Crucial to the way that the shaping
forces of complementarity and distance examined in Chapter 2 evolve
will be, of course, developments within
the economies and societies of both Australia and Japan. These internal
developments will also influence how firms and governments in both
countries respond to and participate in the continuing change that is
afoot in the regional and global economies. This chapter looks ahead at
the key factors that are likely to drive those internal developments in
the medium to long term, and speculates about their possible impact on
the shape of the bilateral commercial relationship.

Predictions are almost always wrong.
If asked 20 years ago where the two economies would stand today, many
commentators would have predicted a future very different from that
which has actually transpired. Japan at that point seemed in the heyday
of its economic vibrancy, making large and highly visible investments
in international assets, and touted by many as on a course to wrest
economic ascendancy from the United States sometime in the first half
of the 21st century. Since then it has been on a roller-coaster ride:
from a 'lost decade' of economic stagnation in the 1990s; to its
longest stretch of uninterrupted growth since World War II between 2002
and 2008 (OECD 2008); before, in late 2008, falling back into recession
following the onset of the global financial crisis.

Twenty years ago, Australia, on the
other hand, was still digesting the implications of its then
Treasurer's 1986 warning that continuing on its existing course could
lead it to 'banana republic' status, but it has since become
consistently one of the fastest-growing economies in the OECD during
what has also been its longest period of uninterrupted growth since
World War II. More recently, expectations have again been turned on
their head as the global financial crisis has seen a massive
depreciation of the Australian dollar, a large appreciation of the yen
and dramatic declines in commodity prices.

We do not, therefore, presume to
know where the events of the next 20 years or more will leave either
the Australian or the Japanese economy. Nor does the Economic
Analytical Unit have specific insights of its own that would radically
challenge the views of others-indeed, it must be noted at the outset
that much of the commentary on the Japanese economy contained below
draws on ideas from policy papers of the Japanese Government itself,
which is acutely aware of the challenges the country faces. Rather, our
aim is to bring together some of the key issues identified by
authoritative commentators as important to the medium- to long-term
future of each economy and use these as a prism through which to view
the possible development of Australia-Japan commercial relations into
the future. While our focus is the impact of these trends in the years
to come, we start by examining the recent past to shed light on how
these trends are developing and provide a basis for analysing how they
will affect the two countries in the future.

The Japanese economy

Public commentary on the performance
of the Japanese economy in recent times, and prognostications for its
short-term future, tend inevitably to the gloomy. Growth in the 2002-08
period, though relatively long-lived, was anaemic and uncertain, and
reform prospects are widely seen as remote in a fraught political
situation where there is apparently no political party or political
figure in a strong position to promote sustained reform. Not, in short,
an apparently enticing prospect for business at the macro level.

But is all as it seems? It is not
the intention of this report to gloss over the very real difficulties
of economic and political management that Japanese governments are
likely to face for some time to come. We do, however, believe that
there is value in going beyond the headlines and challenging the idea
that relatively low levels of aggregate growth and a problematic
environment for reform mean that new opportunities for mutually
beneficial business partnerships are not occurring. Why?

The first reason is Japan's size and
wealth. These are important regardless of growth. Japan's economy
remains the second-largest single national economy in the world (after
the United States) in market exchange rate terms. Its GDP is several
times that of Australia-meaning that even relatively small shifts are
of disproportionate potential significance to Australian companies that
are used to dealing with a smaller market. For example, though the
growth rate of the Japanese economy as a whole has been relatively low since the 1990s, the magnitude
of growth in the fastest growing sector-the services sector-alone since
the beginning of the 1990s is in fact larger than the total size of the
Australian economy (Figures 3.1 and 3.2).

It is also important to remember
that, although Japan's per capita GDP has declined relative to that of
the OECD as a whole since the beginning of its 'lost decade' of the
1990s, it remains the richest major market in Asia by some margin.
While the slowing of the pace of its GDP growth is particularly stark
by comparison with other regional economies-and despite its growth
being forecast to remain slower well into the future (Goldman Sachs
2007)-Japan's purchasing power remains far higher and will be for the
foreseeable future (Figure 3.3).

Noticeable from this projection-and
remembering that it is just one possible scenario, even if it
approximates what most analysts think likely-is the fact that while
countries such as China and India are expected to grow at a greater rate from their low bases than Japan is from its high base, the actual quantum
of increase projected per Japanese person between 2006 and 2030-about
US$15,900-is, in fact, slightly greater than the increase per Chinese
person (about US$15,500). Moreover, as we shall see, savings rates in
Japan are already falling, and can be expected to fall further as the
society ages; meaning that, overall, while the increase relative to current expenditure
for Japan may not be as great as it is for China, the actual increase
in potential expenditure per person is nevertheless likely to be
substantial.

The second reason is expectations of
rates of growth and changes in the structure of Japan's economy.
Japan's success is that it has been one of the relatively few countries
in the post-war era that has been able to move itself out of the
low-income bracket, through the middle-income category, and into the
ranks of high-income economies. While the high levels of economic
growth Japan enjoyed in the post-war period have been replicated by
many others at times, few have sustained the growth for long enough to
achieve what Japan has (Gill and Kharas 2007).

Figure 3.1

Even when growing slowly, Japan's size makes the numbers large ...

Japan's real GDP by sector, 1970-2005

Figure 3.2

... larger than for Australia, even when growing more rapidly

Australia's real GDP by sector, 1970–2005

Note: An international dollar has the same purchasing power over GDP as a US dollar has in the United States at a set point in time, in this case 2005.Source: OECD.Stat database.

Figure 3.3

Even as others catch up Japan grows a lot in absolute terms

Per capita GDP in selected countries, 2006 (actual) and 2030 (projected)

Source: Goldman Sachs (2007).

Once the Japanese economy had
essentially caught up with the productivity levels of other developed
economies, it was inevitable that growth would slow down. In and of
itself this would imply a smaller manufacturing sector as the absence
of rapidly expanding industries reduced demand for capital equipment.
This, and the shifts in the global economy explored later in this
chapter, means that deep structural changes in the Japanese economy
have been occurring since the early 1990s. This period of structural
change has in itself tended to slow growth for the period.

Expectations of future growth based
on memories of the post-war period therefore need to be revised,
meaning that the comparators often used by commentators- China and the
other dynamic Asian developing economies-are no longer relevant.
Japan's growth rates between 2002 and 2008, which averaged around 2 per
cent, seem insipid in the context of its post-war boom, but are not
markedly out of kilter with those of the other rich developed
economies, particularly when the demographic factors outlined below are
taken into account. While Japan's economy has clearly made this
transition, it is arguable that many observers' expectations have not.

Looking to the future: the demographic challenge…

The single predominant structural
challenge that Japan's economy will face in the future is to deal with
the well-documented and profound demographic shifts now under way.
According to UN Population Division projections, Japan's population has
now peaked, and is likely to decline progressively over the years
between 2008 and 2050, falling from a peak of around 128 million to
approximately 112 million in 2050 (Figure 3.4).⁹

Figure 3.4

Japan grows older

Japan's population by age group, 1950-2050 (UN medium scenario)

Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2005 Revision, <http://esa.un.org/unpp&gt;.

