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Analysis of the Flying Geese Model for Japan

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The last 15 years we have observed an enormous growth of activity by multinational corporations, as measured by inflows and outflows of foreign direct investment (FDI). On the other hand of world-wide growth, Japan is in the 18th year of stagnation with a prolonged financial malaise. Almost two decades ago, Japan's phenomenal growth was admired and even feared as unstoppable in the world. It is almost shrinking economy. However FDI has grown much faster. The worldwide nominal GDP increased at 7.2 percent per year. Also the worldwide imports grew at 9.2 percent and worldwide nominal inflows of FDI increased at 17.6 percent between 1985 and 1997. In the 80s to late 80s, we have observed Japanese financial bubble which was based on industrial advance after the Second World War. These figures mentioned above prove the new financial investments while Japanese economy was growing rapidly, retained earnings of affiliates, and cross border mergers and acquisitions during grew within 70s to 90s.

In this paper, the "flying-geese" model is useful in capturing the essence of Japan's successful industrial upgrading and Asia's trade-led growth against world economies but fails to explain why such success would ever lead to the present economic predicament and still happening especially in China even the world economic crisis. This is because it ignores the institutional, especially financial, underpinning of Japan's catch-up strategy.

Japanese academic scholars and policymakers came to often described Japan's industrial advance in terms of the catching-up growth with a model so-called "flying-geese" model. This model was well-used among media also. What were the key enabling institutional features of Japan's once effective Flying Geese catch-up strategy? How did they function? Why did they come to cause the 1987 - 1990 bubble and the current financial imbroglio? How did Japan increase Outward FDI? How will Japan be "reformed"?

Also by using "Flying Geese model" argues that the conventional Flying Geese model of catch-up strategy, though instrumental in depicting the essence of latecomers' (notably Japan's) industrial upgrading and Asia's trade-led growth, has so far neglected the institutional (especially financial) dimension of such a catch-up, that Japan's present financial imbroglio is paradoxically the very outcome of its successful Flying Geese strategy that was once pursued under a special set of institutional arrangements after the Second World War - that is, the Flying Geese catch-up regime became soon obsolete and even rigidified over years, trapping Japan in the present financial quagmire, and so far, the reform is, strangely enough, "market driven" in the sense that two key market imperatives --- inward mergers and acquisitions (M&As) by foreign investors and the mandate of the Net-Driven New Economy-have begun to compel Japan to remold itself more compatible with the norms of global capitalism.

Mergers and acquisitions (M&A) are a large proportion of the whole especially, among the developed countries with their value constituting 49 percent of total FDI flows in 1996 and 58 percent in 1997 (UNCTAD, 1998). Between 1983 and 1995, foreign affiliates of all nationalities accounted for between one-quarter and one-third of worldwide exports, according to figures from UNCTAD (1998). It is noteworthy that Japan once did play the role of Asia's leading target of FDI Inflow before the burst of the 1987- 1990 asset bubble.

Some commentators have estimated that multinationals are responsible for 75 percent of the world's commodity trade (Dunning, 1993). Firms that invest often have some type of intangible asset they want to keep within the firm, rather than exploit through licensing. Furthermore, investing firms are often the larger firms in their industries. All these developments and issues need to be examined as path-dependent evolutionary events within a reformulated the "flying-geese" model, an "institutional" model of Flying Geese catch-up.

In microeconomic aspect, this paper emphasizes those causes of Japan's current predicaments that are not adequately examined. Japan is not in a real-sector crisis; its fundamentals (technological and productive capabilities and wealth accumulation, through there is definitely a hangover of excess capacity) are as strong as ever. It is in an institutional crisis. There are good reasons why reforms are so hesitantly implemented - that is, not so swiftly and son decisively as outside pundits think Japan should do, particularly when they apply the logic of Anglo-American market-based tenets.

In the contrast of world macro point of view in the model, also focusing into micro aspect, After-all explaining how Japanese economy grew rapidly to catch-up western economies, this paper would like to introduce micro aspects of the world entities by using two distinct types of theoretical models describe the two distinct forms of multinational activity. In models of horizontal activity, mainly focus a trade-off between the fixed costs involved when a company setting up a new plant and the saving transport and tariffs in variable costs on exports. These factors are the key concerns to make the decision for any entities to go multinational. In models of vertical activity, since there is a cost difference in the world for example labour cost, low material cost, and so on. This kind of cost difference is a factor to attract many entities to invest Foreign Direct Investment. Tariffs and transport costs both encourage vertical multinational activity, by expanding price differences. There are disadvantage if headquarters and the affiliates pay more expensive cost. Those two types of models are used to observe latest multinational activity

My second objectives in this paper are to discover main facts and tendencies about the multinational activities by different geographical regions to explain these facts by using the "horizontal" and "vertical" comparison as well as "flying-geese model". My focus from regions, country down to Japan on the location of FDI means that this is not a comprehensive survey of all issues raised by FDI. With overview of theory, I also introduce an overview of the facts about the location of multinationals. Empirical studies explain the pattern of regional location especially Japan.

1. INTRODUCTION

I.I. The top largest amount of foreign direct investment (FDI) is between high income developed countries, U.S. (US$2,093Bil.), U.K. (US$1,348Bil.), France (US$1,026Bil.), Germany (US$630Bil.), Canada (US$521Bil.), Italy (US$364Bil.), Russia (US$324Bil.), Japan (US$133Bil.), and noticeably Belgium (US$748Bi1.), Netherland (US$673Bil.), Spain (US$537Bil.), which are also received high amount of FDI. Among BRICS, we must note that China (US$1,511Bil.), Brazil (US$328Bil.), and India (US$76Bil.), which are increasing. The rest in 2007 figure of GDP but there has been rapid growth of investment in some developing and transition regions during the 1990s. Thus, the ratio of FDI inflows to GDP has remained fairly stable for developed countries, at around 0.9% of GDP. But for developing and transition countries, this ratio has increased from 0.8% in the late 1980s to 1.9% in the mid-1990s. Outward investment from developing countries has also risen recently, but remains modest compared to both developing country GDP and total world outward investment. 1.2 In the mid-1990s, multinational firms undertook total 66% of US exports. Also 45% of these exports went directly to affiliate companies. The one of the biggest economy in the world is U.S. for over four decades. Take a look of US affiliates in this case as an example. The US affiliates which produces their service and products in overseas is three times larger than US exports. It is important for the multinationals in the world economy has steadily increased in micro aspect which is not happening right now controversially.

