Last year, the United States ran an eight billion dollar trade deficit with Japan, and this year the figure is running 50 percent higher. As a key component in the overall U.S. balance-of-payments deficit, a recurring irritant in U.S.-Japanese overall relations, and a significant factor in the decline of the dollar over the past year, the state of trade between the United States and Japan is now a critically important problem.

As the deficit grows, so does, for many, discomfort with the long-held explanation of Japanese surplus. Japan did indeed achieve notoriety by promoting exports and restricting imports. But for some time Japan has been doing less promoting and restricting, yet watching its surplus embarrassingly grow. Further, to perceive the problem in these terms tends to emphasize the role of governments on both sides.

Yet, it is increasingly clear that the market mechanism, not distortions of it, is the main driving force in bilateral trade. This brings us to the United States. The more prolonged the mythology about Japanese behavior, the more deferred is analysis of the realities of U.S. competitive performance in Japan. It is appropriate now to examine this latter issue in some detail.

II

For a very long time and until very recently, Japan was utterly protectionist in every aspect of international economic interaction. All transactions - goods in trade, technology sale and purchase, capital inflow and outflow - were closely regulated and circumscribed. Japan had long been isolated, and has a keen sense of difference from other societies. It felt itself poor, and in fact both in resources and in accumulated wealth remains poor today. There was a real and sharp anxiety lest the nation be overwhelmed by stronger and wealthier foreign interests. A national policy of exclusion of foreign capital and products found a quite willing public.

This is history. Beginning slowly and cautiously in the mid-1960s, and accelerating steadily into the 1970s, the process of dismantling and relaxing controls and regulations was undertaken. It can be argued that the process took too long, and was too slow, even from the point of view of Japan's own interests. But against the historical background, the transition took place with what must be seen as extraordinary speed. At least in terms of official policy, Japan is now about as open in all aspects of transaction as other OECD member countries.

However, history has left its residual. A Japanese public and, more to the present point, Japanese bureaucracy, long schooled in the grim necessity for export efforts and import defense, do not change their attitudes instantly. Bureaucratic survivals - irritants regarding foreign exchange regulations, cumbersome procedures for "automatic" approvals of company actions, exclusion-oriented customs officials - serve as reminders of Japan's very recent past. And, as will be noted, not all of these surviving practices are innocuous. Still, the main current of events and policy has moved in a different direction.

The more important relic of Japan's obdurately protectionist past, in terms of consequences for present trade flows, is found in the attitudes of the U.S. and European business communities and some government officials toward Japan. Most American companies and most senior U.S. businessmen have had direct experience with Japan. Their experience has been with a closed market into which direct investment was possible only under the most onerous conditions, and into which technology could be sold only under rigid scrutiny. The experience has been at best frustrating for most companies, and at its worst has given rise to dangerous competitors in the domestic market. The West has been slow to perceive the recent rapid changes in this distant and ill-understood society; many views and attitudes that are no longer valid are still tenaciously held.

Japan's economic success has itself fostered misperceptions. A non-Western nation achieving the highest levels of output and income is in the nature of things rather a mystery. From the fact that Japan is on the whole homogeneous socially, it is perhaps an inevitable leap to the conclusion that Japan's enormous and complex economy is also homogeneous - that is, centrally directed and monolithic. Thus arose the notion of "Japan, Inc.," an economy that responds instantly to tightly planned and controlled central instructions. Japan's economic policy uncertainties and blunders might well have laid that ghost to rest. The notion persists, however.

These remarks are meant to point out certain hazards in addressing the U.S.-Japan trade interaction. It is well to make some attempt to put these attitudes and historical views to one side, at least for a time, and look instead at the economics of the problem.

III

The well-known U.S. deficit in trade with Japan has a less well-known aspect. Over a wide range of product categories, the United States has for some years been losing its share as an exporter of products to Japan. Table I shows the U.S. share of Japan's imports of both basic materials and manufactured goods, comparing the annual average of the 1968-70 period and the 1976-77 period, and noting the share change over the intervening years.

TABLE I

IMPACT OF IMPORT MARKET SHARE LOSS ON 1977 IMPORTS TO JAPAN FROM THE UNITED STATES

Total 1997

Category Japan Imports 1968-70 U.S. 1976-77 U.S. Impact of Share Loss

(billion dollars) Share (percent) Share (percent) (million dollars)

Food $ 11.3 37.8% 33.5% $ 485

Wood Fiber, Rubber, etc. 6.5 29.6 31.4 (117)

Metal Ores and Scrap 4.8 14.8 5.0 470

Coal 3.5 58.0 32.2 901

Refined Petroleum Products 2.2 21.2 7.0 310

Cotton and Wool 2.0 11.0 17.0 (120)

Basic Materials Sub-Total $ 30.3 $ 1,930

Capital Equipment $ 4.4 61.0% 51.3% $ 428

Chemicals 2.9 41.2 39.6 46

Finished Metals 2.0 8.6 6.3 46

Consumer Nondurables 1.5 32.4 12.6 296

Consumer Durables 1.3 39.5 27.2 161

Textiles 0.7 8.7 5.6 22

Manufactured Sub-Total $12.8 $ 999

TOTAL OF CATEGORIESLISTED $43.1

TOTAL IMPACT $ 2,929

NOTE: All Japanese imports are calculated on a customs clearance basis. The categories included in this table represent 94 percent of Japan's total imports in 1977, excepting crude petroleum.

