ECONOMIC RESEARCH CENTERDISCUSSION PAPER

No.155

Effectiveness of the Flowchart Approach toIndustrial Cluster Policy in Asia
byAkifumi Kuchiki

July 2005

ECONOMIC RESEARCH CENTERSCHOOL OF ECONOMICSNAGOYA UNIVERSITY

Effectiveness of the Flowchart Approach to Industrial Cluster Policy in Asia

KUCHIKI Akifumi＊
Abstract
Our static model concludes that a multinational in industry of diminishing returns toscale will increase production of a region in a developing country if its exchange rate to
the developing country is appreciated. Our dynamic model also shows that the longer
its investment period becomes the more the currency exchange rate of a multinational’s
country should be appreciated to invest in the developing country. The dynamic model
concludes that the longer the investment period becomes the less the country risk of thedeveloping country should be. However, we show that its high country risk can becompensated by lowering the corporate tax rate of the developing country. A more
realistic model of countries in East Asia in the 1980s can confirm this conclusion.
That is, the preferential treatment of tax reductions or exemptions by the developing
countries was effective in inviting foreign direct investment. Our above models imply
that roles of central governments are crucial to inviting foreign direct investment toform industrial clusters by building capacity of infrastructure and institutions.

Key words: flowchart approach, industrial cluster policy, capacity building, institutions,exchange rate, country risk, corporate tax rate
JEL Classification Code: O41, O18, L52, L53, L62*

Executive Vice President, Institute of Developing Economies - Japan External Trade
Organization; Visiting Research Fellow (From April 2004 to March 2005), Economic
Research Center, Graduate School of Economics, Nagoya University.
E-mail: akifumi_kuchik@ide.go.jp

Effectiveness of the Flowchart Approach to Industrial Cluster Policy in Asia
Akifumi Kuchiki

1. Introduction
Central governments in Asian countries such as Japan and Thailand are
implementing industrial cluster policies.

Industrial cluster is a geographic

concentration of manufacturing companies, suppliers, service providers and related
institutions in a particular field of industry. In most of the cases, the industrial cluster
policies are implemented by the local governments. On the other hand, industrial
policies, which are different from industrial cluster policies, are policies implemented
by the central government to foster domestic industries through the reallocation of its
resources. Industrial policy is a selective-intervention policy by central governments.
Scholars to advocate industrial polices have decreased in number after the Asiancurrency crisis in 1997 (see Stiglitz and Yusuf (2001)). Neverthless, we would like toanalyze the following question: What are the roles of central governments to implement
industrial cluster policies to activate local regions?
Many industrial clusters in industrial zones and export processing zones have been
formed in Asia. An export processing zone in Kaohsiung in Taiwan in 1965 was theoriginal model for this in Asia.

Industrial clusters in East Asia in the first half of the

1980s followed those of special economic zones in Shenzhen in China and free tradezones in Penang and Johor in Malaysia. The issue for central governments and local
governments is to judge whether their policies are effective on forming industrial
clusters.

1

The industrialization of East Asia in the latter half of the 1980s was a gameinvolving recipient countries such as Malaysia and Thailand on the one hand, and themultinational

companies of South Korea, Taiwan and Japan on the other. The policiesof these countries were centered on deregulation to attract foreign investment,
permitting 100% ownership of capital by foreign investors, not only in a few specificsectors but over a wide range of export-oriented industries. Moreover, the governmentsof these countries implemented preferential treatment for foreign capital, primarily
involving tax incentives such as low corporate tax rates and tax holidays (exemption)
for a certain period, and provided industrial parks with an infrastructure to entice foreign
investment.
Incentives for multinational companies to establish their subsidiaries in othercountries are to transfer management resources (Penrose, 1956) and to reducetransaction costs (Hymer, 1960). In the case of East Asia in the 1980s, however, cost
reduction was the primary objective. As is proved in this paper, cost was the primary
motivation behind the increasing number of South Korean, Taiwanese and Japanesecompanies that expanded overseas production during the latter half of the 1980s. As
domestic costs rose, due to the increase in wage rates and the appreciation of thedomestic currency rates, the Asian companies reduced costs by expanding overseas
production. As is shown in Figure 1, Kuchiki (2005) proposed the flowchart approachand theoretically proved that industrial cluster policy is effective in forming industrial
clusters by establishing export processing zones, building capacity, and inviting anchor
firms.

The capacity means infrastructure, institutions, human resources, and living

conditions.

The flowchart approach emphasizes the importance of ordering and timing2

of policy measures. Kuchiki (2003) and Kuchiki (2004) illustrated its successful casesof Canon’s effect in Hanoi, Vietnam and Toyota’s effect in Tianjin, China. Canon andToyota are both Japanese companies and function as the anchor companies at the
flowchart approach.

But we have not shown whether policies of inviting foreign direct

investment to export processing zones by central governments are effective in forming
industrial clusters.
The purpose of this paper is to examine whether governmental exchange rate
policies, preferential tax policies, and country risk management policies are effective ininviting foreign investors to the industrial clusters.

