How Does Japan Regulate Capital Movements, and What Are the Implications for Foreign Businesses under OECD Codes?

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

The free flow of capital across borders is a hallmark of the modern globalized economy, facilitating investment, promoting economic efficiency, and fostering growth. However, states also maintain regulatory frameworks to manage these flows, balancing the benefits of openness with concerns for financial stability, national security, and public order. Japan, as a major economic power and a significant player in international finance, has a sophisticated system for regulating capital movements, primarily governed by its Foreign Exchange and Foreign Trade Act (FEFTA). This framework operates in conjunction with Japan's commitments as a member of the Organisation for Economic Co-operation and Development (OECD), particularly under the OECD Codes of Liberalisation. This article delves into Japan's regulation of capital movements, its alignment with OECD principles, and the implications for foreign businesses.

An Overview of Japan's Regulatory Framework: The Foreign Exchange and Foreign Trade Act (FEFTA)

The primary legal instrument governing capital movements and foreign transactions in Japan is the Foreign Exchange and Foreign Trade Act, often referred to as FEFTA (or "Gaitame-hō" in Japanese). Originally enacted in 1949 as the Foreign Exchange and Foreign Trade Control Act, its initial purpose was to manage Japan's foreign exchange reserves and control trade in the post-war recovery period, operating under a principle of "prohibition in principle, permission in exceptional cases."

However, reflecting Japan's economic development and increasing integration into the global economy, FEFTA has undergone significant revisions. A landmark amendment in 1980 (fully effective from December 1980) marked a fundamental shift towards a system of "freedom in principle, regulation in exceptional cases" for external transactions. Subsequent amendments, notably in 1998, further liberalized cross-border capital transactions and foreign exchange business.

The current objectives of FEFTA include:

  • The proper development of foreign transactions.
  • The maintenance of peace and security in Japan and in the international community.
  • Ensuring the smooth implementation of international agreements to which Japan is a party.
  • Maintaining the stability of Japan's currency and financial markets.

FEFTA broadly categorizes international transactions into "capital transactions" and "current transactions." While current transactions (related to trade in goods and services) are generally free, capital transactions (such as direct investments, portfolio investments, loans, and real estate transactions) are subject to specific rules, including notification or permission requirements in certain instances.

Regulation of Inward Direct Investment under FEFTA

For foreign businesses, one of the most pertinent aspects of FEFTA is its regulation of "inward direct investment" (tainai chokusetsu tōshi). While Japan generally welcomes foreign investment, FEFTA establishes a system of prior notification and, in some cases, examination and potential intervention by the government for specific types of inward direct investments.

What Constitutes Inward Direct Investment?
FEFTA defines inward direct investment broadly to include:

  • Acquisition of 10% or more of the shares of a non-listed Japanese company by a foreign investor.
  • Acquisition of 1% or more of the shares of a listed Japanese company by a foreign investor in certain designated sectors (discussed below), or a cumulative holding of 10% or more when combined with closely related persons. (Note: The 1% threshold for listed companies in designated sectors was a significant change introduced by amendments in 2019, effective 2020, lowering it from a previous 10% threshold for most cases).
  • Establishing a branch, factory, or other business office in Japan (excluding representative offices undertaking non-business activities).
  • Providing loans exceeding a certain amount and duration to a Japanese company.
  • Acquiring privately placed bonds of Japanese companies under certain conditions.
  • Consenting to a substantial change in the business objectives of a Japanese company in which the foreign investor holds one-third or more of the shares.

Prior Notification and Examination System:
Foreign investors planning to make an inward direct investment that falls within specified categories must, in principle, submit a prior notification to the Minister of Finance and the minister(s) having jurisdiction over the industry concerned, via the Bank of Japan.

The sectors requiring prior notification are primarily those deemed critical to Japan's national interest. These include, but are not limited to, investments in businesses related to:

  • National Security: Such as arms, aircraft, nuclear energy, space development.
  • Public Order and Public Safety: Including electricity, gas, water supply, telecommunications, broadcasting, transportation (railways, maritime, air), and oil.
  • Maintenance of the Smooth Management of the Japanese Economy: This can include sectors like agriculture, forestry, fisheries, and leather manufacturing, often reflecting historical sensitivities or specific policy considerations.
  • Critical Technologies and Supply Chains: Recent amendments have particularly emphasized the screening of investments that could lead to the leakage of critical technologies or undermine essential supply chains, reflecting global trends in investment security. This often covers advanced materials, cybersecurity, semiconductors, robotics, and sensitive dual-use technologies.

