Most of the world's largest bilateral
commercial relationships are between countries that are geographic
neighbours, share a common cultural, political or legal heritage, have
former colonial ties and/or are partners in a preferential trade
agreement. None of these link Australia and Japan, yet the commercial
relationship between them has been and remains both huge and crucial to
the economic fortunes of both countries (Figure 1.1). Japan was
Australia's largest single trading partner from 1971-72²-for
all but a few years in the late 1990s and early 2000s when it was a
close second to the United States-until that position was overtaken by
China in 2007. And Japan remains (as it has been since 1966-67)
Australia's largest export market for goods and services, by a margin
of 25 per cent over China for exports of goods alone. All in all, Japan
bought just under 19 per cent of Australia's merchandise exports in
2007.

Figure 1.1

Australia's economy has grown strongly in tandem with trade with Japan

Australia's total imports from and exports to Japan, and Australian GDP, 1955-56 to 2007-08

Note: As services trade data are not available before 1966-67, the figures for those years are for merchandise trade only.Sources: DFAT STARS database; ABS (2008a, 2008c, 2008d).

Confirmation that China has
outstripped Japan as a trading partner in terms of total trade (goods
and services) may well provoke some soul-searching about the future of
the relationship. But a quick look at some more detailed statistics
demonstrates just how large and healthy the relationship is and how
important to the economic well-being of both countries are the goods
each imports from the other; and a qualitative analysis underlines the
significance to both countries of the vast trade in energy, resources
and food.

One indication of just how
remarkable the trade relationship is can be gleaned from the indexes of
bilateral trade intensity (Table 1.1). These show that Japan's imports
of goods from Australia are considerably greater than would be expected
given the share of the two countries in world trade (an index greater
than 1 shows higher than expected trade). The same is also true for
Australia's imports of goods from

Japan (although the index is much lower) and, perhaps surprisingly, for services trade in both directions.

Table 1.1: Australia and Japan trade more than might be expected. Trade intensity indexes for goods and services trade between Australia and Japan

	2002	2003	2004
Goods: Australian exports to Japan	4.32	4.40	4.73
Goods: Japanese exports to Australia	1.86	1.85	1.70
Services: Australian exports to Japan	1.80	1.63	1.55
Services: Japanese exports to Australia	1.40	1.43	1.16

Note: This table shows the basic trade intensities for trade between Australia and Japan. An index above 1 indicates that bilateral trade is greater than proportional to the role of each in world trade.

Source: Corbett et al. (2008).

Another statistical indicator of the
importance of the relationship is that Australia has had an often
sizeable trade surplus (exports of goods and services minus imports)
with Japan. This matters not because a surplus is of itself desirable
(as the mercantilists thought) but because it reminds us that a
critical element of trade is the benefit derived from importing what
one needs. Thus, while a long-term constant in trade between Australia
and Japan, Australia's surplus has rarely been an issue in a
relationship that has delivered significant benefits to both countries.
The magnitude of the surplus puts the size and importance of the
relationship between Australia and Japan clearly into perspective: in
2007, it was of the same order as Australia's total trade in goods (exports plus imports) with its fifth-ranked trading partner, New Zealand; and the growth in Australia's merchandise trade with Japan between 2003 and 2007, at more than $14 billion, was greater than its total 2007
trade in goods and services with the fastest-growing major trading
partner in that period, India. Trend growth in Australian merchandise
exports to Japan over the five-year period to 2007 was a robust 10.7
per cent.

Japan is a key destination for much of what Australia exports. Japan buys more than any other country of five
of Australia's ten most valuable merchandise exports: coal, aluminium,
natural gas, bovine meat and copper ores. Of the remaining five, it
ranks second among purchasers of iron ore, Australia's second most
valuable export; and third among buyers of crude petroleum, Australia's
fourth most valuable export. It also is the largest customer for
Australian cheese and curd, seafood, uranium,³ woodchips, animal feed and liquefied butane and propane gas.

