KGRI Working Papers
No.7

Chinese Economy and the Sino-Japanese Economic Relations

Version1.0
March 2017

Yuquing Xing1

Keio University Global Research Institute© Copyright 2017 Yuquing Xing
Professor, National Graduate Institute for Policy Studies
1

Email: yuqing_xing@grips.ac.jp

Abstract
This paper briefly reviews the current status of Chinese economy. It argues that “newnormal” cannot fully explain the dramatic slowdown of the Chinese economy and the
sharp fall of China’s exports growth is mainly due to the reorientation of global value
chains—relocation of low value added tasks out of China. Persistent depreciation of theyuan and massive capital outflows since last summer challenges the stability of theChinese economy and may trigger financial crisis.

Despite of unstable political

relations between China and Japan, the two economies have been closely integrated
through bilateral trade and investment. The two countries will benefit more from further
economic cooperation, especially when the world faces the headwind of antiglobalization.

1

1.

Introduction

After the high growth of three and half decade, the Chinese economy has slowed down
dramatically. In 2015, China’s gross domestic product (GDP) grew 6.9%, the lowest
since 2000. In the first three quarters of 2016, the growth further went down to 6.7%,
according to the official statistics released by the National Statistics Bureau of China.
Many observers of Chinese economy debate whether the dramatic fall of the economic
growth was due to structure problems or business cycle（Yao, 2016). The Chinese
government, however, refers the moderate growth as “a new normal”—an era ofmoderate growth and suggests that the economy would stay on so called “L shape” path
for a few years (People’s Daily, 2016).

The law of diminishing returns can explain the rationale of the new normal. Following
decades of high growth, the Chinese economy has surpassed Japan and turned into thesecond largest in the world, with more than $10 trillion GDP. The enormous size of theeconomy implies that it is natural that the economy started to expand at a moderatepace. Taking the US as an example, its GDP exceeded $10 trillion mark in 2000. Since
then, it has never grown more than 4% annually.

On the other hand, examining dynamic changes of three growth engines: consumption,
investment and exports, which had powered the unprecedented rapid growth, indicatesthat the new normal cannot fully explain the substantial fall of China’s economic
growth. Actually, there are more unanswered questions. First of all, the growth of fixed
capital investment fell off the cliff and dropped sharply to 10% in 2015. During thehigh growth period, fixed capital investment on average rose more than 20% annually.
In the first 11 months of 2016, the growth of fixed capital investment slipped further to
8.3%. Even more alarming is that fixed capital investment of private sectors tumbled
to 3.1% from 10% of a year before. Excess production capacities, deteriorated businessenvironment, concerns over the safety of investment and capital outflows all hinder
domestic investment, which in turn undermines the growth momentum of the Chinese
economy (Zhou, 2016).

Secondly, the engine of exports has lost steam completely. Exports used to be one ofcritical sources of China’s economic growth, in particular after China entered the World2

Trade Organization. It is estimated that exports contributed more than one third of
China’s economic growth from 2001 to 2011 (Xing and Pradhananga, 2013). The
growth of exports plunged significantly in recent years from 20.3% in 2011 to -2.8% in2015 (figure 1). Instead of contributing to the economic growth positively, exports
actually dragged the economy down. From January to November of 2016, exports
further shrank 7.5% in terms of the US dollar compared with one year earlier. Popular
wisdoms blame weakened external demand for the sudden reversal of export growthfrom more than 20% to negative. It is true that falling prices of oil and primarycommodities and sluggish recovery of the world economy dragged down the volume
of world merchandise trade as a whole (WTO, 2016). On the other hand, the structureof China’s exports is very unique with more than 95% manufacturing products, andlargely relies on foreign invested firms and the operation of global value chains (GVC).
The reorientation of GVCs--moving low value added tasks such as assembly out ofChina, because of deteriorating competitiveness of China in conducting labor intensive
tasks, has been undercutting China’s export capacity. In the next section, I will analyze
why the engine of exports lost the growth momentum completely in the context of
GVCs.
Figure 1
Dynamics of Three Growth Engines (%)
40
30
20
10