Japan's imports are largely raw materials, fuel and food. It is these basic materials that account for the large swings in Japan's trade balance and which must be looked to first in seeking relief from a deficit in Japan's trade. The trend is not encouraging. The United States has substantially increased its share of Japan's imports only in the category of cotton and wool. This is the smallest of the basic materials categories, and is moreover the slowest growing as Japan's natural fiber processing industries move offshore. In the category of wood fiber, rubber, etc., the United States has slightly improved its position, due no doubt to the favorable location and competitive position of the Pacific Northwest as wood fiber supplier to Japan.

In all other basic material categories the United States has been losing its share, most dramatically as a supplier of coal to Japan. In less than ten years the United States has moved from being the dominant supplier of coal to a second position after Australia. The Pacific Basin countries, Australia, Canada and "developing Asia" (East Asia less the People's Republic of China) are increasingly the suppliers of coal and other raw materials at U.S. expense.

The pattern is more dramatic still with respect to manufactured goods imported into Japan. The United States has lost its share as supplier to Japan in each category of manufactured imports. Western Europe has also tended to lose share although on balance to a lesser degree than the United States. In each category of manufactured goods, not only in textiles but in such sophisticated categories as capital equipment and chemicals, the share loss has largely been to the developing countries in Asia. As Table I shows, the total impact of this share loss was a diminution of exports to Japan from the United States of some three billion dollars in 1977, of which two billion dollars has been in basic materials and one billion dollars in manufactured goods.

It should be noted that the share losses of the United States as a supplier to Japan are calculated here using 1968-70 as the base period. This is the period during which the yen was exchanged with the U.S. dollar at a fixed rate of 360 to 1. The revaluation of the yen against the U.S. dollar began immediately after this period to the late August 1978 level of about 185 to 1. Most Asian currencies and the Australian dollar have tended to move with the U.S. dollar against the yen as the yen rose in value. Thus there has been little, if any, exchange rate disadvantage for the United States as supplier to Japan against other competitors, and an exchange rate advantage against deutschemark-denominated supplies.

It might be supposed that developing Asia has become a favored source because Japanese investment in the area has won it favored access to the Japanese market. The issue is hard to measure; however, the investment data do not support the notion. At the end of 1976, cumulative direct investment in Asia by Japan and the United States was at a similar level, $5.9 billion for the United States compared with $5.5 billion for Japan. The comparative level of investment in manufacturing is similar, with a difference in mix. For example, U.S. investment in chemical manufacture in Asia is twice that of Japan; the U.S. loss of share of chemical imports to developing Asia might be explained by a multinational company hypothesis, but cannot be explained by a "Japanese conspiracy" theory.

The fact that the United States is losing its share of the Japanese market in most categories of Japanese imports puts the trade balance issue into a rather different perspective. Trade barriers cannot explain these data. Whatever the barriers, the United States is supplying a smaller part of what Japan does in fact take in. This is the case despite U.S. advantages over other suppliers - a longer history of close trade association; much the highest level of what foreign investment there is in Japan; and close strategic association. The United States is losing its market share; it is losing its competitive position. At least this part of the trade balance problem comes back squarely to the United States and its economic performance.

The problem is not confined to U.S. trade with Japan, although it is particularly acute there. The U.S. share of world trade has declined steadily over the last decade, even excluding crude petroleum. In a similar period the U.S. share of Japanese imports (excluding petroleum) declined approximately seven percentage points. The impact of loss of market share in so large a market is great, and Japan's export levels make it especially conspicuous and painful on a bilateral basis. But the basic fact of share decline is the same worldwide and the basic causes are presumably the same. Some considerable part of efforts to redress the Japanese trade balance must be devoted to understanding, and remedying, the total decline in the U.S. world trade position.

IV

When addressing the issue of improvement of the U.S. share, the first question that arises is the ability of the Japanese economy to absorb additional imports. As Japan's 1977 trade balance illustrates, Japan runs a massive surplus in manufactured goods trade, and a massive deficit in trade in food, raw materials and energy. The United States also had a surplus in 1977 on the manufactured goods account but that surplus was down sharply in 1977 from as recently as 1975, owing to a disproportionate increase in imports.1 As was recently highlighted in public discussion concerning the July economic summit in Bonn, recent increases in American imports of manufactured goods have actually been at least as significant in creating the massive overall U.S. trade deficit as the continued high level of U.S. oil imports.

The differences in trade patterns are striking. Japan essentially exports no food, raw materials or energy. Nearly all of Japan's exports are manufactured goods. At the same time, three-quarters of Japan's imports are basic materials, food and fuel. The numbers illustrate a critical point in considering Japan's position. Japan must import. Without imports, Japan's living standard would drop back to the level of more than a century ago. Any rational Japanese policy must focus on the availability and security of supply of the materials needed to maintain and improve the country's level of well-being.

Exports first of all pay for the imports. It is easy now to forget the long period in which Japan's growth was constrained by balance-of-payments problems. Through the 1950s and 1960s, Japan's growth would periodically require more imports than Japan could afford. At about four- to five-year intervals, growth in domestic demand - which was and remains the engine of Japan's total economic growth - had to be cut back sharply to correct a severe payments imbalance.

Despite the crude oil problem, in 1977 only 44 percent of U.S. imports were fuel, raw materials and food. For Japan, the proportion was 78 percent. In other words, despite Japan's growth and export success, the basic issue has not changed - managing to secure necessary imports. It is not surprising that the manufactured goods trade balance has been massively favorable. Only that favorable balance, and a correspondingly favorable exchange rate, made imports possible.