The economic consequences will be
exacerbated by the changing structure of the population that this
implies. As the population gets older, birth rates, which fell below
the rate of replacement in 1975, will continue to decline.
Consequently, as Figure 3.4 shows, the proportion of the population
that is potentially economically productive (notionally the 15-64 age
group, though Japan's relatively high school retention rates mean this
probably overstates the workforce to some extent) will decline
significantly. Between 1990 and 2050, Japan's working age population is
forecast to fall by around 20 percentage points, while the population
over 65 will increase by 24 percentage points to 36 per cent of the
population (Figure 3.4). Broadly speaking, this means that there will
be a shrinking number of working people, and they will be required to
support a constant number of their nonworking compatriots-by 2050, the
ratio of people nominally of working age (15-64) to those not of
working age (0-14 or over 65) will be approximately 1:1 (it is
currently approximately 2:1)-meaning, in other words, one dependant for
each potentially productive worker.

The continued rapid ageing of the
Japanese population will thus place a heavy burden on society-because
of the impacts on fiscal policy, consumer demand, financial markets,
and trade and labour markets-and therefore on future economic
performance (Farrell and Greenberg 2005). Funding the pensions of
Japan's retirees will be a major challenge, especially given the poor
performance of the public pension fund. Returns have been on average
half or less of comparable funds in other developed countries, which
some ascribe to conservatism-much private saving is also invested in
assets that produce low returns-and to the unwillingness to replace the
bureaucrats in charge with professional funds managers (The Economist
2008). Demographic pressures are also expected to have
an impact on health care and the share of GDP spent on that sector. If
the current health-care policies continue, the gap between the
collections of the insurance system and its expenditure will widen.
Total health-care expenses under the National Health Insurance system
were 6.6 per cent of GDP in 2005 but could grow to 13.5 per cent of GDP
by 2035 (Kadonaga et al. 2008).

Modelling results of the
contribution of demographic change to the Japanese economy from 2005 to
2100 show that Japan's demographic change could start detracting from
GDP growth in around 2010 and growth would be up to 1.2 percentage
points lower by 2040. Demographic change in the rest of the world,
predominantly in East Asia, will ameliorate this effect, so that in
2040 growth would be just under one percentage point lower than without
demographic change; this is due to increased international demand for
Japanese goods and increased income earned on Japanese overseas
investments (Batini et al. 2005).

The ageing of the Japanese
population has particularly serious implications for its agricultural
sector. In 2007, 59 per cent of Japan's farmers were 65 years or older
(MAFF 2008); in 2004, only 8 per cent were under 30 (Roberts et al.
2006); and, between 1991 and 2004, the number of people aged 15 years
or over in commercial farm households declined by 26 per cent (Roberts
et al. 2006). Current laws inhibit consolidation of small landholdings
under the ownership of corporate farmers, though in 2007 the Keidanren
(Japan Business Federation) proposed amending them. However, the
combination of ageing and decline in the agricultural workforce is
already leading to an increase in the contracting out of farming
(Roberts et al. 2006).

Japan's dramatic population ageing
will also pose challenges for macroeconomic management in a range of
areas. Fiscal policy, already restricted by the highest levels of
public debt in the OECD, will need to cope with higher social security
and health costs; the contraction of the labour force will directly
affect growth prospects; and financial markets will feel the impact of
changes to financial wealth and savings (Japan's household savings rate
is already showing signs of decline as older workers leave the
workforce and start to consume their retirement nest eggs). Ageing also
adds to the urgency for further reform of social security and the
labour market, which will help to increase the efficiency of the
Japanese economy.

Box 3.1 The end of Japan's high savings rate?

A key element in Japan's 'miracle'
was the high rate of household savings. This provided an important
source of capital for Japanese firms, often available at modest
interest rates given that much of the household savings were in
low-interest accounts, especially in the Post Office savings system.
Already a combination of factors-including changing demographics (older
people tend to spend rather than save) and a higher propensity to
consume among younger generations-have led to a significant drop in the
savings rate (Figure 3.5).

Figure 3.5

The rise and fall of Japan's household savings rate

Household savings rate for Japan, 1955-2006

... and the consequent productivity imperative

GDP is essentially a function of two
main factors: person-hours worked and productivity. In the face of a
declining workforce, there are limited options for maintaining GDP
growth. Where the workforce is not only declining in absolute terms but
also as a proportion of the population, as appears likely to be the
case in Japan, even maintaining growth in per capita GDP becomes
increasingly challenging.

Logically, what are the available options?

The first is to take steps to
reverse the decline in the workforce, either by importing labour
(already evident in some sectors in Japan, where regulations have
recently been amended to allow foreign workers greater access to
Japan); increasing the birthrate (necessarily a longer-term solution);
or increasing the participation rate- in the case of Japan an
imperative that has focused policy-makers on reversing the
traditionally low participation rate of women in the workforce. The
second is to increase the number of hours worked by those who are in
the workforce-an approach that clearly has limitations. The third is
increasing productivity of the workforce, and the fourth is to
supplement GDP through external income generated by external direct
investment-effectively buying in foreign labour without an immigration
program. (This is, of course, the effect of the approach adopted
by many Japanese firms since the late 1980s of shifting production
offshore-primarily of labour-intensive goods-effectively increasing the
workforce available to them.)

It is as yet unclear which, or what
combination, of these steps Japan will implement to address the
challenges raised by its demographic situation. Arguably, it is likely
to be a response involving multiple solutions: 'silver buckshot' (Prins
and Rayner 2007) rather than a 'silver bullet'.

Productivity

Productivity assumes particular
importance if we take a look at the drivers of Japan's remarkable
growth in the decades leading up to the 1990s. Productivity growth was
high, and Japan rapidly closed the gap of output per hour worked with
the United States (Figure 3.6). This levelled off, and even temporarily
dropped, however, when GDP per capita reached approximately 80 per cent
of that of the United States (Figure 3.7)-arguably the point at which
obvious productivity gains through technological 'catch-up' became
harder to achieve.

Figure 3.6

Productivity growth slows ...

Output per hour relative to the United States, 1950-2007, selected countries

Note: US dollars converted at Geary Khamis purchasing power parities.Source: Conference Board and Groningen Growth and Development Centre, 'Total Economy Database', January 2008, <www.conference-board.org/economics&gt;.

Figure 3.7

... and so does growth in relative GDP per capita

GDP per capita as a proportion of US level, 1950-2007, selected countries

Note: US dollars converted at Geary Khamis purchasing power parities.Source: Conference Board and Groningen Growth and Development Centre, 'Total Economy Database', January 2008, <www.conference-board.org/economics&gt;.

Looking at the picture to date, it
is clear that Japan in the 1990s faced what economists in their less
technical moments might describe as a structural double whammy. Just as
the workforce was starting to decline, both as a proportion of
population and in absolute terms, productivity also plateaued.
Unsurprisingly, rapid growth has been difficult to achieve since,
though there have been some signs of improvement in productivity in
recent years.

