Japan’s changing political landscape and implications for its supply chains in Asia

Japan’s leadership change and an era of Abenomics

The landslide victory of Shinzo Abe's conservative Liberal Democratic Party (LDP) in Japan's election in December 2012 has ushered in, so-to-speak, a new era of “Abenomics”. As Japan’s seventh prime minister in six years, Abe is embarking on an ambitious policy of money-printing-and-spending. After stepping down as Prime Minister in September 2007, Abe has seen Japan’s economy shrink to almost one-tenth of its size, with a surging yen badly affecting the country’s manufacturing industry. After two consecutive quarters of recording economic contraction, Japan’s economy managed to rise only 0.2% in the fourth quarter of 2012.

To spur growth and put an end to the decades-long deflationary spiral, Abe has put immense pressure on the Bank of Japan (BOJ) to pursue vigorous monetary easing. The BOJ announced in January 2013 that it would double its inflation target to 2% from 1% set just one year ago, achieving the target through an open-ended asset purchase programme, tantamount to monetisation of government debts with no pre-set limit. Furthermore, there will be the deployment of a massive public works and construction-spending programme. While Abe’s policy may not be especially new, he appears bent on deploying it on an unprecedented scale, with the hope that this policy will yield different results this time.

The value of yen and offshore relocation of Japan’s manufacturing

Abe has made reviving Japan’s economy his top priority. Since making public his distaste for the strong yen and winning the LDP’s presidential election in September 2012, the Japanese currency has weakened by about 20% versus the US dollar (from ¥77.5 to ¥95 to one US$).

By contrast, the yen appreciated by about one-third against the US dollar in the five years before September 2012, and a renewed yen weakness is seen as giving a respite to Japanese exporters, in particular many SMEs that may not have the faculty to hedge against yen appreciation. However, there is the obvious exception of some elite Japanese manufacturers, many of whom are smaller establishments but have dominated the global market thanks to their technological prowess and loyal customers in the global supply chain. According to a recent METI survey, 60% of Japan’s SME exporters were negatively affected by the yen's surge in 2011, with the other 40% saying the impact ranged from nil to a net positive.

Soaring Japanese investment in Asia

In the face of the yen’s surge, Japanese multinational companies have accelerated their establishment of offshore supply chains, taking advantage of lower labour costs in foreign countries, and the increasingly expanding markets therein. In the six years ending 2012, Japan has seen its net outward foreign direct investment (FDI) grow at a compound annual growth rate (CAGR) of around 16%. Besides increasing verticalisation, offshore production has further raised cross-border trade of both intermediate and final products within and outside a region.

China’s WTO ascension in late 2001 may appear to be a watershed in Japan’s investment. Japan’s net outward FDI increased almost fivefold from a mere US$2.6 billion in 2002 to US$13.5 billion in 2012. While Japan’s FDI to China in 2012 surpassed the value to ASEAN (US$10.7 billion), due primarily to the plunge in Japanese investment in Thailand, as the country was hit by massive flooding that caused severe disruption to its supply chains for several quarters from Q3 of 2011.

Excluding the impact of the Thai floods on FDI for 2012, Japan’s net outward FDI to ASEAN grew at a CAGR of 23.2% during 2006-2011, higher than the global average of 16.7% and the China average of 15.4% over the same period. Impressively, FDI to ASEAN more than doubled from US$8.9 billion in 2010 to US$19.6 billion in 2011, only to fall by half to US$10.7 billion, due to the Thai floods. In 2011 alone, FDI to ASEAN accounted for about 18% of Japan’s total net outward investment, compared to about 12% earmarked for China. On the other hand, Japan’s net FDI to China in 2012 showed only a 6.4% year-on-year increase and accounted for 11% of the total.

China-bound investment overshadowed by political wrangling

China-Japan relations have deteriorated since the government of Yoshihiko Noda (predecessor of Shinzo Abe) carried out the supposed nationalisation of some of the disputed Diaoyu Islands in September 2012.

