MW-41 -- Japan's China Card

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 41
Tuesday, August 26, 2003

++ Viewpoint: Japan's China Card

The Bottom Line
Top-Down: Japan's Export Recovery Driven by China, not the US
o Investors who are doubtful of a budding economic recovery
point to the fact that the recovery is almost entirely
export-driven. If the US economic recovery sputters, they
fear, Japan's recovery will also be nipped in the bud. This is
to a degree true for the tech space, where Japan's major
electronic majors, with a few exceptions, turned in a very
disappointing April-June quarter.

o Indeed, Sony's nasty earnings surprise and the downgrading of
Fujitsu's credit to junk status by Standard & Poor's shows
that the recovery of earnings and cash flows has been much
slower than investors had hoped.

o In reality, however, Japan's export recovery is not being
driven by US demand. Indeed, exports to the US are down in the
first six months of the year and have long been surpassed by
exports to Asia. Exports to Asia have accounted for the
majority of the growth in Japan's exports this year and for
the past several years. They now account for 45.1 percent of
Japan's total exports, versus 27.1 percent for the US. China
in particular has been an engine for Asian growth and now
accounts for 11.6 percent of total Japanese exports.

o In addition, the claim that exports to Asia are really derived
from US demand is also no longer true. Some 34 percent of the
output of Japanese companies in China, for example, is sold in
China, while 34 percent is sold back to Japan. Only 32 percent
is exported to third countries, ostensibly the US and Europe.

Bottom-Up: The Real Story behind "Domestic-Oriented" Cyclicals
o The second leg of the current rally in Japanese stocks is
noticeable for its lack of "New Japan" companies, ostensibly
because the weak April-June quarterly numbers have made
investors leery of the traditional tech stocks. Instead, there
has been a focus on cheap "domestic-oriented" companies. But a
look at the top gainers over the past month shows that trading
is moving further and further down the quality curve. Indeed,
some of these stocks are reminiscent of the "spec stocks" that
were active during the bubble years. Day trading individual
investors seem to have adopted the philosophy of traders
during the bubble: "If it moves, trade it. If it doesn't move,
trade it until it moves."

o But the real play is not the "domestic-oriented" cyclical
plays, but China-related demand for companies in mature
industries, particularly where the China business is: a) a
lifesaver for the company/industry, and/or b) the Japanese
company has a competitive edge on global competition that is
also flocking into China. As a source of demand and revenue
growth, China has become such a focus of investors that
natural-resource fund managers are essentially buying whatever
China has a shortage of.

============================= EVENT ==================================

Date: Sept. 19, 2003
Location: JETRO BSC Hall, Akasaka Twin Tower Main Building
Organized by: LINC Media Inc., Japan Inc. Communications KK
(publisher of J@pan Inc magazine) and the Shizuoka
Prefectural Government. We are pleased to present the second
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managers. Our keynote speaker is Mr. Andrew Fried, a
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View complete Seminar information at:
Registration fee: free of charge

++ Viewpoint: Japan's China Card

There are signs that Japan's economy is staging a cyclical recovery,
even without the benefit of additional government stimulus, as
producer inventories bottom out, personal consumption remains
amazingly resilient and export growth is firm.

The debate about the sustainability of Japan's economic recovery
revolves around the fact that the growth in the April-June
quarter was driven by exports (up 0.4 percent quarter on quarter),
that domestic demand continues to shrink (down 0.3 percent), and
whether Japan's economy can continue recovering if the US recovery
sputters. But it is a misperception that the recovery in Japan is
being driven by the US recovery. Looking at Japan's cumulative exports
for the January-June period, total exports were up a strong 13.9
percent year on year, but exports to the US actually declined by 0.3
percent, accounting for 27.1 percent of the total.

Conversely, exports to Asia accounted for 9.4 percentage points of the
13.9-percentage-point rise, with China alone accounting for 4.4
percentage points of this growth. Japan's exports to China surged 49.4
percent year on year and accounting for 11.6 percent of Japan's total
exports. Exports to the EU were 15.9 percent of total exports and
contributed 3.2 percentage points to the overall 13.9-percentage-point

On the other side of the coin, the US reported total import growth of
9.7 percent year on year during the first six months of calendar 2003,
with imports from Asia rising 10.4 percent, and the trade deficit with
Asia rising to $267.7 billion versus $232.7 billion a year earlier.
Imports from China rose by 25.0 percent, and the US trade deficit with
China rose to $107.9 billion, versus $86.3 billion a year earlier.
Conversely, imports from Japan fell by 0.5 percent, and the trade
deficit shrank from $66.2 billion a year ago to $64.4 billion.

