China in Transition

The China Factor is Contributing to Japan's Economic Recovery
- Output expanding as the terms of trade improve

Chi Hung KWAN
Consulting Fellow, RIETI

Japan's economic growth during the fourth quarter of 2003 came to an annualized 7% compared to the previous quarter, marking the highest expansion in 13 years; and solid exports to China are a factor behind this economic recovery. Public opinion regarding the effects that China's economic trends have on the Japanese economy is gradually changing from deflation induced by China to inflation induced by China, but in either case, attention is placed on absolute prices. However, it is changes in relative prices, especially in terms of trade, which affect corporate performance and thus economic growth as a whole.

Terms of trade, as discussed here, is the ratio of export prices to import prices. For firms that import raw materials and export finished products, import prices are, together with wages, a factor that determines production cost. A rise in such input prices signifies an increase in costs and suppresses production through a decline in profits. Moreover, export prices are equivalent to output prices, and if they rise, both profits and production also increase. For Japan, a rise in the prices of imports from China is bad inflation that leads to a deterioration in its terms of trade and suppresses production. On the other hand, a rise in the prices of exports to China is good inflation that improves Japan's terms of trade and expands production. Meanwhile, a fall in the prices of imports from China is good deflation that leads to an increase in production, but a fall in the prices of exports to China is bad deflation that reduces production.

So then, how does China's advance affect Japan's terms of trade? China exports low-tech products while importing high-tech products from industrialized countries like Japan and primary products from developing nations. On the other hand, Japan imports low-tech products from China and primary products from developing countries while exporting high-tech goods. As this shows, Japan and China are in a complementary relationship when it comes to the export of industrial products, but compete in importing crude oil. China's rise simultaneously increases the supply of low-tech products, along with raising the demand for high-tech products and primary products in world markets. As a result of this change in the supply-demand relationship, the prices of low-tech products fall relative to the prices of primary products and high-tech goods. This leads to a deterioration in China's terms of trade.

The deterioration in China's terms of trade as a result of its economic advancement comes largely in the form of a decline in export prices and a rise in the import prices of high-tech goods, rather than a rise in the import prices of primary products from developing nations. This reflects the fact that while China's primary product imports are spread out among many items, its exports and high-tech product imports are concentrated in particular areas. In fact, while it is true that China's demand for primary products is growing, its share of total global imports is still small, such as 3% for crude oil and 3.5% for agricultural products (in 2002, according to the World Trade Organization)(see note). In contrast, China's share of global imports of high-tech products is high - 7.9% for telecommunications equipment and 8.9% for steel - while on the export front, the figures are even higher, with its share being 20.6% for clothing and 13.5% for textiles.

Reflecting this, with China growing 9.1% and Japanese exports to China surging 28.4% in real terms last year, Japan's terms of trade vis-a-vis China improved 6.9%. Of this figure, prices of imports from China fell 3%, while prices of exports to China rose 3.8% (both in yen terms). Indeed, Japan is simultaneously reaping the benefits of both inflation induced by China and deflation induced by China.

February 24, 2004
  • It is true that crude oil prices have been high recently, but this is probably more likely the result of global economic recovery and instability in the Near and Middle East than a China-related factor.
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February 24, 2004