Resilience, not Decoupling: Critical Supply Chains in China-Japan Relations

ARTICLES - 28 August 2020

By Mathieu Duchâtel

"The de-Sinicization of global supply chains (全球供应链去中国化)" – this is the term used in China to describe the policies (or the aspiration) in the United States, Europe and Japan to reduce reliance on Chinese manufacturing, as a lesson learned from the Covid-19 crisis. The idea precedes the pandemic, but the flaws exposed by Covid-19 in critical supply chains, especially for personal protective equipment and medical supplies, have accelerated existing reflections and debates.

Japan deserves particular attention because it has moved fast to adopt policies to increase its resilience. The policy of the Abe government has sometimes been interpreted as encouraging Japanese companies to exit China. This is an exaggeration - Japan’s policy on critical supply chains is a narrowly-focused rebalancing act geared towards resilience and diversification.

The seeds of resilience

A target of Chinese sanctions in the past, Japan has experience in reducing reliance on imports from China. In 2010, China came close to interrupting exports of rare earth after Japan detained a Chinese fishing boat captain who had collided with Japanese Coast Guards in the waters of the Senkaku Islands. This prompted Japan to diversify its sources of supply. In 2010, Japan imported 82% of its rare earth materials from China. This dependence was reduced to 58% in 2019, with the target of less than 50% in 2025. In parallel, in March 2020 the Japanese government announced a new plan to increase the national stockpile of rare earth material from 60 to 180 days of domestic consumption.

In 2010, Japan imported 82% of its rare earth materials from China. This dependence was reduced to 58% in 2019, with the target of less than 50% in 2025.

But the Covid-19 outbreak has exposed another challenge: Japan’s dependence on imports of protective equipment from China. Although Japan never suffered the shortages of masks experienced in Europe, the country went through a period of tension on the supply side in the spring 2020. Between January and May, Japan imported JPY 267.84 billion (US$ 2.5 billion) of masks from China, which amounts to 93.9% of Japanese imports of masks. This makes for a 1.6 times increase from the same period in 2019. Japanese customs statistics for July 2020 show an increase by 38.2% of textile yarns from China year-on-year. During the same period, total imports from China decreased by 9.8%.

This explains the adoption of the supplementary budget for fiscal year 2020, to support the two axes of Japan’s Covid-19 relief package: strengthening supply chains by promoting investment in Japan (JPY 220 billion, or US$2.1 billion) and helping diversification through overseas investment (JPY 23.5 billion, or US$ 220 million). The two programs help cover expenses for feasibility studies, introduction of equipment or building new facilities, with a maximum subsidy of JPY 15 billion (US$ 140 million) for the Japanese domestic program. The stated goal of the Ministry of Trade, Economy and Industry (METI) for this program is to "enhance viability of industries by strengthening supply chain resilience" and it specifically addresses vulnerabilities linked to a "high degree of concentration of production bases".

Three months after the launch of the two programs, the first two batches of companies have been selected. The Ministry has released a list of 57 companies, including 40 SMEs, that have successfully applied for subsidies to invest in Japan, for a total approved budget of JPY 57.4 billion, or US$ 542.4 million – an average of US$ 9.5 million per company. 20 of the companies operate in the medical machinery/equipment and pharmaceutical manufacturing industry, and 14 in textile manufacturing. In total, 13 are listed as producers of different types of masks. Among them is Iris Ohyama, reported to be the first company to have benefited from the scheme to move production from Dalian to an existing facility in the Miyagi prefecture. Other approved industrial projects include material for masks, parts for ventilators, agents for virus testing, PCR test kits, protective clothing, pharmaceuticals, etc.

In addition,124 Japanese firms applied for subsidies to invest in third countries. METI selected 30, including 15 in Vietnam, confirming the attractiveness of Vietnam for Japanese businesses. The list provided by the Japan External Trade Organization (JETRO) shows a similar pattern of targeted action to support SMEs in the medical equipment and textile manufacturing sectors. This is complemented by action on the diplomatic side. METI has initiated discussions with Australia and India to launch a Supply Chain Resilience Initiative. The goal is to expand this initiative to include ASEAN countries. The idea is for governments sharing an interest on the demand or the supply side to create a business environment that facilitates industrial relocations or investment.

In short, Japan is building enhanced resilience to address the Covid-19 pandemic and future public health crises. This is significant and substantial, but far from planning an industrial exodus away from China or a complete reorganization of existing production chains. Japan is the largest foreign investor in China, with more than 50000 firms and an aggregated FDI stock of US$ 111.98 billion in 2018, according to China’s Commerce Ministry.

Japan is building enhanced resilience to address the Covid-19 pandemic and future public health crises.