In addition, it is no longer true that a significant portion of Asian
demand for Japanese exports is in fact a derivative of US demand.
Indeed, one can say that the growth in Japan's exports to Asia
(particularly China) is now more driven by demand within the region.

From the World's Factory to the World's Market
The Japanese media used to portray China as "the world's factory." But
since China's entry into the World Trade Organization (WTO), Japan now
describes its neighbor as "the world's market."

While China figures very large in US and Japanese imports, China's
imports are actually growing faster than exports. The People's Daily
is reporting that imports are expected to grow 12 to 15 percent to
$330-340 billion, while exports are seen rising 8-13 percent to
$350-360 billion in 2003. This compares to growth in imports and
exports of 21.2 and 22.3 percent, respectively, last year.

This growth is attributed mainly to China's entry into the WTO, which
resulted in the lowering of tariffs and non-tariff barriers, as well
as the country's fast economic growth and industrial restructuring.
Indeed, China's Commerce Minister Lu Fuyuan has been quoted as saying
that China will import over $1 trillion worth of goods in the next
three years. This growth, of course, is attracting throngs of foreign
companies. By 2002, over 420,000 foreign and overseas funded
enterprises were registered in China, and the total volume of foreign
direct investment that was actually used hit $448 billion.

The top imported items into China include: industrial and power
generating equipment, electrical/television and radio goods,
textiles/fibers and fabrics, iron and steel, plastic articles,
mineral fuels, fertilizers, cereals, optical/clocks and precision
goods, and organic chemicals. By far the two largest import
commodities are mechanical and electrical equipment and high-tech
products, where imports are growing at around 50 percent. Imports of
crude oil, rolled steel and TV components, while smaller, are
also soaring 80-100 percent year on year.

Japanese Companies Switch their China Focus
Japanese firms are shifting the focus of their business with China
from using it as a production base for exports, to selling their
products locally. According to the People's Daily, cars, steel and
digital cameras were among the imported commodities that registered
highest growth so far this year. In the Shanghai port alone, the
import of digital cameras in the first five months of this year was
53 times that for the same period of last year.

As of 2002, some 60 Japanese companies had local production in
Asia, of which 20 were in China/Hong Kong. As of the first
quarter of 2003, China sales of the local operations of Japanese
companies accounted for 8 percent of total overseas sales, 34 percent
of which was sold in China, 34 percent exported to Japan, and 32
percent exported to third countries, according to METI data. Sales
within the China market were up 12.4 percent year on year during the
quarter, while exports back to Japan were up 10.9 percent. Exports to
other countries were up 19.6 percent.

If China Is Short of It, It's Time to Buy
In Money Watch #39
we suggested that: a) the sharp back up in bond rates was due for at
least a short-term reversal; and b) the rally in the cyclicals was
placing too much faith in a strong economic recovery than was probably
achievable. While the economic data for the US and Japan continue to
gradually improve, there is little evidence that the recovery will be
particularly strong by historical standards. Indeed, just the opposite
may be true.

The Topix sector performance from March-April lows to July highs
was more indicative of a simple reversal from an oversold
condition, and the recovery of the cyclicals was not particularly
noteworthy vis-・vis other sectors. Indeed, the communications
sector had rallied 49 percent and the electricals 43 percent, while
the financials like the securities brokers had soared 74 percent, and
non-bank financials had jumped 51 percent. The only standout in the
cyclicals was steel, having gained 50 percent.

But the April-June quarter was not kind to Japan's tech stocks.
Toshiba's quarterly results were a disappointment, as were
Fujitsu's. These results, of course, followed a disastrous previous
quarter for Sony. The results understandably made investors leery
of the big Japanese tech stocks, as restructuring efforts (with
the exception of Matsushita) did not appear to be taking hold.
Indeed, Fujitsu's credit rating was subsequently lowered to junk
status by S&P, reflecting its weak financial standing (with
1.828 trillion yen in debt) and the slow recovery in earnings and
cash flow despite several years of reforms.

