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

Chapter 4 - The next generation

How the forces identified in Chapter 3 will play out is unclear. What is evident is that they will affect both the Australian and Japanese economies and, consequently, the commercial relationship between the two countries. The interplay between these forces and the long-term drivers of the relationship- complementarity and distance-will crucially affect the opportunities open to business and the challenges that the two governments will face.

It is important to remember that the direction and impact of the changes wrought by the shaping forces identified in Chapters 2 and 3 are not inevitable. In particular, governments in both Australia and Japan, together with business and the broader community, can address some of the impediments posed by distance-in its many dimensions-to the relationship.

Building on complementarity

It seems clear that whatever changes take place within the economies of Australia and Japan, it will be traditional complementarities that continue to drive much of the trading relationship.

Clear national and commercial interests on both sides of the relationship mean it is inevitable that energy and resources will remain critical to it. Regardless of Japan's future rates of economic growth, the sheer size and scale of its economy; the fact that it has very limited indigenous sources of minerals and energy; and the relative geographic proximity and political and economic stability of Australia compared to other potential sources, together with Australia's transparent foreign investment screening process, underpin the complementarity that exists here.

Box 4.1 Energy security and infrastructure

Thus, for the foreseeable future, Australia and Japan will be enormously important to each other in this sector. The predominance and stability of Japanese firms as customers for Australian raw materials clearly underscores the Australian interest in maintaining and enhancing this partnership. This is the case not just for coal (Figure 4.1) and LNG (Table 4.1) but also for a wide range of other resources: in addition to its substantial purchases of nickel, mineral sands and other minerals, as noted in Chapter 1 Japan buys more than any other country of Australia's exports of aluminium and copper. For many of these minerals and energy resources there is a contrast with markets such as China, which is well endowed with natural resources (such as coal). In such markets imports can be marginal inputs-that is, the requirement for them fluctuates as overall production (of steel or whatever products they are inputs into) varies-and, if production falls, imports may not be needed at all. By contrast, in markets such as Japan imports are necessary for all production, with the result that Japanese firms will be steadier, more predictable buyers.

Figure 4.1

Japan remains the largest customer for Australian coal

Australia's exports of coal (steaming and metallurgical), 1998-2007

Source: DFAT STARS database.

Moreover, as noted in Chapter 1, with the reduced availability of LNG in the next decade from Indonesia and Malaysia-currently major sources for Japan-this trade is set to expand significantly in the medium term (Box 4.2).

Box 4.2 The demand for liquefied natural gas

A factor likely to affect the bilateral resources and energy relationship will be climate change and possible domestic and international measures to combat it. There is now international acceptance that major reductions in greenhouse gas emissions will be required. This will inevitably create pressure to reduce demand for fossil fuels but could give rise to opportunity as well.

Japan's technological sophistication, combined with its vested interest in finding economical ways to deal with the climate change challenge, make it an ideal partner for collaborative research on techniques such as carbon sequestration and 'clean coal' technology. As shown in Table 4.2, as part of the Asia-Pacific Partnership on Clean Development and Climate, Australia already works closely with Japan on collaborative efforts between industry, government and researchers in the development, deployment and transfer of cleaner, more efficient technologies.

Table 4.2

Shared interests lead to collaborative efforts to address climate change

Asia-Pacific Partnership on Clean Development and Climate (AP6) projects involving Australia and Japan

CO2-enhanced coal bed methane (Australia, Japan, China)

Oxy-fuel combustion technology road mapping and demonstration program (Australia, Japan, United States of America)

Ultra Clean Coal (Australia, Japan)

Identifying optimal legal frameworks for renewable energy in China, India and Korea (all AP6 partners)

Solar-enhanced fuels for electricity and transport (Australia, China, Japan)

Improving the cost-effectiveness of biomass energy generation (Australia, Japan, Republic of Korea, China)

Accelerating deployment of smart mini/micro grids in AP6 markets

Energy Regulatory and Market Development Forum

Best practice in power generation (all AP6 partners)

Cement centre of excellence (all AP6 partners)

Coalmine safety strategy (all AP6 partners)

Integrated coal production and methane extraction (Australia, China, Japan)

Annual steel experts workshop (all AP6 partners)

In addition to collaboration on research and development, cooperation on policy and regulation may also offer benefits for both countries. An obvious example is the possibility of linking the emissions trading schemes under consideration in both countries.

