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Australia and Japan - How distance and complementarity shape a remarkable commercial relationship

Chapter 3 - Shifting context: change in the Japanese and Australian economies

Crucial to the way that the shaping forces of complementarity and distance examined in Chapter 2 evolve will be, of course, developments within the economies and societies of both Australia and Japan. These internal developments will also influence how firms and governments in both countries respond to and participate in the continuing change that is afoot in the regional and global economies. This chapter looks ahead at the key factors that are likely to drive those internal developments in the medium to long term, and speculates about their possible impact on the shape of the bilateral commercial relationship.

Predictions are almost always wrong. If asked 20 years ago where the two economies would stand today, many commentators would have predicted a future very different from that which has actually transpired. Japan at that point seemed in the heyday of its economic vibrancy, making large and highly visible investments in international assets, and touted by many as on a course to wrest economic ascendancy from the United States sometime in the first half of the 21st century. Since then it has been on a roller-coaster ride: from a 'lost decade' of economic stagnation in the 1990s; to its longest stretch of uninterrupted growth since World War II between 2002 and 2008 (OECD 2008); before, in late 2008, falling back into recession following the onset of the global financial crisis.

Twenty years ago, Australia, on the other hand, was still digesting the implications of its then Treasurer's 1986 warning that continuing on its existing course could lead it to 'banana republic' status, but it has since become consistently one of the fastest-growing economies in the OECD during what has also been its longest period of uninterrupted growth since World War II. More recently, expectations have again been turned on their head as the global financial crisis has seen a massive depreciation of the Australian dollar, a large appreciation of the yen and dramatic declines in commodity prices.

We do not, therefore, presume to know where the events of the next 20 years or more will leave either the Australian or the Japanese economy. Nor does the Economic Analytical Unit have specific insights of its own that would radically challenge the views of others-indeed, it must be noted at the outset that much of the commentary on the Japanese economy contained below draws on ideas from policy papers of the Japanese Government itself, which is acutely aware of the challenges the country faces. Rather, our aim is to bring together some of the key issues identified by authoritative commentators as important to the medium- to long-term future of each economy and use these as a prism through which to view the possible development of Australia-Japan commercial relations into the future. While our focus is the impact of these trends in the years to come, we start by examining the recent past to shed light on how these trends are developing and provide a basis for analysing how they will affect the two countries in the future.

The Japanese economy

Public commentary on the performance of the Japanese economy in recent times, and prognostications for its short-term future, tend inevitably to the gloomy. Growth in the 2002-08 period, though relatively long-lived, was anaemic and uncertain, and reform prospects are widely seen as remote in a fraught political situation where there is apparently no political party or political figure in a strong position to promote sustained reform. Not, in short, an apparently enticing prospect for business at the macro level.

But is all as it seems? It is not the intention of this report to gloss over the very real difficulties of economic and political management that Japanese governments are likely to face for some time to come. We do, however, believe that there is value in going beyond the headlines and challenging the idea that relatively low levels of aggregate growth and a problematic environment for reform mean that new opportunities for mutually beneficial business partnerships are not occurring. Why?

The first reason is Japan's size and wealth. These are important regardless of growth. Japan's economy remains the second-largest single national economy in the world (after the United States) in market exchange rate terms. Its GDP is several times that of Australia-meaning that even relatively small shifts are of disproportionate potential significance to Australian companies that are used to dealing with a smaller market. For example, though the growth rate of the Japanese economy as a whole has been relatively low since the 1990s, the magnitude of growth in the fastest growing sector-the services sector-alone since the beginning of the 1990s is in fact larger than the total size of the Australian economy (Figures 3.1 and 3.2).

It is also important to remember that, although Japan's per capita GDP has declined relative to that of the OECD as a whole since the beginning of its 'lost decade' of the 1990s, it remains the richest major market in Asia by some margin. While the slowing of the pace of its GDP growth is particularly stark by comparison with other regional economies-and despite its growth being forecast to remain slower well into the future (Goldman Sachs 2007)-Japan's purchasing power remains far higher and will be for the foreseeable future (Figure 3.3).

Noticeable from this projection-and remembering that it is just one possible scenario, even if it approximates what most analysts think likely-is the fact that while countries such as China and India are expected to grow at a greater rate from their low bases than Japan is from its high base, the actual quantum of increase projected per Japanese person between 2006 and 2030-about US$15,900-is, in fact, slightly greater than the increase per Chinese person (about US$15,500). Moreover, as we shall see, savings rates in Japan are already falling, and can be expected to fall further as the society ages; meaning that, overall, while the increase relative to current expenditure for Japan may not be as great as it is for China, the actual increase in potential expenditure per person is nevertheless likely to be substantial.

The second reason is expectations of rates of growth and changes in the structure of Japan's economy. Japan's success is that it has been one of the relatively few countries in the post-war era that has been able to move itself out of the low-income bracket, through the middle-income category, and into the ranks of high-income economies. While the high levels of economic growth Japan enjoyed in the post-war period have been replicated by many others at times, few have sustained the growth for long enough to achieve what Japan has (Gill and Kharas 2007).

Figure 3.1

Even when growing slowly, Japan's size makes the numbers large ...

Japan’s real GDP by sector, 1970-2005

Figure 3.2

... larger than for Australia, even when growing more rapidly

Australia’s real GDP by sector, 1970–2005

Note: An international dollar has the same purchasing power over GDP as a US dollar has in the United States at a set point in time, in this case 2005.Source: OECD.Stat database.

Figure 3.3

Even as others catch up Japan grows a lot in absolute terms

Per capita GDP in selected countries, 2006 (actual) and 2030 (projected)

Source: Goldman Sachs (2007).

Once the Japanese economy had essentially caught up with the productivity levels of other developed economies, it was inevitable that growth would slow down. In and of itself this would imply a smaller manufacturing sector as the absence of rapidly expanding industries reduced demand for capital equipment. This, and the shifts in the global economy explored later in this chapter, means that deep structural changes in the Japanese economy have been occurring since the early 1990s. This period of structural change has in itself tended to slow growth for the period.

Expectations of future growth based on memories of the post-war period therefore need to be revised, meaning that the comparators often used by commentators- China and the other dynamic Asian developing economies-are no longer relevant. Japan's growth rates between 2002 and 2008, which averaged around 2 per cent, seem insipid in the context of its post-war boom, but are not markedly out of kilter with those of the other rich developed economies, particularly when the demographic factors outlined below are taken into account. While Japan's economy has clearly made this transition, it is arguable that many observers' expectations have not.

Looking to the future: the demographic challenge ...

The single predominant structural challenge that Japan's economy will face in the future is to deal with the well-documented and profound demographic shifts now under way. According to UN Population Division projections, Japan's population has now peaked, and is likely to decline progressively over the years between 2008 and 2050, falling from a peak of around 128 million to approximately 112 million in 2050 (Figure 3.4).⁹

Figure 3.4

Japan grows older

Japan's population by age group, 1950-2050 (UN medium scenario)

Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2005 Revision, <http://esa.un.org/unpp>.

