Japanese FDI and the China challenge: Gordon Feller explains the where, when and how of Japan's investments in China.

JAPANESE FOREIGN DIRECT INVESTMENT (FDI) inflows to China are both increasing and diversifying from manufacturing to other sectors, attracted by the availability not only of cheap but also qualified labor. At the same time, the new wave of FDI associated with relocation is also stirring opposition within Japan.

In addition to sectoral diversification, a geographical shift in FDI patterns into China is taking place. Japan's original focus on proximate coastal clusters, such as Dalian in Liaoning province, is being supplanted by the pull of Shanghai and the Pearl River Delta (PRD). The arrival of the three major automakers, Toyota, Honda and Nissan, with their Japanese-affiliate part producers, is also creating new FDI clusters.

Considerable discrepancies exist between Japanese and Chinese statistics. It is also difficult to identify Japanese FDI routed through subsidiaries in Hong Kong or other countries. According to Japanese figures, FDI to China from Japan in 1999-2000 dropped sharply to under $1 billion, before recovering to $2 billion in 2001. According to Chinese estimates, Japanese FDI annual totals were $3.8 billion on average in 1996 to 98, $2.9 billion in 1999 to 2000, and $4.3 billion in 2001. According to the Japan External Trade Organization , Japanese companies' investment in China totaled around $1.4 billion in fiscal 2001, up 4 percent from the previous fiscal year.

What is clear is that Japanese FDI to China is now picking up from a trough in fiscal 1999. This owes mainly to increased growth and opportunities brought by the country's entry into the WTO at the end of 2001. Reinvestment by Japanese companies is also testimony to the vibrant nature of Japanese commercial activities in China. China accounted for less than 10 percent of Japanese companies' subsidiaries or joint ventures abroad in fiscal 1995. By fiscal 2001, this had risen to 18 percent.

The main investors are still drawn from the manufacturing sector. In particular, electrical machinery accounted for around one-third of total FDI in the past few years. As a result of Toyota and Nissan's entry into the Chinese market, sales of transportation equipment have also risen. However, other sectors such as information technology (IT) and service sectors are also gaining share. Major retailers had already set up their subsidiaries in China around mid-1995 when China partially opened its market to foreign retailers.

Other big investors in the service sector include real-estate developers, although local operators continue to exert strong market control. Japanese banks and insurance have largely stayed out of the market to date. There is a growing trend among firms to relocate product development to China, particularly among computer software firms. Tose, a Kyoto-based video game software maker, has established subsidiaries in Shanghai and Hangzhou that employ around 200 Chinese programmers and software designers, and it plans to double this figure. Chinese software engineers cost one third of their Japanese counterparts. Japanese companies are increasingly attracted by the availability of skilled labor, which is short in Japan despite its 5.3 percent unemployment rate.

Japan's investment has helped to make China its second-largest trading partner. Exports to China reached a record [yen] 588 million ($5 million) in July. Japan received 18.3 percent of imports--its largest share--from China in 2002, compared with 17 percent for the United States. The role of FD1 in this increase is clear: In 2002, when international FDI in-flows to China reached a record $53 billion, the share of foreign-affiliated companies accounted for 55 percent of China's exports. A similar figure applies to China's exports to Japan.

Historical factors played an important role in determining the concentration of Japanese FDI in Manchuria until the early 1990s, including the affinity of many senior Japanese business executives raised in China. Local officials in Dalian sought to attract Japanese business by appealing to such sentiment. Japan's Overseas Economic Cooperation Fund, now reorganized as the Japanese Bank for International Cooperation, with private-sector participation, built up a Japanese industrial estate in the city in the early 90s. Equally, on certain high-profile projects Japanese investors are also prone to encounter political resistance on historical grounds.

From the mid 90s, Japanese FDI decisions began to reflect cost considerations more directly.

Guangdong and especially the PRD host an agglomeration of IT industries. Many Japanese firms have located their plants in the PRD to take advantage of the inexpensive access to parts and devices geared towards exports. The PRD is also the main destination for Japanese office equipment makers.

For penetrating China's domestic market, the greater Shanghai area is the preferred Japanese FDI destination, as well as serving as an export platform.

In the car industry, new Japanese clusters are appearing: Toyota, Honda and Nissan have started production in China, while their domestic supplier affiliates are setting up their factories near the final assembly plants. Toyota's suppliers are based around Tianjin, Changchun and Guangzhou; Honda's are in Guangzhou and Hubei province, and Nissan's in Hubei province.

The speed, scope and consequences of Japanese FDI to China have generated considerable public unease in Japan. However, those industrial sectors benefiting most from relocation are reluctant to counter bad publicity. According to a survey by the Japan-China Investment Promotion Organization, 82 percent of Japanese investors in China report they are already profitable. However, this has done little to stem the flow of reports claiming that China poses an economic threat to Japan. A common subject of complaint is the infringement of Japanese patents and copyrights--Toyota is currently suing the Geely Group in a Chinese court over the alleged misappropriation of its name and corporate logo. The argument that China is exporting deflation to Japan via an undervalued renminbi is also regularly used by high officials in Japan.

Increasingly sophisticated imported manufactures from China, targeted at specific industrial sectors, are forcing remaining domestic manufacturers in Japan to upgrade their level of technological sophistication. For example, NEC plans to cover 70 percent of its domestic sales this year with Chinese-made computers, and it predicts this share will rise to 85 percent next year. In this sense, imports manufactured in China may provide an important fillip to corporate restructuring and boosting competitiveness.

Most politically sensitive are "boomerang effects" in the agricultural sector and other small-scale sectors that are important for the political support of the ruling Liberal Democratic Party. Exports of Chinese agricultural goods to Japan, which prompted Tokyo to impose tariffs in 2001, are partly due to the transfer of production techniques by Japanese agri-business. China retaliated with its own tariffs on high-technology exports from Japan, forcing a capitulation. Japan's towel makers have demanded similar protection.

The renewed expansion and diversification of Japanese FDI into China may benefit Japan economically by allowing major corporations to reduce operating costs, while encouraging Japan-based manufacturers to move higher up the value chain. However, pressure from politically important sectors and growing complaints of copyright infringements have the potential to fan a wider backlash against further "hollowing out" of the domestic economic base, especially if relocation spreads to services.