1. Introduction

Diminishing Japanese foreign direct investment in Korea has showed no signs of abatement, continuing a precipitous decline from 2.69 billion USD in 2013, 2.49 billion in 2014, and 1.67 billion in 2015 to 1.25 billion in 2016 after peaking at 4.54 billion in 2012.

Persistent issues with Abenomics have played a role in the slowing of investment, including the weakening of the yen. Meanwhile, Korea’s increasingly prohibitive cost structure, the slowing growth of Korean multinationals (particularly assembly manufacturers) and historical and territorial issues that continue to plague political discourse between the two neighbors have all served as a drag on FDI. And yet Japanese corporate investment strategies toward Korea are attracting much attention.

The purpose of this study is to propose municipal and national policy initiatives aimed at attracting Japanese FDI through an analysis of Japanese investment strategies through publicly-available statistics and literature and responses obtained from a questionnaire issued to relevant actors.

The salient characteristics of Japanese investment strategy are described as follows. First, Japanese manufacturing investment is concentrated in the materials and components industry, at 84.2% of all manufacturing FDI. Second, Japanese companies’inroads into Korea are squarely aimed at the capturing domestic market share, and not producing goods for export. Third, Japanese firms operating in Korea have achieved local content ratio of 49.2% in Korea. This is lower than investment analogues in China, Thailand, and India, but higher than in Indonesia, Malaysia and Vietnam. Fourth, the surplus ratio of Japanese enterprises with Korean investments market is valued at 81.0%, as estimated in 2016, the highest level in all of Asia and Oceania, well above the average of 62.8%.

2. Analysis of Investment Decision Factors of Japanese Companies

According to estimates of an analysis performed with a Markov switching model, in recent years, Japanese FDI in Korea has been largely unaffected by economic factors, its fluctuations being based entirely on the won-yen exchange rate. But in the 2000s Japanese FDI was influenced by economic variables. Rapid economic expansion in Korea was the overriding factor motivating Japanese investment, buoyed by favorable conditions in wages, exports, and an exchange rate that helped sustain that growth throughout the decade. But after growth slowed following the global financial crisis, Japanese companies became increasingly concerned with costs, and the exchange rate came to be the primary determining factor in strategic investment formulations.

According to the results of an analysis performed with the dynamic panel model for 20 industries, in the period from 2010 to 2015, corresponding to state 1, Japan’s Korean direct investment was not dramatically affected by other economic variables, excepting for unit labor cost (ULC) and the frequency of labor strikes. However, in the period from 1999 to 2008, which corresponds to state 2, other economic factors indicated an influence on Japanese FDI, such as Japanese agglomeration, unit labor cost, the won-yen exchange rate, and Korean industrial growth. Considering that a significant portion of Japanese FDI targets the domestic market, the growth of Korean industries (and with them, the Korean economy) and the scope of industrial development in the 2000s were important factors behind Japan’s swelling investments. Taking into consideration the estimation results for the period from 2010 to 2015, decreases in the cost of labor made possible by productivity gains and the stabilization of industrial relations are likely to be important factors for attracting Japanese FDI in the future.

Again using the dynamic panel model, in our estimation results for manufacturing industries with sizable Japanese interests (mostly in chemicals, metals, appliances and electronics), we found that FDI by Japan was determined by the size of the industry, the agglomeration of Japanese industry in Korea, labor costs, the exchange rate, and industrial regulations in the period from 2010 to 2015. While from 1999- 2008, we found FDI predominantly influenced by the agglomeration of Japanese industry in Korea, the exchange rate, and the industrial regulation index.

Our empirical analysis based on the dynamic panel model of Japanese investment in industries during the period from 2010 to 2015 (state 1) shows that Japanese FDI in Korea was influenced by the industrial scope of the two countries, the agglomeration of Japanese industry in Korea, the unit labor cost, the won-yen exchange rate, and industrial regulation. And in the period from 1999 to 2008 (state 2), an analysis using the same model results demonstrated that FDI was influenced by the agglomeration of Japanese industry in Korea, the won-yen exchange rate and the industrial regulatory index.

Taken together, the period from 1999~2008 and from 2010~2015, industrial agglomeration, the exchange rate and the industrial regulation index showed statistically significant results but there was a notable divergence compared to the results for 2010~2015 analysis alone, across 20 industries overall. This indicates that the clear shift in Japanese investment attitudes as a whole for the period from 2010~2015 is not significantly related to principal, longstanding investments, but has occurred on the periphery. Also, considering recent wage increases and the depreciation of the yen, we can expect that Japan’s major FDI in Korea will not appreciably increase without active measures that stimulate additional investment.