The economic consequences will be exacerbated by the changing structure of the population that this implies. As the population gets older, birth rates, which fell below the rate of replacement in 1975, will continue to decline. Consequently, as Figure 3.4 shows, the proportion of the population that is potentially economically productive (notionally the 15-64 age group, though Japan's relatively high school retention rates mean this probably overstates the workforce to some extent) will decline significantly. Between 1990 and 2050, Japan's working age population is forecast to fall by around 20 percentage points, while the population over 65 will increase by 24 percentage points to 36 per cent of the population (Figure 3.4). Broadly speaking, this means that there will be a shrinking number of working people, and they will be required to support a constant number of their nonworking compatriots-by 2050, the ratio of people nominally of working age (15-64) to those not of working age (0-14 or over 65) will be approximately 1:1 (it is currently approximately 2:1)-meaning, in other words, one dependant for each potentially productive worker.

The continued rapid ageing of the Japanese population will thus place a heavy burden on society-because of the impacts on fiscal policy, consumer demand, financial markets, and trade and labour markets-and therefore on future economic performance (Farrell and Greenberg 2005). Funding the pensions of Japan's retirees will be a major challenge, especially given the poor performance of the public pension fund. Returns have been on average half or less of comparable funds in other developed countries, which some ascribe to conservatism-much private saving is also invested in assets that produce low returns-and to the unwillingness to replace the bureaucrats in charge with professional funds managers (The Economist 2008). Demographic pressures are also expected to have an impact on health care and the share of GDP spent on that sector. If the current health-care policies continue, the gap between the collections of the insurance system and its expenditure will widen. Total health-care expenses under the National Health Insurance system were 6.6 per cent of GDP in 2005 but could grow to 13.5 per cent of GDP by 2035 (Kadonaga et al. 2008).

Modelling results of the contribution of demographic change to the Japanese economy from 2005 to 2100 show that Japan's demographic change could start detracting from GDP growth in around 2010 and growth would be up to 1.2 percentage points lower by 2040. Demographic change in the rest of the world, predominantly in East Asia, will ameliorate this effect, so that in 2040 growth would be just under one percentage point lower than without demographic change; this is due to increased international demand for Japanese goods and increased income earned on Japanese overseas investments (Batini et al. 2005).

The ageing of the Japanese population has particularly serious implications for its agricultural sector. In 2007, 59 per cent of Japan's farmers were 65 years or older (MAFF 2008); in 2004, only 8 per cent were under 30 (Roberts et al. 2006); and, between 1991 and 2004, the number of people aged 15 years or over in commercial farm households declined by 26 per cent (Roberts et al. 2006). Current laws inhibit consolidation of small landholdings under the ownership of corporate farmers, though in 2007 the Keidanren (Japan Business Federation) proposed amending them. However, the combination of ageing and decline in the agricultural workforce is already leading to an increase in the contracting out of farming (Roberts et al. 2006).

Japan's dramatic population ageing will also pose challenges for macroeconomic management in a range of areas. Fiscal policy, already restricted by the highest levels of public debt in the OECD, will need to cope with higher social security and health costs; the contraction of the labour force will directly affect growth prospects; and financial markets will feel the impact of changes to financial wealth and savings (Japan's household savings rate is already showing signs of decline as older workers leave the workforce and start to consume their retirement nest eggs). Ageing also adds to the urgency for further reform of social security and the labour market, which will help to increase the efficiency of the Japanese economy.

Box 3.1 The end of Japan's high savings rate?

A key element in Japan's 'miracle' was the high rate of household savings. This provided an important source of capital for Japanese firms, often available at modest interest rates given that much of the household savings were in low-interest accounts, especially in the Post Office savings system. Already a combination of factors-including changing demographics (older people tend to spend rather than save) and a higher propensity to consume among younger generations-have led to a significant drop in the savings rate (Figure 3.5).

Figure 3.5

The rise and fall of Japan's household savings rate

Household savings rate for Japan, 1955-2006

... and the consequent productivity imperative

GDP is essentially a function of two main factors: person-hours worked and productivity. In the face of a declining workforce, there are limited options for maintaining GDP growth. Where the workforce is not only declining in absolute terms but also as a proportion of the population, as appears likely to be the case in Japan, even maintaining growth in per capita GDP becomes increasingly challenging.

Logically, what are the available options?

The first is to take steps to reverse the decline in the workforce, either by importing labour (already evident in some sectors in Japan, where regulations have recently been amended to allow foreign workers greater access to Japan); increasing the birthrate (necessarily a longer-term solution); or increasing the participation rate- in the case of Japan an imperative that has focused policy-makers on reversing the traditionally low participation rate of women in the workforce. The second is to increase the number of hours worked by those who are in the workforce-an approach that clearly has limitations. The third is increasing productivity of the workforce, and the fourth is to supplement GDP through external income generated by external direct investment-effectively buying in foreign labour without an immigration program. (This is, of course, the effect of the approach adopted by many Japanese firms since the late 1980s of shifting production offshore-primarily of labour-intensive goods-effectively increasing the workforce available to them.)

It is as yet unclear which, or what combination, of these steps Japan will implement to address the challenges raised by its demographic situation. Arguably, it is likely to be a response involving multiple solutions: 'silver buckshot' (Prins and Rayner 2007) rather than a 'silver bullet'.

Productivity

Productivity assumes particular importance if we take a look at the drivers of Japan's remarkable growth in the decades leading up to the 1990s. Productivity growth was high, and Japan rapidly closed the gap of output per hour worked with the United States (Figure 3.6). This levelled off, and even temporarily dropped, however, when GDP per capita reached approximately 80 per cent of that of the United States (Figure 3.7)-arguably the point at which obvious productivity gains through technological 'catch-up' became harder to achieve.

Figure 3.6

Productivity growth slows ...

Output per hour relative to the United States, 1950-2007, selected countries

Note: US dollars converted at Geary Khamis purchasing power parities.Source: Conference Board and Groningen Growth and Development Centre, 'Total Economy Database', January 2008, <www.conference-board.org/economics>.

Figure 3.7

... and so does growth in relative GDP per capita

GDP per capita as a proportion of US level, 1950-2007, selected countries

Note: US dollars converted at Geary Khamis purchasing power parities.Source: Conference Board and Groningen Growth and Development Centre, 'Total Economy Database', January 2008, <www.conference-board.org/economics>.

Looking at the picture to date, it is clear that Japan in the 1990s faced what economists in their less technical moments might describe as a structural double whammy. Just as the workforce was starting to decline, both as a proportion of population and in absolute terms, productivity also plateaued. Unsurprisingly, rapid growth has been difficult to achieve since, though there have been some signs of improvement in productivity in recent years.