The space available for import of manufactured goods to Japan is certainly much greater now than only a few years ago. In 1974, it required 82 percent of Japan's total export income to pay for imports of raw materials, food and fuel. By 1977, however, this proportion declined to 68 percent, reflecting primarily the export value surge and the decline in the import cost as a result of the combination of the yen revaluation and the large amount of imports denominated in a falling dollar. For the United States, in contrast, the food, raw materials and fuel import bill in 1974 was 53 percent of total exports, and the export income available for import of other goods was substantial. In 1977, the U.S. position was unchanged, with imports of raw materials, food and fuel 54 percent of exports.

How stable this new Japanese ratio may be is, of course, unknown. Japan is under considerable external pressure to increase its economic growth rate, and there are substantial internal reasons as well for the Japanese to place greater emphasis on domestic consumer demand. Yet Japan's dollar exports, swelled by yen revaluation, are now so high that even sustained rapid economic growth around the seven percent level will not raise the ratio significantly. The ability of the Japanese economy to accept manufactured imports, however less proportionately than the United States', is now beyond question. The Japanese consumer can only benefit from any enlarged flow.

This increased capacity to accept manufactured imports means that Japan can in fact accelerate the process of disinvestment in those labor-intensive and energy-intensive sectors that are uneconomic and unsuitable if the economy is to move further forward in output and income. Before examining that issue, however, it must be emphasized again that most of Japan's import market remains in basic materials and most of Japan's foreign exchange income goes to pay for those materials. What is the prospect of U.S. improvements in position in this sector?

V

Taking the principal categories of basic materials shown in Table I in their order of quantitative importance, the picture is roughly as follows:

In food, it is fundamental that Japan - like the European Economic Community and to some degree the United States - is bedeviled by an economically inappropriate agricultural policy. U.S. protests against import restrictions are appropriate and useful. One unofficial estimate puts lost U.S. food exports to Japan attributable to quantitative restrictions and high duties at $800 million. However, political constraints on the Japanese government make any significant sudden change highly unlikely. At present, the United States is holding or gaining share in the main categories of grain, meat, fish, and soybeans. Although the Japanese mix of food imports has turned modestly away from these staples, the U.S. position remains basically strong.

In other raw material import categories, it is economics that dictate. In the case of wood and wood products, for example, improvement in the U.S. position is entirely feasible, for the United States has a plentiful supply and a strong cost position. However, U.S. products typically achieve higher price realizations in the U.S. market and U.S. producers have not been prepared to refit mills to meet Japanese dimension and quality requirements in lumber. There is, too, the problem of prohibition on log exports from federal lands.

In iron ore, scrap and coal, where the U.S. share loss has been substantial, there is again no problem of barriers but rather that, with the Japanese seeking lowest cost sources, other nations have been underpricing American exports, and the U.S. share will probably decrease further as a result of the recent Japanese trade agreement with Peking, which specifically provides for imports of these materials from the People's Republic of China.

Similarly, in refined oil products, the sharp U.S. share loss (principally to Asian refineries) is not due to any sourcing barriers but to relative economies and supplies availability. The issue of petroleum again raises the question of U.S. willingness to supply Japan. The prohibition on sale of North Slope crude abroad is, of course, aimed directly at Japan, the obvious market for that crude. The United States has chosen not to supply, to the considerable disadvantage of the bilateral trade balance and the North Slope producers.

In cotton and wool, the United States is gaining share in a slow-growth category. Again, there are no barriers, and the issue is U.S. competitiveness as Japanese purchases move downstream from basic fibers to yarn, for example. Copper has shown a steady decline in the U.S. share, both in ore and processed copper. And, finally, although paper pulp has not been significant, the U.S. share position is basically good and there is a growing opportunity once the industry emerges from the present temporary inventory glut.

In short, in all areas except food, the issue is whether the United States is the most cost-efficient supplier. It continues to meet this test in food, logs and cotton. But where lower-cost supply has been developed - ores and refined petroleum products - trade has moved away from the United States.

Moreover, it must be said that the credibility of the United States as a reliable supplier is in some question. Japan's needs are for basic materials, which are critical to the Japanese economy. Japan cannot be at the mercy of the world spot market for its basic requirements, nor give a significant proportion of its business to an unreliable supplier. U.S. past practices here raise policy questions for Japan. The long series of restrictions on wood product exports, the restrictions on North Slope crude, the abrogation of soybean contracts - these kinds of U.S. decisions are a real issue for Japan. These decisions may be entirely appropriate for political or other reasons, but they are very expensive for the U.S. economy. In addition, they work against the United States in its efforts to further penetrate Japan's market for imported food, raw materials and energy, and other areas as well. Recent agreements under which Japan will receive substantially increased quantities of basic materials from the People's Republic of China must be seen in this context, and also in terms of Japan's efforts generally to diversify its supply sources.

VI

There can be no question of Japan's move to increase manufactured imports. The foreign exchange position makes it possible; the revaluation of the yen makes it attractive; the further development of the economy requires moves to higher value-added domestic production and increased imports; the economics of the marketplace dictate it; the policy of the Japanese government encourages it. The question is whether the U.S. position will be maintained and improved. The record to date, as indicated in the share loss figures, suggests that while the United States strives with some success to open the trade doors to Japan, other countries' products enter the opening door.

To attempt to assess the Japanese industrial situation in terms of specific product categories and barriers would be a long and tedious task. Rather, let us look broadly at what can be identified as four quite distinct business sectors. Their very diversity helps to convey something of the complexity of the Japanese economy, and to underscore again the limited utility of such stereotypes as "Japan, Inc."

