Information about Asia and the Pacific Asia y el Pacífico

III Japan’s Capital Flows

Guy Meredith, and Ulrich Baumgartner
Published Date:
April 1995
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Juha Kähkönen

Since the early 1980s, Japan has been the world’s largest exporter of capital. Despite having the highest investment rate of all major industrial countries, Japan has invested less at home than it has saved, transferring part of its saving abroad and, as a consequence, running current account surpluses. From modest amounts in 1980, outflows of portfolio capital and foreign direct investment (FDI) have since surged; Japan has also become the world’s largest provider of development assistance. This section discusses the developments in Japan’s net capital outflows, with particular attention paid to the determinants and impact of Japan’s FDI.

The first part provides an overview of capital flows and Japan’s international asset position since 1980. Three phases can be distinguished. In the first half of the 1980s, Japan’s long-term capital outflows, especially portfolio investment, grew rapidly in line with the current account surplus, helped by the liberalization of capital controls. During the second half, the rise in net long-term outflows accelerated, with direct investment gaining importance, but these outflows were partially offset by large net borrowing of short-term capital. These developments were driven by deregulation of domestic financial markets, further capital account liberalization, rising domestic asset prices, and a sharp appreciation of the yen. So far in the 1990s, net long-term outflows have been well below the level reached in the latter half of the 1980s, and Japan’s rising current account surpluses have been accompanied by reductions in short-term liabilities. The changed pattern of Japan’s capitalflowsreflects the completion of the stock adjustment following relaxation of capital controls, the collapse of the asset price “bubble,” and banks’ response to the introduction of Bank of International Settlements (BIS) capital adequacy guidelines.

The second part of the section focuses on FDI. Japan’s outward FDI gained high visibility in the second half of the 1980s, with Japan becoming the largest investor in the world (in flow terms) and with the stock of overseas investment growing fivefold between 1985 and 1992. The pattern of Japanese FDI also changed, from resource-oriented investment in developing countries toward the acquisition of real estate and financial institutions in the major industrial countries. Although much of Japan’s FDI can be seen as part of a process of evolving comparative advantage, the same macroeconomic factors that provided incentives for other types of long-term capital out-flows (such as the yen appreciation, the extraordinary rise in asset prices, and liberalization of foreign exchange controls) were also important determinants of the surge in Japan’s FDI in the late 1980s. The rise in Japan’s FDI can be seen as beneficial to the world economy; not only has it provided potential for the usual gains from international integration to be realized, but there are, in addition, possible positive spillovers into the host economies in the form of new technology and organizational skills. Although FDI, like domestic investment, has effects on the structure of output and employment, any permanent impact on total employment is likely to be small. Similarly, because FDI is unlikely to have a significant influence on the underlying determinants of saving and investment, Japanese FDI will probably have only temporary effects on the current account position.

Recent Developments in the Capital Account

Japan’s capital flows have been the counterpart of the current account balance (Chart 3-1). The current account surplus rose rapidly until 1986–87, reaching a peak of percent of GDP in 1986. (In U.S. dollars, the peak came in 1987, at $87 billion.) Thereafter, the surplus declined steadily, to a low of1¼percent of GDP ($36 billion) in 1990. In the early 1990s, the surplus again rose sharply, stabilizing at about 3 percent of GDP in 1992–93. (In U.S. dollars, an all-time high of $131 billion was recorded in 1993.)

Chart 3-1.Current Account Balance and Capital Flows

Source: Nikkei Telecom.

1 Net inflow of short-term and long-term capital, excluding errors and omissions.

In most years, the combined net outflow of short-term and long-term capital closely matched the current account surplus (Table 3-1). The exceptions were the years 1986–88 and 1993, when a significant part of the surplus was channeled to official reserves, owing to intervention by the Bank of Japan in the foreign exchange market. In particular, in 1987 the monetary authorities absorbed about one half of the current account surplus.

Table 3-1.Summary of the Capital Account(In billions of U.S. dollars)
Current account balance–
Net long-term capital
By type of capital2.3–9.7–15.0–17.7–49.7–64.5–131.5–136.5–130.9–89.2–43.637.1–28.5–78.3
Net direct investment–2.1–4.7–4.1–3.2–6.0–5.8–14.3–18.4–34.7–45.2–46.3–29.4–14.5–13.6
Net securities9.44.42.1–1.9–23.6–43.0–101.4–93.8–66.7–28.0–5.041.0–26.2–62.7
Equities and other3.28.3–0.35.9–6.3–27.640.863.66.987.917.6–32.6
Net loans–2.8–5.3–8.1–8.5–12.0–10.5–9.3–16.3–15.3–4.716.925.08.3–3.8
By asset or liability
Direct investment–2.4–4.9–4.5–3.6–6.0–6.5–14.5–19.5–34.2–44.1–48.0–30.7–17.2–13.7
Equities and other–3.7–3.5–4.0–6.3–9.0–14.9–1.1–19.1–10.7–6.11.3–21.8
Direct investment0.–0.5–
Equities and other6.811.83.712.22.7–12.841.982.717.794.016.4–10.9
Errors and omissions––3.92.8–22.0–20.9–7.8–10.5–0.3
Basic balance1–11.5–4.4–3.45.2–10.9–11.4–43.2–53.4–48.5–54.1–28.7102.178.652.9
Short-term capital–1.9–1.3–6.6–3.513.39.956.995.764.029.47.8–119.2–80.0–29.4
Overall balance–13.4–5.7––1.513.742.315.5–24.7–20.9–17.1–1.423.5
Increase in reserves4.93.2––12.8–7.8–8.1–0.326.9
Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various issues).

Including errors and omissions.

Including yen-denominated holdings of foreign monetary authorities (with sign reversed).

Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various issues).

Including errors and omissions.

Including yen-denominated holdings of foreign monetary authorities (with sign reversed).

Developments in Japan’s capital account since 1980 can be divided into three markedly different phases. In the first half of the decade, long-term capital flows (gross and net) grew rapidly, albeit from a low base, while short-term flows were relatively small and stable, owing to limits on banks’ open short positions in foreign currencies. Overall, Japan’s net foreign assets rose from 1 percent of GDP in 1980 to 6 percent of GDP in 1984 (Chart 3-2). The buoyancy of long-term flows was largely the result of the liberalization of capital controls, starting with the revision of the Foreign Exchange and Transactions Control Law in December 1980, which, among other things, abolished the system of prior approval for foreign securities investment. As a result, both the flow of portfolio capital and the share of securities in foreign assets and liabilities increased markedly during the period. An extensive system of monitoring and administrative guidance remained in place, however, and ceilings on purchases of foreign securities were an effective constraint on an even faster reallocation of Japanese investors’ portfolios.