The government then has a 30-day period (which can be shortened or extended) to examine the notified investment. If the authorities find that the investment poses a risk of:

  • Impairing national security.
  • Disturbing public order.
  • Hindering the protection of public safety.
  • Having a significant adverse effect on the smooth management of the Japanese economy.

They can issue a recommendation or an order to the foreign investor to alter or suspend the investment. One notable instance of such an order was in May 2008, when the Minister of Finance and the Minister of Economy, Trade and Industry ordered a foreign investment fund to suspend its planned acquisition of additional shares in a major Japanese electric power development company, citing national security concerns related to critical infrastructure.

It is important to note that a significant portion of inward direct investments do not require prior notification and can be made freely, only requiring an ex-post report. Exemptions from prior notification exist for investments in many non-sensitive sectors or if the investment meets certain criteria (e.g., portfolio investments below specific thresholds in non-designated sectors, or investments from countries with which Japan has specific agreements).

The OECD Codes of Liberalisation

Japan, as a member of the OECD since 1964, is party to the OECD Codes of Liberalisation, which are legally binding instruments for member countries. These Codes aim to promote the progressive, non-discriminatory liberalization of capital movements and current invisible operations (services and other non-merchandise transactions). The two main Codes are:

  1. The Code of Liberalisation of Capital Movements
  2. The Code of Liberalisation of Current Invisible Operations

These Codes, first adopted in 1961, represent a collective commitment by OECD members to remove restrictions on international transactions. They are based on the principle that liberalization contributes to economic growth and efficiency. Decisions of the OECD Council concerning the Codes are legally binding on member countries.

Key Principles of the OECD Liberalisation Framework

The OECD's approach to liberalization is characterized by several key principles and mechanisms:

1. The Negative List Approach

The Codes employ a "negative list" (or "top-down") approach to liberalization. This means that all capital movements and current invisible operations covered by the Codes are, in principle, to be liberalized. Member countries are then required to list any specific restrictions they maintain as "reservations" to the Codes. This contrasts with a "positive list" (or "bottom-up") approach, where only specifically listed sectors or transactions are liberalized, as seen in some other international agreements. The negative list approach is generally considered more conducive to comprehensive liberalization, as it presumes openness unless an explicit restriction is justified and lodged.

2. Reservations and the Standstill Obligation

When a country joins the OECD or when new liberalization obligations are introduced, it may lodge reservations for specific operations where it is unable to liberalize immediately. These reservations represent deviations from the full liberalization commitment. However, there is a "standstill" obligation, meaning that members should not, in principle, introduce new restrictions on items already liberalized or make existing restrictions more stringent. Adding or expanding reservations is generally not permitted, discouraging backsliding on liberalization commitments.

3. The Ratchet Mechanism (Roll-Back)

The OECD framework incorporates a "ratchet mechanism," also known as "roll-back". This principle means that once a member country removes a restriction covered by a reservation (i.e., liberalizes a particular item), it is generally expected to notify the OECD, and the reservation is effectively "rolled back." The country should not subsequently re-impose restrictions on that item without valid justification under the Codes. This mechanism ensures that liberalization is a progressive and, ideally, irreversible process.

4. Non-Discrimination

A fundamental principle of the Codes is non-discrimination. Liberalization measures must be applied erga omnes, meaning they should benefit all other OECD member countries equally.

5. Derogations

The Codes allow for temporary derogations from liberalization obligations under specific, tightly controlled circumstances. For example, a member country facing serious economic and financial disturbance or balance-of-payments difficulties may be permitted to temporarily suspend certain liberalization measures. Such derogations are subject to OECD scrutiny and are expected to be temporary.

Japan's FEFTA and its Alignment with OECD Codes

Japan's regulatory framework under FEFTA, particularly its provisions for screening certain inward direct investments, is designed to be consistent with its obligations under the OECD Codes. The Japanese government has stated that its screening mechanism is limited to the minimum necessary to protect national security and other essential interests, in line with the exceptions permitted under the OECD Codes.

