White Paper on International Economy and Trade 2006 By Policy Planning and Research Division, Trade Policy Bureau, METI I. Enhancing Japan's Capacity for Sustainable Growth Index of Economic Prosperity: National Disposable Income = GNI Japan must adapt to some major structural changes: (1) globalization; (2) rising Asia; and (3) an aging society. The international economy is approaching structural change that will become a turning point - the current account imbalances of the world are a sign of the activization of international capital flows. The question for Japan is, what strategies must be taken to deal with these structural changes and ensure sustainable economic growth? When discussing economic prosperity, we need an index to measure its levels. When we compiled the White Paper on International Economy and Trade 2006, the index we used is based on national disposable income (the financial resources available to use for its citizens). These financial resources are integrally linked to Gross National Income (GNI), the amount of money earned by all citizens. To halt the downward spiral of a low birth rate and aging population, the Japanese government needs to invest in social infrastructure so that it is easier to bring up children. This objective can be achieved by increasing the national disposable income. If, on the contrary, its disposable income were to decline, our society would fall into a vicious circle: birth rates would be lower and the population would age further, resulting in even less disposable income leading to even fewer children and an even older aged population. The most common index used to measure economic prosperity is the Gross Domestic Product (GDP). The relationship between a national disposable income and the country's GDP can basically be expressed by this equation: National disposable income (linked to GNI) = GDP + income balance Therefore, expansion of GDP and the income surplus will increase the national disposable income. Growth in both macroindices will also boost Japan's capacity for sustainable growth. A Strategy for Expanding GDP As Figure 1 shows, both capital and productivity contribute considerably to Japan's GDP growth, while labor plays a comparatively small role. There is an interplay between productivity and capital: rising productivity increases the rate of return on investment. If Japan is made more attractive as a destination for investment, it will benefit from increased investment, from both at home and abroad. For this reason, increasing productivity is a very effective way to boost Japan's capacity for sustainable growth. A Strategy for Expanding the Income Surplus As Figure 2 shows, Japan's income surplus has generally traced an upward path for many years. This growth has been due to a "single-track" structure, the steady accumulation of overseas assets. What would be preferable for an aging society would be a "double-track" structure promoting the expansion of both outward and inward investment, creating a profit ratio that ensures more profitable returns. One vision of the White Paper 2006 is to lift Japan to the status of an "investment-based country." The government will therefore have to strenuously promote both inward and outward investment. Achieving this vision will help Japan effectively address two of the structural changes mentioned above, globalization and rising Asia as a major player in the world economy. II. The Global Economy: Trends and Structural Change Challenges Facing the Global Economy Global GDP growth rates have remained fairly stable since 1990, at an annual average of 3.1%. However, there have been a number of qualitative changes, especially: (1) inflation in the global economy; (2) global current account imbalances; and (3) a rise in the price of crude oil, with no significant decline in sight. Countering these three trends, however, are major structural changes, especially a decline in home bias thanks to the development of financial technologies and advances in IT, and a strong rise in international capital flows. Inflation in the Global Economy Inflationary pressures are now increasing in the global economy. Behind this trend are two factors creating a cyclical effect: (1) excess liquidity is growing on a global scale, because of loose monetary policies in major countries and an excess in savings in East Asia and oil producing countries; and (2) this excess liquidity flows into commodity and asset markets, causing a rise in asset prices. The excess liquidity travels the world searching for profits, and we can assume that this, too, is a cause of global inflation. To address these upward inflationary pressures, the United States began raising interest rates in June 2004, and this prompted developed countries to change course from loose to tighter monetary policies. Their objectives have been to put a lid on inflation and ensure a soft economic landing. Global Current Account Imbalances The United States, the world's largest economy, has posted a current account deficit year after year. Its deficit in 2005 was the largest ever. (Fig. 3) Its trade deficit with China accounts for about 25% of the total and is a cause of trade friction with China. The value of net oil imports represented 19% of the US current account deficit in 2002, and 27% in 2005; this substantial percentage jump shows how the recent climb in crude oil prices is an important factor boosting the US current