In addition, tech stocks (with the exception of semiconductor
stocks) weren't fairing so well in the US either. The Dow Jones
US sector indexes continue to show a clear preference for
cyclicals, most noticeably at the expense of the traditional
defensive sectors.

While the Japanese techs were prominent in the first leg of
the Tokyo rally, they have now taken a back seat as trading
broadens out to the more late-coming sectors, ostensibly the "old
Japan" sectors, aided by still-abundant liquidity and active
trading by semi-pro individual investors. It also looks like
risk-adverse investors have taken another blow with the latest
sell-off in bonds. The surge in rates has caused some long-term
bond funds to fall below par value.

But a list of the top gainers over the past month indicates that
investors are trading further and further down the quality curve
for returns in individual stocks to the speculative "story
stocks." Indeed, domestic day-trading investors seem to have
taken a page from the bubble market traders' book: "If it
moves, trade it. If it doesn't move, trade it until it moves."

For the Cyclicals, China is a Much Better Story
Foreign investors have already seen the broker lists of late-
coming, ostensibly cheap "domestic-oriented" cyclical stock
recommendations. But the real play is China-related cyclical
plays, not "domestic-oriented" cyclical plays, particularly for
companies in mature industries where the China business is: a) a
lifesaver for the company/industry, and/or b) the Japanese
company has a competitive edge on global competition flocking into
China. As a source of demand and revenue growth, China has become such
a focus of investors that natural-resource fund managers are
essentially buying whatever China has a shortage of.

Japanese companies entering China generally have been outpaced
by more aggressive European and US competitors. Japanese firms
will also meet stiff price competition in China from local firms,
and companies without strong brands will be at a disadvantage.
But burgeoning demand in China is helping revitalize some
Japanese companies that have long suffered from structural
recession in their home markets.

Japanese companies surveyed by Nihon Keizai Shimbun and the Japan
Center for Economic Research expect China sales there to increase by
about 50 percent from the 2001 level by 2005. Still, many Japanese
companies are afraid of focusing too many of their corporate resources
in China and aim to establish a division of labor among their Chinese
and other Asian manufacturing operations. The survey covered 709
companies that have operations in Asia and Asian affiliates in which
they hold a stake of at least 50 percent. Of the respondents, 326
companies expect to generate a combined 2.1 trillion yen from China by
2005, up from 1.78 trillion yen by 401 firms surveyed last year. This
represents an average 45 percent increase per company. Nearly 70
percent of the companies surveyed said the Chinese market will become
one of the most important in the world within five to 10 years.

Asked what should be the best strategy to make a further push
into the Chinese and Asian markets, 52 percent said it is desirable to
work with local companies, while 40 percent said a manufacturing base
designed to serve global markets should be established there to
take advantage of cheap costs. These percentages suggest more
companies are increasingly interested in the potential of the
Chinese market, instead of merely considering their Chinese
operations just as a base for manufacturing goods for export.

While more than 70 percent said they would consider stepping up their
investments in China, many believe that concentrating investments
in just one country is too risky. A total of 47 percent said they will
either consolidate operations in Asian countries outside Japan or
consider doing so, with 35 percent of these saying they will focus
their investments in China, while closing or scaling down operations
in other Asian countries. Conversely, 61 percent said they will not
concentrate their investments in China.

Japanese direct investment in China has evolved from investments
in hotel and service sectors in 1979, to textiles, electrical
appliances, food and chemicals. Investors are now moving into the
agricultural, transportation, energy and communications sectors.
As for specific companies/sectors seeing good leverage from China
demand, a screen of media articles over the past several months
shows that:

* Nippon Steel's pretax profits surged 4.1-fold in fiscal 2002 as
crude steel output rose 14 percent to a 21-year high, fueled by big
gains in exports to China.

* Construction machinery shipments grew 2.9 percent in fiscal '02, the
first rise in six years, on strong exports to China. Exports soared
29.8 percent for the second straight year, as China demand for
construction machines is growing at an annual rate of 70 percent.
Komatsu saw 70 percent growth in exports to China in the past fiscal
year. Hitachi Construction Machinery now sees group operating profit
rising 40 percent in the March 2004 year, as sales of construction
equipment in China rise 30-40 percent on 50-percent growth in China
demand for construction equipment stimulated by the Beijing Olympics
and the Shanghai World Expo.