Australia, though a much smaller
economy than Japan, ranks fifth among its trading partners as a source
of imports. Australia's exports of raw materials have played an
important role in Japan's own development. Starting with coal and wool,
and later including iron ore, non-ferrous metals and liquefied natural
gas (LNG), these imports from Australia were vital inputs to the
manufacture of products whose export helped Japan develop into an
economic giant. Japan already sources more of its energy imports from
Australia than any other country, outstripping Saudi Arabia; and
Australia's position will only be enhanced by the entry into force of a range of major LNG contracts
from 2015 at the same time as Indonesian and Malaysian exports to Japan
wind down; and by increased Japanese interest in uranium as a source of
energy. In 2007 Australia supplied the majority of Japan's imports of
coal (62.5 per cent), iron ore (52.4 per cent), silica and quartz sands (62.6 per
cent) and zirconium (56.6 per cent). In addition, it was the principal
supplier of uranium, gold, lead, ferro-manganese, bauxite and alumina,
titanium and ilmenite; and the second-ranked source of imports of
aluminium, nickel, zinc and manganese.

Australia has been an avid consumer
of Japanese products throughout the postwar period as well. Imports
from Japan were crucial from the early post-war period in meeting
demand in Australia for both consumer goods and industrial equipment
and machinery. In the late 1940s, for example, Australia's requirement
for ceramic insulators-essential in the development of its electricity
grid-was a significant factor providing impetus to its efforts to
reopen trade with Japan in the post-war period (Rix 1986). The
propensity of Australia's people to buy Japanese goods is extremely
high by comparison with comparable trading partners; and growth in per
capita purchases has also been relatively rapid in recent times (Table 1.2).

Table 1.2: Australians lap up Japanese products. Japan's exports per person in importing country, 2002 and 2007 (US$)

	2002	2007
Australia	435.0	716.9
New Zealand	455.3	687.4
United States	432.6	494.8
United Kingdom	215.0	256.5
New Zealand	455.3	687.4

Sources: UN data on the DFAT STARS database; IMF World Economic Outlook database.

The connection is particularly strong in the automotive sector:⁴ many more passenger motor vehicles are imported into Australia from
Japan than from any other country, and Japanese firms are major
investors in the industries of two of the other key exporters of these
products to Australia-Thailand (fourth in 2007) and South Africa (sixth
in 2007). Japan is also the largest exporter of motorcycles and rubber
tyres to Australia, and the second-largest source of imported vehicles
for transporting goods (after Thailand, where Japanese investment again
plays a major role in production), other motor vehicles, and motor
vehicle parts. Despite its relatively small population, Australia is
the third-largest single market for new passenger motor vehicles
manufactured in Japan. Underscoring the closeness of the relationship
in this sector, Toyota Australia, a Japanese-owned company, is the
largest exporter of passenger motor vehicles from Australia. A
significant proportion of the production from Toyota's Altona factory
in Victoria is exported (approximately 100,000 vehicles in 2007), to 23
markets mostly in the Middle East and Persian Gulf but also in
South-East Asia, South Africa and the Pacific.

The example of the automotive
industry demonstrates the multifaceted nature of the interaction
between the economies of Australia and Japan. In many areas- notably
computer equipment, televisions and other consumer electronic and
electrical goods, and communications equipment-Japan has lost its
former preeminence as an exporter of manufactures to Australia, often
to Japanese affiliates now located in other parts of the region as a
result of the investment and trading decisions of those companies.
These affiliates, in turn, are contributing to demand for Australian
exports of raw materials to other parts of the region-in a similar way
to that exemplified by wool (see Box 1.1), where direct exports to
Japan, once huge, are now negligible, but Japanese demand remains
important to Australia's wool trade.