First, there is the heavy industry sector - steel, chemicals, petrochemicals, aluminum, shipbuilding, synthetic fibers. In Japanese terms, this may be called the "Keiretsu/Group Sector," as most of Japan's traditional business groups - Mitsubishi, Mitsui, Sumitomo, and others - are entrenched in this sector. Heavily supported by government in the 1950s when it was truly basic to Japan's growth, it is today - like some of the same industries in Europe and America - under the most pressure from changing economics. With the exception of steel, these industries in Japan are now in trouble. They tend to be raw material-intensive, energy-intensive and pollution-intensive, and Japan is now a high-cost and inefficient site for such operations (apart from the already high and increasing labor costs of Japan, which of course have long refuted the ancient myth about Japanese "cheap labor").2

Hence, Japan is generally now in a situation of domestic overcapacity, and having to cope with the same problems of dislocation and scrapping of existing facilities that the United States has faced. In many industries, Japan itself is now investing abroad in the producing countries that also now have the capacity to produce intermediate materials - chemical feedstocks, aluminum ingots, paper pulp, and the like. For example, Japanese aluminum projects now underway or committed include major facilities in Indonesia, Venezuela, Brazil, and Canada. All of these are joint ventures with local interests. All are world-scale. They will together add more than 25 percent to Japan's capacity. The United States is unlikely under these conditions to be the supplier.

Indeed, the plans of Dow Chemical to establish a world-scale caustic soda facility in South Korea, in part to supply the very high-cost Japanese market, indicate that U.S. industry itself feels compelled to turn to cost-efficient, third-country sources of supply - which, however, means that the U.S. balance of payments is not improved by Japan's market needs.

From the Japanese standpoint, can this process be managed in an orderly fashion, and can Japan be sure that its overseas investments will in fact be the low-cost suppliers? The answer is, of course, No, and there are protectionist possibilities here that must be watched. Moreover, although Japan's basic dependency on raw material imports is immutable and must be lived with, a similar dependency on imported intermediate materials - at the mercy of price swings in these highly cyclical businesses - raises serious questions. To Japan, security of supply may at times be even more basic than cost, and Japan is likely to seek that goal through diversification of sources.

Here, the United States might conceivably make limited gains, if the U.S. public and private sectors could somehow find the means to ensure Japan the security of supply it seeks and requires. But there must be serious doubt whether this can be done from U.S.-based operations.

The second sector, identified here as "political wards," is familiar if not from Japanese experience then from experience in all other developed countries. These are the businesses that present very real political problems. The group includes agriculture, of course, and also retail and wholesale distribution. Moreover, certain labor-intensive businesses - textile weaving and dyeing for one example, stainless steel flatware for another - are regional in location. Exchange rate changes are completing the process of devastation of a number of these business categories. The regional concentration of employment makes it politically necessary to manage the displacement of these businesses, offering adjustment aid and perhaps some trade protection. All of this sector is low in capital intensity, high in labor intensity and hence low in productivity. Changes are needed and will take place, but cannot be abrupt without severe political consequences.

We have already noted the importance of the issue of agricultural policy. Apart from food, most of the businesses in this "political ward" sector are not unlike those in which the United States has pressed for and obtained voluntary quotas - labor-intensive, with low productivity and regionally concentrated employment. The kinds of product areas that may be shielded by the government of Japan offer little to U.S. suppliers - it is Asian suppliers who will be asked for voluntary quotas by Japan, rather than U.S. suppliers. And it is a difficult sector against which to apply U.S. pressure. We are vulnerable.

Retailing is a somewhat special case. Current regulations do not legally discriminate against foreign companies, but there is a retail store law in Japan that limits the growth of large chains of whatever ownership. The situation is not unlike that in the United States in the 1920s and 1930s, when a number of local and state laws sought to limit supermarket growth.

The problem for the foreign entrant is essentially that of scale. To make entry possible, a minimum number of outlets are required. But the Japanese insist on store-by-store approval, which makes any major front-end effort at wholly owned stores by a U.S. retailer risky. Aside from retail investment in Japan, the United States should encourage and support major Japanese retailers in establishing direct buying centers in the United States. The proposed Seibu-Sears link is promising. Seibu, Japan's second largest retailer, has a number of associations with Sears. Access to Sears' buying competence and power by a major Japanese retailer bent on buying and distributing direct will be a real help to U.S. trade.

We have noted that the "Keiretsu/Group" sector is open to American imports from the standpoint of government policy, but the United States may not be the supplier most likely to benefit. In the case of the third business sector, the so-called public policy companies, the reverse is true on both counts. And the political roots of Japan's severe and deliberate barriers to foreign supply have no such understandable basis, or parallels to recent American experience, as in the case of the "political wards."

The 115-odd "special legal entities" in the "public policy" sector include, for example, the Japan Telephone and Telegraph Public Corporation, the Japan National Railways, and the Japan Monopoly Corporation. Their separate budgets are estimated to total about half of Japan's official national budget.3 These corporations are essentially government-managed. They serve an important role as retirement places for Japanese senior bureaucrats, who tend to leave government service when in their fifties. The banking and finance areas, and especially the insurance business, share some of the characteristics of these public corporations in being carefully protected from foreign investment and domestic competition, and in taking in numbers of retired officials, from the Ministry of Finance especially.

The trade barriers against import access to Japan's public corporations are considerable. An example is the public Monopoly Corporation, whose restrictions on the import, sale and marketing of foreign cigarettes and other smoking materials, and whose prices and profits, border on the ludicrous. The barriers here are quite deliberate. The telephone corporation uses product specifications as a thoroughgoing barrier to sales of imported equipment. Public procurement of a broad range of items from computers and telecommunications gear to rolling stock for the rail system is broadly restrictive, even prohibitive. Japanese manufacturing companies supplying these products are competitive internationally and are becoming large exporters. This is a sector above all for government-to-government pressures. Some barriers are perhaps appropriate; many others will prove acutely embarrassing to the government of Japan if properly presented.

