Silviase/jgov_v1.4_full_ann huggingface dataset:
# THE ECONOMIC ANALYSIS

No.1 5 8

May 1999

Economic Research Institute

Economic Planning Agency

Tokyo, Japan

## The Determinants of the Location of Foreign Direct Investment by Japanese Small and Medium-sized Enterprises

## Contents

Abstract ..... 3
I. Introduction ..... 4
II. Recent Trends of Foreign Direct Investment by Japanese SMEs ..... 5
II.1. Rapid Expansion in the 1980s and Subsequent Slowdown in the 1990s ..... 5
II.2. Foreign Direct Investment in Asia by Japanese SMEs ..... 7
III. Motives Behind Japanese FDI in Asia ..... 10
IV. The Problems Encountered by Japanese Firms in Asia ..... 12
V. The Determinants of FDI Locations by Japanese SMEs ..... 14
V.1. Previous Studies ..... 14
V.2. The Model and the Hypotheses on the Determinants of FDI Location ..... 15
(1) The Model ..... 15
(2) The Hypotheses ..... 16
V.3. Empirical Results: An Application of the Conditional Logit Model ..... 19
VI. Conclusions ..... 21
References ..... 24

List of Figures, Tables and Appendix Tables

Figure 1 Foreign Direct Investment by Japanese SMEs ___26
Table 1 Regional Distribution of FDI by Japanese SMEs ___27
Table 2 Country Distribution of FDI by Japanese SMEs in Asia ___28
Table 3 Sectoral Distribution of FDI by Japanese SMEs: World ___29
Table 4 Sectoral Distribution of FDI by Japanese SMEs: Asia ___30
Table 5 Motives Behind Japanese Manufacturing FDI: 1992
A. All Regions ___31
B. Asia ___32
Table 6 Problems Faced by Japanese Manufacturing Firms: 1992
A. All Regions ___33
B. Asia ___34
Table 7 Locational Determinants of Japanese FDI(1980-94)
1. Textiles ___35
2. General Machinery ___36
3. Electric Machinery ___37
4. Transport Machinery ___38
Appendix Table 1 Summary Statistics for Explanatory Variables ___39
Appendix Table 2 The List of Countries Used in the Analysis ___40
# The Determinants of the Location of Foreign Direct Investment by Japanese Small and Medium-sized Enterprises

Shujiro Urata $ ^{*} $

and

Hiroki Kawai $ ^{**} $

May 1999
## Abstract

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. 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-wage labor, well-developed infrastructure, and industrial agglomeration much more importantly than large firms. Greater sensitivity of SMEs to local economic conditions in their decision making concerning FDI location can be explained by their limited availability of financial and human resources and high dependence on overseas production in their business. Recognizing the need to develop SMEs in developing countries to promote economic growth, policy makers in developing countries should attract foreign SMEs to undertake FDI in their countries by providing a very attractive business environment.
### I. Introduction

Countries gain various benefits, which would promote their economic growth, by receiving foreign direct investment (FDI). First, FDI transfers financial resources to recipients or host countries, which could be used to expand production facilities in the host countries. Second, technology and managerial know-how, which play crucial roles in promoting economic growth, may be transferred to the host countries. Third, FDI enables the host countries to participate in various networks such as sales and procurement networks of foreign investors. Using international networks, host countries could not only expand exports but also import high quality parts and materials, which in turn would improve productivity in the host countries.

Besides these benefits that may be gained through receiving FDI undertaken by foreign firms of all sizes, there are some additional benefits that the host countries may gain by receiving FDI undertaken by small and medium-sized enterprises (SMEs). First, parts and components suppliers, consisting of a supporting industry, which are not sufficiently developed in most developing countries but important for promoting industrialization, may be developed by receiving FDI by SMEs engaged in metal and machinery production. Developing a supporting industry has proven recently to be particularly important for avoiding the problem of trade account deficits, which was one of crucial elements behind the recent currency and economic crisis in East Asia. The presence of an efficient supporting industry would in turn attract FDI by large assembling firms, as they could utilize locally produced parts and components for assembling final products. FDI by SMEs would also contribute to economic development of the host country by improving income distribution, as they provide local people with limited experiences and education with jobs and income by utilizing labor-intensive technologies.

