Exchange Rates and Deindustrialization:
Japanese Experiences
Takayuki Yamashita
Department of Economics
Shizuoka Univesity
Ohya 836, Suruge-ku, Shizuoka City, 422-8529, Japan
ennil: jayama@ipc.shizuokaacjp
Abstract
‘The strongest yen's apprediation in 2011 made many Japanese companies choose overseas operations.
‘The general public is worrying that this choice may put them out of work Contrary to this public
debate, academic debate argues that deindustrialization is the natural outcome of the successful
economic devdopment in advanced economies. However a regression analysis on the amet
Japanese economy suggests that the negative deindustrialization associated rising unemployment has
started recently. Based on statistical findings, this paper devdops a system dynanics moda and
examines the negative efect of deindustialization A shift from domestic production to overseas
moduction reduces economic performance litile by little Although foreign direct investment is preferred
to exports under the hone cunrency appredation, this myopic strategy will hollow out the domestic
industry inthelongnn.
Keyword : deindustialization, hollowing-out, foreign directinvestment, unemployment
1, Introduction
Deinchstidization or hollowing-out of the industry is a conhoversidl phenomenon’, Although the
Manufacturing sector in a number of aclvanoed economies shows the deciine in output and employment,
it does not meen the dedine of the economy asa whole. A shift from the manufacturing sector to the
servicesectoris atypical economic devdopment process, predicted by the Petty-Clark’s Law’.
Rowthom and Wéls (1987) examined the merits and demaits of deindustialization of the
economy; they distinguished between deindustrialization eqplanations that sawit as a positive process of
meiutity of the economy and those that associated deindustrialization with negative factors like poor
economic performance Positive deindustiialization is associated with full employment and rising real
incomes; whilst negative deindustialization is associated with rising unemployment and stagnant real
incomes. They suggested deindustrialization might be both an effect and a cause of poor economic
performance.
In Japan, the issue of deindustialization wes first discussed at the end of the 1980s. Given the
1 “ Hollowing-out” was first used to describe the implications of off-shoring by U.S. manufacturers in
1970s.
2 Clark (1940) examined the significance of this tendency and called "Petty's Law’ after Sir William
Petty who first found this type of tendency in Political Arithmetic (1690). This theory is now referred
to as “Petty-Clark’s Law”.
1
rapid aggreciation of the yen after the Plaza Accord in 1985, Japanese manufacturing industries
yroduction bases largely transferred overseas secking cheap labor Japan United States trade frictions
acodeted Japan's oversees productionin the USA. Domestic employment decreased, and there arose
conoans that technology levds would grow stagnanily. Although the debate on hollowing-out
intensified again in the middle of 1990s under the yen appreciation, it faded away in the lae 1990s
because domestic investments recovered under the yen depreciation phase. The most pasuesive
opinion wes thet deindustrialization or hollowing-out wes a sign of maturity because this phenomenon
had been recognized in other advanced economies. Among them, the successful transition from the
Manufacturing sector to service sector of the US economy was one of the good models for Japanese
economy.
In. 1990s, production beses were largdy transferred towards Asia and these beses started to import
components and capital goods fromJapan. Some regarded it as a new intemetional division of labor
‘which would bring benefit to Jagan. Furthermore, others regarded that growing accumulation of net
intemetional investment wes another sign of maturity based on the devdopment stage theory.
‘The issue of deindustialization recurred under the strongest yen appreciation in 2011 (Figure 1).
Many manufactures recorded deficits from exports and planned seriously transfexting their factories
oversees. Among ativanced economies, Japan has been the most eager in maintaining the domestic
manufacturing industry because of anxiey over quality and seeking flexibility and technological
advantagein production However; manufactures cannot endure the stiongyen any more. Presently,
there is a growing concan on moving out of R&D beses, following a transfer of production operations
OVERSEES.
(yen/dollar)
350 aN
300 v"\
250
100 VON ANS
aa
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
‘Source: OECD, Economic Outloak
Figure1 Exchangerate of the Yen
This paper examines the conditions of deindustialization and reveals how the foreign direct
investment (FDI) understrong home currency hamns the manufacturing sector
2. Deindustrialization
Inthis section, we present and discuss some trends in advanced economies. Figure2 showstimesaiies
for share in total employment of manufacturing employment levd. We see a marginal dedine from
1990s in Japan while we see monotonous declines in the UK and the USA.
(%)
_ been A . a ——Gemany
> [Ree
15 AM eerenah ea,
—s- USA
on
0
1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: ILO, Labour Satistics.