0

-10
-20

2005

2006

2007

2008

Retails

Source: China’s Statistics Bureau

2009

2010

2011

Investment

2012

2013

2014

2015

Exports

3

The sluggish performance of exports and the reorientation of GVCs are partially rooted
in the rigid exchange rate regime of China. By any standards, Chinese yuan has been
overvalued against the U.S. dollar. The over-valuation has driven multinational
enterprises (MNEs), which use China as an export platform, to move their production
facilities back to home or relocate to third countries with relatively low production costs.
Revitalizing export growth and eventually stimulating the growth of the Chinese
economy requires substantial depreciation of the yuan. The inflexibility of China’s
exchange rate regime and the government excessive concerns over the stability of
exchange rates, however, have severely hindered the process of the exchange rateadjustment (Yu, 2016). In 2016, Chinese yuan depreciated against the U.S. dollar about
6.4% while foreign exchange reverse dropped to $3.05 trillion by the end of November
from the level of $3.33 trillion at the end of 2015 because of constant interventions of
the People’s Bank of China (PBoC). Now the Chinese government is facing thedilemma of defending the exchange rate or preventing foreign exchange reserves fromfurther depletion. The uncertainty of the yuan’s exchange rate poses a potential risk tothe stability of the Chinese economy and interferes the independence of China’s
monetary policy. It may trigger a financial crisis in China, which has been luckily
untouched by the Asia financial crisis and the global financial crisis. In section 3, I will
discuss the exchange rate dilemma.

Finally, I will briefly review the Sino-Japanese economic relations. Both China andJapan achieved their economic miracles following export-oriented strategy andbenefited significantly from unprecedented globalization of the last decades. With thesurprising victory of Trump, the two countries will face serious challenges of inwardlooking and anti-globalization policy of the Trump administration. Close collaboration
between the two countries is essential for sustaining trade liberalization and regional
economic integration. Both countries will surely benefit from the cooperation.

2. The Reorientation of Global Value Chains and the Fall of China’s Exports
Most of China watchers blame sluggish external demand for disappointing export
growth. To a certain extent, weakened demand of the U.S. Japan and the European
Union, the major destinations of China’s exports, undermined substantially the growth
momentum. Examining the structure of China’s exports, however, tells a different story.
China’s exports consist of ordinary and processing exports. Processing exports are4made with imported intermediate inputs and divided into pure assembly exports (PAE)and mixed assembly exports (MAE). All intermediate inputs used to produce PAE areimported. Chinese workers simply assemble imported parts and components into
products according to the requirement of foreign suppliers and then export PAE abroad.
Low skilled labor services are the only value added to PAE by Chinese workers. 3G
iPhons is a typical example of PAE. Of $179 manufacturing cost per 3G iPhone,
Chinese workers added a merely $6.5, about 3.6% of the total cost (Xing and Detert,
2010). MAE is manufactured with parts and components produced both domesticallyand abroad. Key components defining the sophistication of MAE, such as central
processing units of personal computers, mobile chips of smart phones, lenses of digital
cameras, etc., are generally imported. Moreover, most of MAE carries foreign brands
and is marketed through the global distribution networks of multinational enterprises.

Decomposing China’s exports into ordinary and processing exports shows that, theperformance of those two different categories diverged substantially. Despite of theoverall negative growth of China’s exports, in 2015 ordinary exports rose 1.2%. In
contrast, processing exports plunged greatly, specifically PAE fell 10.1% and MAE
shrank 7.2%. In the first eleven months of 2016, both PAE and MAE further decreased
more than 10%. As a matter of fact, in 2007 PAE started to decline and 2015 is the firstyear that MAE grew negatively since China embraced processing exports as a driver ofexport growth. The significant contraction of processing exports dragged down theoverall performance of China’s exports. The persistent fall of processing exports is very
alarming and challenges the recovery of export growth, as processing exports remains
more than one third of China’s exports (Figure 2).

Processing exports is actually a subset of GVC activities. By engaging in processing
exports, Chinese firms have been successfully integrated with GVCs and gained
accesses to the global market. Lacking in brand recognition, global distribution
networks, and advanced technology, Chinese firms face tremendous difficulties inpenetrating international markets, in particular the markets of high-income countries,
where consumers prefer branded products and high-tech gadgets. Being a part of GVCs,
Chinese firms can easily overcome these obstacles and enter international markets, byleveraging on the advanced technology, brands, and global production networks of
GVCs’ lead firms (Xing, 2016b).
5

The rapid expansion of processing exports suggests that, GVCs have actuallyfunctioned as an effective vehicle for Chinese firms to sell their low skilled labor
services and low value added parts and components to consumers of international
markets. Besides the intrinsic comparative advantage in abundant labor endowment,
plugging into the value chains of the global manufacturing industry by specializing inprocessing exports, explains most of China’s export boom in the last decades. It is theprocessing exports that transformed China into the largest high-tech exporter. About
eighty percent of China’s high-tech exports falls into the category of processing exports.
China’s leading position in the export of information technology products, such as
mobile phones, laptop computers, and digital cameras, was achieved through rapid
expansion of processing exports (Xing, 2014).
Figure 2
Declining Processing Exports (% of China's Total Exports)
60.0
50.0
40.0
30.0
20.0
10.0

0.0

1995

1997

1999

2001

2003

2005

Processing Exports (%)

2007

2009

MAE

2011

PAE

2013

2015

Source: the author’s calculation based on the data of China Customs.