Just as the long-term trade in fossil fuels will be affected by the responses to climate change, demand for uranium, another source of energy of which Australia is already Japan's principal supplier, is expected to increase (subject to the caveats about popular support noted in Chapter 3). Japan already generates some 30 per cent of its domestic electricity from nuclear power; by 2030, this proportion is projected to rise to above 40 per cent (METI 2006) even without the more stringent measures to counter climate change that are now being mooted.

Moreover, Australia has been identified as having large reserves of renewable energy sources including wind, solar, wave power and geothermal resources (Garnaut 2007). As work continues to maximise the exploitation of these renewable energy sources, many of which are also of significant interest to Japan, increased collaboration and cooperation will become important.

Box 4.3 Using solar energy to increase the energy from natural gas

The climate change challenge is also highly relevant to another area in which a complementarity exists between the two economies that is yet to be fully exploited. Agriculture and food, as well as being one of the key complementarities on which the trading relationship has thrived, is also an area in which change, in both countries, seems inevitable. Both the Australian and Japanese agriculture sectors face the likelihood of externally imposed constraints that would result in significant structural changes in the medium to long term.

Trade in food and other agricultural products can, in effect, be thought of as trade in water and land (MAFF 2008). Australia has a lot of land but relatively little water, and much of the precipitation falls outside the major existing agricultural production areas. This situation is forecast to be exacerbated by climate change. While there are numerous scenarios for the possible impact of global warming on Australian agriculture, they tend to converge around conclusions that 'many regions [are] likely to experience increased downside risk in agricultural production' with 'regions such as southwest Australia particularly at risk of adverse outcomes associated with climate change', with farmers 'likely to face additional costs of capital adjustment due to climate change' (Kingwell 2006: 1; see also Garnaut 2008). Other environmental factors such as soil erosion and salinity are also in play-and may be exacerbated by climate change (DCC 2008).

Japan, by contrast, has much water but relatively little land-and faces continual erosion of the amount of land under cultivation through industrialisation and urbanisation. Additionally, as we have seen, Japan's agriculture sector effectively faces demographic pressure from two directions. The ageing of Japan's population and the numerical decline of its workforce are dictating that Japanese policy focus on raising labour productivity throughout the economy; agriculture is one of the key areas where labour productivity is lowest, with average wages in the sector in 2004 running at approximately half average wages overall.

Beyond farming, however, Japan has some strengths in food processing and production that suggest one avenue for increased exploitation of the complementarities between the two countries. In particular, there are likely to be further opportunities to integrate Australian producers with the significant size, strength and growing regional and even global presence of Japan's leading agrifood companies. These companies have made a strategic decision to expand beyond the Japanese market and have established sizeable regional (and for some, global) production and distribution networks, with overseas sales a growing share of their revenues. The recent major investments by the Kirin Group in the Australian dairy sector-National Foods in 2007 and Dairy Farmers in 2008-and the additional investments it is seeking to make in the broader beverages sector may be just the first step in this direction.

Box 4.4 Food security and food safety

From an economist's perspective, greater integration of agrifood production between Australia and Japan in this context would hold out the promise of significant benefits to both economies. The principal benefit would arise through the allocative efficiencies generated by the movement of relatively unproductive resources out of Japan's agriculture sector into areas where they could add greater value-a movement that would appear to be imperative for Japan if it is to achieve the economy-wide improvements of productivity necessitated by its demographic challenges.

