Business as usual? Economic responses to political tensions between China and Japan

Business as usual? Economic responses to political tensions between China and Japan Abstract What is the relationship between political tensions and economic relations? In this study, we explore this question by examining how Japan’s nationalization of the Diaoyu/Senkaku Islands, a territory much disputed with China, has affected bilateral trade between the world’s second and third largest economies. Using monthly data, we find that the nationalization imbroglio has negatively affected the amount of goods Japan exports to China, with the effect being most pronounced for highly salient and visible products such as automobiles and cameras; these experienced immediate and dramatic drops lasting up to 12 months. In contrast, raw materials and intermediate goods were not affected at all; some even experienced increased exports. These findings suggest that consumer and corporate responses to political tensions may follow different logics. For consumers, certain political tensions, especially those involving enduring territorial disputes, could override entrenched economic interests and preferences, at least in the short term. In these instances, it will no longer be business as usual. 1 Introduction Do political tensions between states produce negative economic externalities? Scholars from the two major schools of international relations theory disagree on this crucial question. For realists, the answer is yes; according to them, political tensions lead states to reduce economic interdependence and discourage private actors from having further economic exchanges (Gowa and Mansfield, 1993; Kirshner, 1999). Liberals, however, believe that political tensions do not induce states to punish each other economically, and that economic interdependence and sunk costs make it difficult for private actors to quickly change trade and investment patterns (Oneal and Russett, 1997; Kastner, 2007; Maoz, 2009). In a widely cited study that aimed to adjudicate between these two competing theories, Davis and Meunier (2011) presented empirical evidence in support of the liberal view. Using quarterly economic and events data, they showed that varying levels of political tensions in US–France and China–Japan relations had no negative effects on these nations’ trade and investment flows, both in aggregate terms and in high-salience sectors such as wine and automobiles. In an era of globalization, they concluded, ‘actors lack incentive to link political and economic relations’ (Davis and Meunier, 2011: 628). However, more recent studies – using new cases, methods, and data – have cast doubt on the ‘business as usual’ thesis. Collectively, these have suggested that political tensions could still negatively affect economic relations in a globalized world (Fuchs and Klann, 2013; Pandya and Venkatesan, 2016; Wang, 2015). In this article, we join the debate on the trade-conflict nexus by empirically examining how recent political tensions stemming from Japan’s nationalization of the Diaoyu/Senkaku Islands have affected bilateral trade between China and Japan, the world’s second and third largest economies. Our analyses make two significant contributions. First, while recent studies have focused on the effect of smaller shifts in political relations, we highlight the impact of extreme cases on the political tension spectrum – i.e., territorial disputes with military threat but short of direct confrontation. Second, we rely on more fine-grained trade data at the level of month and industry, making it possible to detect immediate but nonetheless large economic disruptions following sudden political ruptures that could be otherwise masked in yearly or even quarterly data. The use of disaggregated data also allows us to uncover the potential heterogeneous impact of political tensions on different economic sectors. Our results provide evidence that the nationalization incident negatively affected the amount of goods Japan exported to China. The effect was most pronounced for highly salient and visible products such as automobiles and cameras, which experienced immediate, dramatic, and relatively long-term drops lasting up to 12 months. In contrast, Japanese raw materials and intermediate goods were not affected at all, and some even experienced increased exports, suggesting that some Chinese firms might be hedging against possible conflict escalation through increased imports from Japan. These findings provide important qualifications to the results of Davis and Meunier (2011), who argued that sunk costs in existing trade and investment make governments, firms, and consumers unlikely to change their behavior in response to political disputes. Moreover, the China–Japan case, when carefully examined, suggests that responses to political tensions from consumers and firms may follow different logics. For consumers, certain political tensions, especially those involving enduring territorial disputes, could override their entrenched economic interests and preferences. For firms, the story is more complicated; while some do not alter their trade behaviors amidst external political tensions, others do so to hedge against future import disruptions. The latter choice could well translate into high opportunity costs stemming from changing business patterns. In a nutshell, for both consumers and some firms, business will no longer be as usual amidst territorial disputes or other high-level political tensions. The rest of the article proceeds as follows. Section 2 reviews the existing literature. Section 3 provides a brief historical background to the nationalization incident. Section 4 and Section 5 present a set of qualitative and quantitative evidence for the negative impact of the nationalization incident. Section 6 provides additional evidence using the current THADD dispute between China and South Korea. Section 7 concludes with a discussion of the larger implications and areas for future research. 2 The trade-conflict nexus: political animals or Homo Economicus? From a realist perspective, states care first and foremost about their survival in the anarchic international system. Rational calculus should lead states to promote trade only with their political allies, so that they need not worry about gains from trade strengthening a potential adversary (Gowa and Mansfield, 1993). By the same logic, rational private actors should also ‘follow the flag’ when engaging in cross-national business activities – importers buy from friends, consumers punish foes (Pollins 1989a, 1989b). When ‘trade follows the flag,’ however, political tensions result in negative impacts on bilateral economic exchanges, even when governments from rival states do not explicitly sanction each other. Scholars in this line of research have shown that states sharing democratic institutions adopt similar policy positions and have more trust toward each other, and states that are political allies tend to have higher levels of international trade and investment (Dixon and Moon, 1993; Bliss and Russett, 1998; Morrow et al., 1998; Guiso et al., 2004). In contrast, liberals since Adam Smith have long emphasized the pacifying effect of international trade. A core assumption in the liberal perspective is that political conflict is deleterious to international trade and investment. Sustained and increased economic exchanges among states incubate vested domestic interest groups opposed to interstate conflict (Oneal and Russett, 1997; Polachek, 1980). These interest groups in turn lobby their governments not to engage in international conflicts (Mansfield, 1995; Copeland, 1996; Papayoanou, 1997; Kastner, 2007). In addition to nurturing interest groups, trade also helps sustain peace through an informational channel; states engaging in international trade and capital markets can more credibly signal to one another dissatisfaction and resolve (Gartzke et al., 2001). Even low-level political conflict should induce signaling – i.e., different economic behavior – from rival states. Statistical evidence indeed suggests that free trade encourages peace and reduces conflict (Maoz, 2009). Recent scholarship suggests that both the realist and the liberal perspectives are too simplistic to capture new realities in international political economy. In a widely-cited study, Davis and Meunier (2011) argued that, in an era of globalization, states no longer wield substantial control over economic actors, nor do economic actors exert dominance over states. While leaders still retain a certain degree of autonomy in their responses to market and interest-group pressures, their ability to manipulate economies for political purposes is increasingly constrained by low trade barriers, capital mobility, and multinational firms. Moreover, states might even be unwilling to play the economics card for fear of losing investor confidence (Davis and Meunier, 2011: 631). Finally, trade rules embodied by multilateral institutions such as the WTO also have significantly increased the cost of state intervention in international economic affairs. While states nowadays often need to think twice before linking politics with economics in international relations, private firms are even more resistant to suddenly changing their trade and investment patterns, given greater sunk costs in an increasingly globalized economy. Similarly, consumers also have sunk costs in purchasing decisions and are therefore unlikely to change their behavior because of national-level political tensions. In a nutshell, it is costly for everyone – states, firms, and consumers – to change the economic behavior for political reasons. What we should observe, therefore, is economic path-dependence in times of political tensions. In a globalized world, international economics should be independent of international politics. In support of this argument, Davis and Meunier (2011) have shown that aggregate economic flows and high-salience sectors, such as wine and automobiles, have been unaffected by the deterioration in political relations between the United States and France and between China and Japan. They concluded that it is business as usual, even when political tensions are high. But is business always as usual? Recent evidence from works exploring the