Processing exports used to account for more than 50 percent of China’s exports before
the global financial crisis. At its peak, its share reached as high as 57 percent. The
drastic expansion of processing exports powered the double-digit growth of China’s
exports since China officially joined the WTO in 2001, and eventually transformed
China into the No.1 exporting nation in the world. The share of processing exports fell
below 50% after the global financial crisis, and since then decreased steadily to 37
percent by 2015 (Figure 2). It cannot be simply explained as a healthy adjustment of
the export structure. The increase in ordinary exports failed to offset the contraction ofprocessing exports. The decline of processing exports has been accompanied with6

decreasing and even negative growth of overall exports.

The shrinking of processing exports is mainly due to gradual exits of both domestic andforeign firms from processing exports. Wage increases and cumulative appreciation of
the yuan against the U.S. dollar have eroded the competitiveness of both domestic andforeign companies assembling exports in China. From 2000 to 2014, the wage ofChinese workers grew more than 13% annually. In 2014, the annual wage averaged 56,
400 yuan (about U.S. $9,300). If wage growth exceeds workers’ productivity growth,firms’ profits and competitiveness will be undermined. Additionally, in China
employers’ contributions to all benefits of employees, such as pension, healthcare, andunemployment insurance, are based on wages. Higher wages imply more benefit
contribution. The actual production costs rose much more than what the wage increaseindicates. Chinese firms engaging in processing exports generally have no pricing
power and cannot pass on the increased labor cost to foreign buyers. They have toaccept processing fees set by lead firms of value chains, and absorb the increased labor
cost either by improving productivity or lowering profit margins. If they fail to copewith the rising labor cost, they will exit processing exports or relocate to third countries,
which undercut the export capacity and employment of the Chinese economy.
Figure 3
Rapid Wage Growth (1,000 Yuan)

9.3

10.8 12.4

14

15.9

18.1

20.9

24.7

28.9

32.2

36.5

41.8

46.8

51.5

56.4

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: China Statistics Yearbook

Moreover, from July 2005 to July 2015, the yuan appreciated cumulatively against the7

U.S. dollar about 32.2% from 8.2yuan/dollar to 6.2yuan/dollar. During the same period,
both Japanese yen and euro depreciated against the U.S. dollar. As a result, thecompounded effect made the yuan appreciate against the yen and euro even more. The
exchange rate of the yuan to euro fell to 6.8yuan/euro from 9.9yuan/euro, implying a
45.6% nominal depreciation of the yuan; the yuan to yen decreased from
7.3yuan/100yen to 5.0yuan/100yen, about 46% nominal appreciation. Processing feesor the prices of China’s processing exports are mainly invoiced in the U.S. dollar, euroor yen. There exists no automatic transmission mechanism to pass on the appreciation
to foreign contractors or buyers. Chinese firms have to shoulder all the cost associatedwith the appreciation of the yuan. Compounded with the wage increase, theappreciation of the yuan further eroded China’s competitiveness as the assembly centerof the global manufacturing industry, and has resulted in an exodus of export-oriented
foreign investors, which resulted in substantial decrease in China’s processing exports,of which foreign invested firms accounted for more than 70%. The empirical researchsuggests that wage increases and the appreciation of the yuan are the two major factors
undermining the growth of processing exports (Xing, 2016a).
Figure 4

12.0

Yuan’s Appreciation against Major Currencies

10.0
8.0
6.0

Yuan/Dollar

Source: Pacific Exchange Rate Service

Yuan/Euro

Sep-14Jul-15

Feb-15

Apr-14

Nov-13Jan-13Jun-13Aug-12Mar-12Oct-11

May-11

Dec-10

Sep-09Jul-10Feb-10

Apr-09Jun-08Nov-08Jan-08Aug-07Mar-07

Oct-06

Dec-05

May-062.0

Jul-05

4.0

Yuan/100Yen

In recent years, many Japanese firms, such as Panasonic and Citizen Holding closed
8their factories in China and relocated the production facilities either back to Japan orSouth East Asian countries. China had been the top destination of Japanese direct
investment. Now ASEAN has replaced China as the largest host of Japanese direct
investment in Asia because of rising production costs associated with the appreciationof the yuan and rising labor costs (Xing, 2016c). The survey of JETRO (2015) showsthat, Japanese firms that planned to withdraw from or stop expansion in China cited thewage as one of the most important factors. Foxconn, an exclusive assembler of iPhones,has decided to invest $50 billion in India for building assembly facilities andinvestigated the possibility of assembling iPhones in the U.S. As more and more MNEs
relocate their production capacities out of China or reduce the scale of outsourcing low
value added tasks to Chinese firms, China’s processing exports will continue to fall.
Hence, it will be very challenging for China’s exports to regain the growth momentum
unless the yuan could depreciate to the level by which the retreat of foreign investment
could stop.

