How the forces identified in Chapter
3 will play out is unclear. What is evident is that they will affect
both the Australian and Japanese economies and, consequently, the
commercial relationship between the two countries. The interplay
between these forces and the long-term drivers of the relationship-
complementarity and distance-will crucially affect the opportunities
open to business and the challenges that the two governments will face.

It is important to remember that the
direction and impact of the changes wrought by the shaping forces
identified in Chapters 2 and 3 are not inevitable. In particular,
governments in both Australia and Japan, together with business and the
broader community, can address some of the impediments posed by
distance-in its many dimensions-to the relationship.

Building on complementarity

It seems clear that whatever changes
take place within the economies of Australia and Japan, it will be
traditional complementarities that continue to drive much of the
trading relationship.

Clear national and commercial interests on both sides of the relationship mean it is inevitable that energy and resources
will remain critical to it. Regardless of Japan's future rates of
economic growth, the sheer size and scale of its economy; the fact that
it has very limited indigenous sources of minerals and energy; and the
relative geographic proximity and political and economic stability of
Australia compared to other potential sources, together with
Australia's transparent foreign investment screening process, underpin
the complementarity that exists here.

Box 4.1 Energy security and infrastructure

Thus, for the foreseeable future,
Australia and Japan will be enormously important to each other in this
sector. The predominance and stability of Japanese firms as customers
for Australian raw materials clearly underscores the Australian
interest in maintaining and enhancing this partnership. This is the
case not just for coal (Figure 4.1) and LNG (Table 4.1) but also for a
wide range of other resources: in addition to its substantial purchases
of nickel, mineral sands and other minerals, as noted in Chapter 1
Japan buys more than any other country of Australia's exports of
aluminium and copper. For many of these minerals and energy resources
there is a contrast with markets such as China, which is well endowed
with natural resources (such as coal). In such markets imports can be
marginal inputs-that is, the requirement for them fluctuates as overall
production (of steel or whatever products they are inputs into)
varies-and, if production falls, imports may not be needed at all. By
contrast, in markets such as Japan imports are necessary for all
production, with the result that Japanese firms will be steadier, more
predictable buyers.

Moreover, as noted in Chapter 1,
with the reduced availability of LNG in the next decade from Indonesia
and Malaysia-currently major sources for Japan-this trade is set to
expand significantly in the medium term (Box 4.2).

Box 4.2 The demand for liquefied natural gas

A factor likely to affect the
bilateral resources and energy relationship will be climate change and
possible domestic and international measures to combat it. There is now
international acceptance that major reductions in greenhouse gas
emissions will be required. This will inevitably create pressure to
reduce demand for fossil fuels but could give rise to opportunity as
well.

Japan's technological
sophistication, combined with its vested interest in finding economical
ways to deal with the climate change challenge, make it an ideal
partner for collaborative research on techniques such as carbon
sequestration and 'clean coal' technology. As shown in Table 4.2, as
part of the Asia-Pacific Partnership on Clean Development and Climate,
Australia already works closely with Japan on collaborative efforts
between industry, government and researchers in the development,
deployment and transfer of cleaner, more efficient technologies.

Table 4.2: Shared interests lead to collaborative efforts to address climate change. Asia-Pacific Partnership on Clean Development and Climate (AP6) projects involving Australia and Japan

CO2-enhanced coal bed methane (Australia, Japan, China)

Oxy-fuel combustion technology road mapping and demonstration program (Australia, Japan, United States of America)

Ultra Clean Coal (Australia, Japan)

Identifying optimal legal frameworks for renewable energy in China, India and Korea (all AP6 partners)

Solar-enhanced fuels for electricity and transport (Australia, China, Japan)

Improving the cost-effectiveness of biomass energy generation (Australia, Japan, Republic of Korea, China)

Accelerating deployment of smart mini/micro grids in AP6 markets

Energy Regulatory and Market Development Forum

Best practice in power generation (all AP6 partners)

Cement centre of excellence (all AP6 partners)

Coalmine safety strategy (all AP6 partners)

Integrated coal production and methane extraction (Australia, China, Japan)

Annual steel experts workshop (all AP6 partners)

In addition to collaboration on
research and development, cooperation on policy and regulation may also
offer benefits for both countries. An obvious example is the
possibility of linking the emissions trading schemes under
consideration in both countries.

