“API Geoeconomic Briefing” is a weekly analysis of significant geopolitical and geoeconomic developments that precede the post-pandemic world. The briefing is written by experts at Asia Pacific Initiative (API) and includes an assessment of burgeoning trends in international politics and economics and the possible impact on Japan’s national interests and strategic response. (Editor-in-chief: Dr. HOSOYA Yuichi, Research Director, API & Professor, Faculty of Law, Keio University)
This article was posted to the Japan Times on September 14, 2021:
API Geoeconomic Briefing
September 14, 2021
Japan needs a strategy for economic growth in the post-virus era
Former Member of the Policy Board, Bank of Japan
While the economies of major industrialized nations are on a steady path to recovery from the COVID-19 pandemic, Japan is lagging behind as it tries to vaccinate more citizens amid a fifth wave of infections.
However, there is no doubt that moves to improve Japan’s economy for the post-COVID-19 era will be fully underway in 2022 and 2023.
But what are the challenges the Japanese economy faces in the post-pandemic era from a global perspective, especially regarding Japan’s overseas investments? And how should Japanese companies and financial institutions cope with these challenges?
After 2013, Japan managed to come out of a long recession and its economy continued on a path of moderate growth from the latter half of fiscal 2016 through fiscal 2018.
The growth process was backed by large-scale expansion in fiscal spending and a policy of monetary easing, which first led to a quick correction of the yen’s appreciation in 2013, then to continued stable yen rate moves from the latter half of 2016.
The effects of the policies and the correction of the strong yen brought about economic recovery driven by external demand, which then expanded to domestic demand, putting the nation on a path of moderate growth between the fiscal years of 2015 and 2018.
Japan also avoided price deflation during this period, and the country’s unemployment rate dropped to 2.4% in fiscal 2018, close to full employment.
But the economic growth slowed down in 2019, as global trade remained sluggish amid the escalation of the trade war between the United States and China.
Then the economy was dealt with another blow by the global spread of COVID-19 in 2020, causing Japan’s real gross domestic product to post negative growth in fiscal 2019 and 2020.
Globally, Japan’s nominal GDP is the third largest in the world after the United States and China, but there is a clear gap between Japan and the other two countries in terms of the size of their economies — the Chinese economy is nearly three times bigger than Japan’s and the U.S. economy is more than four times bigger.
Meanwhile, Japan has been the world’s top creditor nation for the past two decades, posting net external assets of ¥357 trillion as of the end of 2020, maintaining the level between ¥300 trillion and ¥360 trillion for seven years.
While Germany and China also maintain a positive net foreign assets balance, the U.S. had net external debt of ¥1.4 quadrillion in 2020, with its net debt increasing by some ¥1 quadrillion over the past decade.
Foreign assets held by Japanese institutions and individual investors totaled ¥1.146 quadrillion as of the end of 2020, expanding by 4.5 times in a quarter of a century from about ¥250 trillion in the mid-1990s.
Among the assets held as of the end of 2020, securities investment occupied roughly 46% and direct investment around 18%.
Annual foreign investment flows totaled about ¥40 trillion in recent years, equivalent to 7% to 8% of nominal GDP, with fluctuating securities investment and stable direct investment each amounting to some ¥20 trillion.
Profits from foreign investments are roughly ¥20 trillion a year, with profits from securities investment and direct investment about the same amount.
The rate of return on foreign assets is 1.5% for securities investment and 5.3% for direct investment. Compared with the low return on securities investment reflecting low global interest rates, the return on direct investment is remarkably high.
It should also be noted that about half of Japan’s profits from foreign direct investment (FDI) come from Asia.
Return rates on Japan’s FDI are estimated to be about the same level as those in other industrialized countries. But it can also be assumed that the actual return is higher for Japan, considering the relatively high ratio of investments in Asian countries posting high economic growth and other income from patents and exports related to direct investment.
Japan’s nominal gross national income — including the nominal GDP plus profits from foreign investment — has exceeded the nominal GDP by ¥15 trillion to ¥20 trillion in the past decade.
Moreover, the FDI share in Japanese companies’ overall capital investment has reached 20% to 25% for all industries and 35% for the manufacturing industry.
The ratio of overseas sales is 35% to 38% for all industries and as high as 50% for the manufacturing industry.
While Japanese companies’ exports total as much as ¥100 trillion a year, they are also posting high overseas sales brought about by FDI.
In Japan, domestic savings have constantly been higher than domestic investment. The country needs to urgently create a strategy to develop its economy focusing on foreign investment.