It is true that production capacity and technology of Chinese firms have advanced
substantially in the last decades. Their technologic gaps with the firms of developed
countries have been cut. The advancement of Chinese firms also contributed to thedecline of processing exports. On the other hand, since the overall growth of exports
turned to negative from more than 20% over just a few years, it suggests that the
progress of Chinese local firms, which produce ordinary exports, is limited and has notbeen able to offset the vacuum left by the firms which exited the business of processing
exports.

3. The Depreciation of the Yuan and Capital Outflows
Since Aug. 2015, the yuan has depreciated more than 10% against the U.S. dollar. The
persistent depreciation is positive to revitalize the growth engine of exports, but hascreated anxiety in China and triggered massive capital outflows, which has become amajor financial risk to the stability of the Chinese economy. China’s foreign exchange
reserves dropped $69.1 billion in November of 2016. It has been falling since August
2014. Money had been leaving for more than two years. As a result, China’s foreign
reserves lowered to $3.05 trillion from its peak of $3.96 trillion.

9

Whenever the yuan depreciated against the U.S. dollar, the Chinese policy makers,
media and mainstream analysts, blamed unscrupulous speculators and argued
vehemently that there was no basis for the long-term depreciation of the yuan. The
detailed examination of the evolution of both Chinese and US monetary policies in thelast two years, however, unequivocally suggests that the yuan has been facing apressure of depreciation in the short-run. According to economic theory, interest rate
parity determines the equilibrium of exchange rates in the short-run. The divergence ofmonetary policy between China and the U.S. broke the original interest rate parity. The
adjustment of the yuan’s exchange rate is required to achieve a new equilibrium.
Figure 5
Shrinking Foreign Exchange Reserves (Trillion US dollar)
3.81 3.8 3.73 3.75 3.71 3.69

3.65 3.56 3.51 3.53

3.44 3.33

3.23 3.2 3.21 3.22 3.19 3.21 3.2 3.19 3.17 3.12

3.05 3.01

Source: the People’s Bank of China.

In October 2014, the U.S. officially exited quantitative easing, the non-traditionalmonetary policy adopted by the U.S. Federal Reserve to combat the great recession
following the bursting of the housing bubble in 2008. In December 2015, the U.S.
Federal Reserve raised the interest rate to 0.25 percent from zero, indicating the
beginning of a new cycle of rising interest rates. Again, the U.S. Fed raised the interest
rate 0.25 percentage points in Dec. 2016 and the meeting minutes of the Fed suggestthat there would be three hikes of interest rates in the coming year. In contrast, China
entered a cycle of declining interest rate in November 2014, when the PBoC cut the
one-year deposit rate to 2.75 percent from 3.0 percent to support the growth of theChinese economy. So far, the PBoC has cut interest rates five times and lowered oneyear deposit rate to 1.5%. Clearly, the return of the dollar denominated assets has been10

rising while that of the yuan has been decreasing, which raises the demand for dollar
assets and erodes the demand for yuan assets. Given relative weak economic growth, it
is impossible for the PBoC to raise interest rates in foreseeable future. It is the invisible
hand that has been driving the depreciation of the yuan. All speculators who expected
the yuan to fall are simply smart enough to foresee the trend ahead of the curve.

Purchasing power parity determines the equilibrium of exchange rates in the long run.
The purchasing power of a currency has a negative relationship with money supply.
China’s 4 trillion yuan stimulus implemented by the Chinese government tocounterbalance the shock of the global financial crisis and the subsequent credit
expansions have greatly bloomed the money supply of the Chinese economy, pushingbroad money supply M2 of 2016 to 153 trillion yuan, more than 200% of China’s
nominal GDP, much higher than that in the U.S. The purchasing power of the yuan has
been greatly eroded relative to the U.S. dollar. The buying frenzy of Chinese tourists inJapan and the seemingly unsaturated appetite of Chinese investors for foreign real estate
are evidence that the yuan has been overvalued, not only to the dollar, but also to euro
and Japanese yen.
In a closed economy, it is possible to maintain a fixed exchange rate regime. For an
economy like China, which every year trades about $4 trillion in goods and services
with the rest of the world and has a liberalized current account, it is almost impossible
to maintain a very rigid managed floating system, which only allows a narrow band of
2 percent around predetermined midpoint. The PBoC attempted to reform the rigid
exchange rate regime. On 11 August 2015 it unexpectedly announced that, the central
parity of the yuan’ exchange rates should be based on the closing rate of the previous
day, in conjunction with the demand and supply. It cut the reference rate by 1.9% on
the day. The decision shocked both domestic and foreign markets and triggered massive
volatilities. Market players interpreted the new policy as a green light to gradualdepreciation of the yuan. Since then, the yuan has entered a path of depreciation. To
slow down the pace of the depreciation, the PBoC has repeatedly intervened foreignexchange markets by selling the U.S. dollar at both on-shore and off-shore yuan
markets. In Feb, 2016, the PBoC adopted a new rule to determine the daily reference
rate with a basket of currencies and the closing rate of the previous day. All thesemeasures failed to stabilize the exchange rate of the yuan. The depreciation expectation
11

about the yuan has not faded yet but intensified.

