The trade war between U.S. and China expands and extends almost daily, giving the word “decoupling” a new, and for some increasingly scary, meaning. Today’s news is that China’s two leading technology universities can longer purchase or access U.S. equipment and software without U.S. government approval. While many find these measures justified to level the playing field, others worry that the U.S. decoupling moves may backfire. One doomsday scenario is that trade relations in Asia are becoming more independent from U.S. markets and companies, and the post-COVID recovery in Asia may happen without the United States. It has long been forecast that the 21st century will be the Asian century. If America doesn’t pay attention, it may well be left hung out to dry while Asia reorganizes and grows its own trade relations and consumer markets.

• The Japan-China Connection

The main – and often overlooked – engine feeding into this scenario is the newly emerging Asian trade dynamics, anchored on pragmatic and symbiotic business relations between China and Japan. Perhaps needless to say, these are the world’s second- and third-largest economies. Pre-COVID, their joint GDP was about $15 trillion, compared to $18 trillion in the U.S.. What is more, the two economies are increasingly intertwined by way of a new type of trade dependencies in the Asian supply chains. As U.S. policy-making remains based on 20th century, bilateral, market-to-market thinking, Asia is building its own 21st century network and trade economy. Clearly, both countries still need U.S. market and technology ideas as well as consumer spending. But, should those dry up, it is conceivable that Asia will just turn to or build greener pastures without the U.S.

Relations between China and Japan are as complicated as they are long, dating back to the 7th century at least. Japan has borrowed much from Chinese culture: the written language, Buddhism, and even ramen noodles were originally China imports. In contrast, Japan’s spoken language and grammar, Shintoism and sushi are as homegrown as the Toyota Production System. There are many painful scars from this history, in particular World War II, that run deep and continue to challenge diplomatic relations. There is also a new geopolitical angst concerning China’s rising military power and apparent appetite for expansion. And, the two peoples are quite different in terms of social norms of behavior, preferences and mindset.

But, as much as history is complicated, when it comes to money and trade the two countries have found a new, mutual beneficial equilibrium ruled by pragmatism, as I argue in Chapter 5 of my new book. Perhaps ironically, this situation is symbiotic and stable, not in spite of but because it is highly unequal. Both sides have something the other side needs. While the people may not be best buddies – though more on Gen-Z below – there is a lot of mutual pragmatic give-and-take in business relations, as companies are finding ways for both to win.

• Trade and FDI Between Japan and China: A Pre-COVID Snapshot

In 2018, the bilateral trade between Japan and China was almost balanced, with roughly $178 billion in exports and imports when trade through Hong Kong is included. For Japan, China is by far the largest trading partner, accounting for about 25% of both exports and imports. And 2018 data suggest that for China, Japan was the second largest export destination and third largest import source, after the U.S. and South Korea.

The point with this table is to highlight that over the past two decades, a new situation has emerged whereby China and Japan rank first for each other in a variety of categories. It is still true that the U.S. has long been the largest destination for Japanese foreign direct investment (FDI), dating back to the U.S.-Japan trade wars of 1980s and 1990s when the U.S. established trade rules that incentivized Japanese companies to open production sites in the U.S.. But more recently, Japan has recently become by far the largest foreign operator of business sites in China, with over 32,000 sales offices, factories and partial stakes in companies in China. Conversely, for Japan this number means that China accounts for 43% of Japan’s offshore businesses sites (even though the scale of Japan’s operations in the U.S. is still larger).

• The Northeast Asia Trade Triangle: Japan - China - Taiwan - Korea

This new China-Japan relationship does not exist in a vacuum. Rather, it is part of a larger web of business relations that has been built over the past two decades in Northeast Asia. It is fair to say that there is a new division of labor in Asia: China has become Asia’s assembler, and Japan the specialized manufacturer of high-tech components and the source of innovation and ideation. As more and more Japanese companies are pursuing an aggregate niche strategy, they lead important product categories in the provision of deep-tech input components and materials. These deep-tech input materials reach China mostly via the route of Taiwan and South Korea. There, advanced films, adhesives, and components are built into input parts, such as the screen of your cell phone or computer. Japanese companies look back on over 50 years of experience in these difficult-to-make and difficult-to-imitate inputs, and to this are now adding new capacity-building in deep-tech innovation.

So we get a trade triangle: South Korean and Taiwanese firms buy the input resources, turn them into parts (often using highly advanced Japanese production machinery), and then sell these to companies in China for assembly.

• Japan-China Symbiosis

The reason that this trade mesh has been growing continuously over the past two decades is that its two cornerstones, China and Japan, both need it and enjoy it. Two factors make this new relationship symbiotic. The first is sheer size, including the size of China’s consumer markets and the amount of trade that flows between the two countries. And the second is their different positions in the global value chains. And it is this difference that creates valuable synergies.