Just as the long-term trade in
fossil fuels will be affected by the responses to climate change,
demand for uranium, another source of energy of which Australia is
already Japan's principal supplier, is expected to increase (subject to
the caveats about popular support noted in Chapter 3). Japan already
generates some 30 per cent of its domestic electricity from nuclear
power; by 2030, this proportion is projected to rise to above 40 per
cent (METI 2006) even without the more stringent measures to counter
climate change that are now being mooted.

Moreover, Australia has been
identified as having large reserves of renewable energy sources
including wind, solar, wave power and geothermal resources (Garnaut
2007). As work continues to maximise the exploitation of these
renewable energy sources, many of which are also of significant
interest to Japan, increased collaboration and cooperation will become
important.

Box 4.3 Using solar energy to increase the energy from natural gas

The climate change challenge is also
highly relevant to another area in which a complementarity exists
between the two economies that is yet to be fully exploited. Agriculture and food,
as well as being one of the key complementarities on which the trading
relationship has thrived, is also an area in which change, in both
countries, seems inevitable. Both the Australian and Japanese
agriculture sectors face the likelihood of externally imposed
constraints that would result in significant structural changes in the
medium to long term.

Trade in food and other agricultural
products can, in effect, be thought of as trade in water and land (MAFF
2008). Australia has a lot of land but relatively little water, and
much of the precipitation falls outside the major existing agricultural
production areas. This situation is forecast to be exacerbated by
climate change. While there are numerous scenarios for the possible
impact of global warming on Australian agriculture, they tend to
converge around conclusions that 'many regions [are] likely to
experience increased downside risk in agricultural production' with
'regions such as southwest Australia particularly at risk of adverse
outcomes associated with climate change', with farmers 'likely to face
additional costs of capital adjustment due to climate change' (Kingwell
2006: 1; see also Garnaut 2008). Other environmental factors such as
soil erosion and salinity are also in play-and may be exacerbated by
climate change (DCC 2008).

Japan, by contrast, has much water
but relatively little land-and faces continual erosion of the amount of
land under cultivation through industrialisation and urbanisation.
Additionally, as we have seen, Japan's agriculture sector effectively
faces demographic pressure from two directions. The ageing of Japan's
population and the numerical decline of its workforce are dictating
that Japanese policy focus on raising labour productivity throughout
the economy; agriculture is one of the key areas where labour
productivity is lowest, with average wages in the sector in 2004
running at approximately half average wages overall.

Beyond farming, however, Japan has
some strengths in food processing and production that suggest one
avenue for increased exploitation of the complementarities between the
two countries. In particular, there are likely to be
further opportunities to integrate Australian producers with the
significant size, strength and growing regional and even global
presence of Japan's leading agrifood companies. These companies have
made a strategic decision to expand beyond the Japanese market and have
established sizeable regional (and for some, global) production and
distribution networks, with overseas sales a growing share of their
revenues. The recent major investments by the Kirin Group in the
Australian dairy sector-National Foods in 2007 and Dairy Farmers in
2008-and the additional investments it is seeking to make in the
broader beverages sector may be just the first step in this direction.

Box 4.4 Food security and food safety

From an economist's perspective,
greater integration of agrifood production between Australia and Japan
in this context would hold out the promise of significant benefits to
both economies. The principal benefit would arise through the
allocative efficiencies generated by the movement of relatively
unproductive resources out of Japan's agriculture sector into areas
where they could add greater value-a movement that would appear to be
imperative for Japan if it is to achieve the economy-wide improvements
of productivity necessitated by its demographic challenges.