We will build both static anddynamic models to analyze the effectiveness of each of the policies.
Our static model concludes that a multinational in industry of diminishingreturns to scale will increase production in a developing country if its exchange rates tothe developing country is appreciated. Our dynamic model also shows that the longer
its investment period becomes the more the currency exchange rate of a country ofmultinational companies should be appreciated to invest in the developing country.
The dynamic model concludes that the longer the investment period becomes the lessthe country risk of the developing country should be. However, we show that its highcountry risk can be compensated by lowering the corporate tax rate of the developing
country. A more realistic model of countries in East Asia in the 1980s can confirm
this conclusiton. That is, the preferential treatment of tax reductions or exemptions by
the developing countries was effective in inviting foreign direct investment.

Our

above models imply that roles of central governments are crucial to inviting foreign
direct investment to form industrial clusters by building capacity of infrastructure and3institutions.

It is noted that this paper focuses specifically on institutions of capacity

building as Table 1 shows.
The paper is organized as follows. Section 2 demonstrates how deregulation andpreferential tax treatment, which were selected to encourage foreign investment, played
major roles in enhancing the economic growth of Kaohsiung in Taiwan, the Chinese
province of Guandong, Malaysia, and Thailand. Section 3 presents a decision-making
model for multinational companies which intend to invest overseas. This model
indicates that multinational companies will not become interested in foreign direct
investment unless the overseas costs decrease to a certain threshold, which depends on
tax rates of a recipient country. Preferential tax treatment is thus a crucial factor for
multinational companies to make decisions on their investment in other countries.
Section 4 draws the conclusion of this paper.

2. Export Processing Zones

Export processing zones represent one of the mechanisms for rapid economic
growth in East Asia. The prototype version for Kaohsiung in Taiwan was modeled on
those in Malaysia and Guangdong province in China, and applied to Thailand and other
Asian countries.
We can apply this model to East Asian countries wishing to invite foreign
investment that had established conditions of political and macroeconomic stability andpublic security. The main features of the policies implemented to encourage foreign
investment were as follows: first the quasi-public sector provided production sites, that4

is, industrial parks with well developed “infrastructure” which was a common way to
encourage foreign investment; sequentially, the government selected leading industries
to give preferential treatment for foreign capital, usually involving “tax incentives” suchas low tax rates and tax holidays (exemption) for several years after the first profit has
been generated; at the same time, the government deregulated to allow up to 100%
ownership by foreign investors. The permission reduces the investors’ risk since theyneed not find their partners. It is noted that a high export ratio was the only requiredcondition for incentives such as 100% ownership of capital and preferential tax rates.
The export processing zones with these features, however, was not enough toattract foreign direct investment.

The mechanism will have no effect until companies(usually multinational companies) become interested in increasing overseas production;to achieve this, foreign companies must have incentives to invest outside their own
countries. The most important incentive is to reduce cost, which is determined mainlyby three factors: wages, exchange rates and taxes. Smaller costs had a decisive impact
on the decision for overseas investment by Taiwanese, South Korean and Japanesecompanies in common from 1985 to 1990. We can recognize this fact by the results ofregression analyses presented in the Appendix 1.

3. Theoretical Analyses on Multinational Companies

This section theoretically proves that governments’ policy of the recipient
countries is effective in inviting multinational companies under certain conditions. We
will focus on three policies: (i) currency devaluations, (ii) permission of multinational

5companies with totally foreign owned capital, and (iii) preferential tax treatment bygovernments.

By focusing on these three policies, we get the following threeconclusions.

First, proposition 1 insists that it becomes easier that multinational

companies decide to invest in a country if its government hold a devaluation policy.
Second, Propositions 2, 3, and 4 make clear that it will contribute to inviting
multinational companies if governments of recipient countries reduce country risk bypermitting multinational companies with totally foreign capital.

Third, Proposition 5shows that preferential tax treatment by recipient countries will reduce its country risk
for multinational companies.
The three policies mentioned above were taken in the ASEAN countries from1981 to 1994 and contributed to their high economic growth during the period.

(1) Necessary conditions for overseas investment
The variable θ denotes country risk, the level of political and macroeconomic
stability in the recipient country. The variable θaffects the level of production in therecipient country F ( k , A ) , where k is capital and A labor. t

represents thecorporate tax rate and e the exchange rate of the investing country with respect to therecipient country (per unit of recipient country's currency). P represents the price of
product in investors' currency, r the interest rate, and w wage levels evaluated in thecurrency of the recipient country. The level of profit from overseas production π fcan be expressed as follows:

π f = max (1-t){P θ F(k’,l’)-rk’-ewl’}
k’,l’

6

= (1-t) ){P θ F(k,l)-rk-ewl},
where k’=k, l’=l.
Let us now contrast this with domestic production, using exactly the same
production function. The new variables in an investors' country are θ d (country risk),t d (corporate tax rates) and wd (wage levels). Without loss of generocity we canassume that the country risk of the investers' country is assumed to be 1. the profit π dobtained from domestic production is then