Box 1.1 The evolution of Australia's wool trade with Japan

'Made in Japan' has increasingly
become 'made by Japan elsewhere'. The ratio of manufacturing by
Japanese (multinational) companies outside Japan to manufacturing
production within it has moved significantly in favour of the former.
Toyota, Honda, Sanyo, Sharp, Sony, Hitachi, Panasonic and others
continue to record strong sales in Australia, but these sales (from
offshore affiliates in China and the ASEAN countries) may no longer
show up in Australia-Japan bilateral trade statistics.

Likewise, demand from Japan (and to
some extent involvement by Japanese trading houses) still drives many
of Australia's wool exports-but, as Box 1.1 shows, the fragmentation of
production and growth of supply chains means that initial processing,
once done in Japan, now takes place in ASEAN countries or China.
Accordingly, the 'reality' shown by the trade figures-that there is
only a minuscule bilateral trade in the commodity that once accounted
for some 75 per cent of Australia's exports to Japan-is a misleading
one. While quantification is difficult, it seems clear that Japanese
firms still account, in one way or another, for much more of
Australia's trade in both directions than the raw figures show.

The close link between direct investment and trade

The importance of the contribution
made by Australian primary products to Japan's 'economic miracle' and
the critical need for Japanese purchasers to achieve reliability of
supply quickly drew Japanese consumers and Australian producers into a
cooperative relationship. Japanese demand for raw materials and
Japanese investment have been crucial in the development of many of
Australia's key export industries and, consequently, central to
Australia's own prosperity.

Starting in the 1890s, Japanese
trading houses helped develop an alternative export market for
wool-until then almost the entire clip had been shipped to Britain.
Similarly, in the 1960s and subsequent decades, long-term contracts
from Japanese users of minerals and energy and investment by trading
houses such as Mitsui and Mitsubishi enabled mines and gas fields to be
developed and the necessary infrastructure to be put in place to
exploit these resources and then export them, both to Japan and to
third countries.

More recently, as Japan's market for
beef opened, Japanese investment and demand have been key factors in
the development of a grain-fed beef industry in Australia. As Box 1.4
demonstrates, this is but one aspect of a wide-ranging trade and
investment relationship in the agrifood sector. These developments have
had a major impact in increasing the number and quality of jobs
available to Australians.

While the resources and energy
sectors have been focal points for Japanese investors, Japan has also
been vital to the development of one of Australia's largest
manufacturing export industries, passenger motor vehicles. This began
in 1963 when Toyota built its first factory outside Japan in Port
Melbourne. It was followed, especially between 1973 and 1978, by rival
car producers and associated component suppliers. The 1990s and 2000s
saw more automotive components manufacturers invest in Australia: as in
East Asia and other parts of the world, parts and components suppliers
(such as Denso and Hirotech) followed the vehicle manufacturers with
which they were linked in Japan (Toyota and Mitsubishi respectively).
Toyota's decision in 2008 to invest in the production of the Camry
Hybrid will expand both the range of vehicles produced in Australia and
the technology embodied in them.

Other Japanese manufacturing firms
have also invested in Australia, with some firms establishing a
presence before the 1940s (Hutchinson and Nicholas 1994). In the 1980s
a number of consumer and industrial electronics assemblers established
plants in Australia.

While some manufacturing plants have
closed (including Nissan, Mitsubishi and most of the electronics
assemblers), others have stayed, sometimes expanding their operations.
Some of the companies that withdrew their production from Australia
transformed their operations here into global research and development
centres. (Similar changes occurred with many Japanese financial service
providers, tourism operators and real estate purchasers: many of the
investments made during the bubble years in the late 1980s, and in the
early 1990s, when the flow of Japanese investment to Australia was
equal to that from the United Kingdom and the United States, have since
been sold.)

Getting behind the tariff wall to
produce for the domestic Australian market was often an important
initial motivation for investment in Australia but, as Australia's
barriers have come down, the focus of some Japanese investors has
broadened, with production for third-country markets growing in
importance. This can be seen in the volume and importance of Toyota's
exports to markets in the Middle East and Persian Gulf.