Figure2 Empl share of facturing industry
Although Gemany and Japan still maintain the manufacturing industry in comparison with the UK
and the USA, Figure 3 reveals the difference between two countries. Japan has alow unemployment
tate While Gammny hes ahigh unemploymentrae.
(%)
9 ee
1970 1975 1980 1985 1990 1995 2000 2005 2010
‘Sourte: ILO, Labour Satistics.
Figure3 Unemployment rate in the manufacturing industry
Japan had alow unemployment rate in the manufacturing industry comparing other industies fora long
time(Figure4). Intemsof employment, the manufacturing secorremains a bese industry of Japan.
(%)
4 et = fs —e— Manufacturing
3 An. f \,
=r 4 ay
: NX «gel Pe a —s— Overall
2 a ar 4 ea industries
1
0
1975 1980 1985 1990 1995 2000 2005 2010
Sourve: ILO, Labour Salistics and ILOSTAT Database
Figure4 Unemployment rate in Japan
One of the central issues in the debate of deindustrialization is what factors are responsible for the
observed deciinein manufacturingemployment Several explanations aeavailable
The first eqplanation rests on a strong link between the degree of economic maturity and the
structure of employment. Clark (1940) suggested that, in the initial phase of devdopment, as percapita
income rises the pattem of demand shifts away from food towards industial products. _ In the later
stages of devdopment, the pattem of demand shifts away from industial products towards services.
This devdopment process changes economic structure and the pettem of employment.
The second explanation relies on the difference of productivity growth among sectors. Clark
(1940) argued that productivity gains in the manufacturing sector exceed those in the service sector
Rowthon and Ramaswamy (1997) confirmed this argument and argued that productivity in the
manufacturing sector grows faster than in the service sector +=Productivity growth in the manufacturing
sector has been exceeding those in other sectors, and this phenomenon will shift employment away from
the manufacturing sector into the savice sector Table 1 shows ame growth reies of labor
yaoductivity over the period 1997-2010. Productivity is defined as value ackded at constant 2005
market prices divided by total employment.
Table1 Average labor productivity growth, 1997-2010 (% )
Primary Secondary Tetiay
Gemmy 2.096 2.086 0.427
Japan 2.073 2.872 -0.367
UK 0.657 2714 1.697
USA (since 2000) 3.352 3815 0.917
‘Source: OECD, Economic Outlook.
‘The pattem thet emayes is that the growth rates of labor productivity are highest in the secondary
industry and lowest in the tettiay industry. High productivity in the manufacturing sector leads to labor
saving production, and the excess labor is consumed in the tetiaty industry. The exception is
Jmoductivity growth in Japan in the tertiary industry, which shows minus gowthraes. Thais less
space for the excess labor in Japan than in other advanced economies. The manufacturing sector has
long promised the stable employment and rdativay high wages in Japan. Therefore, people are
‘wonying about arecantiise of the unemployment rae.
‘The third explanation focuses on globelization. There are several factors that we must consider
Tn North-South trade, Southis specializing in labor intensive manufacturing goods. Facing thesecheap
imports, North needs to change the industial structure § Outsourcing of laborintensive activities
yaeviousy canied out within the manufacturing sector to counties with cheaper labor is another
explandion In 1970s, under the pressure of dollar depreciation, offshoring wes adopted among US
manufactures. ‘This tendency hollowed out the manufacturing sector by dosing home factories and
removing employees fromthejob. Scaling down of the manufacturing sector wes compensated by the
expansion of the service sectors. Offshoring production wes put into practice with lage outward
foreign direct investment Bluestone and Hanison (1982) offered the influential account Foreign
direct investment wes once a complement of domestic investment. However it is now a substitute of
domestic investment
Outcomes of FDI depend on types of investment product, and host country. Horizontal FDI
substitutes export, and hence reduces domestic production. Vertical FDI induces capital goods export
and intemediate goods export while introduces remport.
Figure 5 summarizes thesearguments. Domestic factors, suchas expand of the tettiary sectorand
growth of productivity, reduce employment in the manufacturingsector +Extemal factors, North-South
trade and outsourcing, acoderate import which reduces home production. Foreign direct investment
acoderaies oversees production which substitutes home production.