This general area seems likely to be the subject of at least broad agreement in principle in the current Geneva negotiations concerning all trade barriers. If Japan should fail to observe the spirit of these negotiations, direct U.S. government action will be appropriate - provided it is preceded by careful examination of the trade potential and determination of the appropriate pressure points. It is not clear that the improvement in U.S. exports will be massive. Only basic materials offer that kind of improvement potential. But this public corporation sector is highly visible, many of the products concerned have a high value-added, and the sector is a considerable irritant to the U.S. business community.

Finally, there is the sector most familiar to the individual American consumer - that of sophisticated modern manufacturing. Its products include industrial machinery of all kinds, consumer durables including automobiles, electronics, fine chemicals, etc. Here, obviously, Japan is extremely strong in global terms. The sector is the pride of the economy, the source of Japan's current export strength and the basis for future growth.

The clichés regarding Japan fit these businesses poorly. Competition is fierce. The traditional Keiretsu groups have generally failed in these businesses and the trading companies have no significant influence. Successful companies in this sector are profitable with low debt levels. Government direct support today plays a marginal role in the development of this sector, computers being the major exception.

All of these businesses were totally protected from import competition for a long period, but now all are open to import competition. There are instances of high tariffs, as in semiconductors and photographic film until recently, but even these are not critical to import sales performance. Leading companies in this sector - Toyota, Honda, Matsushita, Fuji Film, Shiseido, Seiko, Hitachi, and the like - are profitable, independent and quite well able to compete worldwide without assistance. The sector has its less luminous companies, but they seem unlikely to get special favorable treatment. The market decides the winners and controls the outcome.

There is still some barrier to imports from the United States and elsewhere in the approval procedures for products. The Japanese approval process does impede imports and compares badly with the explicit, readily available and independent procedures provided by Underwriters' Laboratories and other agencies in the United States. Most electrical and machinery items are subject to mandatory product testing for safety and other standards, in Japan as elsewhere, and products cannot be marketed until they have been approved by the designated agency. However, foreign manufacturers cannot apply for approval directly, but rather must depend on a Japanese entity to apply. Further, the testing must be done in Japan, while Underwriters', for example, maintains approval facilities in Japan for exporters to the United States. Finally, because the approval authority is not independent of the ministry concerned, there is substantial room for mistrust and misunderstanding.

For example, farm machinery must be approved by an agency of the Ministry of Agriculture. Any change in model specifications requires a new approval. The application must be accompanied by detailed drawings and specifications. The application goes to the end of the queue. Thus, a change in design of an imported product requires that the design change be made public, and a period of as much as 18 months may elapse before marketing approval is granted. A suspicion on the part of the importer that competitors may have time to study and meet his new design is not surprising.

This area is straightforward. There is no indication that the Japanese government will resist pressures to bring Japanese practice into line with that of the United States. And failure of the government of Japan to follow U.S. practice can easily be countered by a shift in U.S. practice toward the Japanese approach.

With the exception of product approval procedures, the area of modern manufacturing must be considered essentially open. The recent loss of share by the United States in nearly all the aggregate categories of trade in modern manufacturing must be laid to the competitive behavior of U.S. companies. To this we now turn.

VII

U.S. private corporations will ultimately determine the level of U.S. penetration of the Japanese market. As has been discussed, Japan has been doubly protected in the past from foreign products and investment - first by its own system of protectionism and controls, but also by the indifference of a great many U.S. companies toward Japan. The enormous flow of U.S. technology to Japan in the 1950s and 1960s reflected (and compounded) both protectionist trends. On the one hand, entry to Japan was difficult and the Japanese were eager to buy technology. On the other hand, the foreign company often had no real determination to enter Japan. The market seemed small and remote. Technology sales seemed inexpensive. The income from written-off investment in research and development (R&D) was attractive.

The result has been a disaster. Over the years, the cumulative cost to Japan of technology purchases from abroad - more than 25,000 contracts covering essentially all the technology the West had to offer, most of it from the United States - has been about six billion dollars. That is a little more than ten percent of the annual R&D expenditure of the United States. More to the point, that technology has nurtured competitors who now enter or threaten U.S. markets. And as a final irony, technology which might have been a lever to enter the Japanese market has been surrendered, and with it the advantage that might have made entry successful.

Shortsighted? Yes. But natural enough, for the U.S. business community was not alone in underestimating Japan's potential. Further, income from technology sales can be critical to a company that is under severe pressure to improve short-term earnings per share and to a manager under pressure to increase his return on investment. The income is nearly net, with little associated expense. And the investment is nil. Finally, given the current enforcement of U.S. antitrust laws, a number of U.S. companies particularly distinguished for their R&D performance are forced to make patents available worldwide to all buyers at a reasonable price. This continued access to U.S. developments is another of the self-imposed trade penalties under which the United States suffers.

The problems of perspective and of time horizon pervade the question of U.S. corporate performance in Japan. Part of the problem is the well-known issue of relative market size. Like the Dutch, Swiss and Swedes, the Japanese see (or have usually seen) their domestic market as small. Each foreign market is important, and the U.S. market as the largest is critical. To the U.S. company the domestic market is huge and each foreign market is relatively unimportant. Since the less well-understood foreign market also offers higher risks, a tendency to focus on the domestic U.S. market is natural enough. Japan, especially small and especially unknown, not surprisingly came well down on the priority list of most U.S. corporations.

