Can China Lift Japan Out of Recession?

EDITOR'S NOTE: China's plan to stimulate its economy, while expected to lift the country out of recession, may not have a significant impact on Japan's deteriorating economy, says Brian P. Klein, an international affairs fellow with the Council on Foreign Relations in Japan. For the full article, please visit the council's Web site. A few excerpts:

Hopes are high and rising that a near-term China recovery, fueled by an estimated $587 billion stimulus plan and massive bank lending, will be a boon to Japan's ailing export sector. This new demand is expected to lift China out of recession even before the United States and Europe recover. China's stimulus, however, is neither large enough nor necessarily supportive enough of foreign imports to have a significant short-term impact on Japan's rapidly deteriorating economy.

Tokyo's optimism hinges on Japan's comparative advantage in manufacturing and sophisticated machinery. China's planned spending on upgrading transportation and power infrastructure might generate demand for high-speed rail and advanced electricity-generation equipment. A resurgent real estate market could increase Japan's construction machinery exports. Burgeoning Chinese middle-class demand could improve flagging digital camera, flat-screen television, and automobile sales.

Much of this confidence in regional trade was formed during recent boom years. Running in overdrive through most of the past decade, the bilateral economic relationship reached its apex when China surpassed the United States as Japan's top export market for two straight months in 2008. By the end of the year, export growth to China stood at 16 percent (versus 17.6 percent for the year with the United States). These statistics, however, masked the warning signs first appearing in November and December as Japanese exports began a decline, dropping by 4.7 percent and 10.1 percent respectively.

By early 2009, the negative trend was clear. Japanese exports were plummeting across the globe as the bottom dropped out of world markets. Despite claims of decoupling and China's rise as an independent engine of world growth, Chinese demand for Japanese goods also declined. In January 2009, Japanese exports to China fell 45 percent on widespread weakening demand.

Japan under increasing economic pressures

Japan's exports to China have changed little for most of the past decade. From 2000 to 2007 over 80 percent were comprised of machinery and transportation equipment, chemicals, and manufactured goods. Manufacturing, which dropped to 15 percent of the total from 23 percent, is facing pressure from Chinese companies that now produce what they previously imported-an increasing percentage of lower-grade steel, for example, is now produced domestically. In response, Japanese companies are increasingly shifting low-tech production to the mainland to take advantage of labor costs to remain competitive.

The China housing market experienced explosive growth in the decade from 1995 to 2006. Sales grew over 600 percent, a boon to Japanese construction-equipment manufacturers. But as prices far outstripped wage growth, the Chinese government imposed greater lending restrictions, higher down payments, and stricter controls over ownership. Speculation and hot money inflows, which further drove up prices, were rampant; as foreign investment began to flood in, regulators wisely detected an overheated market. The net result is significant overcapacity in both residential and commercial real estate in major cities. By some estimates it may take up to a year for this supply to be absorbed.

Even the domestic consumer market has shown signs of weakness. Despite claims of a rising middle class, estimated at 100 million to 300 million, the current purchasing power of these consumers is still fairly weak. Household savings and wages have actually been shrinking relative to the overall growth in the economy, even during the largest expansion in recent economic history. Domestic consumption, according to official Chinese statistics has steadily declined from 46 percent of gross domestic product (GDP) in 2000 to 36 percent in 2006. The People's Bank of China notes that household disposable income as a percentage of national income has been steadily dropping since 1999. Based on World Bank statistics, wages as a percentage of GDP have shrunk from approximately 53 percent in 1996 to around 43 percent in 2007. The vast majority of this decline came in the last four years.

A broader drop in Western consumption has also affected Japan's use of China as a manufacturing base for re-export. As these markets imploded, the Asian supply chain of Japanese parts routed via China for final assembly into finished goods that fill a steady stream of container ships to Europe and the United States slowed to a crawl.

Limited effects of stimulus on Japanese exports

Positive indicators for a near-term China recovery triggered by the stimulus plan (with the most bullish predictions focusing on the third or fourth quarter this year) include a 30 percent gain in the Shanghai stock market year to date, massive new liquidity (bank lending of over $300 billion in the first two months of this year), rising electricity consumption, and a 15 percent increase in retail spending.

There are, however, several causes for concern regarding how effective the stimulus will be in practice and how reliable the above mentioned statistics are for signaling recovery. Only $173 billion of the $587 billion plan is actually "new" money. The rest was either previously committed Sichuan earthquake relief funding or money to be spent by local governments, banks, or the private sector in support of central government directives. The timeliness and full funding of these efforts remains uncertain.

The amount apportioned to health care, which would benefit Japanese producers of high-end medical equipment, is extremely small. In fact, the majority of this money will go into recently announced hospital construction. Rather than sophisticated imaging machines, China is likely to purchase basic medical supplies for rural clinics.

G-20 cooperation pledge of little impact

None of the pledges at the G-20 will have a direct effect on Japan-China trade relations. Japan pledged an additional $20 billion in overseas development assistance while China is to contribute $40 billion to the International Monetary Fund (IMF). The announced visit of Prime Minister Taro Aso to China, while symbolically encouraging, will also result in little of substance. Elections are due in the next several months and anything Aso agrees to during the planned visit will be reconsidered by a new administration-especially more so if the opposition DPJ party wins a majority.

Avoiding a setting-sun future

With a slow-growth economy and rapidly aging population, Japan stands to gain much from opportunities in China. With a shrinking workforce and rising wages, Japanese manufacturers will continue to seek out lower cost labor in China. If economic liberalization continues and China successfully navigates the transition to a consumption-driven model the promise of new and sustained demand might be realized as well.

For longer-term stability Japan needs to fundamentally restructure its own economy away from an overreliance on exports. Replacing one overseas market for another will not help rebalance rising income inequality, falling household savings rates, and a crippled health care system. While trade will certainly continue to be a major component of growth and generator of much-needed foreign capital to finance imports, maintaining a derivative economy highly susceptible to global imbalances will continue to hinder Japan's further development.