π d = max (1-td){P θ F(k’d,l’d)-rkd’-ewld’}k’d,ld’= (1-td){P θ F(kd,ld)-rkd-wdld},
where k’d=kd, l’d=ld. Here the interest rate r is the same as that in overseas production

π f.
Assume here that the Cobb-Douglas production function for profit from overseas

π f isF(k, l) = kalb (We can assume, without loss of generality, constant=1)
Fluctuations in the exchange rate e then affect k and l as expressed in thefollowing formulae :∂ A / ∂ e= −(A / e) ⋅ (1 − a) /(1 − a − b) < 0∂ k / ∂ e=− (k / e) ⋅ b/(1 − a − b) < 0
where diminishing returns to scale in the form a + b < 1 prevail, representing theincrease in overseas labor input and capital input as the currency of the investors country
appreciates. The reverse could apply for increasing returns to scale.

7

Contrasting profits earned at home π d with profits earned overseas π f , we have

π d / π f = { (1-td)/(1-t)}[(1/ θ )(ew/wd)b]1/(1-a-b)
A multinational company invests overseas if π d/ π f < 1 , i.e. π d < π f
Relative profit π d / π f with respect to the location of production is governed by
the following factors:
Country risk, corporate tax rates, overseas wage levels, and exchange rate
= (θ, t , w, e) .
It should be remembered that these four factors act as a group in determining thefinal outcome. The level of wages in the recipient w is multiplied by the exchange rate

e to obtain the level of wages paid out by the investing company. Since the following
exchange rate analysis is equally valid for all wage levels w, relatively low wage levels
do not constitute the only factor influencing relative profit.
Country risk θ and corporate tax rates ( t ) will be explained briefly.
Country risk θ is governed by:(1) Political stability;(2) Macroeconomic stability.
The concept of political stability requires no explanation. Macroeconomic stability
refers to consumer prices and the international balance of payments. Both forms ofstability are considered pre-conditions for rapid economic growth.
With respect to corporate tax ( t ) , preferential tax treatment via incentives suchas tax holidays (zero taxation for a period of several years, i.e., t = 0 ) provide a major
incentive for overseas production. That is, the relative profit π d / π f is less than 1 if

8(1/ θ ) (ew / wd)b ≤ 0.
The introduction of preferential tax treatment by one East Asian country immediately
puts the others at a disadvantage. Later developers in Southeast Asia -- includingIndonesia, the Philippines and Vietnam -- have thus been obliged to follow suit.

(2) Dynamic analysis
This section presents a dynamic analysis, which can be more realistic and show
the importance of the role of the government. The model examines a multinational
company

operating over two periods. In each period, π f represents the level ofpotential profit from the overseas operation when the company does not set up overseas
facilities. This is dependent on the exchange rate e which is stochastic, has
distributions G , and is identical and independent each other.
A company searches for countries and regions suitable for expansion. The
potential profit earned from overseas operations is given by

π f = (1 − t ) ( Pθ F − rk − ew A ) ,where country risk θ and exchange rate e are considered random variables.
The question here is what is the threshold exchange rate e , representing the point
at which the "yes" decision to invest abroad is taken. Country risk θ likewise has athreshold value. Normally, a yes decision requires both e and θ to be over theirrespective threshold values; one without the other is not sufficient. This allows us toperform a two-stage analysis as follows.
First stage: Dynamic analysis of e with θ constant at θ =1. This is used to9assess the likelihood of a yes decision.
Second stage: Dynamic analysis of θ as a random variable, with given e in theevent that the offer is accepted.
The basic model for the first stage is as follows. The periods are T − 1 and T .
We will consider period T first and then period T − 1. If the value function in period
T is Vt ( e ) and the state variable is exchange rate e , then decision-making behavior

can be expressed thus:
VT (e) = max { π f , π d }Thus, the company invests abroad in the case of π f ≥ π d , that is,(1 − t ) ( PF ( k , A ) − rk − ew A ) ≥ π d .
Therefore, the value of exchange rate should beπ1( PF ( k , A ) − rk − d ) ≥ e .
wA
1− t
Or, e T ≥ e, where e T =π1( PF − rk − d ) , in order that π f ≥ π d .
1− twAThis is illustrated in Figure 2.
In period T − 1, the value function is given by VT −1 ( e , s ) , with the state variabless indicating either D (domestic production) or S (overseas production). The Bellman
formula in this case isVT −1 (e, D) = ma x{(1 + β )π t ,π d + β EVT (e' , D)} ,where β denotes a firm's discount factor (see Sargent(1987) for the Bellman formula).
We find the optimal solution from two possible courses of action: (i) launchingoverseas production during the current period (T-1) at the given exchange rate e and10increasing overseas production in the next period (T); or (ii) carrying on with domestic
production during the current period (T-1), postponing the decision until the next period(T). The value function VT −1 ( e , D ) in this case is⎡(1 + β ) π f
VT −1 ( e, D ) = ⎢⎣π d + β EVT ( e', D )e≤e T −1e≥e T −1

where e T −1 represents the decision threshold at the current period T-1, satisfying
the following expression:(1 + β ) π f = π d + β EVT ( e ' , D ) .

