Japan and China: What’s the Best Way Forward?

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Sometimes, the best strategy is to just leave things as they are, when the alternative is only to make things worse. Signs that tensions between Japan and China may be easing have raised hopes for a long-delayed summit meeting of Japanese Prime Minister Shinzo Abe and Chinese President Xi Jinping during annual APEC (Asia-Pacific Economic Cooperation) summit in Beijing in November. That the two have not met so far has troubled both sides, given the major role both countries play in regional affairs.

A meeting between Abe and Xi on the sidelines of the Pacific rim meeting would be a step toward normalizing relations disrupted by the longstanding dispute over islands in the East China Sea that are claimed by both countries. But analysts say a meeting will not lead to a significant easing of friction unless the two sides can find a mutually acceptable compromise. 

How crucial is it to each side that relations improve? Tensions flared into anti-Japanese riots across China in September 2012 after Japan nationalized the disputed islands, known as the Senkakus in Japan and the Diaoyu islands in China. China has sent ships and aircraft to patrol seas near the islands, drawing indignant responses from Japan. While both sides have refrained from exchanging fire, there have some been some close calls, with military aircraft from the two countries passing just 30 meters away from each other over the East China Sea earlier this year.

Many nations, including the U.S., expressed consternation after China declared it had set up an Air Defense Identification Zone covering the East China Sea, requiring aircraft from other countries to identify themselves. “It is clear that the relationship is under a lot of strain at the moment, and that is likely to continue because [of] political problems within China and the anti-corruption campaign,” says Franklin Allen, a Wharton finance professor. “On top of that, you have the island dispute.”

Accelerated Decline

All the antagonism has accelerated a decline in Japanese foreign direct investment (FDI) into China, which fell 48.8% in the first six months of 2014 from the same period a year earlier to $2.4 billion after declining by 32.5% to $9.1 billion in 2013. But in the longer term, the decrease in Japanese new investment in China has less to do with territorial tensions and more to do with the trends in both the Chinese and Japanese economies.

Japanese companies are finding China a less attractive manufacturing base due to rising wages and other costs. They instead have been shifting new spending into Southeast Asia.

China remains an important economic and trade partner for Japan, as its biggest market and the manufacturing base with the best infrastructure. Since the Chinese mainland has ample capital of its own, it no longer needs as much new investment as before for its over-built manufacturing sector. Japanese companies, meanwhile, are finding China a less attractive manufacturing base due to rising wages and other costs. They instead have been shifting spending into Southeast Asia to tap new, fast-growing pockets of affluence, even though the 10 economies that make up ASEAN are much smaller markets with weaker infrastructure. 

Most experts agree that the sooner Japan and China resolve their differences the better. “The political relationship between the two is the worst ever at the moment, and it is worse than anyone had expected it to be,” says Satoshi Amako, professor at the Graduate School of Asia Pacific Studies at Waseda University and director of the Waseda Institute of Contemporary China Studies.

Still, there are some signs of improvement. China and Japan resumed high level talks on maritime issues in the eastern Chinese city of Qingdao at the end of September. The meeting was the first such bilateral exchange since May 2012. That meeting raised hopes for an easing in the territorial tensions and for an eventual meeting between Abe and Xi. But it ended merely with the foreign ministries of the two countries saying in separate statements that the officials exchanged views on the East China Sea without elaborating further.

At the same time, Japan sent a delegation of more than 200 Japanese business leaders to Beijing at the end of September, where they met with Chinese vice premier Wang Yang. Wang told the Japanese group he seeks an early resumption of high level economic dialogues. “Xi Jinping has strengthened his leadership after the anti-corruption campaign, and he will be able to carry out his plan in a freer manner,” notes Amako. Xi’s top officials — Premier Li Keqiang, vice president Li Yuanchao and vice premier Wang Yang — are making statements on Japan and China, and have been meeting with Japanese economic delegations and officials. “Even the officials in the top leadership would like to make the Japan and China economic relationship normal soon,” Amako says. “China needs help from Japan to revitalize its regional economies and help alleviate worsening environmental problems.”

As for Japan, business leaders and officials of the Japan External Trade Organization (JETRO) have repeatedly emphasized their eagerness to see ties improve. And Abe recently reiterated that he hopes to hold a summit with Xi at the APEC meeting. “It is important for both countries to make quite an effort to improve the bilateral relations,” Abe said recently.

Such a meeting would be mostly symbolic, says Toshiya Tsugami, a China expert and managing director of the Tsugami Workshop consulting company in Japan. It would not guarantee a solution to the longstanding troubles between Asia’s first and second-largest economies. “The summit meeting would not clear all the clouds and make the sun shine,” Tsugami notes. “It is hard to say if the relationship would improve or not.”

Veering Off the Silk Road

In the meantime, Japanese companies are trying to make up for lost time by expanding investments in ASEAN countries, especially Indonesia and Myanmar. Japanese FDI into ASEAN grew by 121.3% from a year earlier to $23.61 billion in 2013, according to JETRO figures. Japan’s trade with ASEAN was up 4.9% in 2012 from the same period a year earlier, but dropped 11.2% in 2013.