It need not be the case that a shift of employment out of agriculture would lead to a decline in production
or food self-sufficiency-particularly given that another consequence of
Japan's ageing and declining population is likely to be a reduction in
demand for food. Indeed, it is quite possible that a demographically
driven move to larger-scale, more sophisticated farming techniques in
Japan, taking advantage of new economies of scale, would have the
potential to increase self-sufficiency through higher productivity. It is worth noting in this regard that average productivity of Australian land devoted to (larger-scale) rice growing is around 30 per cent higher (at around 8.6 tonnes/hectare) than in Japan (6.5 tonnes/ hectare) (Roberts et al. 2006).

Ultimately, pressure will continue
to mount on farmers in both countries to adjust their practices further
so that they produce crops that maximise returns on the factors
involved in production. Liberalisation of trade between the two
countries would facilitate a redistribution of resources in each so
that market forces provided an incentive for farmers to focus on areas
where they would add the most value. The improved competitiveness
brought about by dynamic gains from this increased internationalisation
of Japanese agriculture could also contribute to an improved capacity
to export-particularly in lucrative, high-quality products for which
markets in East Asia are emerging and where Japan has strong
capabilities.

Box 4.5 Adoption of Australian slaughterhouse technology assists Japanese meat industry

It is fairly clear from an economic
perspective that the more market forces are allowed to come into play,
the more likely it is that these beneficial developments will happen.
Market-distorting protectionist measures ultimately hurt domestic
consumers, provide disincentives to farmers to export, and damage the
broader economy by encouraging misallocation of resources.

It is, however, well known that
economics is not the only discipline in play here. Economists can
identify the destination for reform, in which optimal economic outcomes
are achieved. But identifying a practical path to that destination,
determining whether the benefits merit the trade-offs to be made in
terms of managing the effects of change on existing interests, and
leading events in the desirable direction, are all activities that fall
under the preserve of politics. In both Australia and Japan, achieving
reform is particularly complex given that farming is often seen as much
as a way of life as an economic activity. Nevertheless, the Australian
experience has demonstrated that it can be done-and that the benefits
are real, not illusory.

Box 4.6 Dairy industry reform in Australia

As Japanese decision-makers confront
the demographically driven imperative for increased productivity they
will doubtless focus increasingly on where to place the balance between
the need for governments to continue to seek short-term political
support and the requirement to implement economic reform that will be
beneficial in the longer term. It needs to be recognised that it is for
Japan's political system to work through these sensitive issues in its
own time. However, we would argue that ultimately demographics,
together with economics, will prevail and, in the long term, reform of
Japan's agriculture sector will take place. A constructive approach by
Australia's agrifood sector to the issues faced by Japan at that time
could lead to a deeper partnership in this area, in a manner that could
strengthen both the commercial and political relationships between the
two countries.

The importance of Japanese exports of manufactures
as inputs for Australian life and commerce, too, will continue to
evolve as comparative advantage changes. So too will the nature of the
trade relationship between Australia and Japan. 'Made in Japan'
products-already at the high end of the value chain-can be expected to
continue to become still more capital intensive as competition
increases from other, particularly Asian, sources of manufactures.
Australia, as one of the major developed economies in the region, can
be expected to remain an important consumer of these increasingly
sophisticated products. As well, if the trends towards regional
production described in Chapter 3 continue, a significant proportion of
Australia's imports from other regional partners-principally China and
the ASEAN countries-will, in reality, be 'made by Japan' or 'made for
Japan'. Australian businesses and policy-makers will do well to
remember the value of their business links with Japan as they seek
either to locate new sources of quality inputs or to lock Australia in
as a source of supply of inputs to those manufacturing industries.

Evolution will continue to take place in tourism and travel,
too, as it has in merchandise trade. Fundamentally, the complementarity
continues to hold good: each country offers leisure travellers from the
other something that they cannot easily find in their own. But economic
and demographic dynamics are changing the nature of the relationship
here, too. Whereas in the 1980s and 1990s Japan, with its large,
increasingly affluent population of aspirational travellers wielding
highly valued yen, was a growth market for the Australian tourism
industry, between 2003 and 2008 it was Australian travellers who
benefited from the strength of their dollar. Japan, until the massive
currency movements caused by the global financial crisis, had become a
price-competitive destination, and this was reflected in tourism
numbers. Its profile has been raised for Australian travellers, too, by
the prominent Australian investment in skiing-related tourism in
Hokkaido.