Multinational activity in high income countries where as developed countries are overwhelmingly remaining the equal level as previous years as "horizontal". This type of economy involves in production in overseas then import to the host country market. There is a higher proportion of activity in developing countries as `vertical' which involves that manufacture of intermediate stages of the production process then ship to home country to assemble to the final products. Thus, less than 10% of Japanese affiliate production in the EU is sold back to Japan, compared to the numerous affiliates who brings goods back from developing countries 20% or more. There is similar case as Japan to US affiliates also. Only 4% of US affiliate production in the EU is sold back to the US, whereas for developing countries the figure goes up to 18%. Surprisingly, from Mexico more than 40% goods are brought back to US market. This trend tends to be all over the world where they produce service or products in the local market and generate the turn-over within the same strategic region.

1.4 A large share of investment stays close to home-country or neighbouring countries. For example, US investments tends to be heading towards EU countries to adjust for distance with the largest markets which the home countries are culturally-familiar. FDI is a good deal more geographically concentrated than either exports or production as a whole. Thus, while US affiliate production in Europe is as about 7 times larger than US exports to Europe, this ratio goes down to about 4 times for the rest of developed countries and to almost 1.6 for developing countries.

1.5 There are more horizontal investments by the major outward investors in large markets. For the US invests more towards Europe, and especially the UK. Because of there are no barrio in language, which may help. For Japan and Europe directs their investments towards the US but the majority of investment from EU stays within the EU region also. There are certain tendencies we can observe that the major outward investments direct close to their neighbouring countries for example from the US to Mexico, the EU towards Central and Eastern Europe, and Japan to Asia.

1.6 The scale of multinational activity is probably better measured by looking FDI flows and together with sales of multinational firms. We can observe more FDI supply within developed countries predominantly. The most of developed countries controlled 89.8 percent of worldwide FDI stock in1997, compared to 10.2 percent for the developing and transition countries. In 1996, there was $612.0 billion worth of goods exported but about 66 percent of the goods were exported by US multinational parent companies. The most of US multinational parental companies were sold to exporters' own foreign affiliates or related companies. Recent FDI flows show some decline in the dominance by the developed countries; whereas during the period 1988-92 they accounted for 92.5 percent of total FDI outflows, but due to Japanese bubble burst and Asian Currency crisis during the five years from 1993 to 1997. The share fell down to 85.3 percent.

From 1988 to 1992, developed countries received FDI inflows at an average annual rate of 0.90 percent of their GDP. On the same period, developing and transition countries received FDI at an average annual rate of 0.78 percent of their GDP. The inflow rate of developing and transition countries doubled to almost 1.91 percent of their GDP from 1993 to 1997. There was decrease among developed countries slightly down to 0.87 percent. The share of worldwide FDI inflow increased from 21.8 during 1988 to 1992 to 39.8 percent in the 1993 to 1997 period at the developing and transition economies period. As we can observe in the figure 1, there was dramatically increased.

The vivid difference between developing countries and transition countries to developed countries is measured by sheer economic size, and the difference in outflows relative to GDP is perhaps less than might be expected. The distribution of FDI is quite uneven among developing countries. From the 1993 to 1997, only 10 countries as Singapore, Malaysia, China, Indonesia, Mexico, Chile, Brazil, Argentina, Hungary, and Poland accounted for two-thirds of all inward flows. China alone received an annual average of 30.6 percent. Indeed, China has the biggest increase in flows among developing countries. Total world FDI flow rose from $3.2 billion (2.9 percent) during 1988 to 1992, to $45.3 billion (12.2 percent) for 1993 to 1997. This means it increased 14.2 times bigger in amount which counts about five percent of China's GDP in 1997, remains strong still. The main sources are Considered to be Chinese business groups resident in Asia, Chinese businesses resident in China. In contrast, there is part of this world where it has decreased FDI in time to time. All of sub-Saharan Africa including South Africa received an annual average of 3.2 percent during 1993 and 1997, a decrease of almost 2.1 percentage points from the annual average of 5.3 percent during the 1988 to 1992 period. There is slight increase sub-Saharan Africa's share, during 1988 and 1992 from around 1.0 percent, to around 1.3 percent between 1993 and 1997. This helped in its inflows of FDI relative to host country income, as in figure 1, where I see some increase in FDI to Africa, but at levels downsized by more inflows to East Asia and Latin America.

Within developed countries, the share of the world's FDI stock was as follows; the US who controlled 25.6 percent, compared to 45.1 percent for the European Union 15, and 8.0 percent for Japan in 1997. So the biggest single country investor was the US then to Japan in percentage-wise. Japan is in the economic doldrums and even in a potentially imploding financial crisis at that time. It struggles to rebound from a decade of stagnation. However, Japan still invested towards the world FDI investment as 8 percent of share. Before the bubble burst in 1991, Japan's phenomenal growth was once admired and even feared as a juggernaut. Japan and the rest of Asia grew in tandem and basked in clustered regional prosperity, which the World Bank (1993) called the "East Asian miracle." During 1985 to 1997 the developed countries received fully 71.5 percent of FDI flows. Of the G-7 countries, France, Germany, Italy and the UK sent more than three-quarters of their 1997 FDI flows to the rest of the OECD; Canada, Japan, and the US sent more than 60 percent most recently. The common pattern was appearing as intra-industry FDI investment which was almost one-quarter and one-third of worldwide exports, according to figures from UNCTAD (1998). The most shares were accounted by foreign affiliates of all nationalities. Most of FDI investments went to advanced industrial countries. One popular way of describing such a regionally agglomerated growth with its FDI was the model of so-called "flying-Geese" formation. In this depiction, Japan served as Asia's lead FDI investment target, the NIEs as the second-ranking and the ASEAN-4 as the third ranking geese, and China as a new latecomer. Characteristically, most FDI investments is concentrated heavily in industries characterized by high levels of research and development, a large share of professional and technical workers, and production of technically complex or differentiated goods.