How can increased productivity be achieved? At the economy-wide level, there are essentially two factors that need to be addressed. The first relates to efficient allocation of resources-that is, ensuring that resources flow naturally to relatively highly productive sectors of the economy; the second is to improve the productivity of workers within the sectors in which they work.

Allocative efficiency is a critical emerging issue for Japan, with both sectoral and geographic factors in play. At the sectoral level, a striking duality exists in the Japanese economy between highly productive, highly competitive manufacturers that are subject to stringent international competition, and almost everybody else who is not. Essentially, Japan's fortune has been built on the former and distributed to the latter-in much the same way as was the case in Australia over the many years that it 'rode on the sheep's back', an era when the proceeds of competitive rural export industries were used as a means of subsidising a protected manufacturing sector. In Australia's case, the long-term secular decline in international commodity prices, resulting in falling terms of trade, made continuation of this policy untenable: in general, the proceeds of the efficient were no longer adequate to pay for the protection of the uncompetitive.

The drag caused on Japan's higher performing export-oriented sector became particularly apparent in the lost decade, when the performance of the domestic laggards swamped the excellence of the high-profile exporters, resulting in a widening gap in real GDP per capita between Japan and other industrialised economies (Kondo et al. 2000), a situation that improved somewhat after 2002 (Figure 3.7). The world-beating sectors of automobiles, steel, machine tools and consumer electronics have thrived; however, the other 90 per cent of economic activity takes place in companies that do not export, mainly domestic manufacturing and services firms. The 1999 labour productivity levels of the non-exporting firms were only 63 per cent of US levels (Kondo et al. 2000), and the productivity of capital in Japan was even lower (61 per cent of US levels). Agriculture, too, while a relatively small and declining proportion of the economy, demonstrates very low productivity, and consequently accounts for a far larger proportion of the workforce than of GDP. Average wages in the agriculture sector in 2004 were approximately half average wages overall (Roberts et al. 2006).

This issue is particularly acute in the services sector, because of the fact that, in common with the trend in other developed economies, the sector represents a large and increasing proportion of both employment (expanding by more than ten percentage points from 65 per cent in 1985 to 77 per cent in 2005) and GDP (growing from less than 70 per cent in 1985 to almost 80 per cent 20 years later).

Japan's services sector productivity has been disappointing. The OECD's 2008 survey of the Japanese economy found that the sector was largely responsible for low aggregate productivity within the economy, with a decelerating rate of improvement in labour productivity per hour worked over the past 30 years, significant productivity slowdowns in both market and non-market services sectors, and a large gap between services and manufacturing productivity gains. 'In sum', the OECD concluded, 'the slowdown in the service sector has brought down labour productivity growth in the entire economy from more than 4 per cent in the 1976-89 period to less than 2 per cent from 1999-2004' (OECD 2008: 126). Moreover, the OECD found that there had been very little shifting of labour from less to more productive service industries: indeed, in market services and ICT services, labour had been reallocated from more to less productive industries in recent years, leading to the conclusion that further structural change was required to promote the development of more dynamic services industries (OECD 2008).

Another factor affecting allocation of resources within the economy is the geographic distribution of the population. Relative to many OECD countries, Japan retains a large share of its population in rural areas-home to industries that are generally among its least productive-and this is likely to continue despite the fact that a gradual shift to the cities (where more productive employment is generally available) is taking place.

If Japan is to achieve the ambitious increases in productivity needed to prevent declines in per capita income, these populations will have to be much more effectively deployed. The existing drag from declining labour availability is shown in Figure 3.8.

Figure 3.8

Declining labour availability slows GDP growth in Japan

Contributions to GDP growth, OECD countries, 1995-2005, annual average growth in percentage points

Source: OECD (2007: I-3).

By no means coincidentally, the poor productivity performance of Japan's services sector coincides with relatively low levels of participation in international services trade-Japan ranks very low among OECD nations in terms of the proportion of services trade to the size of its overall economy (OECD 2008). Another factor affecting productivity is that Japan's policy approach has had the effect of discouraging inward foreign direct investment, which is the subject of continuing debate with some of its commercial partners. Low levels of inward foreign direct investment are a good indicator of likely levels of services imports, as much trade in services takes place through a commercial presence in the country where the services are delivered (what the World Trade Organization describes as 'mode three'). According to the Bank of Japan, total inward foreign direct investment stocks in Japan as at 31 December 2007 were only ¥15.1 trillion (of the order of A$150 billion)-less than half the direct investment stock held by foreigners in Australia, an economy less than one-quarter the size. Additionally, foreign direct investment into Japan as a proportion of total foreign investment in Japan was extremely low, at around 4 per cent, though this in itself represented a significant increase by comparison with previous years (Bank of Japan 2008); the comparable figure for Australia (which is near the other end of the spectrum) was around 22 per cent (ABS 2008b). It also seems clear that onerous regulatory requirements are significant in inhibiting effective allocation of resources within the services sector, hence reducing the potential for productivity gains (OECD 2008).

As recent Japanese Government policy papers have emphasised, increased competition through domestic deregulation and international trade (especially importing services) is critical to improving the productivity performance of less efficient sectors of the economy. It results in both static allocative efficiencies (as resources move out of low-productivity industries that cannot survive in the face of international competition into more productive industries that can) and in dynamic efficiency gains-as those industries that can compete lift their game to meet the challenge posed by both domestic and international competitors. There are already some signs that official encouragement for the concept of greater inward direct investment could be having an effect (Figure 3.9), but the stock of foreign direct investment remains low both as a share of GDP and as a share of total inward foreign investment.

Figure 3.9

Inward foreign direct investment grows, but from a low base

Stock of Japanese inward foreign direct investment, 1996-2007 (end of calendar year)

Source: Bank of Japan database.

Integrating internationally

The other avenue open to Japan to increase its national per capita income is to make money overseas-either by achieving a higher return on its savings than is available domestically, through portfolio investment, or by effectively expanding its labour force without running a major immigration program, through foreign direct investment. There are clear signs that activity in both these areas is increasing, both at the aggregate level (Figures 3.10 and 3.11) and in the overseas acquisitions by a range of Japanese firms (in industries as diverse as pharmaceuticals, precision equipment and beverages)-to the extent that net earnings from overseas investments now exceed the trade surplus (Figure 3.12). Moreover, media reporting of recent developments suggests that the global financial crisis will result in a quantum increase in the current year, especially in the financial sector (and, indeed, appears also to have eliminated, at least for the time being, Japan's trade surplus).

Figure 3.10

Japan’s investment overseas grows rapidly . . .

Stock of total Japanese outward investment (direct, portfolio and other), 1996–2007 (end of calendar year)

Source: Bank of Japan database.

Figure 3.11

... as does Japan's direct investment overseas

Stock of total Japanese outward direct investment, 1996-2007 (end of calendar year)

Source: Bank of Japan database.

Figure 3.12

Japan's net income from investment overseas exceeds its trade surplus

Japan's net income from investment overseas and trade surplus, 1996-2007

Source: Bank of Japan database.