Many Australian travellers are
experiencing Japan for the first time as a result: this, together with
the repeat business associated with the skiing, makes further growth
possible, although the exchange rate remains an important wildcard.

Australia's popularity as a
destination for Japanese travellers was also affected by the
appreciation of the Australian dollar, as well as demographic and other
factors (see Box 4.7). Even if maintained, the recent depreciation of
the dollar against the yen alone may not be sufficient to attract more
Japanese tourists to Australia in the face of significant competition,
primarily from the increasing openness of China as a tourism
destination. Australia will need to work hard and be innovative if it
is to maintain its position, let alone enhance it.

While a positive brand name has been
established broadly for Australia as a tourist destination, Japanese
tourism operators are now emphasising the need to present Australia as
a diverse destination to which it is worth making multiple visits, and
to meet the specific needs of inbound Japanese tourists, in conjunction
with Japanese tourism operators. More work needs to be done in this
area, and to evolve Australia's approach to accommodate more diverse
groups of travellers- whether the increasing numbers of schoolchildren
travelling in school groups, or an older and possibly less adventurous
group of retired travellers. By contrast with the past, when fears were
frequently expressed that competition between different states for
tourist dollars could be detrimental to Australia's image overall,
different states are now being encouraged to market themselves
individually (but within the overall Australia tourism umbrella)-and
with the specific needs of the Japanese market in mind. One other
important factor will be whether sufficient air services are maintained
between Australia and Japan to provide potential tourists with suitable
options.

Box 4.7 Some of the reasons behind Australia-Japan tourism trends

If it is the case that existing
complementarities will remain important, but that their nature will
continue to change, a frequently posed question is where we might seek
the emergence of new ones.

New areas for services trade and investment

In order to
develop Japan's economy, it is essential to achieve sustainable growth
in the service industry, given that this sector accounts for 70 per
cent of GDP and employment. At the same time as achieving enhanced
international competitiveness through the introduction of new business
models including the promotion of IT investment and utilization that is
lagging behind in Japan in international terms and the expansion of new
business entrants, including foreign companies, it is important to
realize active efforts to enter overseas markets…

[T]he service industry of Japan has not made any advances towards globalization except in a limited number of fields, including the finance and insurance industry, and wholesale and retail industry. (METI 2007.)

As we have seen, the direction of
change in both the Australian and Japanese economies has been in favour
of the services sector, which in both countries has expanded
significantly during the past 15 years. Yet by comparison with the extraordinary
health of bilateral merchandise trade, services trade between the
economies of Australia and Japan seems relatively small. This has led a
number of commentators to suggest that services should be a prime area
to look for 'new complementarities'.

The idea that the next generation of
the Australia-Japan relationship might incorporate a boom in services
trade also has significant appeal in terms of the productivity
challenge faced by each, as identified in Chapter 3. Particularly with
the emergence of international production networks requiring
sophisticated logistical and communications services, an efficient and
productive services sector is seen as essential to improving
productivity of the economy as a whole.¹⁵ As services trade worldwide is increasing, so (as with goods) is
specialisation and the fragmentation of production driving productivity
improvements. Further, there are increasing links between trade in
services and trade in goods (Kiyota 2005). It is clearly in the
interests of both economies that bilateral services trade be allowed to
flourish, and that no obstacles be created to the involvement of
service providers in regional production networks (see Box 4.8).

Box 4.8 Services and production networks

While the idea that new
complementarities might emerge between the two countries that would
significantly boost services trade is beguiling, it is important to
keep prospects in perspective.

First, it appears that the
perception of underperformance in this part of the commercial
relationship may be somewhat overstated. As noted in Chapter 1,
empirical research undertaken for this report by the Australia-Japan
Research Centre at the Australian National University (Corbett et al.
2008, available in an online appendix to this report at
<www.dfat.gov.au/eau&gt;) suggests that while it is considerably
less intense than the goods trade between the two countries, bilateral
services trade is greater than might be expected given the extent of
each country's participation in global services trade.