It need not be the case that a shift of employment out of agriculture would lead to a decline in production or food self-sufficiency-particularly given that another consequence of Japan's ageing and declining population is likely to be a reduction in demand for food. Indeed, it is quite possible that a demographically driven move to larger-scale, more sophisticated farming techniques in Japan, taking advantage of new economies of scale, would have the potential to increase self-sufficiency through higher productivity. It is worth noting in this regard that average productivity of Australian land devoted to (larger-scale) rice growing is around 30 per cent higher (at around 8.6 tonnes/hectare) than in Japan (6.5 tonnes/ hectare) (Roberts et al. 2006).

Ultimately, pressure will continue to mount on farmers in both countries to adjust their practices further so that they produce crops that maximise returns on the factors involved in production. Liberalisation of trade between the two countries would facilitate a redistribution of resources in each so that market forces provided an incentive for farmers to focus on areas where they would add the most value. The improved competitiveness brought about by dynamic gains from this increased internationalisation of Japanese agriculture could also contribute to an improved capacity to export-particularly in lucrative, high-quality products for which markets in East Asia are emerging and where Japan has strong capabilities.

Box 4.5 Adoption of Australian slaughterhouse technology assists Japanese meat industry

It is fairly clear from an economic perspective that the more market forces are allowed to come into play, the more likely it is that these beneficial developments will happen. Market-distorting protectionist measures ultimately hurt domestic consumers, provide disincentives to farmers to export, and damage the broader economy by encouraging misallocation of resources.

It is, however, well known that economics is not the only discipline in play here. Economists can identify the destination for reform, in which optimal economic outcomes are achieved. But identifying a practical path to that destination, determining whether the benefits merit the trade-offs to be made in terms of managing the effects of change on existing interests, and leading events in the desirable direction, are all activities that fall under the preserve of politics. In both Australia and Japan, achieving reform is particularly complex given that farming is often seen as much as a way of life as an economic activity. Nevertheless, the Australian experience has demonstrated that it can be done-and that the benefits are real, not illusory.

Box 4.6 Dairy industry reform in Australia

As Japanese decision-makers confront the demographically driven imperative for increased productivity they will doubtless focus increasingly on where to place the balance between the need for governments to continue to seek short-term political support and the requirement to implement economic reform that will be beneficial in the longer term. It needs to be recognised that it is for Japan's political system to work through these sensitive issues in its own time. However, we would argue that ultimately demographics, together with economics, will prevail and, in the long term, reform of Japan's agriculture sector will take place. A constructive approach by Australia's agrifood sector to the issues faced by Japan at that time could lead to a deeper partnership in this area, in a manner that could strengthen both the commercial and political relationships between the two countries.

The importance of Japanese exports of manufactures as inputs for Australian life and commerce, too, will continue to evolve as comparative advantage changes. So too will the nature of the trade relationship between Australia and Japan. 'Made in Japan' products-already at the high end of the value chain-can be expected to continue to become still more capital intensive as competition increases from other, particularly Asian, sources of manufactures. Australia, as one of the major developed economies in the region, can be expected to remain an important consumer of these increasingly sophisticated products. As well, if the trends towards regional production described in Chapter 3 continue, a significant proportion of Australia's imports from other regional partners-principally China and the ASEAN countries-will, in reality, be 'made by Japan' or 'made for Japan'. Australian businesses and policy-makers will do well to remember the value of their business links with Japan as they seek either to locate new sources of quality inputs or to lock Australia in as a source of supply of inputs to those manufacturing industries.

Evolution will continue to take place in tourism and travel, too, as it has in merchandise trade. Fundamentally, the complementarity continues to hold good: each country offers leisure travellers from the other something that they cannot easily find in their own. But economic and demographic dynamics are changing the nature of the relationship here, too. Whereas in the 1980s and 1990s Japan, with its large, increasingly affluent population of aspirational travellers wielding highly valued yen, was a growth market for the Australian tourism industry, between 2003 and 2008 it was Australian travellers who benefited from the strength of their dollar. Japan, until the massive currency movements caused by the global financial crisis, had become a price-competitive destination, and this was reflected in tourism numbers. Its profile has been raised for Australian travellers, too, by the prominent Australian investment in skiing-related tourism in Hokkaido.