However Asia's financial crisis seemingly disarrayed FDI investment during 1997-98. By looking at Japanese economy with the enormous FDI effect ever since the start of the 1990s Japan, a supposedly Asia's lead FDI target, has been mired in a self-inflicted financial crisis ever since the bubble of 1987-1990, as well as Europe, Japanese flows boomed during the late 1980s, although have now fallen back to a position broadly in line with existing stocks which is now made all the more dangerous with a "triple deflation"---simultaneous declines in the prices of goods, real estate, and equity shares. The Japanese economy is in a vicious circle of a "drop in share prices ?a decline in bank's asset value and land prices as collateral? a credit crunch ? more business failures ? a rise in bad loans ? a further drop in share prices." Very recently (March 2001), the Bank of Japan adopted a drastic monetary policy to flood the second economy with liquidity. This policy is called "iyoteki kanwa (quantitative easing)," and unprecedented (some called "twilight-zone") monetary policy designed to prevent "price destruction" in hopes of stimulating demand.

Please refer the Figure 2 which shows the time series of FDI outflows relative to source country GDP. Outward flows from the developed countries in average about 1.3 percent of their GDP each year from 1993 to 1997. Noteworthy, the EU had much higher rate than rest of the world which was almost 2 percent of GDP if I calculate together among 19 countries of first EU. Ignoring the fact of intra-EU investments was more common. There was increase of outward FDI flows of their GDP from developing countries during 1988 to 1997 as average 0.3 percent to 0.8 percent during 1993 to 1997. While intra-OECD investment and intra-industry investment within the OECD have been long established facts, an emerging trend is the rise of FDI to developing countries.

Before introducing through the "flying-geese" model, would like to go through the Outward FDI of Japan, the United States and Europe to give good insight of economic development and how the outward FDI increased as the economies grew world-wide. Multi-nationals are spread all around the world to exploit their chance of conservatives may describe as "kokunai sangyou kuudouka" in Japanese means, "emptying national industries". Next chapter will introduce country or region-wise of development of Outward FDI. We would see how it happened on the time line of growth, and why it was necessary to activate as whole in the world by introducing the Outward FDI of Japan, the United States and Europe.

2. Location of multinationals: THEORY

There are two main reasons why a firm should go multinational.

  1. To better serve a local market
  2. To benefit inputting from low cost

FDI in search of low-cost inputs is often called `vertical' FDI. Vertical FDI has its character of slicing the production cost to relocating part of this chain in a low-cost location or country vertically. For example, when a Japanese electronic manufacturing even though component manufacture companies which assemble electronic goods in Asia as Indonesia, Malaysia or Thailand, and final sales might take place in the US or third countries. The biggest merit is cheap inputs of labour in different skill levels starting from primary commodities, intermediate parts, or even externals, such as knowledge spill over. Vertical FDI usually create trade because products are shipped in different location when they find cheaper labour cost of assembling points away from the location where they produce small components and/or intermediate goods before assembly. The distinction between vertical and horizontal FDI can sometimes become blurred because one plant may serve both functions, others may not. It is totally depended on local cost to open a plant to serve a market.

In contrast, FDI designed to serve local markets is often called `horizontal' FDI. It has its character of involving duplicating parts of the production process as additional plants are established to supply different locations. This vertical FDI usually substitutes for trade, since parent firms replace exports with local production. The motive is to reduce the costs involved in supplying the market such as tariffs or transport costs or in some other way to improve the firm's competitive position in the market.

2.1 Vertical FDI and factor endowments:

This vertical FDI was introduced by Helpman (1984, 1985) and Helpman and Krugman (1985). Later on, Heckscher-Ohlin extended trade model with two factors of production and two sectors, one perfectly competitive, producing a homogeneous good under constant returns to scale, and the other producing differentiated products under increasing returns to scale. Firms in the increasing returns significant part of multinational activity takes the form of firms shifting a stage of their production process to low-cost locations in recent years. The idea of this recent vertical FDI trend is due to different parts of the production process have different input requirements. Since input prices vary across countries as Japan is high labour cost as many developed countries compare to the developing, it may be profitable to divide production, undertaking unskilled labour intensive activities in the country where they have sufficient output of labour.

Many sectors have distinct headquarters and production activities in different countries and locations.

When the firm could not find any incentive separating headquarters and production, firm may not activate multinational activity for example, in this vertical FDI model will create similarity of free trade in goods because the international equalisation of factor prices are almost equal to the contribution.

However trade does not equalise factor prices if the relative endowments are sufficiently different. When one economy has a much higher endowment of labour relative to capital than the others, then there is a merit to go multinational and also profitable for firms to divide activities, putting the more capital-intensive part as headquarter of the firm in the country where there is enough capital. The capital-abundant economy evolves an exporter of functional headquarter to its production operations located in another economy.

If the transport costs on trade in final goods are higher than factor price, then it may imbalance the equalisation the consequent international differences in factor prices. The consequent international differences in factor prices increase, then many firms may profit the incentives to divide production unless relative endowments are identical. Also in this analysis, there is regarding to the costs of dividing production. Firms may have to pay additional costs when they have their offices, headquarters and productions in the different countries which make multinational production less attractive. It depends on the interaction between these forces when comes to the decision whether firms go multinational, and where they locate different activities in the different countries.

To analyse whether firms to go multinational or not, may very depends on the cost of transportation in distances from an economy where the firm located to the location where they import goods and/or components which they export at least some of their final output. Transport costs both on imports of intermediate goods and final products and on export sales are higher when firms are located far away from its origin. Since many firms need to face heavy transport to the locations further away from the origin, it is not attractive.

In particular, the price of factors used intensively in the location's export activity will be low, so investment projects that are intensive users of these factors may be attracted to remote locations. The cost matter has always been discussed. It can be a big penalty for firms. It was introduced by Radelet and Sachs (1998). It is nearly impossible to escape from the cost but since these locations also face transport costs on their other trade-able activities, their factor prices will be lower. In general, when firms choose to locate in a particular country, it depends on the factor intensity of the project, relative to the factor intensity of other exports from the country, together with the intensity of project, relative to the transport intensity of other goods traded by the country. This shows some patters of the projects which they locate close to established manufacturing regions, and which will go to the countries far away.5

2.2 Horizontal FDI and market access:

Many firms can choose if they want to supply by exporting or by producing locally in the different countries. This way is already being multinational. Under what circumstances will it choose to become multinational? Firms are required to pay additional cost when they want to establish local production factory. Some are production costs, both variable and fixed, their size depending on factor prices and technology. Also on top of establishment cost, some may have to pay more additional costs for dealing with foreign administrations, regulations, and tax systems. To cut down their additional cost, firms may create joint venture with local firms, give licensing arrangements, or sub-contract. The presence of plant level economies of scale will raise the cost of establishing foreign plants. As long as they can gain merit if they compare the cost production at home to the foreign factory.

