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The effects of the single market on the pattern of Japanese investment.

* The author is Reader in Economics at the University of Reading. Helpful comments were given on an earlier draft of this paper by Professor D. G. Mayes.

The process of economic integration influences the patterns of foreign direct investment through the impact it exerts on the configuration of ownership, internalisation and locational advantages which in turn determine how a firm penetrates into foreign markets. The article specifies how the creation of a single European market alters the locational advantages of producing in Europe and strengthens the ownership specific advantages of European Community firms. It then examines the relative strength of Japanese firms in exploiting the locational advantages of European production by looking at their technological and organisational capacities. Finally, the paper examines recent trends of Japanese direct investment in Europe and finds evidence for the propositions advanced in the analysis reported in the first part of the article.

Economic integration and foreign direct investment

The completion of the European Community's internal market will be achieved through the removal of a host of non-tariff barriers to trade and the mobility of factors of production and the liberalisation of the conditions for the provision of service activities inside the single market. This completion of the European Community's internal market will enhance the locational advantages of European markets.

The propensity of a firm to engage in foreign production is influenced by the combination of ownership specific advantages, internalisation opportunities and locational advantages of the target market (Dunning, 1981). Economic integration increases the locational advantages of the markets inside the trading bloc and in this way it may increase the relative profitability of servicing these markets via local production facilities (direct investment) rather than through exports or licensing.

In addition, the process of economic integration may also affect the distribution of ownership advantages between firms of different origins. The single European market with its expanded size and the opportunities for scale economies that it offers is expected to stimulate innovative activity inside the European Community through the ability to sustain larger R&D expenditure. This increased innovative activity will offer opportunities for the accumulation of ownership specific advantages by firms of European Community origin.

Economic integration brings about changes in the distribution of locational advantages across markets and in the distribution of ownership specific advantages across international firms.

The extent of the global redistribution of locational advantages depends on the changes in the structure of effective protection of the integrated market and the growth-enhancing effects of market unification. These growth effects are both once-for-all changes and permanent additions to the Community's longterm growth (Baldwin, 1989). The removal of the non-tariff barriers in intra-EC goods transactions and factor movements will produce complex changes in the relative degree of protection of Community producers compared to outsiders trading inside the Common Market. Much will depend on the forms the common commercial policy of the European Community will take as the various non-tariff barriers in intra-Community trade are removed.

It may be argued that the removal of many non-tariff barriers to intra-Community trade will bring about benefits (that is, resource cost savings) not only to producers trading inside the common market but also to firms exporting to the single market from outside locations. One can think of the elimination of such non-tariff barriers like contents, packaging and similar regulations in the food industry or the elimination of technical barriers to trade like differences in product specification and in the terms of product certification or the lifting of capital market controls. However, there are other non-tariff barriers whose removal does not have the characteristic of a semi-public good as is the case with the elimination of the type of non-tariff barriers just mentioned. Various market-entry barriers like public procurement or conditions for the provision of service activities can be eliminated by treating differentially insiders and outsiders given the lack of any binding GATT rules in such matters. In addition, the removal of many non-tariff barriers to internal trade often has implications for the common external commercial policy of the Community. The way these changes in the Community's external commercial policy are implemented will shape the structure of effective protection of Community production from outside competition.

Changes in the Community's common commercial policy which can directly affect the relative profitability of exporting to the Community in comparison to producing inside the single market include: quota reorganisation in replacing member state quotas on imports of particular products from specific countries, the future of specific rules of origin like those applicable to microchips or photocopiers, agreement on local content provisions to cope with the question of the screwdriver' plants and the procedures on the application of anti-dumping rules.

The uncertainty as to the final design of the European Community's common commercial policy and the fluidity of some of the rules proposed (for example, on local content) increase the attraction of producing inside the single market rather than exporting to it. Such uncertainties and policy ambiguities invite strategic responses by international firms keen in maintaining or expanding their market share in the unified market of the Community.