Many Australian travellers are experiencing Japan for the first time as a result: this, together with the repeat business associated with the skiing, makes further growth possible, although the exchange rate remains an important wildcard.

Australia's popularity as a destination for Japanese travellers was also affected by the appreciation of the Australian dollar, as well as demographic and other factors (see Box 4.7). Even if maintained, the recent depreciation of the dollar against the yen alone may not be sufficient to attract more Japanese tourists to Australia in the face of significant competition, primarily from the increasing openness of China as a tourism destination. Australia will need to work hard and be innovative if it is to maintain its position, let alone enhance it.

While a positive brand name has been established broadly for Australia as a tourist destination, Japanese tourism operators are now emphasising the need to present Australia as a diverse destination to which it is worth making multiple visits, and to meet the specific needs of inbound Japanese tourists, in conjunction with Japanese tourism operators. More work needs to be done in this area, and to evolve Australia's approach to accommodate more diverse groups of travellers- whether the increasing numbers of schoolchildren travelling in school groups, or an older and possibly less adventurous group of retired travellers. By contrast with the past, when fears were frequently expressed that competition between different states for tourist dollars could be detrimental to Australia's image overall, different states are now being encouraged to market themselves individually (but within the overall Australia tourism umbrella)-and with the specific needs of the Japanese market in mind. One other important factor will be whether sufficient air services are maintained between Australia and Japan to provide potential tourists with suitable options.

Box 4.7 Some of the reasons behind Australia-Japan tourism trends

If it is the case that existing complementarities will remain important, but that their nature will continue to change, a frequently posed question is where we might seek the emergence of new ones.

New areas for services trade and investment

In order to develop Japan's economy, it is essential to achieve sustainable growth in the service industry, given that this sector accounts for 70 per cent of GDP and employment. At the same time as achieving enhanced international competitiveness through the introduction of new business models including the promotion of IT investment and utilization that is lagging behind in Japan in international terms and the expansion of new business entrants, including foreign companies, it is important to realize active efforts to enter overseas markets…

[T]he service industry of Japan has not made any advances towards globalization except in a limited number of fields, including the finance and insurance industry, and wholesale and retail industry. (METI 2007.)

As we have seen, the direction of change in both the Australian and Japanese economies has been in favour of the services sector, which in both countries has expanded significantly during the past 15 years. Yet by comparison with the extraordinary health of bilateral merchandise trade, services trade between the economies of Australia and Japan seems relatively small. This has led a number of commentators to suggest that services should be a prime area to look for 'new complementarities'.

The idea that the next generation of the Australia-Japan relationship might incorporate a boom in services trade also has significant appeal in terms of the productivity challenge faced by each, as identified in Chapter 3. Particularly with the emergence of international production networks requiring sophisticated logistical and communications services, an efficient and productive services sector is seen as essential to improving productivity of the economy as a whole.¹⁵ As services trade worldwide is increasing, so (as with goods) is specialisation and the fragmentation of production driving productivity improvements. Further, there are increasing links between trade in services and trade in goods (Kiyota 2005). It is clearly in the interests of both economies that bilateral services trade be allowed to flourish, and that no obstacles be created to the involvement of service providers in regional production networks (see Box 4.8).

Box 4.8 Services and production networks

While the idea that new complementarities might emerge between the two countries that would significantly boost services trade is beguiling, it is important to keep prospects in perspective.

First, it appears that the perception of underperformance in this part of the commercial relationship may be somewhat overstated. As noted in Chapter 1, empirical research undertaken for this report by the Australia-Japan Research Centre at the Australian National University (Corbett et al. 2008, available in an online appendix to this report at <www.dfat.gov.au/eau>) suggests that while it is considerably less intense than the goods trade between the two countries, bilateral services trade is greater than might be expected given the extent of each country's participation in global services trade.