Both Japan and China have to be mindful of the enormous stake in terms of bilateral trade and investment, as they jointly account for about 15% of global trade. From JETRO figures, Japan’s cumulative investment in China stood at US$83.4 billion as of the end of 2011, representing about one-third of its outward FDI stock in Asia, and 9% of the cumulative total. According to China's National Bureau of Statistics, more than 20,000 Japanese companies and joint ventures operate in China.

Japanese companies with mixed views on China-bound investment

Overshadowed by continued political tensions, as well as rising wages in China, Japanese companies have rather mixed views on the overall appeal of China. A JETRO survey released in December 2012 found that 52% of respondents plan to expand business operations in China over the following one to two years; down from 67% as reported in the 2011 survey and marking the biggest drop among Japanese companies in the surveyed countries or regions. Nonetheless, rising labour costs in China, rather than political tensions, were cited as the most notable reason for the decline.

Another JETRO survey, released in November 2012, reported that the wage matter in China was also compounded by increasing difficulties in securing workers in the country’s coastal areas. However, China’s outstanding industry clusters and established supply chains, along with its fast expanding consumer market, make it attractive for Japanese makers of electronics appliances and auto parts to stay in China. Similarly, Japan’s non-manufacturers, like logistics firms and retailers, are eyeing the business opportunities in the China market to continue investment expansion.

In comparison, the JETRO survey found an accelerated shift by Japanese makers of labour-intensive products, including apparel and small “zakka” or general goods, to lower-wage countries such as Vietnam and Myanmar.

China-plus-one strategy getting stronger attention

Japanese companies, large manufacturers in particular, have for many years employed the “China-plus-one” strategy in the face of the yen’s relentless surge, relocating part of their production to other parts of Asia, with Thailand being a popular choice.

While wage trends generally point up in the region, Southeast Asia has not seen wages rise as fast as in China. In the case of Thailand, Bangkok’s minimum wage has shot above US$230 a month, yet this average wage remains far below that in Southern China of more than US$500.

As a hub of Japan’s offshore manufacturing in Southeast Asia, Thailand has attracted many Japanese automakers and electronics producers, with its well-developed industry clusters and supply chains. In essence, Japan is the largest foreign investor in Thailand, with the country being the top investment destination for Japanese companies in the 10-member ASEAN. As at end-2011, Japan’s cumulative investment in Thailand stood at US$35.2 billion, followed by US$31.7 billion in Singapore.

However, Thailand’s ability to attract FDI from Japan in 2012 was compromised by the severe floods that hit the country in Q3 of 2011, with supply chains being substantially disrupted. Japan’s net outward FDI to Thailand declined by more than 90% to less than US$0.4 billion in 2012, tumbling from more than US$7 billion in 2011 and also bringing down ASEAN’s inward FDI from Japan.

Since China-Japan relations started to aggravate in September 2012 amid the islands dispute, the “China-plus-one” strategy has gained greater traction among Japanese companies. While Japanese companies are increasingly using Southeast Asia as an alternative manufacturing base to balance their China risks, there is a sober realisation of not laying all eggs in one basket following the Thai floods. These occurred only months after Japan’s March-11 earthquakes took a heavy toll on its home manufacturing with a persisted spill-over impact on their global supply chains.

Apparently, the China-plus strategy needed to be re-examined in light of the fast changing geopolitical and economic developments in the region, culminating in greater risks sharing manoeuvres by Japanese companies in a number of Southeast Asian countries. In terms of expansion plans for the next one to two years, the JETRO survey of December 2012 found that Japanese companies scaled back somewhat from 2011 in Thailand, Malaysia and Singapore, while stepping up investment in Indonesia, Cambodia, Myanmar and Laos, as well as India and Bangladesh.

Not surprisingly, such survey findings are in line with the official figures for Japan’s net outward FDI for 2012 outlined in the above table, with Vietnam notably registering a yearly growth of 38% on the one hand, and Singapore and Thailand respectively recording yearly declines of 65% and 92% on the other.