On the other side of effect, switching from exporting to local production will bring cost savings, the most obvious of which are savings in transport costs or tariffs. If the factory is close the market, they gain more advantage in shorter delivery times and ability to respond to local situations and preferences. Even when some accident or damage occurred to the operation of delivery from the factory to market, they can sort instead of sending labour from headquarters.

Theoretical modelling of this sort of FDI has typically posed the issue as one of a trade-off between the additional fixed costs involved in setting up a new plant, and the saving in variable costs transport costs and tariffs on exports. Analysis is usually based on a `new trade theory' model, in which there are distinct firms, and the issues of increasing returns and market structure are addressed explicitly (Smith, 1987, Horstmann and Markusen, 1987, and Markusen and Venables, 1998).

The first point is that the value of FDI to the firm may realize net costs exceed in its budget, even a firm gain strategic value by establishing local production. In an monopolized environment each firms' sales depend on the marginal costs of all other firms. If one firm reduces its marginal costs then it may stimulate rival firms to reduce their sales, and this will be of value. Essentially, firm who invested FDI may pay a commitment to supply the local market since they control the market. This commitment may change the behaviour of competitors. Turning to the location of FDI, the theory predicts that FDI will replace exports in markets where the costs of market access through exports especially in the countries where tariffs and transport costs are high, or where the costs of setting up a local plant are low. These predictions seem to be at odds with the facts of high (and rising) FDI between economies with low (and falling) trade barriers for example, within the EU and between North America and Europe, although the apparent contradiction might be resolved by the simple fact that countries with low trade barriers also tend to have low barriers to FDI.

The theory also predicts that FDI is more likely to replace exports the larger is the market. There are two reasons. The first reason is that the fixed cost each plant by plant may differ. If the market is bigger, then the output of production has to be the larger. The second is that larger markets will tend to have more local firms. This means more competition in the big market than smaller markets. This competition in the big market will lead to a lower price. If the marginal cost of supply through exports is relatively high, be particularly damaging to the profitability of exporting, tipping the firm's decision in favour of local production. Markusen and Venables (1998), they extend these models to a full multi-country framework, analyse the mix of multinational and national firms operating in each country. They sorted the multinational firms in the each country in size, and also in other economic dimensions, such as technology and factor endowments. Thus, as Europe has become integrated as EU where is expanding the economic integration. Since EU creates common registration and trade barrier to the foreign investments for their economic protection on the other hand costs of supplying have been declining. So it has become more worthwhile for US and Japanese FDI to enter European market.

The market size and factor endowment models suggest that all locations have some production, but only some locations will have FDI, meaning that FDI will appear to be clustered. Therefore there is some evidence that FDI is spatially more clustered than other forms of production. This could appear in the data for reasons we have already seen. Since foreign investors are able to access to invest to privatization programs easier than since cross-country variations in legal framework barrio has been lowered, particularly in transition economies where are growing, where Alternatively, clustering of FDI may be due to positive linkages between projects, creating incentives to locate close to other firms. There are several important mechanisms. One is the spill-over created by research and development. Another is gaining confidence and experience, and the possibility that firms come together; firms are not always sure whether FDI to a particular country is a good idea until they get results or advice from other firms. So they rely on the successful advice of forefront firms which have been invested FDI as a signal of underlying national characteristics. Arising supply and demand for intermediate goods have been extensively analysed, but not particularly from the perspective of FDI.

3. Japanese Outward FDI:

I now review the empirical studies on the determinants of the location of FDI. I therefore organize the material of Japan. Japan is one of the heavily researched country who seems to be benefiting from FDI.

First, the more than half of investment to developed countries were shared countries as Japan, the US, and EU. However the US was the dominant host. The feature of Japanese multinationals has a distinctive character which is the way export strategy has effective together with investment strategy. The heaviest Japanese investments were occurred in the US in the 1970s. During 1970s was in distribution boom rather than production. Japanese companies could market their durable-goods exports, such as automobiles. There were subsequent investments on automobile industries for their productive facilities to spread distribution networks within the world market especially in the US. Another result of this export success was that the threat of quantitative restrictions on exports, starting in the late 1970s, turned into a significant motivator for Japanese FDI in the US and Europe (Gittelman and Dunning 1992). They described that Japanese investment in both the US and Europe responded to such threats in trade balance, though investment activity in the US seemed to lead investment activity in Europe. It continued until several years during the 1980s. Japanese were expanding their distribution network in Europe while the Japanese were putting most of their efforts into productive facilities in the US in the early 1980s. After 1980s, there was trade off balance issue occurred in the US and Europe, so after investment in productive facilities, follow-on investment arrived to establish local production of inputs. A second characteristic of Japanese FDI is the significant amount of resource-based FDI, since Japan has no resource within their country. Particularly heavy investment was invested in Latin America and Australia (Caves, 1993, and Drake and Caves, 1992). As we see from table 2 that around one third of output from Japanese FDI in these regions is exported back to Japan. The third characteristic of Japanese FDI is its role in the development of the wider East Asian economy. It certainly attracted Japanese investments because lower wage economies as a base from which to supply the Japanese market in short delivery distance and export to third markets which it has involved relocation of Japanese production. While FDI played only an important role after-war reconstruction purpose in the development of some of the first wave of Asian newly industrialised countries as Taiwan and Korea. The second wave was also important, with the share of foreign affiliates in manufacturing sales exceeding 40 percent in total in Thailand, Philippines, Malaysia, Indonesia, and Singapore. In fact, while Japanese manufacturing FDI to developing countries as a group stagnated from the mid-1970s to at least the late 1980s, FDI to Asia increased steadily (Takeuchi, 1991). Japanese investments are shown on the table 2 into several countries in Asia.