trade-conflict nexus seem to indicate otherwise. Fuchs and Klann (2013), for example, found that countries that received the Dalai Lama at the highest level during the Hu Jintao era experienced reduced export to China in sectors such as machinery and transport equipment. Revisiting the US–France relationship during the 2003 Iraq War, a case carefully examined by Davis and Meunier (2011), Pandya and Venkatesan (2014) discovered that the market share of French-sounding US supermarket brands declined, and that the effect was larger in supermarkets where a higher proportion of customers were US citizens. Focusing on China’s enduring territorial tensions with the Philippines in the South China Sea, Wang (2015) showed that episodes of tension between the two countries had significantly reduced bilateral trade, and that the reduction had been proportional to the level of tension. We join this debate on the relationship between political tensions and economic relations. Rather than challenging the ‘business-as-usual’ thesis directly, however, we believe that the existing empirical indeterminacy can be reconciled with a more nuanced argument. In marketing research, an emerging body of work has examined the concept of ‘consumer animosity’ (Klein et al., 1998; Riefler and Diamantopoulos, 2007), defined as ‘remnants of antipathy related to previous or ongoing military, political or economic events (p. 90)’. Empirical studies in the United States, Europe and Asia have demonstrated that such animosity can lead to negative impacts on consumers’ willingness to buy products of companies from the offending nation (Shin, 2001; Klein et al., 2004; Nijssen and Douglas, 2004). Drawing on these insights, we argue that certain political tensions – especially those involving enduring territorial disputes – could override entrenched economic interests, resulting in abrupt changes in bilateral trade as consumers boycott foreign products and firms change export destinations. Furthermore, there is reason to believe that consumers and firms might be responding differently toward different goods produced by the other country. That is, not all products will be affected equally during political turmoil. The literature on boycott suggests that products purchased or used publicly, such as clothing and cars, present opportunities for social enforcement and selective incentives, such as reputational costs, belonging, and praise, which help overcome collective action problems, and thus are more likely to be targets of boycott (McCracken, 1990; Ram, 2007; Warde, 2015; Benstead and Reif, 2017). Profit maximizing firms, on the other hand, are less susceptible to such social pressure, especially if their trade with the other country are primarily in intermediate or raw materials – products that are not ‘visible’ to the public. To test these arguments, we leverage a recent shock to the Sino-Japanese relations – Japan’s nationalization of the Diaoyu/Senkaku Islands in September 2012 – and examine its impact on trade between the two countries, using disaggregated trade data. If our arguments hold, we should expect to see disruptions in trade between the two countries following the nationalization incident. Furthermore, the degree of disruption should vary with respect to the nature of the products being traded, with salient and visible products and industries suffering more losses. 3 The Diaoyu/Senkaku dispute and the nationalization incident Recent political tensions between China and Japan center on eight small, uninhabited Islands located about 120 miles northeast of Taipei, Taiwan.1 The Japanese call them the Senkaku, the Chinese Diaoyu. Dispute over the Diaoyu/Senkaku Islands has been long-standing. China claims that the Islands have been considered part of the Chinese empire since the Ming Dynasty (1368–1644), as they appeared on maps and documents associated with coastal defenses of the Ming Empire. The subsequent Qing dynasty (1644–1911) strengthened its control over the Islands by placing it under the administration of Taiwan, which was then part of the Qing (State Council, China, 25 September 2012). However, contending claims suggest that although Chinese fishermen used the Islands as temporary shelter, China never established a permanent civilian or military personnel presence on it, nor did it have a strong naval presence in the surrounding waters (Cheng, 1974). Japan seized the Islands in 1885 after defeating the Qing navy in the first Sino-Japanese War, asserting the Islands were unoccupied and terra nullius (as empty land) and annexed it in 1895 (Fravel, 2010: 146). The Japanese had long claimed that their seizure was unrelated to winning the war, and that the Islands showed ‘no trace of having been under the control of China’ when they acquired them (Ministry of Foreign Affairs Japan, October 2010). In 1932, Japan sold the Islands to descendants of the original settlers. The Chinese contested Japan’s acquisition as a result of the Shimonoseki Treaty, calling it an ‘unequal treaty’ the Qing government had been forced to sign after losing the war, in which the Chinese agreed to cede Formosa (Taiwan) to Japan, ‘together with all the islets appertaining or belonging to the said Islands of Formosa’ (Manyin, 2013: 3). The treaty, however, did not mention Diaoyu/Senkaku, nor were the Islands discussed during the Sino-Japanese negotiations (Upton, 1972). Toward the end of World War II, the Allies’ declarations at Cairo and Potsdam demanded that Japan return to China all Chinese territories seized by force. In 1945, Japan relinquished sovereignty over Formosa (Taiwan) but without mentioning Diaoyu/Senkaku. After the signing of the 1951 Peace Treaty with Japan, Diaoyu/Senkaku was put under de facto American administration in 1953.2 When signing the 1971 Okinawa Reversion Treaty, several US officials asserted that in the Japan Peace Treaty, ‘Nansei Shoto south of 29 degrees north latitude’ was ‘understood by the United States and Japan to include the Senkaku Islands’ (Okinawa Reversion Hearings, 1971: 90–91, 93, 147).3 As a result, Japan currently administers the Islands, which geologists believe sit close to significant oil and gas deposits (Manyin, 2013). When China and Japan normalized their diplomatic relations in 1972, they agreed to shelve the dispute and let future leaders decide on how to deal with it. In April 2012, the year that marked the 40th anniversary of the normalization of diplomatic relations between China and Japan, Shintaro Ishihara, Governor of Tokyo, announced that the metropolitan government of Tokyo had been in negotiations of purchase with the two Saitama-based businessmen that currently own the four Islands in the Diaoyu/Senkaku chain (Yukio, 2012). The Ishihara proposal drew criticisms from within and outside of Japan, and soon the main opposition party and the ruling Democratic Party joined the fray, as both saw political gains in nationalizing the Islands (Drifte, 2014). Four months after the Ishihara proposal, on 14 August 2012, a group of Hong Kong activists reached the disputed Islands by sea for the first time since 1996. Seven disembarked onto the Islands – defying Japan’s prohibition – and asserted Chinese sovereignty. In response, a group of Japanese nationalists swam ashore and raised Japanese flags. These developments prompted the Japanese government to expedite the negotiation process with the private businessmen. On 10 September 2012, the government sealed the deal by offering JPY 2.05 billion to the owner. The move, according to the Japanese government, was to prevent the conservative, anti-China governor of Tokyo from buying the Islands and developing them (New York Times, 11 September 2012). The Chinese government responded immediately by condemning Japan’s nationalization of the Islands as a gross violation of China’s sovereignty. The Chinese Ministry of Defense issued a rare, harsh statement saying that the ‘Chinese government and armed forces stand firm … in their determination to safeguard the nation’s sovereignty and territory’ (Xinhua, 11 September 2012). The situation since then has been regarded as ‘the most serious in Sino-Japanese relations in the post-war period in terms of the risk of militarized conflict’ (BBC, 8 February 2013), with the USA worrying about being drawn into a Sino-Japanese violent confrontation (Manyin, 2016: 1). In the remaining days of the month of nationalization, China dispatched 13 ships to the waters surrounding the disputed area – more than the total number of vessels in the previous 45 months. The nationalization of the disputed Islands also led to an unprecedented wave of anti-Japanese protests in China. Adding fuel to the fire, the sale came a week before the 18th of September, the date of Japan’s invasion of China’s Manchurian region 81 years earlier. Over the weekend, thousands of Chinese protesters hurled bottles and eggs at the Japanese embassy in Beijing, chanting ‘down with Japanese imperialism’ and calling for war. Elsewhere in China, anti-Japanese rallies also broke out and sometimes turned violent, especially in localities with more migrants, college students, and the so-called patriotic education bases (Wallace and Weiss, 2015). Messages and photos posted on Chinese social media sites showed angry mobs in numerous cities ransacking Japanese stores and restaurants as well as smashing and burning cars of Japanese make (CNN, 12 September 2012). In addition to taking it to the street, enraged Chinese also took it to the internet to vent their anger. Many targeted not only the Japanese government, but also their own, which heavily censored internet comments of all sorts following the nationalization incident (Cairns and Carlson, 2016). 