North —e Expand of
Trade Teritary Sector
A a
Foreign Direct, Overseas =. Hanis
Investment Production Paci —Pempinment
Exchange
nN
+ NN
Growth of
Productivity
Figure5 Causes of deindustrialization
While public debete about deindustidlization tends to emphasize the rising unemployment and the
hollowing-out in the manufacturing sector, academic debate argues that deindustialization is an evitable
feature of the process of economic devdopment and unemployment is temporal. The latterarguments
often evaluate the deindustiialization of the USA. as arole modd whichJapan should follow. Figure6
shows outward FDI of Japan. In 1980s, automobiles manufacturers and dectric-appliance manufactures
yomoted the horizontal FDI in the USA and Europe to avoid trade fridions. In 1990s, the light
5
manufacturing, such as textile makers, promoted the FDI to use the cheap labor Laborintensive
Manufacturing gradually moved abroad, and domestic makers shifted to export capital goods. In
2000's the cost-cutting pressure became severe and more menufactures consideed FDI while
Jiresexving research and development centers and components factories in Japan.
(million dollar)
140,000
120,000
i
100,000 |
| \ —+— Manufacturing
80,000 }
60,000 A, A
F \ Vaal \ wv —= Overall
‘ A industries
40,000 / oe
Zs
20,000 a
0
1970 1975 1980 1985 1990 1995 2000 2005, 2010
Source: OECD, Intemational Direct Investrent Databases
Figure6 Foreign direct investment of Japan
3. Exchange Rates and Deindustrialization
Among causal factors of deindustiialization, oversees transfer of production is a key factor of the
deéindustidizaioninJapan FDI inthe manufacturing sector grows in response to the yen appreciation.
We found many enqirical studies on deindustialization in 1990s. However most of them did not
catch the evidence of deindustidization inJapar’.
Tn order to examine the deindustialization phenomena in Japan, we focus on the unemployment
rain the manufacturing sector because this variable must he raised in the process of deindustiialization.
Our regression andlysis reveels the interesting features of deindustialization (Table 2). The
dependent variable in the regressions is the unemployment rate in the manufacturing industry (UEM, ),
which is defined as migie us from ILO Labour Saltistics database.
FDIM, is the FDI in the manufacturing industry in Figure 6. sR, is the proportion of savices to the
gross domestic production from the cabinet office's Annual Report on National Accounts.
FDI and tend toward a sawvice economy had litle to the nemploymentin the period from 1977 to
1997. Both variables became significant in the patiod from 1990 to 2008. These results indicae that
there wes no deaindustialization phenomenon in Japan until 1990s. Deindustiialization started behind
the UK andthe USA. FDI is oneof the causes of the cment deindistidlization or hollowing-out, but
its effect appears with atimelag. The existence of a time lag prevents us to understand the hollowing
-out phenomena wall.
3 This is one of the reasons that the arguments on deindustrialization has calmed until 2011.
6
Table2 Regression analysis of unemployment rate in facturing industry*
const. FDIM, , FDIM, 2 FDIM, 3 SR R
8303 -8.91e-06 0.0331
(14.606) (-0.763)
UEM q - 1.56e- 05 0.0870
1977-97 (15.899) (-1.273)
1.8576 -1.60e- 05 0.0750
(16.054) (-1.174)
1.3898 0.5983 0.0029
(0.847) (0.223)
.3320 8.84e- 0.0077
(4.503) (0.363)
UEM . 2.12e- 06 0.0003
1990-08 (4.446) (0.075)
1.2766 7.50e- 05 0.3330
(2.779) (2.914)
- 22.615 38.393 0.7656
(-6.706) (7.451)
Note Theregessions takerthefom, UEM=a+b-FDIM, UEM=a+b-SrR.
4 Matsushita, Goto and Yamashita (2011), p.22.
How does FDI affect the deindustrialization? The appreciation of the home currency
harms the competitiveness of the manufacturing sector in the domestic market as well as in
the world market. ‘To maintain the competitiveness, manufacturing companies are obliged to
use the cheap labor and consider overseas production. Japanese manufacturers prefer local
production supplying the demand for host markets to offshore production. Although
offshore production substitutes and decreases the home production, overseas local production,
moving out a part of the production process, increases the export of the home production.
The recent yen appreciation makes manufacturers to consider moving larger part of
production processes and R&D bases to abroad.
Figure 7 shows the percentages of subsidiaries and affiliated companies owned by
Japanese manufacturers. The percentage of overseas subsidiaries continues to rise.
(%)
90.0
80.0 24
70.0
60.0 Se
Par Ek, —+— domestic
50.
40.0 pa
30.0 =
20.0
10.0
0.0 L L L L L L 1 L L
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Sourve: Ministry of Economy, Trade and Industry, Basic Survey of Japanese Business Structure and Activities
Figure 7 Ownership of subsidiaries and affiliated companies
Consequences of FDI in the home country are not clear comparing those in the host
country. In a theoretical sense, vertical direct investment increases export from the home
country to the host country, whereas horizontal direct investment decreases export. Actual
FDI can substitute for trade or can be complementary trade. In 1980's, FDI in the
automobile industry was intended to stop the export from Japan to USA or Europe avoiding
trade frictions. However, the current FDI aims to supply the home market and increases the
volume of export and import.