Thatcompares with a 3.3% decrease in total trade between Japan and China in 2012 and a 6.3% drop in in 2013, according to JETRO. Total trade between the two in the first six months of this year rose by 4.4% over the same period a year ago. “We expect total exports to grow slightly this year for the first time in three years, but they are unlikely to reach the level [they were at] before the territorial dispute expanded in 2013,” says Dai Hakozaki, director of JETRO’s China and North Asia Division. 

An annual survey of more than 990 Japanese companies about FDI by the Japan Bank for International Cooperation shows China was considered the most promising investment destination for Japanese companies in the past, but dropped to fourth in 2013. Indonesia was considered the ranking FDI destination over the next three years, followed by India and Thailand.

“The political relationship between [China and Japan] is the worst ever at the moment, and it is worse than anyone had expected it to be.” –Satoshi Amako

In the 2012 survey, China at was the top and India was second, followed by Indonesia and Thailand. “The main reason why China dropped to No. 4 for the first time in over 20 years from No.1 is not the worsening bilateral situation, but rising costs and intensifying competition in China’s domestic market,” says Tsugami, who also is a former senior official of the Ministry of Economy, Trade and Industry. “There is also more concern about China’s growth as the economy is slowing down.” 

The second- and third-biggest reasons cited by those surveyed were growing competition with other companies and Japan’s own slowing economy. Political risk was ranked fourth. JETRO’s Hakozaki points out that there is some improvement in attitudes toward China’s business prospects, judging from a JETRO survey of more than 4,500 Japanese companies in China and Oceania. In the 2013 survey, the number of Japanese companies in China that planned to expand their China operations over the coming one to two years rose to 54.2% from 52.3% in 2012. The companies that would like to reduce their operations or withdraw in the next one to two years declined to 39.5% in 2013 from 42% in 2012. 

Some regional experts say that Japan’s shift in investment from China to ASEAN and India will accelerate due to China’s rising labor costs. “Japan has two drivers. One is geopolitical risk with China, the reaction of China we saw in 2012,” says Rajiv Biswas, Asia Pacific chief economist at IHS in Singapore. “The second is rising wage costs in China. Both are good strategic reasons why Japanese companies are moving away from China and looking to invest in other places. ASEAN is the biggest attraction, and India as well.” 

He adds that “Japanese multinationals are expected to continue their pivot toward ASEAN, which will result in sustained FDI flow from Japan to ASEAN. The ASEAN region offers considerable opportunities for Japanese firms, not only as a manufacturing hub, but also because of their large populations and the fast-growing middle class in some of ASEAN’s largest economies, including Indonesia, the Philippines and Vietnam.”

‘China Plus One’

Still, it will take time for ASEAN to develop the logistics and other supporting industries and infrastructure now found in China. For now, China will remain a major base for Japanese industry. “The total stock of Japanese investment in China is much bigger than in ASEAN,” says Tsugami. And while Japan may be shifting the direction of its investment to favor ASEAN overall, “this trend does not mean that Japan has shifted its total investment to ASEAN….” 

Notes Mariko Watanabe, a professor of economics and China expert at Tokyo’s Gakushuin University, “If you look at the auto industry in Guangzhou, there are not only Japanese major car companies with production bases, but also U.S. and European automakers. [There is] strong support industries for automakers and auto part makers there. But if you look at Thailand, there are only Japanese carmakers. China has a very dynamic market.”

“I am pessimistic about China-Japan relations in the medium to short term…. Japanese investment into China will continue, but will not grow as it had done in the past.”–Franklin Allen

Instead of fleeing China, Japanese companies are hedging their bets with a “China Plus One” strategy, says Amako. “No one can deny China is a big market, and China is one of the main pillars of the Japanese economy. But now Japanese companies think they need to have an alternative base apart from China since the Japanese economy would be devastated if there were no trade and economic relations with China.”

Biswas believes that in the long run, China will become even more important to Japan. “But in the near term, we have seen the shift toward ASEAN and South Asia, which will play out in the next few years. Investment flows to China probably will increase again, but this also will depend on the political situation. Nothing is sure about the political mood in China. So it depends on how the geopolitical situation develops.”

Most experts say a war between Japan and China is unlikely, but accidents can happen. “It is very hard for either side to give in on the island issue, and the longer it goes on, the more chances something is going to happen,” Allen says. “Someone is going to make a mistake, or they may have something like a plane crash.”

Noriyoshi Ehara agrees. He is the chief economist at the nonprofit foundation, Institute for International Trade and Investment. “We do worry about potential accidents or mistakes beyond our control.” So, the two sides remain trapped for now in a potentially very volatile situation. Each side is aware it needs the other. “But even if the top leaders meet, it will be difficult to solve the island issue because both countries have their own views on the islands.”

The most workable option for now would be a tacit agreement not to address the island issue, Amako said. “The Chinese side could take this as suspending the issue, while the Japanese side can interpret it as keeping its stance on the issue,” he says, referring to Japan’s position that there is no dispute because the islands are controlled by Japan. “China will not take action to take over the islands due to the high risk of intervention by the U.S., Japan’s top ally.”

Without some form of mutual accommodation for the sake of better relations, Japan may continue to shift more to ASEAN, which would hurt both the Japanese and Chinese economies, says Allen. “I am pessimistic about China-Japan relations in the medium to short term.  Twitter The current situation is more likely to continue in the next five to 10 years, and Japanese investment into China will continue, but will not grow as it had done in the past. Japanese firms will diversify into ASEAN and India much more in the next five to 10 years.”

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