And since
eo

∞

0

eo

EVT (e' , D) = ∫ π f dG (e' ) + ∫ π d dG (e' ) ,the threshold value e T −1 during period T − 1 is given by:π
β 01( PF (k , A) − rk − d ) −G (e' )de' .
wA
1 − t 1 + β ∫0ee T −1 =Comparing the threshold e T in period T with the threshold e T −1 in period T − 1,
we have:e T −1 − e T = −βe0

1 + β ∫0

G (e' )de'<0,

Thus

e

T −1

< eT ．

The critical value of exchange rate of overseas investment in period T ( e T ) should be
more appreciated than that of investment in period T-1 ( e T −1 ). That is, the threshold11

value in the current period T-1 is smaller than that in the next period T.

Amultinational company will invest abroad in the current period unless its currency ismore appreciated than the rate in the next period when it makes decision on theinvestment. This means that it will decide to invest abroad for two periods T-1 and T
if its currency is relatively appreciated. We can continue to iterate this process asfollows.

e

T −2< eT −1 ．

The condition of the critical values for three periods is

e

T −2

< eT −1 < eT .

Taking Japanese investment as an example, we can use the above expression to argue
the following from a dynamic point of view.

Proposition 1: The longer the investment period of a multinational company
becomes, the more appreciated its currency is required to be.

In the same way, a yes decision is possible even under a relatively weak yen if theinvestment can be recouped in short term. This explains why relatively short-term Hong
Kong investment are more likely to be directed towards China than Japanese investment.
Next we shall employ the mean-preserving spread (Sargent (1987)) to examine
overseas expansion with respect to risk of exchange rate. G1 and G2 represent
distribution functions for the exchange rate e for the periods T-1 and T, which varies
within a limited range, from zero to B.

12

Assuming a mean-preserving spread, we can say:yy

∫ G (e)de≤∫ G (e' )de' , 0 ≤ y ≤ B.
1

2

0

0

Accordingly, with e Ti −1 as the threshold value corresponding to Gi

πd
β 0
1
e T −1 = wA ( PF (k , A) − rk − 1 − t ) − 1 + β ∫ Gi (e' )de' ,0eiwhere i is equal to 1 and 2.
Therefore,

e

1
T −1

− e T −1 = −
2

β

e0

e0

( G1 (e' )de' − ∫ G2 (e' )de' ) ．
wA(1 + β ) ∫00

And soe1
T −1< e T −1 ．
2

From this we derive the following:

Proposition 2: The higher the risk of exchange rate is, the stronger the currency of
the investers country is required to generate a yes decision.

Now we shall consider the basic model for the second stage, looking at country
risk θ with the exchange rate fixed at e=1. As before, we will use two periods, T − 1
and T . The value function in period T is given VT ( θ )VT (θ ) = ma x{π f ,π d },where θis a state variable with a distribution function H.

13

When overseas production is more profitable than domestic production, π f ≥ π d ,(1 − t 2 ) ( PF θ − rk2 − ewA 2 ) ≥ π d .

The decision will be yes. The threshold is then given byθ T = (1 / PF ){rk 2 + wA 2 + π d /(1 − t 2 )}.
If country risk exceeds this value the decision will be yes; otherwise the company
will choose to remain at home. This is illustrated in Figure 3.
The value function for period T − 1 is VT −1 ( θ , s ) , where s = D (domestic
production) or S (overseas production). The Bellman formula in this case is{}VT −1 (θ , D ) = max (1 + β ) π f , π d + β EVT (θ ' , D) .

The value function in this case is⎡ (1 + β )π f ,VT −1 (θ ,D ) = ⎢⎣π d + β EVT (θ ' , D),
where θ T −1θ ≥θ T −1,θ ≤θ T −1

represents the decision threshold, satisfying the following

expression:( 1 + β ) π f = π d + β VT ( θ ' , D ) .

Country risk θ is greater than θ T −1 . Thus, if country risk is higher than that ofdomestic production, the decision will be yes. If lower, the company will choose to stayat home, postponing the decision until period T .
Comparing threshold θ T in period T with threshold θ T −1 in period T − 1, we
find:

β ∞
θ T −1 − θ T =(θ '−θ ) dH ≥ 0,
1 + β θ∫14

where H is a distribution function for θ’.
Thusθ T −1 >θ T .
We can therefore argue as follows:− −− > θ T −3 > θ T −2 > θ T −1 >θ T .

Proposition 3: The longer the investment period, the higher the country risk level
required to generate a yes decision.

We shall now examine the issue of preferential tax treatment.

Proposition 4: Preferential tax treatment (i.e., lower rates of corporate tax t 2 ) generates
a yes decision in the face of high country risk θ T −1 at period T-1.

