China-Japan relations have long been characterized as being “hot in economics and cold in politics”. However, the strained political relations have shown signs of improvement in recent years. During the G20 Summit in July 2017, Japan’s Prime Minister Shinzo Abe and Chinese President Xi Jinping agreed to enhance talks and exchanges. In September of the same year, Abe attended a ceremony marking China’s upcoming National Day and the 45th anniversary of the normalization of Japan-China relations at the Chinese Embassy in Tokyo. In April 2018, China and Japan pledged a “new starting point” for bilateral relations during a three-day visit by Chinese Foreign Affairs Minister Wang Yi to Japan. In May, Tokyo hosted the China-Japan-South Korea trilateral summit, suspended since 2015. The three countries not only shared a desire for denuclearization on the Korean Peninsula but also advocated free trade and globalization.
Unlike the warmer political relations, Sino-Japan economic ties have become more distant than before. Japan once accounted for over 20 percent of China’s total imports in 1997. The ratio declined sharply to only 10.9 percent in 2017. During the same period, Japan’s share in China’s total inward foreign direct investment (FDI) also declined from 9.1 percent to 2.5 percent according to China’s official statistics. In absolute amounts, Japan’s investment in China dropped sharply from nearly USD 20 billion in 2013 to USD 8.3 billion in 2017.1
As such, the questions are: Why have Sino-Japanese economic connections have become less close than before? And: will the warmer political relations help to boost their economic ties?
Sino-Japan Relations in the Cold War Context
After the Communist regime took over China in 1949, Japan initially wanted to reconstruct its damaged domestic economy by making economic contact with China, especially when the supplies from its pre-war colonies such as Korea and Taiwan became limited. Communist China also favored trade with Japan as a way to gain foreign exchange reserves and advanced technology, as well as to reduce full dependence on the Soviet Union. The Sino-Japanese plan for trade was however severed by the United States. The Americans were concerned that Japanese political ties with the United States would be negatively affected if Japan did not depend entirely on non-communist nations for trade. The United States was also worried that Sino-Japanese trade would strengthen the military force of Communist China and even that of the Soviet Union.
The China-US reconciliation and the rise of the pro-China Japanese Prime Minister Tanaka Kakuei (1972-1974) led to the normalization of China-Japan relations in 1972. Japan’s embrace of China’s economic reform was fundamental to the close bilateral economic linkage in the subsequent years. The Treaty of Peace and Friendship in 1978 was signed in the face of a common threat in the Soviet Union, forging the political foundation of bilateral relations. The common political and economic interests allowed both countries to enjoy relatively smooth relations in the 1970s and the 1980s. It was after the mid-1990s that China-Japan disputes over history and territorial issues became more pronounced in spite of the continuous close economic relations. On one hand, with the collapse of Soviet Union at the time, there was no longer a need to stand united against a common enemy or to submerge their differences. On the other hand, China’s rise coupled with Japan’s relative decline has transformed their friendly diplomatic ties into hostility and distrust.
Rising Political Antagonism in Last Two Decades
Deng Xiaoping’s demise and Jiang Zemin’s takeover of as China’s President (1993-2003) signified a turning point in Sino-Japan relations. Unlike his predecessors, Jiang Zemin, who held personal bad memories about prewar Japan, made a series of harsh remarks about historical issues. The Sino-Japan political antagonism became even more apparent after the 2000s. Bilateral political relations deteriorated further following a series of political incidents and military confrontation. An anti-Japanese riot broke out in 2005 in several Chinese cities after Japanese Prime Minister Junichiro Koizumi’s visit to the Yasukuni Shrine, the Japanese government’s approval of a revisionist textbook, and Japan’s application for permanent membership in the United Nations Security Council. In 2010, Sino-Japanese relations became tense again when the Japanese Coast Guard arrested a Chinese captain after a Japanese boat collided with a Chinese trawler.
In 2012, the Japanese government’s purchase of the disputed Senkaku (Diaoyu) islands from the Kurihara family further irritated an already tense relationship. In May 2013, Japan refused to recognize China’s declared Air Defence Identification Zone which extends to the Japan-administered Senkaku islands. In 2014, the Chinese and Japanese military aircraft encounter in the disputed airspace over the East China Sea further heightened tensions. The political dispute has also extended to the military front. In September 2015, Abe successfully pushed through security laws that permit Japan’s troops to participate in overseas combat missions. Its record high military spending in 2016 was aimed at countering Chinese military power expansion in the East China Sea and North Korea’s missile threat. In counterpoint, China’s 2015 defense white paper stated that the United States’ “rebalancing policy” in the Asia-Pacific region, Japan’s changes in military policy, territorial disputes, the Taiwan issue, and terrorism are the major concerns of the Chinese military.