Chart 3-2.Foreign Assets and Liabilities

Source: Japan, Economic Planning Agency (EPA), Annual Report on National Accounts (Tokyo, 1993).

In the second half of the 1980s, gross long-term capital outflows continued their rapid rise, with foreign direct investment becoming an important component of capital exports, and net long-term outflow also reached record levels. In contrast to developments earlier in the decade, however, there was a large net inflow of short-term capital. Reflecting these partially offsetting flows, Japan’s net foreign asset position remained stable at around 10 percent of GDP in 1985–89. A combination of factors was responsible for the pattern of capital flows observed during this period. Dismantling of capital controls again played an important role. This time the liberalization measures not only stimulated long-term capital outflows but also enabled banks to import substantial amounts of short-term capital, since limits on open short positions in foreign currencies were lifted in June 1984.1 Deregulation and structural changes in the domestic financial sector also had a major impact. Deregulation increased competition and induced domestic financial institutions to search for profit opportunities abroad, while a structural change from depository-type financial institutions (such as postal savings banks) toward securities-oriented institutions (such as insurance companies and investment trusts) increased a trend toward foreign securities holding. The sharp increases in land and equity prices during the bubble period in the late 1980s also contributed to the accumulation of foreign assets by Japanese residents. Rising asset prices made equity-related bond issues a low-cost form of financing, and institutional investors were able to convert capital gains into income gains by engaging in capital account transactions.2 Finally, the sharp appreciation of the yen, especially in 1985–86, stimulated net capital outflows by providing incentives for FDI.

The 1990s have witnessed a major departure from past patterns of capital flows. The gross outflow of long-term capital has declined dramatically from the record level in 1989, and the net long-term outflow has been subdued (it even was negative in 1991). Further, having borrowed heavily short term in the latter half of the 1980s, Japan has become a major net exporter of short-term capital in the 1990s. These developments are largely the result of three factors. First, the stock adjustment following relaxation of capital controls appears to have been largely completed by the late 1980s, with Japanese investors having had sufficient time to reach a desired degree of international diversification. Consequently, these investors became more sensitive to the fundamental determinants of capital flows, including interest rate differentials (adjusted for expected exchange rate changes) and exchange risk. The already heavy exposure to foreign currency assets, the associated exchange risk, and reduced interest differentials in favor of foreign-currency-denominated assets following the tightening of Japanese monetary policy from mid-1989 all reduced incentives for continued rapid accumulation of foreign assets.

Second, the collapse of the asset price bubble in 1990 reduced financial institutions’ “hidden” assets (unrealized capital gains). Because exchange losses could not be offset by capital gains to the same extent as before, the institutions became reluctant to purchase foreign securities. The bursting of the bubble also depressed net capital outflow by attracting foreign buyers of Japanese equity and by discouraging direct investment abroad, especially in real estate. Third, concern about capital adequacy, in particular the need to conform with BIS guidelines, made banks adjust their international strategy. Although banks had in the 1980s accumulated large amounts of long-term foreign assets (closely matched by short-term borrowing in foreign currencies, to satisfy regulations to keep banks’ open foreign currency positions within a narrow limit), they now had to downsize their international positions.

Long-Term Capital Flows

Accompanying the increase in the current account surplus up to 1987, net long-term capital outflows rose rapidly, reaching a high of $137 billion in 1987. With the external surplus falling in 1988–90, the deficit in the long-term capital account also narrowed. In 1991, however, when the current account surplus again started to rise, there was a net inflow of long-term capital, of $37 billion, for the first time since 1980. In 1992–93, the long-term capital account again recorded net out-flows, but the amounts ($29 billion in 1992 and $78 billion in 1993) were well below the average annual outflow of $110 billion in the second half of the 1980s.

The ups and downs in net outflows of long-term capital were the result of a markedly different pattern of growth in assets (foreign assets accumulated by Japanese residents—outflow) and liabilities (Japanese assets acquired by foreigners—inflow). The outflow grew rapidly throughout the 1980s, peaking at $192 billion (6½ percent of GDP) in 1989, but it declined thereafter and averaged $66 billion in 1992–93 (see Table 3-3). By contrast, the inflow was relatively small—less than $20 billion annually—until 1989, when it jumped to over $100 billion. The inflow peaked in 1991 at $159 billion, which exceeded that year’s outflow. In 1992–93, however, the inflow returned to the low pre-1989 levels, averaging $13 billion.

Securities have been by far the most important vehicle for transferring Japan’s savings surpluses abroad, accounting for 52 percent of the net outflow in 1980–93. Investment by Japanese residents in foreign securities grew more than tenfold between 1982 and 1986, reaching a high of $113 billion in 1989. The rapid rise in securities investment was almost entirely in the form of bonds (Table 3-2). In the second half of the 1980s, the bulk of this rise was the result of increased offshore intermediation of Japanese funds in the form of purchases by Japanese investors of equity-related bonds issued by Japanese companies in Euromarkets.3 When a major plunge in stock prices in Tokyo made equity warrants less desirable in 1990, securities investment abroad also declined sharply and has remained subdued, averaging $50 billion annually in 1990–93.

Table 3-2.Flows of Securities(In billions of U.S. dollars)
Net securities (+ = outflow)–9.443.0101.493.866.728.05.0–41.026.2–62.7
Japan's investment in foreign securities3.859.8102.087.886.9113.239.774.334.451.7
Stocks and shares––3.015.3
Yen-denominated external bonds, etc.–2.0–
Foreign investment in Japanese securities13.116.70.5–6.120.385.134.7115.38.2–11.1
Stocks and shares6.5–0.7–15.8––13.346.88.720.0
External bonds1.212.918.430.135.175.730.947.37.6–30.8
Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various issues).
Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various issues).

Japanese investment in securities other than regular bonds has generally been small. Purchases of foreign stocks and shares have been relatively limited, exceeding $10 billion only twice (in 1987 and 1989). The small share of foreign stocks in Japanese equity portfolios could reflect that stocks, compared with bonds, are less standardized and more difficult to manage (Kawai (1991)) or that Japanese investors expect higher average returns in the domestic stock market than in foreign stock markets (French and Poterba (1991)).4 Japanese purchases of Samurai bonds (yen-denominated external bonds) and Shogun bonds (dollar-denominated external bonds issued in Tokyo) have also been small.

FDI, which had averaged $4 billion in the first half of the 1980s, became an increasingly important contributor to the intermediation of the saving surpluses in the latter half of the decade. A peak was reached in 1990, when outward FDI amounted to $48 billion and accounted for 40 percent of the total outflow of long-term capital. Since then, however, FDI has declined steadily, falling to $14 billion in 1993. (For a more detailed discussion of developments in FDI, see “Foreign Direct Investment,” below.)

