Japan looks to diversify supply chains out of China

Japan wants to reduce its manufacturing dependence on China, and bring its firms home and diversify its supply chains, but the deep integration of their supply chains makes it an arduous task
Associate Faculty at University of London – SIM-Global
Research Scholar at Jawaharlal Nehru University

Japan wants to reduce its manufacturing dependence on China, and bring its firms home and diversify its supply chains, but the deep integration of their supply chains makes it an arduous task

Until the close of 2019, Japan was keen on improving ties with China. After all, China has been Japan’s largest trading partner in recent years and the largest source of inbound travellers, accounting for 30% of all tourists into the country in 2019.

But in the past six months, Japan has taken a more aggressive diplomatic stance towards China – most recently taking the lead with G7 against Hong Kong’s new security law.

Japan, a close ally of the US, increasingly finds China’s moves more expansionist, and China’s territorial disputes on its land borders with India, and in the South China Sea with Southeast Asian nations, strengthen that view. Japan and China are themselves embroiled in a dispute over the Senkaku islands. Most recently, in May 2020, Japan condemned and protested against Chinese action after two China Coast Guard cutters chased a Japanese fishing boat operating in Japanese territorial waters near the Senkaku islands.

Post-COVID realities

As the coronavirus spread, Prime Minister Shinzo Abe announced an economic stimulus package worth JPY108.2 trillion ($1.1 trillion) in April, or equivalent to 20% of Japan’s GDP. Interestingly, of this record stimulus, JPY243.5 billion was earmarked to help Japanese manufacturers shift production out of China. Of this, JPY220 billion was for companies shifting production back to Japan, and the remaining for companies shifting production to other countries, particularly in Southeast Asia.

While this sum is meagre considering that Japan-China bilateral trade was almost worth $304 billion in 2019, this is still a particularly significant move that indicates Japan’s desire to reduce its dependence on China.

China is Japan’s largest trading partner, but imports from China fell substantially as factories shut down in China due to COVID-19. This meant Japanese manufacturers were hit as Japan’s supply chains are closely linked to China’s.

Figure 1: China remains Japan’s largest trading partner, both for exports and imports

Note: Does not include trade in services
Source: IMF DOTS (accessed 12 July 2020); Plot by Dharish David

But Abe’s move does not point to the desire of decoupling – rather, it is a move to adjust to risk perceptions in the near future and to relocate production bases to Japan and other countries to stop relying on a single country for production facilities.

Easier said than done

Not all Japanese companies are ready to withdraw from China so soon, however. Japan is heavily invested in China, with its companies serving the large Chinese domestic market, and with large supply chains located in the country. This makes Japanese corporations weary about moving out.

As a result, this shift will only be gradual at most, unless the manufacturing activity is related to sensitive technologies or strategic interests. For instance, Toyota has no plans to change its strategy and shift production out of China as its dependence on its current supply chains makes it impossible to switch so soon. Bilateral China-Japan data suggests that export and imports are deeply integrated, especially for high tech goods (Figure 2).

Figure 2: Japan’s three largest product imports and exports from China (2019)

Note: Product terminologies simplified for ease of understanding
Source: UN Comtrade 2020 (accessed 12 July 2020)

In addition to its imports from China, Japan also exports a larger share of partially finished goods to China than it does to other industrial nations. In fact, China and Hong Kong together account for almost a quarter of Japan’s total trade. Therefore, it is not going to be easy for Japan to decouple from China to promote diversification and localisation of its global output bases as this would end up impairing companies’ cost advantages.

The financial support provided by the government is intended to encourage Japanese manufacturers to strike a production balance between reshoring to Japan and expanding further in countries in the ASEAN region and beyond.

Not all Japanese companies are ready to withdraw from China so soon. Japan is heavily invested in China, with its companies serving the large Chinese domestic market, and with large supply chains located in the country.

Japan may adopt a similar strategy as it did in 2011 with Thailand+1 following the disruptions to supply chains in Thailand due to the floods there As a result of this pandemic, and with the Japanese government’s support, there could be a gradual shift of companies to ASEAN, and possibly other markets like India.

Diversification of supply chains, the shortening of production networks and reshoring from China are conceivable for Japanese companies in the long run. This is because COVID-19 has, once again, exposed the fragility of supply chains that are heavily reliant on one economy – China in this case.

The pandemic has also weakened trust in China’s governance. Other problems such as reduced exports, public discontent and almost half a million businesses shutting down will create more risk for all businesses. In addition, deteriorating Sino-US relations may further motivate Japan to implement this plan. Although Japan has tried to work more closely with China’s Belt and Road Initiative under Abe, the COVID-19 outbreak cancelled Xi’s visit to Japan and left Abe with no choice but to step back from China’s embrace.

Japan’s options

With its main security ally, the US, also raising the rhetoric around asking its companies to move production out of China, the US and Japan will get an opportunity to strategically partner and advance their Free and Open Indo-Pacific initiative. The Japanese government prioritises economic security, and diversifying supply chains out of China will help bring investment and trade to the Indo-Pacific developing country partners.

Given that China has a less open economy than other G20 nations, it may be more beneficial for Japan to join the US and its allies in the larger technological decoupling with China. This could mean keeping a tab on and imposing tougher export licensing requirements for specific emerging technologies if they are sold to China. With Japan exporting more high-tech products to China than vice-versa, it will be crucial for Japan to maintain its competitive advantage in areas like robotics, transportation equipment, high-end electronics manufacturing and to invest more in R&D with like-minded countries.

The Japanese government prioritises economic security, and diversifying supply chains out of China will help bring investment and trade to the Indo-Pacific developing country partners.

The Japanese government prioritises economic security, and diversifying supply chains out of China will help bring investment and trade to the Indo-Pacific developing country partners.

The political environment is suitable for the Abe government to consider such supply chain shifts, especially if the US-China trade and technological war escalates further. Japanese firms that are reliant on Chinese supply chains might find themselves facing higher tariffs to bear with US economic sanctions.

While this shift will not happen overnight, it marks a change in Japan’s economic imperatives. In many ways, this could be another chapter in the theme of a post-COVID economic decoupling from China that has gained currency in recent months.

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Associate Faculty at University of London – SIM-Global

Dharish David (PhD) is an associate faculty member for the University of London at the Singapore Institute of Management – Global Education (SIM-GE), teaching courses relating to political economy. He writes extensively on infrastructure development, Asian political economy, economic development and international relations.

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Research Scholar at Jawaharlal Nehru University

Simran Walia is a Research Scholar, currently pursuing M.Phil in Japanese Studies under the Centre for East Asian Studies from Jawaharlal Nehru University. Prior to this, she worked as a Research Assistant at the Observer Research Foundation in India.

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