CIAO DATE: 1/99

Whither Trade Policy with Japan? A Position Paper for the CFR Study Group

In the late 1990s, bilateral trade issues with Japan have subsided to a low murmur. With the Japanese economy reeling from recession and the financial sector wallowing in a mountain of bad debt, the question of access for foreign firms has diminished in relative importance. Nevertheless, a variety of indicators suggest that access problems remain and that Japanese government resistance to dismantling those barriers continues. This paper addresses several questions concerning trade relations: What is the "problem"? What have we learned in 20 years of negotiations? What might we do now?

Defining the Issue

What is of concern is access to the domestic Japanese market by foreign-owned firms. Defined in this manner, the problem encompasses both trade and investment. Firms can participate in foreign markets either by exporting goods and services from their home country (or a third country) or by investing directly. Actually, market participation often involves a combination of both, and trade relations with Japan involves issues related to both traditional trade barriers and investment problems.

The Primary Sector

For raw materials, barriers have been minimal, although subsidies to inefficient domestic raw material industries (principally coal) have lingered. American oil companies have long been embedded in Japan in the form of 50-50 joint ventures established in the 1950s to import crude oil, and refine and distribute petroleum products. The dilemma that some American firms in raw materials face is that they are vertically integrated and would prefer to export processed materials rather than raw materials. Oil companies gained the capability to export gasoline to Japan only in 1987, and wood product companies still face problems on manufactured wood products.

Agriculture presents a very mixed picture. Some parts of the market have been closed(especially rice. Other parts of the market have been very open, including wheat, corn, soybeans, and sorghum. Other agricultural products are between these extremes, some facing tariff or tax problems (such as whiskey) and others facing phytosanitary standards that have been used as de facto import barriers (because the standards exceed any reasonable scientific case for their necessity).

In general, barriers in agriculture have not prevented a gradually rising foreign participation in the domestic food and beverage sector. From only 6 percent in fiscal year 1965, imports accounted for 38 percent of the value of food and beverages consumed in Japan in fiscal 1995, and on a caloric basis the shift was from 27 percent to 58 percent.

These trends do not mean that the whole agricultural sector is now open; instead, it means that the government has gradually diminished its protection of the domestic agricultural sector as it has become increasingly inefficient. Farmers are politically powerful, but have not been able to entirely stave off market liberalization. In contrast to some manufactured goods, the reduction of overt import barriers in the agricultural sector has led to substantial inroads for some foreign products. Without remaining barriers, though, imports would be higher for a wide variety of food and beverage products that still face problems.

Gains in the past decade have been especially noticeable for processed food and beverage products. From the late 1980s, imports of processed products (such as frozen meat, frozen pizza, frozen french fries, ketchup, beverages, and other products) have generally risen faster than total food imports. Even here, though, the picture is somewhat less rosy than the broad data indicate. The sharp rise in beverage imports in the 1993 to 1995 period was driven largely by beer. Foreign beer enjoyed a very temporary inroad as discount chains used imported beer to break the domestic beer cartel's high prices; once broken, the cartel regrouped at a lower price and imported beer declined rapidly. At its peak in 1994, foreign beer had a four percent market share, which had dropped in half by 1996.

Manufactures

One simple way to view the penetration of foreign-manufactured products is the ratio of imported manufactured goods to the apparent domestic consumption of manufactures (defined as domestic production plus imports, minus exports). This ratio has been considerably lower in Japan (18 percent in 1995) than in other countries, including the United States (37 percent in 1993). The ratio exhibited little change from the late 1980s to 1993; there was, however, a noticeable jump in the 1994 to 1996 period. A broader comparison shows Japan's penetration level (ratio) as below that of most other countries; of 76 countries that reported the necessary data in 1990, only 3 (Argentina, Brazil, and Estonia) had a penetration level lower than that of Japan.

