The Japan-China Relationship: The triumph of economics over politics

I will examine how China and Japan have managed to separate their economic relationship and their political relationship to an extent—what is known as "hot economics, cold politics." An economic relationship which is disconnected from its political relations is a rare occurrence outside of Asia and throughout history. In fact, the confrontational political situations of India–Pakistan or South Korea–North Korea are evidence of the rarity. These countries, which were once unified nation states, had free flow of labor, movement and capital. A major factor in the difference between these situations and that of the Japan–China relationship is China's (and Japan's) commitment to the global trading system. From 1986-2001, unilateral liberalizations which China undertook demonstrated its commitment to opening up and to the global trading system, aimed at World Trade Organization (WTO) accession. This liberalization required major institutional and structural economic change. There are three distinct phases in this seminar to understand the China-Japan economic relationship: the 15-year period of pre-WTO accession, the 10-year period after WTO accession, and a period of marked change when China reached the Lewis turning point. The framework for the recent stability in the Japan–China relationship is being undermined by President Trump's American First agenda which erodes the rules-based global economic order. Japan and China have no free trade agreement and as such the framework for the relationship is the global trading system.

The Japan–China trading relationship is the third largest globally, and is comprised of the second and third largest economies. Japan also provides the third largest source of investment, after Hong Kong and Taiwan, with a stock of investment at 118 billion USD. This even supersedes the U.S. relationship in which companies are not as committed as Japanese companies. Japan offers technology, knowhow, and human capital which furthers China's modernization. China previously provided lost-cost manufacturing, but now provides a market for sales. The Japan–China relationship is nested within a highly-integrated region; and the two nations are the drivers of global supply chains.

Bilateral trade between Japan and China shows trade of under 90 billion USD on the eve of the accession to the WTO, which rose to a peak of 345 billion USD by 2011, which has since reduced partly due to changes in the structure of the Chinese economy. Japanese direct investment stock in China has shown continued steady growth reaching 118 billion USD in 2017 in spite of periods of political tension, such as the Senkaku Islands dispute. The investment relationship offers more insight than the trade relationship as it shows the commitment of Japanese companies to China.

The political relationship shows instances of unresolved political history, regional rivalry and disputed territory. Large-scale public demonstrations have resulted in China and led to destruction of Japanese property and that of other nations. These events could also be a form of more general protest, however the 2005 and 2012 occurrences were directed at Japan. These demonstrations have not caused any major issue for the economic relationship as trade and investment have continued to grow, because of commitments to the rules of the WTO and global trading system from both China and Japan.

Trade and investment data reveal no obvious signs of influence from the turbulence in the political relationship. If there is uncertainty in the political relationship, many assume that it must affect firms and the wider economic relationship. A counterfactual analysis of expected trade and investment considering the countries' characteristics measured against real-world data could provide evidence. According to some papers, sales have been seen to fall in Japanese companies doing business with Chinese state-owned enterprises during periods of tension. In addition, a small effect on the Japanese share price of companies exposed to China can be seen. There is also a large amount of anecdotal evidence, for instance, the Beijing–Shanghai high speed rail contract which was given to a French company instead of a Japanese company. Furthermore, comments from Bo Xilai, when he served as minister of commerce, suggested that bilateral political relations affected economic relations, which saw slow growth in 2005, and that the main point of contention for China is the Japanese leaders repeated visits to Yasukuni Shrine. However, despite the reduction in trade growth in 2005, it still remained at a substantial level. As such, anecdotal evidence can be drawn into question, regardless of some firms reporting negative effects of political circumstances in 2005 and 2012.

A counterfactual examination using a gravity model framework which compares actual trade to potential trade was conducted, taking into account distance and scale of the two economies, and controlling for endowments and multilateral resistances, etc. The results show that the performance of the Japan–China relationship measuring actual against potential trade is higher than overall Chinese or Japanese average performance, and much higher than world average performance. Given the size and structure, while controlling for third party countries, the Japan–China trade relationship is higher than expected. This fact reassures us that politics has not had significant impact in undermining the economic relationship.