The recent decline in direct investment has been attributed to the fact that investments in traditional industries have been sluggish due to the economic slowdown in Korea, and also because Japanese investments in new industries are notably lacking. In the future, there may  be cases in which Japanese companies enter the Korean market for the express purpose of marketing their products domestically, but in the kinds of legacy industries that once typified Japanese FDI, we can expect few additional direct investments in Korea’s production base (specifically, for products intended for export), as most Japanese firms are working to improve manufacturing competitiveness, and doing so primarily through cost reduction. In other words, since the two countries are increasingly competing with each other within the same portfolio of products with the same composition ratio in the manufacturing industry, any significant FDI from Japan is not likely to avoid stagnation unless made in new growth industries with better potential for returns.

So it becomes important to attract new Japanese FDI in emerging industries in the ICT and biotech sectors, which are showing growth potential as key technologies of the 4th industrial revolution, rather than in the traditional parts, materials, and capital goods sectors that are historically the primary targets of Japanese FDI. And at the level of individual private companies, some believe in “joint development”, a popular buzzword in economic circles, above all else. As discussed in the above-mentioned analysis, FDI determinants have changed drastically over time, but Japanese investment strategies have not considerably altered. So any policy aimed at attracting new Japanese FDI in Korea should point investment toward new industries; specific demand in e fields should be explored, including joint development in the high technologies of the 4th industrial revolution, in environmental business, and so forth.

3. Japanese Firms’ Assessment of the Korean Investment Environment and FDI Attraction Policy

According to a survey of Japanese affiliated firms operating in Korea inquiring as to the strengths of the Korean investment environment (multiple response), 36.9% of respondents said high-quality labor, 28.6% said a strong market and high growth potential, 28.6% said high quality procurement systems and infrastructure, 27.4% said ease of export and import due to the geographical proximity, 25.0% said cultural similarity, and 23.8% said the possibility of delivery growth.

Regarding difficulties in the Korean investment environment (multiple response), 53.6% of respondents said intensifying competition, 50.0% said a high cost structure, 38.1% said security risks (re: North Korean), and 15.5% of respondents each said the small domestic market and low growth rate, labor disputes and turnover rate, and diplomatic friction with Japan. Regarding changes in investment patterns after the implementation of Abenomics policies (multiple response), 42.9% of respondents said Korea’s economic slowdown and curtailment of investment by conglomerates, 32.1% said more promising investments were located outside of Korea, and 20.2% of respondents each said price merit decline and the weakening of the yen. In addition, investment attractiveness declined by 8.3% due to diplomatic tensions and deregulation. And 8.3% also reported that the deregulation of the Japanese market made investing at home more attractive, with 4.8% saying they would increase investments domestically.

Regarding the most important factors regarding future investment in Korea, 63.1% of survey respondents said growth potential was the most important consideration. 48.8% said profitability, 38.1% said cost factors (such as wages), 26.2% said infrastructure and utilities, and 22.6% said labor quality and the stability of labor relations. In the next 2-3 years, 66.7% of respondents answered that they expect conditions to be similar to the current situation in Korea. However, 26.2% of respondents reported that they expect the situation to deteriorate, with 23.8% expecting general decline and 2.4% expecting precipitous decline. We found pessimism among the respondents to be considerably more common than optimism: only 7.1% of firms surveyed expected short-term economic improvement.

Regarding why these firms expected the investment situation to deteriorate (multiple responses, N=22), 54.5% of respondents cited an increase in costs, 45.5% said slowing market growth, 36.4% blamed stiffening competition, 31.8% said increasing risk, 27.3% said the strengthening of regulations, and 22.7% said the aggravation of payability. Among the respondents, only six companies expected investment fortunes to improve in the future, and among them only one was a manufacturer.

When questioned regarding the strengths of the Korean government’s FDI policy (multiple response), 46.4% of respondents cited government investment incentives, 26.2% referred to the existence of industrial complexes exclusive to foreign enterprises, 17.9% cited comparatively lax regulations, 11.9% referred to Korea’s active pursuit of FTA agreements, 11.9% said the promotion of industrial-institutional cooperation, and 10.7% cited government assistance offered to established Japanese-affiliated companies on penetrating the local market in Korea.

