For the most part, the increase in Japan’s export rate has been caused by the renewed growth and increased demand of East Asian economies, especially China. In 2009, 17 per cent of Japan’s total trade was with China. This surpassed Japan’s total trade with the United States (14 per cent). At the same time, these figures should be interpreted with caution. Japanese outsourcing and development of production networks in East Asia has made the use of bilateral trade flow measures less and less meaningful.

Another critical element of Japanese international economic engagement is foreign direct investment by Japanese corporations. Japanese corporate foreign direct investment is often directly tied to exports and imports. Japanese FDI outflows more than doubled between 2005 and 2008, dropped significantly in 2009, but are picking up once again. There are many factors at work: outsourcing, production networks, mergers and acquisitions, corporate reinvested earnings. As a colleague quipped, ‘Japanese manufacturing is alive and well, it’s just not located in Japan.’ Japan’s FDI is diversified both geographically and by sector. Some 48 per cent of Japan’s reported FDI stock of ¥68.2 trillion ($758 billion) at the end of 2009 was in manufacturing.

Investment in Asia accounts for 24 per cent of Japan’s total FDI, and investment in China accounts for 7.4 per cent. Nonetheless, the United States remains the largest market for Japanese foreign direct investors. It accounts for 31 per cent of total Japanese foreign direct investment. With Japan’s domestic market growth limited and labor expensive, Japanese firms will continue to invest abroad vigorously, particularly in dynamic Asia. In addition, with a stronger yen and large cash balances, purchases of foreign companies will continue to grow.

At the same time, Japanese companies who invest abroad will remain vulnerable because of traditional management mindsets, a weak command of foreign languages, and limited understanding of foreign markets and the cultures they embody.

Japan’s ‘new growth strategy’ and regional tactics

The DPJ’s strategy to foster Japan’s international economic relations is part of its a ‘new growth strategy’ announced in June. The plan appropriately emphasises East Asia, focusing on trade integration, two-way FDI, and tourism into Japan. The ‘new growth strategy’ builds upon existing market-driven economic integration within Asia, which is already quite deep.

In the near term, the ‘new growth strategy’ envisages expansion and multilateralisation of Japan’s bilateral Economic Partnership Agreements (EPAs). This is a logical move. Unfortunately Japan’s trade negotiations continue to be constrained by the strong protection extended to its deeply inefficient agricultural sector. Until agriculture is reformed and import obstacles removed, Japan cannot succeed with trade negotiations in bilateral, regional, or global forums.

Partly for this reason, when Japan hosts the annual APEC (Asia-Pacific Economic Cooperation) ministerial and summit meetings in November 2010, any push for a Free Trade Area of the Asia-Pacific (FTAAP) is for appearances only. Such an agreement has been on the APEC agenda for several years, but is unlikely to be negotiated and agreed on in the foreseeable future due to continuing  protectionism within the region.  Japan must take its fair share of responsibility for this. More fundamentally, such regional agreements are second-best to a WTO – based global approach; unfortunately the Doha Round seems virtually moribund.

On the broader issue of East Asian regionalism, Japan has proposed an East Asian Community but the specifics are not yet defined. In this respect, Japan is moving in the right direction. As it currently stands, East Asian regionalism is a bottom-up process, with only limited regional governmental institution-building. So an attempt build a region-wide community based around economic cooperation is good rhetoric; it appeals to the national interests of all East Asian economies.

But such cooperation is easier to propose than to implement.

For a start, encouraging cooperating in the area of trade is easier than cooperation in finance and exchange rate determination, and even in this area, cooperation is hard to make effective. There are underlying tensions in East Asia that stem from individual national security interests. In addition, any East Asian Community needs to somehow include the United States. But because of the strategic ambitions of some East Asian nations, the formal integration of the United States into a regional framework will prove problematic.

A major challenge for Japan is how to deal with China. Two pressing issues that will define the relationship is:

(a) To what extent do Japan’s economic interests align with those of China?;

(b) Will the two countries be able to agree on a common set of East Asian regional rules for trade, FDI, or exchange rates?

These questions raise issues that extend beyond economics, and, inevitably, the United States will be involved in trying to answer them.

Professor Hugh Patrick is Director of Columbia’s Center on Japanese Economy and Business. He has published research 15 books and some 60 articles and essays, on Japan’s macroeconomic performance and policy, banking and financial markets, government-business relations and Japan–United States economic relations.