4 Economic responses to the nationalization incident Has the political crisis produced negative economic externalities for China and Japan? Have relevant economic actors changed their behavior as a result of heightened political tension? Business reports and newspaper editorials all suggest that this is the case, and the effects seemed to be particularly large for Japan. In January 2013, Bloomberg wrote that political tension was ‘taking a rising toll’ on the Japanese and Chinese economies (Bloomberg News, 8 January 2013). The tension ‘has become increasingly costly as Japan’s dependence on China as an export market has risen,’ and as ‘nationalism around the issue has resulted in lower demand for Japanese products in China’ said Tony Nash, a managing director at IHS Inc, an industry research and analytics firm for industries. JPMorgan Chase & Co. even estimated that the nationalization incident might have cut Japanese economic growth by 1% in the last quarter of 2012 (Bloomberg News, 8 January 2013). These macrolevel estimates are consistent with reports from different sectors and industries. For example, Japan’s largest airline had 46,000 seats cancelled on flights between China and Japan between September 2012 and November 2012. Sales of Japanese electronic products also dropped sharply after September 2012, as fewer Chinese customers showed open interest in buying such products, according to Chinese retailers in Beijing (Xinhua, 12 September 2012). A famous Japanese casual-wear retailer shut more than a third of its stores in China because of the diplomatic crisis. Anti-Japanese protests in China’s central Hunan Province forced a large Japanese supermarket to close for more than a month, incurring a loss of more than JPY 500 million (Xinhua, 12 September 2012). Consistent with our argument, highly visible goods were the most likely targets of consumer boycott. For example, it was reported that sales of the popular cosmetics and skin-care products made by the Japanese company Shiseido tumbled, partly because many customers refrained from sending them as holiday gifts (Katz, 2013), as gift exchanges are a rational ritual enhancing/undermining social relationships (Bourdieu, 1977). Automobiles, another example of visible good, were particularly hard hit. Toyota Motor Corporation revealed in November 2012 that output in China had experienced the biggest decline in the last decade, while Nissan Motor Corporation also reported the biggest output decline since the 2008 financial crisis (Katz, 2013). SocGen’s Kiyoko Katahira wrote that after the nationalization incident, Chinese consumers started avoiding Japanese products, and that the car industry was one of the most affected areas. In October, more than half of the decline in total exports to China can be explained by a large drop in motor vehicles exports (a drop of 54.1% from a year ago, or a contribution of –6.1 pp to total export growth), which were increasing in the months before the Islands dispute flared up (Business Insider, 21 November 2012). China’s economy could also be negatively affected in the long run, should political tension continue. One month after the spike in political tension, over a quarter of Japanese manufacturers suggested that they were thinking about shifting their production elsewhere, according to a Reuters Corporate Survey (Reuters, 23 October 2012). About 37% of the firms surveyed expressed ‘caution’ over the medium- and long-term prospects of using China as their production hub. In the same survey, 24% of the firms indicated that they would delay or reduce investment in China (Reuters, 23 October 2012). 5 Empirical evidence with disaggregated trade data We now turn to our empirical analysis to more formally assess whether the nationalization incident has harmed the bilateral trade. We use disaggregated, monthly trade data drawn from Chinese and Japanese Customs, respectively. The use of more fine-grained data allows us to detect economic disruptions following sudden political ruptures that could be otherwise masked in yearly or even quarterly data employed in most existing studies (e.g. Davis and Meunier, 2011). We begin by plotting the aggregate data for bilateral trade from September 2010 to January 2014 (Fig. 1). The first thing to notice is that that there are sharp drops around January and February due to Chinese New Year. Nevertheless, the volume of exports usually recovers in March.4 Looking at the top panel first, we can see that Chinese exports to Japan did not seem to be suffering from the nationalization incident. The volume of exports followed a steady upward trend for the entire period between September 2010 and January 2014. In other words, business appears to have been ‘as usual.’ Chinese exporters were not shipping their products to other markets, nor were the Japanese refraining from buying Chinese products. Figure 1 View largeDownload slide China–Japan bilateral trade, 2010–14. Note: These figures show the volume of Chinese/Japanese exports to Japan/China before and after the nationalization incident, which is represented by the vertical line. Horizontal lines are also given to represent the linear trend in exports. Source: China Customs. Figure 1 View largeDownload slide China–Japan bilateral trade, 2010–14. Note: These figures show the volume of Chinese/Japanese exports to Japan/China before and after the nationalization incident, which is represented by the vertical line. Horizontal lines are also given to represent the linear trend in exports. Source: China Customs. However, business certainly was not as usual when we consider Japan’s exports to China, in the bottom panel of Fig. 1. Here, we can see that the amount of exports prior to the nationalization incident followed a very slow downward trend. After the nationalization incident, however, Japan’s exports to China dropped sharply and did not recover until January of the following year. Overall, the linear trend lines of the two periods reveal a distinct overall downward shift in Japanese exports following the nationalization incident. Between September 2010 and August 2012, the average monthly exports from Japan to China amounted to USD 15.8 billion. This number was reduced to USD 13.7 billion during the next 18 months. The difference between the two period is statistically significant at the 0.01 level (t-statistic = 2.68; P = 0.0051). It could be that the drop in Japan’s exports to China was the result of a slump in Chinese demand for all foreign products. We investigate this possibility in Fig. 2, where we plot China’s imports from nine of its top 10 trading partners during the same period.5 The results are striking. The United States, Taiwan, Hong Kong, South Korea, Malaysia, and Australia all experienced increased exports to China in the post-nationalization period. While Brazil and Germany’s exports followed the same downward trend as Japan’s, the initial point of the decline preceded the nationalization incident, and they both returned to or even exceeded the pre-nationalization level shortly afterwards. The same can be said in the case of Russia – i.e. the overall downward trend began about six months prior to the nationalization incident and, by the end of 2013, the exports were starting to pick up. These cross-country comparisons suggest that the nationalization incident only had a negative impact on Japan’s exports. Furthermore, it seems that while China was not buying from Japan, it was compensating for the loss by increasing imports from its other major trading partners. That is, the nationalization incident has had a trade-diverting effect. Figure 2 View largeDownload slide China’s imports from its top 10 trading partners (excluding Japan), 2010–14. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: China Customs. Figure 2 View largeDownload slide China’s imports from its top 10 trading partners (excluding Japan), 2010–14. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: China Customs. Thus far, we have demonstrated the negative consequences of the nationalization incident on Japan’s aggregate export to China. We next use disaggregated data to examine whether some industries were more affected than others. We first break Japan’s exports to China into nine broad sectors. They are, in descending order as measured by the average volume of exports from August 2008 to August 2013, electromechanical, mechanical, manufacturing, chemical, other, transportation, raw materials, mineral fuel, and food. Figure 3 plots variation of Japan’s sector-level exports to China before and after the nationalization incident. Figure 3 View largeDownload slide Japan’s export to China by sector, 2008–13. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. Figure 3 View largeDownload slide Japan’s export to China by sector, 2008–13. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. Several patterns emerge from the sector-level data. First, the Chinese people continued to enjoy Japanese food products despite the nationalization incident; Japan’s food exports to China remained fairly stable and increased steadily over time. Second, sectors that primarily consist of intermediary goods, including raw materials, mineral fuels, chemicals, and others, saw moderate to sharp increases in the post-nationalization period. In contrast, the remaining four sectors all experienced, or continued to experience, reductions in their export volume after the nationalization incident. Notably, these sectors – mechanical, electromechanical, transportation, and manufacturing – are more likely to contain consumer goods. These contrasting patterns lend support to our expectation that responses to political tensions from consumers and firms may follow different logics. Immediately following the nationalization incident, Chinese consumers seemed to have overcome their entrenched economic interests and preferences and changed their purchasing behaviors, leading to substantial reductions in Japanese exports to China in sectors more concentrated in consumer goods. The effects lasted six months in the case of the transportation sector and 12 months in the case of the electromechanical sector. In the meantime, Chinese firms that relied on Japanese imports for intermediate and raw materials seemed to put business before politics. The fact that imports of raw materials and chemicals from Japan went up in some sectors suggests that some Chinese firms might have deliberately sped up their imports from Japan, lest the crisis escalated; escalation could have prompted Beijing to demand that firms reduce or cut their imports from Japan. In other words, the observed increase of imports in these sectors could reflect that Chinese firms were hedging against future state intervention and crisis escalation. Similar patterns exist not only at the sector level but also at the industry level once we further disaggregate the data. We do this for the four sectors that experienced drops after the nationalization incident, but for brevity here we only report the results for the electromechanical sector (Fig. 4).6 Here, we see that three industries saw immediate, dramatic drops in their export to China: image equipment, recorders, and heavy electrics; the effects are most obvious for image equipment and recorders. Similar to what we observe in the sector-level data, these negatively affected industries gradually bounced back after about six months, but they took longer to return to the pre-nationalization levels. The fact that image equipment (e.g. cameras) and recorders were particularly hard hit provides further evidence that it was individual consumers, rather than firms that use integrated circuit or battery storage imports from Japan, who were choosing to reduce their purchases of certain Japanese products that have high visibility (consumers mostly use cameras in public spaces rather than in private). Figure 4 View largeDownload slide Exports to China from Japan’s electromechanical sector. