Roughly speaking, the world could be divided into three economical zones: the European Union with 23.2% of global GDP, the US (22%) and the uneasy couple, China and Japan (20%, respectively 11.5% and 8.4%). After the Great Financial Crisis, the world turned to Asia to pick up the global economy, and China did indeed take the helm by spending its way through the crisis. However, with a crisis in the Eurozone sovereign debt crisis and a sluggish American economy, Asia has troubles to expand its exportation abroad especially China. Moreover, Japan seems to leap from crisis to crisis. The recent economic policies, dubbed Abenomics, only show how desperate the government is. At the same time, China is slowing down much faster than anticipated (a continuous coverage of the analysts' consensus shows a dramatic downsize of expectations in only 6 months time).
On top of this already shaky background, the world has been witnessing rising tensions between 2 of the 3 largest individual economies, China and Japan. A disputes about the ownership of strategically located islands between the 2 countries has sparked incredible political tensions and stirred the old ghosts of the past. In this article, we will look from an economical point of view what would be the impact of worsening relations between these countries.
Japan – China economical ties
Despite multiple political clashes, bilateral trade between China and Japan has steadily grown over the past 40 years: in 2012, Japan represented 7% of Chinese exportations while China accounted for 30% of Japanese exportations. The total value of their bilateral trade is worth $340 billion a year.
As we can see, Japanese investments were pretty constant during this period. After having reached a low point in 2007, it increased back to the early 2000's level. We can also see the impact of political frictions, in 2006, 2010 and 2012. At the same time, exports from Japan to China have steadily increased as demand from US and Europe dried up (left chart below).
On the other hand,as we can see on the right chart, Japanese imports from China barely changed in the last 5 years.
But this does not take into account the complex trade relationships in Asia. In the last 10 years, China has been a regional powerhouse, dragging in its wake many of the local economies in a variety of sectors. Quite a lot of countries are heavily exposed to China and the cross-relationships suggest that the risks are more systemic than idiosyncratic (meaning that Asian countries are more likely to experience economic boom and busts together rather than individually). You will find below the exports of Asian countries to China.
As the table shows, Japan's exports only represent 2.4% of its GDP, yet account for 18% of its total exports. However, this does not take into account the individual sectors exposed to China. Below is a table detailing the exports and imports of major sectors traded by Japan. As the table shows, iron, steel, and semiconductors are quite directly exposed to China. And once again, this does not account for potential ripple effects across the region.
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Once again, as the chart above shows, China is a key partner for Japan especially regarding iron & steel and semiconductors. On the other hand, Japan relies massively on China for clothes and relies significantly on China for non-ferrous metals. Non-ferrous exports to Japan including the following metals:
- aluminium (cars, aircraft, railway, windows, doors, buildings…);
- copper (electrical wires, roofing and plumbing, industrial machinery);
- nickel (stainless steel, magnets, coinage, rechargeable batteries);
- zinc (Galvanization, which is the coating of iron or steel to protect the metals against corrosion);
- and more…
Impact of territorial dispute for China and Japan
In the table below are the summarized the implication of bilateral trade between China and Japan as well as long term opportunities and threats for both country.
Click to enlarge
Source: CTDToday Research Unit
Which Japanese companies are the most exposed to China?
First of all, there is no doubt that China is drastically slowing down. Chinese GDP is officially 7.5% but the numbers are quite heavily manipulated. As a result, some analysts estimate that true GDP is only about 4%. China's overstated GDP is due to a number of reasons including: wrong incentives for local governments to report numbers, central government's desire to please foreign investors, non reporting of true costs of capital (including subsidies, externalities (non-accountable parameters like pollution, education and other), waste on a historical record scale, and an unsustainable rise in debt-servicing costs compared to debt created value.
On top of it, the worldwide slowdown impacts Chinese exportation. Given the unemployment and ultimately political pressures to change this unsustainable system (which includes an unprecedented rise in debt coupled with a once-in-a-thousand-years housing bubble), the new leadership is trying to reform the current economic model.
There are only two 'exits' of the current development: either the government decides to really engage reforms and in this case growth will be very low for the next few years. This is an arithmetical necessity: investments account for anywhere between 40 and 50% of GDP and are rising at 20% a year. This means that if in year 1, China builds 100 buildings, it must build a 120 new ones the next year. Thus, any decrease in the rate of investment growth would instantly have a direct and significant impact on total GDP.
The second case is that the current leadership will not have enough political power to reverse the imbalances and will keep growth strong in the short term, postponing and compounding the problems. As a result, in any case, we think that several Japanese companies could experience great difficulties in the coming months/years, and thus could be an efficient way to bet on a Chinese slowdown.
You should of course not rely on this article to invest but instead use it as a starting point and do your own research afterwards. Another factor to consider is that despite some macroeconomic observations, the impact of the monetary policies conducted by central banks (including the Federal Reserve) should also be carefully analysed. Indeed it can have a greater impact on stock prices than the underlying fundamentals of the company itself. What follows is a brief overview of key Japanese sectors exposed to China.
Japanese automotive industry
Japanese auto makers have suffered from territorial dispute. The automotive industry is one of the Japanese economy’s core industrial sector. In 2010, automotive shipments accounted for 16.4% of the total value of Japan’s manufacturing shipments, and 36.6% of the value of the machinery industries’ combined shipments. Automotive shipments (both domestic and exports shipments, including motorcycles, auto parts, etc) in value terms totalled 47.3 trillion yen in 2010, up 16.8% from the previous year.