Low import penetration level may be due to many causes, but the statistical evidence is consistent with the perception of American firms that they have more difficulty obtaining access to Japanese markets than they have in obtaining access to the markets of other countries. The evidence on import penetration is all the more telling when combined with the price disparities considered below.

Services

Trade data for the service sector do not exhibit the same lopsided imbalances between the United States and Japan as do manufactured goods trade data, but there is certainly evidence of problems in some areas. Japan has run a trade deficit, both globally and bilaterally with the United States that has generally widened over time (although the situation varies widely by sector). Some of the most difficult negotiations in the past decade involved severe and obvious access barriers in service industries--such as insurance, retailing, civil aviation, and telecommunications. In general, the service sector in Japan is characterized by extensive regulation that has tended to raise prices and limit foreign entry. While deregulation has been proceeding in the 1990s, the pace has been slow and weak in most cases.

The one exception to the general pattern of weak deregulation appears to be the financial sector. Faced with evidence of massive management failure exacerbated by cozy government-industry ties, the financial sector appears to be moving forward with deregulation. More important, the extreme nature of distress among financial institutions has lessened the usual Japanese government antipathy toward participation of foreign firms, extending even to the capability of foreign financial institutions to acquire domestic ones (such as Merrill Lynch's acquisition of 50 branches belonging to the bankrupt Yamaichi Securities). Acquisitions were unthinkable as recently as two years ago. How long this situation will last, however, is uncertain.

Prices

A pattern of substantially higher prices for goods and services in Japan as compared to the United States for comparable goods and services continued unabated in the 1990s. These differences would have engendered substantial arbitrage if markets were fully open (with entrepreneurs buying goods abroad and selling them in Japan). Estimates of price differences vary, but even the Japanese government acknowledged that in 1994 Tokyo prices were somewhere in the range of 50 to 80 percent higher than in New York. Behind the averages, prices for some goods and services continued to be startlingly higher in Japan(with pacemakers 6.9 times the U.S. price, and refrigerators running 3.3 times higher (in terms of price per cubic unit of capacity). Retail prices for consumer goods and services are the normal object of these price comparisons, but work by study group participant Mark Tilton indicates that similar price disparities exist for basic materials such as cement and steel.

With the yen's depreciation after 1995, some of the disparity on consumer retail prices has abated, but the disparity is far from gone. Even at the very weak Yen140 per dollar rate of the summer of 1998 left prices for many goods in Japan much higher than in the United States (refrigerators, television sets, microwave ovens, and sports shoes among them). Indeed, a careful comparison of refrigerator prices indicates only a minor decline to a 2.9 times differential.

Price differences matter. In an open environment, high prices should cause an inflow of cheaper imports. The fact that price differences continue to exist while manufactured imports remain much lower than in other nations provides strong evidence that market barriers exist.

Direct Investment

Conceivably, direct investment by foreign firms could offset the low trade indicators if sales by local subsidiaries are a substitute for exports. However, this is not the case. Investment into Japan has also been low relative to investment into the United States or other countries. Data on investment are notoriously inaccurate, especially in Japan (where data are based on partial, inaccurate surveys). Even adjustments to the data leave the conclusion that foreign-owned firms generate a much smaller share of economic activity in Japan than they do in the United States or other major countries. For example, in 1996 majority-owned affiliates in Japan accounted for no more than 3.1 percent of domestic corporate sales (making very generous assumptions in adjusting the flawed official data), whereas they represented 9.4 percent of total corporate sales in the United States.

Direct investment into Japan is not constrained by overt barriers, which were dismantled in a series of steps lasting from the late 1960s to the early 1980s. However, problems do remain, of which the most serious is the difficulty in acquiring existing Japanese firms (a common form of entry for foreign firms entering a national market). Another obstacle to direct investment is the foreign-firm perception that market barriers in Japan are not at the border (tariffs or quotas) but within the market (standards, testing procedures, and collusion), so that investment within Japan does not necessarily enhance a firm's capability to penetrate the market.