How can increased productivity be
achieved? At the economy-wide level, there are essentially two factors
that need to be addressed. The first relates to efficient allocation of
resources-that is, ensuring that resources flow naturally to relatively
highly productive sectors of the economy; the second is to improve the
productivity of workers within the sectors in which they work.

Allocative efficiency
is a critical emerging issue for Japan, with both sectoral and
geographic factors in play. At the sectoral level, a striking duality
exists in the Japanese economy between highly productive, highly
competitive manufacturers that are subject to stringent international
competition, and almost everybody else who is not. Essentially, Japan's
fortune has been built on the former and distributed to the latter-in
much the same way as was the case in Australia over the many years that
it 'rode on the sheep's back', an era when the proceeds of competitive
rural export industries were used as a means of subsidising a protected
manufacturing sector. In Australia's case, the long-term secular
decline in international commodity prices, resulting in falling terms
of trade, made continuation of this policy untenable: in general, the
proceeds of the efficient were no longer adequate to pay for the
protection of the uncompetitive.

The drag caused on Japan's higher
performing export-oriented sector became particularly apparent in the
lost decade, when the performance of the domestic laggards swamped the
excellence of the high-profile exporters, resulting in a widening gap
in real GDP per capita between Japan and other industrialised economies
(Kondo et al. 2000), a situation that improved somewhat after 2002
(Figure 3.7). The world-beating sectors of automobiles, steel, machine
tools and consumer electronics have thrived; however, the other 90 per
cent of economic activity takes place in companies that do not export,
mainly domestic manufacturing and services firms. The 1999 labour
productivity levels of the non-exporting firms were only 63 per cent of
US levels (Kondo et al. 2000), and the productivity of capital in Japan
was even lower (61 per cent of US levels). Agriculture, too, while a
relatively small and declining proportion of the economy, demonstrates
very low productivity, and consequently accounts for a far larger
proportion of the workforce than of GDP. Average wages in the
agriculture sector in 2004 were approximately half average wages
overall (Roberts et al. 2006).

This issue is particularly acute in
the services sector, because of the fact that, in common with the trend
in other developed economies, the sector represents a large and
increasing proportion of both employment (expanding by more than ten
percentage points from 65 per cent in 1985 to 77 per cent in 2005) and
GDP (growing from less than 70 per cent in 1985 to almost 80 per cent
20 years later).

Japan's services sector productivity
has been disappointing. The OECD's 2008 survey of the Japanese economy
found that the sector was largely responsible for low aggregate
productivity within the economy, with a decelerating rate of
improvement in labour productivity per hour worked over the past 30
years, significant productivity slowdowns in both market and non-market
services sectors, and a large gap between services and manufacturing
productivity gains. 'In sum', the OECD concluded, 'the slowdown in the
service sector has brought down labour productivity growth in the
entire economy from more than 4 per cent in the 1976-89 period to less
than 2 per cent from 1999-2004' (OECD 2008: 126). Moreover, the OECD
found that there had been very little shifting of labour from less to
more productive service industries: indeed, in market services and ICT
services, labour had been reallocated from more to less
productive industries in recent years, leading to the conclusion that
further structural change was required to promote the development of
more dynamic services industries (OECD 2008).

Another factor affecting allocation
of resources within the economy is the geographic distribution of the
population. Relative to many OECD countries, Japan retains a large
share of its population in rural areas-home to industries that are
generally among its least productive-and this is likely to continue
despite the fact that a gradual shift to the cities (where more
productive employment is generally available) is taking place.

If Japan is to achieve the ambitious
increases in productivity needed to prevent declines in per capita
income, these populations will have to be much more effectively
deployed. The existing drag from declining labour availability is shown
in Figure 3.8.

Figure 3.8

Declining labour availability slows GDP growth in Japan

Contributions to GDP growth, OECD countries, 1995-2005, annual average growth in percentage points

Source: OECD (2007: I-3).

By no means coincidentally, the poor
productivity performance of Japan's services sector coincides with
relatively low levels of participation in international services
trade-Japan ranks very low among OECD nations in terms of the
proportion of services trade to the size of its overall economy (OECD
2008). Another factor affecting productivity is that Japan's policy
approach has had the effect of discouraging inward foreign direct
investment, which is the subject of continuing debate with some of its
commercial partners. Low levels of inward foreign direct investment are
a good indicator of likely levels of services imports, as much trade in
services takes place through a commercial presence in the country where
the services are delivered (what the World Trade Organization describes
as 'mode three'). According to the Bank of Japan, total inward foreign
direct investment stocks in Japan as at 31 December 2007 were only
Â¥15.1 trillion (of the order of A$150 billion)-less than half the
direct investment stock held by foreigners in Australia, an economy
less than one-quarter the size. Additionally, foreign direct investment
into Japan as a proportion of total foreign investment in Japan was
extremely low, at around 4 per cent, though this in itself represented
a significant increase by comparison with previous years (Bank of Japan
2008); the comparable figure for Australia (which is near the other end
of the spectrum) was around 22 per cent (ABS 2008b). It also seems
clear that onerous regulatory requirements are significant in
inhibiting effective allocation of resources within the services
sector, hence reducing the potential for productivity gains (OECD
2008).

As recent Japanese Government policy
papers have emphasised, increased competition through domestic
deregulation and international trade (especially importing services) is
critical to improving the productivity performance of less efficient
sectors of the economy. It results in both static allocative
efficiencies (as resources move out of low-productivity industries that
cannot survive in the face of international competition into more
productive industries that can) and in dynamic efficiency gains-as
those industries that can compete lift their game to meet the challenge
posed by both domestic and international competitors. There are already
some signs that official encouragement for the concept of greater
inward direct investment could be having an effect (Figure 3.9), but
the stock of foreign direct investment remains low both as a share of
GDP and as a share of total inward foreign investment.

Figure 3.9

Inward foreign direct investment grows, but from a low base

Stock of Japanese inward foreign direct investment, 1996-2007 (end of calendar year)

Source: Bank of Japan database.

Integrating internationally

The other avenue open to Japan to
increase its national per capita income is to make money
overseas-either by achieving a higher return on its savings than is
available domestically, through portfolio investment, or by effectively
expanding its labour force without running a major immigration program,
through foreign direct investment. There are clear signs that activity
in both these areas is increasing, both at the aggregate level (Figures
3.10 and 3.11) and in the overseas acquisitions by a range of Japanese
firms (in industries as diverse as pharmaceuticals, precision equipment
and beverages)-to the extent that net earnings from overseas
investments now exceed the trade surplus (Figure 3.12). Moreover, media
reporting of recent developments suggests that the global financial
crisis will result in a quantum increase in the current year,
especially in the financial sector (and, indeed, appears also to have
eliminated, at least for the time being, Japan's trade surplus).

Figure 3.10

Japan's investment overseas grows rapidly . . .