On the weaknesses of the Korean government’s FDI policy (multiple response) 36.9% of respondents cited excessive regulations, 32.1%  reported taxation difficulties, and 16.7% said their policy suggestions were not fully heard. Insufficient investment incentives, inadequate law enforcement on illegal labor movements, and the as-of-yet unconcluded Korea-Japan FTA accounted for and 15.5% of responses each; 11.9 percent of respondents reported other reasons.

Regarding plans for future investments in Korea, 63.1% of respondents expected to maintain the status quo, 16.7% were considering expanding existing investments, 14.3% were considering making new investments, 4.8% were considering reducing their stakes, and 1.2% were considering outright withdrawal.

Finally, according to a survey of 24 Japanese companies that expressed an interest in future Korea investment, 38.5% of respondents cited they would direct investment to new growth sectors, 34.6% said they would increase investments due to growth of the Korean market, and 30.8% cited the expansion of contracting opportunities.

Sorted by field, 32.1% of respondents said the IT and electronics industries showed the most promise, 28.6% said biopharmaceuticals, 19% said chemicals and chemical engineering, 14.3% said general machinery, 11.9% said logistics, and 10.7% said automobiles. For this study, Toray Advanced Materials (TAK), Ajinomoto Genexin Co., Ltd. and KOREA NIKKEN LTD. were included to supplement the Questionnaire survey.

4. Policy Tasks for the Future Expansion of Japanese FDI

To summarize, the first reason for the plunge in Japanese investment since 2013 is psychological in nature. In August of 2012, former President Lee Myung-bak visited the contested islet of Dokdo and a requested an apology of the Japanese emperor. Japanese investors’attitudes toward Korea have soured ever since. The second reason can be ascribed to deregulation and the weakening of the yen caused in part by Abenomics, significantly altering the influx of Japanese capital. The third reason is related to the contracting domestic investment of Korean conglomerates, which seems largely due to a collective preference to expand operations in lower-cost nations rather than at home. Fourth, in terms of individual Japanese investors, the investment environment is deteriorating and investment merit is decreasing due to policy factors such as cost increases, strengthened regulations, and the ever-present North Korean nuclear risk. Fifth, and finally, Japanese investors’image of Korea is that of a nation roiled by labor strife, with frequent strikes and powerful unions.

In order to revitalize Japanese investment in the future, more than anything else it is necessary to tactfully manage disputes between the two nations, so that political settlements of extant issues through bilateral summits do not damper investment. And considering current trends in the reduction of Japanese investment, it is possible that for general-purpose products, Japanese companies are increasingly unable to justify any manufacturing at all in Korea. Yet even as Abenomics as a whole has somewhat weakened Japanese investment drive, there is still some consensus among Japanese companies that Koreabased production has some merit in value-added fields.

Second, it is imperative that the difficulties Japanese companies currently face when entering Korea be resolved prior to making overtures to new investors. Japanese companies are often consulted by JETRO and others when investing in Korea, and typically seek advice on investment-related concerns from Japanese companies already running operations in Korea.

Third, it is necessary to develop policy measures that address concerns Japanese investors are weighing before investing in Korea. Attracting more investment from Japanese companies is a matter of increasing profitability, principally through growing sales and curbing costs. To achieve this goal, it is necessary to establish a framework that also encourages Korean companies to expand domestic investment, in doing so reducing the capital reduction ratio, which is primary the risk factor for any future investment.

Fourth, there is a need for efforts that better attract Japanese investment in relatively new fields currently undergoing fundamental changes and restructuring, due to both a rapidly-aging society and the fourth industrial revolution.

Fifth, a new business model in which logistics and manufacturing are combined is a promising endeavor, and the government should expand its support for it. In connection with the development of Busan New Port, a Japanese logistics enterprise has advanced to the rear estate complex, with the intent of eventually carrying out its manufacturing operations from Korea, owing to reduced transshipment costs. In the future, it is desirable to develop investment promotion activities that accurately grasp economic efficiency and the needs of Japanese companies.

Finally, it is necessary to strengthen Korean FDI through efforts that enhance its coherence, stability and transparency, in addition to further revising the government’s foreign investment promotion policies. The government’s policies on foreign investment are changing drastically. Expertise in foreign investment should be both utilized and nurtured, through both the long-running foreign investment attraction bureaus such as the Korea Trade and Investment Promotion Agency (KOTRA) and local governments. Local governments have not proven particularly effective at recruiting Japanese investment through independent delegations to Japanese companies; this needs to change. Therefore it is necessary to construct a cooperative mechanism to attract Japanese investment.