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February 01, 2012, Wednesday

Development without FDI: the case of Japan and Korea (1)

Although there are voluminous books on the merits of foreign direct investment (FDI) in the development of developing countries, it is incredibly difficult to find convincing country cases that achieved development primarily through FDI inflows. As I discussed in a previous article, formalized facts about the inflow of FDI are the attractive combination of growth, availability of highly skilled workers and competitive cost levels in the host country.

This means that FDI comes into a country if the above conditions are fulfilled. That is to say, if a country has a big market with high and sustained real growth, then the county would be an attractive destination for FDI inflows. Then, why do we need FDI for growth, provided we can succeed without FDI?

Although this question is not totally illogical, the situation is highly complicated. It seems that FDI can also be attracted within a win-win paradigm. Depending on the paradigm of the FDI management in the host country, it would potentially contribute to the host economy via a learning curve effect and productivity spillovers, and the host country’s exports would catch up with the desired quality and therefore help increase the unit values of exportable goods due to multinationals’ superior technology and marketing techniques. Obviously, the fulfillment of all these potential benefits are conditional upon the level of domestic investment/savings, mode of entry (merger and acquisitions or Greenfield [new] investments), the sectors involved, the country’s ability to regulate investments and the degree of openness (that is, not protected or sheltered from competition).

The major lesson from the evolving FDI literature is that its quality and efficacy in upgrading the host country economy, not the volume or the quantity of FDI, are of critical importance. At this point, the cases of Japan, and then Korea, will be helpful in understanding how to benefit from FDI. Before focusing on the country cases, we should highlight that global as well as local conditions were radically different at the time of Japan’s drive for development both before World War I and after World War II. Despite this fact, we can still cultivate some useful lessons. The amount of foreign capital invested directly in Japan from 1899 to 1931 was not large. However, the impact in terms of the learning curve effect was very great indeed. FDI participated in and stimulated a broad range of business endeavors, often employing advanced methods, provided valuable knowledge about Western technology and management practices and affected the internal economic geography of Japan during the given period.

The mentality and attitude of the Japanese did not change in the post-World War II either. It is not radically different even today. FDI flows into Japan have surged since the latter half of the 1990s, when Japan entered a long-term stagnation after the burst of its bubble economy in the early 1990s. From 1990 to 1996, direct investment in Japan hovered at an average of $1 billion annually. This figure reached the $3 billion mark in 1997 and came to $12.7 billion in 1999 (on a balance of payments basis). This inflow has since decreased but is still at a high level compared to past years -- around $6 billion to $9 billion per year through 2004. The recent rise in inward FDI since 2003 is driven by several factors, such as the deregulation of state and private sectors; foreign acquisitions of companies because of corporate bankruptcies; a changing legal framework supporting mergers and acquisitions (M&As); a decline in cross-shareholding, which has put more shares on the market; the global push to reorganize industries, encouraging entry into Japan by foreign firms; and the yen’s appreciation, making Japanese assets more attractive.

Despite the low realization of FDI, case study evidence shows that foreign firms helped to develop such strategic industries as semiconductors and raise productivity through the transfer of technology and managerial know-how. I will discuss examples of such firms in my next column.