Long-term loans extended by Japanese residents (including official development assistance) were more important than FDI until the mid-1980s, but the situation has subsequently been reversed. Other outflows, including trade credits, have typically been a very small share of total outflows.

The Japanese long-term capital outflow has been directed mainly to industrial countries (Table 3-3).5 In 1988–93, the United States and the European Union (EU) received three fourths of the outflow. The newly industrializing Asian economies (Hong Kong, Korea, Singapore, and Taiwan Province of China) were the destination of less than 2 percent of Japan’s long-term capital exports. Although about one half of outward FDI went to the United States, over 60 percent of Japanese investment in securities was directed to the EU, in particular Luxembourg and the United Kingdom. Both countries offer Euromarkets where many Japanese firms issued equity-related external bonds. In addition, in London, U.K. “gilts” also attract Japanese investors. Loans have been primarily channeled to developing countries (included in the “other” category in Table 3-3).

Table 3-3.Long-Term Capital Outflow by Region and Type
YearTotalDirect InvestmentSecuritiesLoansOther
In billions of U.S. dollars
United States198861.519.
European Union198855.55.842.61.85.4
Of which: United Kingdom198816.32.910.70.91.8
Newly industrializing economies119882.82.1–
In percent of total flow in 1988–93
United States31.751.423.227.433.8
European Union42.721.861.010.927.3
Of which: United Kingdom13.711.
Newly industrializing economies11.–4.4
Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various April issues).

Hone Kong, Korea, Singapore, and Taiwan Province of China.

Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various April issues).

Hone Kong, Korea, Singapore, and Taiwan Province of China.

Long-term capital inflows have mainly been in the form of securities, which have generally been even more dominant than in the case of outflows (Table 3-4). Purchases of Japanese securities by foreigners were particularly important in 1989, when Japanese residents issued large amounts of overseas bonds, and in 1991, when sharply lower equity prices in Japan led foreign investors to buy a record-high amount of stocks in Tokyo, in addition to continued large purchases of Japanese bonds by nonresidents. With inward foreign investment having been insignificant, loans have been the only other important source of long-term capital inflow, particularly since 1989. European countries have been the source of the bulk of inward securities investment, and the newly industrializing economies have accounted for the largest share in loans to Japan.

Table 3-4.Long-Term Capital Inflow by Region and Type
YearTotalDirect InvestmentSecuritiesLoansOther
In billions of U.S. dollars
United States19882.2–0.62.9–0.1
European Union198821.40.121.4
Of which: United Kingdom198822.622.7
Newly industrializing economies11988–5.2–5.2
In percent of total flow in 1988–93
United States–0.6–6.7–1.41.3–1.1
European Union72.454.3103.112.2
Of which: United Kingdom69.934.4100.011.7
Newly industrializing economies125.312.2–1.486.6
Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various April issues).

Hone Kong, Korea, Singapore, and Taiwan Province of China.

Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various April issues).

Hone Kong, Korea, Singapore, and Taiwan Province of China.

With few exceptions, the regional pattern of net long-term capital flows is different from the pattern of trade flows, which is to be expected under a multilateral payments system and free capital movement (Table 3-5). In the case of the United States, the recent large bilateral trade surpluses in favor of Japan have been by and large matched by net exports of long-term capital from Japan to the United States. However, the United Kingdom, having had approximately balanced trade with Japan in 1988–93, and the newly industrializing economies, having run large trade deficits with Japan, were major sources of net inflow of long-term capital to Japan.6 By contrast, the developing countries had a trade surplus with Japan and also were important recipients of Japanese long-term capital outflows.

Table 3-5.Net Long-Term Capital Outflow by Region and Type(In billions of U.S. dollars)
United States198859.319.633.32.83.5
European Union198834.15.721.21.85.4
Of which: United Kingdom1988–6.32.9–
Newly industrializing economies119888.
Average, 1988–932
Current account82.4
Long-term capital account55.6
United States
Current account45.3
Long-term capital account38.2
European Union
Current account21.3
Long-term capital account4.8
Of which: United Kingdom
Current account0.5
Long-term capital account–28.3
Newly industrializing economies1
Current account30.8
Long-term capital account–14.0
Current account–15.0
Long-term capital account26.6
Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various April issues).

Hong Kong, Korea, Singapore, and Taiwan Province of China.

Current account surplus in favor of Japan, and net long-term capital outflow from Japan.

Source: Bank of Japan, Balance of Payments Monthly (Tokyo, various April issues).

Hong Kong, Korea, Singapore, and Taiwan Province of China.

Current account surplus in favor of Japan, and net long-term capital outflow from Japan.

Short-Term Capital Flows

The fluctuations in short-term capital flows have been even sharper than those in long-term flows (see Table 3-1). The net inflow, which had been negligible in the first half of the 1980s, surged in the second half to an average of $51 billion, peaking in 1987 at $96 billion. This increase mainly reflected the activities of private banks, which accumulated net foreign liabilities of $194 billion in 1985–89. Following a small net inflow in 1990, the short-term capital account turned to a large outflow position of $119 billion in 1991 and has remained in deficit since. Banks already had become net exporters of short-term capital in 1990, and by end-1993 they had reversed all of the massive run-up in net foreign liabilities during the second half of the 1980s. By contrast, almost half of the $85 billion increase in the nonbank private sector’s net short-term liabilities in 1987–90 remains outstanding.

Flow of Financial Resources to Developing Countries

Although the bulk of Japan’s large current account surpluses has been intermediated to other industrial countries through private sector financial institutions, especially institutional investors, a significant portion of the surpluses has also been transferred to developing countries, both by the Government and the private sector. Indeed, by 1987 net financial flows from Japan to developing countries were the largest in the world, and since 1989 Japan has ranked first in official development assistance.

Since the mid-1980s, Japan has taken several initiatives to stimulate the flow of financial resources to the developing countries. The most comprehensive initiatives have been two multiyear plans—a capital recycling plan for 1987–92 amounting to $65 billion, and a “Funds for Development” initiative for 1993–97 with a target of $120 billion. The recycling plan pulled together official development assistance, other official flows, and private flows into one package, with official flows intended to serve as a catalyst for increased privateflows, particularly to heavily indebted countries. Financing under that plan included direct bilateral lending, cofinancing with multilateral lending agencies, parallel lending with the IMF, and funds allocated to highly indebted countries under the strengthened debt strategy. The new $120 billion plan consists of $70 billion in untied official funds and $50 billion in other financing, including loans from the Export-Import Bank of Japan and international trade insurance.