4, Structure of the model
The statistical findings in the previous sections tell us that the time-lag plays a crucial role in
the deindustrialization phenomena. In modeling a FDI-led deindustralization, a system
dynamics approach is much more useful than other methods because we can handle time-lags
in various variables. A system dynamics approach is also useful in building decision making
process.
4.1 Macroeconomic sector
The standard Keynesian aggregate demand model can be applied to the national economy.
Gross domestic expenditure (GDE, ) consists of private final consumption expenditure (CP, ),
private capital formation (1,), govemment expenditure (G,), exports (EX,), and imports
(M,).
- GDE, = CP, +1, +G, + EX, -IM, (3.1)
A subscript means time t.
Private final consumption expenditure
Private final consumption expenditure is a large and stable component inGDE. Private
final consumption expenditure function is assumed as a Keynesian type function in which the
level of consumption depends on the gross domestic product (GDP, ).
CP, = CP. (GDP) (3.2)
Gross private fixed capital formation
The gross private fixed capital formation consists of the private residential investment
(IH, ), the private nonresidential investment (IP, ), the private inventories (IV, ).
1, =1H,+1B+, (3.3)
The private residential investment is primarily the domestic demand by household. We
assume that it is influenced by the previous investment and the previous demand for imports.
TH, = IH, (IH,_,, IM, ;) (3.4)
Tt is an advantage the model is developed in the system dynamics that control the variable
with the delay easily.
The private nonresidential investment and private inventories are actions of the fim.
We assume the private nonresidential investment depended on the previous investment and
the change of exports demand.
IR, = IRR, 4, EX, ~ EX, y) (3.5)
Private inventories are related to business fluctuations. We assume that the production.
plan of the firm is influenced by the economic growth.
IV, = IV, (GDP_, - GDR_2) (3.6)
Government Expenditure
‘We assume that the govemment expenditure grows steadily year by year
G, = G, (TIME) (3.7)
Exports
The exports to other countries are assumed to depend on the exchange rate ( EXR, ) and
the wodd GDP (WGDR). Weuse the world GDP measured by US dollars at current prices
and current exchange rates in millions (Source: UnctadStat).
EX, = EX(EXR,,WGDR) (3.8)
Imports
Imports are dependent on the consumption expenditure and the exchange rate; thus we
assumed following regional imports function.
IM, = IM,(CB, EXR) 9)
Figure 8 shows the causal relation of the macroeconomic sector
Previous GBP
|
4 Change in Previoous GDP |
EXR
Figure 8 Macroeconomic sector®
4.2 Foreign direct investment
We assume that the volume of the foreign direct investment in the manufacturing industry is
dependent on the exchange rate.
FDIM, = FDIM,(EXR, ) (3.10)
4.3 Manufacturing sector
In the manufacturing sector we focus on employment and overseas investment A
significant part of investment in manufacturing companies is for their subsidiaries and
affiliated companies. We assume the investment for overseas subsidiaries and affiliated
companies ( INVOS, ) is dependent on investment for all subsidiaries and affiliated companies
(CINVS, ) and the propensity to invest overseas subsidiaries ( POS, ) by the parent company.
INVOS, = POS, x INVS, (CP, ) (3.11)
The investment for all subsidiaries and affiliated companies (INVS,) is well explained by
private final consumption expenditure (CP.) because the Japanese economy is a domestic
consumption-led economy. We use the perventage of the investment for subsidiaries and
affiliated companies owned by manufacturers as the propensity to invest overseas subsidiaries.
This percentage was gradually rising from 0.527 in 1994 to 0.586 in 2010.
We assume that the demand for labor ( LDM, ) is affected by the private nonresidential
investment and foreign direct investment from 1975 to 1993.
LDM, = LDM, (IP,, EX,, FDIM, ) (3.12a)
Form 1994, we assume that demand for labor is well explained by the private nonresidential
investment and investment for overseas subsidiaries and affiliated companies®.
5 The model was developed on STELLA Ver.9.
6 The investment data for subsidiaries and affiliated companies were available from 1994.
10
LDM, = LDM, (IP., INVOS,) (3.12b)
Figure 9 shows the causal relation of the manufacturing sector
Outflaw of LD
Change in LDM
FOM
Figure 9 Manufacturing sector
5. Simulation
Let us examine simulations. We have three scenarios: yen appreciation (77.0 yen/dollar)’,
yen depreciation (95.0 yen/dollar), and yen super depreciation (120.0 yen/dollar) from 2012 to
20208. Figure 10 and 11 summarize the results. Along with public belief, GDP will be
smaller under yen appreciation scenario than under yen depreciation scenarios for the future.