Stock of total Japanese outward investment (direct, portfolio and other),
1996–2007 (end of calendar year)

Source: Bank of Japan database.

Figure 3.11

... as does Japan's direct investment overseas

Stock of total Japanese outward direct investment, 1996-2007 (end of calendar year)

Source: Bank of Japan database.

Figure 3.12

Japan's net income from investment overseas exceeds its trade surplus

Japan's net income from investment overseas and trade surplus, 1996-2007

Source: Bank of Japan database.

'Factory Asia': the growth of East Asia and intra-regional trade

Japan's and Australia's
economies-and the commercial relationship between the two countries-are
also being affected by international integration, much of it linked to
the growth of East Asia (in particular, China), and the changing nature
of investment, production and trade in the region associated with the
fragmentation of production and the growth of regional production
networks. The response of companies-in Japan especially, but also to
some extent in Australia-has altered the structure of the two
countries' domestic economies as well as the structure of trade with
and within East Asia, and contributed to the growth of the region.

The growth of the region

No region of the world has grown
more, or more rapidly, than East Asia during recent decades. In the
wake of Japan's expansion in the 1950s and 1960s and its subsequent
economic success, first the Newly Industrialised Economies (Hong Kong,
the Republic of Korea, Singapore and Taiwan) also grew rapidly and then
the ASEAN4 (Indonesia, Malaysia, the Philippines and Thailand)
expanded. These economies were joined in the 1980s and, especially, the
1990s by China and, more recently, by Vietnam.

The development of these economies
has had a significant effect on both Australia and Japan. As a result
of the policies adopted by their governments and the responses of
firms, these East Asian economies' share of trade and investment
increased, and, consequently, so did their importance in the global
economy.¹⁰

Reflecting its size and its
sustained rapid economic growth from the late 1980s, in the mid-2000s
around 10 per cent per annum, it is China that has had the greatest
impact. This can be seen in China's rising share of both Australia's
and Japan's imports and exports (Table 3.1) and in its ranking among
trading partners: in 2007 China ranked first among Australia's and
Japan's partners in two-way trade (merchandise trade only for Japan,
goods and services for Australia), in both cases for the first time.

Table 3.1: China grows in importance for both Australia and Japan. Australia's and Japan's imports from and exports to China, percentage share of total merchandise imports and exports, 1987-2007

Country		1987*	1992	1997	2002	2007
Australia	Imports	1.9	4.2	5.7	10.1	15.4
	Exports	4.0	3.2	4.7	7.0	14.1
Japan	Imports	5.3	7.3	12.4	18.3	20.6
	Exports	3.6	3.5	5.2	9.6	15.3

* 1988 for Japan.Sources: DFAT STARS database; Ministry of Finance, Japan, database.

Japan's closer trade and investment
links with East Asia and, from a much lower base, South Asia-together,
the source of more than 40 per cent of Japan's imports and the
destination of nearly 50 per cent of its exports in 2007 (Figures 3.13,
3.14 and 3.15)-have been key factors in sustaining export growth
(notwithstanding the relative decline in trade with the United States
and the European Union). This was one of the major contributors to the
expansion of the Japanese economy between 2002 and 2008; the difference
from earlier periods of growth was that previously domestic demand was
also growing, whereas this time domestic demand was weak.

Figure 3.13

Japan becomes more closely integrated with Asia, as an exporter ...

Japan's exports to the world, country and regional shares, 1988-2007

Note: China includes Hong Kong and Macau.

Source: Ministry of Finance, Japan, database.

Figure 3.14

... and as an importer ...

Japan's imports from the world, country and regional shares, 1988-2007

Note: China includes Hong Kong and Macau. Source: Ministry of Finance, Japan, database.

Figure 3.15

... but more gradually as a foreign direct investor

Japan's global foreign direct investment stock, country and regional shares, 1996-2007

Note: China includes Hong Kong and Macau. Source: Bank of Japan database.

Figure 3.16

China's growth reduces Japan's direct share of Australia's trade

Japan's share of Australia's imports and exports of goods and services, 1955–56 to
2007–08

Note: The data for 1956-57 to 1965-66 are for trade in goods only as services data only became available on a country basis from 1966-67.Sources: DFAT STARS database; ABS (2008c, 2008d).

One of the main reasons for the
growth of imports from China is that Japanese firms (as well as firms
from other countries) established factories there and export finished
products-primarily consumer goods-to Australia, Japan and other
markets. This has been especially true of consumer electronics, where
Japanese brands remain significant, and machinery. Some commentators
have described this phenomenon, which encompasses the ASEAN countries
as well, as 'factory Asia' (Baldwin 2006a).

As noted in Chapter 1, one important
consequence is that the nature of the Australia-Japan commercial
relationship has changed: instead of Australian consumer purchases of
the products of Japanese firms being reflected in the bilateral trade
flows, they now show up as imports from China (and some other countries
in the region). There have also been impacts on Australia's exports to
Japan and China (and other countries in the region): sales of wool and
some other raw materials moved from Japan to the new centres of
production following the relocation of production or changes in the
type of production undertaken in Japan.

Regional production networks and intra-regional trade

The investments by Japanese firms in
China and other regional countries have contributed to and become an
important part of production networks that are fundamentally changing
the nature of the regional economy, with impacts on Australian firms
and on direct commercial links between Australia and Japan. This can be
seen in the dramatic increases in the number of affiliates¹¹ established by Japanese firms in East Asia and India (Table 3.2) and in
the number of plants established in China and some of the ASEAN
countries by Japanese automotive and electrical machinery firms (Figure
3.17). While total Japanese direct investment in East Asia is no
greater than Japanese direct investment in Europe or North America
(Figure 3.15), there are more Japanese firms with affiliates in East
Asia than in North America or Europe, and a much larger percentage of
these affiliates are in manufacturing, especially machinery (Ando and Kimura 2003).

Table 3.2: Japanese firms increase their affiliates in China and ASEAN countries. Number of affiliates of Japanese firms in Asian countries, 1990-2004

Country	1990	1994	2000	2004
China	315	1,061	2,432	4,041
Thailand	766	983	1,342	1,512
Hong Kong	793	1,022	1,112	1,121
Singapore	743	961	1,129	1,067
Taiwan	727	812	891	909
Malaysia	509	709	881	805
Indonesia	292	439	676	698
Korea	399	404	496	640
Philippines	171	234	426	453
Vietnam	1	21	174	220
India	71	81	168	193

Source: Fujita and Hamaguchi (2006).

Figure 3.17

Japanese automotive and electrical machinery firms relocate to China and ASEAN

Number of plants (cumulative) established in East Asia by Japanese automotive and electrical machinery firms, 1975-2004

Source: 'The
coming age of China-plus-one', Fujita and Hamaguchi presentation at
IDE-JETRO workshop, January 2006, reproduced in Baldwin (2006a).

These firm-level data are reflected
in the broader data on Japanese investment into Asia (Figure 3.18),
which show that the major growth destinations are China and ASEAN
countries-important centres for the cross-border production networks
that are behind much of the expansion of manufactures trade in the
region (Donald 2008).

