Author: | Published: 5 Jan 2004
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Summary of the Fukao Report commissioned by the ACCJ FDI Task Force

In his January 2003 speech to the Diet, prime minister Koizumi announced his goal of doubling foreign direct investment (FDI) in five years. In response, the American Chamber of Commerce in Japan set up a Foreign Direct Investment (FDI) Task Force. This group then engaged the services of professor Kyoji Fukao of Hitotsubashi University and Tomofumi Amano of Toyo University, to conduct objective analysis and write a report to illuminate the facts concerning FDI in Japan and the benefits it brings, and to suggest policy implications.

Unlike portfolio investment, direct investment brings lasting benefits, for example, new management resources, know-how, technology, methods and products. Although the Japanese government has declared its intention to double foreign direct investment (FDI) in five years and urged the people of Japan to welcome foreign money, a surprising lack of empirical analysis of FDI hampers achieving that objective—especially on mergers and acquisitions, which constitute the bulk of FDI among developed countries, including Japan. Consequently, numerous misunderstandings and an aversion to FDI remain widespread in Japan.

Investment trends

FDI flowing into Japan is low compared with other industrialized countries. As a percentage of GDP, Japan's cumulative stock of FDI is one-eleventh that of the US, one twenty-second that of Germany, and far less than that of China or South Korea. Only 1.36% of workers in Japan are employed by foreign-affiliated firms. In the US that figure is 11%.

These low levels result from policies dating back to the Meiji period that have included outright prohibition, restrictive licensing, currency controls, liberalization only as Japanese companies become competitive, cross-shareholdings, other barriers to M&A, and import restrictions. This historically restrictive policy stance has contributed to the misunderstandings and negative feelings towards foreign investment among the Japanese people.

At the same time, the rapid and large outflow of direct investment from Japan is hollowing out Japan's manufacturing sector. These outflows are five to 10 times as large as the inward FDI flows. The effect of this disinvestment on the economy is not being offset. As in other developed countries, M&A is the main driver of inward FDI, but since Japan's M&A market (even now) is narrow and undeveloped, total FDI inflows remain relatively small.

Japan can no longer rely on its high savings rate and its own management and research and development resources to compete in global markets and generate sufficient domestic investment to support growth of the economy and employment. To ensure this, the government will need to attract investment that has higher productivity - and is therefore more sustainable - from any source it can.

FDI in Japan is concentrated in a limited number of industries. One reason for this is that some industries are sanctuaries that are not open to entry by any new investors, foreign or domestic. Examples include transportation, employment services, agriculture services, health care, education, and electric power. Another reason is that trade tends to precede investment, and therefore import barriers have dampened inward investment that might have come later had trade flows been larger. Today, most impediments relate more to entry restrictions that equally affect all new investors than to trade barriers. Although FDI has grown nearly 50% in the past four years, in the services area it is still only one-fifth, and in manufacturing sector only one-eighth, of the US level.

Contrary to popular belief, FDI in Japan has benefited regional Japanese economies. While 87% of foreign affiliated firms are headquartered in Tokyo, Kanagawa and Osaka, 54% of their facilities and more than half of the jobs are located elsewhere. This is despite the fact that local governments have had limited resources and authority to attract foreign investors.

A so-called FDI boom during the second half of the 1990s was spurred by deregulation (largely in non-manufacturing), declining stock and land prices, and the global boom in M&A. But in relative terms, Japan is still losing out in the international competition to attract investment from global companies—including Japanese companies—that would support the jobs and wealth of the Japanese people.

Do foreign firms bring higher productivity?

Empirical analysis shows that relative to Japanese companies, foreign firms in Japan have about 10% higher total factor productivity (TFP) and profitability, employ a higher rate of capital investment per employee, spend more on R&D per worker, grow their tangible assets 4% faster, pay wages that are Y1.21 million ($11,233) higher per employee and enjoy 2.3% higher sales margins, and higher per-worker operating margins. Moreover, between 1994 and 1998, foreign firms did not appear to reduce employment more than Japanese firms.

Target companies in inbound M&A transactions (more than 33.4% equity) also demonstrated higher TFP gains, return on capital and labour efficiency than firms acquired in domestic M&A transactions. (On average, M&A between domestic firms lowered TFP.)

