Japanese foreign direct investment and regional trade

There has been considerable debate in Japan about the impact of foreign direct investment (FDI) outflows, largely focused on whether the economy is .hollowing out.. The surge in outward Japanese FDI over the last decade, together with the fact that FDI outflows outweigh corresponding inflows by an order of magnitude, has resulted in a rapid net movement of Japanese productive capacity abroad. The relocation of Japanese production abroad is also thought to have led to changes in Japan.s trade structure. The first part of the paper examines FDI outflows to determine whether, besides the .natural. maturation of the economy, FDI can be explained by macroeconomic factors. The results suggest that it can. Aggregate FDI has been driven by investment in Japan and the exchange rate, while the geographic distribution of such investment has been influenced by foreign economic conditions. The link with the real exchange rate has been well established. The close relationship between domestic investment and outward FDI is of more interest, as it implies that FDI is a complement to, rather than a substitute for, domestic capital. We then examine the relationship between FDI outflows and Japanese trade patterns. Estimation suggests that FDI has only a temporary impact on Japanese exports, while a higher stock of Japanese FDI in a foreign country has permanently affected imports, increasing merchandise imports by around 10 percent between 1990 and 1995. A plausible interpretation of both sets of results is that Japanese firms are diversifying the location of their production, moving those parts of their operations in which they are losing comparative advantage off-shore. While the recent depreciation of the yen is likely to temper such a relocation, Japanese FDI outflows are part of a difficult, but necessary, restructuring of the Japanese economy.