Silviase/jgov_v1.4_full_ann huggingface dataset:
one finds that the shortage of skilled labor is the most serious problem, as it received the highest frequency of the responses. Specifically, one out of three SMEs indicated the presence of labor shortage problem. The fact that a greater proportion of SMEs suffer from the labor shortage problem than large firms reflects a common observation that SMEs face a greater difficulty in attracting labor compared to large firms, possibly because of their less attractive working conditions. Coupled with an earlier finding that a main motive behind FDI by SMEs was to utilize local labor, this finding indicates that a large proportion of SMEs have not fulfilled their objective of undertaking FDI.

The problem of underdevelopment of supporting industries was indicated by approximately 25 percent of SMEs. Among the manufacturing sub-sectors, machinery and metal producing sectors, which use a number of parts and components, tend to suffer from the lack of supporting industries.

Insufficient infrastructure and high inflation are regarded as the problems by approximately one-fifth of the SMEs. Availability of good infrastructure, whose main components include the provision of transportation and communication services as well as electricity generation, plays an important role in the determination of economic performance of the firms. In spite of the recognition of this point, a number of developing countries have difficulty solving the problem of insufficient infrastructure mainly because of a lack of financial resources. This problem is felt more strongly by SMEs than large firms. One explanation for this difference is that large firms, having greater financial resources, can avoid the problem that stems from the lack of sufficient infrastructure by constructing its own, while limited financial resources makes it difficult for SMEs to do so. High inflation poses a problem to the firms, as it increases the cost of production and the uncertainty regarding business environment.

Turning to the problems associated with the regulations on FDI, one finds that approximately 10 percent of SMEs experienced the import restrictions on materials and parts, and export requirements of their products. Among the manufacturing sub-sectors, a relatively high response rate was reported for the Asian affiliates in transport machinery. This apparently reflects the restrictive FDI policies adopted for the transport machinery sector in some Asian countries, in order to promote local automobile producers.
### V. The Determinants of FDI Locations by Japanese SMEs

The examination of the motives of FDI by Japanese SMEs and the problems they face in their overseas operation in the previous sections revealed some important factors that attract FDI by Japanese SMEs. Some of the important factors that would attract FDI by Japanese SMEs include the availability of labor, presence of a large local market, macroeconomic stability, availability of infrastructure and supporting industries, and investor friendly FDI policies. In this section the importance of these factors is examined in detail by the use of a statistical analysis. Before conducting the analysis, a brief review of previous studies is in order. As noted in the introduction, a major purpose of this paper is to shed light on the impact of the firm size on Japanese firms' decision of FDI locations. Although none of the previous studies examined the differences in the decision making of FDI location by Japanese firms of different sizes, a review of previous studies should prove useful in analyzing our results to be given below.

#### V. 1. Previous Studies

Several recent studies examined the determinants of the location of Japanese FDI by considering the characteristics of the host countries under the framework of the conditional logit model. Fukao and Chung (1996) and Wakasugi (1997) examined the determinants of Japanese manufacturing FDI, and Tokunaga and Ishii (1995), and Fukao and Yue (1997) examined the determinants of FDI by Japanese electronics firms. As an indicator of firm's decision on FDI, Fukao and Chung, and Wakasugi used the number of FDI cases by industry, reported to the Ministry of Finance, while Tokunaga and Ishii, and Fukao and Yue used the number of FDI cases by Japanese electronics firms, compiled from firm-level data sets. Fukao and Chung, and Fukao and Yue analyzed the determinants of Japanese FDI at global level, while Tokunaga and Ishii, and Wakasugi examined the determinants at regional (East Asia) level, in addition to their analysis at global level.

There are some variations in their findings, but major common findings include the following. In the global location analysis, high wages are found to discourage Japanese FDI, while the presence of large local market attracts Japanese FDI. However, these relationships are
not strong for the regional location analysis. The availability of infrastructure was found to attract Japanese FDI in the global FDI decision, but it was not important in the local FDI decision. Industry agglomeration was shown to be an important element for attracting Japanese FDI, probably indicating the importance of supporting industries in the decision making of Japanese FDI. Fukao and Chung found that low country risk attracts Japanese manufacturing FDI. $ ^{8} $

### V. 2 The Model and the Hypotheses on the Determinants of FDI Location

## (1) The Model $ ^{9} $

To model the location of Japanese FDI, we assume that Japanese firms undertake FDI in a country where they can maximize their profits after evaluating relevant characteristics of alternative locations. Let us describe the profit ( $ \pi $ ) of firm i obtained from undertaking FDI in country j as (1).

$$ \pi_{ij}=a_{0}X_{1j}^{a_{1}}\cdots X_{mj}^{a_{m}}\cdot e^{u_{ij}} $$

where a's are unknown parameters, $ X_{sj} $ ( $ s=1,\ldots,m $ ) are variables describing the characteristics of country j ( $ j=1,\ldots,n $ ), and $ u_{ij} $ is a random disturbance term.