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. Figure 4 View largeDownload slide Exports to China from Japan’s electromechanical sector. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. One salient industry examined closely in Davis and Meunier (2011) – using quarterly data – is Japan’s automobile exports to China, which they find to be immune to political tensions between the two countries. Although covering a different time period, our monthly data present a vastly different picture. Figure 5 plots Japan’s auto exports to China between 2009 and 2014, using data from Japan’s Ministry of Finance. As a comparison, we also plot Japan’s auto exports to the European Union and the United States for the same period. Figure 5 View largeDownload slide Japan’s auto exports to China, the EU, and the United States. Source: Ministry of Finance, Japan. Figure 5 View largeDownload slide Japan’s auto exports to China, the EU, and the United States. Source: Ministry of Finance, Japan. The pattern is similar to what we found before, but the impact is much more dramatic. Car sales plummeted right after the nationalization incident, dropping from JPY 33,883 million in September 2012 to JPY 8,387 million one month later. And it took almost an entire year for the auto exports to recover from the fallout. Meanwhile, Japan’s auto exports to the EU and the United States remained unperturbed. This corroborates the anecdotal evidence reported by media and business groups – that is, Japan’s auto sector has been a conspicuous victim of rising political tensions between the two countries, stemming from the nationalization incident. To further buttress our finding, i.e. Japan’s auto exports to China was uniquely affected, we use monthly data from the China Passenger Car Association (CPCA) to compare car exports to China from various countries. Due to data limitation, we restrict the time frame to three months before and after the nationalization incident. As can be seen in Table 1, only Japan’s export experienced an immediate and dramatic drop after September 2012, while exports from other countries all increased. Table 1 China’s auto imports from various countries (Unit: 10,000 cars) Source: China Passenger Car Association (CPCA). Table 1 China’s auto imports from various countries (Unit: 10,000 cars) Source: China Passenger Car Association (CPCA). 6 Additional evidence: the THAAD case The divergent responses to political tensions between consumers and firms are not unique to the nationalization incident. A similar case is the recent anti-Korean boycott across China after South Korea decided to deploy the Terminal High Altitude Area Defense (THAAD) system to counter threats from North Korea.7 Right after the board of an affiliate of South Korea’s Lotte Group approved a land swap with the South Korean government for deployment of THAAD, the Chinese government, along with Chinese consumers, retaliated. More than 88 of the 99 Lotte stores in China were forced by the government to shut down due to alleged violations of fire code (Shanghaiist, 21 March 2017). Reminiscent of the Cultural Revolution era, even primary school students were mobilized to boycott food items sold in Lotte stores (Shanghaiist, 13 March 2017). Putting patriotism above tourism, in a spectacular show of national solidarity, more than 3,000 Chinese tourists refused to disembark from their cruise ship at South Korea’s Jeju island, a popular destination that attracted more than two million Chinese in 2016 (Reuters, 14 March 2017). What sets the THAAD episode apart from the nationalization incident is the conspicuous involvement of the Chinese state. The People’s Daily, for example, published an editorial claiming that if Lotte could take actions harming China in the name of protecting national interests, then Chinese consumers could also say no to Lotte and its products for protecting China’s national interests (Xinhua, 27 March 2017). Such articles and commentaries went viral on all kinds of social media in China. The Communist Youth League even published a comprehensive list containing the location of every single Lotte store in China, calling for nation-wide boycott (Communist Youth League, 1 March 2017). Firms in China, on the other hand, behaved in a diametrically different way. In spite of the consumer fervor in response to state encouragement of the boycott and Lotte stores being shut down, recent statistics from the Korean government show that the country’s aggregate export to China has recorded a consecutive five-month growth amidst the THAAD crisis, and its exports of USD 11.6 billion in March 2017 were up by 12.1% compared to the same month the year before. However, as we would expect, driving this growth are not consumer products but Chinese firms’ imports of petrochemical materials, LCD screens, microchips, as well as other information technology related intermediary products – none of which are purchased directly by individual consumers (Free Asia TV, 4 April 2017). The THAAD episode only reinforces our finding from the China–Japan case: that despite differences in terms of state involvement in coordinating consumer responses, in a globalized world with ever deepening economic integration, politics continues to have a clear grip on the economic behaviors and fortunes of states, firms, and individuals. During times of heightened political tensions, business will no longer be as usual. 7 Discussion In understanding the relationship between economics and politics among states, the ‘business as usual’ thesis contends that sunk costs in existing trade and investment reduce the likelihood that governments, firms, and consumers would change their behavior in response to political tensions. In contrast, we argue that business may not always be ‘as usual.’ Certain political tensions, especially those involving enduring territorial disputes, could motivate domestic actors to change their preferences and behaviors, leading to disruptions in bilateral economic exchanges. In the case of China–Japan relations, our results provide evidence that Japan’s nationalization of the Diaoyu/Senkaku Islands negatively affected its exports to China. Using disaggregated data, we further show that the effect is most pronounced for highly salient and visible consumer products, such as automobiles and cameras, which experienced substantial drops lasting for up to 12 months. The lesson for policymakers is that they should not assume that there would be no economic ramifications when making political decisions, especially those involving sensitive territorial disputes. The evidence is clear that there will be. One interesting puzzle revealed by our analysis is that the disruptive effects of the nationalization incident only affected Japan’s exports – during the same period, China’s exports to Japan remained largely unchanged. There are a couple of potential explanations. First, what we observed may have been due to the fact that Japan was exporting more consumer goods to China rather than intermediate and raw materials; users of the latter are primarily firms. Second, it is possible that economic transactions other than trade were affected on the Chinese side. For instance, it was reported that Japanese investment in China declined by 4.3% in 2013 and further dropped by nearly half in the first six months of 2014, after posting a growth rate of 16.3% in 2012 (Bloomberg Businessweek, 16 July 2014). These potential explanations will be fruitful areas of inquiry for future research. Our industry-level analyses also suggest that responses to political tensions from consumers and firms may follow different logics. While consumers swiftly organized to boycott highly visible Japanese goods, firms seemed to put business before politics, sticking with their Japanese suppliers for intermediary goods and raw materials, and even potentially hedging against dispute escalation by stocking up on imports from Japan. Our discussion of the ongoing THAAD episode provides additional evidence for this pattern. Unpacking the mechanisms that drive the divergent behaviors between consumers and firms presents yet another promising topic for future research. Supplementary material Supplementary material is available at IRASIA International Relations of the Asia-Pacific online. Footnotes 1 The government of the Republic of China on Taiwan also claims sovereignty over the Islands. In this article, we will focus only on two claimants: China and Japan. 2 Treaty of Peace with Japan, signed on 8 September 1951, 3 U.S.T. 3169. 3 The State Department officials included: Robert Starr, Acting Assistant Legal Adviser for East Asian and Pacific Affairs; Harrison Symmes, Acting Assistant Secretary of State for Congressional Relations; and Howard McElroy, Country Officer for Japan. 4 The Chinese Near Year falls in January in some years and February in others. During this time, factories stop production; migrant workers return home and financial markets are closed. The seasonal disruption of the Chinese New Year to the economy is visible in all of the import data series. 5 We used the 2013 data to determine the top 10 trading partners of China, which are, in descending order, United States, Hong Kong, Japan, South Korea, Taiwan, Germany, Australia, Malaysia, Brazil, and Russia. 6 Results for the other sectors can be found in the Online Appendix. 7 China believed that the THAAD system, which has a powerful radar capable of penetrating the interior of China’s territory, could reduce China’s strategic leverage over other military powers in the region. 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Published by Oxford University Press in association with the Japan Association of International Relations; all rights reserved. For Permissions, please e-mail: journals.permissions@oup.com http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png International Relations of the Asia-Pacific Oxford University Press

