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Economists' Pick > Research Articles > Research ArticlesSino-Japan tensions and why the economics matter toHong KongChina-Japan relations strained by escalating Diaoyu Islands disputeThe 40th anniversary of the normalisation of Sino-Japan relations was overshadowed bythe escalating tensions due to the territorial dispute over the Diaoyu Islands. Central tothe flare-up between China and Japan was a move around mid September 2012 by the Japanese Government to buy some of the disputed Diaoyu Islands, subsequent to thereported negotiations by the Tokyo Metropolitan Government with the so-called owner ofthe concerned islands.Despite the Japanese Government’s claim that the purchase of the islands at JPY2 billion was an attempt to maintain the status quo, it has touched off a row in bilateral relations,also prompting a strong reaction in Chinese society. Anti-Japan protests erupted acrossmajor Chinese mainland cities in mid-to-late September, with some violent conflicts inwhich Japanese stores and factories were reportedly damaged and looted.Japanese clothing retailer Uniqlo announced suspension of 19 Mainland shops (out of 145). Aeon also suspended 30 retail outlets on the Mainland. Japanese manufacturersincluding Canon, Panasonic, Sony, Honda and Mazda announced suspensions in many oftheir Mainland factories. Although most of the effected Japanese stores and factories onthe Chinese mainland have reportedly resumed operations, they are very cautious ofongoing developments in China-Japan relations.T he territorial dispute over the Diaoyu Islands is also dealing a blow to Japan’s tourism industry, as anti-Japan sentiment has caused a slump in the number of Chinese touriststraveling to Japan. All Nippon Airways Co. and Japan Airlines Co. have seen more than50,000 cancellations by group tourists from both Japan and China. According to theJapan National Tourism Organization, there were just over one million Chinese tourists Travelling to Japan in 2011, the second largest group after South Korean tourists.If China and Japan are to swiftly resolve the conflicts diplomatically the likely economicimpact would be minimal. However, with no immediate signs that such conflict could beso resolved, it would hardly be surprising that sour bilateral relations could translate,directly or indirectly, into real economic damage to both Chinese and Japanese economies.For example, there were alleged reports in September 2012 of Chinese Customs slowing the processing of cargo related to Japanese companies on the Mainland, which manyanalysts in Japan interpret as the Chinese Government applying pressure through tradeSino-Japan tensions and why the economics matter to Hong Kongchannels. It was also reported in October 2012 that several big Chinese banks hadcancelled their participation in IMF-related events held in Japan, citing “Japan-China relations”.A spoke in the works of bilateral economic tiesChina-Japan economic ties have been growing rapidly over the past four decades after bilateral relations were normalised in 1972. Since the introduction of Deng Xiaoping’s“Open Door Policy” in the late 1970s, China has developed into the “world’s factory” andhas become an indispensable part of the supply chain in Asia.In the decade after China’s WTO accession in December2001, China developed afast-growing consumer market. For Japanese companies, China is not just a key offshore manufacturing base for Japanese producers of electronics and automobiles, but also an increasingly attractive market for selling their products.According to data from the Japan External Trade Organisation (JETRO), China had been the third largest export market of Japan until 2007, when it overtook Europe. After theglobal financial crisis, China became Japan’s largest export market in 2009, surpa ssingthe US. Japanese cars, electronics and clothing have won a reputation in China for their reliability, good quality and where after-sale services are applicable, high standards of services. Profits generated in China approximately account for one-fifth of majorJapanese automakers such as Toyota and Nissan.Overall, China was Japan’s biggest trading partner in 2011 for five consecutive years, accounting for 21% of Japan’s total trade. Conversely, Japan was China’s second larges t trading partner in 2011, accounting for 9% of China’s total trade. In this regard, Japanonly trailed the US, which accounted for 12% of China’s total trade. In 2011, the tradebetween China and Japan, the world’s second and third largest economies respe ctively, reached US$345 billion. This was even bigger than China’s combined trade with theBRICS and the UK. It sheds light on the size of bilateral trade that would be at stake ifChina and Japan slipped into a trade war.China’s total trade of US$3.6 trillion and Japan’s total trade of US$1.7 trillion combined Sino-Japan tensions and why the economics matter to Hong Kong to make up 15% of the world’s total trade in 2011. Although direct bilateral trade between China and Japan accounted for less than 1% of the world’s total, any crack in Sino-Japan economic ties would deal a severe blow to the two economies, with an expected domino effect on the regional supply chain quickly affecting global trade and damaging the global economy.On the investment front, Japan's direct foreign investment (FDI) in China reachedUS$12.6 billion in 