In the table 2 of column 5 indicates the relatively high levels of sales by these affiliates back to the Japanese market. Less than half the output is sold in the host country, and much goes to other affiliates in the region. Exports to Japan have been particularly important in general machinery, precision machines, and equipment, transport equipment, and electrical and electronic machinery and most sales pooled back to Japan are to the parent company. The activities of majority-owned Japanese affiliates in East Asia specifically, Korea, Taiwan, Hong Kong, Singapore, Malaysia, Thailand, Philippines, Indonesia, and China compared to the rest of the world (Kimura 1998). Not only do the Asian affiliates sell more back to Japan, they also sell a much higher share of their production to Japanese affiliates. Japanese Asian affiliates are part of vertically integrated production networks, while the non-Asian affiliates are more likely to serve foreign markets. Reviewing changes in the pattern of Japanese FDI since 1972, shows both a changing composition of investments, and a geographical broadening of those investments throughout Asia (Kojima 1995). Broadening also took place significantly, with investment spreading in waves from early host countries to neighbours. For example, in 1972, the top three Asian locations for machinery manufacturing (Singapore, Taiwan, and Korea) held 81.5 percent of total Japanese investment stock in machinery manufacturing in Asia. By 1989, the top three (Thailand, Singapore, and Taiwan) held only 51.3 percent of the total. And Thailand, which held 5.1 percent of the total in 1972, moved up to first place by 1989, with 18.6 percent. Labour costs throughout Asia are lower than in Japan. The concentration in manufacturing has declined, with a rapid increase in service investment; the average labour skill requirements have increased correspondingly. Not only low labour costs was the real attractor for the Japanese to go multinational but together with labour quality did, suggesting that unit labour costs rather than low labour costs mattered see Table 2. Japanese firms investing in Asia were motivated partly by high Japanese capital costs.

The importance of production costs in choice of locations was confirmed by a firm level survey. Finally, a firm's export character from Japan was negatively correlated with the firm's share of investment in Asia. Japanese firms have not invested in Asia under threat of trade barriers. Rather, they have gone in search of efficient production and low-cost inputs (Mody, Dasgupta, and Sinha 1998). After 70s, Japanese were lead into the forming of bubble to burst of its bubble. It is noteworthy that Japan once did play the role of Asia's leading FDI investment target before the burst of the 1987-1990 asset bubble. Some commentators have estimated that Japanese multinationals are responsible for 75 percent of the world's commodity trade (Dunning, 1993). The "flying-geese" model is useful in capturing the essence of Japan's successful industrial upgrading character and Asia's trade-led growth against world economies but fails to explain why such success would ever lead to the present economic predicament and still happening especially in China even the world economic crisis. This is because it ignores the institutional, especially financial, underpinning of Japan's catch-up strategy. Japan's embarkation upon the process of modernization in the Meiji era (1868 ,., 1912) brought with it the national goals of catching up with the West in the military and economic dimensions of power - as embodies in the slogan of the time, firkokur kyohei ('rich country, strong army'). Before the Pacific Second World War (1941 - 1945), Japan had made great strides towards the achievement of these twin military and economic objectives. After the surrender and defeat of 15th Aug in 1945, it effectively eliminated any post-war ambition to match the other major industrialized powers military. Nevertheless, the economic catch-up and overtaking of the West have remained key national goals in the post-war era. In this situation, the Japanese state, its `hollowing out' of Japanese industry at home as Japan's giant electronics manufacturers shift to China in the early twenty-first century, the most familiar and evocative images remain overwhelmingly economic.

Indeed, Japan instantly conjures up statistics of economic prowess and sheer size. After the US, it possesses the second largest national economy in the world. With a GDP of US$ 4.3 Trillion in 2003, accounting for 12% of the world's total, Japan is clearly an economic giant. Other statistics paint a similar thing as; Japan's exports and imports in 2002 amounted to US$ 416 billion and US$ 337bllion respectively, occupying 6.5% and 5.1 % of the world's totals, and ranking it as the third largest individual national trader in the world after China and US (JETRO 2003). In the realm of finance, Japan's external assets in 2003 stood at 172.8 trillion Yen and it has been the largest creditor since 1985 (with the sole exception of 1990 when it was overtaken by Germany). Japan's foreign exchange reserves at US$652.8 billion in 2003 are the world's largest (Economic Intelligence Unit 2004). Japan in 2003 was the source of US$55 billion in FDI and has been the world's number-one investor in 1990 (US$51 billion). In 2003 Japan disbursed a total of US$8.8 billion in Official Development Assistance (ODA), having been the large single donor of ODA from 1991 to 2000.

In contrast, the size of Japan's national debt has been growing in the wake of the bursting of the `bubble economy'. The government's general deficit widened to more than 8% of GDP in 2003. Japan's gross public debt amounted to 157% of GDP at the end of 2003, enormous 159% increases compared to the 1990 figure. This now makes the Japanese government the biggest borrower among the major industrialized powers, although most of this is borrowing from domestic sources. The IMF forecasted that in this year 2008, government debt will have risen to as high as 205% of GDP.

Beyond those statistics, Japan's economic presence is felt materially also though the products and activities of its TNCs and other business enterprises. Since Japan's economic renaissance in the early 1960's, its products have come to dominate rapidly and successively markets in the ship-building, steel, chemicals, consumer electronics and automobiles. The words `Made in Japan', stamped on Honda Accord, the Toyota Lexus, and the Sony Walkman, the Canon IXUS, as well as the Sharp LCD television, are now consumer bywords for quality and innovation. In contrast, an earlier post-war generation viewed the label as synonymous with shoddy, cheap toys and trinkets. Now, Japanese companies such as Honda, Toyota, Sony, Canon, and Nissan (although the latter has been part foreign-owned by Renault since 1999.), have become household names and stand at the forefront of global business. They are in many cases the `face' of Japan's overseas economic activities and the physical manifestation of its global power and reach (Emmott 1991).

Japan's rise to economic superpower status has been given substance through its gradual enhanced-presence in global economic situations. Its rehabilitation started with the US's sponsorship of its entry into the three pillars of the Cold War political economy: the IMF and the World Bank in the 1952; and the General Agreement on GATT effective from 1955. Ever since, the Japanese government has worked to increase both its economic and its political power within these multilateral institutions through the expansion of its financial contribution and attachment voting shares. By 2004, Japan was firmly positioned as the second largest financial contributor to the IMF and the World Bank and had secured, the second largest share of votes in both institutions at 6.15% respectively.