Recognizing these benefits from hosting FDI, a number of developing countries have attempted to attract FDI by using various incentives such as preferential tax treatment. In light of these observations, it is important on the part of potential host countries to discern the important factors that would attract or discourage FDI by SMEs. The purpose of this paper is to identify these factors by examining the patterns of FDI by Japanese SMEs. For the analysis we adopt two approaches; one analyzing the tabulated results of the survey on the motives of FDI and the difficulties associated with FDI, and the other undertaking a statistical analysis of the locational
determinants of FDI by Japanese SMEs. Japanese SMEs have actively undertaking FDI in recent years. In terms of the number of FDI cases, SMEs account for approximately 50 percent of total number of FDI cases by Japanese firms.

Being more seriously constrained by financial and human resources compared to large firms, SMEs are likely to be more sensitive to local conditions than large firms in undertaking FDI. Several authors have examined the factors that determine the location of Japanese FDI in general, but no previous studies have analyzed them for Japanese SMEs by explicitly taking the firm size into consideration. $ ^{1} $ Therefore, the analysis in this paper would be useful not only for researchers interested in FDI but also for policy makers engaged in economic development.

The structure of the paper is as follows. In section II, we present an overview of the recent patterns of FDI by Japanese SMEs. In sections III and IV, we examine the motives of FDI by Japanese SMEs and the problems faced by them, respectively, in order to discern the important factors determining the location of their FDI. In light of these findings, in section V, we examine the determinants of FDI location by Japanese SMEs by conducting a statistical analysis. Finally, in section VI, we present some concluding remarks.

### I I. Recent Trends of Foreign Direct Investment by Japanese SMEs $ ^{2} $

II.1. Rapid Expansion in the 1980s and Subsequent Slowdown in the 1990s

Similar to the pattern observed for FDI by Japanese firms of all sizes, FDI by Japanese SMEs increased on a large scale and underwent major changes in its regional and sectoral compositions in the latter half of the 1980s (Figure 1 and Tables 1-4). The number of annual FDI cases increased sharply from around 300 in the early 1980s to more than 1,000 in the latter half of the 1980s. Equally as dramatic as the size of the boom was the pace at which FDI by Japanese SMEs declined after reaching a peak in 1988. The decline in annual FDI cases continued until 1992, when the number of annual FDI cases amounted to almost one third of that recorded in 1988. In 1993 the number of FDI cases by Japanese SMEs increased to around 700,
and it remained at around 700 with some fluctuations through 1996.

One identifies both "push" and "pull" factors behind the recent developments of FDI by Japanese SMEs. The push factors are those in the investing country, that is Japan in this case, while the pull factors are those in the host countries. We will take up the push factors in this section and pull factors in turn in the next section in explaining the recent patterns of FDI by Japanese SMEs.

Several push factors were responsible for the rapid growth of FDI by Japanese SMEs in the latter half of the 1980s. The rapid and steep appreciation of the yen exchange rate against other currencies was the most important macroeconomic factor leading to the expansion of Japanese FDI in the second half of the 1980s. The yen appreciated by 37 percent between 1985 and 1988 on a real, effective basis. The drastic yen appreciation stimulated FDI by Japanese SMEs in two ways. One way was the dramatic "relative price" effect, and the other was the "liquidity" or "wealth" effect. The relative price effect substantially reduced the international price competitiveness of Japanese products, resulting in a decline in Japan's export volume. To cope with the new international price structure, a number of Japanese manufacturing firms moved their production base to foreign countries, especially to East Asia, where production costs were lower.

Yen appreciation had a positive impact on FDI by Japanese SMEs through the "liquidity" or "wealth" effect as well. To the extent that yen appreciation made Japanese firms relatively more "wealthy" in the sense of increased collateral and liquidity, it enabled them to finance FDI relatively more cheaply as a result of the yen appreciation.