Foreign direct investment responses

Foreign production through direct investment in the single market becomes the strategic response of firms in coping with changes in relative competitiveness, locational advantages and ownership strengths brought about through the removal of intraCommunity barriers and the re-design of the common commercial policy of the Community.

Four types of investment responses by international firms can be identified: defensive import-substituting investment to cope with the trade diverting effects of integration, offensive import-substituting investment to take advantage of the opening up of the new markets and the expected expansion in their size, re-organisation investment to redistribute production already established inside the Community towards locations with more favourable cost conditions in the unified, single, market and rationalised investment which is undertaken in response to the new international differences in production costs generated through the enhanced efficiency inside the single market following the removal of the various intra-EC non-tariff barriers to trade (Yannopoulos, 1990). Although these four types of direct investment are responses to the trade effects of further European integration, nevertheless they are not necessarily trade replacing. Defensive import-substituting investment is certainly trade replacing whilst offensive import-substituting investment is likely to restrict opportunities for trade expansion. However, rationalised and re-organisation investments are likely to be complementary to trade encouraging either more trade of the inter-industry type (in the case of rationalised investments) or of the intra-industry variety (in the case of re-organisation investments).

Changes in the configuration of ownership, location and internalisation advantages do not by themselves stimulate new foreign direct investment. Foreign direct investment will be the main instrument to service a foreign market if the firm has the capacity to exploit simultaneously all the three advantages: ownership, internalisation and location. On the basis of the discussion in the first section, the process of further integration in the European Community has two effects on the configuration of ownership internalisation and locational advantages affecting foreign direct investment decisions by nonCommunity multinational enterprises. On the one hand, the locational advantages of production sites inside the Community increase, making production in the Community a more attractive alternative to service the Community markets. On the other hand, the dynamic effects of further integration on R&D activities and innovation potential will strengthen the ownership specific advantages of multinational firms of Community origin. if the second effect is more immediate and stronger then it may outweigh the attraction to foreign direct investment generated by the first effect. in any case, even if changes in locational advantages are preponderant, these will not bring foreign direct investment flows to the Community if outside firms do not possess adequate ownership specific advantages.

In order to assess the potential response of Japanese multinational firms to the changes in locational advantages generated from further European integration we must now turn our attention to the technological and organisational strengths of Japanese firms. This will give us an indication of the sectors in which Japanese firms have strong ownership specific advantages which they can combine with any emerging locational advantages of European production to engage in foreign direct investment.

Relative strengths

To assess the extent to which Japanese firms can take advantage of the benefits of the single market by investing in the Community it is not sufficient to look only at the revealed comparative advantages of Japanese firms through trade. A country's relative trade performance may not reveal the technological strength of its industries if exports and international production are more substitutable for one another, rather than complementary. Indeed in countries like the UK and the USA where their multinational firms are in the phase of maturity of their internationalisation history, there is strong evidence of substitutability. However, this does not appear to be the case with Japan as its firms are at a relatively early stage in their internationalisation growth. (UNCTC, 1990).

A good indication of the potential ownership specific advantages enjoyed by firms is to look at their comparative advantage in innovative activity. Dunning and Cantwell (1989), derived a measure of revealed technological advantage to capture the firm's comparative advantage in innovative activity by using data on foreign patenting in the USA.

Comparing the technological and organisation strengths of Japanese firms in relation to their European rivals one clearly sees the Japanese firms enjoy their technological strengths in the electrical equipment and motor vehicles sectors.

In table 1 we summarise the findings from the Dunning and Cantwell study of comparative technological and trade advantages of Japanese firms vis it vis their European rivals. This table classifies the size of the comparative advantage (technological or trading) into three classes: S = small (up to -5), M = medium 0-5 - .99) and L = large (1 0 and above). in addition it shows whether the index of revealed comparative advantage, technological or trading, has been falling (F) or rising (R) between 1970 and 1986.

