China in Transition

"Japan Plus One" Implies a Boom of Japanese Investment in China

Chi Hung KWAN
Consulting Fellow, RIETI

(Published on the June 21, 2011 edition of the Allatanys Newspaper Guide)

The recent Great East Japan Earthquake, ensuing tsunami, and nuclear power plant accident caused widespread damage to infrastructure and production facilities in Japan, particularly those in the Tohoku region. As a result, some parts manufacturers were forced to close factories or terminate their business completely, and supply chains were disrupted in the automobile and electronic industries, among other sectors. The impact was not confined to Japan but spread to the overseas markets as well, including China, which has become the "workshop of the world."

Tailwind for China in the long run

Japan is the largest supplier for China, which depends heavily on Japan particularly for parts and materials. Because of the effect of the Great East Japan Earthquake, exports from Japan to China declined 6.8% year on year in April, of which, exports of manufactured goods classified by materials, electrical machinery, and transport equipment all fell significantly, declining 10.9%, 11.0%, and 40.5%, respectively (on a yen basis, based on the Trade Statistics of Japan). As a consequence, some companies in China, notably Japanese firms, were also forced to reduce production.

Among these companies, the impact on the automotive sector has been particularly serious, as symbolized by Toyota Motor, which implemented a production cutback to reduce output of assembled vehicles at factories in China to about 30%-50% normal levels for around six weeks from April 21. Thanks also to the termination of new-car subsidies at the end of last year and rising gasoline prices, new car sales in China declined 4.0% year on year in May, lower than the year-ago level for two consecutive months. In particular, new car sales fell 35% and 32% year on year for Toyota and Honda, respectively.

As noted above, China is adversely affected in the short term by the disruption of supply chains attributable to the recent earthquake in Japan. Over the medium term and long term, however, China is likely to benefit. This is because Japanese companies are trying to accelerate the overseas transfer of their factories to diversify risk in the wake of the earthquake, and China has emerged as the preferred investment destination.

Reviewing the "China plus one" strategy

When dealing with China, many Japanese companies have been pursuing a strategy of "China plus one," in which they invest a certain amount in another country in parallel to their investment in China, to avoid concentrating their investments in China and to reduce and diversify risks. This reflects concern about unstable relations between the two countries.

After the recent earthquake, however, it has become evident that concentrating production facilities in Japan is also as risky as or riskier than concentrating investments in China. Combined with the electric power shortage associated with the shutdown of nuclear power plants, some companies are beginning to explore a "Japan plus one" strategy. In fact, in an "Urgent Questionnaire on the Actual State of Restoration and Reconstruction of Supply Chains and Hollowing out after the Great East Japan Earthquake" released by the Ministry of Economy, Trade and Industry in May 2011, 69% of companies, when asked "Do you think that there is a possibility that the overseas transfer of supply chains will accelerate in the future due to the direct or indirect effect of the earthquake?," answered that the overseas transfer of all or some parts of their supply chains could accelerate.

In this situation, China is attracting attention as the prime candidate location for Japanese companies looking to transfer their production overseas. The "Japan plus one" strategy centering on China is prevailing not only in the manufacturing industry but also in the finance and service industries, as observed in the step taken by Nomura Holdings to pursue a policy of using its offshore center in Dalian, China, which commenced operations in May, as an alternative base for continuing business in the event of disaster (Nihon Keizai Shimbun on April 29, 2011).

Factors for and against investing in China

Japanese companies have been viewing China as a major investment destination, despite many barriers there. In the "FY2010 Survey Report on Overseas Business Operations by Japanese Manufacturing Companies, the results of an annual survey on Japanese manufacturers' overseas business operations," released by the Japan Bank for International Cooperation before the earthquake, China was ranked first in the medium term (for about three years) among promising countries or regions for overseas operations, with a 77.3% share of the vote (multiple answers), even higher than the 73.5% it achieved in the previous fiscal year.

In this survey, "rising labor costs," "weak implementation of laws," "intense competition with other companies," "insufficient protection of intellectual property rights," and "labor problems" were cited as major barriers for investing in China. Also, in light of the collision of a Chinese fishing boat with Japanese patrol vessels in September 2010 and the subsequent deterioration in Japan-China relations, 43.8% of the companies responding indicated that diversifying risk to other countries and regions was important, even though they would continue to make efforts to operate in China.

In contrast, China was positively valued in factors such as "the future growth potential of the local market," "the current size of the local market," "inexpensive labor," "as a supply base for assembly manufacturers," and "inexpensive parts and raw materials." Also, following the earthquake, Japanese companies, which have come to emphasize the restoration of supply chains and diversification of risks, have found China, with its strong industrial base and low transportation costs thanks to its geographical proximity to Japan, even more attractive than before relative to other competitors.

Unlike in the past, new investment projects undertaken by Japanese companies in China are expected to be concentrated in high-tech areas rather than in low-tech areas. China regards this as a golden opportunity to upgrade its industrial structure. At the same time, however, the risk of an industrial hollowing out will increase for Japan, and to avoid this, improvements in the domestic investment environment through tax system reform and other measures are required.

The original text in Japanese was posted on June 22, 2011

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