How Should We Understand the Economic Impact of the Soured Relationship between Japan and China?

ITO Banri
Fellow, RIETI

Amid rising downside risks around the world, concerns are growing in Japan over the economic impact of the soured relationship with China. Japanese companies operating in China are being forced to curtail their production drastically. For instance, major automobile manufacturers have decided to decrease their output by 30% to 50% for the time being. Meanwhile, trade statistics for September 2012 showed that Japan's exports to China dropped by 14.1% year on year, a significantly larger decrease than those to other destinations in Asia. Japan's exports to newly industrialized economies (NIEs) and the Association of Southeast Asian Nations (ASEAN) in September dropped by 7.7% and 4.9% respectively. Major contributors to the 14.1% drop in Japan's exports to China were automobile-related items, namely, motor vehicles (accounting for 2.5 percentage points), power generating machines (1.6 percentage points), motor vehicle parts (1.0 percentage point), and iron and steel products (1.0 percentage point). Due partly to these factors, Japan's industrial output index in September fell by 4.1% from the previous month, and its gross domestic product (GDP) for the July-September quarter contracted by 0.9% year on year (3.5% on an annualized basis), raising concerns over the potential impact on the real economy.

Recovery from the sharp drop in exports expected to be moderate

Since the collapse of Lehman Brothers, Japan has been suffering a succession of negative events, each of which has had a significant dampening effect on its exports. In the course of the recession following the wake of the global financial crisis in 2008, Japan's exports plunged by half in the first four months and continued to post negative growth year on year for the subsequent 14 months. In 2011, the Great East Japan Earthquake caused a huge contraction in the capacity on the supply side as seen in the stalled or paralyzed production due to extensive disruptions in the supply chains. As a result, Japan's exports continued to fall below the previous year's level from March through July 2011. Then came the floods in Thailand. As Japanese manufacturers' local affiliates were forced to suspend production activities, Japan's exports of parts and materials to Thailand dropped sharply (Note 1).

Meanwhile, one major factor behind the latest downturn in Japan's exports is a sharp decrease in demand for Japanese products, conspicuously exemplified by the halving of demand for Japanese cars in China. The ongoing situation resembles the one observed in the period subsequent to Lehman's downfall in that the primary cause of the decline in exports is a drastic decrease in external demand. In those cases, recovery in exports hinges on the course of the economy and production trends in export destinations. Thus, unlike cases where exports fall due to lowered capacity on the supply side as seen in the March 11 earthquake in Japan and the floods in Thailand, the pace of recovery is hard to predict.

Also behind the downward trend in Japan's exports are structural factors associated with the cross-border production networks in East Asia. Japan exports intermediate goods such as parts, components, and processed goods to China and ASEAN countries. They are typically transformed into final goods in China for export to the United States and Europe. China's exports to the European Union (EU), its largest trade partner, increased by 14.4% in 2011 but turned downward this year with the cumulative total for the period January through October dropping 5.8% year on year (Note 2). Accordingly, demand for intermediate goods in China and ASEAN countries declined, resulting in a sharp decrease in Japan's intermediate goods exports to those destinations. As such, downward pressure on trade in intermediate goods within Asia is expected to continue until demand for final goods begins to pick up in the United States and Europe.

Japanese companies' localization has an impact on the Chinese economy

When Japanese companies cut back production in China, its impact is felt not only by themselves but also by Chinese enterprises. This is because many Japanese companies have localized their operations in China and are now actively doing business with local companies both as purchasers and suppliers. As shown in the chart below, which is based on data from the Basic Survey of Overseas Business Activities conducted by the Ministry of Economy, Trade and Industry (METI), the ratio of local sales and that of local procurements for Chinese affiliates of Japanese companies—both manufacturers and non-manufacturers—have been on an upward trend over the years, and the move toward localization accelerated from around 2005. For instance, manufacturers' local procurement ratio increased from 43% in 2001 to 61% in 2010 and local sales ratio from 46% to 68%.

Although those figures include procurement from and sales to Chinese affiliates of Japanese companies, transactions with Chinese enterprises account for the largest proportion. According to the same METI survey, local sales to Chinese enterprises accounted for about 39% of total sales of manufacturing affiliates of Japanese companies in mainland China in 2010, exceeding that to other affiliates of Japanese companies and exports to Japan, which respectively accounted for 28% and 20%. Likewise, Chinese enterprises were the largest suppliers to Japanese companies' affiliates in China, accounting for 43% of their total procurement, followed by imports from Japan at 28% and purchases from other affiliates of Japanese companies at 20%. A decrease in the supply of parts, components, and so forth from manufacturing affiliates of Japanese companies as a result of production cutbacks can lead to lower production by their Chinese customers (forward linkage effects) and a decrease in their procurement to lower production by their Chinese suppliers (backward linkage effects).

Local sales and procurement ratios for Japanese companies' affiliates in ChinaLocal sales and procurement ratios for Japanese companies' affiliates in China
Source: Created by the author based on data from METI's Basic Survey of Overseas Business Activities.