In the area of services, too,
investment has been significant. Japanese investment in Australia's
tourism industry played an important role in establishing Australia as
a major holiday destination for Japanese holiday-makers. While Japanese
tourist numbers have been declining, the importance of investment is
now being seen in the other direction. Where, to date, Australia's wide
open spaces, pristine beaches and unique wildlife have been major
attractions for Japanese travellers, increasingly now the reciprocal
benefits of Japan's fields of powder snow, allied with the favourable
exchange rate between 2003 and early 2008, have drawn more Australians
northwards to enjoy cross-seasonal skiing. Bilateral investment, again,
has been a key element of this relationship.

Portfolio investment growing in size and importance

Portfolio investment is also
becoming a significant part of the relationship, increasingly for
structural reasons. The connection between Australia's need for
external savings to finance economic development (leading to relatively
high interest rates) and Japanese savers' need to find higher returns
on their savings in the face of continued low interest rates in
Japan-increasingly vital as retirement looms for larger proportions of
the population-has resulted in a significant expansion of Japanese
portfolio investment in Australia by both Japanese mutual funds and
personal investors. The stock of Japanese portfolio investment in
Australia, which peaked in 2004 at $24.8 billion, increased marginally
from $19.9 billion in 2001 to $20.1 billion in 2007. While overall
levels have remained fairly stable, one change has been in Australia's
importance as a destination for the offshore investments of private
mutual funds: in 2007 it was estimated that about 12 per cent of these
investments were in Australia, second only to investment in the United
States (approximately 43 per cent); in 2001, by contrast, Australia had
been the 12th-ranked destination, accounting for less than 1 per cent
of such offshore investment (Australian Financial Review 2007).

Complementing the demand from
Japanese investors for Australian dollar- denominated instruments,
banks and companies in Australia have been looking to Japan as a source
of funds. This can be seen in the growth of so-called 'uridashi' bonds
(since 2001 in particular) and samurai bonds since the mid-1990s (see
Box 1.6). These transactions arise from the combination of high levels
of savings in Japan seeking reasonable returns and banks and companies
in Australia being unable to raise capital as cheaply in the domestic
Australian market or other international markets. The nature of the
foreign-exchange exposure of the two countries also suggests that they
are natural counterparties for swaps and derivatives to hedge foreign
exchange risk: Japanese investors and firms tend to have US
dollar-denominated debt assets, while Australian investors and firms
tend to have US dollar-denominated debt liabilities.

Box 1.6 Raising funds in Japan: uridashi and samurai bonds

Not all rosy ...

The clear picture from the
discussion above is one of a huge and successful relationship.
Nevertheless, it is also true that some further critical examination is
needed of where commercial relations with Japan are headed. For
although it has been highly successful in some areas, the relationship
seems to have been less so in others.

There is an unusually clear
distinction between the types of products sold by Australia to Japan
and those sold by Japan to Australia. Japan's exports to Australia
almost wholly comprise manufactures (Figure 1.4), whereas Australia's
exports to Japan are heavily concentrated in primary products (Figure
1.5).

Figure 1.4

Australia's major imports from Japan comprise automotive, electrical and other equipment and machinery

Australia's merchandise imports from Japan by major category, percentage share by value, 1989-2007

Source: DFAT STARS database.

Figure 1.5

Japan's major imports from Australia are primary products

Japan's merchandise imports from Australia by major category, percentage share by value, 1975-2007

Sources: METI, White Paper on International Trade, 1977-1986; UN data on the DFAT STARS database.

The concentration of Japan's imports
from Australia in bulk commodities is also reflected in the number of
firms that export from Australia to Japan. Whereas Japan is the largest
export market for Australia, it is only the ninth-ranked market in
terms of the number of exporters from Australia.

These export patterns are, in fact,
significantly at odds with both Australia's and Japan's patterns of
trade with the world as a whole. That is because the evolution of trade
patterns that is occurring in many other relationships does not appear
to be happening in this one.