'Factory Asia': the growth of East Asia and intra-regional trade

Japan's and Australia's economies-and the commercial relationship between the two countries-are also being affected by international integration, much of it linked to the growth of East Asia (in particular, China), and the changing nature of investment, production and trade in the region associated with the fragmentation of production and the growth of regional production networks. The response of companies-in Japan especially, but also to some extent in Australia-has altered the structure of the two countries' domestic economies as well as the structure of trade with and within East Asia, and contributed to the growth of the region.

The growth of the region

No region of the world has grown more, or more rapidly, than East Asia during recent decades. In the wake of Japan's expansion in the 1950s and 1960s and its subsequent economic success, first the Newly Industrialised Economies (Hong Kong, the Republic of Korea, Singapore and Taiwan) also grew rapidly and then the ASEAN4 (Indonesia, Malaysia, the Philippines and Thailand) expanded. These economies were joined in the 1980s and, especially, the 1990s by China and, more recently, by Vietnam.

The development of these economies has had a significant effect on both Australia and Japan. As a result of the policies adopted by their governments and the responses of firms, these East Asian economies' share of trade and investment increased, and, consequently, so did their importance in the global economy.¹⁰

Reflecting its size and its sustained rapid economic growth from the late 1980s, in the mid-2000s around 10 per cent per annum, it is China that has had the greatest impact. This can be seen in China's rising share of both Australia's and Japan's imports and exports (Table 3.1) and in its ranking among trading partners: in 2007 China ranked first among Australia's and Japan's partners in two-way trade (merchandise trade only for Japan, goods and services for Australia), in both cases for the first time.

Table 3.1

China grows in importance for both Australia and Japan

Australia's and Japan's imports from and exports to China, percentage share of total merchandise imports and exports, 1987-2007

		1987*	1992	1997	2002	2007
Australia	Imports	1.9	4.2	5.7	10.1	15.4
	Exports	4.0	3.2	4.7	7.0	14.1
Japan	Imports	5.3	7.3	12.4	18.3	20.6
	Exports	3.6	3.5	5.2	9.6	15.3

* 1988 for Japan.Sources: DFAT STARS database; Ministry of Finance, Japan, database.

Japan's closer trade and investment links with East Asia and, from a much lower base, South Asia-together, the source of more than 40 per cent of Japan's imports and the destination of nearly 50 per cent of its exports in 2007 (Figures 3.13, 3.14 and 3.15)-have been key factors in sustaining export growth (notwithstanding the relative decline in trade with the United States and the European Union). This was one of the major contributors to the expansion of the Japanese economy between 2002 and 2008; the difference from earlier periods of growth was that previously domestic demand was also growing, whereas this time domestic demand was weak.

Figure 3.13

Japan becomes more closely integrated with Asia, as an exporter ...

Japan's exports to the world, country and regional shares, 1988-2007

Note: China includes Hong Kong and Macau.
Source: Ministry of Finance, Japan, database.

Figure 3.14

... and as an importer ...

Japan's imports from the world, country and regional shares, 1988-2007

Note: China includes Hong Kong and Macau. Source: Ministry of Finance, Japan, database.

Figure 3.15

... but more gradually as a foreign direct investor

Japan's global foreign direct investment stock, country and regional shares, 1996-2007

Note: China includes Hong Kong and Macau. Source: Bank of Japan database.

Figure 3.16

China’s growth reduces Japan’s direct share of Australia’s trade

Japan’s share of Australia’s imports and exports of goods and services, 1955–56 to 2007–08

Note: The data for 1956-57 to 1965-66 are for trade in goods only as services data only became available on a country basis from 1966-67.Sources: DFAT STARS database; ABS (2008c, 2008d).

One of the main reasons for the growth of imports from China is that Japanese firms (as well as firms from other countries) established factories there and export finished products-primarily consumer goods-to Australia, Japan and other markets. This has been especially true of consumer electronics, where Japanese brands remain significant, and machinery. Some commentators have described this phenomenon, which encompasses the ASEAN countries as well, as 'factory Asia' (Baldwin 2006a).

As noted in Chapter 1, one important consequence is that the nature of the Australia-Japan commercial relationship has changed: instead of Australian consumer purchases of the products of Japanese firms being reflected in the bilateral trade flows, they now show up as imports from China (and some other countries in the region). There have also been impacts on Australia's exports to Japan and China (and other countries in the region): sales of wool and some other raw materials moved from Japan to the new centres of production following the relocation of production or changes in the type of production undertaken in Japan.

Regional production networks and intra-regional trade

The investments by Japanese firms in China and other regional countries have contributed to and become an important part of production networks that are fundamentally changing the nature of the regional economy, with impacts on Australian firms and on direct commercial links between Australia and Japan. This can be seen in the dramatic increases in the number of affiliates¹¹ established by Japanese firms in East Asia and India (Table 3.2) and in the number of plants established in China and some of the ASEAN countries by Japanese automotive and electrical machinery firms (Figure 3.17). While total Japanese direct investment in East Asia is no greater than Japanese direct investment in Europe or North America (Figure 3.15), there are more Japanese firms with affiliates in East Asia than in North America or Europe, and a much larger percentage of these affiliates are in manufacturing, especially machinery (Ando and Kimura 2003).

Table 3.2

Japanese firms increase their affiliates in China and ASEAN countries

Number of affiliates of Japanese firms in Asian countries, 1990-2004

	1990	1994	2000	2004
China	315	1,061	2,432	4,041
Thailand	766	983	1,342	1,512
Hong Kong	793	1,022	1,112	1,121
Singapore	743	961	1,129	1,067
Taiwan	727	812	891	909
Malaysia	509	709	881	805
Indonesia	292	439	676	698
Korea	399	404	496	640
Philippines	171	234	426	453
Vietnam	1	21	174	220
India	71	81	168	193

Source: Fujita and Hamaguchi (2006).

Figure 3.17

Japanese automotive and electrical machinery firms relocate to China and ASEAN

Number of plants (cumulative) established in East Asia by Japanese automotive and electrical machinery firms, 1975-2004

Source: 'The coming age of China-plus-one', Fujita and Hamaguchi presentation at IDE-JETRO workshop, January 2006, reproduced in Baldwin (2006a).

These firm-level data are reflected in the broader data on Japanese investment into Asia (Figure 3.18), which show that the major growth destinations are China and ASEAN countries-important centres for the cross-border production networks that are behind much of the expansion of manufactures trade in the region (Donald 2008).

Figure 3.18

Japanese direct investment into Asia is concentrated in China and ASEAN

Stock of foreign direct investment by Japan in Asia (end of calendar year)

Source: Bank of Japan database.

Box 3.2 What are regional production networks?