Moreover, gravity modelling, which takes into account various elements of distance,¹⁶ shows that services trade flows between Australia and Japan are
comparable with the flows predicted by the model for flows between OECD
economies-indeed the Australia to Japan flow does not differ from the
average, while the Japan to Australia flow appears slightly above
average. The model is, of course, just that, and the findings of this
research are not conclusive. But it can be said that it does not
produce strong evidence for performance that differs from the average,
at least among OECD countries (Corbett et al. 2008).

It seems likely, then, that the
perception of underperformance in the services relationship may in fact
be an illusion created by the overperformance of other parts of the
relationship. If this is so, it is possible that the scope for an
increase in services trade might not be so great as we might otherwise
think.

That said, supplementing this
picture with more detailed data from Japanese and Australian sources
strengthens the impression that many services sectors are below the
average of bilateral trade, even after taking account of country
characteristics and the intensity of goods trade. There are a number of
sectors (travel, insurance, finance, personal and computer services)
where Australia's exports to the world are greater than might be
expected given the size of its economy and its share of global services
trade, but where the share of those going to Japan is lower than might
be expected. These are also sectors where Australia has below-average
imports from Japan, suggesting that there may be possibilities for
increasing two-way flows (Corbett et al. 2008).

The second point to be made is that
certain elements of the CAGE concept of distance (see Chapter 2) are
particularly applicable to trade in services. Services exports, unlike
goods (and particularly bulk commodities) can be delivered in a range
of ways; and, far more so than for trade in commodities, many of these
require a capacity by a firm or individuals to operate within the
market of another country. Aspects of distance such as differences of
culture, language and legal and administrative systems can be
particularly important in inhibiting trade, and its close companion
investment, in these areas.

The success of the Australia-Japan
bilateral trade and investment relationship in respect of goods has
been that the two economies' complementarity has been such that the
hurdles of distance, even when high, have been overcome. In the case of
services, the complementarities are less clear, and the hurdles seem
higher.

Australia is known worldwide as a
world-class source of primary products, and Japan as a world-class
source of manufactures. Both have significant high-end capabilities in
services. However, as Australian business interlocutors in Japan who
were consulted in the research process for this report repeatedly
emphasised (with some notable exceptions), neither country has such an
established general reputation in this regard as to make it the first
port of call for potential customers from the other. As others (for
example, de Brouwer and Warren 2001) have pointed out, this means that
Australian companies in Japan, and Japanese companies in Australia, are
likely to have to compete for both initial attention and subsequent
business with a much wider range of domestic and international
companies in seeking to enter each other's market than is often the
case with goods trade. While a certain degree of expansion of the
services relationship can be expected as a result of the ongoing
development of merchandise trade (for example, the need for legal
services for new energy and resources contracts), pushing the
relationship into new areas may be harder.

Other, more structural, hurdles
exist that will have to be overcome if services trade is to emerge as
the new growth area of the bilateral relationship. In Australia's case,
in particular, corporate size and structure is an important issue. Many
of Australia's most innovative services providers are relatively small
companies, especially in international terms. Even for major companies,
undertaking steps toward internationalisation or globalisation of
operations should not be done for its own sake, but rather needs to be
based on a rigorous assessment of the specific opportunity in question
(Ghemawat 2007). If anything, smaller companies need to be even more
rigorous in their assessments, as the costs of failure are more likely
to threaten the success of the company.

Box 4.9 Financial services and portfolio investment flows

Issues such as the lack of common
standards and complexity-or perceived complexity-of regulation and its
application have also been identified as hurdles that have tended to
deter Australian companies from embarking on establishing a presence in
Japan.¹⁷ Discussions with Australian companies operating successfully in Japan
during research for this report suggested that in some key growth
sectors, such as health-care products and services, this could be
particularly discouraging for companies-whether Japanese or
foreign-with new or innovative products, which could be subjected to
long and arduous testing processes before acceptance. As such, these
regulations and their enforcement were seen as potentially affecting
Japan's ability to react nimbly to the increasing health-care
challenges likely to result from the ageing of its population.

