Determinants of the Profitability of Japanese Manufacturing Affiliates in China and Other Regions: Does Localization of Procurement, Sales, and Management Matter?

Does localization of procurements, sales, and management contribute to the profitability of overseas affiliates? This study examines this question by analyzing the performance of Japanese multinationals' manufacturing affiliates in China using a comprehensive affiliate-level dataset for the period from 1989 to 2002 collected by the Ministry of Economy, Trade and Industry (METI). We find that even though foreign multinationals often seem to enter China for the local market potential, affiliates with a higher local sales ratio tend to be less profitable - a pattern that is conspicuously different from that observed for Japanese affiliates in other regions such as the USA or the ASEAN-4, where local sales orientation has a positive impact on profitability. On the other hand, we find that Japanese affiliates' profitability was positively associated with their local procurement ratio. Using the coefficients of the profit function estimated from data on all Japanese manufacturing affiliates around the world, we can calculate the effect of localization (local sales and local procurements) on profitability by country, controlling for the level of GDP and per-capita GDP. In the case of China, the localization effects are positive following the country's accession to the WTO, suggesting that both local procurement and sales expansion contribute to higher profitability in China.