Finally, the economic dimension of Japan-European relations has been at the core of the overall relationship since it restarted in the 1950's after the end of the Second World War. In particular, the development of EEC and the rapid growth of Japan from the late 1950s drew attention to both Japan and Europe as economic powers. This dissertation examines the path that Japan has taken in pursuing bilateral trade with the major European powers alongside a developing economic relationship with EEC. It demonstrates how these developments have been driven by changes in the structure of the international system from the 1970s and particularly from the 1980s, as well as by specific economic policy-making agents. Changes brought about by the Nixon shocks of 1971 and by the oil crisis of 1973 caused Japan to review its international economic relations, particularly those with the US and Europeans. In the early 1970s, the expanded EC attempted not only to develop its own monetary union but also to deal with external economic affairs as a unitary actor. As a result, the European Commission began to deal with Japan on behalf of the EC.

International conditions, however, also led to decline in Japan-Europe relations at the end of the 1970s. At that time, the oil crisis of 1979, combined with economic stagnation in the EC, began to slow down attempts to deal with Japan in the economic dimension. It was only in the 1980s that a strong Yen and a vitalized EC promoted Japan and the EC once again to pay attention to one another's economic development. Since that time, their economic relations have been constantly refined and reinforced. Since the 1990s, the development of a Single European Market (SEM), the introduction of a single European currency as Euro and EU enlargement have all intensified this trend.

4. "FLYING-GEESE" CATCH-UP STRATEGY

The Flying Geese model of economic development was originally introduced by Kaname Akamatsu, a well-known Japanese economist, in the 1930s (inter alia, Akamatsu 1935) and has been expanded by his followers, notably Kojima (1958, 1960, 2000), Shinohara (1972), Yamazawa (1990), Kojima and Ozawa (1984, 1985), and Ozawa (1993, 1996, 2000). Akamatsu was among the very first to recognize the economic significance of what he identified as "the alignment from developed nations to backward nations according to their stages of growth." He argued that "It is impossible to study the economic growth of the developing countries in modem times without considering the mutual interactions between these economy and those of the developed countries" (Akamatsu 1962). However he did not leave any formalized model to explain his ideas. The Flying Geese analogy came from his empirical findings of the "import ? domestic production ? export" pattern of sequential growth in some pre-war Japanese industries ( such as textiles) which traced out a wave - like pattern of each activity in the sequence similar to a model of sequential catch-up through teacher-learner relations among the nationas along the stages of industrial upgrading. It was a model of derived economic development in a latecomer nation.

In fact, the world history of economic development is nothing but a repeated history of industrial leadership and subsequent emulation. Ever since the industrial Revolution in England, industrialization in the rest of the world wherever successful has been essentially a derived phenomenon, in the sense that a follower or learner economy can emulate and learn from the already developed (leader or teacher) economies. Continental Europe industrialized by following Britain through commercial contacts and conscious efforts for leaning and emulation (Landes 1969). So did the United States; as (Lester Thurow 1985) bluntly put it, "American started off as a copier" and "stole British technology." Of course, America certainly added numerous innovations and improvements, particularly in the area of mass production and marketing. So did Russia in its modernization efforts (Gerschenkron, 1962). And likewise, Japan's economic miracle in both the pre- and post-Second-World-War periods was based on this mechanism of learning and emulation under the hegemony of Pax Britania early on and under that Pax Americana more recently. Both hegemonies created a concatenation of leader-follower links among the nations. Nowadays it is happening on BRICS.

Thus, Japan's sequence of industrial transformation is basically the same one trekked by the developed West over a much longer period of time (over country). But Japan was able to accomplish catch-up industrialization in a time-compressed fashion as a latecomer by learning from the West. This time compression of industrial upgrading is accelerating for a variety of reasons. The NIEs have done more quickly than Japan; so will China than the NIEs and ASEAN-4.

The catch-up regime Japan set up after the Second World War was, however, rather a nationalistic (self-centred) kanryou one which stressed an "infant industry" protection for domestic industries with restrictions inward foreign direct investment (FDI). This kanryou development approach was the essence of Japan's Flying Geese catch-up strategy.

Three critical types of industrial policy were pursued under the Flying Geese strategy;

  1. A policy for industrial upgrading from low value-added (low-productivity) to higher value-added (higher productivity) industries.
  2. A policy for importing-substitution-cum-export-promotion (ISEP)-that is, to replace imports with domestic output and later to promote exports.
  3. A policy to transfer comparatively disadvantaged industries or industrial segments onto other countries (mostly nearby developing Asian countries) so as to retain higher value-added industries at home, a process that may be identified as "comparative advantage recycling (CAR) and resource reallocation at home."

Obviously, the outcomes of these policies were closely and sequentially interrelated. Industrial upgrading policy is the ultimate goal of the Flying Geese strategy. And it can be accomplished by the ISEP sequence and the CAD mechanism. Once a new comparative advantage (commensurable with Japan's prevailing / newly altered factor endowments and technological conditions at a given point in time) was created out of formerly disadvantaged industries through the ISEP policy, Japan continued to foster other future growth industries at home - that is, to move up the ladder of industrial upgrading. And once export industries (or industrial segments) began to lose competitiveness (i.e., now become comparatively disadvantaged), they were transplanted via overseas investment onto other countries, especially the developing Asian countries where the factor endowments and technological conditions are still suitable for such industries. What is more, those goods transferred and produced overseas are now imported back to home --- hence, the ISEP policy eventually turns to the sequence of "import Ldomestic production ? export ? overseas production via FDI/licensing ? import."

The interface between industrial upgrading at home and CAR via multinational corporation (MNCs) can be best described in terms of the "industrial restructuring" model of FDI (Ozawa 1992), which is actually a reformulated Flying Geese industrial policy (2) above explained, with emphasis on the role of cross-border investments as a facilitator of structural change, Japan's industrial structure has gone through continuous metamorphic changes, a process that can be chronologically divided into four sequential stages of transformation:

  • Phase1. Expansion of labour-intensive manufacturing in textiles, sundries, and other light industries goods as the leading export sector (1950 to the mid- 1960s)
  • Phase2. Economy of Scale-based modernization of heavy and chemical industries such as steel, petrochemicals, and synthetic fibres as the leading growth sector ( the late 1950s to the early 1970s)
  • Phase3. Assembly-based, subcontracting-dependant, mass production of consumer durable, such as automobiles and early-generation electric/electronics goods (TVs, VCRs) such as the dominant sector (late 1960s to the present)
  • Phase4. Based on mechatronics, computer-aided flexible (or Lean) manufacturing of highly differentiated multi-variety goods, along with R&D-driven breakthroughs such as HDTVs and other latest-generation electronics, new materials, fine chemicals, and more developed microchips (the early 1980s onwards)

The transformation from one phase to another has certainly not been clear-cut but has overlapped in the above chronological approximations. On the theoretical plane, the leading sector in the first phase may be identified as the "Heckscher-Ohlin industries," the second phase the "non-differentiated Smithian industries," the third the "differentiated Smithian industries," and the forth the "Schumpeter industries." The model is basically a "leading growth sector" model a la Schumpeter, in which a sequence of growth is punctuated by stages in each of which a certain industrial sector can be identified as the main engine for structural transformation. This model is basically a leading-growth-sector model a la Schumpeter (1935). It is in sharp contrast to the neoclassical view of growth as a smooth incremental accumulation of capital.