Given profit equation (1) and assuming that $ u_{ij} $ are independently and identically distributed with Weibull density functions, then we obtain that the probability of undertaking FDI in country j is given by equation (2). (McFadden: 1973)

$$ P_{_{ij}}=\frac{\exp(\sum_{s=1}^{m}a_{_{s}}\ln X_{_{sj}})}{\sum_{j=1}^{n}\exp(\sum_{s=1}^{m}a_{_{s}}\ln X_{_{sj}})} $$

Expressing the number of FDI selections made by Japanese firm i in country j as $ W_{ij} $ ( $ j=1,\ldots,n $ ), we obtain the probability of observing such FDI pattern as equation (3).

$$ L=\prod_{i}\prod_{j=1}^{n}P_{ij}^{Wij} $$

This type of model is called the conditional logit model, and the parameters (a's), which indicate the characteristics of potential host countries to Japanese FDI, are estimated by the
maximum likelihood estimation method, which maximizes the likelihood function (3).

## (2) The Hypotheses

Taking account of the result of the survey discussed above and the results of the previous studies, we undertake a statistical analysis of the determinants of the location of Japanese FDI. In addition to a similar analysis carried out by the previous studies, which only dealt with the characteristics of the host countries of FDI, we carry out an analysis by examining explicitly the effect of the firm size on their decision of FDI location. As to the characteristics of the host countries, we examine the effects of the following variables on Japanese FDI, exchange rate, exchange rate volatility, wage rate, market size, macroeconomic stability, labor quality, infrastructure, agglomeration (cumulative FDI cases by Japanese firms), and governance. In the remaining of this section we first discuss the hypotheses on the determinants of Japanese FDI location and the expected signs of the estimated coefficients on explanatory variables, and then discuss the estimated results. $ ^{10} $

The exchange rate is an important determinant of FDI location for several reasons. First, a country whose currency depreciates is likely to attract FDI, as the depreciation makes it easier for foreign firms with foreign currency denominated assets to invest in that country by appreciating the value of the assets in terms of depreciating currency. Second, for the firms interested in export production, depreciation of the currency of a host country increases the attractiveness of that country as a host to FDI, because the depreciation tends to improve export competitiveness of the products produced in that country. Following these observations, we expect that the exchange rate of the host country (denoted by EXR), which is constructed in such a way that depreciation results in the increase in its value, to be positive.

Large fluctuations in the exchange rate tend to discourage FDI inflow, as they increase uncertainty associated with economic environment of the host country. Several studies have found the inhibiting effect of exchange rate volatility on foreign trade. $ ^{[11]} $ But there have not
been any studies that examined the effect of exchange volatility on FDI. Following the discussions above, we expect the estimated coefficient on exchange rate volatility (EXRV) to be negative.

One of the important motives of Japanese manufacturing FDI is to utilize low-wage local labor, and therefore the expected sign of the wage variable (WAGE) in negative. Based on the result of the MITI survey discussed above that shows the importance of local sales motive behind Japanese FDI, the coefficient on the market size, here proxied by purchasing power parity adjusted GDP (GDP), is expected to be positive. A number of Japanese firms in the MITI survey noted that inflation is one of the problems they face in overseas operation. Accordingly, we include the consumer price index as an indicator of inflation (CPI) in our analysis to test the statistical validity of this observation. The expected impact of inflation is negative.

Shortage of skilled labor was found to be a serious problem for Japanese firms operating overseas in the MITI survey. One would therefore expect that Japanese FDI would be attracted to an economy where high quality labor is available. Given the difficulty in measuring the quality of labor, we use the secondary education enrollment ratio (EDU) as a proxy for skilled labor. Based on the discussion above, the expected sign of the estimated coefficient on EDU is positive. Infrastructure plays an important role for attracting FDI. Various indicators such as the availability of transportation and communications facilities may be used for the measurement of infrastructure. Among these indicators, we use the level of electricity generation per person (ELEC) as a proxy for infrastructure, because most Japanese manufacturing firms regard the availability of electricity as a key factor for producing high quality products. We expect the coefficient on electricity to be positive. It should be added that electricity generation and other indicators of infrastructure are highly correlated.

