INWARD FDI AND THE JAPANESE ECONOMY

Kyoji Fukao Professor, Institute of Economic Research, Hitotsubashi University Faculty Fellow, Research Institute of Economy, Trade and Industry Tomofumi Amano Assistant Professor, Department of Business Administration, Toyo University October, 2003

Table of Contents
CHAPTER 1: INTRODUCTION What is FDI? Unlike international portfolio investment, direct investment brings new management resources, and methods (know-how, technology, and products) FDI sticks: It is slow to leave, and is committed for the long term Empirical analysis and data on FDI is shockingly non-existent The absence of empirical data and analysis frustrates government policy objectives There is a deep-seated need to look at the real facts and data about FDI, and to dispel misunderstandings Study Objectives Major Conclusions Case Study 1.1 Starbucks Coffee Japan Case Study 1.2 AFLAC CHAPTER 2: FDI IN JAPAN: SURVEY, ANALYSIS AND BACKGROUND Structures and Conclusions for Chapter 2 2.l: FDI in Japan Very Low Ratio of inward FDI to GDP only 1/11th U.S. and 1/28th of England FDI makes important contributions to employment and capital investment in other developed countries The present low level of FDI flows cannot offset the hollowing out of Japanese industry Globalization of the economy and Japans crisis 2.2: The Importance of M&A Investment M&A is the main vehicle and driver for FDI among all developed countries, including Japan 2.3: FDI Tends to Flow to Certain Industries Employment due to FDI has grown nearly 50% in the past 4 Years Most FDI flows to non-manufacturing industries Services trade has been liberalized but foreign investment is still only 1/5 compared to the US Foreign presence in manufacturing is 1/8 of the U.S. level Low manufactured import levels cause low inward investment: Trade precedes investment Restrictions have created sanctuaries, preventing the entry of foreign firms Barriers to inward FDI are not just national treatment but market access for all new investors Today, barriers against inward FDI often do not relate to national treatment as much as restrictions on entry by all new investors 2.4: Does FDI Benefit Local Economies?

A baseless myth: inward investment does not benefit local economies 54% of all the offices are located outside Tokyo, Kanagawa or Osaka Local government policies to attract FDI are not necessarily successful Local governments need authority and flexibility to attract FDI 2.5: Why Inward Investment is Low: Historical Background In the Meiji period, foreign technicians were employed, capital goods were imported In 1889, inward investment became possible In 1945, inward FDI relatively free under GHQ In 1952, reinstated permission system: technology obtained through licensing contracts and capital equipment importation After joining the OECD in 1964, investment gradually become freer in areas where Japanese makers became competitive Postwar strategically planned liberalization of investment extremely successful in restricting inward FDI From the last half of the 1990s cross shareholding progressively block inward investment Barriers still exist to inward investment in non-manufacturing, mainly by restricting market entry 2.6: Why Did an Inward Investment Boom Occur in the Last Half of the 1990s? Deregulation spurs inward investment largely in non-manufacturing Declining stock and land prices A global boom in M&A contributed to inward investment expansion 2.7: Conclusions Case Study 2.1 Procter & Gamble (P&G) Case Study 2.2 IBM CHAPTER 3: WHY IS INWARD DIRECT INVESTMENT IMPORTANT TO JAPAN? Structures and Conclusions for Chapter 3 3.1: Low Earnings and Private Fixed Capital Investment Japans structural excess savings problem Why did Japans corporate earnings and fixed capital investment shrink? Aging population, accompanied by a low birth rate and slowdown in TPF growth Limits to growth led by deepening capital investment in manufacturing Foreign firms have high earnings and active fixed capital investment 3.2: Excess Savings and Long-term Stagnation Uses for excess savings The failed bubble period: the futility of (ever-) expanding private investment Inefficient governmental spending and injections of public funds Unexpandable current account surplus Difficulties in increasing private consumption Excess savings brought on economic stagnation 3.3 The Basic Causes For Low Growth: A Statistical Analysis During the 1990s, labor investment, capital investment and TFP levels all restrained growth Compared to the US, Japans growth rates in labor input and TFP remarkably low 3.4 Why Is The Drop In TFP Growth A Serious Problem? TFP is the key to economic growth and revitalization 3.5 Reasons for changes in TFP growth levels by industry