The United States initially supported China's accession to the WTO if it meant increasing their level of compliance to global rules of trade. In 1999 Bill Clinton stated that rejecting their membership bid despite efforts to comply would be an "inexplicable mistake," notwithstanding the recent changes in U.S. economic policy and reconsiderations of the appropriateness of China's accession. China applied for entry into the WTO's predecessor, the GATT, in 1986, and was championed throughout the process by Japan in spite of politically damaging incidents, such as the 1989 Tiananmen Square protests. The accession process took 15 years. China engaged in liberalization efforts including the agreement at the 1995 Osaka Asia-Pacific Economic Cooperation (APEC) summit to cut tariffs by 33 percent. Their accession was ratified in 2001 and had massive effects on the global economic system. In the US, the effect on manufacturing and low-income labor was dubbed the "China shock," which displaced trade and workers. This effect experienced after China joined the WTO was not felt to the same extent in Australia or Japan due to various factors, including having a functioning social safety net, and better redistribution of the gains of globalization. The accession was also an event which irrevocably changed international trade and economic policy. It also encouraged foreign companies to engage in China.

China's simple average tariff rate was cut from 55 percent in 1982 to 15 percent in 2001, due to unilateral liberalization aimed at WTO accession. China's trade as a ratio of GDP significantly jumped from 2001. While most tariff reductions occurred before 2001, the "confidence effect" from WTO accession in 2001 clearly caused the dramatic increase. Japanese import and export trade with China increased rapidly in the early 2000s; however, this surge in trade with Japan was outdone by a vast increase in European and U.S. trade brought about by the confidence associated with WTO accession. Comparatively, Japanese firms had already established foothold in China, whereas European and U.S. companies were starting their activities. Due to the start of changes to the structure of the Chinese economy as a whole, the increases in trade and GDP ratio began to flatten in 2006.

Chinese reformers adopted a blueprint of reforms from the WTO and institutionalized the changes to a significant extent. China also agreed to not restrict the exports of natural resources, and take other measures which exceeded commitments of other members during accession. These accession protocols were largely implemented due to outside pressure which led to domestic reform. The commitments involved in their accession provided assurance to European, American and other investors.

The post-WTO accession period coincided with increased political tension between Japan and China. After the accession and public approval given by the Japanese government, controversial visits to Yasukuni Shrine by Japanese leadership and other political events culminated in anti-Japanese demonstrations in China in 2005.

Following this period, the "rare earth metal trade dispute" occurred. An export embargo began after a collision of a Chinese trawler with a Japanese coastguard ship. The captain of the trawler was arrested and China supposedly stopped exports of rare earth metals. Rare earth metals, which are used in high-tech devices including defense technology, were predominantly exported by China with Japan being the largest importer. In previous more unstable times, for example, the interwar period between World War I and World War II, such an embargo could have led to conflict due to the lack of resolution mechanisms. Rare earth mining itself is highly damaging to the environment unless significant measures are put in place. China was only able to gain a large market share due to significantly lower prices as a result of low wages, lack of environmental safeguards and other illegal mining procedures. Some have asserted that because China lacked domestic regulation to stop illegal mining, it could have been creating barriers at the border to slow exports. Japan, the EU and United States brought a case before the WTO against China, where China lost and accepted the ruling.

During the embargo, tensions between Japan and China never got out of control, and business interests constrained government behavior. The deep and broad economic relationship creates a plurality of interests between the countries which serves to restrict the negative effects of politics on both sides. This effect was seen in Prime Minister Abe in 2006 being elected on a message of reconciliation with China, making his first visit abroad as Prime Minister to China, and Chinese demonstrations remaining under control.

In the Japan Bank for International Cooperation surveys, China ranked number one as most promising country to conduct business overseas for Japanese companies until 2012. It was subsequently marginally surpassed by Thailand, Indonesia and India, but again returned to the number 1 destination in 2017, marginally overtaking India. This change in behavior of Japanese companies was reported as being due to rising labor costs in China, which were followed by reforms in competition destinations, such as Indonesia which were intent on maintaining Japanese investment interest. Future growth potential and size of the Chinese market are, however, considered benefits to Chinese business engagement.

The Lewis turning point is a phase of development where a country runs out of surplus labor in rural sectors which causes wages to rise rapidly. Industrial upgrading becomes more capital intensive and economic growth slows. Japan reached this turning point between approximately 1955 and 1961. During 2001-2017, Chinese wages increased 13 percent per year, a rate faster than income and GDP growth which indicates it too was experiencing the Lewis turning point. China has been undergoing a transition from an investment- and export-led model to a consumption- and services-led growth model. This transition is considered to be endogenous, though policy has accelerated this process.