Concerned with the depletion of foreign exchange reserves and continuous depreciationof the yuan, the Chinese government introduced capital controls from the beginning of
2017. Overseas investment has been recentralized. All overseas investment projects
more than $5 million should be approved by the State Administration of Foreign
Exchanges (SAFE). Even though SAFE keeps $50,000 annual quota for each individual
retail consumer unchanged, purchasing U.S. dollar or any foreign currencies has
become difficult and subject to rigorous screening. Chinese residents should fillcomplicated forms and state clearly why they purchase foreign currencies and when
they will use them. False reporting may be subjected to a penalty equivalent to 30% of
the transactions and of losing the $50,000 quota for two years.

In fact, China has entered the trilemma of open macroeconomic policy — independent
monetary policy, capital mobility, and a fixed exchange rate cannot be achieved
simultaneously and any combination of two policy objectives implies the third is
impossible. The trilemma is true, regardless of the size of an economy. As the second
largest economy with more than $10 trillion GDP, China cannot afford to lose theindependence of monetary policy. A series of interest rate cuts since September 2014
and a recent cut on the required reserve ratio of commercial banks indicate thatmonetary policy remains an indispensable tool to stimulate the growth of the Chinese
economy. On the other hand, the intervention of the PBoC in foreign exchange markets
actually sterilized the monetary expansion induced by the decrease of interest rate.
Continuous interventions not only deplete foreign exchange reserve, more importantly
weaken the autonomy of monetary policy. China’s foreign exchange reserves have
dropped almost $1 trillion since PBoC started to reform the exchange rate regime in thesummer of 2015. Actually, China had managed to maintain a handsome surplus in tradeof goods and services. Adding the trade surplus to the top of the reduction in foreignexchange reserves, cumulative capital outflows from Aug. 2015 to Nov. 2016,
amounted about $1.67 trillion. No other country could afford such a huge capitaloutflow. The ratio of China’s foreign exchange reserves to money supply M2 has fallen
below 14%, much lower than the safe level 20% recommended by the International
Monetary Fund. As the stock of the foreign exchange reserve gradually shrinks, the12ammunition that the PBoC can use to stabilize the exchange rate of the yuan will
become less, which may further strengthen the belief that the PBoC would eventually
give up its intervention, like all the central banks which attempted to defend fixedexchange rate regime during crisis but eventually ended up with sharp depreciation. It
is highly likely that a one-time sharp depreciation of the yuan and continuous capitaloutflows might trigger financial turmoil and severely undermine the stability of theChinese economy, which is the major risk of the Chinese economy in the short-term.

Chinese firms and households have accumulated enormous wealth after the high growthof last decades. They desire to diversify their asset portfolios and pursue investment
opportunities abroad. The 4 trillion yuan stimulus led to overcapacity in manufacturingindustry. For instance, China’s total production capacity of steel in 2012 was 470
million tons, much higher than aggregated demand of 320 million tons; total production
capacity of electrolytic aluminum of the country was 11 million tons, far exceeding thenational demand of 7.2 million tons (Zhu, 2016). Facing with the overcapacity
challenge, many Chinese manufacturing firms had looked for opportunities to expand
abroad through mergers and acquisition or green field direct investment. In 2016,
China’s overseas investment totaled $221 billion, more than doubled that in 2015. The
overseas investment activities also facilitated capital outflows. That is why the Chinese
government has re-centralized the approval of overseas investment from the beginningof 2017 to curb the tide of capital outflows.

