The Economic Fallout from the Senkaku/Diaoyu Flap

The alarming pictures coming out of China over the past fortnight, as mobs reminiscent of the Red Guards overturned Japanese cars and even beat the Chinese drivers of them, as well as forcing the temporary closure of Japanese factories in China, raise disturbing questions.

Japanese companies including Honda, Mazda, and Nissan have all were forced to suspend operations. Toyota and Honda reported damage to dealerships in Qingdao. The factories have now cautiously reopened as the Golden Week holiday starts Oct. 1, meaning millions of Chinese will return to their families, and tension can be expected to abate markedly.

But the mobs descending on Japanese establishments of all kinds were triggered not by any major incident but by a confrontation over a few islets equidistant from the two countries and a long way from anywhere. Their strategic importance appears to have been significantly outweighed by their domestic political importance. The leadership in Beijing, headed for a major change sometime in October, and heading a country enmeshed in growing economic turmoil, appears to have deliberately unleashed the mobs to take their minds off various Chinese troubles.

The fact is that whatever lingering outrage there is 65 years after the end of World War II, Japan and China are two of the most important trading partners in the world. The squabble over the islands, known to the Japanese as the Senkakus* and to the Chinese as the Diaoyus, stands a chance of disrupting that bilateral relationship, which probably wouldn’t do either country any good. Japan’s Ministry of Finance estimates trade between the two countries was nearly US$350 billion, almost double two-way trade with the United States.

The immediate impact may not be that big. China’s headlong growth, even if it has slowed in recent months, still means it remains attractive as an end market for Japanese consumer companies. The significant investment that Japanese companies have made in China can’t be reversed overnight, and probably won’t be unless the Chinese leadership decides it can afford to rev up the animosity agaom. The supply chains between the two countries are complicated to the point where disruption would hurt them both too badly.

China accounts for 21 percent of Japanese exports and 20 percent of its imports. As with the confrontation last year over the same islands, when Beijing cut back on exports of rare earths, the metals used in the manufacture of everything from computers to cars to airplanes to wind turbines, any disruption in the trade process means trouble for Japan. But the process cuts both ways, Japan is China’s second-largest trading partner after the US. A loss of a major portion of Japan-bound trade would be difficult for China’s export-oriented economy to absorb, flagging as it is already because of falling exports to both the Eurozone and the United States.

Nearly two fifths of Japan's exports to China consist of intermediate goods, which are then assembled and re-exported as core components in Chinese exports to the rest of the world. Japan is estimated to produce 20 percent of the world's electronic components, which are strategic inputs in electronic and auto manufacturing, accounting for 57 percent (US$32.4 billion) of China's parts and components imports from Japan. Another US$8.2 billion in component imports went to China’s transport equipment industry.

If the trouble were to metastasize, Japanese industry could consider moving operations to other countries across Southeast and South Asia. That is not a new idea. Japanese industry is used to it. After the drastic upward valuation of the yen in the mid-1980s, called the endaka period, which cut into the competitiveness of Japanese exports, Japanese industry quickly exported a major portion of its industrial plant offshore. The beneficiaries were Singapore and Malaysia, which became electronics assembly centers, and Thailand, which became the auto assembly center of the region. The exodus of Japanese investment played a major role in driving a new East Asian miracle and rescuing the countries from the mid-1980s recession.

As Asia Sentinel reported on 12 October 2011, the unprecedented 9.0 Fukushima earthquake of March 11, 2011, sent Japanese government officials and many owners of Japan’s small and medium overseas, looking for new locales for ancillary manufacturing operations, offshoring to move closer to their assembly satellites in Thailand, Singapore and China.

The October, 2011 floods in Thailand derailed that effort. However, with plant managers in China growing more concerned about the potential for violence, they may be ready to seek out other countries. Growing wage inflation in China, labor disputes such as the frenzy that hit Foxconn’s factory this week, corruption and regulatory risk all play a role.

Nonetheless, in 2011, the 10 Asean countries were beneficiaries of US$19.6 billion in foreign direct investment from japan, double the rate of the previous year, with at least part of that being driven by the Fukushima effect. Japanese FDI the Asean region, at US$74.1 billion, isn’t that far behind China, at US$83.4billion.

The increased investment could also at have a positive effect on Japan-Asean trade. FDI flows to Vietnam have risen by 30 percent over the past decade. As with the effect from the endaka period, a relatively moderate increase in Japanese trade flows and investments could resulted in rising exports and lift economic growth during a period when global trade and investment flows have flagged.

There is also the potential impact of deteriorating China-Japan relations on foreign direct investment flows. Japan was China's third largest source of FDI after the United States and Hong Kong in 2011, investing US$12.7 billion.

The figure represents approximately 11 percent of total Chinese FDI inflows, which hit a record high of US$116 billion last year. Japan's investment in China has grown at a combined annual rate of 19 percent since 2001.

Japan's FDI outflows into China reached 11 percent in 2011, up from 2 percent in 1999, making China the third largest recipient of Japanese outward FDI, following the United States at US$14.7 billion and the United Kingdom at US$14.1billion.

Japanese consumer companies, facing dwindling domestic demand, are also following their manufacturing brethren into China. According to the Teikoku Databank, approximately 14,400 companies were operating in China by last August. Although manufacturing led the list, with 41 percent or 5,950 companies, many of them auto-parts suppliers, apparel came in second, with 5050 companies, which comprised 35.1 percent. How long it is going to take for the China-Japan relationship to really turn sour remains to be seen. But Asean countries, particularly Indonesia and Vietnam, are eager to take advantage of the situation.

We apologize for our embarassing mispelllng of the Senkaku island name -- Eds.