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This study proposes two hypotheses to identify the cause(s) behind the short‐term cyclical Japanese manufacturing foreign direct investment in the European Community (EC) in the late 1980s and early 1990s: (i) a catch‐up process of Japanese firms in anticipation of EC single market integration in 1993 and (ii) the so‐called bubble economic phenomenon caused by the overheated economy following expansionary monetary policy in Japan in the late 1980s. Applying multinomial logit models to the data on parent firms of 283 Japanese manufacturing subsidiaries established in the EC from 1988 to 1992 reveals strong support for the bubble economy hypothesis but not for the catch‐up hypothesis. Results also show that under a bubble economy situation, tax‐related incentive policies in host countries—e.g., an investment tax allowance for foreign direct investment—are quite important in attracting Japanese firms.