Agglomeration of Japanese FDI would attract new Japanese FDI for several reasons. A potential Japanese investor would think that an economy where a substantial number of Japanese FDI already exist to be a safe and suitable place for investment. Investing Japanese firms may also expect abundant business opportunities with Japanese firms, with whom they feel most comfortable to do business. We measure the extent of agglomeration by the number of cumulative FDI cases by Japanese firms (FDI), and we expect the estimated coefficient to be
positive.

Governance capability of the host government has an important impact on the decision of FDI for several reasons. First, in spite of recent liberalization in the FDI regime in many economies, FDI is still subject to various government regulations. Second, investing firms are concerned with the security of their FDI, as FDI involves substantial commitment in the forms of financial and human resources. We measure the quality of governance capability by incorporating the following five indicators: government repudiation of contracts, risk of expropriation, corruption, law and order tradition, and bureaucratic quality. Government repudiation of contracts and risk of expropriation are indicators of government credibility. $ ^{12} $ Law and order tradition, and government repudiation of contracts measure the presence or absence of peaceful mechanisms for adjudicating disputes, and therefore they may be interpreted as proxies for the security of property and contract rights. Corruption and bureaucratic quality are considered as proxies for the efficiency of the government in providing public services. In addition, they appear to have implications on the degree of uncertainty regarding the credibility of government commitments.

In order to derive an explanatory variable, which captures the essential properties of these five indicators, we carry out a factor analysis. From the analysis, we obtain the first principal component, which is constructed as a weighted average of the five indicators with more or less similar weight. As the governance variable (GOV) is constructed in such a way that high value indicates high quality of governance, we expect the estimated coefficient to be positive.

Based on our earlier findings of substantial differences in the motives and problems associated with FDI between SMEs and large firms, we would expect the differences in the degrees of sensitivity in FDI decision making to the local conditions in the host countries between them. To test this hypothesis, we included dummy variables representing SMEs for all the explanatory variables. Being more constrained by financial and human resources, and generally relying more on overseas production, compared to large firms, SMEs are expected to be more
sensitive to the conditions in the host countries in selecting FDI location. As such, we would expect the absolute size of the estimated coefficients be larger for SMEs, compared to that for large firms. One exception may be the coefficient on the size of host market (GDP), which is expected to be greater for large firms than SMEs. This is because large firms attach a greater importance to local sales, compared to SMEs.

#### V. 3. Empirical Results: An Application of the Conditional Logit Model

To examine the importance of the characteristics of host countries in the decision making of FDI location by Japanese firms, we estimated the determinants of Japanese FDI by using the conditional logit model. $ ^{13} $ In the estimation, we consider 117 countries as possible sites for Japanese FDI. The choice of 117 countries depended on their importance as a host to Japanese FDI and the availability of necessary data for the estimation. In addition, we performed analyses on the subsets of these countries, developed and developing countries, and Asian countries. The analysis was conducted for four manufacturing sub-sectors, textiles, general machinery, electric machinery, but transport machinery, which account for a dominant share of Japanese FDI. In order to see if small and medium sized firms have different patterns of decision making on the location of their FDI than large firms, we added an SME dummy in the analysis.

The results of the estimation are shown in Table 7. The estimated coefficients of the exchange rate (EXR) are shown to have mixed signs. EXR is positive for textiles and transport machinery, as expected, but it is statistically significant only for textiles. According to these findings, exchange rate does not necessarily play an important role in the determination of the location of Japanese FDI. Exchange rate volatility (EXRV) has a negative impact on attracting Japanese FDI in electric machinery, and transport machinery, as expected. FDI discouraging effect is particularly strong for FDI in developing countries in Asia.

The estimated coefficients of the wage rate (WAGE) are negative for all the industries, as expected, and all of them are statistically significant. It is important to note that WAGE has a strongly negative impact on Japanese FDI in developing countries and in Asian countries. These
results, which indicate that Japanese firms select a country with low-wage labor as a site for their investment, are consistent with an earlier observation from the MITI survey that the use of local labor is one of the important motives of undertaking FDI by Japanese firms in Asia. The results on SME dummy variables show that SMEs are more sensitive to wage rates than large firms in the three machinery sectors. Suffering from a labor shortage more acutely than large firms, SMEs put a greater significance to the availability of low-wage labor in selecting a site for their FDI.

Market size (GDP) has an expected positive sign in all the industries and they are statistically significant. Market size is a particularly important characteristic to attract Japanese FDI in developed countries. This is particularly the case for large firms. By contrast, for Japanese FDI in developing countries the coefficients on GDP turn out to be negative for the three machinery sectors. These findings appear to show that Japanese firms undertake FDI in developing countries to produce products not for local market but for exports. The estimated coefficients on inflation (CPI) are mostly negative, as expected, but only a few coefficients are statistically significant. Relatively speaking, inflation plays a discouraging role for the determination of Japanese FDI in developing countries.

