-Analysis-

BEIJING - The “Made in China” export label is by now an integral part of the entire Chinese economy. With Japan as its fourth-largest trading partner, Bejing is starting to ask what weight the ongoing China-Japan islands dispute will have on the Chinese economy.

China's Ministry of Commerce reports that direct investment by Japanese companies in China this year totaled $460 million, a nearly one-third drop from last year. Japan’s total direct investment in China was knocked down from an annual growth rate of 17% in the first nine months of 2012 to 11%.

Moreover, the dispute over the Diaoyu Islands (or Senkaku in Japanese) has triggered a series of consumer reactions and dragged down the performance of major Japanese brands on the Chinese market. According to the China Association of Automobile Manufacturers, Japanese automobile sales in September were down 41% from last year, while their market share in China decreased by 6%. The market share of Japanese home appliance brands such as Sony, Panasonic, Toshiba and Sanyo have also declined.

China’s economy is currently stabilized at the bottom of the cycle and is in a critical period of structural adjustment. Although China’s dependence on foreign trade has decreased in recent years, it still accounts for more than 50% of its economy, and remains an important factor for economic growth.

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.

The possible degree of substitution in China’s domestic market is very low or non-existent. Once a supply shortage appears, the negative impact on the relevant industries’ production is tremendous.

The decreased sales of Japanese goods in China will have two impacts.

Firstly, it provides an opportunity for European, American and even Chinese brands. In September, for instance, American, French and Korean car manufacturers increased their Chinese market shares from 0.47% to 0.62%. Meanwhile, the Chinese Great Wall Hover H6 has squeezed out the Japanese Honda CR-V, which has long been the champion of sales, with more than 15,000 cars sold.

In addition to the gradual desertion of Japanese products, the China-Japan dispute will accelerate the rise of domestic brands and the shrinking of the Japanese commodity market share in China.

The damage to Japanese brands will also have a negative impact on China's economy and society. For instance, in 2011 Toyota had about 500 dealerships and over 30,000 employees in China. The Diaoyu Islands standoff has hit Toyota’s sales in China hard, and forced it to make adjustments to its development strategies and objectives in the Chinese market. This will impact local joint ventures, dealerships, employment, but also Chinese fiscal revenue.

In the aftermath of the 2011 earthquake and tsunami, the energy shortage and the appreciation of the yen, Japan has accelerated the pace of outsourcing, especially in the manufacturing sector. From an industrial point of view, as China's comparative advantage has changed, the focus of Japanese investment has shifted toward Southeast Asia.

In 2011, Japanese investment in the ASEAN (Association Of South East Asian Nations) reached 1.5 trillion yen ($18.3 billion), up 2.4 times from 2010. From January to August of this year, Japan's foreign investment grew by 45%, while the growth rate of its investment in China was only 16%.

In this context, the fear of political escalation risks becoming an "accelerator" for the withdrawal of Japanese companies from China, prompting Japan to speed up its industrial expansion in Southeast Asia.

Last month, Japan announced that it would be importing rare earth elements (REEs) from India in order to get rid of its long-term REEs dependence on China. China accounts for around 90% of the world’s global REEs output. Meanwhile, Japan is also looking for ways to limit its industrial dependence on REEs, an important component in certain manufacturing sectors. Panasonic, for instance, has developed a technology of recycling neodymium from used home appliances. Honda is extracting REEs from batteries used in hybrid vehicles.

Developing cross-border transactions

Japan’s investment transfer will certainly not help the Chinese economy. What’s worse, China has lost an opportunity to optimize and upgrade its industrial structure through Japanese industrial transfer.

In December 2011, China and Japan signed a financial cooperation agreement, focusing on promoting the use of the yuan and the yen in cross-border transactions; developing markets for direct exchange of the two currencies and encouraging the private sector to develop yuan and yen dominated financial products and services in overseas markets.

But since the escalation of the islands dispute, the pace of financial cooperation has slowed down and high-level exchanges have suffered a setback. The annual meeting of the International Monetary Fund (IMF) and the World Bank was held in Tokyo last month, but China's finance minister, central bank governor and the four major banks were a no-show.

China and Japan had agreed to buy each other’s sovereign debt, but this has been put on hold, while the stability of the yuan and the yen’s exchange rate has been impacted as well. Since September, due to the debt crisis in Japan, Chinese investors have been getting rid of their yen and Japanese government bonds.

Japan is the first G7 country to have made the yuan a reserve currency. Once the yuan becomes Japan's reserve currency, it will be a huge step in the internationalization of China’s currency and toward the emergence of the yuan as a new global reserve currency. However, the slowdown of bilateral financial cooperation in the second half of this year has affected expected progress.

China is still highly dependent on foreign trade. In this period of weak market demand from Europe and the U.S., its economic recovery will be adversely affected by the islands dispute. The boycott of Japanese goods will create a negative impact on Japanese-Chinese joint ventures, on the employment of Chinese workers and on local governments’ fiscal revenue. Japanese companies will leave China for Southeast Asia. All of this will have a disastrous impact on China’s much needed industrial upgrade and structural adjustement.