This can be demonstrated quite readily as shown below.
∞π1θ T −1 =(rk 2 + wA 2 + d ) + {β /(1 + β )}∫ (θ '−θ ) dH (θ ) .
PF
1 − t2θAnd so∂ θ T −1
πd
=
>0 .
∂ t2
PF (1 − t 2 ) 2That is, a company faces two thresholds in the decision to expand overseas, bothof which must be satisfied to generate a yes decision. One is the cost threshold,15

appreciated exchange rate and increased wage level of the investing countries. The otheris country risk, determined by political stability, public security and macroeconomic
stability. In addition, preferential tax treatment provided by developing countries makes
a critical contribution towards passing the two thresholds.

(3) East Asian Model
Let us now develop a general model with respect to three considerations.
The first is preliminary survey costs associated with overseas investment, denoted
as C. The costs are burdened by profits in the domestic or overseas production.
Information has to be obtained from abroad and investing firms use to dispatch study
missions abroad. These costs are very high as for Japanese companies, which tend to
take longer time to decide overseas production.
Next is the possibility that changes in the candidate country render the planned
expansion unfeasible in the event that overseas production has been postponed until thefollowing period. One example of this is the bottleneck caused by rapid economic
growth in Thailand and Malaysia in the late 1980s and early 1990s. As infrastructure
inadequacies in Thailand and labor shortages in Malaysia became evident, companies
were forced to abandon earlier plans for expansion. The probability of suchcircumstances arising is denoted as x. Here we can assume that the probability (x) toabandon a plan for overseas production becomes lower as we increase survey costs (C).
That is, ∂x/∂C < 0.
Lastly, we have the possibility that a company with overseas operations is forced
to revert to domestic production (or move to a different country) when operations

16

become untenable. This was witnessed in Singapore, Taiwan, South Korea and other
Asian NIEs. For instance, a number of foreign companies attracted to the Julon
Industrial Park in Singapore in the late 1970s were subsequently obliged to pull out oflabor-intensive industries, unable to maintain production under the three-year wage
doubling policy brought in during the early 1980s. The probability of such an outcome
is denoted as δ .
The three variables in the model are thus: preliminary survey costs C ; theprobability x of overseas production being rendered unfeasible sometime between thecurrent period and the next; and the probability δ of overseas operations establishedduring the current period becoming untenable in the next.
The value function for period T is
VT ( θ , θ c , C , s ) ,where θrepresents country risk in the country under consideration (thereciprocal of country risk); θ C , country risk in a second candidate country; C ,preliminary survey costs; and s , either domestic production D or overseas productionS.
The Bellman equation in this case is:VT(θc,θ,C,D) = max {πf – C, πd –C}.
As before

θT =

1 πd
(
+ wA + rk ) .
PF 1 − tNote that profits from production in the second candidate country at productivity

θ c are assumed to be below profits π f from the primary country under consideration.

17

In period T − 1:
VT-1(θc,θ,C,D) = max {A, B}.
Here,
A = π f − C + β [ δ EVT (θ ', θ c', C , D) + (1 − δ ) EVT ( θ ', θ c', C , F )] ,B = π d − C + β [ x (c) EVT (θ ,θ c ' , C , D)+ (1 − x(c)) EVT (θ ' , θ c ' , C , D)] ,∂ x/∂ C <0 .
Where B is calculated as follows. During period T − 1, production is carried out
at home and prior survey costs C are incurred, so B = π d − C .

With x as theprobability that overseas production in period T becomes underside, the total expectedvalue B for period T is obtained by summing expected values xEVT(θ,θc’,C,D)and (1-x)EVT(θ’,θc’,C,D) and discounting the total at a factor of β.
A is calculated as follows. Due to overseas production and prior survey costs C

during period T − 1, the value is π f − C . With δ as the probability that overall
operations become untenable during period T , at the point when overseas expansion isconsidered for the second time, the expected value isδ EVT (θ ' , θ c', C , D) .
The expected value when overseas production continues and expansion into asecond country is also being considered is given by(1 − δ ) EVT (θ , θ c', C , F ) ,where A is the total sum of the above three expressions. Thus:⎡ A,θ ≥θ T −1.
VT −1 (θ ,θ c ' ,C , D)=⎢
B
,
θ
θ
≤
T −1
⎣

18

The threshold value at this time isθ T −1 =β (1 − x − δ )1 πd+ wA + rk ) +((Z − Z c ) ,PF 1 − t
PF (1 − t )

where
∞

Z = (1 − t ) PF (k , A) ∫ (θ '−θ T )dH (θ ' ),θ0∞

Z = (1 − t 2 ) PF (k 2 , A 2 ) ∫ (θ '−θ Tc )dH c (θ ' ) .
c

θ0

C

Since Z c ≥ 0 and Z ≥ 0 at all times, the above may be rewritten as follows:∂ (θ T −1 − θ T ) β (1 − x (C ) − δ )Z c
=
≥0 .
∂t
PF (k , A)
Reduced corporate tax rates therefore provide incentive for multinational
companies to set up overseas operations, and preferential treatment is also effective if
the following condition holds. That is,
1 − x (C ) − δ >0 .

