In Southern China’s Pearl River delta, Japanese manufacturers Kyocera Corp and Konica Minolta Holdings are building high-tech optical products. In plants stretching across China, Japan’s Matsushita Electric Industrial Co., the parent company of Panasonic, has 60,000 employees in 59 separate companies making everything from batteries to microwave ovens to semiconductors. And Toyota Motor Corp., Japan’s premiere industrial company, just announced it has selected China for the first overseas production of its hot-selling hybrid Prius.

Increasing production and investment in China’s booming economy are keys to Japan’s recent financial turnaround after 15 years of recession and sputtering recoveries that eventually died out.

Yet with centuries of suspicion and warfare between them, China and Japan approach their budding trade relationship with caution. Nationalist tensions lie close to the surface, particularly deep-rooted anger in China and throughout Asia about Japanese wartime atrocities. “China is a big part of why the Japanese are doing so well. That’s the big hope for Japan,” says Wharton finance professor Franklin Allen, who points out that trade with China could boost Japan’s GDP from an estimated 2% this year to between 3% and 4% over time. That might allow Japan enough breathing room to pay down some of its whopping national debt.

China is poised to play a big part in Japan’s future growth as a low-cost production center for outsourced manufacturing, but also as a market for Japanese goods, Allen adds. While the ancient tensions between the two should not be ignored, it’s also true that the potential for China and Japan to benefit from closer economic ties is huge.

Wharton management professor John Paul MacDuffie agrees. Japanese companies have been slower than other Asian nations to develop supply chains and production in China, but are now stepping up the pace, he says. “Japanese companies in the 1990s began to seriously develop business relationships and establish the foundation for expanding in Southeast Asia,” particularly in Thailand and, more recently, in Vietnam. “China has been a little bit complicated because of the history and some tension at the national level. The companies have been affected by those associations.”

Hyundai, the Korean auto manufacturer, has had greater success in China and India. The company is moving “at a tremendously rapid rate with the right product area at the right time. The fact is, there is less of that negative history,” suggests MacDuffie, who describes Toyota’s decision to build the Prius in China as ambitious. Demand for the car in China has not yet been proven and the assembly process has a higher degree of technical complexity than automakers typically bring to a developing country in the early stages of industrialization.

“But it is a sign of Toyota wanting to build a reputation that is in the here and now, independent of some of the negative history, and that could be seen as contributing to solving some of the environmental problems in China,” he says, adding that Japanese industrialists have found ways to keep their domestic manufacturing sector alive by focusing on the most innovative products and processes at home.

He outlines a Japanese theory that describes two major approaches to product architecture: modular and integral. An example of the modular approach to producing a personal computer would have each component designed and manufactured separately in plants around the world. “The integral approach is when all the individual pieces are designed together with [a high degree] of communication and simultaneous engineering.” He says Japan appears to excel at the more integrated approach, while the United States is more modular.

Following this theory, Japan should concentrate on products that benefit most from an integral approach, including automobiles. “Another example is video games,” says MacDuffie. “Unlike other kinds of software, the development of the story, the visuals and the music all have to be done in an integral fashion to end up with a game where everything works and the experience is also satisfying.”

According to MacDuffie, it is difficult for companies entering China to gauge how they should pitch their products. “At first, the firms that were successful were selling to the middle and upper classes, but Chinese demand has shifted, partly because of changes in credit and concerns about energy.” Japanese manufacturers may be able to build on their reputation for being energy conscious and environmentally sensitive as they try to appeal to Chinese consumers.

Missing the Gold Rush

Investment from Japan into China now totals $31.5 billion, and Japan is China’s second-largest trade partner, behind the United States. Total trade between China and Japan was valued at $86.5 billion in the first half of 2005, up 10% from the same period a year earlier, according to Chinese custom statistics. During the same period, U.S. trade with China was up 25% to $96.2 billion.

Japan is the largest importer into China, selling $46.3 billion to China in the first half of the year, an increase of 2.7% over the same period in 2004. South Korea is catching up, selling $35.5 billion to China, an increase of 21% over the same period a year earlier.

Despite China’s growing economic strength, Japan still has a surplus with China. In the first half of 2005, it received Chinese exports valued at $40.3 billion, an increase of 20.5% over the first half of 2004. The United States is the largest recipient of Chinese exports, with Hong Kong second.

Japanese manufacturers who have made inroads into China have done so mainly without the backing of Japanese banks and financial institutions, points out Jennifer Amyx, political science professor at the University of Pennsylvania and a member of The Graduate Group in International Studies at Wharton’s Lauder Institute. “Japanese financial institutions are not poised to take advantage of this gold rush into China,” she says.