A key driver of the investment decisions of Japanese firms, and the consequent growth of regional production networks, was the reduction in competitiveness that flowed from the major appreciation of the yen against the US dollar and other major currencies after the 1985 Plaza accord (under which the US, UK, Japanese, French and West German central banks agreed to intervene in currency markets), and the emergence of Japan's bubble economy in the second half of the 1980s (Urata 2006). Another critical factor, especially for many small and medium-sized enterprises, was the importance of maintaining relationships with their major customers. Thus, many suppliers of parts and components, especially in the automotive, machinery, electronics and electrical equipment industries, followed large Japanese firms abroad. This was evident in Australia, where a number of 'tier one' and other preferred Japanese suppliers to Toyota and Mitsubishi opened factories near the carmakers' plants. Estimates suggest that up to 50 per cent of Japanese outward direct investment in the 1990s was by small and medium-sized enterprises (Urata 2006).

While there has been concern in Japan, from the mid-1980s, that this trend would lead to a 'hollowing out' (kudoka) of manufacturing industry in Japan, and in Australia about possible effects on Japanese demand for imports from Australia of minerals, energy and other inputs into manufacturing, the data are mixed. On the one hand, a 2006 survey of more than 5,000 large firms across all manufacturing sectors showed that only 21 per cent were outsourcing offshore (this included service delivery-research and development, information services, customer support and professional services-as well as production of goods) and this offshoring included both foreign-owned firms and subsidiaries of other Japanese firms, in addition to the firms' own subsidiaries (Ito et al. 2007).

On the other hand, earlier survey data cited in Urata (2006) showed that cheaper offshore production was a key factor in investment and affected the proportion of production undertaken in Japan. According to firms, especially those in the textiles sector and those producing non-transportation machinery, low-cost production for export back to Japan and other markets motivated much of the direct investment in East Asia (in contrast to direct investment in North America, where the most important reason was local sales). The overseas production ratio for Japanese firms with overseas investments rose from 18.3 per cent in 1993 to 41 per cent in 2002, and for all Japanese firms (multi-national and domestic) the increase was from

7.4 per cent to 17.1 per cent. However, there were significant differences between sectors: much of this increase came from the transport machinery and electrical machinery sectors (Urata 2006). Research by Ando and Kimura (2007) shows that the employment effects were mixed: manufacturing firms with offshore affiliates were more likely than other firms to increase employment in Japan and, when jobs in Japan were shed, the percentage decrease was likely to be smaller.

These investments in East Asia have led to patterns of production-and trade-that differ considerably from those associated with Japanese investment in North America, Europe and Latin America. In those regions, Japanese investment-while in total exceeding that in East Asia (see Figure 3.15)-has not been associated with production networks and with the dramatic changes to trade flows found in East Asia, including to and from Japan. In East Asia, Japanese investment has led to increases in intra-firm, intra-industry and intra-regional trade.

Intra-firm trade (trade between an affiliate and headquarters, or between different affiliates) rose sharply between 1992 and 2001 (Urata 2006). In the early years of Japanese investment in East Asia such transactions were largely parts and components being exported from Japan to factories offshore which then produced finished goods that were exported back to Japan or other developed-country markets. However, exports from affiliates to the parent firm in Japan constituted only a small proportion of the large increase in intra-firm trade, and the value of transactions where the Japanese parent sold intermediate goods to its affiliates in East Asia actually declined. Rather, most of the increase was in the share of intra-firm transactions by affiliates in their country of location and with affiliates in third countries (Urata 2006). This finding is consistent with the clustering of related producers, as reflected in the investment and production patterns of the automotive industry and other machinery firms where preferred suppliers accompany producers when they establish offshore operations.

Intra-industry trade-indicative of regional production networks-expanded substantially from 23 per cent in 1985 to 40.9 per cent in 2003 (Aminian et al. 2007). Much of the increase was in 'vertical' intra-industry trade (in which products of different quality and price are traded, most commonly parts in one direction and finished products in another). Trade in parts is particularly important in the machinery and electrical equipment sectors.

Similarly, intra-regional trade in East Asia has grown considerably-from less than 35 per cent in 1980 to around 50 per cent in 2007-while intra-regional trade in the European Union and North America has not grown as much (Fujita and Hamaguchi 2006 and authors' calculations).¹² As a result of the growth of production networks, more than 60 per cent of intra-regional trade in 2003 was in parts and components (Fujita and Hamaguchi 2006), while, for some sectors such as electrical goods, the figure was even higher-85 per cent between 2000 and 2004 (Urata 2006). Intra-regional trade expanded across the spectrum of manufactured goods; only in the textiles and clothing sector did trade in parts not increase as a share of intra-regional trade (Urata 2006). Reflecting the industries in which production networks have been most significant, trade in electrical and general machinery as a share of total inter-regional trade grew from 28 per cent in 1990 to 46 per cent in 2003 (Fujita and Hamaguchi 2006).

Box 3.3 Trade with Japanese companies but not with Japan

In contrast to the significant participation of Japanese firms in regional production networks, the involvement of Australian firms-including subsidiaries of Japanese multinational corporations-is more limited, although the picture appears to be different for service providers than for manufacturers. (One reason few Australian subsidiaries of Japanese firms are participants in East Asian regional production networks is that the vast majority of these firms also have subsidiaries in China or other East Asian countries, and the degree to which these different subsidiaries are allowed to compete with each other is unclear.) Australian exports of parts and components for machinery (including motor vehicles) and ICT-the sectors where East Asian production networks and intra-industry trade are strongest-are small but growing. As a result of the geographic distance between Australia and East Asian countries, this trade is concentrated in higher value-added products that are less sensitive to time and cost demands (Donald 2008).

In the case of services, trade and investment data suggest a greater involvement by Australian firms in regional production networks. This includes production networks to deliver services (for example, hospital management) and services embodied in the production of goods (including business services and logistics) (Donald 2008). A growing proportion of direct investment into and out of Australia is in services. Australia's overall trade in services is greater than might be expected given characteristics such as distance from major markets and income levels, according to gravity model and trade intensity index research commissioned for this report (Corbett et al. 2008).

Box 3.4 The impact of trade agreements on regional trade and investment

What does this mean for the Australia-Japan relationship?

If integration continues at current or greater levels-an assumption that may be threatened if increased transport costs reduce the profitability of such arrangements (see Hayakawa 2008 for a discussion of transport arrangements chosen by Japanese firms for intra-regional trade) or if exchange rate volatility increases the hedging and associated costs needed to sustain the production networks (Hayakawa and Kimura 2008)-the potential impact on firms in Australia and Japan may be profound. In particular, high levels of integration place a premium on participation, as the prospects for firms outside production networks will be curtailed. While Japanese firms have played a prominent role in the development and expansion of such networks, firms in Australia have been less successful to date, although there are exceptions, especially in the services sector.

The ongoing restructuring suggests both that Japanese investment in China and ASEAN countries in particular will continue to draw Australian exports of commodities into the region more broadly (rather than just to Japan), and that the region will continue to be increasingly important as the source of 'made by Japan' imports into Australia.