Japan has so far fully completed the first three phases of industrial metamorphosis and is currently in the midst of its fourth stage. And interestingly enough, Japan's overseas investment has exhibited similarly varied patterns, so far four major distinct patterns in a sequential manner, each reflecting the nature of its corresponding era of industrial activity at home. This stages-specific correspondence between structural transformation and FDI. The reveal phases of FDI can be identified as (1) the elementary stage of offshore production (or low-wage-seeking investment), (2) resource-seeking and house-cleaning investment, (3) assembly-transporting investment, and (4) alliance-seeking (strategically networking) investment.

The ISEP policy in particular required heavy involvement of government in protection, technology imports and infrastructural development, industrial finance and export protection, especially for modernization of pre-war built heavy and chemical industries. As will be explored below, Japan's keiretsu system was promoted and utilized as part an parcel of industry policy. And in this trade-focused strategy of development of a specific good or industry, inward FDI was restricted and critical technology was acquired in an "unpackaged" manner, this is, mostly under licenses. Later on, the sequence shifted to that of basic technology import L commercialization at home (i.e., domestic production) L export (TICE), as best seen in many of Japanese innovations such as transistor radios, pocket-size calculators, quartz watches, etc. In this later version, government role declined, while adaptive corporate R&D and entrepreneurship played a crucial role in innovation.

For the purpose of my analysis, it is important to stress that Japan enjoyed a high growth period when it went through both the labor-driven "Heckshere-Ohlin" stage and the scale-based "non-differentiated Smithian" stage during 1950s, and 1960s, and the early 1970s. Such high growth can be most appropriately called "input-driven" a la Krugman (1994), where an abundance of labour is mobilized mostly from the rural areas output, although the Japanese experience was also accomplished by a rapid rise in efficiency itself.

Seen in this light, Japan's industrial rise has been almost flawless. Thanks to the

Flying Geese strategy of catch-up (i.e. aquire adavanced industrial knowledge as much and as quickly as possible from the West through emulation), its technological level and productive capability are now overall on a par with the United States and the EU. It has a huge reservoir of private wealth, and is a formidable competitor in the world economy. There is nothing wrong with its "fundamentals". But its economy is in a financial shambles, and even considered a drag on the rest of the world. What went wrong with the Flying Geese strategy? In order to explain why the Flying Geese industrial upgrading succeeded in Japan-and why it has later ended up with a financial debacle, it has to be understood its kanryou catch-up regime.

5. JAPAN'S INSTITUTIONAL MATRIX FOR Flying Geese CATCH-UP

What is missing from the rosy picture of Japan's growth as depicted in the above Flying Geese model of catch-up is its much neglected institutional dimension. Each economy has its own set of institutions for economic activities, and its overall economic performance is largely determined (enhanced or retarded) by such an institutional arrangement (North 1990). Such as a set can also be called "an institutional matrix that defines the incentive structure of society" against the backdrop of "the belief system" that connect "reality" to the institutions (North 1999). Japan arranged a catch-up regime suitable for its own prevailing socio-economic conditions in the early post war period by combining formal rules with traditional norms and mores or "Asian values".

Japan's Flying Geese catch-up regime was effective mostly during the high-growth stage of heavy and chemical industrialization (up until the mid-1970s). It was based on, and supported by, four key elements: (1) state-directed bank-based finance (the "main bank system" and the "stakeholder model" of corporate governance), (2) Keiretsu formation, system, (3) the "privatized welfare/pork-barrel" sector, and (4) the principal of "job primacy over efficiency" as an implicit social contract. As will be explored below, these elements have evolved and converged in a sequential and path-dependent fashion to cause some critical institutional misalignments (incongruities) which culminated in the recent and current economic crises as the vicissitudes of Japan's once phenomenal catch-up growth, Flying Geese -style. The institutional misalignments have been caused by the combined forces of the fast-changing market conditions that Japan's kanryou catch-up regime itself created and the registration evolutionary developments that have transpired.

5.1 State-directed bank-based finance and repressed capital markets As is typically the case with any developing countries, Japan once resorted to and maximized the use of bank-based finance for catch-up growth instead of capital -market-based finance. In this scheme, Japan also used "central-bank-based finance" (the Bank of Japan created funds internally) rather than "CA-deficit-based finance" (i.e. borrowing from overseas)( Ozawa 1999, 2001). These two, but especially the latter, are the crucial financial aspects catch-up growth which the Flying Geese model has not so far taken into account, but which can shed light on the puzzle of successful Flying Geese catch-up process suddenly winding up in a crisis.

At the start of post war growth the stock market initially did play as a source of funds for corporate investment in Japan. Yet, the stock market (especially the Tokyo Stock Exchange or TSE) was meant only for large well-established corporations and not for start-ups (even if promising), which were badly in need of new capital. The latter had to show profits for at least three consecutive years to be qualified for stock listing (hence no chance for any promising start-ups to be listed.). Furthermore, even if qualified, they had to climb up the hierarchy of the stock markets, starting first with one of the country's eight local bourses, the over-the-counter market, or on the TSE's second section-and finally, under rigorous screening, on the TSE's first section, a time-consuming journey taking as long as 20years.

Soon, however, bank loans were purposefully promoted for corporate finance as the essential financial strategy of overall Flying Geese industrial development policy, and equity finance quickly became secondary to bank loans. In order to control credit expansion, moreover, the government prohibited corporations from issuing bonds. A bond-issuing privilege was granted only to those financial institutions (mainly, three long-term credit banks and utilities) that were specially designed to finance public purpose long-term projects. Consequently, there was early on no choice on the part of corporations but to borrow from banks.