In recent years, Japan’s total net financial flows to developing countries have averaged $20 billion annually (Table 3-6). About half of the total has been accounted for by official development assistance, which takes the form of contributions to the multilateral financial institutions and bilateral loans, grants, and technical assistance. Other official flows, including loans by the Export-Import Bank of Japan, have been about 10 percent of the total. The remaining part has originated from the private sector, including loans from commercial banks, direct investment, and commercial bank cofinancing with the Export-Import Bank and with multilateral development institutions.

Table 3-6.Net Flow of Financial Resources to Developing Countries and Multilateral Agencies from Japan1
198719881989199019911992Est. 1993
In billions of U.S. dollars
Official development assistance7.
Grants and other2.
Other official flows–1.8–
Export credit–2.0–1.8–1.2–1.0–0.50.1
Direct investment0.
Private flows14.712.814.36.311.21.5
Export credit1.–1.0
Direct investment7.
Other bilateral4.42.81.3–
Grants by private
voluntary agencies0.
Total resource flows20.521.425.618.724.916.2
In percent of GNP
Official development assistance0.310.320.310.310.320.300.26
Total resource flows0.860.750.840.630.730.44
Source: Japanese authorities.

Calendar years; Development Assistance Committee (OECD) basis.

Source: Japanese authorities.

Calendar years; Development Assistance Committee (OECD) basis.

Japan’s net disbursements of official development assistance amounted to about $11 billion a year in 1991–93. Although Japan remains the world’s largest supplier of nonmilitary aid, its ratio of official assistance to GNP (0.26 percent in 1993) is slightly below the OECD’s Development Assistance Committee average and falls well short of the United Nations target of 0.7 percent. The target for 1993–97 has been set at $70-75 billion, enhancing Japan’s position as the largest donor over the medium term but implying little change in the aid-to GNP ratio. The new plan is the first implemented by the Government since an Official Development Assistance Charter was adopted in 1992. The Charter outlines four principles that mandate more stringent conditions for foreign aid. They stipulate that Japan must pay close attention to the following issues: environmental concerns; restraint in military expenditures and weapons development; democratization and human rights; and the fostering of market-oriented economies.

The regional allocation of Japan’s official assistance is well diversified. Although Asia receives the bulk of Japan’s bilateral aid—with Indonesia, China, the Philippines, India, and Thailand accounting for over 40 percent of the total—Africa, the Middle East, and Latin America are also major recipient areas (Egypt, Jordan, Turkey, and Peru have recently been among the top ten recipients of aid). Japan is now the leading donor in some 30 developing countries, not only in Asia but also in parts of Africa.

Foreign Direct Investment

Japanese outward FDI surged in the second half of the 1980s, with the stock of overseas investment growing almost fivefold between 1985 and 1992 (Chart 3-3). This spectacular increase prompts a number of questions:

  • Was the increase in FDI particular to Japan, or was it part of a worldwide spurt in FDI? Is Japan’s FDI unusually large by international standards?

  • What is the regional and sectoral distribution of Japanese FDI, and how has the pattern changed over the years? To what extent was the rapid growth in the second half of the 1980s attributable to investment in real estate and financial institutions in the United States?

  • What have been the main factors responsible for the rapid growth in FDI? Is the increase a natural part of the process of industrial restructuring, or did it occur in response to government intervention (tax policy, trade barriers) or because of macroeconomic factors (yen appreciation, asset price bubble)?

  • What are the salient characteristics of Japanese over-seas subsidiaries? Do Japanese affiliates differ from those involved in other countries’ FDI, with respect to profitability, repatriation rates, imports, and destination of production?

  • What have been the main effects of Japanese FDI on other economies? Has Japanese investment created jobs and promoted growth in the host countries, and has it been a drain on these countries’ trade accounts?

  • Has FDI had a significant impact on Japan’s economy, especially the external surplus? Are Japanese exports and FDI complementary, or does FDI generate increased imports from overseas subsidiaries? Does income from direct investment provide a significant contribution to foreign exchange receipts?

These issues will be addressed in the remainder of this section, preceded by a discussion of the concept and measurement of FDI and a review of main developments since the 1950s.

Concept and Measurement

Conceptually, FDI refers to an investment made by a foreign resident to acquire a controlling interest in a host-country company (IMF (1992, p. 24)). It is the motive of the investment—corporate control—that distinguishes FDI from portfolio investment, which is simply the establishment of a claim on an asset for the purpose of realizing a return without being involved in management.

In practice, capital inflows designated as direct investment are distinguished from portfolio investment solely on the basis of percentage of foreign ownership. At present, the international standard (also followed by Japan) is a cross-border holding of 10 percent or more of the voting power in an incorporated enterprise (or a similar interest in an unincorporated enterprise). Although the 10 percent ownership criterion is arbitrary, it is unlikely to be an important source of measurement errors (Graham and Krugman (1991, pp. 7-11) and IMF (1992, pp. 24-25)). For example, foreign companies with operations in the United States own on average an 80 percent share of their affiliates, suggesting that for most of these affiliates foreign ownership is both clear in practice and accurately recorded in balance of payments statistics (Froot (1991)). FDI data, however, tend to understate actual foreign control because they do not include investment by foreign affiliates that is financed by selling securities to unrelated parties (domestic or foreign). Furthermore, official statistics record only the book value of the FDI and do not allow for increases in the value of foreign-controlled assets.

There are two main sources of data on Japanese FDI. The Bank of Japan compiles monthly balance of payments data, with no breakdown by industry but with some aggregated breakdown by host country made available on an annual basis. The Ministry of Finance publishes annual flow and stock data on FDI on a notification basis, with a detailed breakdown by industry and host country. These data tend to overstate the actual amount of FDI because some investment announced is not actually undertaken and because implementation may follow notification with a considerable lag. In recent years, the annual inflows of FDI as reported by the Ministry of Finance have been about 50 percent larger than those recorded in the balance of payments by the Bank of Japan (see Chart 3-3). In addition to these two main data sources, the Ministry of International Trade and Industry (MITI) conducts questionnaire surveys on Japanese enterprises’ activities abroad. These surveys provide information on the market destination of Japanese FDI and on cross-border intrafirm trade. The following discussion mainly uses balance of payments data, so that international comparisons can be made. Ministry of Finance data are used in analyzing the regional and sectoral composition of FDI and are supplemented by results from MITI surveys.

Chart 3-3.Outward Foreign Direct Investment

(In percent of GNP)

Sources: Bank of Japan, Balance of Payments Monthly (Tokyo, various issues); and Japan, Ministry of Finance, Zaisei Kinyu Tokei Geppo (Tokyo, various issues).

