Japan Reconsiders Its Investment in East Asia

5 MINS READSep 28, 2012 | 01:01 GMT

A senior Philippine trade official said Thursday that Manila is currently in talks with 15 Japanese firms looking to shift manufacturing operations out of China. The statement comes after a week of heightened Sino-Japanese diplomatic tensions over the disputed Diaoyu/Senkaku island chain, which has forced some Japanese firms — including automakers Nissan, Tokyo and Honda — to temporarily halt production.

Notwithstanding the coincidental timing, it is unlikely that the trade official's comments were prompted by the ongoing row between Tokyo and Beijing. However, the statement does reflect a broader shift under way in the geographic distribution of Japanese investment and, potentially, the future of economic activity in Asia.

What is a Geopolitical Diary? George Friedman explains.

As wages and input costs rise in China's coastal manufacturing centers, firms from Japan and other countries have gradually begun shifting production to countries like Indonesia, Vietnam and the Philippines. In 2012, Tsuneishi Holdings, Japan's second-largest shipbuilder, opened a shipyard on Cebu Island in the central Philippines. Likewise, Japanese imports of electronics and optical equipment from the Philippines have nearly tripled since 2009 (to $2.7 billion in 2011) fueled largely by Japanese firms' efforts to shift some of their lowest value-added operations away from China. In 2011, Japanese investment into the Philippines grew by 30.6 percent year-on-year, accounting for 30.2 percent of the Philippines' total inbound foreign investment for the year.

At the same time, Japanese manufacturers will not leave China en masse in the near future. In part, this is because China now consumes a quarter of all Japanese exports and accounts for almost 10 percent of cumulative Japanese outbound investment globally ($82.5 billion by 2011, $6.8 billion of which came in 2011 alone). Japanese companies operating in China now derive the majority of their revenue selling to Chinese consumers.

More troublesome for countries like the Philippines looking to poach some manufacturing business from China is manufacturers' dependence on China's unparalleled parts processing and sourcing systems. Japanese manufacturers are deeply embedded in Chinese supply chains and rely on the ability of those chains to source a wide variety of parts quickly and efficiently. Shifting operations to a country like the Philippines may reduce foreign firms' overhead, but until the Philippines develops the infrastructure necessary to support broader business-to-business sourcing, such a move carries inherent risks to business continuity — especially in an island country ill-equipped to manage natural disasters. Inexorably rising costs in coastal China make some degree of relocation either to interior China or emerging economies in the region inevitable. But any wholesale alteration to the geography of Japanese investments abroad will be both costly and time-consuming.

Adding to the challenge is the fact that many of these countries lack the basic infrastructure hardware to sustain large-scale manufacturing outside a handful of cities like Jakarta, Surabaya, Manila or Hanoi. In the past year, as rising costs and slowing demand in China have triggered substantial foreign capital flight, Indonesia and the Philippines have begun outlining plans for comprehensive power and transport infrastructure development in an effort to attract more foreign investment. Meanwhile, foreign firms looking to gain a foothold in new potential markets have raised investment in these countries in everything from manufacturing to building local metals and minerals processing capacity to developing electricity and telecommunications networks.

These countries lag far behind China and the "Asian Tigers," and any effort to effectively develop national transport or power infrastructure will require regulatory consolidation and political willpower far beyond what Indonesia and the Philippines have thus far shown. But ultimately, what they lack in infrastructure, they make up for in demographics. The Chinese workforce has reached its peak; in the coming decades, the number of working-age men and women will shrink dramatically as the population ages. The Philippines, by contrast, is not expected to reach its demographic peak for another 30 years, making it highly attractive as a potential producer for aging, labor-poor but capital-rich countries like Japan.

In the meantime, however, China, Japan and the region as a whole will have to contend with the widespread consequences of China's passage out of a three-decade old economic arrangement built on low-cost, low value-added manufacturing for export in coastal Chinese cities. This model made China the workshop of the world but it is no longer economically viable, and has not been for several years despite Beijing's strenuous efforts to keep manufacturers afloat through a combination of tax incentives, subsidies, price controls on raw materials and import/export tariff reductions.

Beijing, for its part, has worked to prepare for the inevitable shift of low-end manufacturing away from coastal urban centers by developing transport and power generation networks in interior provinces and encouraging coastal producers to shift up the value-added chain. But while it is recognized that low-end manufacturing will gradually move elsewhere, and that this in turn will necessitate structural rebalancing in the Chinese economy, it remains unclear how this process will play out politically and socially, both within China and throughout the region.

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