated consumers and other users. European and U.S. enterprises generally (with numerous important exceptions) do not yet know well the kinds of products and services wanted by Japanese consumers and enterprises. For many years, Japanese firms have studied the U.S. and European markets to find which products were likely to satisfy the needs of European and U.S. consumers and to develop and produce such products. Most U.S. and European firms are only in the early stages of studying the Japanese market seriously. Thus, many products are unable to sell in Japan, not that Japanese consumers discriminated foreign-made products.

However, there are evidences that Japan’s Market is closed.

The ownership in a joint stock company depends upon the number of voting shares owned by an individual or organisation. However, Japanese owners are ascendant and that intra-group cross-shareholding gives each member “stable shareholders,” who controlled over half of their outstanding equity shares and never trade them. This Japan’s structure also blocks foreign acquisitions of Japanese firms as a way of entering the Japanese market. Acquisition of an existing firm is often a better marketing strategy than a joint venture, licensing agreement, or greenfield start-up. Japan’s blocking of acquisitions is not only an anticompetitive practice but also a nontariff barrier to trade. Furthermore, the tax system discourages the sale of land because annual property taxes are low compared to sales and inheritance taxes. This greatly restricts the supply of land available for development while encouraging the use of land as collateral for speculative borrowing and investment.

The difference between domestic and foreign prices for Japanese products is the classic sign of mercantilist trade policies. The response of Japanese exporters to the rapid yen appreciation since 1985 provides further indication of the closed nature of the Japanese market. Japanese export prices have fallen sharply relative to domestic wholesale prices. This implies a kind of price discrimination by Japanese producers, with export prices bearing little relationship to domestic prices. Since price discrimination can persist only if the two markets are kept separate, Japanese exporters appear able to keep their exports from reentering the domestic market to undercut domestic price. Keeping the two markets separate is one consequence of Japanese governmental policies, dango, the distribution system, nonenforcement of the Antimonopoly Law, and several other structural features of the Japanese economy. Dango system can also be typified in the case of the Japanese construction industry. In order for the Ministry of Construction to put a firm on its lists of qualified bidders, it considers only the quality of work done previously in Japan. This, for a foreign firm to win a contract it must make a bid, but it is not allowed to make a bid unless it has won a previous contract.  Obviously, these rules could be changed, but the obstacles to doing so are so political.

The Japanese government has tightly controlled retailing since 1937 in order to serve the interests of small retailers defined as outlets with four or fewer employees. For example, there are some 70,000 Japanese stores in electrical appliances alone that are vertically organized distribution channels from manufacturers to retailers, referred as keiretzu. Therefore, price is an irrelevant factor in this case because foreign goods are normally not allowed in the distribution system, as these channels restrict competition in terms of price and close the distribution system to newcomers and outsiders. In Japan, wholesalers and manufacturers use their leverage to prevent their customers from changing to cheaper sources, and they are undeterred by the courts or so-called antitrust authorities.

Japan is the only major democratic nation without a code of administrative procedure. There is no system of laws that establishes explicit, transparent rules governing Japan’s administrative procedure. Therefore, an outsider cannot learn and conform to any set of laws to understand the regulation in Japan.

What are the future trends of FDI between Japan, US and EU?

The above parts state the fact that in last twenty years Japanese FDI stock in USA and Europe has grown far more rapidly than US and European FDI in Japan. However what’s the future trends FDI between these three countries. I will analyze it in the following part.

1. EU-Japan

The EU and Japan form two of the main pillars of the world economy. Japan is the world's second largest national economy, accounting for one seventh of world GDP and around 10% of world exports and imports. In 2000 the trade between the EU and Japan in goods and services was worth a staggering 160 billion euro. Japan is the EU's third largest export market and second largest source of imports. Against this background there are enormous potential opportunities for European businesses in Japan. However   This important trade relationship had  a strong trade surplus in favour of Japan, Therefore  EU-Japan Regulatory Reform Dialogue begun in 1994, aim to   improve each other’s regulatory environments with a view to improving mutual flows of  and .  

The European Union firmly believes that a comprehensive and bold programme of regulatory reform measures is essential for the restoration of Japan’s sustainable economic growth in Japan. Introduced rapidly and in a transparent and predictable way, these measures can make a vital contribution to a faster recovery and help Japan to play an important role in the stabilization and growth of the world economy. 