Dependence, on bank loan thus became the critical mechanism through which a policy of financial repression was implemented by keeping interest rates low, controlling market competition (via entry regulations), and channelling capital to policy-targeted sectors and projects. Under close supervision and control of the Bank of Japan, which was virtually a policy arm of the ministry of Finance, the six major keiretsu banks (Mitsui, Mitsubishi, Sumitomo, Fuji, Sanwa, and Daiichi Kangin Bank)played the role of "main banks" for their respective groups in investing in heavy and chemical industries the capital injected by the central bank. Bank-created money did not lead to any serious inflation, since (1) the funds were carefully invested in supply-increasing industrial projects and (2) the monetary spigot was turned off as soon as Japan encountered a balance-of-payments deficit, a deficit caused by such an expansionary monetary policy (Wallich and Wallich, 1976). That central-bank-augmented credit creation for growth was a classic case of development finance in the early stage of industrial capitalism as envisaged and theorized by Schumpeter (1934), who even called the banks as "the headquarters of the capitalist system.

Capital markets were given a supplementary role, and the bond market in particular was even discouraged to develop until the mid-1980s; corporate issues and the development of a secondary market were severely discouraged (Patrick, 1994). That state-augmented banking system naturally produced a "moral hazard" effect, since high-risk investments were encouraged LL I and the central bank always stood ready to bail out any significant to fail. Small and even inefficient banks were equally protected under the scheme popularly referred to as a "convoy system", in which strong banks were obliged to guard weak ones. The result was that banks' operations became extremely asset-expensive as they eagerly extended loans---especially in the context of inter-keiretsu oligopolistic rivalry as the keiretsu competed vigorously with each other in setting up a similar set of industries, a phenomenon that came to be called the "one-set" principle (Miyazaki 1980). Banks---and their keiretsu customers---were thus all the more willing to take risks because they could count on government help. Moral hazard was actually needed as an inducement to promote large-scale investments in capital-intensive, scale-driven industries, since these industries imposed high financial risks on the private sector.

Without government support and the keiretsu formation, individual enterprises alone might have been reluctant to plunge into new large-scale ventures during Japan's heavy and chemical industrialization (from the mid-1950s to the early 1970s). A rise in national output capacity (aggregate supply) had to be induced to match the liquidity (aggregate demand) pumped into the economy by the central-bank-augmented credit creation in order to prevent inflation (as emphasized by Schumpeter). This type of moral hazard, then, can be identified as the social justifiable type, since it induced socially desirable investments in the modern sector, thereby facilitating a swift industrial transformation. Ironically, the very success of kanf you of bank-based capitalism, however, came to undermine the privileged position of banks. It was a self-destructive system. Thanks to the low-cost capital made available under such a system, big corporations, mostly in the keiretsu, grew quickly and accumulated internal reserves. That accumulation itself was made possible because companies did not need to pay out much dividends (post-tax payments) and paid mainly a fixed amount of interest (pre-tax payments) without regards to profitability. This setup left greater retained earnings. The rapid expansion of internal reserves served as an emancipator from dependence on banks. In other word, the main bank system itself was responsible for making the banks' clients less and less dependent on loans---hence less susceptible to monitoring and more autonomous in investment decisions (Ozawa 2000). Moreover, as Japan entered the subsequent phase of assembly-based, components-intensive industries, notably automobiles and electronics, leaving behind heavy and chemical industries, there soon emerged new world-class manufacturers.

Many of these manufacturers actually did not originate as Keiretsu firms which were supposedly best coached by their main banks. These new companies started out as outsiders (non-keiretsu upstarts) in the post war period and have largely remain as such ever since. They were also those maverick companies that began actively to issue new stocks at market prices, thereby breaking the custom of par-value issues. A prime example is Toyota Motor Corporation, now the world's most efficient car maker, which has had no affiliation either with any zaibatsu (in the pre-war days since its establishment in 1937) or any major keiretsu (in the post war period). In fact, the company has persistently avoided external debts. Its internal reserves became enormous, so much so that Toyota itself came to be known as the "Toyota Bank." Honda is another example, which in its infancy had a hard time securing bank loans because of its initial status as an independent upstart. It originated as a bike repair shop in the early postwar period. Only later on, the company became "affiliated" with the Mitsubishi Bank (now Tokyo-Mitsubishi UFJ Bank). Likewise, Matsushita Electronic Industries (now Panasonic) quickly accumulated huge internal funds and has ever since been practically free from external debt. It is also often called the "Matsushita Bank." Sony was also no exception as a non-keiretsu firm. Furthermore, some successful Japanese corporations were soon able to tap the international capital markets for their financing needs at low costs as restrictions on borrowings from abroad were lifted with the amendment of the Foreign Exchange Control Law 1980. As the result of ever-increasing internal funds and the opportunities to raise capital abroad, there was thus no reason for them to be subservient to their banks and to be dictated about how to run their own businesses by bank officials. Besides, the main bank system might not have been as beneficial for the affiliated firms as described by its proponents, who emphasize the magic of the system in solving the problems of information asymmetry and transaction costs. "Over the 1983 -87 period (that is, at height of assembly-based "differentiated Smithian" manufacturing), retained earnings accounted for as much as 53 percent of the sources of funds in Japan. One empirical study (Weinstein and Yafeh 1998) reveals (1) that the cost of capital of bank-affiliated firms was higher that of their peers (nonbank-affiliated ones) and (2) that most of the benefits from relation banking were appropriated by the banks. No wonder, then, the "departure from banks" syndrome intensified. Japan's main bank system was effective in capital allocation only during the early stages of Japan's post war Flying Geese catch-up growth-at most until the early 1980s with 1975 as its watershed year.

It was against background of this rapid structural change in the market that a bubble economy (1987-1990), stemming from, and fed by, speculative investments in real estate and stocks, occurred. Because of the easy monetary policy adopted to combat the so-called "high-yen" recession after the Group-Five (G&) Plaza accord in 1985, the banks became awash in liquidity. They found small-and medium-sized enterprises, real estate firms, distributors (both wholesalers and retailers), and construction companies as their new major borrowers. The share of this grou


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