Another important push factor was the emergence of the "bubble" economy in Japan. The liquidity effect discussed above was strengthened by the bubble economy, in which the prices of assets such as shares and land increased enormously. Indeed, the average share prices more than doubled in four years from 1985 to 1989, as the index of share prices increased from 45.7 in 1985 to 117.8 in 1989. The Bank of Japan injected liquidity into the economy to deal with the recessionary impact caused by the drastic yen appreciation. Active fiscal spending for the same purpose of reflating the economy was an additional factor leading to the bubble economy.

An increasing shortage of labor was a particularly important push factor that has
activated FDI by SMEs. During the bubble economy period, labor market became very tight as many firms were expanding their employment. Under such circumstances, SMEs had difficulty attracting workers. To deal with the labor shortage situation, a large number of SMEs shifted their operation abroad, where low-wage labor was abundantly available. It is also important to note that a number of Japanese subcontracting SMEs followed their parent companies that invested overseas, to maintain business.

The decline in the number of FDI cases by Japanese SMEs in the early 1990s resulted mainly from the burst of the bubble economy in 1989. The depreciation of the yen also contributed to the decline. The recent increase in FDI in the mid-1990s is attributable to the substantial appreciation of the yen, whose real effective exchange rate increased by 17 percent in a year from 1992 to 1993. The appreciation of the yen set off the relative price effect discussed above, to result in the expansion of FDI by Japanese SMEs. It is worth noting that unlike the remarkable increase in FDI by Japanese SMEs in the second half of the 1980s, the recent increase in FDI by Japanese SMEs is taking place in the absence of the bubble economy. This difference is reflected in the changes in the regional as well as sectoral distribution of FDI by Japanese SMEs over time, to which we will turn next.

#### I I.2. Foreign Direct Investment in Asia by Japanese SMEs

FDI by Japanese SMEs in the first half of the 1980s was directed largely to North America (Table 1). North America absorbed approximately fifty percent of the FDI cases by SMEs during the period. Beginning in the second half of the 1980s, Asia started to attract Japanese FDI by SMEs on a large scale. Consequently, the share of Asia in total FDI cases by SMEs started to rise, while the corresponding share for North America started to decline. These trends continued through the mid-1990s, and in 1996 the shares of Asia and North America in the total FDI cases by SMEs stood at 66.9 and 22.9 percent, respectively. It should be noted that Asia and North America absorbed as much as 80-90 percent of overall FDI cases by Japanese SMEs. The shift of geographical orientation of FDI by Japanese SMEs from North America to Asia in the early 1990s appears to reflect the changes in SMEs' strategy, which put a greater emphasis on reducing production cost to be competitive in the international market. Furthermore,
rapid economic growth in Asia contributed to this shift, as it attracted FDI that was seeking for market.

Since the mid-1980s, geographical distribution of Japan's FDI to Asia has changed significantly, from the Asia NIEs to ASEAN, and then to China and other Asian countries. (Table 2) $ ^{3} $ The NIEs attracted FDI until the late 1980s mainly by pursuing FDI promotion policies. Policy makers in Korea, Taiwan, and Singapore, in particular, promoted inward FDI in their pursuit of high-tech industrialization. These countries enjoyed positive growth brought about by the simultaneous expansion of trade and inward FDI.

However, Japanese FDI in the Asian NIEs reached a peak in 1988. The Asian NIEs started to lose some of their cost advantages due to rapid wage increases and currency appreciation. Firms in Japan and other investing countries therefore started to look to other East Asian countries such as ASEAN as hosts for investment. One important factor behind attracting FDI in manufacturing to ASEAN has been the ASEAN countries' shift from inward-oriented to outward-oriented strategies, which were carried out through their unilateral liberalization of trade and FDI policies. Such regime changes have been prompted by the earlier success of outward-oriented policies in the NIEs.