Japanese banks and financial firms failed to enter China because they were weighed down by their own non-performing loans, but also because of the way they have historically conducted business, Amyx notes. Japanese banks view their role as supporting Japanese firms and do not see China as a retail opportunity for themselves. “They were not willing to take the risk needed to buy out Chinese banks and have equity participation in local financial institutions, which is what other foreign banks are doing.” As a result, Japanese banks lack networks in China to offer their Japanese customers assistance in doing business there. Furthermore, Japanese banks have not kept up with information technology and cannot offer their clients the same kind of services, such as cash management, as other international banks.

“They are just not competitive,” she says. “Now you have Hitachi and other major corporations that just use Japanese banks domestically. It is not the image of the past, when the Japanese firms advanced with their financial institutions in tow.”

Street Riots in China

While economic ties deepen, political tensions remain high. This spring, street riots broke out throughout China as workers protested against Japan, enraged by Japan’s adoption of school textbooks that dismissed Japanese wartime atrocities, including the 1937 massacres in Nanjing, as “incidents.”

In October, Japanese Prime Minister Junichiro Koizumi further infuriated Chinese officials when he insisted on making his controversial annual visit to the Yasukuni Shrine in Central Tokyo. The shrine is a memorial to the 2.5 million Japanese who died in foreign and civil wars since 1853. The honored dead include 14 convicted war criminals who were tried and executed after World War II. In 1978, their names were added to the shrine’s roster. In previous years, Koizumi’s visits to Yasukuni Shrine have prompted massive street protests in China and South Korea.

Following Koizumi’s landslide reelection in September, Robert Alan Feldman, a Morgan Stanley analyst in Tokyo, wrote: “One area that has worried both voters and investors is Japan’s relationship with China. Given Koizumi’s insistence on visiting Yasukuni Shrine, China-Japan political relations are not likely to improve soon. However, China will no doubt see the strong victory in this election as a sign that Koizumi must be treated with caution. China and Japan need each other and excessive disputes about history could damage both economies.”

Following the anti-Japanese riots in China last spring, the Japan External Trade Organization (JETRO) conducted a survey to measure the effect of the protests on the business plans of Japanese firms operating in China. Roughly a third expected the disturbances would negatively impact their business within the year. Comparing the results of the May survey to those obtained in a November-December 2004 survey, the percentage of companies planning to expand operations in China dropped nearly 32 points, to 54.8%.

As a result of the simmering hostilities, Amyx says Japanese firms are adopting what is called a “China-plus” strategy in which they will invest in China, but in other Asian nations, too. That approach will protect them in case relations between China and Japan worsen. “Japanese firms clearly are not putting all their eggs in one basket,” says Amyx, who is currently a Council on Foreign Relations International Affairs fellow in Tokyo. She recently spoke to a Japanese manufacturer who plans to move into China as his business expands but will continue to maintain his current operations in Malaysia. “There is still a lot of risk in the China market.” 

Idea Generation by the Billion

The new global focus on China has quieted U.S. complaints about Japan’s exchange-rate policy, according to MacDuffie, who says U.S. officials are now more concerned about the Chinese currency. While the Japanese exchange rate was a major worry during the Clinton administration, the long economic slump in Japan makes it difficult to complain. “It’s now a lot harder to [make the case] that Japan, Inc. is an unfair competitor,” he says, “both because nobody sees the Japanese economy as powerful the way they used to, and because the Japanese companies that are multinationals have done so much foreign direct investment in the United States that they [feel] they are local.”

Adrian Tschoegl, adjunct professor of management at Wharton, points to an economic theory known as the “gravity model of trade” when he discusses the changing pattern of trade between China and Japan. The theory states that the volume of trade between countries can be forecast based on national incomes and distance between the countries. The traditional patterns have been out of synch in Asia for 50 years, he says. “Now you are seeing a rearrangement of trading patterns in ways that are logical, that would have been in place had World War II, the Depression and Communism not gotten in the way. That’s probably a good thing overall.”

He goes on to suggest that the most important factor in the trade equation over time is China’s position as the most populous nation on earth, with 1.2 billion citizens. “In the long run, the number of good commercial ideas is proportional to the people you have. Pretty soon, in the next two generations, most of the good ideas will come out of China and India.”

As China and other developing countries grow richer and begin to develop better educational systems, they will generate an increasing share of successful ideas that can take hold. “Developed countries like Japan and the United States have benefited by being the only place to have good ideas. They have had enough people with the income, education and training to generate more ideas per capita than India or China currently do,” says Tschoegl. “In the long run that will change. India and China will be the countries where the ideas come from. That, ultimately, is what makes national wealth.”