At the same time, it has long been
suggested (see, for example, de Brouwer and Warren 2001) that both
Australian and Japanese services providers have tended to be less than
fully aware of the opportunities residing in each other's market-
whether due to stereotyping of each economy in the minds of companies
in the other, or because other, seemingly brighter, opportunities are
perceived to exist elsewhere.

Interlocutors consulted in the
research process for this report suggested that this issue may have
assumed greater prominence in recent years as an obstacle to further
development of Australia-Japan commercial relations. The high-profile
emergence of China and India, in particular, but also increasingly
other East Asian economies such as Vietnam, as growth centres, has, not
unnaturally, acted as a magnet for the attention of both Australian and
Japanese business in a way that each other's economies have not.

Australian companies established
successfully in Japan view these developments with a degree of
bemusement. While conceding that Japan is not the place to go in search
of overnight success, they point in particular to what they
characterise as the greater certainty provided both by the more
developed legal systems and business practices that Japan offers, and
by the store set by Japanese partners on the development of long-term
relationships, involving a level of trust seldom found in other
markets. Australian companies cited examples such as that of a
long-term Japanese customer paying in advance (on their own initiative)
for large orders of agricultural produce when they became aware that
the drought was causing financial problems for their Australian
supplier, and of handshake deals that were honoured without question
despite significant adverse price shifts between the shaking of hands
and the signing of a contract.

Companies with a more global outlook
reiterate, too, that the often tortuous process of developing a market
for their products or services in Japan-arguably one of the most
quality-conscious markets in the world-has proved enormously beneficial
to their overall ability to produce and guarantee higher-quality
product and to develop the flexibility to meet changing customer
specifications. They frequently cited these results of expansion into
Japan as having assisted them to sell into other developed country
markets.

Box 4.10 Making it in Japan-the Australian way(s)

Overcoming distance

Implicit in much of the above is
that any 'new complementarities' that might arise, especially in the
services sector, are likely to be less obvious and more nuanced in
nature than the 'raw materials for manufactured products'
complementarity that has underpinned the merchandise trading
relationship to date; and, being less obvious, they are likely to
require more work on both sides both to identify and to pursue. This is
because these new complementarities are likely to be in areas where
distance is a greater factor, and the relevant dimensions will not be
the lack of geographic proximity. Some of these dimensions (in areas
such as regulation and enforcement) can be addressed directly by
governments. For example, Japanese authorities have reformed accounting
standards to align them more closely with those in other jurisdictions.
Others can only be addressed indirectly by governments (supporting
increased people-to-people contact through scholarships and similar
programs, for example) or not at all (changing cultural values and
norms).

Governments can make a real
difference in the development and implementation of regulation, as the
vast majority of regulations are administered by government.
Recognising that these are impediments is the first step; altering them
is the second. One important vehicle for both identifying impediments
and taking appropriate action will be the free trade agreement under
negotiation between Australia and Japan.

Ensuring that the skills exist on
both sides to take advantage of opportunities to develop 'new
complementarities' will be critical if the relationship is to move
further into these areas. In that regard, a crucial role-and one that
needs to be continued and nurtured-must be played by education.

It appears that in this area, too,
the rise of other major economies is having an impact. Australia has
traditionally been quite well placed, relative to competition in the
Japanese market from other developed countries, for availability of
Japanese language skills; but the signs (see Box 2.3) are that this
important resource is likely to be eroded in coming years, at least in
relative terms. Japanese interest in studying in Australia also appears
to be waning, even as Australia's provision of international education
is expanding rapidly. If on-the-ground knowledge of each other's
economy is likely to be crucial to identifying and taking up new
opportunities for mutual benefit, this is an area that needs to be
addressed urgently. The Japanese Government's decision, announced in
June 2008, to create a young business persons program which will bring
50 young Australians to Japan each year, is an example of how
governments can contribute to the building of closer links.