Japan’s Shifting Investment Strategy
The growing political tensions took place when Japan’s investment in China was declining. As shown in Figure 1, China’s share in Japan’s investment in Asia has clearly decreased since 2005. At the same time, ASEAN’s importance in Japan’s outward direct investment (ODI) in Asia has gradually increased. The development of ODI in ASEAN was triggered by China’s implementation of minimum wages in 2004. During 2005-2012 period, China and ASEAN accounted for similar shares in Japan’s ODI in Asia. In 2013, China’s share clearly dropped to 22 percent, from 40 percent in the previous year. Meanwhile, ASEAN’s weight in Japan’s ODI in Asia increased from 32 percent to 58 percent. In 2016, Japan’s ODI to China declined further to USD 8.6 billion. However, China’s share in Japan’s total ODI in Asia jumped to 79 percent. The surge was attributed to the sudden decline of Japan’s net investment outflow to Singapore, according Japan External Trade Organization’s (JETRO) statistics. With USD 38 billion of Japan’s investment in Asia in 2017, 58 percent was destined to ASEAN compared to only 25 percent to China.
Figure 1. Breakdown of Japan’s Investment in Asia 1997-2018 (Jan-March).
Japan’s shift of investment from China to ASEAN is attributed to both political and economic reasons. Following the Sino-Japanese territorial disputes between July and September 2012 that provoked large scale protests against Japanese products and business presence in China, a survey done between October and November 2012 indicated that only 52 percent of Japanese firms in China plan to expand their business operations in the next one or two years, a clear decline from 67 percent in 2011.2 According to the Japan Bank for International Cooperation’s survey report in 2013, 17 percent of Japanese firms surveyed considered political relations with China as a major concern for their businesses. This ratio was still lower than the economic concerns, e.g.: rising production cost, intense business competition and China’s economic slow-down (82 percent). In response, Japanese companies have embarked on the “China plus one” strategy, usually to countries in Southeast Asia in order to reduce and diversify risks of investment in China.
Japan’s investment in China could continue to be developed slowly. JETRO’s survey in 2017 showed that 40 percent of Japanese firms indicated their willingness to expand their business in China in the next 1-2 years, declining from 67 percent in 2011. Growing labor costs and declining sales were the main reasons indicated in the report. Rising labor costs and uncertain political relations have put China in a less advantageous position vis-à-vis ASEAN for attracting Japan’s investment. China’s continuous economic reforms and transformation from an export-oriented to a consumption-based economy also pose critical challenges for Japanese firms.
Changing Dynamics of Sino-Japanese Trade Linkage
China-based Japanese firms’ demand for capital equipment and key components from Japan has been the main driver behind Japan’s exports to China. With China’s economic development, Japan’s main import items from China have changed from energy resources in the 1980s to manufactured goods in the 1990s and products with high technology intensity after the 2000s. Most of the products imported from China are made by the Japanese firms in China.
Japan’s imports have developed more rapidly than its exports to China in the last two decades. As a result, Japan has run a trade deficit with China, according to Japanese official figures. Japan’s trade deficit with China has widened further since 2012 with a more rapid decline in exports. As shown in Figure 2, Japan’s exports shrank from USD 162 billion in 2011 to USD 133 billion in 2017 (declined by USD 29 billion) whereas its imports from China dropped from USD 184 billion to USD 165 billion (down by USD 19 billion) during the same period. Japan’s trade deficit with China would become smaller if Japan’s exports to Hong Kong were included. Japan’s large exports of semi-industrial goods to Hong Kong were evidently headed for final assembly in China. Unlike exports, Japan’s imports from Hong Kong (probably originally from China) have been insignificant.
Figure 2. Japan’s Trade with China 1997-2018 (Jan-March).
Source: Direction of Trade Statistics Yearbook, International Monetary Fund, various years; Worlds Trade Atlas.