Combined with the trade data, the investment data confirm the continued disparity in the presence of foreign firms and their goods or services relative to the situation in other nations. This disparity could be due to normal economic factors, but few economists subscribe to this conclusion. Most analyses(even those using data from the 1990s(conclude that access to Japanese markets is lower than can be explained only by economic factors. This outcome is consistent with the continued complaints of foreign firms in Japan about a multitude of access impediments. The 35 years since Japan first began dismantling its extensive quota system in 1963 have included numerous negotiations and trade liberalization actions, but these have left a nation that still lags behind on access. Japan is certainly far more open today to many foreign goods and services than in the 1960s, but so is the rest of the world. Relative to other countries today, Japan is still less open.

Lessons Learned

What has the past decade taught us about the bilateral trade relationship between the United States and Japan? The past decade of bilateral trade negotiations yields these four conclusions:

1. Lack of major change in Japan. At various times Americans have had the impression that Japan was in the process of radical domestic change that would either yield more open markets by itself or at least produce an easier negotiating task. The rapid growth and sense of self-confidence in the late 1980s produced considerable talk of reform, but relatively little action. The stagnation of the 1990s produced talk and some action on deregulation motivated by a fear that overregulation was stifling growth, but the results during the period from 1993 through mid-1998 were disappointing. Any process in which the bureaucracy itself is in charge of deregulation, and in which the emphasis is on producing long lists of individual items slated for some form of action, is guaranteed to be weak. Furthermore, at the same time that the government moved forward with deregulation, it continued to implement new laws perpetuating the tradition of industrial policy. Administrative reform, which could have produced a smaller government consistent with the notion of less government involvement in the economy, resulted only in a plan to reshuffle ministries with little or no net reduction in personnel or elimination of function.

   Lack of vigorous change was obvious at the bargaining table. Most bilateral trade negotiations proved to be quite difficult. Japanese government negotiators remained fundamentally opposed to American requests even though the thrust of those requests was in the direction of deregulation and openness. Some individual officials and some pressure groups in Japan favored change on various issues, but the negotiating posture resulting from the internal decision-making process was generally one of determined opposition to American positions and often included post-negotiation efforts to minimize the importance of signed commitments.

   One could argue that by mid-1998 the situation was finally changing. The continued poor performance of Japan's economy and the daunting level of bad debts in its financial sector may produce a more vigorous domestic push for reform and deregulation. The public (as demonstrated in the July 12 election for Japan's Upper House) wants the government to do "something" to get the economy growing, but whether they really want this process accompanied by thorough deregulation and open markets is questionable. The outcome of the current economic turmoil in Japan could lead to more structural change and deregulation, but this outcome is by no means obvious, necessary, or guaranteed.

2. Large themes can be counterproductive. On several occasions the U.S. government has chosen to highlight negotiations with Japan by creating a broad but concentrated negotiating agenda. The Yen-Dollar Talks of 1983-1984, the Market Oriented Sector Selective (MOSS) talks in 1985-1986, the Structural Impediments Initiative (SII) in 1989-1990, and the Framework Agreement of 1993-1996 represent four attempts to follow this approach. By creating a sense of urgency through including multiple issues and creating deadlines, one could argue that the theme approach accelerates progress (especially in Japan where bundling problems and creating a perception of crisis is a common tactic to achieve progress on sticky domestic issues). However, the experience has not been especially good. Confronted with an enthusiastic American administration, the Japanese government acts on the assumption that Washington will become tired of the agenda in 12 to 18 months and deploy delaying tactics. To bring home signed agreements as a demonstration of success within imposed deadlines, U.S. trade negotiators are under pressure to accept relatively poor outcomes.