Increasingly, with the emergence of
regional and global production networks and value chains, trading
partners, particularly in the Asia-Pacific region, are seeing an
increase in 'intra-industry' trade, in which similar items are being
traded back and forth across borders. Consistent with this, Japan,
while a major exporter of elaborately transformed manufactures (Figure
1.6), is also a major importer (Figure 1.7). Australia's imports, too,
are dominated by elaborately transformed manufactures (to some extent a
reflection of its comparative advantage in primary products), but, in
addition to Australia's strength in primary products, elaborately
transformed manufactures make up a significant proportion of its
exports as well (Figure 1.8). However, Australia's exports of
elaborately transformed manufactures to Japan are very small and not
growing (Figure 1.9).

Figure 1.6

Elaborately transformed manufactures dominate Japan's merchandise exports ...

Japan's merchandise exports to the world by category, 1989-2007

Note: 'Other goods' are gold and confidential items that comprise almost entirely primary products or simply transformed manufactures. Source: DFAT STARS database.

Figure 1.7

... but are also highly significant in its imports

Japan's merchandise imports from the world by category, 1989-2007

Note: 'Other goods' are gold and confidential items that comprise almost entirely primary products or simply transformed manufactures. Source: DFAT STARS database.

Figure 1.8

Australia exports proportionately far more elaborately transformed manufactures to the world ...

Note: 'Other goods' are gold and confidential items that comprise almost entirely primary products or simply transformed manufactures. Source: DFAT STARS database.

Figure 1.9

... than it does to Japan

Australia's merchandise exports to Japan by category, 1989-2007

Note: 'Other goods' are gold and confidential items that comprise almost entirely primary products or simply transformed manufactures. Source: DFAT STARS database.

Moreover, as a closer examination of
the statistics on manufactures exports from Australia makes clear, the
growth trend in Australia's manufactures exports to Japan (Figure 1.10)
is not consistent with the trend of Australia's manufactures exports to
the world (Figure 1.11).

Figure 1.10

The gap between Australia's simply and elaborately transformed manufactures exports to Japan widens ...

Australia's exports of simply and elaborately transformed manufactures to Japan, 1989-2007

Source: DFAT. STARS database.

Figure 1.11

... even as elaborately transformed manufactures exports lead the way in trade with the rest of the world

Australia's exports of simply and elaborately transformed manufactures to the world, 1989-2007

Source: DFAT STARS database.

... in services as well as goods

Services trade poses a similar
conundrum. For some time, both Australia's and Japan's economies have
been dominated by services-in excess of 75 per cent of Australia's GDP
and even more in Japan.

This has led many commentators on
the relationship to posit that there is scope for a significant
increase in bilateral services trade (see, for example, de Brouwer and
Warren 2001). But such an increase has, to date, proved elusive.
Despite the vastness of the overall trading relationship, Japan ranks
only fifth as a trading partner (sixth as an export market) for
Australia in services; and, worse, trade in this sector is actually
falling-whereas with other major Asian trading partners (and the world)
it is rising significantly (Figure 1.12).

Figure 1.12

Australia's services trade with other East Asian countries grows more rapidly than with Japan

Australia's exports and imports of services, selected countries, 1999-2007

Source: ABS (2008f).

Australian services exports to Japan
show tourism and transport services as the dominant components, with
both declining over time (see Figures 1.13 and 1.14). Financial
services exports, increasingly regarded as a significant Australian
strength, are minuscule. Education and business-related travel are
relatively moderate, both in absolute number-Japan (with the
second-largest trade relationship) ranked sixth as a source of business
visitors-and, by comparison with other markets, as a share of the total
number of travellers, and show no significant signs of an increasing
trend.

Nor would the situation be likely to
improve if exports delivered through 'mode three'-commercial presence
in the other country-were able to be included.⁶ A
survey of services trade in 2002-03 by the Australian Bureau of
Statistics found that exports delivered in this way represented
approximately 65 per cent of total sales of services overseas (and over
90 per cent of total sales of financial services) by Australian
companies (ABS 2004). However, sales of services by Australian
companies located in Japan represented only 11.8 per cent of
Australia's total services sales to Japan, the smallest proportion of
any major market.