The impact on Chinese enterprises may not be limited to a decrease in transactions with Japanese companies' affiliates. It has been pointed out that the presence of foreign firms has spillover effects (technological externalities) on domestic firms through enhanced competition and the transfer of technological knowledge (Note 3). Together with RIETI Faculty Fellow Ryuhei Wakasugi, Consulting Fellow Naomitsu Yashiro, and others, I conducted empirical analysis of Chinese enterprises to examine whether and to what extent they are impacted by such effects (Ito et al., 2012). We found that the presence of foreign firms not only led to knowledge transfer and an increase in the number of inventions patented by Chinese enterprises but also an improvement in the productivity of those in the downstream industries. Such spillover effects, which can be obtained through non-market channels, may be reduced if Japanese companies continue to cut back on their production in China or pull out from the market.

Globalization in a way adaptive to market multi-polarization

As the impact of the soured relationship between the two countries is likely to continue for some time, Japanese companies should consider ways to make up for a sudden plunge in exports to and sales and production in China. Indeed, Japan's exports have been exposed to a series of negative shocks to date, and the risk of excessive reliance on a specific market was pointed out as early as at the time of the global financial crisis (Note 4). In the period subsequent to the crisis, Japan suffered a much sharper drop in exports than other advanced economies, and one of the reasons behind this is perceived to be its heavy reliance on exports of high-value-added products—those that are among the first to be hit when demand declines—to the United States (Wakasugi, 2009). Although it is important to capture shares in the enormous Chinese market, the lesson derived from the above experience is that Japanese companies need to respond to multi-polarization in the global market and diversify their export and investment destinations, for instance, to include other emerging economies so as to alleviate the impact of sudden external shocks. This, however, may require companies to make difficult decisions. Just like the United States, China is so enormous that lost profits from not moving into this market—i.e., the opportunity costs of moving into other emerging markets instead—are prohibitively large.

Globalizing operations (exporting products and making direct investments abroad) involves huge initial fixed costs because companies would have to conduct market research, create supply chains, build distribution networks, and so forth. Recent research has shown both theoretically and empirically that only those that are highly productive and capable of bearing such fixed costs can enter into the global market (Note 5). In order to globalize operations in a way adaptable to today's multipolar market, individual companies must improve their productivity. At the same time, however, efforts must be made to reduce the costs involved. Taking significant opportunity costs as given, how can we help companies save on their fixed costs in moving into emerging markets that are smaller in size? In terms of government policies, it will become more important than ever to pursue the establishment of efficient global trade and investment rules as well as to implement measures to facilitate the globalization of Japanese companies, for instance, by providing useful information to help them minimize the fixed costs involved.

November 20, 2012
  1. ^ Chapter 2 of the White Paper on International Economy and Trade 2012 provides a detailed analysis of monthly trade figures during this period of time.
  2. ^ China's exports to the world during the period January through October 2012 posted a year-on-year increase of 7.8%, slowing down from the 20.3% increase in 2011, according to China Customs statistics (
  3. ^ Earlier studies have shown that spillover effects differ across countries and industries. For instance, Ito (2011) found that the presence of foreign multinationals has no positive impact on Japanese companies both in the manufacturing and non-manufacturing sectors. Todo (2008) provides detailed analysis on the spillover effects of foreign firms based on a series of research findings.
  4. ^ Chapter 2 of the White Paper on International Economy and Trade 2009 points out that, unlike Japanese exporters, German exporters were able to abate the impact of a sharp decline in demand in the United States and Europe by increasing exports to areas less affected by the crisis, such as South America, the Middle East, and Africa.
  5. ^ Wakasugi et al. (2008) provide empirical findings on Japanese companies along with an outline of preceding research findings.
  • Ministry of Economy, Trade and Industry, White Paper on International Economy and Trade 2009 and White Paper on International Economy and Trade 2012.
  • Todo, Yasuyuki (2008), "Gijutsu Denpa to Keizai Seicho: Gurobaruka Jidai no Tojokoku Keizai Bunseki [Technology Diffusion and Economic Growth: Analysis of Developing Economies in the Globalized World]," Keiso Shobo
  • Wakasugi, Ryuhei, Yasuyuki Todo, Hitoshi Sato, Shuichiro Nishioka, Toshiyuki Matsuura, Banri Ito, and Ayumu Tanaka (2008), "The Internationalization of Japanese Firms: New findings based on firm-level data" (in Japanese), RIETI Discussion Paper Series 08-J-046.
  • Ito, Banri, Naomitsu Yashiro, Zhaoyuan Xu, XiaoHong Chen, and Ryuhei Wakasugi, (2012), "How Do Chinese Industries Benefit from FDI Spillovers?" China Economic Review 23, pp.342-356 (RIETI Discussion Paper Series 10-E-026, May 2010)
  • Ito, Keiko (2011), "Entry of Foreign Multinational Firms and Productivity Growth of Domestic Firms: The case of Japanese firms," RIETI Discussion Paper Series 11-E-063.
  • Wakasugi, R. (2009), "Why the Financial Crisis Affected Japanese Exports So Seriously?" Keio/Kyoto Global COE Discussion Paper Series, DP2009-009.

November 20, 2012

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