Figure 3.18

Japanese direct investment into Asia is concentrated in China and ASEAN

Stock of foreign direct investment by Japan in Asia (end of calendar year)

Source: Bank of Japan database.

Box 3.2 What are regional production networks?

A key driver of the investment
decisions of Japanese firms, and the consequent growth of regional
production networks, was the reduction in competitiveness that flowed
from the major appreciation of the yen against the US dollar and other
major currencies after the 1985 Plaza accord (under which the US, UK,
Japanese, French and West German central banks agreed to intervene in
currency markets), and the emergence of Japan's bubble economy in the
second half of the 1980s (Urata 2006). Another critical factor,
especially for many small and medium-sized enterprises, was the
importance of maintaining relationships with their major customers.
Thus, many suppliers of parts and components, especially in the
automotive, machinery, electronics and electrical equipment industries,
followed large Japanese firms abroad. This was evident in Australia,
where a number of 'tier one' and other preferred Japanese suppliers to
Toyota and Mitsubishi opened factories near the carmakers' plants.
Estimates suggest that up to 50 per cent of Japanese outward direct
investment in the 1990s was by small and medium-sized enterprises
(Urata 2006).

While there has been concern in Japan, from the mid-1980s, that this trend would lead to a 'hollowing out' (kudoka)
of manufacturing industry in Japan, and in Australia about possible
effects on Japanese demand for imports from Australia of minerals,
energy and other inputs into manufacturing, the data are mixed. On the
one hand, a 2006 survey of more than 5,000 large firms across all
manufacturing sectors showed that only 21 per cent were outsourcing
offshore (this included service delivery-research and development,
information services, customer support and professional services-as
well as production of goods) and this offshoring included both
foreign-owned firms and subsidiaries of other Japanese firms, in
addition to the firms' own subsidiaries (Ito et al. 2007).

On the other hand, earlier survey
data cited in Urata (2006) showed that cheaper offshore production was
a key factor in investment and affected the proportion of production
undertaken in Japan. According to firms, especially those in the
textiles sector and those producing non-transportation machinery,
low-cost production for export back to Japan and other markets
motivated much of the direct investment in East Asia (in contrast to
direct investment in North America, where the most important reason was
local sales). The overseas production ratio for Japanese firms with
overseas investments rose from 18.3 per cent in 1993 to 41 per cent in
2002, and for all Japanese firms (multi-national and domestic) the
increase was from

7.4 per
cent to 17.1 per cent. However, there were significant differences
between sectors: much of this increase came from the transport
machinery and electrical machinery sectors (Urata 2006). Research by
Ando and Kimura (2007) shows that the employment effects were mixed:
manufacturing firms with offshore affiliates were more likely than
other firms to increase employment in Japan and, when jobs in Japan
were shed, the percentage decrease was likely to be smaller.

These investments in East Asia have
led to patterns of production-and trade-that differ considerably from
those associated with Japanese investment in North America, Europe and
Latin America. In those regions, Japanese investment-while in total
exceeding that in East Asia (see Figure 3.15)-has not been associated
with production networks and with the dramatic changes to trade flows
found in East Asia, including to and from Japan. In East Asia, Japanese
investment has led to increases in intra-firm, intra-industry and
intra-regional trade.

Intra-firm trade (trade between an
affiliate and headquarters, or between different affiliates) rose
sharply between 1992 and 2001 (Urata 2006). In the early years of
Japanese investment in East Asia such transactions were largely parts
and components being exported from Japan to factories offshore which
then produced finished goods that were exported back to Japan or other
developed-country markets. However, exports from affiliates to the
parent firm in Japan constituted only a small proportion of the large
increase in intra-firm trade, and the value of transactions where the
Japanese parent sold intermediate goods to its affiliates in East Asia
actually declined. Rather, most of the increase was in the share of
intra-firm transactions by affiliates in their country of location and
with affiliates in third
countries (Urata 2006). This finding is consistent with the clustering
of related producers, as reflected in the investment and production
patterns of the automotive industry and other machinery firms where
preferred suppliers accompany producers when they establish offshore
operations.

Intra-industry trade-indicative of
regional production networks-expanded substantially from 23 per cent in
1985 to 40.9 per cent in 2003 (Aminian et al. 2007). Much of the
increase was in 'vertical' intra-industry trade (in which products of
different quality and price are traded, most commonly parts in one
direction and finished products in another). Trade in parts is
particularly important in the machinery and electrical equipment
sectors.

Similarly, intra-regional trade in
East Asia has grown considerably-from less than 35 per cent in 1980 to
around 50 per cent in 2007-while intra-regional trade in the European
Union and North America has not grown as much (Fujita and Hamaguchi
2006 and authors' calculations).¹² As a result of the growth of production networks, more than 60 per cent
of intra-regional trade in 2003 was in parts and components (Fujita and
Hamaguchi 2006), while, for some sectors such as electrical goods, the
figure was even higher-85 per cent between 2000 and 2004 (Urata 2006).
Intra-regional trade expanded across the spectrum of manufactured
goods; only in the textiles and clothing sector did trade in parts not
increase as a share of intra-regional trade (Urata 2006). Reflecting
the industries in which production networks have been most significant,
trade in electrical and general machinery as a share of total
inter-regional trade grew from 28 per cent in 1990 to 46 per cent in
2003 (Fujita and Hamaguchi 2006).

Box 3.3 Trade with Japanese companies but not with Japan

In contrast to the significant
participation of Japanese firms in regional production networks, the
involvement of Australian firms-including subsidiaries of Japanese
multinational corporations-is more limited, although the picture
appears to be different for service providers than for manufacturers.
(One reason few Australian subsidiaries of Japanese firms are
participants in East Asian regional production networks is that the
vast majority of these firms also have subsidiaries in China or other
East Asian countries, and the degree to which these different
subsidiaries are allowed to compete with each other is unclear.)
Australian exports of parts and components for machinery (including
motor vehicles) and ICT-the sectors where East Asian production
networks and intra-industry trade are strongest-are small but growing.
As a result of the geographic distance between Australia and East Asian
countries, this trade is concentrated in higher value-added products
that are less sensitive to time and cost demands (Donald 2008).

In the case of services, trade and
investment data suggest a greater involvement by Australian firms in
regional production networks. This includes production networks to
deliver services (for example, hospital management) and services
embodied in the production of goods (including business services and
logistics) (Donald 2008). A growing proportion of direct investment
into and out of Australia is in services. Australia's overall trade in
services is greater than might be expected given characteristics such
as distance from major markets and income levels, according to gravity
model and trade intensity index research commissioned for this report
(Corbett et al. 2008).

Box 3.4 The impact of trade agreements on regional trade and investment

What does this mean for the Australia-Japan relationship?

