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SPECIAL
Saturday, Feb. 4, 2006


REPORT ON JAPAN: JAPAN AND CHINA

Juggling tension and trade

Special to The Globe and Mail

TOKYO -- Watching the economic relationship between Japan and China can be rather like staring at a work by Escher: Apparently sound pictures can quickly turn into disturbing paradoxes.

The two countries are linked more tightly than they have been for decades, but are increasingly hostile. They are benefiting from one another's talents more than ever, but live in deepening fear of their rival's success. Mutual understanding is high, mutual trust is low.

And onto the economic story are stacked layers of history: war-related bitterness, disputed islands, cultural dislike. The Japanese prime minister visits a controversial war memorial and weeks later a Chinese naval submarine encroaches on Japanese waters. There is no shortage of flashpoints between the two countries.

But at the corporate level, something is clicking very well indeed. Tokyo and Beijing may not always see eye to eye, but managers in both countries have at least agreed on one thing -- that it is a profound mistake to view the future relationship as a zero-sum game.

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As Japanese Finance Minister Sadakazu Tanigaki said: "Japan's economic and trade ties with China are extremely close, and we must view this issue within the broader context of how we should steer our overall relationship with China."

Japan's recovery from long years of slump is coming because so much of what Japanese industry does well complements China's staggering growth. As China's middle classes splash out as consumers, Japan is ready to sell them high-end electronics. As China's industry and constructors demand better and better components, machines and materials, Japan is perfectly placed to turn on the taps.

Japan's "big four" steel makers, for example, have all just revealed record profits in fiscal 2004 as China boomed. As CLSA Asia's chief China economist, Andy Rothman, explained: "The transformation of China means it has become the largest source of technology imports to the U.S. -- selling finished DVD players and TVs. It will be a long time before China catches up with Japan, but China as a tech exporter places huge, positive pressure on Japan to innovate more."

In 2004, trade between the neighbours rose more than 17 per cent to top $211-billion (U.S.). With that single leap, China finally replaced the U.S. as Japan's biggest trading partner: a shift of such dramatic importance to the region that even conservative Japanese lawmakers are at last prepared to talk about the "Asian century."

But while direct investment into China by Japan is rising, real levels reflect enduring conservatism within some reaches of corporate Japan. According to figures from the Japan External Trade Organization (JETRO), just over 8 per cent of Japan's total outward foreign direct investment (FDI) went to China in 2003; that's eight times the 1999 level, but remains a low base. Psychologically, it seems, Japanese management translates images from TV of huge Beijing warehouses full of pirated DVDs as a message of overall risk in China.

With Japan still the world's second largest annual filer of patents, the question of "what is it safe to produce in China?" has, within the past 12 months, become the prevailing dilemma for Japanese manufacturers. At the moment, the two countries only compete in 18 per cent of exports to the rest of the world. A company such as Sharp takes the view that all the innovation and sensitive production should be conducted in Japan, where trade secrets can be reliably defended. NEC, meanwhile, has a $212- million (U.S.) stake in an LCD screen plant in Shanghai. Matsushita Electric, which saw Chinese sales jump 20 per cent on the year in January, plans to begin local start-to-finish production and sales of 42-inch high-definition plasma televisions this month.

Some, of course, had been predicting rich pickings for a good while. The presidents and CEOs of such companies as Nippon Steel, Canon, Itochu and Hitachi Construction have long peppered their public statements with messages of faith in China as a lucrative market, rather than a remorseless scoop that will hollow Japan out. Last year, Akio Toyoda, the great-grandson of the Toyota Motor founder, claimed that the market was so crucial that there was no future for his company -- currently the strongest auto maker in the world -- if it "messed up" in China.

Even better news, say analysts at the giant steel maker JFE, is that the Beijing Olympics should increasingly be viewed as an economic irrelevance. The Chinese construction drive is a trend that will survive well past 2008. If the entire planned expenditure on the Olympics were added up, it would only represent 2 per cent of last year's infrastructure investments.

Many more Japanese firms have been far quieter in their optimism and are making the jump cautiously. The majority of Japanese firms with investments in China treat information rather like a dirty secret -- to be covered up for as long as possible. They still, however, follow the underlying policy ethos of Prime Minister Junichro Koizumi and mark China in the "opportunities" column.

This, say the economists at Nomura Securities, is the key to understanding Japan's future relationship with China: It is critical to avoid thinking of China as a market of 1.2 billion people, but as a far more moderate 60 million middle-class households. This still equates to a formidable group of consumers -- who despite an instinctive dislike of Japan are ravenously hungry for Japanese goods from video games to self-heating toilet seats.

A recent survey of Japanese companies operating in China found that more than two-thirds believe that profits made in China will improve in the coming year -- a similar number said that they would ncrease their investments there by as much as 20 per cent. Break the numbers down further and the picture is even more interesting: Almost half of Japanese companies in China are sourcing less than a fifth of their components and raw materials from the mainland. As China improves its ability to supply those cheaply, the margins at Japanese corporations will soar.

In the immediate future, though, the relationship between Japan and China is likely to feel the most strain from rivalry over resources. The prices of non-ferrous metals, coke, coal, and iron ore have all taken sharp hikes in recent months but oil and gas are likely to present the more deep-seated issues.

Japan and China have already clashed over the route of a critical Russian pipeline -- Japan won that round by pledging $7.5-billion (U.S.) to a project with a more favourable route. China, meanwhile, has embarked on exploratory drilling for gas in an area of the East Sea that Japan believes it has a claim to.

As one of Japan's most senior bureaucrats in the energy resource department of the Ministry for Economy, Trade and Industry put it: "What we have seen so far are mere skirmishes. But growth means oil and oil means trouble."



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