This Nation Is An Island

Increased investment from outside would bring countless benefits to the economy—not only fresh management expertise and ideas but also a competitive jolt that could spur innovation and productivity. And that's exactly the sort of inspiration Japan desperately needs if it is to overcome the limits of a work force that's both shrinking and graying. The last three Japanese governments have called robust growth in FDI an "indispensable condition" if the aging economy is to prosper in the 21st century. Japanese officials vow to increase the level to 5 percent of GDP by 2010—but that "seems extremely difficult," says van den Heuvel. "And if they do [achieve], it's still then a low level."

The other problem is Japan's inability to get better returns out of its assets. Little over half of individual financial assets—over $15 trillion—are kept in the form of bank deposits, which yields almost no returns. And most of them are in yen, with foreign-currency denominated assets accounting for less than 5 percent. That's hard to do at home, given the country's near zero interest rates and lingering deflation. Koji Shimamoto, chief strategist at BNP Paribas Securities, Japan, notes that the Japanese approach to financing pensions, for example, has always tended to be insular by definition—consisting of investments in Japanese government bonds and equity. In the old days, he says, "[t]hat was OK since it was the domestic economy that was growing. Today, Japan needs to seek outside markets for growth. Yet we don't seem to be equipped to make the change." Noguchi notes that compared with other developed countries, Japan's outward investment is conspicuously low. At 10.3 percent of GDP, it's merely about half that of the United States'.

Case in point: Japan's relationship to its own Asian hinterland. While other Asian countries were busily setting up free-trade agreements and trying to boost regional cooperation over the past decade, Japan remained aloof. Only recently has Tokyo woken up—to find itself lagging far behind Beijing, which has been especially aggressive in setting up FTAs with its regional trading partners.

According to a recent study of global capital flows by the McKinsey Global Institute, most of Japan's cross-border investments are in developed markets such as North America or Europe. But it's Asia that has been the source of the world's most dynamic growth for years, and it's there, surprisingly, that Japan remains a minor player. From 1990 to 2006, the report notes, Japan's share of global financial assets in Asia fell from 23 percent to 12 percent, while China's share increased from less than 1 percent to 5 percent. The report also says the financial assets of Asian countries outside Japan are growing much faster and that emerging markets have seen their share of financial assets slowly rise over time. By 2006, the report noted, financial assets in other Asian countries grew to $18.8 trillion, just shy of Japan's $19.5 trillion. While Japan's total financial assets remained flat, the rest of Asia's grew with astounding rapidity—led, of course, by China. For the time being, the study concludes, "Japan remains shut out of Asia's financial integration."

That judgment seems particularly ironic in light of the Japanese government's oft expressed intention to transform Tokyo into an Asian financial hub that might one day rival London or New York. For about one year now Japanese officials have been pushing the idea of an "international zone" in the city's downtown area where overseas bankers, insurance companies and investment funds could enjoy cosmopolitan culture and liberal regulation. The supporters of Tokyo's bid argue that making the city into a hub would give a much-needed jolt to Japan's calcified business culture by fomenting competition and spurring the modernization of its relatively staid financial establishment. "To make Tokyo change we need to have an international financial center here," says Ken Yagi, CEO of Bayview Asset Management, a Japanese investment fund based in Tokyo.

Sounds like a great idea—except that, given recent developments, it now seems virtually dead in the water. The recent turbulence in world financial markets has triggered a flight from Japanese stock markets that has sliced away nearly a quarter of the value of Japanese shares since last summer—despite the fact that Japanese credit institutions have had only minimal exposure to the subprime crash. A key reason is that foreign investors, who began piling into Japanese shares during the 2001–2006 term of the reform-minded prime minister, Junichiro Koizumi, have lost faith in the reform ability of his successors, including the present government of Prime Minister Yasuo Fukuda.