account deficit. The macroeconomic definition for a current account balance is the difference between a country's savings and its investment (current account balance = savings - investment). Thus, an increase in a current account deficit indicates a growing imbalance between investments and savings (investments > savings). Often, interest rates are adjusted to bring the investments/savings imbalance back toward equilibrium. For example, if there is an excess of investments over savings, raising interest rates will place downward pressure on investments and upward pressure on savings, reducing the imbalance between investments and savings. The higher interest rates will also boost demand for that country's currency, attracting back money that had flowed out of the country as part of the process that had boosted the current account deficit in the first place. Interestingly, though, over the last few years the relationship between current account/GDP ratios and actual long-term interest rates indicates that these adjustment mechanisms are no longer functioning in the same way. On the flip side of these trends, interest rates are converging due to the decline in long-term interest rates and activization of international capital flows, which are themselves due to the above-mentioned increase in excess liquidity. As a result, it would seem, capital continues to flow steadily into the United States and its current account deficit continues to grow. Two other reasons can be given for this flow of liquid capital into the United States: (1) the United States remains an attractive destination for foreign investment; (2) although its current account deficit continues to grow, it still enjoys an income surplus. These facts seem to indicate that current account imbalances, as exemplified by the US current account deficit, actually have a positive side - they indicate the energized movement of international capital, and this presents an opportunity for Japan to establish itself as an "investment-based country." III. "Asian Dynamism" and Development of an International Business Network Rising Asia as a Major Player in the World Economy Asian countries and regions have been eager to become destinations for direct investment from Japan and other parts of the world. The investment has spurred economic growth in Asia, and it has encouraged more investments, setting in motion a virtuous circle leading to even higher economic growth. China and other parts of Asia have been expanding their share of global manufacturing production, to the point where Asia now exerts a major presence as the "world's factory." The rise in income levels in Asia has made its markets more attractive. However, income disparities are recognized by the countries themselves as a challenge that must be tackled, and if living standards are raised further, purchasing power will become even greater, making the markets even more attractive. This perspective leads to the conclusion that, with globalization, Asia's influence on the world economy will continue to grow. Development of an International Business Network to Boost Productivity We saw above how growth in capital (investment) and higher productivity are important factors in Japan's GDP growth rate. Now we will look at how the development of an international business network centered on Asia can raise productivity from multiple dimensions. The development of the international business network can raise productivity at three levels: (1) at the micro (company) level, by reducing a company's costs and leveraging its strong points; (2) at the semi-macro (industrial sector) level, by promoting competition within specific industrial sectors; and (3) at the macro level, by promoting the movement of domestic labor and capital to areas offering more opportunity for higher productivity. Micro level: One can assume that productivity at the micro level is boosted when a company expands overseas - about 80% of all companies responding to an opinion poll on their productivity levels after they expanded overseas stated that their productivity had indeed risen, or that they expected it to rise. Semi-macro level: According to statistical studies of the relationship between (a) the contribution that productivity makes in boosting the GDP growth rate (expressed as a productivity index) and (b) the overseas sales ratio (overseas sales percentage share of total sales, expressed as an overseas expansion level index), productivity is greater among industries with a higher concentration of overseas operations. Macro level: According to statistical studies, there is a positive relationship between (a) the amount of capital invested directly overseas (expressed as an overseas expansion index), and (b) the extent of economic growth achieved by redistributing industrial activities. In other words, foreign direct investments to redistribute industrial activities can raise productivity. From the above, we can conclude that an international business network will create opportunities for higher productivity at every level. Since higher productivity will become increasingly important as a lever to boost economic growth, promoting the development of an international business network that raises productivity will boost Japan's economic capacity and counter the effects of its low birth rate and aging population. China and ASEAN: The Most Promising Locations for Japan's International