Main Developments

Japanese postwar FDI was conducted only on a small scale until the early 1970s, in part because of stringent government regulations imposed because of the weak balance of payments. According to balance of payments data, annual outflows rose slowly, to an average of $150 million in the second half of the 1960s, and at end-1970 the stock of FDI was about 2 percent of that year’s GDP. During this period, Japanese FDI took two principal forms. One was the acquisition of raw materials (especially mining products) to supply manufacturing industries in resources-short Japan. The other was foreign investment in labor-intensive manufacturing activities in the nearby Asian countries. Overall, almost two thirds of Japanese FDI in the 1950s and 1960s went to developing countries (Table 3-7).

Table 3-7.Foreign Direct Investment by Region and Industry(In percent of tolal)
By Region
PeriodUnited StatesAllAsia (newly industrializing economies)EuropeLatin AmericaMiddle EastOceaniaOtherTotal
By Industry
ManufacturingAgriculture, forestry, and fisheryMiningCommerceFinance andinsuranceTransportReal estateOtherTotal
Source: Japan, Ministry of Finance, Taigai chyokusetsu-toshi no kyoka todokede zisseki (Tokyo, various issues).
Source: Japan, Ministry of Finance, Taigai chyokusetsu-toshi no kyoka todokede zisseki (Tokyo, various issues).

In the early 1970s, Japanese FDI surged, rising fivefold between 1971 and 1973 before stabilizing at around $2 billion for the remainder of the decade. The large increase was induced in part by an improvement in Japan’s current account position, which turned into a surplus. This led not only to the easing of government regulations on FDI but also to a policy to promote it: restrictions on FDI were eased in four steps in 1969–72; the Export-Import Bank of Japan lowered interest rates on loans for foreign investment; and, in order to reduce the risks of FDI, tax provisions for overseas investment loss reserves were revised (Komiya and Wakasugi (1991, p. 51)). As regards the pattern of Japanese FDI in the 1970s, the share of mining declined substantially, and large investments were made in the U.S. distribution sector to support the marketing of exports of automobiles and other durable goods. Nevertheless, developing countries continued to host the bulk of Japanese FDI.

During the 1980s, Japan’s FDI grew spectacularly. In the first half of the decade, overseas investment increased briskly, tripling to $6.5 billion (½ of 1 percent of GDP) between 1980 and 1985. Even more extraordinary growth was experienced in the second half of the decade. Japanese FDI during the four-year period 1986–89 exceeded the cumulative overseas investment from all postwar years combined by the late 1980s, Japan’s FDI outflow had become the largest in the world, and a peak outflow of $48 billion (1½ percent of GDP) was reached in 1990. At that time, the annual flow was 20 times larger than a decade before, and the stock of FDI stood at $302 billion (10 percent of GDP) compared with $48 billion (4 percent of GDP) in 1980.

The unprecedented growth in FDI in the late 1980s was accompanied by a substantial change in the pattern of overseas investment. During the 1980s, the share of Japanese FDI in manufacturing declined sharply, whereas the tertiary sectors, which had earlier accounted for less than half of the total, gained a combined share of more than 70 percent. Overseas investment increased particularly fast in finance and insurance, transport, and real estate, all of which had played only a minor role in Japanese FDI before the 1980s. Regionally, the share of developing countries (not only in Africa and Latin America but also in Asia) declined sharply, whereas industrial countries absorbed over two thirds of Japanese FDI, with the United States alone receiving over 40 percent of the investment.

The boom in Japanese FDI came to an end in the early 1990s, with the annual outflow declining steadily from the peak of $48 billion (1½ percent of GDP) in 1990 to $14 billion (⅓ of 1 percent of GDP) in 1993. Although the outflows were still large in absolute terms, relative to GDP they marked a return to the level first reached in the early 1970s. The regional and sectoral pattern of FDI remained broadly the same as in the years of rapid growth. The latest surveys of FDI intentions suggest that future areas of growth in Japanese overseas investment will be machinery, chemicals, and automobiles, with Asian countries (especially China and the members of the Association of South-East Asian Nations, ASEAN) likely to receive an increasing share of total Japanese FDI.

Worldwide Perspective

The recent surge in FDI was not simply a Japanese phenomenon (Chart 3-4). World FDI rose sharply in the second half of the 1980s, both in absolute terms (to a peak of $238 billion in 1990) and relative to output (from a long-term average of ½ of 1 percent of GDP to over 1 percent of GDP in 1989–90). As in Japan, world FDI has been on a declining trend so far in the 1990s. The rapid growth of world FDI in the second half of the 1980s can be attributed in part to easing of restrictions on capital movements, deregulation of financial markets, and a lagged adjustment to exchange rate misalignments.

Chart 3-4.Japanese and World Direct Investment Outflows

(In percent of GNP)

Source: IMF, International Financial Statistics (IFS) (Washington, various issues).

The growth in Japan’s overseas investment in the 1980s was, however, faster than that in the other major industrial countries (Chart 3-5). In absolute terms, Japan had been the fourth largest direct investor in the 1970s (behind the United States, the United Kingdom, and Germany), accounting on average for 5 percent of world FDI. In the early 1980s, Japan moved to the top three, and during 1989–91 it was the world’s leading direct investor, with a share of as much as 20 percent of the total. Even during these peak years, Japan’s overseas investment relative to the size of the economy was low in comparison with other major industrial countries (except the United States). Moreover, despite large recent FDI outflows, Japanese overseas subsidiaries produce a relatively small share of the parent companies’ output in comparison with affiliates of other industrial countries. In 1989, overseas production accounted for only 5 percent of the total sales of Japanese manufacturing corporations, compared with 15-20 percent for the United States and a number of European countries.

Chart 3-5.Direct Investment Outflows Among Five Major Industrial Countries

(In percent of GNP)

Source: IMF, IFS (Washington, various issues).

Although Japanese overseas investment flows have long been at levels comparable with other industrial countries, Japan remains an outlier in terms of inward FDI, with an insignificant share of the world total FDI going to Japan (Chart 3-6). Nevertheless, in contrast to developments in outward investment, Japanese inward FDI has risen steadily in recent years, from an annual average of $200 million in the 1980s to an average$1½ billion in 1990–93.

Chart 3-6.Direct Investment Inflows Among Five Major Insdustrial Countries

(In percent of GNP)

Source: IMF, IFS (Washington, various issues).