Business as usual? Economic responses to political tensions between China and Japan

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Abstract

Abstract What is the relationship between political tensions and economic relations? In this study, we explore this question by examining how Japan’s nationalization of the Diaoyu/Senkaku Islands, a territory much disputed with China, has affected bilateral trade between the world’s second and third largest economies. Using monthly data, we find that the nationalization imbroglio has negatively affected the amount of goods Japan exports to China, with the effect being most pronounced for highly salient and visible products such as automobiles and cameras; these experienced immediate and dramatic drops lasting up to 12 months. In contrast, raw materials and intermediate goods were not affected at all; some even experienced increased exports. These findings suggest that consumer and corporate responses to political tensions may follow different logics. For consumers, certain political tensions, especially those involving enduring territorial disputes, could override entrenched economic interests and preferences, at least in the short term. In these instances, it will no longer be business as usual. 1 Introduction Do political tensions between states produce negative economic externalities? Scholars from the two major schools of international relations theory disagree on this crucial question. For realists, the answer is yes; according to them, political tensions lead states to reduce economic interdependence and discourage private actors from having further economic exchanges (Gowa and Mansfield, 1993; Kirshner, 1999). Liberals, however, believe that political tensions do not induce states to punish each other economically, and that economic interdependence and sunk costs make it difficult for private actors to quickly change trade and investment patterns (Oneal and Russett, 1997; Kastner, 2007; Maoz, 2009). In a widely cited study that aimed to adjudicate between these two competing theories, Davis and Meunier (2011) presented empirical evidence in support of the liberal view. Using quarterly economic and events data, they showed that varying levels of political tensions in US–France and China–Japan relations had no negative effects on these nations’ trade and investment flows, both in aggregate terms and in high-salience sectors such as wine and automobiles. In an era of globalization, they concluded, ‘actors lack incentive to link political and economic relations’ (Davis and Meunier, 2011: 628). However, more recent studies – using new cases, methods, and data – have cast doubt on the ‘business as usual’ thesis. Collectively, these have suggested that political tensions could still negatively affect economic relations in a globalized world (Fuchs and Klann, 2013; Pandya and Venkatesan, 2016; Wang, 2015). In this article, we join the debate on the trade-conflict nexus by empirically examining how recent political tensions stemming from Japan’s nationalization of the Diaoyu/Senkaku Islands have affected bilateral trade between China and Japan, the world’s second and third largest economies. Our analyses make two significant contributions. First, while recent studies have focused on the effect of smaller shifts in political relations, we highlight the impact of extreme cases on the political tension spectrum – i.e., territorial disputes with military threat but short of direct confrontation. Second, we rely on more fine-grained trade data at the level of month and industry, making it possible to detect immediate but nonetheless large economic disruptions following sudden political ruptures that could be otherwise masked in yearly or even quarterly data. The use of disaggregated data also allows us to uncover the potential heterogeneous impact of political tensions on different economic sectors. Our results provide evidence that the nationalization incident negatively affected the amount of goods Japan exported to China. The effect was most pronounced for highly salient and visible products such as automobiles and cameras, which experienced immediate, dramatic, and relatively long-term drops lasting up to 12 months. In contrast, Japanese raw materials and intermediate goods were not affected at all, and some even experienced increased exports, suggesting that some Chinese firms might be hedging against possible conflict escalation through increased imports from Japan. These findings provide important qualifications to the results of Davis and Meunier (2011), who argued that sunk costs in existing trade and investment make governments, firms, and consumers unlikely to change their behavior in response to political disputes. Moreover, the China–Japan case, when carefully examined, suggests that responses to political tensions from consumers and firms may follow different logics. For consumers, certain political tensions, especially those involving enduring territorial disputes, could override their entrenched economic interests and preferences. For firms, the story is more complicated; while some do not alter their trade behaviors amidst external political tensions, others do so to hedge against future import disruptions. The latter choice could well translate into high opportunity costs stemming from changing business patterns. In a nutshell, for both consumers and some firms, business will no longer be as usual amidst territorial disputes or other high-level political tensions. The rest of the article proceeds as follows. Section 2 reviews the existing literature. Section 3 provides a brief historical background to the nationalization incident. Section 4 and Section 5 present a set of qualitative and quantitative evidence for the negative impact of the nationalization incident. Section 6 provides additional evidence using the current THADD dispute between China and South Korea. Section 7 concludes with a discussion of the larger implications and areas for future research. 2 The trade-conflict nexus: political animals or Homo Economicus? From a realist perspective, states care first and foremost about their survival in the anarchic international system. Rational calculus should lead states to promote trade only with their political allies, so that they need not worry about gains from trade strengthening a potential adversary (Gowa and Mansfield, 1993). By the same logic, rational private actors should also ‘follow the flag’ when engaging in cross-national business activities – importers buy from friends, consumers punish foes (Pollins 1989a, 1989b). When ‘trade follows the flag,’ however, political tensions result in negative impacts on bilateral economic exchanges, even when governments from rival states do not explicitly sanction each other. Scholars in this line of research have shown that states sharing democratic institutions adopt similar policy positions and have more trust toward each other, and states that are political allies tend to have higher levels of international trade and investment (Dixon and Moon, 1993; Bliss and Russett, 1998; Morrow et al., 1998; Guiso et al., 2004). In contrast, liberals since Adam Smith have long emphasized the pacifying effect of international trade. A core assumption in the liberal perspective is that political conflict is deleterious to international trade and investment. Sustained and increased economic exchanges among states incubate vested domestic interest groups opposed to interstate conflict (Oneal and Russett, 1997; Polachek, 1980). These interest groups in turn lobby their governments not to engage in international conflicts (Mansfield, 1995; Copeland, 1996; Papayoanou, 1997; Kastner, 2007). In addition to nurturing interest groups, trade also helps sustain peace through an informational channel; states engaging in international trade and capital markets can more credibly signal to one another dissatisfaction and resolve (Gartzke et al., 2001). Even low-level political conflict should induce signaling – i.e., different economic behavior – from rival states. Statistical evidence indeed suggests that free trade encourages peace and reduces conflict (Maoz, 2009). Recent scholarship suggests that both the realist and the liberal perspectives are too simplistic to capture new realities in international political economy. In a widely-cited study, Davis and Meunier (2011) argued that, in an era of globalization, states no longer wield substantial control over economic actors, nor do economic actors exert dominance over states. While leaders still retain a certain degree of autonomy in their responses to market and interest-group pressures, their ability to manipulate economies for political purposes is increasingly constrained by low trade barriers, capital mobility, and multinational firms. Moreover, states might even be unwilling to play the economics card for fear of losing investor confidence (Davis and Meunier, 2011: 631). Finally, trade rules embodied by multilateral institutions such as the WTO also have significantly increased the cost of state intervention in international economic affairs. While states nowadays often need to think twice before linking politics with economics in international relations, private firms are even more resistant to suddenly changing their trade and investment patterns, given greater sunk costs in an increasingly globalized economy. Similarly, consumers also have sunk costs in purchasing decisions and are therefore unlikely to change their behavior because of national-level political tensions. In a nutshell, it is costly for everyone – states, firms, and consumers – to change the economic behavior for political reasons. What we should observe, therefore, is