The future of Japan’s economy is tied to that of East Asia. China, the “factory of the world,” is rising rapidly while newly industrialized countries such as South Korea and Taiwan are catching up with Japan. The challenge for this nation is to define and secure its place in this region of vast economic potential.

The Japanese market is already flooded with a dazzling array of capital and consumer goods from these up-and-coming countries. Many of these products are highly competitive in price. That puts Japan, a high-wage country, at a heavy disadvantage in price competition. In this sense, dogged deflation here stems from wide cost disparities between Japan and low-wage countries elsewhere in Asia.

How should Japan meet the challenge? The answer, according to the latest annual government report on international trade, is to set up an East Asia economic zone, a free-trade area comparable to the common markets of the European Union and North America. The report, released Tuesday by the Ministry of Economy, Trade and Industry, stresses the importance of creating a framework for multilateral cooperation, including free-trade agreements.

China is going to be the biggest factor in the equation. The question is how best to promote relations with that emerging economic giant. The report rightly says that Japan should act to bolster cooperation with economic centers such as Shanghai and Beijing, rather than worry endlessly about the “hollowing out” of domestic industry — the increasing shift of Japanese production to China.

Toyota’s decision to assemble cars in China indicates that there is no bucking the rising trend of Japanese direct investment there. This begs the question: As an industrially advanced nation, how should Japan promote division of labor with China? The sensible approach, as described by the report, is to maintain research and development facilities — the nerve center of manufacturing — at home. Not all R&D specialists agree, however. Development and planning prowess, they say, may be weakened if research facilities are located too far from production sites.

The recent relocation to Singapore of a Kyoto University genetic research team suggests the possibility that the research sector in Japan may also become hollowed out unless a better research environment is created at home. In this sense, America provides useful lessons. U.S. manufacturing, which declined in the 1980s, staged a dramatic comeback in the 1990s through R&D investment in information technology and biotechnology.

The message for Japan is clear enough: To maintain its manufacturing power, it should also give a big push to R&D projects. Much that needs to be done. For example, cooperation between industry and academia, an area in which the U.S. is taking the lead, should be facilitated through deregulation.

Building “industrial clusters” around industrial-academic cooperation in selected areas across the country — a program introduced in the ministry’s 2002 report on manufacturing — is also a step in the right direction. It is important, however, that these complexes be managed under the initiative of local governments and universities, and not under the rigid direction of the central government’s industrial policy.

Effective division of work also demands that Japan concentrate on goods and services of higher value. The marketing here of Chinese washing machines, for example, is a reminder that Japan’s future does not belong in such conventional products of lower value. Just as American manufacturers of home appliances withdrew from color televisions and video tape recorders in the face of Japanese competition, Japan should withdraw from old product lines to make way for countries such as China and South Korea.

Shifting managerial resources in favor of high-end goods and services requires change in the industrial structure. A free-trade agreement will facilitate such change by eliminating trade and investment barriers between member countries. Already a bilateral free-trade pact between Japan and Singapore, signed earlier this year, is set to take effect this autumn. What’s more, Japan and South Korea are in talks to conclude a similar agreement. Tokyo is also considering signing such accords with Mexico and other countries.

In these and other efforts toward economic integration, Japan is lagging behind the EU and North America. Both regions have set an encouraging precedent by developing new avenues of growth through structural reforms that a common market requires. Now is the time for Japan to spell out its own policy for East Asia so that it can achieve solid growth in this highly promising region.

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