Analysis of the Flying Geese Model for Japan

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 s