Employment by inbound M&A target firms usually falls in the short term - without restructuring many of these firms almost certainly would have failed. Although so far data is limited, it can be assumed that inbound M&A targets will reach the levels attained by other foreign affiliated firms for profitability, capital investment, wage rates, and R&D expenditures, thus stimulating the economy and creating new and better jobs.

 M&A transactions in Japan (foreign v total)
Data source: record of M&A databook 1988 to 2002

Increases in inbound M&A

Most of the recent increases in Japan's FDI has come through new inbound M&A transactions or follow-on investments to grow acquired firms, rather than greenfield investment.

However, Japan's M&A market is not large by international standards. Domestic firms carried out by far the largest number of transactions during the 1990s. The inbound portion of all M&A peaked at around 11% in 1999 and fell to 7.5% in 2002. Furthermore, of the M&A flows involving foreign-affiliated firms listed on the Tokyo stock exchange, 63.9% were already affiliated with foreign capital. If these cases and those involving inward investment to make up for capital deficiencies because of the recession are excluded, inbound M&A only accounted for 5% of total M&A on a value basis. Thus there is much room for expansion.

Private equity funds serve many purposes, including investing in new ventures and spin-offs from existing firms, and rehabilitating distressed firms so they can be sold at a profit. Reforms to the Corporate Rehabilitation Law and various government laws and policies have led to a proliferation of private equity funds in recent years, including by government-owned financial institutions such as the Industrial Revitalization Corporation, mainly to deal with excessive non-performing loans and revive distressed companies. It is estimated that today 30% of private equity investment relates to distressed loan assets in some way.

At the beginning of 2002, the growing number of M&A deals by private equity funds comprised almost 20% of total announced M&A volume in Japan. Yet despite media reports that sometimes suggest otherwise, investments by foreign private equity funds account for only about 5% of total inbound M&A by foreign firms.

As is the case with out-in M&A, inbound private equity transactions tend to be large deals. Also, their objective is often to revive the acquired company quickly and then sell it, which is why they are known as vulture funds. However, this short-term technique for reviving companies could become more widespread.

In terms of type of M&A transaction, in 2002 only 4.9% of transactions were mergers. Acquisitions comprised 34%; business transfers totaled 24.7%; capital participation deals made up 31.7%; and capital increases comprised 4.8%. Further, more than 77% of all deals were between domestic companies. Out-in transactions constituted only 7.9% of all M&A in that year.

Most M&A takes the form of acquisition or capital participation because foreign investors cannot use parent company stock for stock-swap or merger transactions. And foreign acquirers usually seek management control to speed up decision-making and revive the company quickly.

In Japan, M&A of any type has long been inhibited by corporate governance practices such as internally promoted board directors (or blood relatives in the case of family businesses) and the restrictive or defensive influence of main banks and cross shareholdings. Other inhibiting factors include a high level of retained earnings (internal financing), and in some cases, the inability to rationalize operations through labour force adjustments.

Most of the recent regulatory reforms have focused on facilitating re-organization by domestic companies or among companies belonging to the same business group, rather than facilitating M&A with unrelated third parties, including foreign companies. Non-cash structural methods, such as cross-border stock exchanges on a deferred tax basis, or so-called triangular mergers, are not available to foreign acquirers. (In contrast, 70% of domestic M&A in 2002 consisted of transactions including such non-cash components.) Also, low corporate earnings, severe domestic competition and lack of labour mobility and employment rules have contributed to making Japan's M&A market the least active and smallest among OECD countries.

Post-deal performance of inbound M&A targets

Successfully restructuring a target company has four essential elements: changing the business portfolio (or lines of business); obtaining economies of scale through integration and rationalization; adopting the right financial structure; and/or re-organizing top management.

Usually a firm pursues an M&A strategy to obtain new know-how or management methods, product lines or productivity-enhancing technology, a sales network, a better financial structure, operational integration and greater efficiency, and a management team that has the new ideas and skills to improve productivity. Mergers in Japan between companies in different industries have generally resulted in higher profitability, whereas mergers in the same industry experience declining profits on a cash-flow basis many mergers are agreed principally to save a seriously ailing company from failing rather than for more rational strategic goals. This explains why stock valuations for individual companies have tended to track closely the movement of the market as a whole, rather than displaying more variance.

M&A has been effective in bringing increased cash flow and higher returns on stock prices, especially for transactions done on a cash basis, and even more so when the two companies are from different industries. In industries where deregulation has occurred, M&A has spurred industrial revitalization, strengthened competitiveness, spawned new markets, and improved productivity.