Moreover, gravity modelling, which takes into account various elements of distance,¹⁶ shows that services trade flows between Australia and Japan are comparable with the flows predicted by the model for flows between OECD economies-indeed the Australia to Japan flow does not differ from the average, while the Japan to Australia flow appears slightly above average. The model is, of course, just that, and the findings of this research are not conclusive. But it can be said that it does not produce strong evidence for performance that differs from the average, at least among OECD countries (Corbett et al. 2008).

It seems likely, then, that the perception of underperformance in the services relationship may in fact be an illusion created by the overperformance of other parts of the relationship. If this is so, it is possible that the scope for an increase in services trade might not be so great as we might otherwise think.

That said, supplementing this picture with more detailed data from Japanese and Australian sources strengthens the impression that many services sectors are below the average of bilateral trade, even after taking account of country characteristics and the intensity of goods trade. There are a number of sectors (travel, insurance, finance, personal and computer services) where Australia's exports to the world are greater than might be expected given the size of its economy and its share of global services trade, but where the share of those going to Japan is lower than might be expected. These are also sectors where Australia has below-average imports from Japan, suggesting that there may be possibilities for increasing two-way flows (Corbett et al. 2008).

The second point to be made is that certain elements of the CAGE concept of distance (see Chapter 2) are particularly applicable to trade in services. Services exports, unlike goods (and particularly bulk commodities) can be delivered in a range of ways; and, far more so than for trade in commodities, many of these require a capacity by a firm or individuals to operate within the market of another country. Aspects of distance such as differences of culture, language and legal and administrative systems can be particularly important in inhibiting trade, and its close companion investment, in these areas.

The success of the Australia-Japan bilateral trade and investment relationship in respect of goods has been that the two economies' complementarity has been such that the hurdles of distance, even when high, have been overcome. In the case of services, the complementarities are less clear, and the hurdles seem higher.

Australia is known worldwide as a world-class source of primary products, and Japan as a world-class source of manufactures. Both have significant high-end capabilities in services. However, as Australian business interlocutors in Japan who were consulted in the research process for this report repeatedly emphasised (with some notable exceptions), neither country has such an established general reputation in this regard as to make it the first port of call for potential customers from the other. As others (for example, de Brouwer and Warren 2001) have pointed out, this means that Australian companies in Japan, and Japanese companies in Australia, are likely to have to compete for both initial attention and subsequent business with a much wider range of domestic and international companies in seeking to enter each other's market than is often the case with goods trade. While a certain degree of expansion of the services relationship can be expected as a result of the ongoing development of merchandise trade (for example, the need for legal services for new energy and resources contracts), pushing the relationship into new areas may be harder.

Other, more structural, hurdles exist that will have to be overcome if services trade is to emerge as the new growth area of the bilateral relationship. In Australia's case, in particular, corporate size and structure is an important issue. Many of Australia's most innovative services providers are relatively small companies, especially in international terms. Even for major companies, undertaking steps toward internationalisation or globalisation of operations should not be done for its own sake, but rather needs to be based on a rigorous assessment of the specific opportunity in question (Ghemawat 2007). If anything, smaller companies need to be even more rigorous in their assessments, as the costs of failure are more likely to threaten the success of the company.

Box 4.9 Financial services and portfolio investment flows

Issues such as the lack of common standards and complexity-or perceived complexity-of regulation and its application have also been identified as hurdles that have tended to deter Australian companies from embarking on establishing a presence in Japan.¹⁷ Discussions with Australian companies operating successfully in Japan during research for this report suggested that in some key growth sectors, such as health-care products and services, this could be particularly discouraging for companies-whether Japanese or foreign-with new or innovative products, which could be subjected to long and arduous testing processes before acceptance. As such, these regulations and their enforcement were seen as potentially affecting Japan's ability to react nimbly to the increasing health-care challenges likely to result from the ageing of its population.

