Japan and China: Growing economic interdependence amid decoupling talks

In recent years, while there has been concern about geopolitical tensions affecting the global and regional economy - including increasing export controls preventing Chinese entities from acquiring semiconductors and high-tech machinery - sentiment has generally been calm in East Asia.

As the most advanced East Asian economy, how Japan manages its political economic ties with the US and China bears watching. Japanese firms, courtesy of their role as orchestrators of production networks, come to the fore in this analysis.

Indeed, concerns are growing amongst these firms that the changing geopolitical climate and increasing focus on economic security might push them to reduce their exposure to the Chinese market. However, how, and to what extent, would such "decoupling" occur?

China's automobile industry offers us several insights. It overtook the US as the world's largest automobile market in 2009 and has since maintained its grip on the coveted spot. While China has not produced its automobile "national champion" (yet), there is growing acknowledgement that it is one of the most aggressive in pushing technological upgrading in tackling the "green" transition. Its unorthodox policy measures have yielded some tentative results such as in producing bright sparks such as electric vehicle (EV) manufacturer BYD Auto.

Asia's largest economy has also attracted the investment dollars of Austin-headquartered Tesla, arguably the most sophisticated automobile and renewable energy company. In 2018, Tesla laid the foundation for its first production facility outside of the US in Shanghai. The rationale behind its investment decision includes better access to Chinese consumers, lower transportation and manufacturing costs, and bypassing tariffs induced by the ongoing China-US trade dispute.

Not to be outdone, Toyota in 2019 formed a joint venture with Panasonic, a Japanese electronics lead firm, to boost the production of batteries for EVs. Toyota will have a 51% stake and Panasonic a 49% stake in the joint venture company. It will run Panasonic battery production lines at factories in the western Japanese prefecture of Hyogo and Liaoning province in northeastern China. The joint venture is expected to more purposefully transition Toyota toward electric vehicles (EVs), a market segment in which it has so far failed to gain a significant presence.

There is a salient subtext to Toyota's strategy in China. Put simply, the Japanese firm has grown increasingly reliant on the Chinese market.

Figure 1 shows that the contribution of the Chinese market toward Toyota's entire sales portfolio has increased from 9.79% in 2012 to 20.68% in 2020. During the same period, Toyota's production in China also increased substantially, suggesting a tighter integration with Chinese-based stakeholders. The trend even intensified after 2016, when Sino-US economic ties worsened noticeably. Although both production and sales in China dropped slightly during the Covid-19 pandemic, China remains Toyota's largest overseas production facility. Compared to its performance in China, both Toyota's production and sales in the US are shrinking.

Taking a longer-term perspective, Japanese trade (and more broadly, economic) ties with China have blossomed, especially since China's joining the World Trade Organization in late 2001. Japan also ranks as one of the few economies in the world that enjoys a substantial merchandise trade surplus vis-à-vis China.

When it comes to exports, China accounted for 21.6% of Japan's market share. This is close to 4% higher than Japanese exports to its second largest market, the US. The gap widens when one includes Hong Kong (4.7% of Japanese exports) in the Chinese basket. The import statistics highlight a similar dynamic with China contributing close to one-quarter of all that Japan imports. The next two biggest suppliers to Japan are the US (10.7%) and Australia (6.8%).

A recent analysis of the Japan-China trade composition shows us that the major products spearheading Japanese exports are general/electric machinery, chemicals, and transport equipment. It imports mainly general/electric machinery and chemicals from China, although the value-added of these goods are rather low. The role played by general/electric machinery and chemicals is especially important as they tend to constitute capital goods and intermediate goods respectively, both needed to manufacture and market finished goods.

The overall picture is that the supply of capital goods, as well as intermediate goods from Japan to China, is increasing, and that China can only export relatively low-value-added merchandise goods to its eastern neighbour.

Although China's technological sophistication has surely improved over time, the fact remains that a higher proportion of profit has - as of the present period - been captured by Japanese entities. More importantly, it denotes the interdependence of both these Northeast Asian economies, which in turn promotes cooperation and stability for the region at large.

What do we make of the analysis thus far then? For one, US-China tensions are unlikely to go away anytime soon. Commenting on the latest US export controls on semiconductors, senior Japanese technology executives concur that these moves may have a short-term impact on Chinese ambitions.

There is truth to their words - a chip shortage in China has already fuelled a thriving "grey market" where brokers trade components legally sold but not authorised by the original manufacturers. These transactions carry risks because of their lack of traceability. Additionally, this "gray market" is only able to fulfill demand from isolated industrial segments.

Nevertheless, China's presence in emerging fields like artificial intelligence and supercomputers will likely continue to grow. Several of these Japanese technology firms will also not be greatly affected by the sanctions as they have moved to reduce their exposure to the mainland market.

While high politics rage on, it is only wise that alternative, issue-specific plans are hatched to move things along within East Asia. To this end, both Japanese and Chinese executives and technocrats can locate common areas or topics where cooperation is most likely to take place.

Those that immediately come to mind are climate change policies and fiscal consolidation measures in a third country. As alluded to earlier on, it is in the interest of both Japanese and Chinese firms to transition quickly to green vehicles. The Toyota example shows us the benefits of forging and even deepening production networks across borders.

In terms of intergovernmental cooperation, fiscal support measures in a third country are equally - if not more - tricky to implement, but could potentially stabilise a global economy facing several interrelated challenges, ranging from high energy prices to geopolitical tensions.

In developing Asia, several economies already face soaring inflation and even sovereign debt default risks. While candid dialogue with multilateral organisations is essential, the fact that Japan and China are big lenders and end customers to these economies means that any support packages cannot be cobbled effectively without Japanese-Chinese backing.

As far as East Asia is concerned, its last two economic crises of 1997 and 2008 saw strong coordination between Tokyo, Beijing, and the rest of the region. There is little to suggest that such feats cannot be repeated.

This article is partially based on the findings of a recent research paper, titled "The Political Economy of Japan's Development Strategy under China-US Rivalry: The Crane, the Dragon,and the Bald Eagle", published in The Chinese Economy.

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