FDI inflows into China have also grown sharply since 1990 due to China's gradual but persistent economic reforms, liberalization in trade and FDI policies, and its political and social stability despite the Tiananmen Square incident in 1989. Since 1990 China has attracted the largest number of FDI cases by Japanese SMEs in Asia. The attractiveness of China as a host to FDI has increased recently, being reflected on the substantial increase in the share of China in overall FDI by Japanese SMEs. The attractiveness of China as a host to FDI from Japan and other countries increased, as some ASEAN countries have lost their attractiveness mainly due to the rapid increase in the production costs including wages, material and services costs. The increase in the production costs in turn resulted from the currency appreciation, shortage of
manpower, emergence of serious bottlenecks in infrastructure and other factors. $ ^{4} $ In recent years, despite at a significantly lower scale, Japanese FDI to other Asian countries such as Vietnam has begun to increase (not shown in the table). Liberalization of FDI policies by these countries attracted Japanese investors.

Turning to the sectoral distribution of Japanese FDI by SMEs, there was a dramatic shift from non-manufacturing to manufacturing from the 1980s to the mid-1990s. Specifically, the share of manufacturing in total FDI cases increased notably from around 30 percent in 1980 to around 70 percent in the mid-1990s, while the corresponding share for non-manufacturing declined from 70 to 30 percent. (Table 3) Among the manufacturing sub-sectors, FDI was undertaken actively in textiles and machinery. In particular, the number of FDI cases rose remarkably in textiles from 6 in 1980 to 293 in 1994, before declining to 180 in 1996. The trends in other sectors were similar, albeit at a smaller scale. In 1996 the number of FDI cases in textiles and machinery stood at 180 and 135, respectively, capturing 26.7 and 20.1 percent of all FDI cases. As to FDI in the non-manufacturing sector, commerce was active in undertaking FDI. However, the number of FDI cases declined significantly in the 1990s. The shift from non-manufacturing to manufacturing, and especially to textiles and machinery, is mainly attributable to the fact that the manufacturing sector, a substantial part of whose output are sold in international markets, was adversely affected by the yen appreciation.

As Asia became a dominant region for attracting FDI by Japanese SMEs in the middle of the 1990s, the sectoral patterns of FDI by Japanese SMEs in Asia are largely reflected on those of FDI by Japanese firms of all sizes, which were discussed above. However, one may observe that a distinct characteristic of FDI by Japanese SMEs in Asia is the large share of manufacturing in comparison to other regions. The share of manufacturing in total FDI by SMEs in Asia increased from around 50 percent in the early 1980s to 80 percent in the mid-1990s, while the corresponding share for FDI by all firms increased from 30 to 70 percent. (Tables 3 and 4) Among the manufacturing sub-sectors, the number of FDI cases in textiles increased rapidly from around 3-5 in the early 1980s to more than 200 in the mid-1990s, registering the largest share of
FDI by SMEs at 38.2 percent in 1996. Textiles was followed by machinery at 21.3 percent. In non-manufacturing it is noteworthy that the number of FDI cases in commerce dropped sharply from the peak of 132 in 1989 to 24 in 1996.

### I II. Motives Behind Japanese FDI in Asia

Several factors promoting recent Japanese FDI were explained in the previous section. This section examines the motives behind Japanese FDI in more detail, because these motives influence the pattern of geographical distribution of Japanese FDI, which is our main concern in this paper.

Several questionnaire surveys on the motives of Japanese firms for undertaking FDI are conducted on a regular basis. The most comprehensive is a questionnaire survey conducted by the Ministry of International Trade and Industry (MITI) of the Japanese government. $ ^{5} $ Table 5 summarizes the results of the 1992 MITI survey conducted on the motives behind Japanese FDI in all regions and in Asia. In the table the survey results are disaggregated into those for SMEs and those for large firms.