The performance of U.S. companies selling into Japan is mixed. Some have done very well, manufacturing from a U.S. base, hoarding their technology, investing in Japanese distribution, and both fending off competitors and preventing backward integration by customers. Nor are these necessarily large corporations. Dupont, Boeing, Upjohn, Texas Instruments, and their like understandably have developed strong Japanese market positions through import. So, too, have the lesser known Omark Industries, Locktite and Memorex in their products.

Among those American corporations that have made an effort to crack the Japanese market - or now propose such an effort - it is common to hear complaints that the Japanese distribution system poses a barrier to market entry. In our judgment this complaint has only limited validity. It is useful to consider separately the distribution of industrial products, usually requiring sales engineering and after-service, and of consumer products sold into wholesale and retail distribution to the mass consumer. The problems are different.

For the industrial or large-ticket consumer item, the problem all too often results from an effort on the part of the exporter to Japan to obtain market entry without out-of-pocket expense. A trading company is often engaged as distributor, for example. Now, the general trading companies are many things, but they are not effective distributors of products requiring promotion and service. They are not staffed for that (with some exceptions); it is not their main business. The trading companies are effective in large volume transactions where financing and logistics are critical.

A frequent complaint about Japanese industrial distributors is that they demand too high a margin or, more often, that they exact too high a price in the market. This kind of complaint, like the complaint about an ineffective distributor, is surely naïve. Distributors have an interest in high margins and sales at minimum cost. The manufacturer is interested in building market share, market position, while maintaining adequate margins. To complain that a distributor in Japan is inadequate or unsuitable simply indicates that the exporter to Japan has not taken the trouble (that is, expense) to study the market, select the proper channel and motivate it appropriately.

There is nothing for either government to do in correcting basic business mistakes, although it would be useful to Japan-U.S. relations if the U.S. government were less prone to lend credence to these kinds of complaints. One area in which the U.S. government might play a useful role is in the review of tax laws that can make it difficult for an aggressive U.S. company to cut price into Japan. The issue here is transfer price between U.S. parent and overseas sales subsidiary and the degree to which price cutting from the parent is viewed as an effort to displace income to a different tax jurisdiction. The Internal Revenue Service can hinder U.S. companies from repaying the Japanese in kind and price cutting into the Japanese competitors' home market.

A case in point is a U.S. machinery manufacturer, a dominant and low-cost world producer. A major Japanese company entered its product area, and by aggressive sales of small-size products took a major share of the Southeast Asian and West European markets. By the time the U.S. producer awoke to the threat, its share in many markets was second to the Japanese company's. The threat is now being met by the U.S. company. But the most effective strategy is to attack the Japanese company in the Japanese market. The Japanese firm's sales there are large, the U.S. company's negligible. Sharp price cutting into Japan could cut off the cash flow that is supporting the Japanese company's worldwide attack. The U.S. company intends to do so, but because of U.S. tax laws has chosen to go into production in Hong Kong as a supply base for attacking the Japanese market.

This true story illustrates several themes: the late perception of the Japanese threat, the failure to be aggressive in the Japanese market, the Japanese pattern of moving first into the smaller world markets before engaging the American competitor in his home market, the Japanese pattern of gaining cost position in a sheltered domestic market and in third-country markets before moving to the jugular.

The Japanese market is large. It is fiercely competitive. Like any large, competitive market, it is expensive to enter. Too few U.S. companies are prepared to pay the price of entry, in large part because too many U.S. companies maintain an out-of-date view of Japan.

The retail distribution problem is different in some respects from the industrial distribution problem. Most complaints about Japanese distribution focus on this area. In truth, the Japanese distribution system is difficult. That the problems can be overcome, nevertheless, is demonstrated by the spectacular success of companies like Nestlé, Schick, Polaroid, Lipton, Coca Cola, and many others. However, in retail food distribution in particular, nearly all successes have been achieved through using the distribution system of a well-established Japanese company.

Japan, truly a nation of shopkeepers, has hundreds of thousands of retail outlets, most small and poorly financed. No company could conceivably bear the cost of reaching a significant number of these shops through direct distribution. And the large outlet or supermarket is still only a small part of total retail sales. Further, advertising and promotion costs are high, as would be expected in a developed and heavily populated market.

Still, to speak of the distribution system, however complex and costly, as a non-tariff barrier to trade is a curious use of the phrase. The Japanese language is a non-tariff barrier to trade if we are to interpret the term so loosely. The system was not designed to frustrate foreigners, although it may do so in practice. It can be equally frustrating to Japanese manufacturers, especially marginal competitors. To expect or insist on change because current practice inconveniences foreigners is, to put it mildly, unreasonable. And, as noted, the system can be dealt with successfully by those who take the time and expense to do so.

The expense issue leads directly to the question of the time horizon of U.S. companies. There is little U.S. investment in Japan. In fact, foreign capital-related companies (those with 25 percent or more foreign-owned equity) account for only four percent of total Japanese manufacturing sales and only two percent of total business sales. Some foreign investments have been stunning successes. Some have failed. Investment is relevant to the issue of trade because investment in Japan is a powerful stimulant to export sales to Japan. Foreign companies on average import more than seven times as much as the average Japanese company imports, while exporting much less from Japan than the average company. The issue here rests with the problem of undertaking acquisitions in Japan.

U.S. companies have traditionally entered advanced markets in Europe via acquisition, and European companies are now replaying the pattern in their U.S. entry. Acquisition of a successful company solves at one stroke the whole series of problems usually cited as obstacles to entering the Japanese market. A well-selected acquisition of a local company brings with it capable management and staff, effective government relations, and physical plant and facilities. Equally important, through acquisition the cost of entry can be capitalized and need not affect earnings.