As far as the EU’s regulatory reform proposals for Japan are concerned, there is strong mutuality between what the EU is seeking in Japan and the need to revitalize the Japanese economy. The EU’s proposals point to areas where benefits will accrue to both domestic and foreign firms. The EU strongly believes that addressing structural and regulatory issues in the Japanese economy is a prerequisite for a sustainable economic recovery in Japan. AS this reason, the EU unequivocally welcomes the more favorable political environment provided by the Japanese government’s firm support for structural reform of the economy, but also takes a clear view of where priority action is needed. EU has been emphasizing three fundamental pillars where thoroughgoing reform would bring benefits right across Japan’s economy:

-           Improving the conditions for investment. Despite recent major improvements in Japan’s performance in attracting Foreign Direct Investment (FDI), there is still a need for administrative decisions to be made more transparent, for removal of the accumulation of regulations which keep Japan’s business start-up rate below that of its major trading partners, and for improvement of basic business service infrastructure such as access to top-flight advice from proper multi-jurisdictional legal partnerships.

-           Enforcing competition policy with true vigour. Japan has the legal sanctions to deal with competition infringements, but they lie to a large extent unused. This skews the playing field for all, pushing up costs and harming the consumer. Abusive behaviour by dominant players in the market needs to be cracked down upon with severity.

-           Adopting the model of independent regulation. Experience in many other countries has shown that the road to liberalization of former state-owned monopolies is long, and that users need to have an independent regulator to look after their interests and stop newcomers being bullied by incumbents.

 The EU's regulatory reform proposals for Japan are developed in close co-operation with the business community through fora such as the  and the . Active input from the business community ensures that the Regulatory Reform Dialogue deals with issues of most concern to EU companies in the Japanese business environment. This is all the more important as increased direct investment has transformed these companies into stakeholders in Japan.  In recent years trade figures have become much more balanced between EU and Japan.

U.S.-Japan

When looking at the 1990s from today's perspective, we can clearly distinguish two changes in U.S.-Japan economic relations, which both led to a shift of power from Japan to the U.S.

First, the severe economic crisis that has characterized Japan through much of the 1990s (and other Asian countries toward the end of this decade) has deconstructed the ”Asian myth”. The neomercantilist model of Japanese trade and economic policy has clearly failed to yield the results it brought in former decades. Second, the "American way” of doing business through allocation within free and well-functioning markets has worked brilliantly in the United States, reconfirming the vigour of the American economic model. With continuing liberalisation and globalisation, this model increasingly sets the rules for the other triad members. The former economic supremacy of Japan compared to the U.S., which the Japanese had even sometimes explained on racist grounds, has ended.

It is, of course, yet too early to say whether present U.S. supremacy in economic terms will be more sustainable than Japanese supremacy proved to be in the past. However, there are no signs of a significant change in the relative positions as far as the foreseeable future is concerned. Some basic mechanisms that made work "Japan Inc.” so well in the past are changing, and Japan has not yet found a new economic (and political) identity. This on-going identity crisis in Japan and underlying structural problems do not raise expectations for changes in relative positions during the foreseeable future. Japan's position is further weakened by the fact that countries large enough in resource terms and ambitious enough on a political and economic level to be willing to break Japan’s still dominant position in the Eastern Pacific surround it. With the decline of economic power and political cohesion in Japan, the United States' readiness to tolerate an uneven trade balance may further decline, thereby keeping economic relations tense. 

As far as U.S.-Japan relations on the economic or economic policy level are concerned, there is at present no danger that an alliance Washington-Tokyo could evolve to the detriment of Europe, as economic interests in Japan and in the U.S. are too divergent.

There have been fears in the first years of the Clinton administration that Japan and the United States could move closer together and build up a huge trade bloc through their commitment to the Asia-Pacific Economic Co-operation (APEC) that could leave Europeans out in the rain. But such fears have proved groundless in the past and will probably not be justified in the future:

First, APEC is - unlike the European Union - a business-driven, voluntary approach to trade liberalisation. It is not an inward-looking regional trade bloc and does therefore not fall within the scope of Art. XXIV GATT. APEC's approach to liberalisation is unilateral, voluntary and non-discriminatory. Its members have agreed to establish free trade and investment in the region by 2010 for developed member countries and by 2020 for developing member countries. APEC perceives itself as a "WTO plus”, contributing to multilateral trade liberalisation. Therefore, given the character of liberalisation within APEC, Europeans do not need to fear that APEC activities would endanger their access to APEC member markets.