For SMEs, the most common motive is the use of local labor, as 68 percent of the responding SMEs indicated the use of local labor as one of their motives for undertaking FDI. $ ^{6} $ For the Asian affiliates of Japanese SMEs, the use of local labor is even more important motive since as large as 78.6 percent of the respondents indicated such a motive. One realizes the importance of the use of local labor as an FDI motive for SMEs, as the proportion of the large firms indicated the use of local labor as a motive is significantly smaller at 37.5 (46.1) percent for those investing in all regions (Asia). The use of labor is the most important motive for almost all the sub-sectors, as it captured the largest share in most of them. These observations suggest that
a large number of SMEs undertook FDI in order to cope with the labor shortage in Japan.

A large number of SMEs identified local sales as one of their motives behind undertaking FDI, as 46.2 percent of responding SMEs indicated such a motive. The importance of local sales motive is somewhat less for FDI by SMEs in Asia, as the proportion of SMEs indicating local sales as a motive is smaller at 37.8 percent. This is quite a contrast to the case for large firms. For large firms, local sales is the most common motive behind their FDI, as two-thirds of large firms indicated that expanding local sales as one of their motives.

Exports, particularly those to Japan, have shown to be an important motive behind FDI by Japanese SMEs. This pattern is more evident for FDI in Asia. Indeed, 37.8 and 22.4 percent of SMEs undertaking FDI in Asia indicated exports to Japan and exports to the third countries respectively as their motives for undertaking FDI. The importance of exports to Japan as a motive for FDI by SMEs can be seen clearly, if one observes that the share of large firms indicating such motive is much smaller at 13.1 percent.

One out of five SMEs undertook FDI, to respond to the industrial policies in the host countries. Although it is not clear from the survey as to the specific policies that SMEs responded to, one may argue that host country policies appear to influence the decision of FDI by SMEs.

In sum, the results from the MITI survey have shown that Japanese SMEs have undertaken FDI to export their products to Japan by utilizing low-wage local labor, in response to the labor shortage or high wage situation in Japan. These FDI patterns by Japanese SMEs seem to indicate that they act as a member of networks such as subcontracting networks, or keiretsu, because they supply a large portion of their products produced in East Asia to their trading partners in Japan. These findings also confirm an observation that SMEs adopt labor-intensive production technologies, in comparison to large firms. The fact that the use of local labor as a motive for Japanese FDI in Asia may reflect rational behavior of Japanese firms from the point of view of comparative advantage in Asia. Richly endowed with labor, Asian countries have a comparative advantage in the production that requires labor-intensive techniques. Furthermore, one may argue that the technologies used by SMEs are suitable or appropriate for the local condition.
### I V. The Problems Encountered by Japanese Firms in Asia

An investigation of the problems that are faced by overseas affiliates of Japanese SMEs would provide useful information on the determinants of FDI locations by Japanese SMEs. This is because the firms would select the location of their investment where the probability of encountering problems is minimal. Below two kinds of problems are investigated. One is the economic environment in the host countries under which Japanese firms conduct their business, and the other concerns the regulations imposed on their activities.

Table 6 shows the frequency of the responses given by Japanese firms to some of the problems in their overseas operation. One immediately notices that SMEs are operating under more difficult conditions that large firms, as the response rates for all the problems listed in the table except one are greater for SMEs that large firms. The fact that SMEs face more problems than large firms may be explained by an observation that SMEs are more constrained than large firms in terms of financial, human and other resources, to deal with the problems. Furthermore, the severity of the problems appears to be greater for SMEs than large firms, as SMEs attach a greater significance to their overseas operation in relation to their home operation, compared to large firms. Indeed, the share of overseas sales in total sales (overseas sales plus home sales) for manufacturing SMEs is significantly higher at 36.6 percent than that for large firms at 17.7 percent (both for 1992). $ ^{7} $

One exception to the pattern that SMEs face more problems than large firms, is severe competition in the local market, for which the response rate is greater for large firms than SMEs. This finding may reflect the differences in the motives of FDI by SMEs and by large firms. Large firms, whose motivation behind FDI is to sell their products in the local market, feel severe competition in the host market, while SMEs, which are more interested in exporting their products, feel less competitive pressure in the local market. The remaining part of this section examines other kinds of problems faced by SMEs.

To begin with the problems concerning economic environment of the host countries,