China, not unlike Japan in the 1960s and 1970s, achieved rapid growth through export promotion and low-cost manufacturing of consumer goods. Government subsidies, high domestic savings, and technology adaption were the main drivers, though with the obvious differences that China is not a democracy and most of its large firms are state-owned enterprises. However, whereas Japan in the 1960-1980s had closed down its markets to any foreign investment, China’s growth has depended critically on foreign capital and knowledge, and China happily became the world’s assembler. This means that Japan grew by developing its own, entirely domestic vertical production capabilities, with constant upgrading and organizational learning. In contrast, Chinese companies copied the technologies that foreigners brought into the country, but then specialized in the lower value-added, lower cost parts of value creation, i.e., final assembly. Thus, China developed a system built for import, assembly, and reexport, whereas Japan had developed a complete domestic value chain from product design to final sale.

This put Japan at an advantage when companies decided to relinquish low-tech consumer end product markets and move upstream into deep-tech technologies and advanced materials – from the assembly of toaster-ovens to advanced components and sensors, so to say. Few Japanese companies make semiconductors today, but there are certain steps in the global production of semiconductors that rely to 100% on a technology from Japan. Having built capabilities across the entire value chain in its version of the “developmental state” means that Japanese companies can in fact exit the lower value-added activities and switch into the higher margin, upstream niches. China now wants to do something similar, and turn from the “factory of the world” to its own, independent economic powerhouse. This was proposed in its 2015 industrial policy program “Made in China 2025”, which identifies industries such as pharmaceuticals, automotive and aerospace industries, semiconductors, IT and robotics as growth sectors. All of these are large-scale industries and encroach on Japan’s bailiwick. However, today China does not have the capabilities to produce all inputs at global quality levels. Enter Japan.

In the medium run, the industrial structures and goals of the two countries are more complementary than competitive. Given China’s population size and pressures to scale fast, China’s focus for 2025 is on industries that promise large volume and huge manufacturing installations. The areas that Japanese companies are focusing on in the aggregate niche strategy are small and demand different innovation and manufacturing capabilities. Given Japan’s shrinking population and labor shortages, scale is no longer as important as profit margins, so it can afford to zoom in on these smaller niches.

A second, perhaps quite obvious, reason for the symbiotic pragmatism underlying the China-Japan business relations is that China’s #1 aspiration right now is not be dependent on the U.S.. Being dependent on Japan for a set of critical input parts may not be desirable, but it is much preferable over being depending on the United States.

Will this last? Naturally, some Chinese companies are exploring the technologies and processes that are currently procured from Japan. It is unlikely that Japan’s aggregate niche strategy will last forever, as markets are dynamics and coalitions shift constantly. But as of 2020, this situation seems to be in a medium-run equilibrium. Chinese companies still lag behind Japanese companies in some of these advanced materials and components, and of course none of these competitors is sitting still. Even though from the distance a rising China may look like a threat to Japan, currently the aggregate niche strategy affords Japan’s leading companies a nice competitive advantage. Even under “Made in China 2025”, China still needs Japan. And for Japan with its aging and shrinking society, China has already become the largest export and consumer market.

• Asia’s Gen Z: “What history?”

And, finally, there is also the generational shift, and the new “hipness” factor that Japan enjoys in Asia. The table above showed that China is Japan’s largest trading partner in tourism, and almost half of foreign students in Japan hail from China. And, Japan’s stellar reputation for high-quality products and brands, from cosmetics to shoes, has turned “Made in Japan” labels into the new aspiration of upward-bound young Asians, and young Chinese are no exception. These growing cultural ties are underlying the broader economic nexus in East and Southeast Asia. First, there is a cultural affinity and shared fashion preferences among up-and-coming young Asian. And, the milennials — and certainly Gen-Z that was born after China had already launched its rise in the 1990s – carry less of a history grudge.

Many have wholeheartedly embraced Japanese pop culture, beauty products, and fashion, as the quality of Japanese products has made Japanese cosmetics, movies, and brands the #1 symbol of luxury and accomplishment. Travel to Japan, eating raw fish, getting a Japanese-style haircut, and wearing made-in-Japan Uniqlo are signs of accomplishment across Asia. Many quietly, and some even openly, agree with this observation of an industry executive in Asia: “Japan is the place the kids are looking up to”.

• The Post-COVID Asia Trade Triangle

Then what does this mean for post-Corona economic recovery in Asia? Given the structure and stickiness of the supply chain network in Asia, barring a huge disaster or war, it appears that decoupling is effectively impossible in Asia. Too many economies are too dependent on each other and the supply chain network they have created over the past three decades, for anybody to be interested in breaking these down. Each of these countries has their own domestic baggage to carry, but in terms of regional recovery of economic activity, it appears that Asia is tied together. A recent IMF forecast predicting vastly differential growth rates in Japan, Korea and China seems somewhat implausible.

As long as there no unexpected major shocks – an extension of the pandemic, an earthquake, etc. — it is in the interest of both Japan and China to keep a good thing going, and if need be, without the querulous U.S.. And as U.S. consumer markets fall flat due to a severe recession, they view the exploration and growth of new markets, such as in South East Asia, as ever more important. Of course, counterbalancing this business bliss is the growing fear about world peace and world order stability, as well as global health. But ceteris paribus, just in business terms, it may just so happen that Asia will launch its economic recovery without the U.S. consumer as their core address.