(Billion yen)
750,000
650,000
=
450,000
350,000
250,000
150,000
1980 1985 1990 1995 2000 2005 2010 2015, 2020
Yen appreciation | —s—Yen depreciation —%— Yen super depreciation
Figure 10 GDP simulation
The labor demand in the manufacturing industry will be smaller under yen depreciation
7 OECD Economic Outlook estimated 77.0 yen/dollar for 2012 and 2013 in November 2011.
8 95 yen per dollar are the assumed exchange rate by major companies for the 1st quarter
2014.
11
scenarios than under yen appreciation scenario after the short recovery. This result implies
the importance of manufacturers’ decisions. This is dependent on the parent companies
decisions ( POS, ) in the model.
(Thousands)
18,000
16,000
14,000
12,000
10,000 a
8,000 =
6,000 %
4,000
2,000
0
1980 1985 1990 1995 2000 2005, 2010 2015 2020
‘Yen appreciation —s— Yen depreciation —a— Yen super depreciation
Figure 11 Employment simulation
Figure 12 shows the propensity to invest overseas subsidiaries ( POS, ) simulation result
under yen depreciation case. Reducing investment towards overseas subsidiaries will
increase domestic employment. Industrial policy calling back Japanese manufacturers to
home country is more effective than currency policy.
(Thousands)
18,000
16,000
14,000 —
10,000 Wwe
8,000 SS
6,000
4,000
2,000
0
1980 1985 1990 1995 2000 2005 2010 2015, 2020
Yen depreciation (0.586) _—s—Yen depreciation (0.527) _—#— Yen depreciation (0.468)
Figure 12 Effect of propensity to invest (POS)
12
6. Conclusion
The findings of this paper can be summarized as follows.
1) FDL, especially vertical FDI, is a key factor of deindustrialization.
2) Under the home currency appreciation, deindustrialization is a negative phenomenon
contrary to many academic debates.
3) The negative effect of FDI appears with delays. System dynamics approach is
particularly useful to express these delays.
4) System dynamics model highlights an important result that is unpredictable in other
economic forecasting. Yen depreciation will recover the manufacturing employment for a
while but will not fora longer tem.
5) Industrial policy calling back manufactures to home country is desirable than the currency
policy.
Although overseas transfer of production is a formula for deficit-ridden manufacturers, it
will hollow out the economy in the long-rnm. Thousands of manufacturing jobs may be lost
in the future.
Appendix: Estimation of functions
A data set was assembled for the years from 1975 to 2010. A value in parentheses under the
coefficient is t-distribution, R? is a coefficient of determination, R a coefficient of
determination adjusted for the degrees of freedom.
CP, = 35739,8651+ 0.5111GDP,, R? = 0.9854
(8101) (47.868)
TH, = 2810,6003+ 0.9635 1H, , ~ 0.049041M, . R’ = 0.8495
860) (13.956) (3.075)
TR, = 3890,1502+ 0.9358IP, , + 0.3835(EX, ~ EX, 1) R’ = 0.9500
IV, = 3A5,7746+ 0.1045(GDR, GDR.) R? = 0.3188
(0.941) (3.989)
G,= ~ 4500833, 8851+ 2291.16 1615TIME R* = 0.9401
log(EX,) =- 5806+ 0.4856 log(EXR, ) + 0. 0. S710 log(WGDF, ) R’ = 09707
=2
IM, = ~ 21050.5388+ 0.2268CR, + 42.9251 EXR, + 0,3863FDIM, R = 0.8443
2
log(FDIM, ) = 24, 6565- 3 423 log(EXR ) R° =0.7977
INVS, = — 214561250.3684+ 877.3657CP, R? = 0.9201
(11.266) (13.141)
LDM, = 10567, 1832+ 0.025231R, + 0.08682EX, ~ 0.0357 FDIM, R’ = 0.9677
13
LDM, = 14384.1067+ 0.1067 IP, — 0.097554IM, - 0,0002551INVOS, R’ = 0.8783
(8.056) (1.895) (-1.638) (-3.694)
Acknowledgements
The author would be much obliged to the anonymous reviewers for their valuable comments
on an earlier version of this paper This research is supported by JSPS KAKENHI
(Grant-in-Aid for Scientific Research (C)) Grant Number 24530297.
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