Figure 1.13

Travel and transport dominate Australian exports of services to Japan

Australia's exports of services to Japan, 1999-2007

Source: ABS (2008f).

Figure 1.14

Japanese visitor numbers to Australia trend downwards

Total visitor arrivals from Japan
(holiday, visiting friends and relatives, business, education,
employment and other), 1991-2007

Source: ABS (2008g).

Australia's imports of services from
Japan are similarly focused around transportation-unsurprisingly in
light of the size of the goods trade between the two countries (Figure
1.15).

Figure 1.15

Transport services are larger than all other Australian imports of services from Japan

Note: No data are available for royalties and licence fees in 2006 and 2007, or for communications in 2007.Source: ABS (2008f).

Again, business travel is
conspicuously smaller than the size of the overall relationship would
suggest, with Japan (Australia's largest export market) ranking just
seventh as a business travel destination for Australia. Though
education-related travel also looks relatively small, and is not
growing, Japan is in fact the third-largest destination for Australians
studying overseas in terms of expenditure per year. The overall picture
on services, then, appears to be one of little dynamism and much
reliance on external factors-such as volumes of goods trade.

Conclusions and implications

The data on trade and investment
remind us that the bilateral commercial relationship between Australia
and Japan is based on substantial flows of goods, services and capital;
that the relationship is closely aligned with the strengths and needs
of each economy; and that, as those needs and strengths have evolved,
the relationship has evolved too. It is clear, also, that as Japan's
and Australia's commercial interests in East Asia broaden and change,
the two countries continue to benefit from their partnership in a wider
range of ways, even if this is not reflected in bilateral trade and
investment data. In this light, it is clear that talk of decline in the
importance of the Australia-Japan relationship is indeed premature.

The same trade and investment data,
and the comparison with other markets, however, make clear that
commercial relations between Australia and Japan, while remaining
strong and vital, are operating on two tracks. Japan is an enthusiastic
customer for Australian primary and simply transformed manufactures,
just as Australia is (still) for Japanese firms' manufactures, whether
they are made in Japan or elsewhere. Trade in such products, even where
there are very substantial barriers in place (such as in agriculture),
is flowing at quite high levels. The picture on Japanese direct
investment is similar: with Japanese investment in Australia's car
industry now focused on Toyota and its suppliers, Japanese direct
investment related to goods, too, is increasingly concentrated around
energy, resources and agrifood. But beyond these relatively clearly
defined and well-known strengths, the trade and investment relationship
seems less robust than might be expected.

Does this matter? In one sense, the
answer might seem to be no. Japan will continue to be hungry for
Australian minerals and energy and, for some products, long-term
contracts already in place will cement Japan's position as a dominant
customer. While it is unclear whether future movements in commodity
prices will continue the 2003-08 trend of increasing values for imports
from Australia even while volumes varied little, contracts in place for
LNG will see the volume of Japan's purchases of LNG from Australia,
already larger than those of all Australia's other overseas customers
combined, increase still further. The security of food supply provided
by agricultural trade between Australia and Japan, equally, should
ensure a healthy future for that part of the relationship. There are,
therefore, strong grounds for expecting that the relationship will
remain of huge importance for the foreseeable future.

But there are dangers in the
relationship remaining too lopsided. The high degree of direct contact
implied by healthy trade in areas such as education and business and
financial services of itself creates a virtuous circle enabling early
identification and exploitation of future opportunities. The lack of
such contact can also be (detrimentally) self-reinforcing, as lack of
knowledge leads consecutively to a failure to identify opportunities;
thence to a perception that opportunities no longer exist; and then to
a further loss of incentive to develop additional contact and
knowledge; and so on. These themes are explored in subsequent chapters.