The Japanese government has tightened export control against South Korea. If Japanese exports to South Korea decrease as a result, that would have negative economic effects on Japan as well as on South Korea.
According to an estimate by the Korea Economic Research Institute , if the tightening of export control causes a 30% shortfall in the supply of semiconductor materials against South Korean companies' demand, it would lead not only to a decline of 2.2% in South Korea's GDP but also to a fall of 0.04% in Japan's GDP. However, this estimate does not fully take into consideration the possibility that the economic impact may propagate throughout the world through global supply chains. Therefore, it underestimates the scale of the impact.
Japan experienced the propagation of economic impacts throughout the entire economy through supply chains after the Great East Japan Earthquake. As a result of the disruptions in the supply of parts and materials from the disaster areas and reduced demand there after the earthquake, many factories across Japan and some in other countries were forced to temporarily suspend operations.
I have been conducting quantitative studies on propagation of economic effects through supply chains for 10 years. Through this research, I have found that when companies reduce production for some reason or other, the knock-on effects that propagate through supply chains are far more extensive than the direct impact on the companies themselves.
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According to simulations conducted by me and one of my coauthors, the amount of value-added production lost as a direct result of the destruction of production equipment due to the Great East Japan Earthquake was around 100 billion yen, or equivalent to 0.02% of GDP. However, as all prefectures were affected by production declines caused by the disruptions in supply chains, the total amount of value added production lost was 11 trillion yen, or equivalent to 2.3% of GDP. The scale of the knock-on effects was around 100 times larger than the direct impact.
However, the scale of knock-on effects may vary significantly depending on the supply chain structure. Our research has found that when the supply of parts or materials from a supplier (such as a parts maker) is disrupted, the scale of the knock-on effects is greatly influenced by the degree of availability of substitutes for the parts or materials, namely by the degree of irreplaceability of the parts or materials.
In addition, most companies have only several major suppliers or client companies, but some companies, as supply chain hubs, are connected with more than 10,000 companies. Knock-on effects could rapidly spread through the entire economy via hub companies.
The flow of goods through supply chains is not necessarily one-way, from materials manufacturers in the upstream to final goods manufacturers in the downstream. Goods may flow from downstream to upstream in some cases—such as when a supplier company purchases production machinery from a machinery producer—creating complex loops within supply chains. In such cases, the impact of a production decline at a company tends to be amplified and prolonged as it circulates in a loop.
Moreover, financial factors could also trigger knock-on effects that spread through supply chains. A company's default causes financing problems at its suppliers, which in turn lead to problems further upstream. Dr. Yoshiyuki Arata, a research fellow at the Research Institute of Economy, Trade and Industry, has shown, based on Japanese data, that the bankruptcy of a company affects its direct and indirect suppliers.
As the first step in the tightening of export control announced in July, Japan stepped up control over exports of materials to South Korean semiconductor manufacturers, including Samsung Electronics and SK hynix. In terms of semiconductor sales, Samsung Electronics and SK hynix are the global No. 1 and No. 3, respectively, and they are doing business with companies in many countries, including Japan. Their products, such as DRAM and smartphones, are used as a means of production by manufacturers around the world. In short, the companies are hubs and are creating complex loops within global supply chains.
Therefore, if exports of materials from Japan to those companies stop, it will do more than just reduce production at companies making the materials. The impact will expand to companies supplying other materials to the South Korean companies, indirect suppliers serving those direct suppliers, and Japanese companies making goods using products supplied by the South Korean semiconductor makers (see the figure below). The impact may be amplified while travelling through loops within the supply chain.
Moreover, because all of the materials for which export control has been tightened are ones over which Japanese companies have technological superiority, it is difficult for South Korean companies to substitute them with products imported from other countries. On the other hand, for Japanese companies, it is not easy to find alternative customers to South Korean companies with such large global market shares. The impact of the tightening of export control is very serious in this case compared with cases where it is possible to procure alternative materials from other sources.
Unfortunately, because detailed data on Japanese and South Korean supply chains are not available for the moment, we cannot accurately describe the impact in numerical terms. Still, there is no doubt that the impact will be far greater than the estimate by the Korea Economic Research Institute, as is suggested by the case of the Great East Japan Earthquake.
In August, Japan tightened export control over a broader range of items by removing South Korea from the list of countries eligible for preferential treatment in the form of simplified export procedures (white list countries). The application of stronger control to a broad range of items will naturally have a larger impact compared with when only semiconductor materials are subject to tightened control.
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However, the impact is expected to become extensive only when exports from Japan to South Korea actually decline steeply. Fortunately, as the Japanese government has made clear, the tightening export control is nothing more than a change made in the enforcement of export control in cases related to national security. The objective is not restricting exports indiscriminately. Japan has started to grant permission for exports of some semiconductor materials to South Korea.
If exports continue to be permitted in cases where no security issues are discovered, the supply chain will not be disrupted even though the labor and time required for export procedures may increase. Therefore, the impact will be short-lived and small.
However, South Korea is trying to retaliate against the change in Japan's export control enforcement by taking various measures. If Japan reacts by taking export control measures for reasons unrelated to security, the impact on the Japanese economy will not be negligible. The Japanese government should deal with this matter in a rule-based manner and limit the tightening of export control to a necessary minimum in due consideration of the impact.
Companies need time and information in order to adapt to the new export control environment. The government must promptly support companies, particularly small and medium-sized ones, in order to prevent the impact of a slowdown in production during the period of adjustment from creating extensive knock-on effects. Some controlled items may be substituted by products supplied from other countries. By supporting companies in quickly adapting to the changes, the government can prevent controlled items from being substituted on a permanent basis due to the increased complexity of export procedures.
Having played the leading role in concluding the Comprehensive and Progressive Agreement for the Trans-Pacific Partnership (CPTPP or TPP11) and having concluded a free trade agreement (FTA) with the European Union, Japan is in a position to act as a global leader of free trade. Unfortunately, Japan's intention in changing the export control enforcement appears to have been misunderstood, sowing some doubt in the world about the country's commitment to free trade. The government should resolve such doubts and misunderstandings by using export data for the period just before and after the implementation of the measure to carefully explain to the international community that the tightening of export controls is a necessary minimum measure limited to cases related to security concerns.
The government should also take a similar approach in dealing with South Korea. Even though the South Korean government may be reacting negatively to the Japanese measure, the government should patiently continue to explain its position to the South Korean citizens and business community based on data. As a further deterioration in Japan-South Korean relations is not desirable in light of the rapidly changing economic and political order in Asia, both the public and private sectors should pursue diverse strategies from a long-term perspective.
* Translated by RIETI.
August 21, 2019 Nihon Keizai Shimbun