The index of revealed technological advantage is derived from data on US patents in industry i, granted to residents of a foreign country j, in period t, (P[.sub.]ij,) compared to all foreign patents granted by US authorities to residents of all foreign countries seeking patent protection in US according to the following formula:

Index of revealed technological advantage

(P[.sub.]ijt/[sigma][.sub.]j P[.sub.]ijt/[sigma][.sub.]i[sigma][.sub.]j P[.sub.]ijt)

The trend in comparative advantage in trade is assessed by the index of revealed comparative advantage which is calculated as follows: Where X[.sub.]ij stands for the value of exports in industry i from country j in a given period.

The evidence summarised in table 1 shows strong and rising technological advantages in motor vehicles, strong but slightly falling technological advantages in electrical equipment, in other transport equipment, in textiles and in non-metallic minerals. The rate of decline of the index of technological advantage was not so significant to bring the value of the index below the critical level of 1 00 at the end of the period.

It is interesting to note that the sectors where the Japanese firms have considerable technological advantages are precisely those where the uncertainties surrounding the future course of the common commercial policy and consequently the effective protection of European production are higher. This coincidence of Japanese technological advantages (and thus of potential ownership specific advantages) and expected changes in the relative protection rates of European production in the unified single market will encourage Japanese foreign direct investment of the import-substituting type-both defensive and offensive. This coincidence is not of course unexplained. The move towards a more protectionist stance of the common commercial policy in the single market is encouraged by lobbies of industries threatened by the strength of Japanese competition. Indeed, it is in those sectors where Japanese direct investment in Europe is showing signs of acceleration.

The Japanese direct investment abroad has been encouraged not just by their strengthened technological advantages but also by the rising value of the yen. The continuous appreciation of the yen in the 1980s has acted as an important factor facilitating the globalisation of Japanese industry.

Trends in Japanese investment in the Community

Data on Japanese direct investment abroad show that at least up to 1987 Europe (including also the non-EC countries) accounted for approximately 15 per cent of the cumulative total of Japanese direct investment abroad. Other regions of the world like North America, Asia and Latin America accounted for a larger share of Japanese direct investment abroad (table 2).

The data in table 2 show that 'non-manufacturing' investment was three times as large as manufacturing investment. It is possible that part of the nonmanufacturing' investment may indeed be manufacturing related and may have been classified as manufacturing if the services were provided on a unitary site.

During the 1980s the stock of Japanese direct investment in the European Community has grown at a rate of approximately 1 0 per cent per annum during 1980-5 and then subsequently (after 1985) at an annual rate of over 12 per cent (table 3).

The changing position of the European Community in the strategies of Japanese multinationals can be seen from table 4 which shows the share of the Japanese direct investment abroad chanelled to the countries of the European Community.

Between 1973-7 and 1983-7 the share of the Japanese direct investment abroad located in European Community countries doubled from 6.0 per cent to 14.5 per cent. This big jump appears to have been taken around 1984-5 which coincides with the publication of the White Paper on the completion of the internal market and the start of the discussions on Fortress Europe'. This trend has continued as shown by the fact that in 1988 the number of Japanese manufacturing ventures in the Community increased to 392 from 282 a year earlier (UNCTC, 1990). The growing importance of European Community locations in the global strategies of Japanese multinational firms seems to coincide with another change in the sectoral composition of Japanese direct investment in the Community. As one can see from the data in table 5 the largest part, indeed at least 80 per cent of Japanese direct investment in the countries of the Community (with the exception of italy and France) was concentrated in financial services and trade.

This pattern of foreign direct investment is partly explained by the early phase of the multinationalisation of the Japanese firms and the fact that during this early phase foreign direct investment was supportive of the export thrust of Japanese firms. Trading and financing activities were spreading globally to sustain and strengthen the export drive of Japan's manufacturing firms.

Changes in the locational advantages of European Community markets encouraged not only by the growth enhancing effects of the internal market programme but by uncertainties regarding the future course of the Community's external commercial policy particularly on quota reorganisation (for example, motor vehicles) and rules of origin (for example, electronic products) have already induced new trends towards more investment in manufacturing. This is perhaps more noticeable in motor car production. Nissan, Toyota, Honda, Subaru, Suzuki and Hino have all established assembly, production and coproduction operations in selected locations within the European Community. Their pattern of operations inside the European Community suggests that they act by considering the single market as having been established already, choosing locations offering the most advantageous cost for each specific production process.