At the same time, it has long been suggested (see, for example, de Brouwer and Warren 2001) that both Australian and Japanese services providers have tended to be less than fully aware of the opportunities residing in each other's market- whether due to stereotyping of each economy in the minds of companies in the other, or because other, seemingly brighter, opportunities are perceived to exist elsewhere.

Interlocutors consulted in the research process for this report suggested that this issue may have assumed greater prominence in recent years as an obstacle to further development of Australia-Japan commercial relations. The high-profile emergence of China and India, in particular, but also increasingly other East Asian economies such as Vietnam, as growth centres, has, not unnaturally, acted as a magnet for the attention of both Australian and Japanese business in a way that each other's economies have not.

Australian companies established successfully in Japan view these developments with a degree of bemusement. While conceding that Japan is not the place to go in search of overnight success, they point in particular to what they characterise as the greater certainty provided both by the more developed legal systems and business practices that Japan offers, and by the store set by Japanese partners on the development of long-term relationships, involving a level of trust seldom found in other markets. Australian companies cited examples such as that of a long-term Japanese customer paying in advance (on their own initiative) for large orders of agricultural produce when they became aware that the drought was causing financial problems for their Australian supplier, and of handshake deals that were honoured without question despite significant adverse price shifts between the shaking of hands and the signing of a contract.

Companies with a more global outlook reiterate, too, that the often tortuous process of developing a market for their products or services in Japan-arguably one of the most quality-conscious markets in the world-has proved enormously beneficial to their overall ability to produce and guarantee higher-quality product and to develop the flexibility to meet changing customer specifications. They frequently cited these results of expansion into Japan as having assisted them to sell into other developed country markets.

Box 4.10 Making it in Japan-the Australian way(s)

Overcoming distance

Implicit in much of the above is that any 'new complementarities' that might arise, especially in the services sector, are likely to be less obvious and more nuanced in nature than the 'raw materials for manufactured products' complementarity that has underpinned the merchandise trading relationship to date; and, being less obvious, they are likely to require more work on both sides both to identify and to pursue. This is because these new complementarities are likely to be in areas where distance is a greater factor, and the relevant dimensions will not be the lack of geographic proximity. Some of these dimensions (in areas such as regulation and enforcement) can be addressed directly by governments. For example, Japanese authorities have reformed accounting standards to align them more closely with those in other jurisdictions. Others can only be addressed indirectly by governments (supporting increased people-to-people contact through scholarships and similar programs, for example) or not at all (changing cultural values and norms).

Governments can make a real difference in the development and implementation of regulation, as the vast majority of regulations are administered by government. Recognising that these are impediments is the first step; altering them is the second. One important vehicle for both identifying impediments and taking appropriate action will be the free trade agreement under negotiation between Australia and Japan.

Ensuring that the skills exist on both sides to take advantage of opportunities to develop 'new complementarities' will be critical if the relationship is to move further into these areas. In that regard, a crucial role-and one that needs to be continued and nurtured-must be played by education.

It appears that in this area, too, the rise of other major economies is having an impact. Australia has traditionally been quite well placed, relative to competition in the Japanese market from other developed countries, for availability of Japanese language skills; but the signs (see Box 2.3) are that this important resource is likely to be eroded in coming years, at least in relative terms. Japanese interest in studying in Australia also appears to be waning, even as Australia's provision of international education is expanding rapidly. If on-the-ground knowledge of each other's economy is likely to be crucial to identifying and taking up new opportunities for mutual benefit, this is an area that needs to be addressed urgently. The Japanese Government's decision, announced in June 2008, to create a young business persons program which will bring 50 young Australians to Japan each year, is an example of how governments can contribute to the building of closer links.

Box 4.11 New opportunities in education

Governments can also play a crucial role through their cooperation in other areas such as research. While the cooperation noted earlier on climate change issues is echoed in some other areas, more active approaches by other countries-which use a considerable proportion of the available capacity for joint research-can reinforce pre-existing perceptions that there might be only limited benefits from programs of cooperation between Australia and Japan.

