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A Barking Dog Won’t Bite

Sigma Investment Counselors

September 19, 2012

The territorial disputes between China and Japan over a group of uninhabited islands in the East China Sea have sparked protests in China since last month. The intensity of the dispute increased last week after the Japanese government bought some of the islands from a private Japanese owner. On Sunday, the biggest anti-Japanese protests in decades occurred in more than 50 Chinese cities. In some large cities, the demonstrations escalated to violent attacks on Japanese businesses or even Chinese-owned Japanese stores and restaurants. On Monday, the People’s Daily, the mouthpiece of the Communist Party, warned that China could resort to economic retaliation if the dispute festers. Can China really afford a trade war right now?

It is important to understand that the trade and economic interests of China and Japan have become increasingly interwoven. China is Japan’s biggest trade partner and Japan is China’s third largest. The trade relationship between China and Japan has tripled in the past decade to reach more than $340 billion last year. Although Japan relies more on China for economic growth than vice versa, we cannot ignore the fact that China is also facing pressure to boost their domestic economy that is growing at its slowest rate since the 2008 financial crisis. The financial turmoil in Europe and the slow pace of economic growth in the US have dragged down exports from China.

Economic data, released in August, showed that in July Chinese exports were up just 1% from the same month a year ago, far below expectations. Furthermore, Japanese firms often form joint ventures with Chinese local companies to sell their products, especially in the auto industry. It would be hard for the Chinese government to place trade sanctions on those Japanese firms. Having been born and raised in China, I am familiar with this kind of pattern of behavior in which the Chinese government manipulates the mass protests to put the pressure on the foreign governments and achieve its foreign policy goals. Similar demonstrations swept China in 2005 and the protesters called for a boycott of Japanese products. However, this did not prevent Chinese imports from Japan going up 15.2% in 2006.

This intense relationship between China and Japan might benefit Detroit’s automakers. According to a set of Bloomberg data this month, the sales of Japanese branded passenger cars fell in August in China, compared with gains of more than 10% for German, American and South Korean vehicles.

Sigma will continue monitoring the developments on this matter and incorporate our observations into our investment strategies.

Comments or questions are welcome.

Wenma Gorman, CFA

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