The specific sectors subject to prior notification under FEFTA are, in many cases, related to Japan's reservations lodged under the OECD Code of Liberalisation of Capital Movements. For example, Article 3, Paragraph 2 of the Cabinet Order on Inward Direct Investment (Cabinet Order No. 261 of 1980, as amended), which defines industries requiring prior notification, is structured to correspond with Japan's OECD commitments and reservations.

The OECD, through its Investment Committee and other relevant bodies, continuously monitors member countries' compliance with the Codes. This involves regular peer reviews and examinations of members' reservations and any new measures affecting capital movements. If a member's measure is deemed inconsistent with the Codes, the OECD may engage in discussions with the country to encourage alignment.

Implications for Foreign Businesses Investing in Japan

Understanding Japan's capital movement regulations under FEFTA and its OECD commitments is crucial for foreign businesses.

  • Transparency and Predictability: While the "freedom in principle" approach of FEFTA provides a generally open environment, the prior notification and screening system for specific sectors introduces an element of regulatory review. Japan has made efforts to enhance the transparency of this system, for example, by publishing lists of designated business sectors and providing guidelines. However, the specific criteria for national security reviews can sometimes lack full transparency, which can create uncertainty for investors in sensitive areas.
  • Sectors Requiring Careful Attention: Foreign investors targeting sectors related to national security, critical infrastructure (energy, telecommunications, transport), critical technologies, or those on Japan's list of reserved industries under the OECD Codes should anticipate the need for prior notification and a potential government review. Engaging with legal counsel early in the investment planning process is advisable for such investments.
  • Compliance Burden: The prior notification process involves submitting detailed information about the proposed investment and the investor. While the majority of notified cases are approved without conditions, the process itself can add time and administrative costs to the investment transaction.
  • Benefit of Liberalisation Commitments: Japan's adherence to the OECD Codes, including the standstill and ratchet mechanisms, provides a degree of assurance to foreign investors that the overall trend will be towards further liberalization and that existing levels of openness are unlikely to be arbitrarily reversed.
  • Recent Tightening of Scrutiny: In line with global trends, Japan amended FEFTA in 2019 (effective May 2020 and further implemented) to strengthen its scrutiny of foreign investments in national security-related sectors. This included lowering the shareholding threshold for prior notification in listed companies in designated sectors from 10% to 1% and expanding the scope of businesses deemed critical. Exemptions were also introduced for certain types of investors (e.g., passive portfolio investors, foreign financial institutions) subject to conditions, aiming to balance security concerns with the need to maintain an open investment environment.

Recent Developments and Future Outlook

Japan's foreign investment regime continues to evolve. Recent FEFTA amendments reflect a global shift towards more robust national security reviews of foreign investments, particularly in areas involving critical technologies, critical infrastructure, and sensitive data. This is driven by a desire to protect national economic and security interests in an increasingly complex geopolitical environment.

At the same time, the Japanese government actively promotes inward FDI as a means to revitalize its economy, introduce innovation, and enhance global competitiveness. Efforts are being made to streamline administrative procedures, provide information to potential investors, and improve the overall business environment.

Japan is also actively negotiating and concluding Economic Partnership Agreements (EPAs) and Free Trade Agreements (FTAs) with various countries and regions. These agreements often include comprehensive investment chapters that reaffirm and sometimes expand upon existing liberalization commitments, potentially offering even greater protection and market access to investors from partner countries. The interplay between these newer agreements, FEFTA, and Japan's OECD commitments will continue to shape the landscape for foreign investment.

Conclusion

Japan's regulation of capital movements under the Foreign Exchange and Foreign Trade Act represents a framework that balances the principle of free capital flow with the state's prerogative to safeguard national security and other vital public interests. Its adherence to the OECD Codes of Liberalisation provides an important international underpinning for its policies, promoting transparency and a commitment to progressive liberalization.

For foreign businesses, navigating this regulatory environment requires a clear understanding of FEFTA's provisions, particularly the prior notification and screening system for inward direct investment in designated sectors. While Japan remains an attractive and generally open destination for foreign investment, careful due diligence, and, where necessary, consultation with legal experts, are essential, especially for investments in areas that may be subject to heightened scrutiny. The ongoing evolution of both domestic regulations and international commitments means that businesses must remain informed of changes to effectively plan and execute their investment strategies in Japan.