Determinants of Japanese Outward Foreign Direct Investment

There are two main approaches to explaining FDI: micro (industrial organization) theories, and macro (cost-of-capital) theories.7 The industrial-organization view emphasizes that firm-specific intangible assets—such as patents, brand names, superior technology, and organizational skills—may under certain circumstances make it profitable for a firm to internalize the rents on these advantages through overseas investment, rather than through licensing or exports. According to this view, the presence of transaction costs in markets for intermediate goods, the desire to keep technological secrets, and attempts to circumvent trade restrictions are examples of possible reasons for direct investment. The cost-of-capital view, by contrast, holds that if an investment is made by a foreign firm, rather than a domestic company, it may be because the foreign firm has a lower cost of capital and therefore requires lower returns.8 In that case, incentives for FDI can be provided by the liberalization of capital markets, exchange rate movements, and macroeconomic policies (especially monetary and tax measures), among other things.

Lower costs of production in the host country compared with the source country—a factor often mentioned in popular discussions—alone cannot be a reason for FDI. If, say, labor is relatively cheap in the host country, it is cheap for domestic and foreign firms alike. Hence, foreign firms, rather than domestic ones, will carry out the investment more profitably only if they possess specific advantages, such as those mentioned above under the micro and macro approaches.

How well do the micro and macro approaches explain developments in Japan’s FDI? The distinction between the industrial-organization and cost-of-capital explanations has important implications (Graham and Krugman (1991, p. 38)). If overseas investment is motivated purely by industrial-organization considerations, Japan’s FDI has little to do with the transfer of Japan’s surplus saving. However, if macroeconomic factors are behind Japan’s overseas investment, future FDI flows are to some extent linked to prospects for the current account. Most studies agree that both approaches are relevant to explaining the rapid growth of Japan’s overseas investment in the 1980s and its subsequent decline.9

Proponents of the microeconomic approach point out that much of Japanese FDI has been in response to industrial restructuring and evolving comparative advantage. As mentioned above, in the 1950s and 1960s, the bulk of Japanese overseas investment was in the areas of natural resource acquisition and labor-intensive manufacturing. The FDI in natural resource extraction represented a form of backward vertical integration by Japanese users of raw materials or by Japanese trading companies having close links to them. Similarly, the investment in manufacturing in nearby Asian countries represented a transfer of production abroad in a sector where Japan was losing comparative advantage. In the 1970s, the heavy investments in the distribution sector to support the marketing of consumer durables, especially automobiles, were a form of forward vertical integration by Japanese manufacturers. As noted by Caves (1993), these investments were in accordance with the standard theory of FDI based on transaction costs, with controlled-distribution subsidiaries displacing arm’s-length distributors. As regards the more recent period, empirical studies (such as Kogut and Chang (1991) and Hennart and Park (1991)) have established a positive relationship between the rapid growth of research and development expenditure by Japanese firms and Japan’s FDI, consistent with the industrial-organization view that overseas investment takes place to arbitrage intangible assets (specific advantages) accumulated by firms in the source country.10

The industrial-organization literature on FDI also regards circumventing trade restrictions (existing or prospective) as an important explanation for Japanese FDI. Increased protection reduces a foreign company’s net revenues from exporting, raising the relative profitability of foreign investment and turning the exporter into a direct investor.11 As surveyed by Caves (1993, p. 290), there is a wealth of evidence from econometric and case studies that trade restrictions in the United States have had a significant positive effect on FDI from Japan. In particular, voluntary export restraints in the automobile sector and the 1986 semiconductor trade agreement have been shown to induce sizable direct investment flows from Japan. As for Japanese FDI to the EU, the evidence is less clear-cut (see Thomsen (1993, pp. 306–09)). Many studies, including Barrell and Pain (1993) and Heitger and Stehn (1990), have found protection in the EU or the prospect of a single European market (or both) to have been an important determinant of Japanese FDI to the EU; however, some (notably Nicolaides and Thomsen (1991)) have suggested that preparation for the single market affected mainly the timing, rather than the longrun level, of direct investment in the EU. Besides the United States and the EU, trade restrictions also motivated some of Japan’s FDI in other Asian countries, the exports of which were not subject to the trade barriers aimed at Japanese exporters.

Although industrial-organization considerations may well explain a major part of Japan’s trend FDI and some of the increase in Japanese FDI in the 1980s, most analysts agree that macroeconomic factors are also needed to explain the increase.12 Indeed, the purchase of property abroad (which was responsible for 24 percent of the increase in Japanese FDI in 1986–90) and part of the investment in banking and finance, though recorded as direct investment, are clearly more akin to portfolio investment and therefore unrelated to industrial-organization motives.13 Among the macroeconomic determinants, three factors seem to have played key roles: the appreciation of the yen; the extraordinary rise in asset prices; and liberalization of foreign exchange controls. Albeit potentially important, changes in tax policy and the business cycle do not appear to have had a significant effect.

Between the fall of 1985 and late 1988, the yen appreciated by 42 percent in real effective terms. This strengthening of the yen brought about a sharp decline in the cost of production and investment in host countries relative to the cost in Japan, raising the profitability of direct investment. Exchange rate appreciation also worked through other channels to increase FDI. For example, with a stronger yen, Japanese firms, whose book values rose compared with those of foreign companies, were able to collateralize assets to finance new investment more easily than were their competitors in countries with depreciated currencies (Froot and Stein (1991)). This enabled Japanese investors to pay higher prices than liquidity-constrained bidders in host countries. Another possible channel, often mentioned in popular discussions but implying irrational behavior, is that Japanese investors may have focused on the comparatively low prices of physical assets in host countries with depreciated currencies, neglecting the question of whether the economic returns were equivalent (Graham and Krugman (1991, p. 46)). Whatever the transmission mechanism, empirical studies, such as those by Caves (1989), Froot and Stein (1991), and Mann (1993), have typically found a significant positive relationship between exchange rate appreciation and outward FDI.

In the second half of the 1980s, the Japanese economy experienced an asset price bubble during which land prices doubled and stock prices tripled.14 The spectacular price increases were in part driven by an easy monetary policy, and they enabled Japanese companies to increase their overseas investment both through lower cost of capital and through additional liquidity. The increased liquidity was created by Japanese banks, which could count 45 percent of their large, unrealized capital gains on stockholdings as capital, enabling them to lend more than competitors elsewhere. The borrowers, including companies engaged in FDI, could in turn use high-priced land and equities as collateral to increase their investment. As noted by Graham and Krugman (1991, p. 47), to the extent that the asset price increases represented a bubble, the lower cost of capital can be interpreted as a subsidy to Japanese firms investing abroad that was paid by those who bought the overpriced stocks and land.

