This Nation Is An Island

To understand Japan's economic milieu, you could do worse than to look at the current battle between famed British hedge-fund manager Christopher Hohn and the Japanese government. In January, Hohn, an activist investor who runs the London-based Children's Investment Fund, decided to double its stake in J-Power, Japan's largest electricity wholesaler, hoping to trim fat and boost returns at the top-heavy firm. The Japanese government promptly rejected the bid, citing nebulous concerns about "maintenance of public order." Hohn, who has been involved in shake-ups at ABN Amro and Deutsche Börse, wasn't deterred.

He's enlisted EU Trade Commissioner Peter Mandelson to plead his case to the Japanese, and has petitioned Brus-sels to begin trade sanctions. While the situation seems unlikely to evolve into a full-blown trade battle, Tokyo has clearly drawn a line in the sand.

The resistance toward not only Hohn, but many other foreign investors, encapsulates growing Japanese anxiety about their economy and place in an increasingly competitive global environment. Japan, of course, has always had an ambiguous relationship to the outside world. Throughout its history the country has oscillated between pathological suspicion of foreigners and eager imitation of alien ways. Recently some of the buried legacy of isolationism—manifested in a stubborn resistance to foreign investment and a reluctance to capitalize on the opportunities of globalization— has been coming back to the surface. And it's happening, arguably, at a moment when Japan can least afford it. In an age marked by the rise of the sovereign wealth fund, the non-Western multinational and near-instantaneous capital flows, Japanese insularity, say critics, is becoming a luxury that the country can no longer afford. "In the old days, foreign investors had no choice but to invest in Japan, and Japan could afford to respond to their calls [for change] gradually," says Kengo Nishiyama, strategist at Nomura Securities. "Today it has competitors in emerging countries; unless Japan moves fast, its relative attractiveness could fade."

To be sure, Japan is still plenty wealthy. It's the world's second largest national economy, it's the world's leading creditor nation and its blue-chip corporations still wield immense prestige and power around Asia and the globe. Yet Japan's relative position in the global economy has been dragged down by its own structural weaknesses (like its sagging demographics and slowing productivity) even as other countries are joining the ranks of the wealthy. In rankings of per capita GDP it has fallen from the No. 2 position 15 years ago to No. 18 today. Its share of the global economy has slid from 18 percent in 1994 to 10 percent in 2006. These shifts aren't absolute; view Japan's performance through the lens of purchasing power rather than nominal GDP figures (which can be distorted by exchange rates), and the situation doesn't look quite so dire. Yet the trend is clear.

Yukio Noguchi, a professor of finance at Waseda University, says that Japan is missing out on what he calls "the 21st-century version of globalization" based on the free flow of capital and knowledge. He has also coined a phrase that captures what he considers to be the essence of modern-day Japan: shihon sakoku (a closed capital nation).

Modern-day Japan is closed in two fundamental ways. First is its striking reluctance to allow foreign direct investment (FDI). Within the Organization for Economic Cooperation and Development, the club of the world's wealthy industrialized nations, Japan ranks dead last in terms of its ability to attract FDI. According to the Japanese Cabinet Office, the country's ratio of FDI to GDP in 2006 was 2.5 percent—compared with 8.8 in Korea, 13.5 in the United States, 25.1 in Germany and 44.6 in the U.K. The reason is a host of political and bureaucratic impediments—from product regulations to cross-shareholdings—that make it hard for foreigners to build up large shares in Japanese firms. "It all just sort of encourages foreign investors to look elsewhere, where investment rules are more transparent and predictable," notes Peter van den Heuvel, head of the trade section of the EU delegation in Japan. According to him, the attitude in Japan is that " 'we are very good; we don't need you all. If you want to come to Japan, work on our terms.' But that's not what international business is all about."