The overwhelming majority of Japanese business in China remains untouched by this policy. In 2019, 73% of the manufacturing output of China-based Japanese companies was sold to the Chinese market. These companies have no intention to leave. The November 2019 survey by JETRO, regarding the business conditions of Japanese companies in Asia, showed that only 5.4% of Japanese companies were considering a reduction of their Chinese operations, and 0.9% a withdrawal. As much as 43.2% were thinking of expanding and 50.6% of sticking to the status quo. JETRO’s data also shows that 68.5% of Japanese companies in China make a profit, while 13.2% suffer losses. The future in China is particularly promising for Japan’s automotive industry, which, taken together as an ecosystem of manufacturers of cars, components and spare parts, represents half of Japan’s FDI in China. Even if some spare parts manufacturers arranged substitute production sites during the peak of the Covid-19 lockdowns in China, their plan was to return to China once normal production resumed. According to a 2019 prediction by Kiyoyuki Seguchi from the Canon Institute for Global Studies, Japan’s share of car sales in the Chinese market is expected to rise from 18.8% in 2018 to 25% in the coming years. Demand for Japanese cars in China is now returning to pre-Covid-19 levels.

China’s confidence

Given the highly targeted scope of the subsidy program, it should not be surprising that Chinese analysts are overall relatively relaxed regarding its impact on Chinese interests. Tao Tao, professor of international economics and trade at Peking University, anticipates that most Japanese companies will stay in China. The business model of Japanese companies in China increasingly targets domestic consumption inside China rather than export markets. The percentage of exports in the total sales of China-based Japanese companies has declined from 40.3% in 2013 to 36.6% in 2018, according to JETRO.

The percentage of exports in the total sales of China-based Japanese companies has declined from 40.3% in 2013 to 36.6% in 2018, according to JETRO.

Access to China’s domestic market is thus increasingly the main rationale for Japanese companies to stay or invest in China. China’s cost advantage diminishes - average manufacturing costs in China are currently 80.5% of what they would be in Japan. But there is a "business momentum" to rely more on the Chinese market according to Tao Tao: profitability gains depend on the capacity of these companies to increase their sales in China. As a result, he concludes, a period of restructuring of China-Japan business relations will continue until "the question of what kind of interdependence is optimal" reaches a rational balance.

Yao Yang, Dean of the National School of Development at Peking University, sees two reasons why the global supply chains will not easily be "de-Sinicized". First, global value chains reflect economic rationality. Each microeconomic decision by firms to organize the manufacturing of their products is based on a cost-advantage analysis of the division of labor, technical specialization and overall costs. The arrangement of supply chains is constantly improved and optimized. For example, China has long been mostly a location for assembling iPhone devices by Taiwanese giant Foxconn. Today, Chinese companies are involved in the manufacturing of key components. Moreover, rumors abound in the technology press that Apple will soon select China’s BOE Technology at the expense of Samsung and LG Display for manufacturing the OLED screens of the next generations of iPhones. The textile industry is moving from China to Southeast Asia, but Chinese exports of intermediate textile products to Southeast Asia have increased simultaneously. Yao Yang expects the Chinese industry to continue moving up the value chain. Second, he underlines the importance of Japan’s automotive industry for the stability of China-Japan business relations: the business interests of a Japanese spare part supplier to Toyota are likely to prevail over soft guidelines of the Japanese government if Toyota builds a car factory in China.

Gui Yongtao, Vice-Dean of the School of International Studies at Peking University, argues that unlike the Trump administration, the Abe government does not regard relations with China as zero-sum competition. The difference between the US and Japan is particularly important in trade. Japan is exposed to the "friendly artillery fire" (友军炮火) of American tariffs against China and fears US tariffs on cars as much as Germany, given that 76% of Japan’s trade surplus with the US is derived from the automotive sector. Gui Yongtao argues that Japan pursues a rather modest goal, that explains the trajectory of its bilateral and multilateral trade agreements in recent years: deny China the leadership of regional trade integration.

That the policy of resilience implemented by METI strictly targets healthcare equipment related to Covid-19 means that it comes at almost no political cost for China-Japan relations, but it also does not sum up the overall dynamic in China-Japan relations, which is characterized by deep distrust and security competition. Japan is not pursuing a strategy of decoupling from China, but decoupling could still happen in information and communication technology. The US crackdown on Huawei’s supply chain already affects many Japanese companies – Huawei’s procurement in Japan increased by 50% in 2019, reaching US$10,3 billion. The cost for Japan’s ICT suppliers would further increase if the US restrictions on exports of semiconductor products continued to expand beyond Huawei and its affiliates – a scenario that China takes seriously.

Resilience, not Decoupling: Critical Supply Chains in China-Japan Relations

By Mathieu Duchâtel

The seeds of resilience

China’s confidence

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