Second, the 21 APEC member states, including, inter alia, the U.S., Chile, China, Japan, Indonesia, Mexico, Russia and Vietnam would be far too different (economically, politically and culturally) to be able to reach consensus necessary for the creation of strong common institutions. The fact that APEC countries agreed on using the WTO dispute settlement mechanism to resolve their trade disputes is not only a sign of APEC's commitment to multilateral liberalisation but also a sign of its own weakness. From this perspective, APEC is not really a threat to the European position in the world economic system.

Third, the strong Asia-Pacific orientation of the Clinton Administration with regard to economic policy in its first years (along with the negligence of the transatlantic partnership) has weakened during the last years, especially in the light of the recent Asian crisis. Americans know about the importance of Europe. As an economically sound world region with consolidated democracies and a large market, Europe will keep its strategic importance for the U.S. well into the next century.

Conclusion

From our above analysis, Japan’s low inward FDI is attributed to six reasons: 1) Less attractive factor price 2) Low profitability 3) Regulations in industries 4) Paucity of M&A 5) Distribution problems 6) Labour issues. The first two are relevant to the reduced attraction for foreign firms to invest in Japan, and the rest four are about the entry barriers, due to the distinctive way adopted by Japanese firms and industries. On the basis of Dunning’s Ecelectic Paradigm, we deduce that the low propensity of foreign firms to invest in Japan must be due to a uniquely unfavorable OLI configuration. From porter’s Diamond Paradigm, four factors (factor and demand conditions, related and supporting industries and the government) are identified in the diamond of Japanese national advantage paradigm as particularly relevant to explain the low inward FDI to Japan from western countries. The very “diamond” that deliberately built to achieve the national competitiveness of Japan works against her attraction to foreign direct investment to a significant extent.

United States and Europe are two main destinations of Japan’s FDI. More investment was directed to the United States than to Europe. It was a reflection of the former’s more pronounced L advantages, and the fact that because of differing regulatory environments, Japanese firms could internalize the market for their O advantages more easily in the United States than they could in Europe.

The analysis of Japan’s inward and outward FDI leads us to contemplate over whether Japan’s market is closed or open.  From some aspects, Japan seems to have an open market. But there are also evidences showing that Japan’s market is closed.

Patient efforts will be required of both the Japanese government and foreign entrepreneurs to boost FDI into Japan. On the one hand, steps must be taken by Japan to reduce the high costs the MNEs face. Japanese government should take active actions to improve the FDI environment and hold a more favorable view towards FDI. Moreover Japan needs to undergo a cultural change in the way it deals with its economy, especially as concerns regulations bureaucracy. On the other hand, foreign firms must strive to develop the ownership advantages that are the key to overcome these costs. In one word, the only solution to the paucity of FDI into Japan is for both sides to work towards closing the gap between the high extra costs of doing business in Japan for foreign firms and their relatively weak ownership advantages for overcoming the costs.

References

1.   Yoshihara Kunio, Japanese Economic Development, Third Edition, Oxford University Press.

2. Dunning, J, The Internationalisation of the Firm, Second Edition, London: ITB Press.
3. LECLAIR, MARK S. (1998): Regional Integration and Global Free Trade - Addressing the fundamental conflict; Aldershot: Ashgate
4. STUART, DOUGLAS T. (1997): ‘Toward Concert in Asia’ in Asian Survey, Vol. 37, No. 3, pp. 229-244
5. DENG, YONG (1997): ‘Japan in APEC - The Problematic Leadership Role’ in Asian Survey, Vol. 37, No. 4, pp. 353-367
6. Porter, Michael E.(1990) The Competitive Advantage of Nations, London: McMillan.
7. Yoshitomi, M. and Graham, E. Ed (1996) Foreign Direct Investment in Japan, , Edward Elgar Publishing Limited.