Box 4.11 New opportunities in education

Governments can also play a crucial
role through their cooperation in other areas such as research. While
the cooperation noted earlier on climate change issues is echoed in
some other areas, more active approaches by other countries-which use a
considerable proportion of the available capacity for joint
research-can reinforce pre-existing perceptions that there might be
only limited benefits from programs of cooperation between Australia
and Japan.

Box 4.12 Cooperation on science and technology

Thinking beyond 'bilateral' relations

As noted above, both Australia and
Japan, as developed economies in the Asia- Pacific region, are
increasingly engaging with the rapidly emerging countries in the
region. Both Australian and Japanese business could arguably benefit
from leveraging their existing engagement and cooperation with each
other to exploit opportunities in third-country markets.

Of particular relevance in this
regard is the emergence of cross-border production networks, in which
Japanese companies have been key players. As a result of these new
patterns of trade, simple bilateral flows are becoming less relevant as
an indicator of the economic interactions of trading partners.

Production networks essentially
represent the natural progression of the economic theory of comparative
advantage, in which each producer increasingly specialises in what it
does best relative to others, so that production of individual items is
'unbundled' into a number of separate processes often performed
geographically remotely from each other (Baldwin 2006b). As such, trade
liberalisation, through measures such as tariff reduction, has been a
major catalyst; international networks are most prevalent in industries
such as electronics, where protection is lowest. But another factor in
the spread of production networks has been the rapid improvement in the
efficiency of enabling services, such as transportation, communications
and logistics-services in which Australia has significant capabilities
(Donald 2008).

Australia and Japan stand to benefit
from cooperation in relation to these developments at two levels. At
the policy or intergovernmental level, the impact of the conclusion of
the Australia-Japan Free Trade Agreement currently under negotiation-as
the first such agreement between major developed economies in the
region-is potentially of real significance in the context of the
ongoing emergence of production networks.

There is a significant literature on
the interaction between free trade agreements and the new trading
patterns emerging both within the Asia-Pacific region and globally
(see, for example, Baldwin 2006a). Among the key findings of much of
this literature is that, while they are generally liberalising in
nature, free trade agreements differ from multilateral liberalisation
efforts in that they may also be distorting of broad patterns of trade
if they tend to divert
rather than create trade by favouring less efficient producers over
more efficient producers. Additionally, there are well-known concerns
about the potential for a 'noodle bowl' effect, in which a multiplicity
of different provisions between different countries (especially in
relation to rules of origin) acts to complicate, rather than simplify,
trade.

As two of the major developed
economies on the western side of the Pacific, the shape of any
arrangement between Australia and Japan stands to be highly influential
in the dynamics of negotiations between other major economies.
Additionally, Australia and Japan are currently undertaking
negotiations with a range of other countries or groups in the region.
The extent to which there is effective consistency or otherwise between
their respective agreements could have a significant impact on the
future workability of trade in the region.

At the business level, the
increasing internationalisation of both Japanese and Australian
companies, and their involvement in production networks and
international supply chains, could open up new opportunities which, we
would argue, should lead to the recognition that the Australia-Japan
relationship extends beyond the bilateral trade and investment flows.
As the case of wool suggests, the shifting of Japanese productive
capacity offshore in the region has the potential to drag with it flows
of raw materials from Australia previously used for production in
Japan. Use of their existing relationships with Japanese buyers to open
new avenues of trade could be symbolic of a shift in thinking in
Australian export strategy away from the purely 'bilateral' towards a
regional perspective.

Services are likely to be important
in this context too, both for their role as the 'glue' that binds
existing manufacturing production networks together, and because of the
increasing trend for the production of services to be networked. As
Japanese firms play their part in driving the ongoing trend towards
manufacturing production networks, opportunities will arise for
Australian services providers in a range of markets well beyond Japan
to participate in the activity generated.