If integration continues at current
or greater levels-an assumption that may be threatened if increased
transport costs reduce the profitability of such arrangements (see
Hayakawa 2008 for a discussion of transport arrangements chosen by
Japanese firms for intra-regional trade) or if exchange rate volatility
increases the hedging and associated costs needed to sustain the
production networks (Hayakawa and Kimura 2008)-the potential impact on
firms in Australia and Japan may be profound. In particular, high
levels of integration place a premium on participation, as the
prospects for firms outside production networks will be curtailed.
While Japanese firms have played a prominent role in the development
and expansion of such networks, firms in Australia have been less
successful to date, although there are exceptions, especially in the
services sector.

The ongoing restructuring suggests
both that Japanese investment in China and ASEAN countries in
particular will continue to draw Australian exports of commodities into
the region more broadly (rather than just to Japan), and that the
region will continue to be increasingly important as the source of
'made by Japan' imports into Australia.

Combating carbon

Both Australia's and Japan's
economies will be affected, perhaps transformed, by policy responses to
concerns about climate change-in particular the emission of carbon
dioxide (CO₂)
and other greenhouse gases to the atmosphere. These effects may in turn
have major implications for the bilateral commercial relationship given
its highly carbon-intensive nature.¹³

Economic structure

The economic impact of climate
change depends on a number of factors. One of the most important is the
structure of each country's economy. Japan's economy is both less
energy intensive and less carbon intensive than Australia's. This is a
consequence, among other things, of the two countries' natural resource
endowments and energy policies (and associated responses by companies
and consumers).

Japan is more energy efficient compared not only to Australia but also to most other industrialised economies.¹⁴ Japan's high degree of energy efficiency reflects the changes in its
energy policy (and consequent major adjustments by companies and
consumers) in response to the first and second oil shocks in the early
and late 1970s as well as, to a lesser extent, the policies Japan
introduced to comply with its Kyoto Protocol commitments. These
measures had the effect of partially decoupling energy use and economic
growth: energy use had grown more rapidly than GDP from the late 1950s
to the first oil shock but effectively plateaued between the mid-1970s
and the early 1980s, and only then began to increase again, albeit more
slowly than before. At the same time, energy intensity (measured in
energy use per unit of GDP) improved: between 1973 (the time of first
oil shock) and 2005, it decreased by 35 per cent (Kanekiyo 2007).

This end-point comparison of energy
intensity, however, does not present a complete picture as most of the
aggregate improvement in efficiency was achieved in the 1970s and early
1980s; since 1984 total energy efficiency has remained steady at about
0.14 kilograms of oil equivalent per dollar of GDP. (This contrasts
with the steady improvement in energy efficiency in the United States
and the OECD during that period, albeit to levels more than 33 per cent
and 20 per cent respectively above those of Japan. A number of European
countries, however, are improving rapidly and may overtake Japan in the
next few years.) This is not to suggest that there have not been
improvements in Japan: industries such as steel production now use up
to 35 per cent less energy per tonne of steel than in the 1970s (Katz
2008). However, the improvement in the industrial sector has been
balanced by worsening domestic energy efficiency, in part because of
the increased number of electric and
electronic appliances. Thus, energy consumption per capita, which fell
after both the oil shocks, rose steadily from the early 1980s until the
mid-1990s and has remained stable since, albeit almost 50 per cent
higher than in 1982 (Kanekiyo 2007).

The oil shocks also caused a change
in Japan's energy composition: oil had accounted for over 70 per cent
of its energy mix at the time of the first oil shock; by 2000 it had
fallen to about 55 per cent with some increase in the use of coal and
the growth from virtually nothing of nuclear power and natural gas
(Ninomiya and Jung 2003). Japan's consumption of oil has fallen by 13
per cent since peaking in 1996, with demand dropping more rapidly after
the price of oil began to rise dramatically in 2004 (Katz 2008).

Japan's carbon intensity (emissions
per unit of GDP) has also changed over time. The expansion of
energy-intensive industries during the 1950s and 1960s, and the mix of
fuels Japan was then using, meant that the carbon intensity of its
economy increased up to the mid-1970s. Since the oil crises, Japan's
carbon intensity has consistently decreased. However, the rate of the
decline slowed during the 1990s from the 2.5 per cent per annum of the
previous decade to 0.3 per cent per annum. The improvement (i.e.
reduction) in carbon intensity has been greater than the 30 per cent
improvement in energy efficiency during the same period, meaning that
there has been a decline in carbon emitted per unit of energy used
(Ninomiya and Jung 2003).

Table 3.3: Japan's economy is far less carbon intensive than Australia's. Emissions of carbon dioxide per unit of GDP, 2005

Country	GDP (US$ billions)	CO2 emissions (millions of tonnes)	CO2 emissions per unit of GDP (tonnes/US$ thousand)
Japan	4,571.3	1,293.5	0.283
Australia	708.0	387.3	0.547

Sources: IMF database; UNFCCC database.

Japan's high level of energy
efficiency compared with Australia and other economies offers potential
advantages and disadvantages in responding to concerns about climate
change. On the one hand, the policies adopted in response to the oil
crises show how firms can adapt, and offer some lessons in both
designing and implementing energy efficiency policies and measures. On
the other, Japan's previous success may constrain its future options
for domestic action, at least in certain industries.

Improving energy efficiency has been
identified as a central element of potential carbon abatement policies.
Some analysts have argued that 'picking the low-hanging fruit' through
easily implemented energy efficiency measures would allow significant
reductions in carbon emissions without major economic disruption
(Enkvist et al. 2008). In some sectors Japan's remaining fruit,
however, are hanging higher, because many of the measures that can be
easily implemented are already in place. In the production of steel and
cement (including clinker), for example, firms in Japan already use
less energy per tonne of output than their rivals in major developed
and developing countries; and in the chemicals sector and the
production of pulp and paper, Japanese firms are close to world's best.
Similarly, while household energy consumption has increased, Japan has
already replaced incandescent
globes with fluorescent ones and there is widespread use of highly
efficient heat pump technology in water heaters (METI 2008).

Australia's economy is more energy
intensive-and carbon intensive-than Japan's (and all but six other OECD
countries). Notwithstanding this high ranking, Australia's economy is
'about 5 per cent less energy intensive than the world average and
about 8 per cent more energy intensive than the OECD average' (Garnaut
2008: 158). In contrast to Japan, Australia's energy intensity was
'broadly stable during the 1970s and 1980s, and then fell by an average
of 1.1 per cent a year during the 1990s' (Garnaut 2008: 158).

Australia's higher energy intensity
is a consequence of many factors. One is the plentiful supply of many
forms of energy-in contrast to Japan's almost complete dependence on
imported energy-especially coal, of which Australia is a major global
producer and the world's leading exporter. Another is that the oil
shocks did not lead to similar policy responses in Australia, in part
because a number of significant sources of energy were discovered
and/or came on-stream around the time of the oil shocks (such as the
Bass Strait oil and gas fields and the North West Shelf gas fields).
Yet another is the extensive production of energy-intensive products
such as aluminium and the smelting of non-ferrous metals.