economic path-dependence in times of political tensions. In a globalized world, international economics should be independent of international politics. In support of this argument, Davis and Meunier (2011) have shown that aggregate economic flows and high-salience sectors, such as wine and automobiles, have been unaffected by the deterioration in political relations between the United States and France and between China and Japan. They concluded that it is business as usual, even when political tensions are high. But is business always as usual? Recent evidence from works exploring the trade-conflict nexus seem to indicate otherwise. Fuchs and Klann (2013), for example, found that countries that received the Dalai Lama at the highest level during the Hu Jintao era experienced reduced export to China in sectors such as machinery and transport equipment. Revisiting the US–France relationship during the 2003 Iraq War, a case carefully examined by Davis and Meunier (2011), Pandya and Venkatesan (2014) discovered that the market share of French-sounding US supermarket brands declined, and that the effect was larger in supermarkets where a higher proportion of customers were US citizens. Focusing on China’s enduring territorial tensions with the Philippines in the South China Sea, Wang (2015) showed that episodes of tension between the two countries had significantly reduced bilateral trade, and that the reduction had been proportional to the level of tension. We join this debate on the relationship between political tensions and economic relations. Rather than challenging the ‘business-as-usual’ thesis directly, however, we believe that the existing empirical indeterminacy can be reconciled with a more nuanced argument. In marketing research, an emerging body of work has examined the concept of ‘consumer animosity’ (Klein et al., 1998; Riefler and Diamantopoulos, 2007), defined as ‘remnants of antipathy related to previous or ongoing military, political or economic events (p. 90)’. Empirical studies in the United States, Europe and Asia have demonstrated that such animosity can lead to negative impacts on consumers’ willingness to buy products of companies from the offending nation (Shin, 2001; Klein et al., 2004; Nijssen and Douglas, 2004). Drawing on these insights, we argue that certain political tensions – especially those involving enduring territorial disputes – could override entrenched economic interests, resulting in abrupt changes in bilateral trade as consumers boycott foreign products and firms change export destinations. Furthermore, there is reason to believe that consumers and firms might be responding differently toward different goods produced by the other country. That is, not all products will be affected equally during political turmoil. The literature on boycott suggests that products purchased or used publicly, such as clothing and cars, present opportunities for social enforcement and selective incentives, such as reputational costs, belonging, and praise, which help overcome collective action problems, and thus are more likely to be targets of boycott (McCracken, 1990; Ram, 2007; Warde, 2015; Benstead and Reif, 2017). Profit maximizing firms, on the other hand, are less susceptible to such social pressure, especially if their trade with the other country are primarily in intermediate or raw materials – products that are not ‘visible’ to the public. To test these arguments, we leverage a recent shock to the Sino-Japanese relations – Japan’s nationalization of the Diaoyu/Senkaku Islands in September 2012 – and examine its impact on trade between the two countries, using disaggregated trade data. If our arguments hold, we should expect to see disruptions in trade between the two countries following the nationalization incident. Furthermore, the degree of disruption should vary with respect to the nature of the products being traded, with salient and visible products and industries suffering more losses. 3 The Diaoyu/Senkaku dispute and the nationalization incident Recent political tensions between China and Japan center on eight small, uninhabited Islands located about 120 miles northeast of Taipei, Taiwan.1 The Japanese call them the Senkaku, the Chinese Diaoyu. Dispute over the Diaoyu/Senkaku Islands has been long-standing. China claims that the Islands have been considered part of the Chinese empire since the Ming Dynasty (1368–1644), as they appeared on maps and documents associated with coastal defenses of the Ming Empire. The subsequent Qing dynasty (1644–1911) strengthened its control over the Islands by placing it under the administration of Taiwan, which was then part of the Qing (State Council, China, 25 September 2012). However, contending claims suggest that although Chinese fishermen used the Islands as temporary shelter, China never established a permanent civilian or military personnel presence on it, nor did it have a strong naval presence in the surrounding waters (Cheng, 1974). Japan seized the Islands in 1885 after defeating the Qing navy in the first Sino-Japanese War, asserting the Islands were unoccupied and terra nullius (as empty land) and annexed it in 1895 (Fravel, 2010: 146). The Japanese had long claimed that their seizure was unrelated to winning the war, and that the Islands showed ‘no trace of having been under the control of China’ when they acquired them (Ministry of Foreign Affairs Japan, October 2010). In 1932, Japan sold the Islands to descendants of the original settlers. The Chinese contested Japan’s acquisition as a result of the Shimonoseki Treaty, calling it an ‘unequal treaty’ the Qing government had been forced to sign after losing the war, in which the Chinese agreed to cede Formosa (Taiwan) to Japan, ‘together with all the islets appertaining or belonging to the said Islands of Formosa’ (Manyin, 2013: 3). The treaty, however, did not mention Diaoyu/Senkaku, nor were the Islands discussed during the Sino-Japanese negotiations (Upton, 1972). Toward the end of World War II, the Allies’ declarations at Cairo and Potsdam demanded that Japan return to China all Chinese territories seized by force. In 1945, Japan relinquished sovereignty over Formosa (Taiwan) but without mentioning Diaoyu/Senkaku. After the signing of the 1951 Peace Treaty with Japan, Diaoyu/Senkaku was put under de facto American administration in 1953.2 When signing the 1971 Okinawa Reversion Treaty, several US officials asserted that in the Japan Peace Treaty, ‘Nansei Shoto south of 29 degrees north latitude’ was ‘understood by the United States and Japan to include the Senkaku Islands’ (Okinawa Reversion Hearings, 1971: 90–91, 93, 147).3 As a result, Japan currently administers the Islands, which geologists believe sit close to significant oil and gas deposits (Manyin, 2013). When China and Japan normalized their diplomatic relations in 1972, they agreed to shelve the dispute and let future leaders decide on how to deal with it. In April 2012, the year that marked the 40th anniversary of the normalization of diplomatic relations between China and Japan, Shintaro Ishihara, Governor of Tokyo, announced that the metropolitan government of Tokyo had been in negotiations of purchase with the two Saitama-based businessmen that currently own the four Islands in the Diaoyu/Senkaku chain (Yukio, 2012). The Ishihara proposal drew criticisms from within and outside of Japan, and soon the main opposition party and the ruling Democratic Party joined the fray, as both saw political gains in nationalizing the Islands (Drifte, 2014). Four months after the Ishihara proposal, on 14 August 2012, a group of Hong Kong activists reached the disputed Islands by sea for the first time since 1996. Seven disembarked onto the Islands – defying Japan’s prohibition – and asserted Chinese sovereignty. In response, a group of Japanese nationalists swam ashore and raised Japanese flags. These developments prompted the Japanese government to expedite the negotiation process with the private businessmen. On 10 September 2012, the government sealed the deal by offering JPY 2.05 billion to the owner. The move, according to the Japanese government, was to prevent the conservative, anti-China governor of Tokyo from buying the Islands and developing them (New York Times, 11 September 2012). The Chinese government responded immediately by condemning Japan’s nationalization of the Islands as a gross violation of China’s sovereignty. The Chinese Ministry of Defense issued a rare, harsh statement saying that the ‘Chinese government and armed forces stand firm … in their determination to safeguard the nation’s sovereignty and territory’ (Xinhua, 11 September 2012). The situation since then has been regarded as ‘the most serious in Sino-Japanese relations in the post-war period in terms of the risk of militarized conflict’ (BBC, 8 February 2013), with the USA worrying about being drawn into a Sino-Japanese violent confrontation (Manyin, 2016: 1). In the remaining days of the month of nationalization, China dispatched 13 ships to the waters surrounding the disputed area – more than the total number of vessels in the previous 45 months. The nationalization of the disputed Islands also led to an unprecedented wave of anti-Japanese protests in China. Adding fuel to the fire, the sale came a week before the 18th of September, the date of Japan’s invasion of China’s Manchurian region 81 years earlier. Over the weekend, thousands of Chinese protesters hurled bottles and eggs at the Japanese embassy in Beijing, chanting ‘down with Japanese imperialism’ and calling for war. Elsewhere in China, anti-Japanese rallies also broke out and sometimes turned violent, especially in localities with more migrants, college students, and the so-called patriotic education bases (Wallace and Weiss, 2015). Messages and photos posted on Chinese social media sites showed angry mobs in numerous cities ransacking Japanese stores and restaurants as well as smashing and burning cars of Japanese make (CNN, 12 September 2012). In addition to taking it to the street, enraged Chinese also took it to the internet to vent their anger. Many targeted not only the Japanese government, but also their own, which heavily censored internet comments of all sorts following the nationalization incident (Cairns and Carlson, 2016). 