We showed that the smaller x(C) is, the more the chance to satisfy necessary
conditions. This is the case where overseas expansion is being investigated during thecurrent period with a view to implementation in the next period under the same set of
conditions. At the same time, efforts must be made to boost survey costs ( C ) to reduce
x(C). We can conclude that whether preferential tax treatment is effective in inviting
foreign direct investment depends on value x (C).

Preferential tax treatment iseffective under a condition of smaller values of x (C).
Let us now consider the case where a second candidate country introduces

19preferential tax treatment in competition with the first. This was witnessed in East Asia
during the 1990s, as countries such as Indonesia and the Philippines deregulated incompetition with one another. In this case∂ θ T −1 β (1 − x − δ )Z
.
=
∂ t2
1− t
Thus, the introduction of preferential treatment by a second country facilitates
overseas expansion. For instance, a multinational company considering setting up
operations in Vietnam benefits when Indonesia and the Philippines introduce
preferential tax measures. Insufficient infrastructure and laws (θ ) in Vietnam would
still not render expansion unviable. In this way, foreign capital is dispersed evenly
throughout East Asia. Deregulation and preferential treatment in other regions (namely
Southeast Asia) therefore serve to facilitate the inflow of foreign capital, which leads tothe following:

Proposition 5: Whether foreign direct investment by a multinational company in a
candidate country will be more unlikely depends on value x (C) when preferential tax
treatment is introduced in other countries. The more unlikely a multinational company
invests in the country the higher the probability of overseas production being rendered
unfeasible sometime between the current period and the next period becomes.

This paper focused especially on capacity building with respect to the flowchart
approach to industrial cluster policy. Among several factors of capacity building, thepaper examined the effectiveness of policies on institutions such as tax incentives in20

forming an industrial cluster.
Kuchiki and Tsuji (2005) proves that the implementation of governmental policies
has positive effect on inviting foreign capital and forming the industrial cluster in Hanoi,
Vietnam and Guadalajara, Mexico, as Table 2 shows. Similarly, “tax incentives forinvestment” has a positive effect in China and Vietnam, where 17.4% and 14.1% of theinterviewed companies, respectively, has picked it up as one of the reasons to invest, as
Table 3 shows. In Vietnam, 20.0% of the interviewed companies had admitted “stable
political and social conditions” as one of the reasons to invest in that country. The
paper examined theoretically these facts.

5. Conclusions
On one side, developing countries in East Asia in the latter half of the 1980s
established export processing zones with sufficient infrastructure to attract multinational
companies to invest by carrying out deregulation geared towards foreign investment,
authorizing export-oriented sectors as picking winners, and granting preferential tax
treatment. On the other hand, multinational companies especially of South Korea,
Japan, and Taiwan, where domestic wages were rising due to their tight labor markets,were forced to invest in other countries to reduce their costs. Their investment was
further increased by the appreciated exchange rates, which made the domestic wages
higher in dollar terms.

So that EPZs in developing countries in East Asia wereeffective in inviting the multinational companies.
This paper theoretically proved that policies of both devaluations of currency
exchange rate and preferential tax treatment were effective in inviting foreign direct21

investment to countries in East Asia in the 1980s. Our static model showed that a
multinational company in industry of diminishing returns to scale would increase
production in a developing country if its exchange rates to the developing country isappreciated. Our dynamic model also showed that the longer its investment period
becomes the more the exchange rate had to be appreciated for the multinational
company to invest in the developing country. The dynamic model made clear that thelonger the investment period became the less the country risk of the developing country
had to be. However, we showed that its high country risk in the developing country
could be compensated by reducing the corporate tax rate of the developing country. A
more realistic model of countries in the East Asia in the latter half of the 1980s
confirmed this conclusion.

That is, preferential treatment of tax reductions or

exemptions by the developing countries was effective in inviting foreign direct
investment. Our above models implies that roles of central governments are crucial for
inviting foreign direct investment to form industrial clusters by building capacity. Thatis, roles of central governments in developing countries or receipient countries tosupport the industrial cluster policy are to depreciate the exchange rates, to lower the
corporate tax rates, and to stabilize the macroeconomic condition.

22

Appendix 1.
This Appendix discusses the underlying motivation for direct investment, as
revealed in questionnaire surveys on direct foreign investment by Japanese companies.
When wages in receipent countries were low, the major incentive for multinational
companies was a cheap labor: over 70% of companies investing in Thailand (1985) andChina (1990) named low wages as the reason for investment. At the same time, thegrowth in domestic markets in Asian NIEs and ASEAN countries prompted morecompanies (over 70% in 1993) to set up overseas operations in anticipation of risingdemand levels in those countries.
It is clear, then, that direct investment by Japan was motivated by the cost factor in
the 1980s. Let us now examine the correlation between the Japanese direct investment
and the wages. Wage levels and exchange rates are the major considerations whencomparing costs in terms of labor wages. Fluctuations in the exchange rate played aparticularly important role in direct investment of South Korea, Taiwan and Japan into
other Asian countries during the latter half of the 1980s.
We regressed the correlation between wage level indices for South Korea, Taiwan
and Japan (converted into dollars) and the approved value of foreign direct investment
by each country over the period 1981-1991. The findings are shown below.