Box 4.12 Cooperation on science and technology

Thinking beyond 'bilateral' relations

As noted above, both Australia and Japan, as developed economies in the Asia- Pacific region, are increasingly engaging with the rapidly emerging countries in the region. Both Australian and Japanese business could arguably benefit from leveraging their existing engagement and cooperation with each other to exploit opportunities in third-country markets.

Of particular relevance in this regard is the emergence of cross-border production networks, in which Japanese companies have been key players. As a result of these new patterns of trade, simple bilateral flows are becoming less relevant as an indicator of the economic interactions of trading partners.

Production networks essentially represent the natural progression of the economic theory of comparative advantage, in which each producer increasingly specialises in what it does best relative to others, so that production of individual items is 'unbundled' into a number of separate processes often performed geographically remotely from each other (Baldwin 2006b). As such, trade liberalisation, through measures such as tariff reduction, has been a major catalyst; international networks are most prevalent in industries such as electronics, where protection is lowest. But another factor in the spread of production networks has been the rapid improvement in the efficiency of enabling services, such as transportation, communications and logistics-services in which Australia has significant capabilities (Donald 2008).

Australia and Japan stand to benefit from cooperation in relation to these developments at two levels. At the policy or intergovernmental level, the impact of the conclusion of the Australia-Japan Free Trade Agreement currently under negotiation-as the first such agreement between major developed economies in the region-is potentially of real significance in the context of the ongoing emergence of production networks.

There is a significant literature on the interaction between free trade agreements and the new trading patterns emerging both within the Asia-Pacific region and globally (see, for example, Baldwin 2006a). Among the key findings of much of this literature is that, while they are generally liberalising in nature, free trade agreements differ from multilateral liberalisation efforts in that they may also be distorting of broad patterns of trade if they tend to divert rather than create trade by favouring less efficient producers over more efficient producers. Additionally, there are well-known concerns about the potential for a 'noodle bowl' effect, in which a multiplicity of different provisions between different countries (especially in relation to rules of origin) acts to complicate, rather than simplify, trade.

As two of the major developed economies on the western side of the Pacific, the shape of any arrangement between Australia and Japan stands to be highly influential in the dynamics of negotiations between other major economies. Additionally, Australia and Japan are currently undertaking negotiations with a range of other countries or groups in the region. The extent to which there is effective consistency or otherwise between their respective agreements could have a significant impact on the future workability of trade in the region.

At the business level, the increasing internationalisation of both Japanese and Australian companies, and their involvement in production networks and international supply chains, could open up new opportunities which, we would argue, should lead to the recognition that the Australia-Japan relationship extends beyond the bilateral trade and investment flows. As the case of wool suggests, the shifting of Japanese productive capacity offshore in the region has the potential to drag with it flows of raw materials from Australia previously used for production in Japan. Use of their existing relationships with Japanese buyers to open new avenues of trade could be symbolic of a shift in thinking in Australian export strategy away from the purely 'bilateral' towards a regional perspective.

Services are likely to be important in this context too, both for their role as the 'glue' that binds existing manufacturing production networks together, and because of the increasing trend for the production of services to be networked. As Japanese firms play their part in driving the ongoing trend towards manufacturing production networks, opportunities will arise for Australian services providers in a range of markets well beyond Japan to participate in the activity generated.

It remains to be seen what the precise division of roles will be in services networks as they develop. Typically, the fragmentation of roles that occurs in manufacturing networks is characterised by the specialised production of high value-added components in those economies where labour skills and costs are higher, with final assembly taking place where labour costs the least-predominantly China, but also increasingly countries such as Vietnam. In the case of services, different patterns may apply and, as two of the major developed economies in the region, Australia and Japan, with their large and relatively sophisticated services sectors, are likely to have a major role in the coordination of these networks.