* Given the housing boom in China, Matsushita Electric Works is
doubling the number of offices in China to achieve 100 billion yen in
sales in the next five years, a 900-percent increase from fiscal 2002.
The company will be outsourcing production to local companies. Toto is
aiming for a 50-percent increase in China sales and is building
Chinese and Vietnamese factories to supply this demand.

* Keihin, an auto parts maker affiliated with Honda Motor, saw exports
to China jump 150 percent. Shipments have increased further since the
beginning of this year, mainly to supply Keihin's Guangdong Province
plant, which opened in January and produces fuel injection devices for
auto engines.

* Okuma plans to raise its sales in China 50 percent this fiscal year
to 6 billion yen by building a sales network in partnership with five
or six trading firms. Mitsubishi Heavy Industries is selling
automobile engine machine tools and gear-processing equipment in
China. The company saw its business in China grow 2.5 times to 3.5
billion yen in the year through March 2003, and it is targeting 40
percent growth to 5 billion yen this fiscal year. The company has
begun outsourcing production of injection molding machines to a firm
operating near Shanghai this spring. The Chinese firm will make
150-200 units per year, or about 30 percent of Mitsubishi Heavy's
output of such equipment. Machine tool exports have swelled on surging
demand for metal molds and auto parts following a wholesale shift in
production to China by Japanese manufacturers and strong demand
in South Korea. Japanese machine tool manufacturers received more
orders from the rest of Asia than from North America for the
first time in 2002, when orders from Asia were up 46.6 percent for the
year. China led the rise in orders from Asia and represented 30
percent of the Asian total. When exports reaching China through
Taiwan are included, total China exposure is thought to be closer to
40 percent.

* Japan's PVC exports climbed 10 percent in 2002, with more than 90
percent of demand coming from China. Local demand is seen rising by
500,000 tons a year for the next five to six years. Tosoh affiliate
Taiyo Vinyl has acquired the PVC business of Kureha Chemical, leaving
only five players in Japan's PVC market. Taiyo has now become the
number one producer of PVC in Asia.

* Murata Manufacturing sees a tripling of sales for its cellular phone
and PC parts produced at its plant in China by March 2005. Almost all
of the parts and materials needed in production are imported from

* Sumitomo Metal is moving to boost copper production to 450,000 tons
by the end of 2008 in response to the shortage of copper in China.

* Because consumer electronic firms like Matsushita and Hitachi
were early investors in consumer electronic production in China,
growing competition has forced them to consolidate and refocus
their efforts. Hitachi, for example, was forced to withdraw from
production of small and midsized TVs in China. Japanese
manufacturers are now moving to produce leading-edge consumer
electronic products -- plasma display panel TVs, DVD players and
digital cameras, for example -- in China. Japanese home appliance
manufacturers are beefing up marketing of audiovisual equipment
in China in a bid to meet demand for high-end products among the
growing urban wealthy. Based on figures from a survey by a private
firm, the consumer market in large metropolitan areas is an estimated
1 trillion yen for the lunar New Year holiday season alone.

Matsushita Electric is on track to produce 1 trillion of revenues in
China by 2005, or more than three times current revenues, and is
looking for an operating ratio of 10 percent. One trillion yen of
revenues compares to current parent-only revenues of some 4 trillion
yen. Sanyo Electric has forging a strategic alliance with Haier, the
largest consumer electronic product maker in China. Hefei Rongshida
Sanyo Electric Appliances will list its shares in China
(yuan-denominated A-shares), making it the first Japanese joint
venture to go public since Beijing relaxed listing rules in 2001.

-- Darrel Whitten

============================= EVENT ==================================
Date: Nov. 19-21, 2003
Location: Le Meridien Grand Pacific (Odaiba, Tokyo)

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===============================EVENT =================================
The Entrepreneur Association of Tokyo - Our September seminar will
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J@PAN INC magazine -- the journal of business, technology and people
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The October 2003 special ad section will feature the major companies
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For more information please contact:
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Written by Darrel Whitten

Edited by J@pan Inc staff (


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