The dramatic changes occurring in China had consequences for the structure of its engagement with other countries. The share of Japanese investment in Chinese manufacturing peaked in 2009 and has fallen since. Growth for Japanese investment in China occurred in wholesale and retail sectors as Chinese consumption increased. These changes happened alongside changes in foreign direct investment from other countries.

The data of domestic sales of Japanese subsidiaries in China show a steady increase since 2003 due to fundamental changes in Japanese business operations.

Japanese investment in China continued to grow in spite of difficulties, which led to further commitment in the country. It began with the aim of cheap production but continued due to sales. As such the two economies are inextricably linked. However, Japanese companies face theft of intellectual property, forced technology transfer, not unlike other countries. In contrast to responses of other countries though, Japan's approach to these problems is fairly pragmatic. Heightened Japan–China political tensions also affect Japanese business. Nevertheless, Japanese companies continue to invest as the market becomes ever more important.

The Japan–China political relationship has improved in recent years. Both countries having relatively strong political leaders who came to power at a similar time. The structural economic forces now underpin the relationship which is why the recent improvement can be seen as a natural course. The uncertainty of Trump and the America First policy may also have contributed to the warming of Japan–China relations. A result of the improved relationship are the visits by both leaders to the respective countries in 2018, and join infrastructure investment projects in third party countries.

The benefit of the WTO to the Japan-China relationship is also true in East Asia more broadly. Whereas Europe has close political cooperation and strong institutions which led economic integration, East Asia has market-led economic integration with political relations and institutional development following. Large unilateral liberalization efforts in the region with commitments to the global trading system strengthen economic relations between East Asian countries in spite of political differences. The United States created and underwrote the system in the post-war period and brought stability; nevertheless, the America First policy is now the biggest threat to this system.

Q: Is there a possibility of a bilateral free trade agreement between China and Japan in the future, considering the Trump administration?

Shiro ARMSTRONG
A free trade agreement between Japan and China may not have been important previously. The current state of the global trading system could be a reason to begin considerations of a free trade agreement. The China–Japan–Korea trilateral negotiations have persisted despite difficulties between members and RCEP is also promising. However, there is risk of a U.S. deal including measures preventing trade with non-market economies, or currency restrictions that could limit the freedom of Japan's central bank.

Q: In your opinion, what about the Japan-China relationship specifically has allowed for this success in separating economics from politics? Some say that the military relationship with the US has allowed for this success. Do you think those circumstances could change in coming years? What is your assessment of this?

Shiro ARMSTRONG
The separation of economics and politics is not unique to Japan–China. China's relationships with other countries can be characterized in this way. Chinese commitment to the WTO has fundamentally led to the separation. Japan's national security situation is also a major factor, as the U.S. involvement in defense led to stability in the region. There are significant considerations needed for the new role the United States is taking in leadership going forward.

Q: Should China be considered a developed country since it has reached the Lewis turning point?

Shiro ARMSTRONG
China has reached the turning period but it is difficult to be precise when the process is truly complete, as seen in the length of the Japanese turning point. Regardless of the rural and coastal sector disparity, China is still a middle-income country and not a high income country and so it must take steps to avoid the middle-income "trap" which may prevent it from becoming a high income nation. The WTO's self-declaration system for developing status is obviously in need of change, and there are other models used by the World Bank etc., which could be adopted to provide stricter definitions of developing or developed country status.

Q: In the case of South Korea, do you feel that politics has triumphed over economics? What are the implications of other bilateral agreements for Japan?

Shiro ARMSTRONG
Many relationships in East Asia and South East Asia are both based on, and maintained by, the WTO framework, which provides the dispute resolution mechanism for the region and the framework within which to manage relations. The economic relationships to a certain extent dictate the political relationships because of a lack of supranational authorities. In contrast, South Asia, in which there is no significant economic interdependence, despite an overarching trade agreement, because of a lack of commitment to openness, the relationships are dominated by political tensions and intra-regional trade is extremely low. Liberalization of trade has yet to occur there, whereas East Asia is committed to openness in trade.