As Japan’s exports to China have been driven by its investment in China, the changes in Japan’s ODI from China to ASEAN explained the drop of Japan’s exports to China in recent years. The higher ratio of local procurement by China-based Japanese firms is another important reason for Japan’s fewer exports to China. According to JETRO’s survey in 2017, 67 percent of Japanese companies in China procured raw material and industrial parts in China, against 58 percent in the previous year and 43 percent in 2001. Japan’s trade deficit with China is less likely to be reversed as over 81 percent of Japanese firms in the survey responded that they will continue to procure local material for production in the future, the highest ratio compared to Japanese firms in other East Asian countries. The same survey also showed that due to the lower cost, local Chinese companies are the largest source of procurement for Japanese firms in China, accounting for 60 percent of total responses, followed by 34 percent from Japanese affiliates and 6 percent from other foreign affiliates in China.3 As such, despite the slower development in bilateral trade, Sino-Japan business linkages remains strong. Japanese firms have established close manufacturing alliances with local Chinese firms.
China-Japan Relations in Regional Political Economy
The close economic relations with Japan have been important for China’s industrial catching up and its transition from a low- to a middle-income country. For Japan, after the bursting of the asset-price bubble in the 1990s, its economic engagement with China has been important for energizing its stagnant economic growth. Despite the mutually beneficial economic relations, China’s growing economic strength has posed challenges to Japan. In 1986, Japan’s GDP was 7-8 times greater than China’s. In 2017 however, it is only 37 percent of China’s GDP. While the Asian financial crisis had dealt a great blow to the Japanese economy, its impact on China’s economy had been relatively muted. That closed up the gap between two countries’ GDP after the crisis. When the Chinese economy surged quickly after the mid-2000s, Japan’s economy progressed haltingly from 2005 to 2012 and eventually contracted after 2013 (Figure 3).
Figure 3. Comparison of Japan’s GDP and China’s GDP 1987-2017.
Source: International Monetary Fund.
China’s economic growth, partially through Japan’s investments and trade, has helped to develop its political influence and military strength. This shows that Japan’s strategy to incorporate China as cooperative partner through economic ties did not work. Instead, the two countries have started to view each other as political obstacles to their own ambitions to be great powers in the region.
With the rapid development of institutionalized economic integration in East Asia, the two countries sought to have greater influence in the region. First, after the United States withdrew from the Trans-Pacific Partnership (TPP), Japan has been wary of China’s ambitions in shaping the regional free trade agreement (FTA) framework through the Regional Comprehensive Economic Partnership (RCEP). Japanese Prime Minister Abe Shinzo has admitted the futility of the TPP without US participation. Economically, the impact of TPP without the United States on Japan may not be significant as America has a relatively more open economy than most of the countries in the world. Politically, however, the US withdrawal from the TPP left a power vacuum in the region that could be filled by China.
Second, China is now in competition with Japan for lucrative infrastructure contracts in the region. Japan is advocating the construction of “high-quality infrastructure” in Asia through its backing of the Asian Development Bank (ADB). China, on the other hand, is offering the region an alternative funding through the Asian Infrastructure Investment Bank (AIIB). Since 2014, Japan and the United States has persistently opted out of the AIIB or refused to endorse the Belt and Road Initiative (BRI). Japan viewed these initiatives as a challenge to ADB’s leadership in regional infrastructure development and to other US-led international organizations in the global economy. Japan’s negative views toward the AIIB have changed since 2017. In May, Abe said he would be open to joining the AIIB. In June, he further declared that “Japan is ready to extend cooperation” with China’s BRI. Japan’s positive responses were welcomed by President Xi.
The improving Sino-American relations might also be a reason behind Japan’s changing attitude towards the AIIB and BRI. The Mar-a-Lago meeting in March 2017 had seemingly built personal bonds between US President Donald Trump and President Xi, and the two made important deals which would allow US beef and financial companies to access China’s market. Japan might have also wanted to maintain its influence in the region through working with other developed countries in the AIIB. Given Japan’s strong desire for infrastructure export and its business interests in Southeast Asia, Japan’s participation in the AIIB is understandable. The AIIB could be a platform for more Sino-Japanese cooperation in the future. However, the depth of bilateral cooperation would have its limit. Japan may still feel uneasy about China’s power rise and its close US-Japan security alliance may also hinder progress in Sino-Japanese relations.
It is uncertain how long these friendly gestures by the leaders of two countries may last given the several unsettled territorial issues, the historical legacy of World War II, and Sino-Japanese competition for the regional leadership. The unstable North Korean regime and the growing tension between the United States and China will add further uncertainties to China-Japan relations in the future.
1. Data source: CEIC.
2. Survey of Japanese-affiliated companies in Asia and Oceania, JETRO, December 2012, p. 16.
3. JETRO Survey on business conditions of Japanese companies in Asian and Oceania (2017), Japan External Trade Organisation. Retrieved from https://www.jetro.go.jp/ext_images/en/reports/survey/pdf/rp_firms_asia_oceania2017.pdf