The availability of skilled labor (EDU), expressed by the secondary school enrollment ratio, has an unexpected negative impact on Japanese FDI in most cases. A comparison of the results covering developed countries and developing countries brings out an interesting contrast that EDU has an importantly positive impact on Japanese FDI in developed countries but not in developing countries. This finding indicates that Japanese firms investing in developed countries give importance to the availability of highly educated population while those investing in developing countries are interested in using low-skilled, low-wage labor. The combination of different motives regarding the use of local labor by Japanese firms in developed countries and those in developing countries are reflected in these contrasting results.

Capability of generating electricity (ELEC) is shown to be an important factor in attracting FDI, since the estimated coefficients on ELEC are positive and statistically significant in many cases. This finding indicates that the availability of well-developed infrastructure is important for attracting Japanese FDI. As expected, ELEC has a significant impact on the FDI.
decision making of the locations among developing countries. The estimated SME dummy coefficients are positive in all sectors, and they are statistically significant in textiles, general machinery and electric machinery, indicating that the availability of electricity is particularly important for SMEs in making their selection of FDI sites. Richly endowed with financial resources, large firms can deal with the problem resulting from the lack of electricity by building their own power generating facilities. However, SMEs with limited resources have to depend on the local facilities for the supply of electricity, thus more sensitive to the local capability of generating electricity.

The estimated coefficients on agglomeration (CFDI) are positive and significant in all the industries except in the case of textiles in developed countries. This observation indicates the importance of inter-firm relations for Japanese firms in the forms of inter-firm transactions and information exchange. In general machinery, electric machinery, and transport machinery, agglomeration has a greater impact on SMEs compared to large firms, especially in their selection of FDI sites in developing countries. These findings may indicate the importance of supporting industries in machinery sectors, as they require a large number of reliable parts and components in their production, a large part of which are supplied by other Japanese firms in the region. This observation is consistent with the result of the MITI survey indicating the lack of supporting industries as one of the problems in operating in Asia.

Governance (GOV) has an expected positive coefficient with statistical significance in all the industries, supporting the validity of the observation that good governance of the host government promotes Japanese FDI. Governance is especially important for Japanese firms interested in investing in developing countries. Compared to large firms, SMEs in electric machinery and transport machinery put greater emphasis on governance when they invest in developing countries.

### V I. Conclusions

The empirical results of the determinants of FDI location by Japanese firms show that both supply-side and demand-side factors in the host countries are important determinants. Supply-side factors include abundance of low-wage labor, availability of good infrastructure and
good governance, while an important demand-side factor is the presence of sizable local market. Industrial agglomeration, which has both supply-side and demand-side elements, has an important influence on the decision making by Japanese firms.

Supply-side factors including abundance of low-wage labor, availability of good infrastructure, and good governance are important factors in attracting Japanese FDI in developing countries, while a demand-side factor, large local market is an important factor for Japanese FDI in developed countries. These different patterns reflect the differences in the motive of Japanese FDI and the level of economic development in these two groups of host countries. For Japanese firms investing in developing countries, especially those in developing Asia, export production is an important motive, while for those investing in developed countries local sales is a major motive. Japanese firms interested in export production place importance to production conditions, while those interested in local sales are naturally concerned with the size of local market. The importance attached to the availability of good infrastructure and good governance by Japanese firms interested in investing in developing countries is due to poor infrastructure in developing countries, which in turn is attributable to low level of economic development.

Industrial agglomeration, here indicated by the cumulative FDI by Japanese firms, is shown to be an important element for attracting Japanese FDI both in developed and developing countries. This finding indicates the importance of inter-firm relationship among Japanese firms not only for the procurement of parts and components but also for the sales of their products. Although close inter-firm relationship may be justified on the ground of increasing technical efficiency for Japanese firms, it may not be accepted favorably by the host country if such relationship discriminates against the local firms.

Japanese firms are shown to be risk-averse, as they are discouraged to invest in a country with high economic risks represented by high exchange risk volatility and high inflation. We may also add a political risk expressed by "governance" as an important factor in the determination of the location of FDI by Japanese firms.

A comparison of the results obtained for SMEs with those for large firms reveals that SMEs are more sensitive to local conditions in making their decision on FDI, especially when they make investments in developing countries. Specifically, SMEs regard the availability of low-