In the late 1980s, Japanese manufacturing foreign direct investment (hereafter, Japanese FDI) in the European Community (EC) countries was unprecedented, and its surge was concomitant with EC market integration. The annual net increase in Japanese manufacturing subsidiaries in the EC was more than 100 firms in 1988, 1989, and 1990. However, the net increase fell suddenly to 60 in 1991, 20 in 1992, and 19 in 1993 (JETRO, 1994).
Recent empirical studies on Japanese FDI (e.g., Heitger and Stehn, 1990; Kogut and Chang, 1991; Yamawaki, 1991 and 1993) support the traditional theories of intangible assets and the product cycle to elucidate long-term relationships between parent firm characteristics and FDI. On the other hand, their empirical findings are less convincing in explaining the short-term cyclical movement of Japanese FDI in the EC in the late 1980s and early 1990s. Furthermore, Japanese FDI out-flows in the same period reveal that the surge and plunge in the number of Japanese manufacturing subsidiaries was a global phenomenon. Only China received an increasing number of Japanese FDI towards the mid-1990s.
This study identifies the cause(s) behind the short-term cyclical Japanese FDI in the EC in the late 1980s and early 1990s and proposes two testable hypotheses: (i) a bubble economy hypothesis attributing the sharp increase and subsequent precipitous decline in Japanese FDI in the EC due to the Japanese economy's overheating in the late 1980s and its waning in the early 1990s and (ii) a catch-up hypothesis attributing the upward surge in Japanese FDI in the EC in the late 1980s to the anticipation of EC integration into a single market from January, 1993.
Empirical investigation shows that, first, the short-term cyclical Japanese FDI in the EC was due mainly to the cyclical effect of the bubble economy in Japan. Second, the cost minimizing behavior of Japanese parent firms is highly related to the choice of country decision, so that tax-related incentive policies in a host country play a significant role in encouraging Japanese FDI. Third, the characteristics of parent firms explain long-term FDI behavior but not the short-term cyclical movement of Japanese FDI. One can draw some policy implications regarding these results.
A bubble economic phenomenon, as that in Japan in the late 1980s, appreciates the value of a firm's assets - e.g., stocks and real estate - and increases costs of domestic production. This phenomenon provides domestic manufacturing firms with the incentive and potential to invest abroad. In addition, the appreciation of the Japanese exchange rate provided an additional financial incentive for FDI and also made the manufacturing firms become more competitive than their counterparts from other potential FDI-exporting countries. In third countries like the United States, manufacturing firms that face severe competition in financing their FDI in a global financial market and in setting up their subsidiaries in a FDI-importing host country need to promote their managerial abilities with respect to achieving long-run goals. Competition among the FDI-exporting countries will increase benefits to the host country in terms of higher employment and production.
On the other hand, the host country must be aware that the size and timing of incoming FDI is highly sensitive to the economic situation of the FDI-exporting country. An abrupt tightening of liquidity in the exporting country, as happened in Japan, drains FDI quickly from the host country. This may have a significant impact on the economic performance of the latter. Hence, the government in the host country may need to take appropriate measures to counteract the drainage of FDI in the short run and to create favorable product and factor markets. For example, tax-related FDI incentive policies were one of the key factors that sustained the inflow of Japanese FDI to the EC. In addition, eliminating various technical and fiscal barriers has been equally effective in stimulating FDI. …