Conclusions and implications

The change in the ranking of the Australia-Japan trade relationship serves as a valuable stimulus for those on both sides to take stock, and to ponder future directions. This report has sought to place such consideration into context, and to raise issues that might be expected to shape the relationship into the future.

The key conclusion is that there will be a need for perspective and realism in viewing and presenting the importance of the Australia-Japan commercial relationship into the future. Existing complementarities will continue to ensure the relationship remains one of Australia's top three commercial relationships in absolute size far into the future, even if commodity prices were to fall significantly from current levels.

The rapid emergence of China, India and other developing economies in the region is likely to mean that the relative importance of the direct relationship to overall Australian and Japanese trade and investment patterns will continue to decline. In the terms of the gravity model used to assess services trade for this chapter, distance remaining equal, objects of greater mass (economic size) will tend to demonstrate more attraction. Governments will need to resist the temptation to see an inevitable decline in the relative size of the direct trading relationship as an indication of failure or lack of future potential. It will be crucial, in this context, in assessing the importance of the relationship to both countries, to focus on its size in absolute terms, rather than on fluctuating relativities between it and other trading relationships.

If it is governments that wish for strong commercial relationships between countries that share many other factors in common, it is companies that build them. Robust bilateral relations in general do have spin-offs for companies-for example, by creating favourable generic perceptions about national capabilities that make market entry easier, or by creating a critical mass of support networks that facilitate operating in an otherwise alien environment. But they do not, of themselves, form a rationale for commercial decisions. Companies can only properly make those decisions based on a hard-edged assessment of their own commercial interests. The task for governments in pursuing their goals is to maximise the chances that businesses will see advantages for themselves in behaving in ways that also further government objectives.

The first key to this is ensuring that businesses are able to do business. The free trade agreement negotiations may provide a useful stepping stone. It will be important that these negotiations identify the real impediments to bilateral trade and investment and do something about them. Identifying such impediments will mean not only talking to those companies that are already doing business bilaterally, but also to those that are not, to find out why, and what would make them change their minds. Publicity for the changes that result from the free trade agreement will also be crucial, and it will be important that such publicity occurs at a time that maximises the head-turning effect that the signing of the agreement should have.

The second key will be ensuring that businesses become aware of the opportunities that exist within the market, and that it is in fact possible for them to act upon them. This involves more than the provision of information-though that, too, is important. As this report has suggested, it can mean looking below the flood of information at the aggregate level to identify individual sectors where growth may be occurring, and individual opportunities. It also involves understanding the ways in which collaboration and business relationships develop in the new fields in which there is potential for the relationship to grow, and encouraging and facilitating the type of in-depth contact that is necessary for companies in both countries to identify and exploit such opportunities.

Acting on opportunities that arise within services sectors, where, as we have seen, cultural and linguistic distance can be a particularly relevant factor, requires people with the necessary cross-cultural skills. Both countries have a reasonably solid foundation in this regard, with study of the language of the other at a relatively high level in each. However, it needs to be recognised that the skills and relationships required to develop and take advantage of full-blown commercial opportunities are relatively time-consuming to acquire. More opportunities need to be made for Australians to hone their Japanese language and cultural skills in Japan, and for Japanese people to gain experience of Australia through education, living and work placements.

It will be through such efforts to overcome the many dimensions of distance that new complementarities can emerge alongside the traditional ones that will continue to drive so much of the Australia-Japan commercial relationship.

Footnotes

15 For a summary of academic literature on the importance of services trade to economic growth, see Hoekman and Mattoo (2008).

16 Intensity indexes are useful as a general measure of the extent to which trade is higher or lower than proportional to the share of the exporting and the importing countries in world trade, but they do not fully capture whether a bilateral trade flow is greater or smaller than would be expected given the characteristics of each country relative to the characteristics that, on average, determine bilateral trade flows. For that, gravity models are required.

17 Japan does rank high according to the World Bank's Doing Business project (<www.doingbusiness.org/economyrankings>), but this is heavily influenced by its rating as the easiest place to close a business, not to establish or operate one.

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