Unfortunately, because of basic differences in corporate philosophy and in the concept of the company, it is the habit in Japan to envisage acquisition (from any source) only when a company is essentially bankrupt, and as an alternative to the bankruptcy court. This is hardly the sort of acquisition an entering foreign company will seek. This state of affairs, however, should not be interpreted as a barrier to foreign investment, since successful businesses are not available for acquisition by Japanese companies any more than by foreigners.

Because acquisitions of successful companies are not possible, the high costs of entry to Japan - acquiring land, warehouses and plant, searching out staff in a country with little job mobility, building a distribution system, establishing a brand position - all must be treated as expenses out of current earnings. And with dollar devaluation, the already high cost is rising rapidly to even higher levels. Few U.S. companies and few U.S. managers are in a position to undertake that sort of reduction in reported earnings for the sustained period necessary to establish a position in a highly competitive market. Further, U.S. share prices are directly related to earnings per share, and to short-term changes in earnings per share. U.S. executive compensation is importantly linked to share price levels. The combination makes financing entry into the Japanese market by expense investment extremely difficult.

It appears well worth exploring the possibility of changes in U.S. tax laws and accounting practices that would allow companies to capitalize the expense of entry into the Japanese market. Special handling of R&D expenses has been possible. And if the mind of man could conceive the original tax and accounting procedures, surely it can conceive constructive changes in them.

In the last analysis, U.S. trade success or failure depends on the decisions of a great many individual U.S. businessmen. Exhortation or criticism is not likely to be useful. If the trade problem with Japan is to be solved, specific actions helpful to U.S. business in the areas of tax and antitrust enforcement and information programs at the most senior level will be needed, as well as concerted effort by the U.S. government and business to work together.

VIII

Japan will be a major raw material, food and fuel importer and will be heavily in deficit in that trade for the foreseeable future. Further, Japan will continue to be heavily in deficit in the "invisibles" account for some years.4 To pay for these goods and services, Japan will run a surplus in its manufactured goods trade account. These goods will go in large proportion to the United States, which, while declining in importance as a market for Japan, remains overwhelmingly the largest single market for manufactured goods exports.

Further, Japan will be an exporter of capital in rapidly increasing amounts to secure low-cost labor and to secure sources of raw materials and intermediates. It is in the interest of the United States and the world that Japan do so, for Japanese capital and technology, and the Japanese market, can do much to help in developing new raw material sources and to aid the economic development of host countries. However, this export of capital over time requires surplus on the current trade account to meet Japan's economic aspirations.

Japan's industrial policy is essentially the economically rational one of a steady effort to move to higher levels of productivity and higher levels of value-added. This means explicitly that some industries erode and absorb more imports while others grow rapidly in production and export. The government does not direct these things to happen nor does it any longer protect and generously nurture major modern manufacturing industries, except computers. But it does gear tax laws, depreciation schedules, trade policies, antitrust enforcement, and R&D subsidies to encourage structural change. It also exerts considerable informal pressure to that end. It remains a pleasant surprise to have minor bureaucrats address public meetings and discuss programs to cut back inappropriate sectors. The government typically buffers the decline but promotes it nonetheless.

In this framework, Japan's pattern of trade is rational and economically sound even if the current levels and balance of trade are not. Although Japan's import level relative to exports is highly inadequate, the pattern industry by industry reflects basic market forces and is consistent with the industrial policy. In industries where Japan has no future - textiles, heavy inorganic chemicals, low-end consumer electronics, aluminum, etc. - imports are rising significantly faster than exports. In industries where Japan is or is becoming the dominant international competitor - small-sized construction equipment, watches, materials-handling equipment, etc. - exports are growing faster than imports. In yet a third category where Japan's best companies are competing worldwide with strong Western firms and where the latter have made significant investment of late in the Japanese market - autos, computers, integrated circuits, large internal combustion engines, etc. - both exports and imports are growing fast, well above Japan's average.

Revaluation will reinforce this pattern over time as the various lags of perception and reinvestment cycles work themselves out. As this occurs, Japan's trade pattern shifts Japan's domestic production mix toward higher standards of living. It is worth, incidentally, pausing at the question of whether revaluation will go too far and choke off Japan's export growth. The yen can and will experience excessive swings in its value. However, in the longer run, the yen will move to generate a large net manufactured trade surplus. Japan's peculiar structure of trade and payments will make this so. Only a shift in the Finance Ministry's resolve to limit the yen's reserve currency role will change this.

These data need to be seen together with Japan's pattern of savings and investment to gauge future trade interaction. Japan's rate of investment has been for two decades higher by a considerable margin than that of other major economies. Productivity increases have been, correspondingly, roughly twice as rapid as those of other major economies. This is part and parcel of a shift to higher value-added, even though national income accounting typically disguises the data. Investment in the current generation of high-technology industries increasingly takes the form of R&D, applications engineering and software development, most of which is not capitalized as accounting investment like plant and equipment but rather is expensed in the period. The current fall in investments' share of Japanese GNP is therefore deceptive. Japanese firms retain their motivation to invest - appreciation of the value of market share, mobility of a skilled career labor force, and a healthy disregard for short-term movements of earnings per share.

Investment has, as its counterpart, savings. Japan saves in large amounts. Savings rates in all sectors - household, corporate, and government - have been high compared to other major economies. To the extent the United States tends to consume, rather than save and invest, it will consistently lose competitive advantage in the higher value-added sectors where trade among the advanced economies is concentrating. Investment means productivity, and productivity means cost reduction and superior product design.

