JAPAN: AT CROSS-ROADS ON POST-INDUSTRIAL SOCIETY

8:51 AM Mar 1, 1996

JAPAN: AT CROSS-ROADS ON POST-INDUSTRIAL SOCIETY
Geneva 1 Mar (Chakravarthi Raghavan) -- Japan which through active government role achieved a spectacular industrialization through a profit-investment nexus, now faces serious structural problems in changing to a post-industrial society and its choice of policy may determine whether it will follow the path of Western economies into a low-growth and high-unemployment path or a different one, according to an UNCTAD senior economist.

In a paper for the 'Conference on East Asian Development: Lessons for a New Global Environment', sponsored by UNCTAD and financed by the Japanese government, now taking place at Kuala Lumpur (Malaysia), the head of UNCTAD Global Interdependence Division discusses the new trends in Japanese Trade and Foreign Direct Investment (FDI), and says that the policies Japan will adopt, and the path chosen will have implications for others, in particular developing economies of Asia, given the fact that Japan emerged as the leading international investor in the past decade and its trade and investment policies are undergoing some changes.

During its industrialization, Japan followed a different path from the Anglo-American model, and effected a rapid industrialization. That process involved extensive government intervention in the economy. Whether or not Japanese transformation to post-industrial society would also take a different route was a complex one.

But from a macro-economic point of view whether or not Japanese economy will transform to a state of low-growth and high-unemployment typical of post-industrial Western economies would depend very much on how the problem of effective demand is handled, and particularly whether domestic spending would replace exports as a source of growth.

A positive transformation would require a considerable restructuring of the pattern of effective demand and earnings -- a shift from manufacturing to infrastructure in order to raise public consumption and a shift of incomes from profits to wages in order to raise private consumption, Akyuz adds.

On the general trade-FDI-development issue, the paper notes that links and causality, if any, involving Foreign Direct Investment, Trade, Domestic Savings and capital accumulation in economies are not so clear and available empirical evidence does not show that in a world of free capital mobility, capital will flow from excess savings countries to low-savings countries to promote development.

The paper surveys the existing literature on international trade and FDI to point out that empirical evidence do not seem to bear out either the currently fashionable orthodox theories of Trade and FDI relations and their interchangeability nor the neo-classical view that in a financially free world of capital mobility, capital would flow from countries with excess savings and low-returns to low-savings countries with ample investment opportunities.

The standard theory of international trade seeks to explain comparative advantage in terms of country-wide factors, while literature on FDI determinants concentrate on firm-specific micro-economic factors.

"The two are not always consistent," Akyuz notes. "The theory of comparative advantages is based on assumptions of perfect competition, while FDI is explained in terms of imperfections and market failures. And the neo-classical theory of capital movements based on international differences in thrift and productivity make no explicit references to the theory of comparative advantage nor does it contribute to understanding determinants of FDI, since it leaves open the allocation of excess savings between portfolio and productive investment. The theories do not provide much insight into behaviour of trade and FDI through the industrialization process."

Many authors have favoured the "FDI follows Trade" hypothesis where outsourcing through FDI implies a general loss of competitiveness, rather than loss of firm-specific comparative advantages.

But empirical studies on relations between FDI and trade have not been conclusive in indicating causality nor whether FDI replaces exports and trade. FDI in natural resources do not replace trade and domestic investment, and FDI in ancillary services such as sale and service networks abroad are complementary with trade.

In the American model, FDI is governed by the micro-economic interests of the TNCs and takes place mainly in sectors ranking high in the scale of comparative advantage -- replacing home investment and adversely affecting trade performance of the home country.

In the Japanese trade-oriented model of FDI, there is no trade off between aggregate domestic investment and FDI, and global investment continuously increases, promoting trade flows.

The rationale of this model is similar to that in the 'flying geeze' model -- involving a vertical division of labour among countries at various stages of industrial development, and there is a continuous shift in competitiveness in export sectors from countries at a higher stage to those at lower ones.

But this assumes that the lead country can always upgrade its industrial structure, introducing new production methods and products as rapidly as those catching up.

However, the innovation-imitation lag between mature economies and the NICs have considerably shortened over the last two decades - not only due to greater flexibility and divisibility of production technology, but also the rapid pace of accumulation of physical and human capital in the NICs. Thus, the lead countries may no longer maintain a pace of technological progress and productivity growth that would allow them to expand simultaneously FDI, trade and domestic investment.

[The WTO's TRIPs agreement is intended by the lead countries to inhibit this catch-up process, but IPR experts believe that recourse to anti-monopoly and individual product/process approach and compulsory licensing procedures still available, the follower countries could still access, use, and learnt to adapt and innovate]

According to neo-classical paradigm, if capital is allowed to move freely, it would flow to countries in response to opportunities for real investment and allow individual countries either to save more than they invest or invest more than they save.

In this view, a perfect integration of global capital markets (which is sought to be achieved through financial liberalization and an investment agreement in the WTO) would allow global savings to be pooled and allocated globally, through movement of capital across countries, thus equalizing rates of returns on investment everywhere.

But there is little empirical support for a positive link between FDI flows and international differences in rates of return, Akyuz points out.

The simple neoclassical approach does not distinguish between FDI and portfolio investment or why differences in rates of return should lead to FDI rather than portfolio investment abroad. But it maintains that whatever the form of capital movement, it should always lead to equalization of rate of return on capital investment and thus predicts under free capital mobility, domestic capital formation is independent of national savings, and there is no trade-off between domestic investment and outward FDI.

However, much of global financial flows are governed by perceptions of prospects of short-term capital gains or losses, rather than long-term yields on capital investment.