3. The GATT/WTO is useful but remains imperfect. Some problems with Japan have been addressed successfully through the dispute resolution mechanism of the General Agreement on Tariffs and Trade/World Trade Organization (GATT/WTO). Successful pressure on Japan in the 1980s to end the quotas on beef imports relied on filing a GATT case (though Japan then reacted favorably before the case was heard). In the 1990s, the WTO has been useful on the liquor tax issue and phytosanitary standards. However, coverage by the WTO remains incomplete and some U.S.-Japan disputes involve industries outside its jurisdiction. Furthermore, many market barriers in Japan are quite informal and often include multiple sets of overlapping policies. The color film case was an attempt to test the WTO's capability to deal with these informal and complex cases. The negative outcome of that case implies strongly that the WTO is either not willing or not ready to take on this task. The WTO is a useful venue only for cases that are relatively simple and straightforward and that involve written government documents.

4. Exchange rates matter. At various times in the past decade, pundits have claimed that exchange rates do not work. They do, but may have an impact that is more complex than usually assumed by economists. First, it is worth noting that exchange rates have had a normal impact on Japan's global and bilateral trade (with a stronger yen causing Japan's surpluses to shrink and a weaker one causing them to rise), even though that impact may be somewhat smaller and slower than Americans would like. Second, there may be a discontinuous impact. Even relatively protectionist economies like Japan's must weigh the costs and benefits of protectionism. At some exchange rate, continued reliance on domestic suppliers imposes an unacceptable cost on buyers, or presents competitors with irresistible profit opportunities. A strong yen, therefore, reinforces the negotiating agenda with Japan by putting more pressures into the system in favor of change. For example, Japanese car manufacturers were concerned over the costs of sticking with traditional keiretsu parts suppliers as the yen rose strongly in 1994-1995. At the same time, Japanese regional supermarket chains began buying American processed foods for the first time. Having broken the instinctive resistance to purchases from foreign firms, these changes in behavior may remain even after the exchange rate weakens. This pattern appears to have been true for food products; whether it will be true for manufactured goods remains to be seen.

Possible Trade Policy Approaches

What should the U.S. government do now? There are several possibilities, none of which is new. One of the realities is that there is no magic new policy possibility that will solve market access problems in Japan. I exclude from this discussion macroeconomic issues that the study group has discussed already. A stronger yen and a Japanese economy that returns to positive economic growth have an obvious positive impact on the sale of American goods and services. The following points focus, however, on trade policy more traditionally defined(the process of trying to make the rules for access to the Japanese market more open.

• Ignore market access problems. Japan is facing a serious recession compounded by an enormous bad debt problem in the financial sector. In comparison, market access issues seem relatively trivial and their pursuit could detract Japan from solving its macroeconomic problems. Japan's markets are generally not entirely closed and most American firms do manage to sell some goods and services, even if less than they would like or believe they could if the market were truly open. In addition, maybe the optimistic view is correct and domestic problems are sufficiently serious that they will finally drive a more rigorous domestic deregulation process. Therefore, bilateral trade relations could be assigned a low priority status, in which cases are pursued as they arise, but without permitting them to rise to a high level of attention and without applying any pressure tactics.

  The problem with this option is that the overall malaise of the Japanese economy and our sympathy with it masks two problems in the notion of domestically driven change. First, some competitive firms in the export sector continue to perform very well and continue to benefit from partial closure of their home market (enhancing their profits, and thereby enabling them to be more aggressive in pursuing foreign markets). If this was a problem in the 1980s, it remains a problem today; these industries are loath to lose their domestic advantage. Second, one of the aspects of domestic malaise is the poor performance of some sectors or industries that are not competitive internationally and that resist foreign inroads. Finance is a prime example of this problem (financial firms appeared competitive in the 1980s in terms of grabbing market share in international financial markets but they had little technical or management expertise). A crucial part of economic recovery comes from weeding out or transforming such inefficient sectors and industries. Foreign firms can play a useful role in this process by either acquiring domestic firms and restructuring them, or by establishing wholly owned subsidiaries that provide pressure on domestic firms to reform. This now appears to be happening in finance to some extent, but the more general reaction is fear of takeovers or other inroads by foreign firms in domestically weak industries. Even in finance, the recent success of foreign firms may not last long if concerns over foreign dominance rise.