Combating carbon

Both Australia's and Japan's economies will be affected, perhaps transformed, by policy responses to concerns about climate change-in particular the emission of carbon dioxide (CO₂) and other greenhouse gases to the atmosphere. These effects may in turn have major implications for the bilateral commercial relationship given its highly carbon-intensive nature.¹³

Economic structure

The economic impact of climate change depends on a number of factors. One of the most important is the structure of each country's economy. Japan's economy is both less energy intensive and less carbon intensive than Australia's. This is a consequence, among other things, of the two countries' natural resource endowments and energy policies (and associated responses by companies and consumers).

Japan is more energy efficient compared not only to Australia but also to most other industrialised economies.¹⁴ Japan's high degree of energy efficiency reflects the changes in its energy policy (and consequent major adjustments by companies and consumers) in response to the first and second oil shocks in the early and late 1970s as well as, to a lesser extent, the policies Japan introduced to comply with its Kyoto Protocol commitments. These measures had the effect of partially decoupling energy use and economic growth: energy use had grown more rapidly than GDP from the late 1950s to the first oil shock but effectively plateaued between the mid-1970s and the early 1980s, and only then began to increase again, albeit more slowly than before. At the same time, energy intensity (measured in energy use per unit of GDP) improved: between 1973 (the time of first oil shock) and 2005, it decreased by 35 per cent (Kanekiyo 2007).

This end-point comparison of energy intensity, however, does not present a complete picture as most of the aggregate improvement in efficiency was achieved in the 1970s and early 1980s; since 1984 total energy efficiency has remained steady at about 0.14 kilograms of oil equivalent per dollar of GDP. (This contrasts with the steady improvement in energy efficiency in the United States and the OECD during that period, albeit to levels more than 33 per cent and 20 per cent respectively above those of Japan. A number of European countries, however, are improving rapidly and may overtake Japan in the next few years.) This is not to suggest that there have not been improvements in Japan: industries such as steel production now use up to 35 per cent less energy per tonne of steel than in the 1970s (Katz 2008). However, the improvement in the industrial sector has been balanced by worsening domestic energy efficiency, in part because of the increased number of electric and electronic appliances. Thus, energy consumption per capita, which fell after both the oil shocks, rose steadily from the early 1980s until the mid-1990s and has remained stable since, albeit almost 50 per cent higher than in 1982 (Kanekiyo 2007).

The oil shocks also caused a change in Japan's energy composition: oil had accounted for over 70 per cent of its energy mix at the time of the first oil shock; by 2000 it had fallen to about 55 per cent with some increase in the use of coal and the growth from virtually nothing of nuclear power and natural gas (Ninomiya and Jung 2003). Japan's consumption of oil has fallen by 13 per cent since peaking in 1996, with demand dropping more rapidly after the price of oil began to rise dramatically in 2004 (Katz 2008).

Japan's carbon intensity (emissions per unit of GDP) has also changed over time. The expansion of energy-intensive industries during the 1950s and 1960s, and the mix of fuels Japan was then using, meant that the carbon intensity of its economy increased up to the mid-1970s. Since the oil crises, Japan's carbon intensity has consistently decreased. However, the rate of the decline slowed during the 1990s from the 2.5 per cent per annum of the previous decade to 0.3 per cent per annum. The improvement (i.e. reduction) in carbon intensity has been greater than the 30 per cent improvement in energy efficiency during the same period, meaning that there has been a decline in carbon emitted per unit of energy used (Ninomiya and Jung 2003).

Table 3.3

Japan's economy is far less carbon intensive than Australia's

Emissions of carbon dioxide per unit of GDP, 2005

	GDP (US$ billions)	CO2 emissions (millions of tonnes)	CO2 emissions per unit of GDP (tonnes/US$ thousand)
Japan	4,571.3	1,293.5	0.283
Australia	708.0	387.3	0.547

Sources: IMF database; UNFCCC database.

Japan's high level of energy efficiency compared with Australia and other economies offers potential advantages and disadvantages in responding to concerns about climate change. On the one hand, the policies adopted in response to the oil crises show how firms can adapt, and offer some lessons in both designing and implementing energy efficiency policies and measures. On the other, Japan's previous success may constrain its future options for domestic action, at least in certain industries.

Improving energy efficiency has been identified as a central element of potential carbon abatement policies. Some analysts have argued that 'picking the low-hanging fruit' through easily implemented energy efficiency measures would allow significant reductions in carbon emissions without major economic disruption (Enkvist et al. 2008). In some sectors Japan's remaining fruit, however, are hanging higher, because many of the measures that can be easily implemented are already in place. In the production of steel and cement (including clinker), for example, firms in Japan already use less energy per tonne of output than their rivals in major developed and developing countries; and in the chemicals sector and the production of pulp and paper, Japanese firms are close to world's best. Similarly, while household energy consumption has increased, Japan has already replaced incandescent globes with fluorescent ones and there is widespread use of highly efficient heat pump technology in water heaters (METI 2008).

Australia's economy is more energy intensive-and carbon intensive-than Japan's (and all but six other OECD countries). Notwithstanding this high ranking, Australia's economy is 'about 5 per cent less energy intensive than the world average and about 8 per cent more energy intensive than the OECD average' (Garnaut 2008: 158). In contrast to Japan, Australia's energy intensity was 'broadly stable during the 1970s and 1980s, and then fell by an average of 1.1 per cent a year during the 1990s' (Garnaut 2008: 158).

Australia's higher energy intensity is a consequence of many factors. One is the plentiful supply of many forms of energy-in contrast to Japan's almost complete dependence on imported energy-especially coal, of which Australia is a major global producer and the world's leading exporter. Another is that the oil shocks did not lead to similar policy responses in Australia, in part because a number of significant sources of energy were discovered and/or came on-stream around the time of the oil shocks (such as the Bass Strait oil and gas fields and the North West Shelf gas fields). Yet another is the extensive production of energy-intensive products such as aluminium and the smelting of non-ferrous metals.

This difference in economic structure-together with other aspects of the two countries' different resource endowments which have meant that land clearing has increased CO₂ and other greenhouse gas emissions in Australia but not in Japan-is reflected in the data on carbon intensity (Table 3.3) and on CO₂ emissions per capita: Australia has consistently emitted at least 175 per cent of Japan's levels and, for most of the decade since the late 1990s, closer to (or more than) twice Japan's levels. The major contributing factor is the high emissions intensity of energy generation and use in Australia, a consequence of Australia's reliance on coal for electricity (Garnaut 2008). Differences in economic structure and resource endowments also contribute to the differences between Australia and Japan in emissions of other greenhouse gases. For example, the large numbers of sheep and cattle mean that 'Australia's per capita agricultural emissions are among the highest in the world' (Garnaut 2008: 153).

Other factors can also affect the demand for energy and the efficiency with which it is used. One of these is change in population size. The extent to which Japan's demographic trends will contribute to reductions in energy consumption and increases in energy efficiency is unclear. In general, however, a declining population should reduce demand for energy; conversely, the expected growth in Australia's population is likely to increase demand for energy.