It remains to be seen what the
precise division of roles will be in services networks as they develop.
Typically, the fragmentation of roles that occurs in manufacturing
networks is characterised by the specialised production of high
value-added components in those economies where labour skills and costs
are higher, with final assembly taking place where labour costs the
least-predominantly China, but also increasingly countries such as
Vietnam. In the case of services, different patterns may apply and, as
two of the major developed economies in the region, Australia and
Japan, with their large and relatively sophisticated services sectors,
are likely to have a major role in the coordination of these networks.

Conclusions and implications

The change in the ranking of the
Australia-Japan trade relationship serves as a valuable stimulus for
those on both sides to take stock, and to ponder future directions.
This report has sought to place such consideration into context, and to
raise issues that might be expected to shape the relationship into the
future.

The key conclusion is that there
will be a need for perspective and realism in viewing and presenting
the importance of the Australia-Japan commercial relationship into the
future. Existing complementarities will continue to ensure the
relationship remains one of Australia's top three commercial
relationships in absolute size far into the future, even if commodity
prices were to fall significantly from current levels.

The rapid emergence of China, India and other developing economies in the region is likely to mean that the relative
importance of the direct relationship to overall Australian and
Japanese trade and investment patterns will continue to decline. In the
terms of the gravity model used to assess services trade for this
chapter, distance remaining equal, objects of greater mass (economic
size) will tend to demonstrate more attraction. Governments will need
to resist the temptation to see an inevitable decline in the relative
size of the direct trading relationship as an indication of failure or
lack of future potential. It will be crucial, in this context, in
assessing the importance of the relationship to both countries, to
focus on its size in absolute terms, rather than on fluctuating
relativities between it and other trading relationships.

If it is governments that wish for
strong commercial relationships between countries that share many other
factors in common, it is companies that build them. Robust bilateral
relations in general do have spin-offs for companies-for example, by
creating favourable generic perceptions about national capabilities
that make market entry easier, or by creating a critical mass of
support networks that facilitate operating in an otherwise alien
environment. But they do not, of themselves, form a rationale for
commercial decisions. Companies can only properly make those decisions
based on a hard-edged assessment of their own commercial interests. The
task for governments in pursuing their
goals is to maximise the chances that businesses will see advantages
for themselves in behaving in ways that also further government
objectives.

The first key to this is ensuring
that businesses are able to do business. The free trade agreement
negotiations may provide a useful stepping stone. It will be important
that these negotiations identify the real impediments to bilateral
trade and investment and do something about them. Identifying such
impediments will mean not only talking to those companies that are
already doing business bilaterally, but also to those that are not, to
find out why, and what would make them change their minds. Publicity
for the changes that result from the free trade agreement will also be
crucial, and it will be important that such publicity occurs at a time
that maximises the head-turning effect that the signing of the
agreement should have.

The second key will be ensuring that
businesses become aware of the opportunities that exist within the
market, and that it is in fact possible for them to act upon them. This
involves more than the provision of information-though that, too, is
important. As this report has suggested, it can mean looking below the
flood of information at the aggregate level to identify individual
sectors where growth may be
occurring, and individual opportunities. It also involves understanding
the ways in which collaboration and business relationships develop in
the new fields in which there is potential for the relationship to
grow, and encouraging and facilitating the type of in-depth contact
that is necessary for companies in both countries to identify and
exploit such opportunities.

Acting on opportunities that arise
within services sectors, where, as we have seen, cultural and
linguistic distance can be a particularly relevant factor, requires
people with the necessary cross-cultural skills. Both countries have a
reasonably solid foundation in this regard, with study of the language
of the other at a relatively high level in each. However, it needs to
be recognised that the skills and relationships required to develop and
take advantage of full-blown commercial opportunities are relatively
time-consuming to acquire. More opportunities need to be made for
Australians to hone their Japanese language and cultural skills in
Japan, and for Japanese people to gain experience of Australia through
education, living and work placements.

It will be through such efforts to
overcome the many dimensions of distance that new complementarities can
emerge alongside the traditional ones that will continue to drive so
much of the Australia-Japan commercial relationship.