4 Economic responses to the nationalization incident Has the political crisis produced negative economic externalities for China and Japan? Have relevant economic actors changed their behavior as a result of heightened political tension? Business reports and newspaper editorials all suggest that this is the case, and the effects seemed to be particularly large for Japan. In January 2013, Bloomberg wrote that political tension was ‘taking a rising toll’ on the Japanese and Chinese economies (Bloomberg News, 8 January 2013). The tension ‘has become increasingly costly as Japan’s dependence on China as an export market has risen,’ and as ‘nationalism around the issue has resulted in lower demand for Japanese products in China’ said Tony Nash, a managing director at IHS Inc, an industry research and analytics firm for industries. JPMorgan Chase & Co. even estimated that the nationalization incident might have cut Japanese economic growth by 1% in the last quarter of 2012 (Bloomberg News, 8 January 2013). These macrolevel estimates are consistent with reports from different sectors and industries. For example, Japan’s largest airline had 46,000 seats cancelled on flights between China and Japan between September 2012 and November 2012. Sales of Japanese electronic products also dropped sharply after September 2012, as fewer Chinese customers showed open interest in buying such products, according to Chinese retailers in Beijing (Xinhua, 12 September 2012). A famous Japanese casual-wear retailer shut more than a third of its stores in China because of the diplomatic crisis. Anti-Japanese protests in China’s central Hunan Province forced a large Japanese supermarket to close for more than a month, incurring a loss of more than JPY 500 million (Xinhua, 12 September 2012). Consistent with our argument, highly visible goods were the most likely targets of consumer boycott. For example, it was reported that sales of the popular cosmetics and skin-care products made by the Japanese company Shiseido tumbled, partly because many customers refrained from sending them as holiday gifts (Katz, 2013), as gift exchanges are a rational ritual enhancing/undermining social relationships (Bourdieu, 1977). Automobiles, another example of visible good, were particularly hard hit. Toyota Motor Corporation revealed in November 2012 that output in China had experienced the biggest decline in the last decade, while Nissan Motor Corporation also reported the biggest output decline since the 2008 financial crisis (Katz, 2013). SocGen’s Kiyoko Katahira wrote that after the nationalization incident, Chinese consumers started avoiding Japanese products, and that the car industry was one of the most affected areas. In October, more than half of the decline in total exports to China can be explained by a large drop in motor vehicles exports (a drop of 54.1% from a year ago, or a contribution of –6.1 pp to total export growth), which were increasing in the months before the Islands dispute flared up (Business Insider, 21 November 2012). China’s economy could also be negatively affected in the long run, should political tension continue. One month after the spike in political tension, over a quarter of Japanese manufacturers suggested that they were thinking about shifting their production elsewhere, according to a Reuters Corporate Survey (Reuters, 23 October 2012). About 37% of the firms surveyed expressed ‘caution’ over the medium- and long-term prospects of using China as their production hub. In the same survey, 24% of the firms indicated that they would delay or reduce investment in China (Reuters, 23 October 2012). 5 Empirical evidence with disaggregated trade data We now turn to our empirical analysis to more formally assess whether the nationalization incident has harmed the bilateral trade. We use disaggregated, monthly trade data drawn from Chinese and Japanese Customs, respectively. The use of more fine-grained data allows us to detect economic disruptions following sudden political ruptures that could be otherwise masked in yearly or even quarterly data employed in most existing studies (e.g. Davis and Meunier, 2011). We begin by plotting the aggregate data for bilateral trade from September 2010 to January 2014 (Fig. 1). The first thing to notice is that that there are sharp drops around January and February due to Chinese New Year. Nevertheless, the volume of exports usually recovers in March.4 Looking at the top panel first, we can see that Chinese exports to Japan did not seem to be suffering from the nationalization incident. The volume of exports followed a steady upward trend for the entire period between September 2010 and January 2014. In other words, business appears to have been ‘as usual.’ Chinese exporters were not shipping their products to other markets, nor were the Japanese refraining from buying Chinese products. Figure 1 View largeDownload slide China–Japan bilateral trade, 2010–14. Note: These figures show the volume of Chinese/Japanese exports to Japan/China before and after the nationalization incident, which is represented by the vertical line. Horizontal lines are also given to represent the linear trend in exports. Source: China Customs. Figure 1 View largeDownload slide China–Japan bilateral trade, 2010–14. Note: These figures show the volume of Chinese/Japanese exports to Japan/China before and after the nationalization incident, which is represented by the vertical line. Horizontal lines are also given to represent the linear trend in exports. Source: China Customs. However, business certainly was not as usual when we consider Japan’s exports to China, in the bottom panel of Fig. 1. Here, we can see that the amount of exports prior to the nationalization incident followed a very slow downward trend. After the nationalization incident, however, Japan’s exports to China dropped sharply and did not recover until January of the following year. Overall, the linear trend lines of the two periods reveal a distinct overall downward shift in Japanese exports following the nationalization incident. Between September 2010 and August 2012, the average monthly exports from Japan to China amounted to USD 15.8 billion. This number was reduced to USD 13.7 billion during the next 18 months. The difference between the two period is statistically significant at the 0.01 level (t-statistic = 2.68; P = 0.0051). It could be that the drop in Japan’s exports to China was the result of a slump in Chinese demand for all foreign products. We investigate this possibility in Fig. 2, where we plot China’s imports from nine of its top 10 trading partners during the same period.5 The results are striking. The United States, Taiwan, Hong Kong, South Korea, Malaysia, and Australia all experienced increased exports to China in the post-nationalization period. While Brazil and Germany’s exports followed the same downward trend as Japan’s, the initial point of the decline preceded the nationalization incident, and they both returned to or even exceeded the pre-nationalization level shortly afterwards. The same can be said in the case of Russia – i.e. the overall downward trend began about six months prior to the nationalization incident and, by the end of 2013, the exports were starting to pick up. These cross-country comparisons suggest that the nationalization incident only had a negative impact on Japan’s exports. Furthermore, it seems that while China was not buying from Japan, it was compensating for the loss by increasing imports from its other major trading partners. That is, the nationalization incident has had a trade-diverting effect. Figure 2 View largeDownload slide China’s imports from its top 10 trading partners (excluding Japan), 2010–14. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: China Customs. Figure 2 View largeDownload slide China’s imports from its top 10 trading partners (excluding Japan), 2010–14. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: China Customs. Thus far, we have demonstrated the negative consequences of the nationalization incident on Japan’s aggregate export to China. We next use disaggregated data to examine whether some industries were more affected than others. We first break Japan’s exports to China into nine broad sectors. They are, in descending order as measured by the average volume of exports from August 2008 to August 2013, electromechanical, mechanical, manufacturing, chemical, other, transportation, raw materials, mineral fuel, and food. Figure 3 plots variation of Japan’s sector-level exports to China before and after the nationalization incident. Figure 3 View largeDownload slide Japan’s export to China by sector, 2008–13. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. Figure 3 View largeDownload slide Japan’s export to China by sector, 2008–13. