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From Beijing to Brussels and Washington to Westminster, trade is becoming increasingly politicised. Against this backdrop, rising tensions between two Asian neighbours could exacerbate disruptions to the global supply chain. While Japan and South Korea both trade more with the United States and China than they do with each other, their two-way trade relationship is still worth an estimated $85 billion a year, much of which consists of intermediate goods.

Both Seoul and Tokyo have expressed willingness to continue their diplomatic dialogue so the door remains open to a solution. For its part, Japan has been contending with the spectre of trade spats on multiple fronts, and recently reached a deal with the United States to remove some sticking points over shipments of selected agricultural and manufactured goods. Japan will cut its tariffs mostly in line with what it would have done under the Trans-Pacific Partnership (TPP), from which the US withdrew soon after President Donald Trump took office, while the US will reduce its industrial tariffs but not for autos or auto parts.

Historical tensions 

Relations between Japan and South Korea have historically been challenged, and the latest flare-up came last year, after Korea’s Supreme Court ruled that Japanese companies should compensate victims for their forced labor during Japan's occupation of the Korean Peninsula in 1910-1945. Tokyo maintains that the issue of compensation was settled under a treaty signed by both countries in 1965.

The headlines led to economic fallout, specifically in the form of negative sentiment in South Korea toward Japanese brands. Calls for boycotts began after the Japanese government surprised with an announcement of export restrictions on certain products, the timing of which made it appear that it was in response to the Supreme Court ruling, although Japan did not officially link the two.

Japanese beer sales dropped 96 per cent in September from the same month a year ago at South Korean hypermarkets, some of which stopped stocking Japanese beer altogether, while convenience stores excluded it from their price promotions, which are an important driver of purchases. In September, outbound travel to Japan down was 75 per cent and 91 per cent respectively for South Korea’s two largest listed tour companies. Japanese apparel retailers also took a hit, though there were no clear domestic beneficiaries in Korea’s fragmented apparel market.

Economists say South Korea’s growth would take more of a hit than Japan’s if the current stalemate continues, but the whole world suffers from trade wars. According to the IMF, the cumulative effect of trade conflicts could mean a loss of around $700 billion by 2020 for the world economy, or about 0.8 per cent of global GDP. 

South Korean chip production in focus 

The biggest salvo in the current spat came in July, when Japan tightened export restrictions on polyimides, photoresist material and hydrogen fluoride - three key materials used by South Korean technology companies to make smartphone displays and memory chips - and Seoul responded by taking its complaint to the World Trade Organization (WTO). In September, South Korea dropped Japan from its whitelist of favoured trade partners that can secure fast-tracked approvals, after Japan removed South Korea from its own similar list of trusted partners a month before.

Japan’s move was not a flat-out export ban, and shipments are going through. But if tensions were to worsen, the tech sector - particularly memory chips - would suffer because South Korean memory production relies heavily on Japanese suppliers for high-purity hydrogen fluoride etching gas. Japan has approved several batches of exports since it removed South Korea from its whitelist, so supply appears secure for now. But any shortages of this raw material could lead to lower production yields and, in a worst-case scenario, potentially force production cuts once inventory is depleted.

Spot prices of DRAM (dynamic random access memory) chips and NAND flash memory chips for long-term data storage have now begun to retreat after rallying sharply when Japan first announced the export curbs. While spot prices are not always a reliable indicator of the true underlying market due to its illiquidity, their moves did call attention to some buyers’ concerns that memory supply could be affected. Buyers are now more willing to hold slightly more memory inventory as security.

In the longer term, the tensions with Japan and the risks it poses to supply have prompted South Korean memory producers to seek to diversify their sources. They are testing supplies from domestic sources, as well as China and Russia, to reduce their future reliance on Japanese suppliers.

The impact of export restrictions on the other two materials has been limited so far. Photoresist material is used to make information-processing logic chips in a cutting-edge ultraviolet lithography process, and it appears some exports of it were allowed to resume. Colourless polyimide is used to make screen protectors for folding OLED smartphones, of which relatively few units are produced so far, and it can also be sourced locally

Supply chain for auto parts could face disruption

When it comes to autos, neither South Korean nor Japanese auto makers have a meaningful share in each other’s home markets, so the overall impact has been limited. However, negative sentiment toward Japanese brands winnowed the small share that Japanese imports do have, with their market share in Korea falling to 0.83 per cent in September - below the 1 per cent mark for the first time since 2006.

Chart 1: Japanese auto sales in South Korea plunge

Source: Korea Automobile Manufacturers Association and Korea Automobile Importers & Distributors Association, September 2019

Last year, Japan imported about 78.5 billion yen ($729.1 million) worth auto of auto parts from South Korea and exported 70.1 billion yen worth of auto parts to that country. Some companies in both countries moved to accumulate inventory ahead of potential trade restrictions, and if these are in fact imposed, the need to change vendors could lead to temporary production delays. Issues could also arise for advanced materials used in next-generation vehicles, such as carbon fiber, where a few Japanese companies are specialists.

Japan's pact with US is hopeful sign

Japan’s recent trade pact with the US underscores the two countries’ willingness to negotiate. While historical and economic ties between Japan and Korea are profoundly different, the US deal raises hopes that trade tensions within Asia can also be defused.

The trade ministries of Korea and Japan began bilateral talks in Geneva earlier this month, the first step in the WTO’s dispute settlement process, and agreed additional talks should be scheduled through diplomatic channels. If the negotiations break down, South Korea could request that the WTO set up a dispute settlement panel, with investors no doubt hoping for a quick resolution instead of another prolonged stalemate.


Casey McLean

Casey McLean

Portfolio Manager and Analyst

Erica Kim

Erica Kim

Meeyoung Kim

Meeyoung Kim