Business Network The most promising places for Japan to develop an international business network are China and ASEAN, where the Asian high economic growth phenomenon is pronounced. An analysis of current business conditions there is a necessary step in the development of such a network. A comparison of business costs in China and ASEAN shows that China, however attractive its workforce may have been, is slowly losing its predominance as a low-wage country, while some ASEAN countries have gained over it. (Fig. 4) China used to offer some of the best business profit ratios but as Figure 5 indicates, ASEAN is gaining on China. This is probably due to the above-mentioned higher business costs in China, and the fact that Japanese companies now face greater competition there from other Japanese corporations, from European and US ventures operating in China, and from local enterprises. IV. Increasing Capacity for Sustainable Growth Business Environment Improvements for International Business Network Development of an international business network requires liberalization, harmonization and stabilization. Liberalization: Liberalization requires lower tariffs and relaxed investment rules among other countries. Liberalization would spark two of the advantages of globalization - increased trade and investment - thereby improving the economic welfare of the countries concerned. Every effort should be made to promote trade and investment liberalization through the World Trade Organization (WTO) and Economic Partnership Agreements (EPAs). Also essential are trade facilitation measures such as: (1) improvement of port infrastructure; (2) customs transparency; and (3) simplification and acceleration of customs procedures. Harmonization: Areas requiring harmonization include: (1) competition policies; (2) intellectual property systems; and (3) company-related systems. Of special concern are intellectual property systems - when operating within an international business network, companies have to make patent applications in multiple countries and regions, but current patent systems pose problems: (1) patent application procedures differ by country and region, creating complications for the applicant; and (2) an application fee must be paid in each of many countries and regions, adding to business costs. To help companies avoid such problems in the future, steps should be taken over the mid- to long-term to harmonize patent systems in Asia, following the example of steps in the EU to develop an EU patent system. Stabilization: Foreign exchange and financial systems need to be stabilized. The development of an international business network will lead to more international transactions, so foreign exchange rate fluctuations will impact even more on the profitability of exporting companies. Greater fluctuations would increase the uncertainty of corporate activities and have a negative impact on exports. Measures being considered as ways to manage foreign exchange risk in East Asia include: (1) adoption of a single common currency; and (2) an exchange rate mechanism (ERM) providing for a common basket peg. There are a number of forums promoting regional cooperation, particularly the ASEAN+3 and the Asia-Pacific Economic Cooperation (APEC), and these should be used to resolve the above-mentioned problems and improve the international business environment, especially in Asia. Expanding Inward Direct Investment in Japan At the beginning of this article we developed the concept that Japan should become an investment-based country and that it can do this by expanding its income balance through a double-track structure. To move from a single to a double-track structure, we need to increase outward investment while at the same time boosting inward investment through greater productivity. These goals can be achieved with mechanisms that (1) introduce technology, know-how and new business models from abroad in order to boost productivity; and (2) stimulate competition within specific industrial sectors in order to increase the weight of highly productive companies and encourage unproductive companies to withdraw from the market. As Figure 6 shows, over the last few years Japan's ratio of inward direct-investment to outward direct investment has been moving toward the levels seen in other developed countries, although inward direct investment is still low. One effective way to expand the flow of direct investment into Japan would be to encourage investments targeting mergers and acquisitions to use the managerial resources of companies of the recipient country, Japan. The Japan Investment Council, a governmental organization, decided at a March 2006 meeting to promote the doubling of overseas capital invested in Japan by 2010, to about 5% of GDP (it was 2.1% of GDP in 2004). In order to achieve this goal, Japan's business environment needs to be more attractive and familiar to foreign investors. This will require eliminating barriers to market entry, and ensuring Japan's status as a preeminent venture location. Enhancing and Better Utilization of Human Capital Earlier in this article, we saw how labor contributes far less to Japanese GDP than capital or productivity. The decline in Japan's working population must be offset by raising the quality of its labor force, thereby maintaining a high level of human capital overall. To improve labor quality, the first step is to rationalize the