4. The Sino-Japanese Relations
There is no doubt that a stable and prosperous Chinese economy benefits the growth ofJapanese economy, which remains dependent on external demand, in particular as its
population is aging and declining. In spite of political uncertainty, the economies ofChina and Japan have been closely integrated together through bilateral trade andcapital flows, which has enhanced significantly the inter-dependence of the twocountries. In 1990, the scale of Sino-Japan bilateral trade was relatively small andamounted $18.1 billion. It rose drastically in the last two decades and in 2011 reacheda record high of $345.9 billion, more than 19 times of that in 1990. China’s transition
from a closed to an open economy and the unprecedented high growth of last three
decades, has nurtured a new market with 1.4 billion population and more than $8,000
GDP per capita, which has provided enormous growth potential to Japanese exporting13

firms. Japanese firms have seen their exports to China rising exponentially. In 1990,
Japan exported $6.1 billion goods to China, about 2.1% of its total exports. By 2011,
the annual volume surged more than 25 times and reached $162 billion, accounted for
19.7% of Japanese exports to the world (Figure 6). As a result, Japan’s exports to China
in 2004 exceeded that to the U.S. for the first time. Since then, China has turned into
the largest market of Japanese exports.
Figure 6
Sino-Japanese Bilateral Trade (billion US dollar)
200.0
160.0
120.0
80.0

0.0

1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

40.0

Chinese exports to Japan

Source: Japan External Trade Organization

Japanese Exports to China

As a high-income country with more than 125 million population, Japan has been an
indispensable market of Chinese exports. In 1990, China’s export to Japan valued at$12 billion. It continues to expand the market share in Japan. By 2012, the annual
volume reached a record high of $188.5 billion, about 9.2% of China’s total exports tothe world. Moreover, during the period of 1990 to 2015, China run trade surplus against
Japan every year. The trade surplus increased substantially from $5.9 billion to $51.3
billion per year, contributing significantly to China’s foreign exchange reserves.

It is worthy to mention that more than half of China’s exports to Japan belongs toprocessing exports, which has functioned as a vehicle for made-in-China products toenter the Japanese market. In 1993, processing exports accounted for 43% of China’s

14

exports to Japan. As more and more Japanese MNEs relocated their assembly capacities
into China or outsourced low value added tasks to Chinese firms, the share ofprocessing exports in China’s exports to Japan surged to 59% by 2005, Due to risinglabor cost and the appreciation of the yuan, Chinese firms have gradually lost thecompetitiveness in low value added task—assembly. Therefore, the share of processing
exports declined slightly in recent years, but remained as high as 51% in 2013 (Xing,
2016b).

The growth momentum of the Sino-Japan bilateral trade seems to discontinue in recent
years. Japanese imports from China decreased to US$160 billion in 2015, about 15%
lower than in 2012. Meanwhile, Japanese exports to China also decreased substantiallyand dropped to $109 billion in 2015, about one third lower than its peak $162 billion in2011 (figure 6). There are a few factors contributing to the contraction of the bilateral
trade. First, the Japanese government’s nationalization of Diaoyu/Senkaku islands
triggered anti-Japanese demonstrations in China, which severely undermined thebilateral diplomatic relations, deteriorated the business environment, and enhanced therisk of Japanese firms doing business in China. Secondly, many Japanese affiliatedfirms in China had used China as an export platform. They imported intermediate inputs
from Japan, and then used those imports to manufacture exports for Japanese markets.
The activities of these firms contributed to the increase of the bilateral trade. Due torising costs of labor and land in China, many Japanese firms have relocated theirproduction facilities either back to Japan or third countries, resulting in the decrease of
the bilateral trade (Xing, 2016c). Finally, the double-digit growth of the Chinese
economy has ended. The Chinese economy has slowed down substantially since 2012
and weakened its demand for Japanese products.
Figure 715

Japanese FDI in China (billion US dollar)
13.5
12.6

3.2

2.3 1.9

1.3

0.4 0.9

2.2 2.6

4.0

5.9

6.6 6.2 6.2 6.5

6.9 7.3

9.1

10.4

8.9

Source: Japan External Trade Orgnization.

Foreign direct investment is another channel of integrating Chinese and Japanese
economies. Japan is one of the largest capital-exporting countries. It holds about 335
trillion Yen overseas assets, the largest in the world. Excluding Hong Kong, Japan has
been the largest FDI sources of China. In 1995, Japanese MNEs invested $3.2 billion
directly. The annual inflows surged to $13.5 billion in 2012, making China the No.1
host of Japanese FDI in Asia (figure 7). According to JETRO, the stock of Japanese
FDI in China totaled US$104 billion by the end of 2014, much larger than that from theUnited States, or any European country.