This difference in economic
structure-together with other aspects of the two countries' different
resource endowments which have meant that land clearing has increased CO₂ and other greenhouse gas emissions in Australia but not in Japan-is
reflected in the data on carbon intensity (Table 3.3) and on CO₂ emissions per capita: Australia has consistently emitted at least 175
per cent of Japan's levels and, for most of the decade since the late
1990s, closer to (or more than) twice Japan's levels. The major
contributing factor is the high emissions intensity of energy
generation and use in Australia, a consequence of Australia's reliance
on coal for electricity (Garnaut 2008). Differences in economic
structure and resource endowments also contribute to the differences
between Australia and Japan in emissions of other greenhouse gases. For
example, the large numbers of sheep and cattle mean that 'Australia's
per capita agricultural emissions are among the highest in the world'
(Garnaut 2008: 153).

Other factors can also affect the
demand for energy and the efficiency with which it is used. One of
these is change in population size. The extent to which Japan's
demographic trends will contribute to reductions in energy consumption
and increases in energy efficiency is unclear. In general, however, a
declining population should reduce demand for energy; conversely, the
expected growth in Australia's population is likely to increase demand
for energy.

Policy responses

Another factor that will affect the
impact of climate change on the economies of the two countries-and on
the bilateral commercial relationship-will be the policies each chooses
to respond to the issue. Both governments have identified climate
change as a critical issue for the future and have foreshadowed
additional policies to help their countries adjust.

The biggest potential impact on the
bilateral commercial relationship will be Japan's decisions about its
future energy mix. Prior to the hike in coal, oil and LNG prices in
2007 and 2008, Japanese authorities envisaged a continuing substantial
role for coal as source of base load power generation but with an
increasing role for LNG.
This has already been reflected in contracts for larger volumes of LNG
starting from 2009. Any reconsideration of the share of coal-sourced
electricity could have mixed effects on the bilateral energy trade:
imports of coal may be reduced while imports of LNG grow. If government
policy and public opinion towards nuclear power change, uranium imports
may also grow. However, changing energy infrastructure takes a long
time and the results of such a reconsideration would not show up in
bilateral energy trade for several years. Changes in Japan's energy mix
are also likely to be limited by the extent to which 'clean coal'
technologies, including carbon capture and storage, become commercially
viable after 2020. Successful commercial use of such technologies would
be likely to enable coal from Australia to remain a principal source of
energy in Japan.

Another critical factor will be the
future size of energy-intensive industries such as steel and cement.
Japanese production of these two products has remained substantial,
notwithstanding the transition from a rapidly growing to a more mature
economy with a substantially greater services sector. One reason has
been the continuing domestic demand from infrastructure spending: one
of the policies adopted by successive Japanese governments during the
lost decade was high levels of spending on roads, bridges and other
public works as part of the package to revitalise the economy. The high
levels of public debt incurred as a consequence-now among the highest
in the OECD-make it unlikely that such policies will be resumed,
especially as expenditure on public works has declined steadily during
the decade from 1998 from over 8 per cent to under 4 per cent of GDP
(The Oriental Economist 2008). However, future steel production may be
affected by industry relocation: two industry leaders, Nippon Steel and
JFE Holdings, have foreshadowed plans to build blast furnaces offshore,
something not previously done by Japanese steel companies (Iinuma
2008).

The impacts on the bilateral
relationship of Australia's policy and technical responses to climate
change are likely to be less and to be felt mainly on Australia's
exports to Japan. These will include the impact of an emissions trading
scheme and other measures on export efficiency and competitiveness; and
the success (or otherwise) in developing carbon capture and storage and
related technologies affecting the greenhouse gas emissions from the
coal industry.

Abatement and mitigation policies
are likely to make Australia a consumer of energy-efficient technology.
While it will be a smaller market than Japan itself or some other
developed countries, it may nonetheless still be potentially important
for Japanese firms. Similarly, if research in Australia-some of which
is being undertaken jointly by the Commonwealth Scientific and
Industrial Research Organisation, Australia's national science agency,
and Japanese researchers-is successful in developing carbon capture and
storage and related technologies then there may be commercial
opportunities for Australian (and Japanese) firms.

Commercial reactions

Yet another factor that will affect
the impact of climate change on the economies of the two countries-and
on the bilateral relationship-will be the reactions of companies to the
issue and to the policies implemented by the governments. As many
analysts have noted, climate change presents both challenges and
opportunities for companies. Many of these will arise from the
imperatives to develop new technology and/or enhance existing
technology, including the support that is likely to be provided by both
governments for R&D. Already a number of Japanese
motor vehicle producers, which are at the forefront of global
technology in this area, have signalled their intention to increase
production of and conduct further research into hybrid cars and
technologies such as fuel cells. Another area where the technological
edge of Japanese firms is likely to present opportunities is in the use
of photovoltaic cells to generate solar energy. Australia's natural
resource endowment-including plentiful sunshine, deposits of silica and
relatively cheap energy-may enable commercial developments to deliver
benefits to both countries.

Challenges confronting Australia

The performance of Australia's
economy during much of the period since the late 1980s has contrasted
with that of Japan's. For many of those years Australia was among the
fastest-growing economies in the OECD, following major market-opening
and regulatory reform in the 1980s and 1990s. After 2003 its growth was
further underpinned by a dramatic increase in international demand for
the natural resources Australia possesses in abundance-principally iron
ore, coal, other minerals and energy-leading to a dramatic improvement
in its terms of trade, a consequent increase in the international
buying power of the Australian dollar, and substantial fiscal
surpluses. Some of the issues that loomed large while the research for
this report was being undertaken-the impact of a strong and
appreciating dollar and the rise in terms of trade to levels not
experienced since the Korean War-induced boom of the early 1950s (see
Figure 3.20)-now look as though they may be yesterday's concerns as a
result of the dramatic changes wrought by the global financial crisis.
Others, however, such as the ongoing need for productivity improvements
and the need to address infrastructure bottlenecks, will continue to
pose challenges.

The imperative for improved
productivity is as salient for Australia as it is for Japan, even if
Australia does not face the same demographic pressures as Japan. The
Australian Government's Intergenerational Report
estimated that annual productivity growth across the economy of 2.25
per cent rather than 1.75 per cent would lead to an economy about 20
per cent larger in 40 years' time (cited in Davis and Rahman 2006).
While there has been a relatively steady improvement in output per hour
compared with the United States since 1960 (Figure 3.6), the trend
since the late 1990s has been less encouraging. This picture at the
aggregate level disguises considerable differences among industries.
For example, Australia's productivity in the mining sector is superior
to that of the United States, but there are large gaps between US and
Australian levels in sectors such as manufacturing, wholesale trade,
retail trade, utilities (electricity, gas and water), communications
and finance (Davis and Rahman 2006; Dolman et al. 2007). (The United
States is used for comparison because it is widely recognised as the
international benchmark.) While a few European countries have levels of
productivity higher than or similar to that of the United States
(typically the result of high productivity in a sector that dominates
the economy like oil and gas in Norway), there are a number of factors
that suggest this is unlikely for Australia. These include aspects of
geography and history such as Australia's relative distance from the
global centres of economic activity and the distance between centres of
economic activity within Australia, which may explain up to 45 per cent
of the productivity gap (Battersby 2006).