Policy responses

Another factor that will affect the impact of climate change on the economies of the two countries-and on the bilateral commercial relationship-will be the policies each chooses to respond to the issue. Both governments have identified climate change as a critical issue for the future and have foreshadowed additional policies to help their countries adjust.

The biggest potential impact on the bilateral commercial relationship will be Japan's decisions about its future energy mix. Prior to the hike in coal, oil and LNG prices in 2007 and 2008, Japanese authorities envisaged a continuing substantial role for coal as source of base load power generation but with an increasing role for LNG. This has already been reflected in contracts for larger volumes of LNG starting from 2009. Any reconsideration of the share of coal-sourced electricity could have mixed effects on the bilateral energy trade: imports of coal may be reduced while imports of LNG grow. If government policy and public opinion towards nuclear power change, uranium imports may also grow. However, changing energy infrastructure takes a long time and the results of such a reconsideration would not show up in bilateral energy trade for several years. Changes in Japan's energy mix are also likely to be limited by the extent to which 'clean coal' technologies, including carbon capture and storage, become commercially viable after 2020. Successful commercial use of such technologies would be likely to enable coal from Australia to remain a principal source of energy in Japan.

Another critical factor will be the future size of energy-intensive industries such as steel and cement. Japanese production of these two products has remained substantial, notwithstanding the transition from a rapidly growing to a more mature economy with a substantially greater services sector. One reason has been the continuing domestic demand from infrastructure spending: one of the policies adopted by successive Japanese governments during the lost decade was high levels of spending on roads, bridges and other public works as part of the package to revitalise the economy. The high levels of public debt incurred as a consequence-now among the highest in the OECD-make it unlikely that such policies will be resumed, especially as expenditure on public works has declined steadily during the decade from 1998 from over 8 per cent to under 4 per cent of GDP (The Oriental Economist 2008). However, future steel production may be affected by industry relocation: two industry leaders, Nippon Steel and JFE Holdings, have foreshadowed plans to build blast furnaces offshore, something not previously done by Japanese steel companies (Iinuma 2008).

The impacts on the bilateral relationship of Australia's policy and technical responses to climate change are likely to be less and to be felt mainly on Australia's exports to Japan. These will include the impact of an emissions trading scheme and other measures on export efficiency and competitiveness; and the success (or otherwise) in developing carbon capture and storage and related technologies affecting the greenhouse gas emissions from the coal industry.

Abatement and mitigation policies are likely to make Australia a consumer of energy-efficient technology. While it will be a smaller market than Japan itself or some other developed countries, it may nonetheless still be potentially important for Japanese firms. Similarly, if research in Australia-some of which is being undertaken jointly by the Commonwealth Scientific and Industrial Research Organisation, Australia's national science agency, and Japanese researchers-is successful in developing carbon capture and storage and related technologies then there may be commercial opportunities for Australian (and Japanese) firms.

Commercial reactions

Yet another factor that will affect the impact of climate change on the economies of the two countries-and on the bilateral relationship-will be the reactions of companies to the issue and to the policies implemented by the governments. As many analysts have noted, climate change presents both challenges and opportunities for companies. Many of these will arise from the imperatives to develop new technology and/or enhance existing technology, including the support that is likely to be provided by both governments for R&D. Already a number of Japanese motor vehicle producers, which are at the forefront of global technology in this area, have signalled their intention to increase production of and conduct further research into hybrid cars and technologies such as fuel cells. Another area where the technological edge of Japanese firms is likely to present opportunities is in the use of photovoltaic cells to generate solar energy. Australia's natural resource endowment-including plentiful sunshine, deposits of silica and relatively cheap energy-may enable commercial developments to deliver benefits to both countries.

Challenges confronting Australia

The performance of Australia's economy during much of the period since the late 1980s has contrasted with that of Japan's. For many of those years Australia was among the fastest-growing economies in the OECD, following major market-opening and regulatory reform in the 1980s and 1990s. After 2003 its growth was further underpinned by a dramatic increase in international demand for the natural resources Australia possesses in abundance-principally iron ore, coal, other minerals and energy-leading to a dramatic improvement in its terms of trade, a consequent increase in the international buying power of the Australian dollar, and substantial fiscal surpluses. Some of the issues that loomed large while the research for this report was being undertaken-the impact of a strong and appreciating dollar and the rise in terms of trade to levels not experienced since the Korean War-induced boom of the early 1950s (see Figure 3.20)-now look as though they may be yesterday's concerns as a result of the dramatic changes wrought by the global financial crisis. Others, however, such as the ongoing need for productivity improvements and the need to address infrastructure bottlenecks, will continue to pose challenges.

The imperative for improved productivity is as salient for Australia as it is for Japan, even if Australia does not face the same demographic pressures as Japan. The Australian Government's Intergenerational Report estimated that annual productivity growth across the economy of 2.25 per cent rather than 1.75 per cent would lead to an economy about 20 per cent larger in 40 years' time (cited in Davis and Rahman 2006). While there has been a relatively steady improvement in output per hour compared with the United States since 1960 (Figure 3.6), the trend since the late 1990s has been less encouraging. This picture at the aggregate level disguises considerable differences among industries. For example, Australia's productivity in the mining sector is superior to that of the United States, but there are large gaps between US and Australian levels in sectors such as manufacturing, wholesale trade, retail trade, utilities (electricity, gas and water), communications and finance (Davis and Rahman 2006; Dolman et al. 2007). (The United States is used for comparison because it is widely recognised as the international benchmark.) While a few European countries have levels of productivity higher than or similar to that of the United States (typically the result of high productivity in a sector that dominates the economy like oil and gas in Norway), there are a number of factors that suggest this is unlikely for Australia. These include aspects of geography and history such as Australia's relative distance from the global centres of economic activity and the distance between centres of economic activity within Australia, which may explain up to 45 per cent of the productivity gap (Battersby 2006).

Productivity is also affected by skill levels. Historically, there has been a large discrepancy between the United States and Australia in the share of the population completing high school, often used as a proxy for skill levels. This has changed over the decades as the proportion of school leavers in Australia completing high school has increased, and there is little difference now between the two countries (Davis and Rahman 2006). Nonetheless, shortages persist in a number of skilled and semi-skilled occupations and, as in Japan, the government faces policy challenges to address the problems. Immigration has been seen as a partial solution but, while attracting considerably less opposition in general than in Japan, recent policies aimed at addressing shortages of unskilled workers in the horticulture sector through a guest worker program, for example, have been criticised.

Demography also affects economic growth prospects and the longer-term demographic trends look more favourable for Australia than for Japan. UN population projections suggest that, while Australia's aged dependency ratio is also starting to rise, Australia will still benefit from a growing workforce and youth population in absolute terms through to 2050 (Figure 3.19). The increase in the birthrate in the 2000s and the increasing levels of net migration from the late 1990s in Australia are having an impact on projected total numbers and, given the increased emphasis on skilled migration, on the skill levels of the workforce.