Before 2005, most of Japanese firms mainly utilized China as an export platform.
Japanese affiliated manufacturers exported most of their products to overseas markets.
The shares of exports were particularly high in the sectors of electrical machinery andtransportation equipment. In 1996, Japanese affiliated manufacturers of electricalmachinery exported 78% of their products aboard while in transportation equipment
overseas sales accounted for 84%. As Chinese economy grows and the income ofChinese households increases, Japanese affiliated firms have gradually raised theirsales in Chinese local market and switched the focus from overseas to the domestic
market. The share of overseas markets decreased steadily while local sales rose rapidly.
By 2005, the share of exports of Japanese affiliated manufacturers as a whole decreased
to 55%, and further fell to 31% in 2015. The transition of Japanese affiliates’ operationin transportation equipment is the most dramatic. In 2015, they exported only 6% of

16their products to overseas markets while sold the rest to Chinese consumers. Becauseof the sustained high growth, China has emerged as the largest automobile market in
the world with an annual sale of more than 20 million units. Automobiles are embraced
as a standard and necessary item of Chinese middle class families. The strong growthof China’s automobile market fueled the shift of Japanese affiliates from exportoriented to domestic market oriented. The successful transition of Japanese affiliates’
operation strategy shows how foreign firms, which entered China for manufacturingexports at the early stage of China’s development, could benefit both in the short andlong run. In the short-run, they could take the advantage of cheap labor while in thelong-run benefit from growing domestic market, as the income of Chinese households
rises and their affordability and preferences of high-quality and big ticket items increase.
Chinese firms have accumulated massive capital after the high growth of more than
three decades. They have started their overseas expansion by investing abroad directly.
Investment flows between the two countries are no longer a one-way phenomenon.
More and more Chinese companies have been searching investment opportunities andacquired Japanese companies. China’s investment in Japan is purely driven by thehunger for strategic assets and intellectual properties, such as advanced technology,
globally recognized brands and international distributional networks. Chinese M&A
deals in Japan exceeded $1.0 billion in 2015, up 34% over the previous year. Comparedwith U.S. and other industries, the scale of Chinese M&A in Japan remains relatively
small. However, a few highly profiled deals concluded by Chinese companies imply an
upward trend of Chinese investment in Japan (table 1).

Table 1 Chinese Firms’ M&A in Japan17

Source: various media reports.

In 2016, Midea, one of leading Chinese home appliance makers, acquired 80% stake ofToshiba Lifestyle Products & Service Corporation with 53.7 billion yen. Toshiba’s
technology and brand are the prime target of the deal. Through this deal, Midea has
obtained the right to use “Toshiba” brand worldwide in white goods for forty years(Midea, 2016). Another Chinese home appliance maker Haier made a similar deal in2011 by acquiring Sanyo Electronic with 10 Billion Japanese yen from Panasonic. The
manufacturing facilities and distributors of Sanyo in South East Asia were transferred
to Haier, thus significantly expanded Haier’s distribution networks and visibility in theregion. Sanyo’s energy efficient refrigerator technology and the corresponding brand‘Aqua” were also transferred to Haier, which can use “Aqua” brand to market
refrigerators both in Japan and overseas. Facing with stiff competition of Korea andChinese electronic makers, Japanese electronic companies have gradually withdrawn
from home appliance industry. Chinese companies’ M&A of Japanese electronic
companies are win-win deals. On the one hand, Chinese companies receive
technologies and brands, which could strengthen their competitiveness and facilitate
the global expansion. On the other hand, Japanese sellers can use the cash payment
provided by Chinese buyers to improve balance sheets and restructure business
operations. Another significant deal is China’s PC giant Lenovo bought 44% stake of
NEC in Lenovo-NEC joint venture for $195 million. The deal will further strengthen
Lenovo’s leading position in Japanese PC market and support the growth of Lenova’s
core business.

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The acquisitions of Midea and Haier target three properties: brands, technologies anddistribution networks of Japanese firms. Lenovo’s deal focuses on the well-establisheddomestic distribution channel and the PC lab of NEC. There are some Chinesecompanies primarily concentrate on technologies of targeted Japanese firms. BYD,
China’s leading electric car maker, took over a factory from Ogihara Corp., a major
Japanese metal die manufacturer, to produce high-precision metal dies for its Chinese
factories. Higher-precision dies can improve the quality of auto bodies and otherproducts. The acquisition would help BYD narrow the technical gap with Japanese andWestern rivals.

Rising Chinese tourists to Japan represents another shining aspect of the economic
integration between the countries. The third arrow of the Abenomics emphasizes thedevelopment of tourism industry to offset the shrinking Japanese domestic demandcaused by ageing and declining population. In 2016, foreign visitors to Japan surged to
24.04 million, exceeding the 20 million target set by the Japanese government for 2020.
6.37 million Chinese tourists, more than a quarter of the total foreign visitors, visited
Japan. It is first time that the number of Chinese tourists exceeded 6 million mark. It isestimated that the Chinese tourists spent 1.48 trillion yen about 40% of foreign visitors
spending in Japan. On average, Chinese tourists spend more much than their peers fromhigh-income countries (Japan Times, 2017). The influx of Chinese tourists and their
extraordinary preferences to “made in Japan” products boosted the revenues ofJapanese retail industry and hotels.