Nissan, for example, has located its financial and regional headquarters in Holland, its distribution centre in Belgium, its passenger car production in Britain and its commercial vehicles division in Spain. Toyota seems to have already adopted a similar pattern.

Japanese firms producing inside the European Community appear to seek ways of strengthening their ownership advantages against a potential encroachment by Community firms by mobilising their organisational capabilities to the full. One of the factors that contributes to strong ownership advantages by Japanese firms in electronics and in motor vehicles is their success in organising contractual networks. These contractual networks bring together diverse groups of small producers acting to supply sourcing and sub-contracting services to the large firms. This ability to organise contractual networks will prove decisive in the internal market. It will be the instrument to exploit this market to the full and take advantage of any prevailing cost and skill differentials.

Similar patterns to those observed in the motor vehicle production are emerging in the semi-conductor industry. The early establishment of test and assembly operations by Fujitsu, NEC and Hitachi has been followed by the setting up of fabrication facilities by these companies.

The strategy of the Japanese multinationals to treat the Community market as a unified entity, as a single market, is reflected in the concentration of Japanese direct investment in a few Community countries that offer the required cost advantages and in addition a more stable investment climate. As one can see from table 6 more than two thirds of the stock of Japanese direct investment in the Community in 1987 is found in four countries: the United Kingdom, the Netherlands, Luxembourg, and Spain. The last three countries increased their share of the stock of Japanese direct investment in the Community from 2.4 per cent in 1970 to 38.5 per cent in 1987.

The Fortress Europe' worries have thus acted as European pull factors for Japanese direct investment in the Community. One should not forget in interpreting these trends that there are also Japanese push factors as well generated both by the programme of exports, their successful penetration of the US market and the stage of their international involvement having reached a phase of some maturity, plus the sheer size of the Japanese investible funds requiring an outlet.


The global redistribution in locational and ownership specific advantages enjoyed by multinational firms stimulated by the internal market programme of the Community has generated concrete strategic responses by Japanese firms previously servicing the markets of the Community primarily through exports. The response is in the form of direct investment in selected locations and the organisation of contractual networks Community-wide with the objective to supply from these locations the entire unified market. The direct investment response has been stronger in the sectors where the Japanese firms have considerable technological advantages such as motor vehicles, other transport equipment, electrical equipment, office equipment and so on.

The further spread of Japanese direct investment in the European Community will depend on four major factors:

(a) the final design of the common external commercial policy and especially the use of specific rules of origin, local content requirements and Community-wide quotas in place of member-state specific quotas;

(b) the extent to which the attempts to forge strategic alliances with Community producers and to set up organisational, contractual, networks, succeed;

(c) the ability of the Japanese multinationals to sustain and enhance their ownership advantages in the face of the strengthened competitive position of the Community firms; and

(d) the future parity of the yen. The continuing appreciation of the yen has proved an important enabling factor in the drive of the Japanese firms towards multinationalisation.


Baldwin, R. (1989), The growth effects of 1992', Economic Policy, no. 9, October, pp. 248-81.

Dunning, J. H., (1981), International Production and Multnational Enterprise, London, Allen and Unwin.

Dunning, J.H. and Cantwell, J.A. (1989), Japanese manufacturing direct investment in the EEC, post 1992: some alternative scenarios', University of Reading discussion papers in international Investment and Business Studies, no. 132, September, pp. 40.

UNCTC, (United Nations Centre for Transnational Corporations), (1990), The implications of the completion of the single internal market of the EC for TNC activity', (forthcoming).

Yannopoulos, G.N. (1990), Foreign direct investment and European integration: the evidence from the formative years of the European Community', Journal of Common Market Studies, vol. 28, no. 3, pp. 235-59.
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Title Annotation:Single European market
Author:Yannopoulos, George N.
Publication:National Institute Economic Review
Article Type:Cover Story
Date:Nov 1, 1990
Previous Article:US views on 1992.
Next Article:ASEAN and EC -- 1992.

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