Comparison of the actual performances of domestic and inbound M&A targets at first reveals that domestic target companies improve sales, profitability and stability, while sustaining employment levels, while inbound target companies (which may have been more distressed to begin with) perform relatively less well because of previous mismanagement that causes headquarters to impose strict financial controls and reduce employment to restore the company to health quickly. However, after some time there is substantial improvement and recovery of sales, profitability and stability.

 M&A transaction (In-In)
Source: Morgan Stanley and Thomson Financial

 M&A Transaction Methods (Out-In)
Source: Morgan Stanley and Thomson Financial

Doubling Japan's inward FDI: policy recommendations

Between 1997 and 2002, Japan's stock of inward FDI rose 2.7 times to Y9.4 trillion on a net foreign assets basis. From this perspective, reaching the government's goal of doubling the stock of FDI in five years might seem easy. However, the first round of deregulation is over; and it is unlikely that significant new investment expansion will occur under present conditions.

FDI into Japan has fallen 42% from the most recent six-month period. Extrapolating from recent trends, inward FDI would rise to Y4.5 trillion - a long way from the Y9.4 trillion needed. Further large-scale deregulation will be necessary to attract more FDI, especially additional M&A, which has the greatest potential to contribute to growth of FDI flows and stock. However, such a policy thrust does not appear to be underway today.

Still, Japan has vast potential to increase inward FDI. It has the world's second largest domestic market and is located in eastern Asia, the home of the world's most dynamic developing economies. If Japan were to raise its stock of inward FDI from 1.1% of GDP to the US level of 12.4%, capital investment by foreign-affiliated firms would lead to a 1.5% increase in capital stock (an Y18.8 trillion impact), and the GDP would expand by 1.5%, or Y7.5 trillion. Moreover, if foreign-affiliated firms raised their share of total employment from the current 1.3% to the US level of 8.6%, they would support some 4.6 million jobs as compared with the current 700,000.

Because M&A is such a large part of FDI in any developed economy, facilitating M&A transactions is an important part of the necessary policy mix. Whereas most recent Commercial Code reforms related to M&A have addressed the needs of domestic companies, foreign companies are not free to engage in cross-border stock swaps or triangular mergers. This should be remedied.

Since most remaining restrictions on FDI (including M&A) in Japan generally affect market entry or actions by both foreign and domestic Japanese companies, the other key to raising the level of FDI in Japan is to deregulate further and remove the restraints on market entry for all newcomers.

The other important area for reform is the privatization of public services such as education, healthcare, posts, social insurance, and social welfare. Estimates suggest that reducing the number of public corporations by one-third would increase employment by non-manufacturing foreign firms 43% compared with 1996 levels.

Between 1996 and 2001, foreign-affiliated employment rose by 209,000 jobs and inward FDI increased by Y3.2 trillion. If employment and FDI move in simple proportion to each other, raising FDI by Y9.4 trillion from its 2002 level would result in an increase of 614,000 jobs. Based on this simple analysis, even deregulating to a US level and privatizing 30% of public corporations would only achieve less than one-half of the government's goal of doubling FDI, if there are no other policy changes made. Clearly, it will not be easy to achieve the government's FDI goals.

More to be done

The government has so far worked to promote FDI through halfway measures such as disseminating information internally and externally, setting up a one-stop investment centre, and creating special reform zones. Such makeshift steps to will not achieve the government's laudable objectives.

Far-reaching reforms are necessary, not policies based on weak analysis and optimistic forecasts that use up valuable resources and do not hold anyone accountable for failure. Since expanding FDI to the level of other developed countries could a be key to lifting the Japanese economy out of stagnation, the Japanese people have a big interest in the success or failure of policies in this area.

Kyoji Fukao

Professor, The Institute of Economic Research, Hitotsubashi University (Since 1999)

Fukao specializes in macroeconomics and international economics. Some of his research topics and activities include: economic analysis of foreign direct investment; sectoral analysis of Japan's economic growth; and Japan's service trade. He was educated at The University of Tokyo and his professional career has included roles at various universities including: Yale University; Boston University; Bocconi University; and The University of Tokyo. Fukao has also done work for the Bank of Japan and the Asia Development Bank Institute.

This article is a summary of the Fukao Report, which was issued in Japanese on October 29 2003 and entitled "Foreign Direct Investment and the Japanese Economy".