Direct investment by South Korea = -5.56 + 3.61 (South Korean wages)(-2.78) (9.11)
Adjusted

R 2 = 0. 89 , D − W = 1. 87

23

Direct investment by Taiwan = -21.8 + 6.59 (Taiwan wages)(-4.41) (6.74)
Adjusted

R 2 = 0. 82 , D − W = 1. 05

Direct investment by Japan = -5.09 + 2.98 (Japanese wages)(-3.00) (8.87)
Adjusted

R 2 = 0. 89 , D − W = 1. 30

Variables have been converted into logarithmic form; manufacturing wages in eachcountry are given in dollar terms with the 1980 level equal to 100.
A high correlation was achieved in all three cases and the coefficients weresignificant with respect to t value. Of particular interest is the similarity between wage
elasticity in South Korea (3.61) and Japan (2.98). Taiwan is close to double the figure,indicating that reaction to cost is twice as great as in Japan and South Korea.
The value of the South Korean, Taiwanese and Japanese currencies all rose
against the dollar following the Plaza Accord in 1986, and wage levels rose likewise.
This led to the threshold mentioned in section 3 and a sharp increase in the level offoreign direct investment from 1987 onwards.

24

<References>

Devereux, J. and L. L. Chen, “Export Zones and Welfare,” Oxford Economic Papers,
No.47, pp.407-713, 1995.
Hymer, S.H., The International Operations of National Firms, Cambridge, MA, MIT
Press, 1960.
Kuchiki, A., “Agglomeration of Exporting Firms in Industrial Zones in Northern
Vietnam,” Kagami, M. and M. Tsuji eds., Industrial Agglomeration, Institute ofDeveloping Economies – JETRO, 2003.
Kuchiki, “A Flowchart Approach to Asia’s Industrial Cluster Policy,” Kuchiki, A. and
M. Tsuji, eds., Industrial Clusters in Asia, Institute of Developing Economies JETRO, A.,2004.
Kuchiki, A., “Theory of the Flowchart Approach to Industrial Cluster Policy,” Kuchiki,
A. and M. Tsuji, eds., Flowchart Approach to Indstrial Cluster Policy in Asia,
Institute of Developing Economies - JETRO, 2005.
Kuchiki, A. and M. Tsuji, eds., Flowchart Approach to Industrial Cluster Policy in Asia,
Institute of Developing Economies - JETRO, Tokyo, 2005.
Penrose, E.T., "Foreign Investment and the Growth of the Firm," Economic Journal,Vol., June, pp. 220-235, 1956.
Sargent,

Dynamic Macroeconomic Theory,

Cambridge, MA, Harvard University

Press, 1987.
Stiglitz J. E. and S. Yusuf eds. 2001, Rethinking the East Asian Miracle, New York:
Oxford University Press for the World Bank.
The World Bank, The East Asian Miracle, Oxford University Press, 1993.

25

Figure 1. An Industrial Cluster Formed by an Anchor Firm

market with saucers
domestic

exportIndustrial zone（a） industrial zone

export processing zone

1. Quasi-public goods（b）capacity building
１．Infrastructure
２．Institutions
３．Human resources
４．Ｌｉｖｉｎｇ conditions

1. Quasi-public goods
Market（c）anchor firm

2. Increasing returns to scale(Productin function)
Fixed capital(d）related firms

3. Economies of scale(Cost function)industrial cluster
Regional economic growth
Source : Author.

26

Figure 2. Threshold of Exchange Rate
(1 − t )( PF − rk ) ≥ π d− (1 − t) wl

πdOverseas
Production

Domestic
Production

e

0

eT =

π
1
( PF − rk − d )wl
1− tSource : Author.

27

Figure 3. Threshold of Country Risk

πfπdOverseas Production

Domestic Production0θT(1-t)PF

Source : Author.

28

θTable 1. Roles of Actors on the Flowchart Approach
ACTORS
Shortage 1
2
3
4
Industrial Zone
Capacity

5

Infrastructure
Institutions

XXX

Human Resources
Living Conditions
Anchor company
Related companies
1. Private companies, 2. Multinational corporations, 3. Foreign assistance
4. Local governments, 5. Central government (The flowchart approach : ordering and timing policies.)
Source :Author.

29

Table 2.