The increased integration of financial markets and massive capital flows of the last two decades have not resulted in a narrowing of rates of return on capital investment among the G-7 countries, nor is there a strong tendency for real interest rates and costs of finance to be equalized among countries.

Similarly, the recent pattern of capital flows do not support the contention that in a financially free world, capital flows from countries with excess savings and low-return on investment to low-savings countries with ample investment opportunities.

Rather, "it has flowed from countries with high investment rates, such as Japan, to countries with low investment rates, such as the U.S. Such capital flows have also served to finance consumption rather than investment - and this is also true of recent capital flows to Latin America." There is also serious doubt on independence of national investment from national savings.

As for the link between outward FDI and domestic capital formation, at an aggregate level, a 1994 study shows that each dollar of assets abroad acquired by US foreign-affiliates reduces US capital stocks by about 38 cents or, conversely, each dollar of displaced domestic capital in the US adds up to $5 to the capital stock abroad.

All these, Akyuz argues, shows serious inconsistencies in the neo-classical analysis of capital markets and international capital movements.

It is not possible to determine the relation among trade, FDI and domestic investment independently of macro-economic factors -- such as growth of and access to markets and factors influencing overall competitiveness -- that influence decisions of firms to invest at home or abroad. And investment decisions themselves alter macroeconomic conditions and competitiveness, and exert an important influence on macro-economic performance, including growth, employment and external balances.

Akyuz notes that the most important factor behind Japan's rapid industrialization in the post-war period was its ability to animate the "profit-investment" nexus -- the dynamic interactions between profits and investment because profits are simultaneously an incentive for investment and a source of investment.

A high share of profits in value added and a high retention ration played an important role in this process. During the 1960s, the gross operating surplus in incorporated non-financial business was around 50% of gross value added and in manufacturing along this was around 55% compared to 25% in the US and UK and 35% in Germany. Much of this was retained as corporate savings.

The high profits, savings and investment continued in Japan during recent years and until recently the investment-profits nexus could be maintained without encountering the realization (effective demand) problem because it was complemented by an "investment-export" nexus whereby rising exports provided an outlet for expanding production capacity in manufacturing.

It now appears this process is no longer sustainable, Akyuz notes.

Japan has suffered loss of competitiveness in a number of lower-skill, lower-technology industries due to appreciation of the yen and emergence of a number of high-productivity, low-wage competitors. It now has a much more limited capacity than in the past to respond by moving rapidly into higher-skill, higher-productivity sectors. Japan can thus no longer rely on the investment-exports nexus to the same extent as in the past to sustain its investment-profits nexus.

Since the capacity in such industries cannot be profitably utilized for exports at prevailing patterns of world prices, wages and exchange rates, profits are squeezed, reducing both the incentive for investment and source of investment, and slowing down accumulation and growth.

A possible response could be to try to cut wages to make up for loss of competitiveness and regain markets lost, at home and abroad. But this is no solution since it would require a permanently large slack in the labour market which could only be maintained if demand for labour is slow. This would be a recipe for low growth and high-unemployment. Also the extent of wage deflation and unemployment needed might not be trivial since NIEs are moving rapidly in the productivity front with considerably lower wages.

Since exports are now longer the driving force of private investment, domestic demand needs to replace them, if the pace of accumulation and growth is to be maintained at a level compatible with full employment.

This Akyuz says would require a redistribution of income from profits to wages. Under present circumstances a higher share of wages and lower share of profits are likely to be associated with a higher rate of accumulation and a higher rate of profits by fuller capacity utilization.

And although part of the increased domestic demand may leak abroad through imports, Japanese firms could capture an important part of it even in lower-skill, lower-technology products. Competing at home is easier than competing abroad, particularly given the institutional set up in Japan. And reduction of the trade surplus would help relieve the upward pressure on yen.

And if Japan maintains a growth rate of around 4% per annum, based on domestic demand, and continue upgrading its industry, though at a slower rate than in the past, it need no experience the kind of de-industrialization as other major industrial countries.

However, Japan cannot expect to attain same growth in manufacturing employment as in the past decades, since goods cannot simply be redirected from exports to the domestic market. It would be difficult to maintain the rate of expansion of products such as automobiles and electronics which have so far accounted for an important part of japanese exports, since their domestic absorption would be limited.

The patterns of investment would need to change, away from manufactures towards non-tradeable public and private services. Greater investment in public services is not merely an adjustment required to provide new sources of jobs and fiscal stimulus to effective demand, but also a necessity to raise quality and quantity of social and economic infrastructure.

From recent debates in Japan, there appears to be a consensus that the problems faced are structural, not cyclical. But the actions taken so far do not measure up to the magnitude of the problem. Events leading to the current financial difficulties show how inaction at an early stage may aggravate problems considerably.

Initially the debt deflation problem in Japan seemed more moderate than in the US (which suffered collapse in financial markets and in markets for real assets). But while the US Federal Reserve acted promptly through monetary relaxation, Japan's monetary policy was hesitant, preoccupied with avoiding another bubble. The Government put no fresh money to deal with bad loans or a major fiscal package to stimulate the economy. As a result, the process became a vicious circle, and became very difficult to deal with after the second appreciation of the yen.

Such a vicious circle could also develop in the form of a low-growth, high-unemployment hysteresis. As experience of other major industrial countries show, once allowed to persist, high-unemployment and low-growth can easily become part of the structural features of the economy, even if initially they may have simply been conceived as a temporary phenomenon necessitated by adjustment to supply shocks. But it is not inevitable that Japan take the same route, the paper adds.