Japan's Joyride On China's Coattails

Soaring exports to the mainland are the driving force behind Japan's first sustained recovery in a decade

Not long ago, Japan Inc. was deeply troubled by the prospect of China's ascendance. Pundits argued that high-wage Japanese workers didn't stand a chance against their Chinese counterparts. Mainland upstarts such as TCL Communications Equipment and Haier Group were splashed across magazine covers as rivals to the likes of Sony (SNE ), Panasonic, and NEC. Politicians wrung their hands over kudoka -- the hollowing out of Japan's vaunted manufacturing sector. It all added up to one seemingly inevitable conclusion: Japan's days as Asia's economic kingpin were numbered.

Today, Japan's corporate and political elite are singing a different song. Instead of a nemesis, China is looking more and more like a savior, fueling Japan's first sustained economic recovery in a decade. On Feb. 18, Japan reported that its economy clocked 7% annualized growth in the October-December quarter, the fourth consecutive quarter of expansion and the biggest jump since 1990. A rebound in corporate earnings, a recovery in capital spending and exports, and even an easing in the country's deflationary scourge all owe much to the hypergrowth wave in China. In 2003, exports to the mainland -- including everything from steel to mobile phones -- shot up a record 44%, to $60 billion. "The panicky rhetoric about China you used to hear has completely gone off the radar screen," marvels Paul Sheard, a Tokyo-based economist for Lehman Brothers Inc. (LEH ).

Sure, the U.S. still matters, and so does consumer spending inside Japan. But Japanese exports to the U.S. slid 10% last year, and domestic consumption is just recovering. So going forward, China will probably be the key driver of Japanese expansion. China is already Japan's top trading partner, and it may soon overtake the U.S. as Japan's biggest export market. China accounted for more than a third of the 2.7% advance in Japan's real gross domestic product in calendar 2003, figures Mamoru Yamazaki, chief economist at Barclays Capital in Tokyo. "The Chinese economy is making a bigger contribution to Japan than the U.S. right now," he says.

LONG-TERM RISKS. Make no mistake: Longer-term, Japan has good reason for concern. China certainly seems destined to overtake Japan in economic output sometime in the next 10 years, and many of its companies may well knock their Japanese competitors from their thrones. And Japan's recovery is far from assured: It's still the land of sick banks, lousy productivity, and the highest government debt burden among the Group of Seven industrialized nations. Furthermore, the newfound reliance on China means the party would end quickly if an overheated Chinese economy stumbled, as some fear.

For now, though, China smells more like an opportunity than a threat. Legions of companies that manufacture industrial equipment are seeing their earnings jump, boosted by demand from China. For instance, construction-equipment maker Komatsu Ltd. says its operating profit soared 89%, to $396 million, for the nine months ended in December, thanks to a doubling in sales to China. Numbers like that helped push Japan's industrial production index up by 3.6% for the October-December quarter, the best showing in 16 years.

China is even helping to defeat Japan's long-term bogeyman: deflation. As China builds ever more skyscrapers, railroads, and highways, demand for steel and raw materials has soared. The price of hot-rolled steel coils, for example, jumped by 16% last year, largely thanks to China's construction boom. That helped push up Japan's corporate goods price index by 0.1% in January, its first rise in more than two years. And it's translating into profits for the likes of JFE Holdings Inc., a joint venture formed last year between top steel producers Kawasaki Steel and NKK. JFE, which sold 20% of its production in China last year, expects its earnings will jump by 30%, to $2 billion, in the fiscal year ending in March. Now the company is doubling down on its China bet: In September, JFE set up a venture with Guangzhou Iron & Steel Enterprises Holdings Ltd. to make galvanized steel sheets for carmakers in China.

HIGH-END ELECTRONICS. Soon, many of JFE's Chinese customers could look a lot like its customers at home. Although they were late to the game, Japanese auto makers in 2003 saw their exports to China grow by 30%, and now they're rushing to manufacture there. Toyota Motor Corp. last April concluded a deal with China FAW Group Corp. to jointly produce four models in China. And Nissan Motor Co. (NSANY ) in 2002 agreed to pour $1 billion into a joint venture with Dongfeng Motor Corp. The company aims to have six locally produced Nissan models in showrooms by 2006 and hopes to double unit sales of both brands in China, to 620,000 vehicles, by 2007. "China will be the main engine of growth for Nissan globally," predicts Katsumi Nakamura, a former Nissan exec dispatched to run the venture.

Even Japan's electronics manufacturers are making the best of what is clearly a challenge from low-cost Chinese producers. Matsushita Electric Industrial Co. (MC ), for instance, knows it can't compete with low-cost Chinese companies that churn out relatively simple white goods such as microwaves and refrigerators at impossible-to-beat prices. So Matsushita is instead concentrating on higher-end products such as DVD recorders, plasma displays, and mobile phones. The strategy is paying off: Matsushita last year saw its sales in China grow by 30%, to $5.7 billion, as Chinese consumers snapped up its camera phones and corporate customers bought its components for handsets and cellular base stations.

The electronics giants are also discovering that one size no longer fits all nations, even when it comes to gizmos such as TVs and cell phones. So Sharp Corp. (SHCAY ) last year opened a consumer-electronics research center in Shanghai to better understand Chinese consumers and design products that suit their tastes. By June, it expects to have 100 or so local designers and others on staff. And NEC Corp. (NIPNY ) on Feb. 2 introduced a camera phone -- which it says is the world's lightest and thinnest, not much bigger than a credit card -- developed specifically to appeal to the cutting-edge taste of wealthy Chinese consumers.

Of course, the day some Chinese rival possesses the engineering and marketing smarts to turn out that kind of gadget will be a cruel one for Japan. Companies of all stripes will face stepped-up competition from China, just as they do today from arriviste worldbeaters such as Samsung Electronics Co. But for now, China's voracious appetite for Japan's products is nowhere near satisfied -- and until it is, China and Japan have the makings of a beautiful friendship.

By Brian Bremner and Hiroko Tashiro in Tokyo, with Dexter Roberts in Shiyan, China

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