Indochina’s production corridor taking shape

In 2012, Indonesia turned out to be the largest recipient of Japan’s net outward FDI within ASEAN, chalking up more than US$3 billion and surpassing Singapore, which received only US$1.6 billion from Japanese investors for the same year. However, Vietnam actually performed better than Indonesia in terms of yearly growth, thanks to a lower base, with Japan’s net inward FDI rising 38% to US$2.1 billion compared to Indonesia’s 5.6% gain to US$3.1 billion.

Increasingly, Japanese companies see Thailand, Vietnam and Cambodia forming a production corridor in Indochina. The recent opening up of Myanmar will certainly broaden the span of such a production corridor, as Japanese companies more seriously rethink their China plus strategy.

Vietnam

As Vietnam’s economy slowed down amid the adoption of stringent measures to curtail inflation in 2012, inward FDI fell 15% to about US$13 billion based on the country’s official statistics, with the manufacturing and processing sector attracting an FDI of US$9.1 billion, or 70% of total inward FDI. Vietnam reported that Japanese investment more than doubled to US$5.1 billion in 2012, a reflection of the increased efforts of Japanese companies to seek out another production base to hedge their China exposure.

Japan stepped up its investment in Vietnam following the country’s WTO accession in 2007, as in the fashion of their investment in China’s post-accession. Vietnam’s appeal to Japanese investors is also borne out by the yearly growth in Japan’s cumulative FDI for 2011, as shown in the table above. Japan’s cumulative FDI in Vietnam expanded at a CAGR of 39% during 2007-2011, far higher than that for China or other ASEAN countries.

As the largest investor in Vietnam, Japan has recently been reported to be widening their investment scope in the country. Increasingly firms are edging away from the business of processing and assembly for exports, whilst moving up the value chain to include production of items such as spare parts, and investing in areas supporting the manufacturing industries. In addition, Japanese companies are taking advantage of the growth of Vietnam as a market, targeting the service sectors in the country.

Myanmar

Since Myanmar opened up about two years ago, Japan has been quick to cement ties with the previously military-run country, and was chosen by Abe’s government to be the first place for an overseas visit. Japan is committed to waiving the more than US$3 billion debt owed by Myanmar, and to providing more than US$570 million of soft loans for infrastructure construction before April 2013, including the development of one of the country’s special economic zones.

Japanese companies are moving in fast to tap the potential of Myanmar, which is resources-rich and endowed with a horde of young workers earning the lowest-wage in the region; given its population of more than 60 million. While Japan is the largest exporter market for garments made in Myanmar, it also exports many used cars to the country, while stepping up production of motorcycles and trucks there. Yet, it may take quite some time for Myanmar to upgrade its supply chain beyond the processing business to better integrate itself with the rest of the region’s supply chains.

Cambodia

Compared to its investment in Vietnam, Japan’s FDI to Cambodia is relatively small, amounting to about US$260 million as of July 2012, with the bulk of Japanese investors operating in the garment sector. Meanwhile, the prospect of Cambodia as an investment destination for Japanese companies is being helped by the fast increasing wage in China.

However, Cambodia is facing an increasing challenge from Myanmar to court Japanese investment, including sectors other than garment manufacturing. Myanmar’s average wage levels are lower than those in Cambodia, with the country having four times the latter’s population of about 15 million.

Currently, the bulk of exports from Cambodia comprise garments (which amount to about five times the value of Myanmar’s current garment exports), but the country is increasingly being used by Thai-based Japanese companies for outward processing of low-tech products, including electronics, especially in the wake of the Thai floods.

Production base diversification to continue despite recent yen losses

Although renewed yen weakness on the back of Abenomics has lately partially undone the sharp gains of the past five years, this may not do much to stop Japanese companies further diversifying their offshore supply chains. With China’s rising wages, labour availability issues, Sino-Japan tensions, as well as a greater need for sharing manufacturing risks following the supply chain disruptions at home and in Thailand, Japanese companies will continue to expand their investment in low-cost production bases, such as Vietnam and, increasingly, other Indochina countries like Myanmar and Cambodia.