Liberalization of capital controls, described in the first part of this section, also contributed to the spurt of FDI in the 1980s. Although Japanese enterprises in manufacturing, commerce, and services were generally free to undertake FDI even before the revision of foreign exchange laws in December 1980, after the revision financial and insurance firms also became free to invest abroad. In the event, FDI in finance and insurance came to account for 31 percent of the increase in Japanese FDI in 1986–90.

Changes in corporate taxation, particularly in the United States and Japan, provide another possible (but probably not a major) explanation for developments in Japan’s FDI since 1980. According to the Japanese tax system, foreign subsidiaries of Japanese firms pay corporate taxes in the host country. However, when they repatriate income to their parent company, they are liable to taxation at the Japanese rate, with a credit for taxes paid abroad. Under this system, a cut in the corporate tax rate abroad puts host-country firms, which receive the full benefit of the tax cut, at an advantage relative to the subsidiaries of Japanese firms, whose lower foreign tax liability would be offset by an increased liability in Japan. Thus, the 1981 corporate tax cuts in the United States, notably the introduction of accelerated depreciation, acted as a disincentive to Japanese FDI in the United States, whereas the 1986 tax reform, which eliminated the special investment incentives, removed this bias against foreign ownership (Graham and Krugman (1991, pp. 47-49)). Similarly, changes in the corporate tax rate in Japan affect the incentives of Japanese firms to invest overseas. The most significant change in Japan’s corporate taxation in recent years was a 4.5 percentage point cut in the corporate tax rate in 1990, which improved the profitability of domestic investment and therefore should have discouraged outward FDI. Although the above-mentioned tax changes in the United States and Japan are likely to have made some contribution to the ups and downs of Japanese FDI over the past decade, empirical studies (reviewed in Iwamoto (1990)) typically find taxation to have played only a subsidiary role.

The business cycle has also been mentioned as a determinant of FDI (Graham and Krugman (1991, pp. 50-1)). There is no obvious reason for cyclical fluctuations to affect the share of foreign control in the host country in a systematic way. However, the balance of payments measure of FDI includes intrafirm financing, which is affected by economic prospects and financing conditions in both the source and host countries. Indeed, simple regressions suggest that world FDI behaves procyclically, rising faster than world output during periods of recovery and falling faster during recessions. Thus, the economic boom in Japan and other major industrial countries in the second half of the 1980s could have been responsible for some of the rapid increase in Japanese FDI. Given that the growth of FDI was many times faster than that of output, other factors are likely to have played a more important role.

What explains the marked decline in Japanese overseas investment after 1990? It is difficult to pinpoint industrial-organization factors that might have played a role, but the reversal of a number of macroeconomic developments seems to provide a plausible explanation: the real effective value of the yen depreciated by 22 percent between late 1988 and mid-1990 and, despite subsequent gradual appreciation, remained below the earlier peak until 1993; the asset price bubble collapsed, with land and equity prices returning to trend levels by 1993; the stock adjustment to the removal of capital controls was likely to have been completed by the early 1990s; and the Japanese economy has been in recession since mid-1991. It is still too early to tell whether the marked appreciation of the yen in 1993–94 will induce another burst of Japanese FDI in the mid-1990s.

Characteristics of Japanese Overseas Subsidiaries

As discussed above, standard industrial-organization and cost-of-capital theories seem to go a long way toward explaining the main developments in Japan’s FDI. Some observers have noted, however, that the overseas affiliates of Japanese companies differ from those of other countries in several respects. They have a greater propensity to import—for example, Japanese manufacturing subsidiaries import three times as much per worker as do other foreign manufacturing affiliates in the United States, which themselves are more import-intensive than domestic companies (Graham and Krugman (1991, p. 78)). The Japanese parent companies import relatively less from their affiliates and strongly direct their interfirm exports to their foreign distribution subsidiaries. Japanese companies have also displayed a marked (but diminishing) preference to establish their investments by building a new facility (“greenfield” investment) instead of acquiring control of an existing company (Caves (1993, p. 291)). Furthermore, the affiliates’ profitability is low compared with that of U.S. firms. The following average profit rates for 1983–88 were adapted from Komiya and Wakasugi (1991):15 Japanese-owned overseas subsidiaries, 0.4 percent (average for all Japanese corporations, 0.9 percent); U.S.-owned overseas subsidiaries, 5.0 percent (average for all U.S. corporations, 2.7 percent).

The differences can probably be attributed primarily to the more recent origin of Japanese FDI rather than to any difference in the underlying microeconomic behavior. Because of the recent rapid growth of Japanese FDI, the average Japanese affiliate has been in operation for a far shorter time than its counterpart from other countries, let alone the average domestic competitor. There is little evidence to suggest that the above-mentioned differences will persist once Japanese FDI matures. Nevertheless, the possibility that reasons such as corporate group (keiretsu) relationships contribute to these differences cannot be excluded.

Effects of Japanese Foreign Direct Investment on Other Economies

The general effects of foreign direct investment are well known. In the absence of distortions, FDI generates net benefits. These benefits include not only the usual gains from trade and international integration—exploitation of comparative advantage, a larger and more efficient scale of production, and increased competition—but also positive externalities in the host economy in the form of new technology, work force skills, and management techniques (Graham and Krugman (1991), Nicolaides (1991), and Georgiou and Weinhold (1992)).

Despite the general presumption that FDI is beneficial, concern has been expressed that foreign investment carries costs for the host country. The adverse effects of FDI are often claimed to include loss of employment and negative trade balance effects. Critics of FDI argue that as foreign-owned companies tend to be import intensive, their activities will result in reduced demand for domestic products, which will cost jobs. In turn, advocates of FDI point to anecdotal evidence that foreign-owned companies employ a large number of workers and account for a significant share of job creation in many countries. For example, Japanese-owned manufacturing companies employ 100,000 Europeans (Thomsen (1993, p. 302)). In the United States, employment in Japanese-controlled firms increased by 428,000 workers between 1977 and 1989 (Graham and Krugman (1991, p. 26)), and in 1987–89 one third of all new manufacturing jobs were the result of Japanese FDI.

Both of these anecdotal views are somewhat misleading because they are based on partial equilibrium analyses. To be sure, foreign investment, like investment by domestic companies, will cause changes in the distribution of employment within the country and across industries, but the net effect on employment is likely to be small beyond the short run. To the extent that FDI has no influence on potential output and the natural rate of unemployment, it should not affect the long-run level of employment. If there is any long-run effect, however, it is likely to be positive: FDI may enhance potential output, and thereby employment, through the externalities discussed earlier.