The U.S. has net foreign liabilities of ¥1.4 quadrillion, and the amount has been increasing. This indicates that the country is utilizing massive flows of foreign capital to boost economic growth.
It is possible for the U.S. to keep growing as long as confidence in the dollar as a key currency is maintained. The U.S. will remain at an advantage as a country not having to bear foreign exchange risk.
Meanwhile, the Japanese economy may be able to keep on growing at a moderate pace, but there are undoubtedly structural limitations preventing the nation from improving its growth potential, such as the shrinking population.
One of the key challenges facing Japan in the post-COVID-19 era is how it can proceed with the structural reform of companies and encourage their innovation, while fully making use of its investments overseas.
The 2008 global financial crisis was a key experience in terms of governments’ policy making, as many industrialized countries demonstrated their ability to respond to the catastrophe by implementing bold monetary easing and fiscal stimulus measures.
Some countries definitely drew on the experience in tackling the COVID-19 pandemic, and are recovering quicker than they did from the global financial crisis.
However, Japan has numerous issues to deal with. Even if the nation gets on a recovery path, there is little possibility for its growth potential to improve largely.
A realistic policy direction would be to implement structural reform while boosting the profitability of overseas investments so that the nation can achieve moderate but sustainable growth.
Improving the profitability of foreign investment will contribute to an increase in corporate profits, thus helping to expand domestic investment.
Between 2016 and the first half of 2019, Japan maintained moderate economic growth as corporate profits improved, including those overseas, backed by proactive fiscal and monetary policy measures.
This created a positive spiral of a glut of jobs alongside a manpower shortage leading to more domestic capital investment.
In the post-COVID-19 era, it is vital for Japan to further improve the profitability of foreign investment in order to strengthen overseas investment and simultaneously realize moderate economic growth.
To do so, it is necessary to reinforce the ability to collect information related to foreign direct investment, including geopolitical risks, and to quickly respond and make judgments.
It will not be long before the global supply chain will start to be reorganized amid the U.S.-China confrontations, and Japan will have to explore several such supply chains.
Another issue is Japanese companies’ structural reform, as problems related to governance and compliance are emerging in many major firms.
There are concerns as to whether innovations and leadership for corporate growth are being secured at such firms, considering that executives’ tenures are generally shorter than those in Western nations, and there are many outside directors.
Focus should be placed also on FDI in the form of mergers and acquisitions, a field that is expanding rapidly.
The total amount of direct investment via M&A is three to five times larger than that of green-field investments in which companies set up a subsidiary in a different country and build operations from the ground up.
Each M&A case involves large sums of money, which means it is crucial to have a high ability to gather information and grasp risks, as well as strong leadership to make decisions.
As for foreign securities investment, the only issue is to drastically improve asset management skills, as Japanese financial institutions are clearly behind Western rivals in this field.
High asset management capabilities in the United States are undoubtedly based on overwhelmingly high information gathering and analysis abilities in such areas as seeking new borrowers, assisting startups and assessing country risks.
Western merchant banks and investment banks, which led the world financially from the 18th century through the beginning of the 20th century, ambitiously challenged risks with their high information collecting abilities and human networks.
By utilizing their high-quality management capabilities, they succeeded in developing the global economy and establishing a foundation through which to excel in foreign investment.
They certainly failed to respond to risks at times, but were tough enough to recover from the failures and maintain their overall management capabilities.
Nurturing human resources
Making foreign investments means using people’s savings and accumulation of companies’ profits in Japan in other countries. Needless to say, they should be conducted under prospects for higher profits and risk aversion.
In order to boost the nation’s foreign investment capabilities, the government should establish and strengthen systems to get a wide range of financial institutions involved in direct investment projects and M&As with relatively high profitability.
It is also necessary to consider setting up a public fund to manage foreign assets, including investments in sovereign wealth funds and stocks.
As a long-term challenge, Japan should also fundamentally review its education system to nurture human resources with skills in liberal arts, languages, mathematics and leadership, as well as experiences in finance and policy making.
Without sufficient accumulation of information backed by overwhelming intelligence with ultra-long-term and wide perspectives, we cannot expect the nation to make the strategy of realizing a moderate economic growth while simultaneously focusing on boosting foreign investment work effectively in the long term.
The views expressed in this API Geoeconomic Briefing do not necessarily reflect those of the API, the API Institute of Geoeconomic Studies or any other organizations to which the author belongs.