During the last decade, a hot topic in Japan and America has been the “hollowing out” of their industrial bases. The share of Japanese-owned productive capacity located abroad has grown from 8% in 1994 to 40% today. The United States currently has just over 50% of its manufacturing base located offshore. For both Japan and America, the large outflows of direct investment, especially to China, have caused an uneasy feeling that both countries had bleak futures as manufacturing centers.

Surprisingly, in Japan the pendulum is now moving back as large Japanese multinationals are busy investing in manufacturing plants at home. Here are just a few examples of this trend. Canon is building a large digital camera facility and plans to spend 80% of its $7.2 billion capital budget in Japan over the next three years. This is a reversal from the past ten years when 80% of its capital budget was spent overseas.

Toshiba is building a $2 billion semiconductor facility. Sharp, Matsushita and Nippon Steel are also building major plants in Japan. Overall, spending on plants and equipment in Japan is rising at a 10% clip.

It’s not that China is not important to Japan’s economic growth. China has passed America to become Japan’s largest export market. In addition, it needs a strong presence in China to tap its rapidly growing consumer market as well as a low cost base to manufacture lower tech products. For certain products like cars it is also likely to keep large manufacturing bases in countries like America. For example, Toyota produces more than 1 million cars annually at eight manufacturing plants in America and has two plants under construction in Texas and Tennessee.

But for the more advanced capital-intensive products, the investment is clearly coming home. How can we account for this surprising turnaround and what are the lessons for America?

Lose Now, Lose Big Later

First, Japanese firms have learned the drawbacks of outsourcing. Supply bottlenecks, poor infrastructure, power shortages, uneven quality, difficult inventory management and high employee turnover are just some of the problems. Secondly, even though China’s wages are about 5% of Japan’s, its increasingly sophisticated factory automation has lessened the importance of labor costs. For advanced high tech products it accounts for only 10-15% of total costs. Having manufacturing closer to home also shortens new product lead times and increases cooperation between R