university curriculum. One problem is the mismatch between the focus of computer courses and the skills required by the IT industry. The IT sector is constantly making technological progress, and worker skill requirements change just as quickly. Universities must adapt to meet at least some of the demands of this rapidly changing work environment. As a start, they should create and seize opportunities to share information with industry. In April 2003, a new specialized graduate school system was launched in Japan to bridge the gap between theory and practice, and new types of graduate schools offering masters' degrees in law, business administration and other disciplines have been established. These institutions have not yet received much international recognition. Their faculties and programs must be enhanced and expanded to further improve the quality of human resources. Japan's labor pool could suffer in the future because today many people have only part-time jobs or are not in employment, education or training (NEET). In addition to tackling these issues, other steps are needed to enhance the country's human capital by, for example, drawing on the potential of latent talent of unemployed women and elderly people, and accepting more human resources from abroad. In addition, the question is, how can Japan's human capital be distributed more efficiently? One advantage of an international business network is that it promotes the redistribution of the tools and resources needed for production. Human capital is one such resource, and a system promoting more flexibility in the workforce would make it easier to distribute workers more effectively. Moving from a Single- to a Double-Track Structure: Making Japan into an Investment- Based Country Until now, this article has explored ways to improve GDP growth. In these last three sections, we will discuss the need to boost Japan's income surplus, which is one factor determining the Japanese disposable income. In the earlier section, we saw that Japan's income surplus has risen sharply, while the trade surplus has remained more or less constant. In 2005, Japan's income surplus exceeded its trade surplus for the first time (income surplus: \11.4 trillion; trade surplus: \10.4 trillion). To deal with the challenges posed by Japan's falling birth rate and aging population, this trend should be promoted further by: (1) moving from the current "single-track" structure (whereby a current account surplus leads to more net external assets, which in turn lead to a higher income surplus), to a "double-track" structure (whereby inward and outward investments are both expanded, leading to an increase in external asset / internal liability profit ratios); and (2) developing a strong, "double-track" income surplus structure characterized by the higher rate of return on external assets that support this "double-track" structure. Leveraging Energized International Capital Flows to Boost Japan's Income Surplus In Chapter II we saw that the macroeconomic definition for a current account balance is the difference between a country's savings and its investment (current account balance = savings - investment). According to this formula, if the current account balance remains constant, the amount of investment is determined by the amount of savings. Investment can be categorized as inward and outward investment, but since total investment is determined by savings, both inward and outward investment remain in an analogous relationship, so an increase in outward investment would mean a decrease in inward investment, which in turn would mean the risk of a "hollowing out" of domestic industry. However, as we also saw in Chapter II, the recent decline in home bias has energized international capital flows, so if Japan becomes a more attractive destination for investment it will receive more inward investment and the overall investment "pie" will grow. In this way, it is possible to expand both inward and outward investment. A Strategy for Expanding Japan's Rate of Return on Foreign Investment Japan's external asset profit ratio is low, compared with the ratios for the United States and the United Kingdom. (Fig. 7) The main reasons for this low ratio are inefficiencies in: (1) portfolio diversification by asset type; (2) asset portfolio diversification by region; and (3) direct investment profit ratios. These problems can be resolved and the income surplus can be raised by expanding direct investment in Asia, where profit ratios are high. (Fig. 8) This strategy is part and parcel of the above-mentioned goal of establishing an international business network for Japanese companies in Asia, and will boost productivity for Japan as a whole. This is how Japan can achieve its aim of becoming an investment-based country. These objectives can be achieved by promoting systemic improvements that lead to: (1) expansion of inward investment (by raising Japan's profile as a promising destination for investment, by making the country an international financial center); (2) expansion of outward investment (through EPAs, by improving the international business environment): and (3) an increase in external asset profit ratios (through an Asian bond market). In addition, the business environment should be improved to permit the unhampered return to Japan of the fruits of this higher income surplus (through improvements in the international tax system).