2011, up 74% from 2010, according to JETRO.According to China's National Bureau of Statistics, there were 22,307 Japanese companies and joint ventures as of the end of 2010, accounting for about 16% of thetotal number of foreign companies in China and employing about 3 million people.If what transpired in September 2012 was any guide, any escalation in bilateral conflicts would potentially ignite anti-Japan sentiment to new levels, with disruptive effects on the operations of Japanese companies in China.In contrast, China's FDI in Japan amounted to US$109 million in 2011, down sharply from US$314 million in 2010, but remaining well above the 2008 level of US$37 million.In other words, Japan’s FDI in China in 2011 was more than 115 times of China’s FDI in Japan.China-Japan trade: an integral part of Asia’s supply chainChina-Japan trade is highly integrated into Asia’s supply chain, involving many parts and components for making cars and electronic/telecom products, with many shipped toother markets, including the US and the EU. As the supply chains of automobiles and electronic/telecom items are very complex and specialised, involving numerous partsand components, it may not be easy to find substitutions in the short time.The strong mutual dependence of other supply chain partners in different parts of Asia and elsewhere can be well illustrated by the impact of Japan’s devastating earthquakesin March 2011 and Thailand’s severe floods in the second half of 2011. It took months of adjustment before most of the affected Japanese companies were able to source therequired parts, either from Japanese suppliers in Japan and other offshore locations, orfrom other offshore suppliers, such as those in South Korea, the US, Taiwan and theChinese mainland.Japan’s possession of a large offshore production capacity readily helped it survive the supply chain disruptions of 2011. However, it would be difficult to envisage the direimp act if China’s huge production capacity was to be seriously disrupted due to escalating disputes between the two countries, be they manufacturing parts or finished goods assembly. Substitution for Chinese supply of concerned parts and components would not come easy, even over a protracted period.In the event of a trade war, where punitive and retaliatory measures would be slappedby each country on the other, the impact could be severe, with much depending on thescale and swiftness of the measures to be adopted.In such a context, any disruption in the production of key components in China would quickly feed into supply chains across the region.As well, disruption in China-Japan trade flows would severely affect not just Asia’s supp lychain, but also the global chain. The domino effect would likely swiftly spill over to the global supply chain, damaging the fragile world economy, which is struggling to recover from persistent Eurozone problems.China produces more than 95% of the wor ld’s rare earths, which are the essential component of making battery and other electronic parts. Chinese exports of rare earthsto Japan, which were temporarily suspended in the wake of diplomatic dispute in 2010,have already disrupted Japan’s supply cha in once. Should there be further deteriorationin China-Japan relations, many analysts fear that Chinese exports of rare earths toJapan could be affected.Hong Kong as a pivotal re-export hub for China-Japan tradeHong Kong has been a pivotal re-export hub for China-Japan trade. In 2011, Hong Kong handled US$39 billion of China-Japan re-exports, accounting for some 10% of the overalltrade between the two countries.China-Japan re-exports contributed 9% of the US$419 billion total value re-exports handled by Hong Kong in 2011, but any disruption in China-Japan trade ties would notbe confined to this trade.The spillover impact on regional supply chains, which are particularly skewed to the production of electronics/telecom products, would also be high. Should this materialise,it would deal a more serious blow to Hong Kong’s overall external trade, as re-exports oforigin other than from Japan or the Chinese mainland would be affected.Diplomatic resolution of Diaoyu conflicts will help Japan, China and othersRecent news reports have had Japanese diplomats saying that bilateral relations haveyet to descend into the deep freeze as seen in September 2010, after Japan arrested aChinese captain who rammed his fishing boat into a Japanese coast guard vessel off theDiaoyu Islands.Attempts to mend bilateral relations were evident in late September 2012, but it wouldtake more positive steps to resolving the current standoff and territorial dispute over theDiaoyu Islands.If China and Japan were to resolve the conflicts diplomatically, the likely impact on the Sino-Japan tensions and why the economics matter to Hong Kongeconomic front would likely be minimal and short-lived, helping not just the two giant economies, but also other Asian economies which are intimately involved in the regional supply chains.At the end of the day, the global economy would not suffer from any devastating blow ifa Sino-Japan trade war is avoided, because this would make considerable economicsense. As IMF Managing Director Christine Lagarde commented recently, the shakyglobal economy needs Japan and China to be fully engaged, warning that the worldcannot afford for the two countries to be distracted by their bitter territorial row.。