TFP Growth: Decreasing in the manufacturing sector, and accelerating in parts of non-manufacturing sectors Part of the service sector moves ahead as a result of deregulation (and market liberalization) Non-manufacturing sector TFP growth increases due to deregulation Nonetheless, TFP growth in the service sector is still much slower than in other developed nations Manufacturing facilities establishment rate is particularly low Factors behind Manufacturing Sector TFP Growth; Results of company level empirical data A slowdown in the manufacturing sectors metabolism, asset reallocation and market share It is possible that the industrys low metabolic rate was brought on by the ailing financial system 3.6 Conclusions CHAPTER 4: DO FOREIGN FIRMS IN FACT BRING GREATER TOTAL FACTOR PRODUCTIVITY (TFP)? Empirical research lacking on the effectiveness of inward investment Structures and Conclusions for Chapter 4 4.1 Do Foreign Capital Firms Have Higher TFP Than Do Japanese Firms? Data sources and outline Results of comparing foreign capital companies and Japanese companies Foreign capital firms have about 10% higher TFP Foreign capital firms use greater concentrations of capital and technology, and engage in greater capital investment Foreign capital firms have higher rates of growth in sales Foreign capital firms have 1.2 million yen higher wage rates, and have higher labor productivity Foreign capital firms have higher profitability It cannot be said that foreign capital firms reduce employment faster 4.2 The Effectiveness Of M&A By Foreign Firms Inward M&A compared to domestic M&A Inward M&A targeted companies realize high TFP, but domestic M&A do not Inward M&A target companies have high rates of improved TFP Inward M&A shows increased capital concentration, research and development, labor productivity, and wage levels Inward M&A companies improve profitability Inward M&A target companies increase sales and expand fixed capital assets more than other companies Manufacturing industry data until 1998 indicates that Employment by inward M&A target firms does not necessarily shrink significantly compared to other firms. 4.3 Conclusions CHAPTER 5: BACKGROUND TO THE INCREASE IN INWARD M&A Structure and conclusions for Chapter 5 5.1 Increased M&A And M&A By Foreign Firms Definitions of M&A Rapid rise in total M&A cases Inward M&A investment cases increasing, But foreign firms have less than 5% of the total

M&A has been growing on a transaction value basis as well Many large inward M&A transactions Increasing number of M&A carried out by private equity funds (PE funds) PE fund M&A is 20% of total M&A, and 5% of inward M&A by foreign firms Top 10 M&A by PE funds: foreign funds favor large scale transactions 5.2 M&A By Market And Type Out-In 7.9% of the total Most Out-In M&A is in the form of acquisition or capital participation Foreign firms actively seek management control 5.3 Structural Barriers Causing Low Levels Of M&A Consideration Of Japanese Management Systems Board of Directors consisting of former managers and internal directors The Main Bank system; factors preventing third party intervention Japanese employment practices and slowness in labor force adjustment Japans M&A lowest among OECD countries 5.4 Recent Changes In The Environment: Background To Rapidly Increasing M&A Weak stock prices and expanded M&A opportunities Collapse of cross shareholding and shareholder diversification Corporate governance reforms Corporate strategies emphasize profitability and added value Increased labor market liquidity and adjustment speed Improved business infrastructure/ professional education Improved systemic M&A infrastructure: simplification of procedures and deregulation 5.5 The Need For Further Deregulation To Encourage Inward M&A 5.6 Conclusions Case Study 5.1 General Electric (GE) Case Study 5.2 Renault and Nissan CHAPTER 6: INWARD M&A AND THE PERFORMANCE OF TARGET COMPANIES Structures and Conclusions for Chapter 6 6.1 Fundamental Characteristics Of The Management Structure Of Target M&A Companies Rebalancing Business portfolios Obtaining scale through integration and rationalization Appropriate financial structure Reorganizing top management teams 6.2 Examining Evidence From Empirical Research In the U.S.: Cash-based acquisitions increase stock returns In the US: Cash flow improves after acquisition In Japan: mergers between companies in different industries bring higher valuations Japans stock market shows lack of thorough structural reform Japanese style corporate governance is deeply intertwined with over-investment and low profitability. Management Team and Corporate Governance Reform 6.3 Industry-Specific Effects Of M&A 6.4 Comparing Performance Of Japanese Domestic And Foreign M&A Target Companies

Domestic M&A target companies improve sales and profits, while preserving employment Inward M&A target companies improve profitability and stability 6.5 Conclusions Case Study 6.1 Kansai Sawayaka Bank (KS Bank) CHAPTER 7: DOUBLING JAPANS INWARD FDI: NEEDED POLICIES AND PREDICTED EFFECTIVENESS Structures and conclusions for Chapter 7 7.1 Short Term Outlook Prospects Gloomy; But Potential Great Difficulties predicted to reach governments goal (to double FDI in five years) But room for potentially large amount of investment 7.2 The Macro-Economic Effects Of Inward FDI: A Simple Calculation The expansion of inward FDI, even when most is M&A, deepens capital investment and spurs economic growth rates The macro-economic effects of inward FDI: Major assumptions A Rough Calculation: If inward FDI expands to other developed country levels, increased capital and improved TFP will raise GDP by 1.5%. 7.3 How Much Would Deregulation And Privatization Expand Inward Investment? Restrictions in non-manufacturing industries Calculation result: Employment by foreign affiliated nonmanufacturing firms would rise 54% through deregulation Privatization of Public Corporations would expand nonmanufacturing employment by foreign firms by 43% (over the 1996 level) 7.4 The Importance Of M&A; And Policies For Its Promotion 7.5 Conclusions Even assuming that expected policies will be effective, doubling FDI will require major reforms Achieving Prime Ministers policy goals endangered by short-term focus on make-shift public relations steps Expanding inward FDI to the level of other developed countries will result in large benefits for Japan