Productivity is also affected by
skill levels. Historically, there has been a large discrepancy between
the United States and Australia in the share of the population
completing high school, often used as a proxy for skill levels. This
has changed over the decades as the proportion of school leavers in
Australia completing high school has increased, and there is little
difference now between the two countries (Davis and Rahman 2006).
Nonetheless, shortages persist in a number of skilled and semi-skilled
occupations and, as in Japan, the government faces policy challenges to
address the problems. Immigration has been seen as a partial solution
but, while attracting considerably less opposition in general than in
Japan, recent policies aimed at addressing shortages of unskilled
workers in the horticulture sector through a guest worker program, for
example, have been criticised.

Demography also affects economic
growth prospects and the longer-term demographic trends look more
favourable for Australia than for Japan. UN population projections
suggest that, while Australia's aged dependency ratio is also starting
to rise, Australia will still benefit from a growing workforce and
youth population in absolute terms through to 2050 (Figure 3.19). The
increase in the birthrate in the 2000s and the increasing levels of net
migration from the late 1990s in Australia are having an impact on
projected total numbers and, given the increased emphasis on skilled
migration, on the skill levels of the workforce.

Figure 3.19

Australia grows older more slowly than Japan

Australia's population by age group, 1950-2050 (UN medium scenario)

Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2005 Revision, <http://esa.un.org/unpp&gt;.

Of course, it is not population size
and age structure alone that determine the size of the labour force:
changes in the participation rate, which measures the percentage of the
working age population in or seeking paid employment, are also
relevant. While the participation rate has increased steadily since the
late 1970s, recent projections assume stable levels in the future,
leading to a slight decline in the contribution to future growth
(Commonwealth of Australia 2007).

Another challenge confronting
Australia is infrastructure. Again, geographic dispersion and the large
distances between major centres of population and economic activity act as constraints
on and impediments to the easy or cheap provision of the infrastructure
necessary to maintain economic growth and a high standard of living.
This problem has been compounded by underinvestment during the 1990s
and the first half of the 2000s. While plans are now under way to
remedy this, it has already had an impact on the Australia-Japan
relationship (see Box 4.1).

One of the factors that will affect
the ongoing demand for infrastructure is whether the resources boom
resumes. The rapid decline in prices began for commodities like nickel
in the second half of 2007 and has now affected virtually all resources
and energy, as well as a number of food and agricultural commodities.
What is unclear is whether these dramatic falls are the bust that has
historically followed every boom or whether they are a hiccup in what
some analysts (for example, Garnaut and Song (eds) 2007) have described
as a 'super-cycle' in which prices stabilise at high levels rather than
return to their long-term secular decline.

If prices do return to anything
approaching the levels reached during the 2003-08 period, Australia
will face an additional range of challenges. Past experience suggests
that higher commodity prices translate into a surge in the terms of
trade (Figure 3.20, which also shows the impact of rising commodity
prices on the terms of trade for Japan, a considerable importer of many
commodities) and an appreciation of the Australian dollar, and then
lead to inflationary and other pressures in the domestic economy that
are difficult to manage. These pressures were mostly contained during
2003-08 (McKissack et al. 2008). However, a particular concern is the
extent to which such pressures might translate into 'Dutch disease',
where the competitiveness of firms in other sectors of the economy
declines. To the extent that such pressures develop and lead to firms
going out of business, they can limit the longer-term options at an
economy-wide level by narrowing a country's economic base.

Figure 3.20

Australia's terms of trade improve while Japan's deteriorate

Terms of trade for Australia and Japan, 1960-2008 (quarterly)

Sources: ABS (2008b); IMF, International Financial Statistics database.

What we can expect is that if
Australia's terms of trade return to anything like the levels of 2007
then manufacturers and services providers in Australia will be under
pressure to increase the value added to their products through
intellectual and technological content. These trends are likely to
drive greater exposure of the Australian economy to trade in services
and to result in increased flows of outward foreign direct investment
from Australia, particularly in the manufacturing and services sectors.
Gravity models currently suggest that Australia actually trades
somewhat more in services than the characteristics of its economy
(including distance from major markets) would suggest, but it remains,
nonetheless, a relatively small international trader in services by
OECD standards.

Conclusions and implications

As noted above, it is not possible
to state with any certainty what the economic fortunes of either
Australia or Japan are likely to be in the medium to long term. Given
the important structural factors outlined above, however, it seems
clear that the Japanese economy, in particular, is likely to undergo
significant change, especially if it is to meet the challenges posed by
its demographic structure. Specifically, it is likely that a successful
Japanese economy in the 2020s and beyond will have:

• a population that is at least
  somewhat more diverse, reflecting the need to import labour in the face
  of shortages of indigenous labour supply
• a far more open and hence productive
  services sector with larger proportions of services consumption in
  Japan sourced from overseas-this in turn is likely to mean that it will
  also have become a larger exporter of services
• a manufacturing sector that remains
  leading-edge in terms of its international competitiveness in highly
  technology-intensive fields-driving a still larger network of offshore
  affiliates, meaning that its economy is far more tightly integrated
  with that of the rest of Asia
• a more productive and efficient
  farming and food processing sector, focused more on higher-value
  agricultural and food products, mainly supplying the domestic market
  but with some exports of high-value, distinctively Japanese-style food
  products, including into Australia; and with Japanese food processing
  firms even more integrated into regional production and trade networks,
  but with Australia continuing as an important base of operations
• a significantly higher propensity to invest savings overseas so as to maximise returns
• public infrastructure development
  that is both funded through more diverse mechanisms than at present and
  delivered through more competition with overseas providers.

For its part, a successful Australian economy in the 2020s is likely to be:

• still heavily reliant on areas of
  comparative advantage in trade-though even with the shift to ' clean
  coal', the climate change phenomenon may have resulted in a shift in,
  for example, energy-related exports towards fuels such as LNG and
  uranium which produce lower levels of (or no) carbon emissions per unit
  of output
• more highly educated than at present, with consequent benefits in the skill levels and productivity of the workforce
• equipped with better infrastructure
• more involved in regional
  manufacturing networks, with a clear niche in high value-added parts
  and components and the provision of design and integration services to
  those networks
• adapting to the challenges of climate change, including for the agrifood, resources and energy and manufacturing sectors
• significantly more integrated in regional services trade.

As well, it seems clear that
Australia and Japan will have particularly convergent interests in
relation to two trends likely to shape the regional trade and
investment environment into the future. The heavy basis of the
commercial relationship in energy products-largely fossil fuels and
particularly carbon-laden coal-dictates a strong interest in both
countries in the pursuit of technological solutions to the carbon
emissions problem, and an incentive to cooperate to find such
solutions. And both political and economic factors are likely to drive
still closer cooperation between the two countries in ongoing efforts
to develop an open, inclusive regional architecture that will
facilitate the ongoing economic integration of the Asia-Pacific region.

Chapter 4 looks at the implications of these trends for the bilateral commercial relationship in the future.