That Japanese-owned firms tend to have a higher propensity to import than do their host-country counterparts has prompted critics to claim that Japanese FDI worsens the external position of host countries. This criticism is again based on partial equilibrium considerations: if production by Japanese affiliates crowds out domestic firms with a lower import content, the sectoral trade balance will worsen in the short run.16 Standard macro-economic theory suggests, however, that any permanent effects of FDI on the aggregate current account balance are likely to be small (Graham and Krugman (1991, pp. 63-4)). By definition, the current account position is the difference between domestic saving and domestic investment. Changes in import propensities, like other microeconomic factors, cannot influence the current account unless they affect the fundamental determinants of saving or investment. However, the higher import propensity of Japanese affiliates will, if sustained, put downward pressure on host-country currencies. A depreciated exchange rate will compensate for the higher import intensity, encouraging exports, discouraging imports, and thereby leaving the overall current account position (but not sectoral trade balances) unchanged. Estimates for the United States, the main destination for Japan’s FDI, suggest that the quantitative importance of the increased share of foreign control on the value of the dollar is small (Graham and Krugman (1991, pp. 69-70)).

Effects on Japan

The discussion in the previous subsection underscores that, in the long run, overseas investment should have little effect on Japan’s employment and current account balance: adjustments in the domestic labor market will bring aggregate employment to the “natural” level, and exchange rate changes will keep the external position, as determined by saving and investment behavior, unchanged. Much attention in Japan has, however, been paid to the influence of growing outward FDI on the trade balance in the short term and medium run (see, for example, Dai-ichi Kangyo Bank (1994) and Japan Research Institute (1990)).

A stylized (partial equilibrium) view of the impact of FDI on the trade balance can be summarized as follows. In the early stages of overseas production, the trade balance is likely to improve, owing to exports of capital goods and intermediate inputs from Japan to the newly established subsidiaries abroad. Later, the trade balance starts to decline, both because of reverse imports (exports to Japan by subsidiaries abroad) and because goods produced by overseas subsidiaries replace exports in local or third-country markets. The latter negative effect on the trade balance is in part offset by decreased imports of inputs for the relaced exports. Similar to the J-curve effect of exchange rate changes, this sequence of movements in the trade surplus is sometimes called the “overseas investment J-curve effect.”

In the long run, once (general equilibrium) adjustments in the exchange rate in response to FDI flows have taken place, the presumption is that the trade balance will be worse than in the absence of FDI by an amount equivalent to the repatriated profits of the subsidiaries. An indication of the magnitude of the likely long-run effect of FDI on Japan’s trade account is obtained by looking at recent trends in overseas direct investment income (Chart 3-7). Between 1978 and 1993, direct investment income from Japanese-owned companies abroad increased tenfold, to over $8 billion. Income from direct investment has also risen relative to the size of the economy, but still amounts to only about 0.2 percent of GDP. The return on FDI (ratio of repatriated profits to the stock of FDI) has, however, declined to about 3 percent in recent years, compared with an average of 6 percent until the mid-1980s. Assuming that this decline, which is likely to reflect the usual lags between investment and profits, is reversed and that direct investment grows in line with GDP, investment income from FDI could rise to 0.4 percent of GDP.

Chart 3-7.Direct Investment Income

Sources: Bank of Japan, Balance of Payments Monthly (Tokyo, various issues); and Nikkei Telecom.

1 Repatriated profits relative to the stock of foreign direct investment (balance of payments data).


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The measures that helped to increase long-term flows included permitting various types of Euroyen transactions, allowing resident purchases of foreign-currency-denominated certificates of deposit and commercial paper (both in 1984), and raising the ceilings on purchases of foreign securities (starting in 1986).

Life insurance companies—major institutional investors—had accumulated a large amount of unrealized capital gains (“hidden” assets) that they could not, according to regulations, distribute to policy holders. However, income gains from foreign securities (which earned higher nominal interest rates than Japanese assets) could be distributed, and capital losses owing to the depreciation of the U.S. dollar could be offset by capital gains from domestic assets—as long as the prices of domestic assets were high and rising. This explains the seemingly puzzling buoyancy of Japanese purchases of foreign securities even when the U.S. dollar was widely expected to depreciate. See Kawai (1991, p. 20) for further discussion.

Many Japanese companies chose to issue dollar-denominated warrants (often combined with currency and interest rate swaps) in the Euromarket to raise funds on favorable terms, avoiding the high cost of flotation in the more restricted Tokyo market. The bulk of these warrants were bought by Japanese institutional investors in the expectation of large capital gains in the then-bullish Tokyo stock market.

French and Poterba (1991) studied the reasons for the tendency of portfolio investors in major industrial countries to hold nearly all of their equity in domestic stocks, despite the well-known benefits of international diversification. (They estimate that Japanese investors had only 1.9 percent of their equity in foreign stocks at end-1989.) After concluding that institutional constraints do not play a major role, French and Poterba showed that current portfolio patterns are consistent with the explanation that investors in each nation expect returns in their domestic equity market to be several hundred basis points higher than returns in other markets.

Offshore intermediation of Japanese funds makes it difficult to establish the actual destination of some types of outflows.

The regional pattern of capital flows is distorted by the existence of offshore markets, especially those in London, Luxembourg, Hong Kong, and Singapore.

For surveys of alternative theories of FDI, see French and Poterba (1991), Kojima and Ozawa (1984), Jones and Neary (1986), Graham and Krugman (1991, pp. 35-38 and Appendix B), and Lizondo (1991). Empirical studies are surveyed in Mann (1993) and United Nations (1992).

This characterization of the macroeconomic view is that of Graham and Krugman (1991, p. 35). These authors also describe the micro-economic view as suggesting that when foreign rather than domestic firms make the investment it is because they expect higher returns—that is, the investment is expected to be more profitable in foreign hands.

Kogut and Chang (1991) also found Japanese FDI to the United States to increase with the intensity of research and development of the industries in the United States. The positive effect of U.S. research and development on Japanese FDI could indicate that Japanese firms come to acquire intangible assets and not just to exploit those already in their possession.

The “tariff-jumping” or “defensive” FDI hypothesis that firms invest abroad to avoid trade barriers was introduced by Mundell (1957). He used a traditional Heckscher-Ohlin trade model to show that when one country imposes a tariff on its importable (capital-intensive) good, this will generate an inflow of capital from the other country that will substitute for trade.

See Tabata (1990) for a discussion of Japanese banks’ FDI to the United States.

See Section VI of this volume for a description and analysis of the asset price bubble.

Profits after taxes, divided by sales.

Partial equilibrium arguments could also lead to the opposite conclusion: if an FDI project has been undertaken to replace exports with host-country production (perhaps to circumvent trade restrictions), the trade balance of the host country will improve.

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