Capacity Building and Industrial Cluster characterized by the Anchor Firms

Country

JAPAN

INDIA

MEXICO

CHINA

CHINA

VIETNAM

City /Prefecture

Okinawa

Bangalore

Guadalajara

Shanghai

Tianjin

Hanoi

Type of Industry

Call Center

Software

Electronic

Automobile

Automobile

Printer* MetalIndustry,
components* Existenceof Daihatsu

Capacity(a) Human Resources* Japanese
speaking HR* College andgraduate
Students(b) Infrastructure(c) Institution* Support on
Communication
system* Support by
the Chamberof Commerce

Governmental
support* NAFTA(d) Living condition

Good climate

Notes

Initial condition* Nationalroads andports
rehabilitation

Positive policy
effectivenessof the central
government* One-stop
service

Positive policy
effectivenessof the central
government* Tax System

Good climate

Initial condition

Anchor Firm

GM, Ford

ToyotaCanon

Automobile /Electronics

Conclusion: 1. Institutional support has a positive effect on industrial cluster formation.
2. There is no need of anchor firms for industries other than automobile, which requires a great number ofcomponents.
3. There are cases where initial condition is decisive.
There are some cases where industrial cluster policy is not effective (not always).
Source: Kuchiki, A. and M. Tsuji eds., Comparison of Industrial Agglomerations between Asia and the Other Regions , IDE-JETRO, 2005

30

Table 3.

Promising Countries for Oversears Business Operations : Reasons of promising prospects for the top ten countries

：

China

ThailandU.S

VietnamIndia(447companies)(141companies)(103companies)(85companies)(69companies)

82.3%
19.7%
7.8%
24.2%
74.9%
34.2%
28.6%
14.3%
4.5%
22.4%
21.9%
9.4%
17.4%
4.5%
1.3%
4.0%

51.1%
17.0%
6.4%
18.4%
57.4%
11.3%
34.0%
21.3%
12.8%
19.9%
29.8%
23.4%
24.8%
14.9%
9.2%
34.0%

48.5%
61.2%
16.5%
24.3%
1.9%
1.0%
26.2%
19.4%
4.9%
0.0%
3.9%
35.9%
2.9%
5.8%
0.0%
37.9%

Potential for growth as a market

Sales

Present local market size
Product development tailored to the local needs
Excellent Human resources
Inexpensive labor force
Law-cost parts and raw materials

Production

Supply base for final assembly manufacturers
Industrial concentration(concentration of sources, buyers and partners)
For a risk diversification
Base for exports to japan
Bases for exports to third coountries
Local infrastructure (electric power, communications, transport etc) is well developed

Infrastructureand systems

Tax incentives for investment
Policies to attract foreign capital are stable
Progress towards regional integration( reduction of tariffs)
Stable political and social conditions

Indonesia

Korea

Taiwan

Malaysia

Russia(42companies)(33companies)(30companies)(25companies)

56.5%
17.7%
3.2%
4.8%
67.7%
12.9%
27.4%
11.3%
8.1%
14.5%
27.4%
6.5%
6.5%
3.2%
9.7%
0.0%

Present local market size
Product development tailored to the local needs
Excellent Human resources
Inexpensive labor force
Law-cost parts and raw materials

Production

Supply base for final assembly manufacturers
Industrial concentration(concentration of sources, buyers and partners)
For a risk diversification
Base for exports to japan
Bases for exports to third coountries
Local infrastructure (electric power, communications, transport etc) is well developed

Infrastructureand systems

76.8%
18.8%
2.9%
30.4%
59.4%
14.5%
24.6%
2.9%
4.3%
10.1%
17.4%
2.9%
4.3%
1.4%
1.4%
1.4%

(62companies)
Potential for growth as a market

Sales

41.2%
5.9%
1.2%
35.3%
74.1%
12.9%
14.1%
2.4%
31.8%
24.7%
21.2%
4.7%
14.1%
7.1%
2.4%
20.0%

Tax incentives for investment
Policies to attract foreign capital are stable
Progress towards regional integration( reduction of tariffs)
Stable political and social conditions

66.7%
40.5%
9.5%
21.4%
7.1%
7.1%
4.8%
19.0%
7.1%
2.4%
9.5%
35.7%
4.8%
7.1%
0.0%
11.9%

30.3%
57.6%
6.1%
18.2%
3.0%
6.1%
15.2%
24.2%
6.1%
3.0%
18.2%
18.2%
6.1%
3.0%
0.0%
18.2%

30.0%
6.7%
6.7%
16.7%
40.0%
13.3%
23.3%
3.3%
23.3%
23.3%
13.3%
26.7%
23.3%
23.3%
6.7%
33.3%

92.0%
16.0%
0.0%
4.0%
8.0%
4.0%
4.0%
4.0%
4.0%
0.0%
0.0%
4.0%
0.0%
0.0%
0.0%
0.0%

Notes: (1) Figures in parentheses under each country name shows the number of respondent companies.
(2) The table represents the share with respect to the total respondent companies of each country.
Source: Survey Report on Overseas Business Operations by Japanese Manufacturing Companies , JBIC Institute, Japan Bank for International Cooperation, 200431