Source: Financial Times and 2012 annual reports
These figures are based on estimations. Despite the fact the lack of stated revenues for car sales in China, the data above clearly show a significant impact of territorial dispute on Japanese cars sales in China. All major Japanese auto makers sold less cars in 2012 compared to 2011. These companies are significantly exposed to China, with anywhere between 1/5 to 1/4 of their sales realized in China. The double pressure of geopolitical tensions as well as a slowdown of Chinese economy could severely damaged Japanese auto makers profit in the long term.
According to Kochi Sugimoto interviewed by The Financial Times:
“In the short term, the carmakers don’t care much about profitability,” said Kochi Sugimoto, an analyst at BNP Paribas in Tokyo. “More important is that sales patterns go back to normal.”
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According to Worldcrunch,
''China’s electronic and automotive industries are bearing the immediate brunt, with an overall drop of economic growth forecast for the fourth quarter of this year. Among imported commodities from Japan, the four major categories: machinery and electronic products, transport equipment, base metals and chemical products, account for over 70%. They are mostly located on the upper reaches of the industrial supply chain and are the critical core components and parts for China’s electronic and automobile sectors.''
Japanese electronics manufacturers were strong during the mid 2000’s but they have lost to Korean and Taiwanese competitors due to high prices. Minor metals like indium, germanium and cobalt are used extensively in electronics.
Pure player: a single business focus
Conglomerate: A corporation that is made up of a number of different, seemingly unrelated businesses
Obviously this chart alone is not enough to evaluate Japanese high-tech strengths, but at least it gives an indication of some of the players' performances. Canon, Hitachi, Fujifilm are well positioned in terms of EBITDA Margin and revenue growth.
Here again, even though figures are based on estimations, they give a rough idea of the general trend: 2012 has seen high-tech Japanese companies suffer from a Chinese slowdown.
Metals & Cement
Nippon Steel & Sumitomo Metal merged in October 2012. They are the second largest steel group in the world. The fusion has notably been set up to face tough competition with Chinese and South Korean companies. The Japanese group is well positioned on high-end steel but is lagging for medium due to lower production cost of competitors. The Yen depreciation also helps a lot the company.
Taiheiyo Cement Corp is the biggest Japanese cement company and has interests in The Ssangyong Cement Industrial Co., Ltd of South Korea and Grand Cement Manufacturing Corporation in the Philippines. As of April 2012, the industry’s production scale spanned 30 plants owned by 17 companies, supporting clinker production capacity of 54.76 million tons. At present, there are large-scale plants with annual clinker production capacity of over 6 million tons. Furthermore, around clinker production capacity per plant stands at approximately 1.8 million tons. These plants continue to advance mechanization and computerization.
Construction machinery makers Komatsu Ltd and Hitachi Construction Machinery Co Ltd have considerable exposure to China. These companies have benefited from the real estate boom in China but this boon seems to be compromised with the new leadership decision to cool the housing market and Chinese growth slowing down more than previously expected (which, as we saw previously, have a direct causality link). Moreover, credit and investment tend to slowdown as the the monetary policy is kept tight. Overall, these factors contribute to a strong slowdown which will last for a while.
Komatsu: In 2012, China accounted for about 7% in terms of sales in of the strategic market, namely Middle East, Asia, Africa, Oceania, China, Latin America, against 20% in 2010 and 11% in 2011. These markets represents 63% of sales compared to 37% for traditional market (Japan, North America, Europe) in 2011.
According to Komatsu annual report:
"With repect to China, demand has remained sluggish since May 2011, as affected by the Chinese government 's credit squeeze measure, and we haven't seen any clear signs of firm recovery. Although there are signs of credit easing, such as decreasing the cash reserve and interest rates, they are not resulting in an increase of new construction projects. In this light, we are projecting annual demand to decline by 20% to 30% from FY2011.
With respect to Asia, we are anticipating that demand for medium-sized and mining equipment for use in coal mines will slow down in Indonesia, the largest Southeast Asian market, as adversely affected by falling prices of thermal coal. Accordingly, we are projecting a decline in demand from FY 2011."
Komatsu is significantly exposed to China & Mining sector. Moreover, Komatsu Machinery has expanded production in Changzhou and Shandong.
Hitachi: According to the annual report 2012 (our emphasis):
''In the fiscal year under review, the company's performance was affected by the Chinese government's moves to tighten monetary conditions, which placed downward pressure on hydraulic excavator sales. This was more than offset, however, by reconstruction demand in Japan, and an increase of infrastructure development projects in emerging countries in Southeast Asia as well as solid mining machinery trends in such resource producing countries as Indonesia and Australia. As a result, sales increased compared with the previous year. On the earnings front, profit climbed sharply year over year. Despite the impact of the strong yen, the surge in earnings is largely attributable to the upswing in sales, boost in sales prices and successful efforts to curtail costs.''
Monetary conditions remain tight in China. Hitachi revenue can still be affected in the future. However, the company is very diversified so it a Chinese slowdown may be mitigated.
Territorial disputes between China and Japan have a significant impact for both economies. This brief article summarized how Japan is exposed to China and gives some indications about to which extend a Chinese hard landing could impact some Japanese sectors. Yet, the ultra-accommodative Japanese monetary policy is able to partially offset these risks but the latest figures on China show signs of heavy stresses.
The Chinese slowdown is not cyclical but structural. As a result, it will take time to put in place all reforms and it won't be achieved without pain. However, Chinese Premier Li said7.0% is bottom line growth in 2013. There is a risk or an opportunity (according to the point of view) that China will revert to its previous policies when growth slowed too much for the central government: more infrastructure spending. China may expand its current high speed train lines, a sector that is already under massive amounts of debt. If so, commodities players will without a doubt benefit from it. As a result, investors should remain in high alert and flexible in their trading strategies.
This article was written by Maverick, with additional participation from Carlito.
About Steve Nguyen
Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.