It is worthy to mention that, immediately after the Japanese government’s
nationalization of Diaoyu/Senkaku islands, many Chinese tour groups cancelled theirplanned trips to protest the nationalization and the number of Chinese tourists to Japanplunged sharply. In 2013, about 1.3 million Chinese visited Japan, about 10% lesscompared with the previous year. It seems that the negative impact of the territorial
dispute on Chinese tourists to Japan has gone completely. Most of Chinese haverationally insulated their personal decisions from the diplomatic disputes of the twocountries. On the contrary, Japanese tourists have been deeply affected by the violent
anti-Japanese demonstrations erupted in China because of the nationalization of
Diaoyu/Senkaku islands. Their perception about the risk of traveling in China has not
19been changed much. According to the statistics of China National Tourisms
Administration, the number of Japanese tourists to China dropped steadily every year
after 2012. In 2015, Japanese tourist to China decreased to 2.49 million, more than one
million less than in 2012. During the period, the total number of outbound Japanese
tourists actually rose, implying that Japanese tourist have turned to be less favorable tovisiting China. Compared with Chinese tourists, Japanese tourists are much more riskaverse and cautious. It remains an open question when the number of Japanese tourist
could resume to the level before the nationalization of Diaoyu/Senkaku islands.

The economic integration between China and Japan through trade, investment andtourists, has been simply driven by the invisible hand. China and Japan have not started
to negotiate a bilateral free trade agreement (FTA) yet. Except that both countries
belong to the WTO, which entitles them to have the status of the most favor nations,
there is no any other institutional arrangement to prompt the bilateral trade of the SinoJapan. Even worse, political tensions and concerns of national security occasionallydamage the progress of FTA negotiations where both China and Japan are involved,
such as China, Japan and Korea FTA and Regional Comprehensive Economic
Partnership (RCEP), which include 10 ASEAN countries plus China, Japan, Korea,
Australia, New Zealand and India.

Japan had given the Trans-pacific Partnership (TPP) top priority in the agenda ofregional cooperation. Unfortunately, on the day one at the Oval Office, President
Trump officially signed an executive order to withdraw the TPP

Without theparticipation of the US, the largest economy in the world, the TPP would deteriorate toa minor FTA and “meaningless”, and be no different with many other trade deals in socalled “FTA spaghetti bowl”. Trump’s rejection of TPP does not means that the Trumpadministration intends to weaken Japan-U.S. alliance and single Japan out for fixing
the huge trade deficit of the U.S. It is just a beginning of a series of anti-globalization
policies, which will be adopted by the Trump administration. China and Japan are oneof the largest beneficiaries of the unprecedented globalization of last decades. The
economic structures of both economies suggest that they remain highly dependent onexports. It is at the best interests of the two countries, at least in terms of economic
welfare, that the countries could cooperate together and jointly defend and lead tradeliberalization and economic integration in Asia-Pacific region. Geopolitical concerns
20and territorial disputes often hurdle close economic cooperation between the twocountries. If the leaders of the two countries could rationally isolate economic matterswith national security issues to a certain degree, both countries will surely benefit fromfurther the close economic cooperation. Any forms of regional economic cooperation
require active and positive participation of both countries. If China and Japan cannot
worker together, both countries will lose and there will be no Asia century.

5. Concluding Remarks
Consumption, investment and exports had supported the rapid growth of the Chinese
economy. Now the pillar of exports collapsed completely as its growth turned tonegative. Rebalancing Chinese economy from export-oriented to consumption oriented
has been called repeatedly by both scholars and policy makers. However, it is easy said
than done. The rebalancing requires drastic changes of the economic structure, whichcannot be completed in the short-run. As more and more MNEs continues to relocate
their production capacities back to home or third countries, Chinese exports willcontinue to fall unless its currency depreciates sharply.

Chinese yuan has depreciated against the US dollar more than 10% since the summerof 2015. As the U.S. continues to raise interest rates, it is expected that the yuan will
depreciate further. The persistent depreciation has caused anxiety in China andtriggered massive capital outflows. China may face a financial crisis if it cannot manage
the consequence of yuan’s excess depreciation and rapid depletion of foreign exchange
reserves.

Both China and Japan achieved their economic miracles by adopting export-oriented
strategy. These two countries have benefited considerably from the unprecedented tradeliberalization and globalization. With the Trump administration, the progress of tradeliberalization and globalization is highly likely to be interrupted, or even reversed. The
two countries should work together and jointly take the leadership to promote regional
economic integration and defend the global trading system. Both countries and thewhole Asia pacific region will benefit from the close cooperation of the two countries.

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Midea, 2016 Toshiba and Midea Agree on the Transfer of Toshiba’s Home Appliances.
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