This suggests that the trade problem with Japan will, first of all, continue, driven by Japan's need for a massive surplus in manufactured goods trade. It suggests further that the crises will continue to roll forward to more sophisticated items. Textiles were once the problem, more recently television sets and steel. Next autos? And next semiconductors? And next? There may be some political relief from the fact that Japan will begin exporting some products only Japan is producing. The videotape recorder is a current example. The trade balance problem will be no less intense, however, even though specific U.S. producers may not be in pain.

We must, however, also be prepared in the United States for an additional problem. Japan is serving as model and as engine for the whole of free Asia. And the pattern of trade described, of raw material, food and fuel imports and manufactured exports, applies not just to Japan but to Taiwan and Korea as well. Table II shows the very high rates of growth and of capital formation throughout Asia. U.S. policies formulated to deal with the trade issues arising from Japan will be sounder if they take into account the broader phenomenon of Asian economic growth. These economies are now competing very successfully against the United States for position in the Japanese market. That competition will not be limited to the Japanese market.

TABLE II

EAST ASIAN GROWTH RATES AND RATES OF CAPITAL FORMATION

Annual Real Growth 1970-75 Gross Capital Formation as Percent of GNP, 1975 (percent)

Japan 5.4 33

South Korea 10.9 27

Taiwan 7.4 38

Hong Kong 5.8 21

Singapore 9.5 39

Indonesia 7.2 19 (1965 = 7%)

Malaysia 7.2 23

Philippines 6.3 24

Thailand 5.9 27

United States 2.1 15-16

IX

It is difficult to be optimistic about the prospects of fundamental improvement in the U.S. trade position with Japan. The root problem lies deep within the U.S. economy. For Japan to continue to be successfully competitive, it is required only that Japan hold to the basic policies it has been pursuing, and that it continue to encourage rather than attempt to interfere unduly with the workings of the market place. High levels of savings and investment, moving in response to market forces, will continue a high level of trade performance (always, of course, assuming no drastic change in world patterns).

Revaluation of the yen, within reasonable ranges, provides only limited relief as well. Revaluation is not linear. Japan's imports are dollar-denominated and revaluation provides negative inflation rates, which in turn add to competitiveness against inflating economies. The revaluation also forces restructuring of the Japanese economy, and painful Japanese political decisions regarding restructuring, more rapidly than would otherwise be the case. Given reasonable political stability in Japan, which appears likely still, the revaluation effects can be quite beneficial.

In many ways, this topic of the U.S.-Japan trade imbalance is a difficult one to address. Although an economic issue, it arouses high emotion. Yet dealing with it requires a rational policy. Japan must import, as must all of Northeast Asia. To deny a surplus on manufactured trade is to deny that import capability. What strategic value do we attach to continued close ties with Japan? What price, if any, are we prepared to pay for stability in Northeast Asia? The warning implicit in Japan's moves to increased trade with mainland China is clear enough. There is a central underlying strategic issue in all this that must be translated into trade policy.

A rational policy must also take account of multilateral balances. Japan is in trade deficit with Australia and Canada, with whom we are in surplus. What level of bilateral deficit with the United States is tolerable? None? How much?

These issues may well have been resolved by the U.S. government, and we are merely not aware of them. Assume we place a considerable value on Northeast Asian stability and prosperity. Assume we approach the issue multilaterally and are quite prepared for a bilateral deficit of substantial size for a long period. It would help the public temper in both countries if this position were more explicit. The reputation of the United States and U.S. companies in Japan has not been helped by recent events. A distinct note of irritation is in the air.

Finally, this review of the U.S. trade position with Japan leads to a conclusion that there is an urgent need for review of the U.S. international economic competitive position and for the development of policies to improve the U.S. position. That is a large task, but a review of the Japan situation makes it clear that the need is no less great.

Footnotes

1 According to the authoritative calculations of the Japanese Ministry of Finance, the overall Japanese trade balance in 1977 showed a surplus of $9.7 billion (comprising $80.5 billion of exports and $70.8 billion of imports). In manufactured goods, the favorable balance was $63.2 billion (comprising $78.9 billion of exports and $15.7 billion of imports). This more than offset the very large unfavorable balance in raw materials and food of $53.5 billion (comprising $1.6 billion of exports and $55.1 billion of imports). Similar authoritative estimates by the Organization for Economic Cooperation and Development in Paris show that the U.S. trade balance in manufactured goods was favorable in 1975 to the tune of $22.3 billion (comprising $71.2 billion of exports and $48.9 billion of imports). In 1977, this favorable balance had shrunk to $6.9 billion, with exports of manufactured goods up to $89.0 billion but imports in the same category substantially increased, to $82.1 billion.

4 These invisibles include all kinds of services such as insurance, banking, tourism, and shipping. In 1977, Japan's net deficit in this area was $6 billion, or roughly one-third of its total surplus in visible trade. It is unlikely this will soon reverse.

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  • James C. Abegglen is President of The Boston Consulting Group's Tokyo subsidiary and lives in Tokyo. Thomas M. Hout is a principal in The Boston Consulting Group. Messrs. Abegglen and Hout are co-authors of Japan in 1980, and Mr. Abegglen is the author of Perspectives on Business Strategies on Japan, Management and Worker: The Japanese Solution, and The Japanese Factory. This article grows out of work prepared earlier this year for Anthony Solomon, Under Secretary of the Treasury for Monetary Affairs. It represents, of course, solely the views of the authors.
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