By Darrel Whitten

Investors who are doubtful of the budding economic recovery in Japan point to the fact that the recovery is almost entirely export-driven. If the U.S. economic recovery sputters, they fear, Japan's recovery will also be nipped in the bud.

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 (+0.4% Q-Q), that domestic demand continues to shrink (-0.3% Q-Q), and therefore whether Japan's economy can continue recovering if the U.S. recovery sputters. 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. 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.

But it is a misperception that that the recovery in Japan's is being driven entirely or even mainly by the U.S. recovery. Looking at Japan’s cumulative exports for the January-June period, total exports were up a strong 13.9% YoY, but exports to the U.S. actually declined by 0.3% YoY, and accounted for 27.1% of the total. Exports to the EU were 15.9% of total exports, and contributed 3.2 percentage points to the overall 13.9 percentage point gain. 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, in surging 49.4% YoY and accounting for 11.6% of Japan’s total exports. Moreover, exports to Asia have accounted for the majority of the growth in Japan's exports this year and for the past several years, and they now account for 45.1% of Japan's total exports.

On the other side of the coin, the U.S. reported total import growth of 9.7% YoY during the first six months of calendar 2003, with imports from Asia rising 10.4% YoY, 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% YoY, and the U.S. trade deficit with China rose to $107.9 billion, versus $86.3 billion a year previous. Conversely, imports from Japan fell by 0.5% YoY, and the trade deficit shrank from $66.2 billion a year ago to $64.4 billion.

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

The Japanese media has changed its tone regarding China's position–from portraying China as "the world's factory" to describing it more as "the world's market," following China's entry into the World Trade Organization. This is because that, while China figures very large indeed in U.S. 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 to $340 billion, while exports are seen rising between 8% and 13% percent to $350 to $360 billion in 2003. This compares to growth in imports and exports of 21.2% and 22.3% percent respectively last year.

Indeed, China’s Commerce Minister has been quoted as saying that China will import over $1,000 billion 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 actually used foreign direct investment 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 for the first half of calendar 2003 are mechanical & electrical equipment and high-tech products, where imports are growing at around 50%. Imports of crude oil, rolled steel and TV components, while smaller, are also soaring between 80% and 100% YoY.

The Japanese media's shift from describing China as the world's factory to describing it as the world's market reflects the shift in perception by Japanese companies, particularly after China's entry into the WTO. The media is getting their cue from Japanese firms, who are shifting the focus of their business with China from utilizing it as a production base for exports to selling their products locally.

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% of total overseas sales; 34% of which was sold in China, 34% of which was exported to Japan, and 32% of which was exported to third countries, according to METI data. Sales within the China market were up 12.4% YoY during the quarter, while exports back to Japan were up 10.9%. Exports to other countries were up 19.6%.

This "China Card" appears to be having an impact on Japanese stock prices, if not as noticeably on Japan's GDP growth. For example, the second up-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 of these "domestic-oriented" companies indicates that the real play in these stocks is not their domestic orientation, but China-related demand–particularly in mature industries where the China business is: a) a life-saver for the company/industry, and/or b) the Japanese company has a competitive edge vis-à-vis their global competition that is also flocking into China.