  For both of these reasons, the "do nothing" option is probably not viable. For leading American firms facing serious global competition from Japan, access to Japanese markets still matters for the same strategic reasons as it did a decade ago. Additionally, we could actually help the process of recovery from the recession if markets in which Japanese firms are not competitive become more open.

• Use the WTO. As noted earlier, the WTO still has fairly serious scope limitations, but it certainly can be useful for some problems. The Uruguay Round produced a new code on technical and phytosanitary standards, for example, that imposes language about needing scientific support, minimizing the impact of these standards on international trade, and accepting international standards whenever possible. A number of problems of access to Japanese markets in the past decade have taken the form of unusual standards and testing policies used as deliberate trade barriers. The U.S. government is currently pursuing a case on Japanese phytosanitary standards at the WTO. In this area, therefore, the WTO may be of greater value than in the past and should be pursued vigorously.

• Establish a bilateral dispute resolution mechanism. From time to time, American or bilateral study groups have recommended establishment of a special bilateral Asia-Pacific Economic Cooperation (APEC) dispute resolution mechanism that could cover disputes falling outside the jurisdiction of the WTO. Most of these seem to be based on the North American Free Trade Agreement (NAFTA) arrangement. This idea will not work for several reasons. First, some bilateral issues concern violations of existing agreements, but many others are about getting Japan to make new commitments to open its markets. A bilateral panel could conceivably rule on violations, but not on new commitments. Second, Japanese panelists chosen from lists established by the Japanese government are unlikely to approach their task in an unbiased fashion (or in an even less unbiased fashion than potential panelists from the United States). Third, a bilateral panel would have an uncertain range of competency. The NAFTA arrangement deals with agreements specific to NAFTA. But U.S. bilateral negotiations with Japan yield most-favored-nation (MFN) agreements. Why should only the United States have access to a grievance procedure when other countries have the same interests or problems and are beneficiaries of the same trade agreements?

• Aggressive unilateralism. This option is a continuation of past policies, but without the creation of unifying themes and timetables. The United States Trade Representative (USTR) and the Department of Commerce, however, should at least be assigned more personnel to pursue problems with Japan on a steady basis. Cases would be handled through the WTO when feasible, and on a bilateral basis when not. In this process, monitoring existing agreements that both the Bush and Clinton administrations have negotiated is important, but this also requires a larger personnel and budget commitment.

The major problem with this approach is leverage. If, as most lawyers believe, Section 301 retaliation is not viable in the wake of the Uruguay Round agreement what can the U.S. government do? One possibility is to search for retaliatory measures outside the scope of the WTO(such as the punitive fees levied on Japanese vessels in the port practices dispute. Another possibility is to impose measures that are sufficiently painful to Japanese firms that these firms would be reluctant to bear the pain while their government pursues a case against the United States at the WTO. Arguably this was the case in the automobile dispute, where Nissan might not have survived the punitive tariffs on luxury cars (the one product on which it was making a profit). But finding other ways to apply pressure could be difficult, and this strategy has been unpopular with those who fear damage to the political and security relationship.

So, what to do? A combination of several of the above choices may be the most reasonable outcome. We should watch carefully what is happening in Japan. The economy faces a situation unlike anything since the late 1940s, and there is at least the possibility for internally generated change. But given the strong possibility that the changes may not make markets more accessible for foreign firms, trade negotiations remain necessary, and need to be pursued even in the midst of the current economic problems in Japan. The WTO offers more opportunities than GATT, and should be pursued in all feasible cases. Other issues, though, should be pushed through the bilateral setting, with a willingness to use retaliation as a tool when feasible. The chief conclusion, though, is that American expectations concerning the pace of possible progress in opening Japanese markets should be lowered; problems remain and removing them will prove to be slow and difficult.