The debate continues on the motivations and risks of China’s decision on November 23 to announce an East China Sea Air Defence Identification Zone (ADIZ) which critically includes the disputed Senkaku Islands (know in China as Daioyu). There is little dispute that the standoff between China, Japan and the US has the capacity to escalate into something much more dangerous unless US Vice-President Joe Biden’s recent Asia trip is effective in ratcheting down tensions.
Has China miscalculated in terms of the rapid US response of B52 bomber sorties over the disputed Islands or prospective US naval deployment build-up in the region? Or is this the preliminary phase of a much longer-term slow creep by China in fulfilling its ambitions in establishing a more dominant regional role? Vietnam, the Philippines, Taiwan, Malaysia and Brunei (all US allies) are – like Japan – enmeshed in arguments with Beijing over relatively minor but potentially strategic bits of maritime real estate. Does the US administration have the willingness to back its allies on all fronts
Others have argued that the new Chinese leadership under President Xi Jinping are using nationalist sentiment to distract the Chinese public from the growth slowdown as well as solidify support among the Chinese military. Meanwhile Japan has been busily building up mutual defence and security ties across southeast Asia, and with Australia and India, as a hedge against Beijing. The state visit of the Japanese Emperor to India to has taken on even more significance.
While the geopolitical dynamics remain fluid and uncertain, a more definite consequence of the dispute may well be to accelerate the China relocation macro theme with major implications for FDI flows in the rest of the region. Up until now the primary motivation for foreign companies with large scale manufacturing operations to relocate from China has been the rapid rise in Chinese labour costs and the growing signs of worker shortages. The case was made most effectively by former World Bank Chief Economist Justin Yifu Lin (see Chandra, Lin and Wang (2012)) who suggested that:
industrial upgrading has increased wages and is causing China to graduate from labor-intensive to more capital-and technology-intensive industries. These industries will shed labor and create a huge opportunity for lower wage countries to start a phase of labor-intensive industrialization.
This process, which they called the Leading Dragon Phenomenon, offers an unprecedented opportunity to low-income countries where the industrial sector is underdeveloped and investment capital and entrepreneurial skills are leading constraints to manufacturing. They also note that low income countries such can seize the opportunity and resolve the constraints by attracting some of the FDI flowing currently from China, India and Brazil into the manufacturing sectors of other developing countries.
So the relocation of factories as a result of China economic rebalancing is a multi-year structural trend that is likely to be the dominant macro theme for developing economies for the next decade and beyond. But it is becoming more apparent that political risk mitigation in the face of resurgent Chinese regional territorial ambitions and aggressiveness will re-inforce the macroeconomic justification for diversifying away from China. Japanese outward FDI has increased for two years in succession, with 2012 the second highest increase in history ($122.4bn, an increase of 12.5 per cent over the previous year). Japan’s total outward FDI stock exceeded $1tn. However what is more interesting, as illustrated in the diagram below, is that Japan’s FDI flow to ASEAN has grown relative to that towards China.
Even if it’s a remote scenario, what if accidental engagement between Japanese and Chinese fighters in the newly announced ADIZ rapidly escalated into a more serious conflict or even declaration of war? The hundreds of billions of dollars of Japanese investment into factories in China would appear at risk. Even if we exclude the expropriation of factories directly, at the very minimum, the experience of Chinese nationalist protests over the Yasukune shrine visits by Japanese politicians or in the more distant past the US bombing of the Chinese embassy in Belgrade are clearly risks that policy makers and boards of Japanese multinationals must be increasingly worried about. And, unlike Chinese holdings of US treasuries that could be liquidated reasonably quickly, albeit potentially at the risk of self-destructively causing a meltdown in global financial markets, FDI in factory assets is, by its very nature, immobile. Moreover Japanese managers and workers in China would also be vulnerable. One might argue that there is a risk of a similar level of concern developing in Seoul or Taipei or perhaps even Washington.
Ifty Islam is the managing partner of AT Capital in Dhaka, Bangladesh. Ifty.islam@ at-capital.com