Figure 3.19

Australia grows older more slowly than Japan

Australia's population by age group, 1950-2050 (UN medium scenario)

Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2005 Revision, <http://esa.un.org/unpp>.

Of course, it is not population size and age structure alone that determine the size of the labour force: changes in the participation rate, which measures the percentage of the working age population in or seeking paid employment, are also relevant. While the participation rate has increased steadily since the late 1970s, recent projections assume stable levels in the future, leading to a slight decline in the contribution to future growth (Commonwealth of Australia 2007).

Another challenge confronting Australia is infrastructure. Again, geographic dispersion and the large distances between major centres of population and economic activity act as constraints on and impediments to the easy or cheap provision of the infrastructure necessary to maintain economic growth and a high standard of living. This problem has been compounded by underinvestment during the 1990s and the first half of the 2000s. While plans are now under way to remedy this, it has already had an impact on the Australia-Japan relationship (see Box 4.1).

One of the factors that will affect the ongoing demand for infrastructure is whether the resources boom resumes. The rapid decline in prices began for commodities like nickel in the second half of 2007 and has now affected virtually all resources and energy, as well as a number of food and agricultural commodities. What is unclear is whether these dramatic falls are the bust that has historically followed every boom or whether they are a hiccup in what some analysts (for example, Garnaut and Song (eds) 2007) have described as a 'super-cycle' in which prices stabilise at high levels rather than return to their long-term secular decline.

If prices do return to anything approaching the levels reached during the 2003-08 period, Australia will face an additional range of challenges. Past experience suggests that higher commodity prices translate into a surge in the terms of trade (Figure 3.20, which also shows the impact of rising commodity prices on the terms of trade for Japan, a considerable importer of many commodities) and an appreciation of the Australian dollar, and then lead to inflationary and other pressures in the domestic economy that are difficult to manage. These pressures were mostly contained during 2003-08 (McKissack et al. 2008). However, a particular concern is the extent to which such pressures might translate into 'Dutch disease', where the competitiveness of firms in other sectors of the economy declines. To the extent that such pressures develop and lead to firms going out of business, they can limit the longer-term options at an economy-wide level by narrowing a country's economic base.

Figure 3.20

Australia's terms of trade improve while Japan's deteriorate

Terms of trade for Australia and Japan, 1960-2008 (quarterly)

Sources: ABS (2008b); IMF, International Financial Statistics database.

What we can expect is that if Australia's terms of trade return to anything like the levels of 2007 then manufacturers and services providers in Australia will be under pressure to increase the value added to their products through intellectual and technological content. These trends are likely to drive greater exposure of the Australian economy to trade in services and to result in increased flows of outward foreign direct investment from Australia, particularly in the manufacturing and services sectors. Gravity models currently suggest that Australia actually trades somewhat more in services than the characteristics of its economy (including distance from major markets) would suggest, but it remains, nonetheless, a relatively small international trader in services by OECD standards.

Conclusions and implications

As noted above, it is not possible to state with any certainty what the economic fortunes of either Australia or Japan are likely to be in the medium to long term. Given the important structural factors outlined above, however, it seems clear that the Japanese economy, in particular, is likely to undergo significant change, especially if it is to meet the challenges posed by its demographic structure. Specifically, it is likely that a successful Japanese economy in the 2020s and beyond will have:

• a population that is at least somewhat more diverse, reflecting the need to import labour in the face of shortages of indigenous labour supply
• a far more open and hence productive services sector with larger proportions of services consumption in Japan sourced from overseas-this in turn is likely to mean that it will also have become a larger exporter of services
• a manufacturing sector that remains leading-edge in terms of its international competitiveness in highly technology-intensive fields-driving a still larger network of offshore affiliates, meaning that its economy is far more tightly integrated with that of the rest of Asia
• a more productive and efficient farming and food processing sector, focused more on higher-value agricultural and food products, mainly supplying the domestic market but with some exports of high-value, distinctively Japanese-style food products, including into Australia; and with Japanese food processing firms even more integrated into regional production and trade networks, but with Australia continuing as an important base of operations
• a significantly higher propensity to invest savings overseas so as to maximise returns
• public infrastructure development that is both funded through more diverse mechanisms than at present and delivered through more competition with overseas providers.

For its part, a successful Australian economy in the 2020s is likely to be:

• still heavily reliant on areas of comparative advantage in trade-though even with the shift to ‘clean coal', the climate change phenomenon may have resulted in a shift in, for example, energy-related exports towards fuels such as LNG and uranium which produce lower levels of (or no) carbon emissions per unit of output
• more highly educated than at present, with consequent benefits in the skill levels and productivity of the workforce
• equipped with better infrastructure
• more involved in regional manufacturing networks, with a clear niche in high value-added parts and components and the provision of design and integration services to those networks
• adapting to the challenges of climate change, including for the agrifood, resources and energy and manufacturing sectors
• significantly more integrated in regional services trade.

As well, it seems clear that Australia and Japan will have particularly convergent interests in relation to two trends likely to shape the regional trade and investment environment into the future. The heavy basis of the commercial relationship in energy products-largely fossil fuels and particularly carbon-laden coal-dictates a strong interest in both countries in the pursuit of technological solutions to the carbon emissions problem, and an incentive to cooperate to find such solutions. And both political and economic factors are likely to drive still closer cooperation between the two countries in ongoing efforts to develop an open, inclusive regional architecture that will facilitate the ongoing economic integration of the Asia-Pacific region.

Chapter 4 looks at the implications of these trends for the bilateral commercial relationship in the future.

Footnotes

9 A range of scenarios for Japan's future population structure exist, with different assumptions for fertility, migration and death rates giving different outcomes. The data in the figure are derived from the UN's medium scenario. All basically agree, however, that Japan's population is starting to shrink; that its working age population started to shrink around 1995; and that by 2050, the workforce and dependent youth will represent a far smaller proportion of the population.

10 The success of East Asian economies has been widely analysed. For a recent review, see Gill and Kharas (2007).

11 Affiliates are defined in the Japanese context to include (1) wholly owned subsidiaries, joint ventures, and firms in which strategic (10+ per cent) shareholdings are held, and (2) firms that are owned 50 per cent or more by firms in category (1).

12 East Asia is defined as ASEAN 10, China, Japan, Hong Kong, Korea and Taiwan; the EU as EU15; and North America as Canada, Mexico and the United States.

13 Strictly speaking, carbon intensity refers to either the ratio of carbon emissions produced to GDP or the ratio of carbon dioxide to energy of different fuels. Here the term is used more broadly to encompass the trade in energy-intensive products such as aluminium and smelted metals as well as in relatively carbon-intensive energy such as coal.

14 While energy consumed per unit of GDP is a commonly used measure of energy efficiency, there are issues relating to the calculation of such data. See Suehiro (2007).

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