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. Several patterns emerge from the sector-level data. First, the Chinese people continued to enjoy Japanese food products despite the nationalization incident; Japan’s food exports to China remained fairly stable and increased steadily over time. Second, sectors that primarily consist of intermediary goods, including raw materials, mineral fuels, chemicals, and others, saw moderate to sharp increases in the post-nationalization period. In contrast, the remaining four sectors all experienced, or continued to experience, reductions in their export volume after the nationalization incident. Notably, these sectors – mechanical, electromechanical, transportation, and manufacturing – are more likely to contain consumer goods. These contrasting patterns lend support to our expectation that responses to political tensions from consumers and firms may follow different logics. Immediately following the nationalization incident, Chinese consumers seemed to have overcome their entrenched economic interests and preferences and changed their purchasing behaviors, leading to substantial reductions in Japanese exports to China in sectors more concentrated in consumer goods. The effects lasted six months in the case of the transportation sector and 12 months in the case of the electromechanical sector. In the meantime, Chinese firms that relied on Japanese imports for intermediate and raw materials seemed to put business before politics. The fact that imports of raw materials and chemicals from Japan went up in some sectors suggests that some Chinese firms might have deliberately sped up their imports from Japan, lest the crisis escalated; escalation could have prompted Beijing to demand that firms reduce or cut their imports from Japan. In other words, the observed increase of imports in these sectors could reflect that Chinese firms were hedging against future state intervention and crisis escalation. Similar patterns exist not only at the sector level but also at the industry level once we further disaggregate the data. We do this for the four sectors that experienced drops after the nationalization incident, but for brevity here we only report the results for the electromechanical sector (Fig. 4).6 Here, we see that three industries saw immediate, dramatic drops in their export to China: image equipment, recorders, and heavy electrics; the effects are most obvious for image equipment and recorders. Similar to what we observe in the sector-level data, these negatively affected industries gradually bounced back after about six months, but they took longer to return to the pre-nationalization levels. The fact that image equipment (e.g. cameras) and recorders were particularly hard hit provides further evidence that it was individual consumers, rather than firms that use integrated circuit or battery storage imports from Japan, who were choosing to reduce their purchases of certain Japanese products that have high visibility (consumers mostly use cameras in public spaces rather than in private). Figure 4 View largeDownload slide Exports to China from Japan’s electromechanical sector. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. Figure 4 View largeDownload slide Exports to China from Japan’s electromechanical sector. Note: The vertical line is the month of the nationalization incident. The horizontal lines are simple linear trends for the two periods. All series are normalized with the volume of exports in September 2012 set to 100. Source: Japan Customs. One salient industry examined closely in Davis and Meunier (2011) – using quarterly data – is Japan’s automobile exports to China, which they find to be immune to political tensions between the two countries. Although covering a different time period, our monthly data present a vastly different picture. Figure 5 plots Japan’s auto exports to China between 2009 and 2014, using data from Japan’s Ministry of Finance. As a comparison, we also plot Japan’s auto exports to the European Union and the United States for the same period. Figure 5 View largeDownload slide Japan’s auto exports to China, the EU, and the United States. Source: Ministry of Finance, Japan. Figure 5 View largeDownload slide Japan’s auto exports to China, the EU, and the United States. Source: Ministry of Finance, Japan. The pattern is similar to what we found before, but the impact is much more dramatic. Car sales plummeted right after the nationalization incident, dropping from JPY 33,883 million in September 2012 to JPY 8,387 million one month later. And it took almost an entire year for the auto exports to recover from the fallout. Meanwhile, Japan’s auto exports to the EU and the United States remained unperturbed. This corroborates the anecdotal evidence reported by media and business groups – that is, Japan’s auto sector has been a conspicuous victim of rising political tensions between the two countries, stemming from the nationalization incident. To further buttress our finding, i.e. Japan’s auto exports to China was uniquely affected, we use monthly data from the China Passenger Car Association (CPCA) to compare car exports to China from various countries. Due to data limitation, we restrict the time frame to three months before and after the nationalization incident. As can be seen in Table 1, only Japan’s export experienced an immediate and dramatic drop after September 2012, while exports from other countries all increased. Table 1 China’s auto imports from various countries (Unit: 10,000 cars) Source: China Passenger Car Association (CPCA). Table 1 China’s auto imports from various countries (Unit: 10,000 cars) Source: China Passenger Car Association (CPCA). 6 Additional evidence: the THAAD case The divergent responses to political tensions between consumers and firms are not unique to the nationalization incident. A similar case is the recent anti-Korean boycott across China after South Korea decided to deploy the Terminal High Altitude Area Defense (THAAD) system to counter threats from North Korea.7 Right after the board of an affiliate of South Korea’s Lotte Group approved a land swap with the South Korean government for deployment of THAAD, the Chinese government, along with Chinese consumers, retaliated. More than 88 of the 99 Lotte stores in China were forced by the government to shut down due to alleged violations of fire code (Shanghaiist, 21 March 2017). Reminiscent of the Cultural Revolution era, even primary school students were mobilized to boycott food items sold in Lotte stores (Shanghaiist, 13 March 2017). Putting patriotism above tourism, in a spectacular show of national solidarity, more than 3,000 Chinese tourists refused to disembark from their cruise ship at South Korea’s Jeju island, a popular destination that attracted more than two million Chinese in 2016 (Reuters, 14 March 2017). What sets the THAAD episode apart from the nationalization incident is the conspicuous involvement of the Chinese state. The People’s Daily, for example, published an editorial claiming that if Lotte could take actions harming China in the name of protecting national interests, then Chinese consumers could also say no to Lotte and its products for protecting China’s national interests (Xinhua, 27 March 2017). Such articles and commentaries went viral on all kinds of social media in China. The Communist Youth League even published a comprehensive list containing the location of every single Lotte store in China, calling for nation-wide boycott (Communist Youth League, 1 March 2017). Firms in China, on the other hand, behaved in a diametrically different way. In spite of the consumer fervor in response to state encouragement of the boycott and Lotte stores being shut down, recent statistics from the Korean government show that the country’s aggregate export to China has recorded a consecutive five-month growth amidst the THAAD crisis, and its exports of USD 11.6 billion in March 2017 were up by 12.1% compared to the same month the year before. However, as we would expect, driving this growth are not consumer products but Chinese firms’ imports of petrochemical materials, LCD screens, microchips, as well as other information technology related intermediary products – none of which are purchased directly by individual consumers (Free Asia TV, 4 April 2017). The THAAD episode only reinforces our finding from the China–Japan case: that despite differences in terms of state involvement in coordinating consumer responses, in a globalized world with ever deepening economic integration, politics continues to have a clear grip on the economic behaviors and fortunes of states, firms, and individuals. During times of heightened political tensions, business will no longer be as usual. 7 Discussion In understanding the relationship between economics and politics among states, the ‘business as usual’ thesis contends that sunk costs in existing trade and investment reduce the likelihood that governments, firms, and consumers would change their behavior in response to political tensions. In contrast, we argue that business may not always be ‘as usual.’ Certain political tensions, especially those involving enduring territorial disputes, could motivate domestic actors to change their preferences and behaviors, leading to disruptions in bilateral economic exchanges. In the case of China–Japan relations, our results provide evidence that Japan’s nationalization of the Diaoyu/Senkaku Islands negatively affected its exports to China. Using disaggregated data, we further show that the effect is most pronounced for highly salient and visible consumer products, such as automobiles and cameras, which experienced substantial drops lasting for up to 12 months. The lesson for policymakers is that they should not assume that there would be no economic ramifications when making political decisions, especially those involving sensitive territorial disputes. The evidence is clear that there will be. One interesting puzzle revealed by our analysis is that the disruptive effects of the nationalization incident only affected Japan’s exports – during the same period, China’s exports to Japan remained largely unchanged. There are a couple of potential explanations. First, what we observed may have been due to the fact that Japan was exporting more consumer goods to China rather than intermediate and raw materials; users of the latter are primarily firms. Second, it is possible that economic transactions other than trade were affected on the Chinese side. For instance, it was reported that Japanese investment in China declined by 4.3% in 2013 and further dropped by nearly half in the first six months of 2014, after posting a growth rate of 16.3% in 2012 (Bloomberg Businessweek, 16 July 2014). These potential explanations will be fruitful areas of inquiry for future research. Our industry-level analyses also suggest that responses to political tensions from consumers and firms may follow different logics. While consumers swiftly organized to boycott highly visible Japanese goods, firms seemed to put business before politics, sticking with their Japanese suppliers for intermediary goods and raw materials, and even potentially hedging against dispute escalation by stocking up on imports from Japan. Our discussion of the ongoing THAAD episode provides additional evidence for this pattern. Unpacking the mechanisms that drive the divergent behaviors between consumers and firms presents yet another promising topic for future research. Supplementary material Supplementary material is available at IRASIA International Relations of the Asia-Pacific online. Footnotes 1 The government of the Republic of China on Taiwan also claims sovereignty over the Islands. In this article, we will focus only on two claimants: China and Japan. 2 Treaty of Peace with Japan, signed on 8 September 1951, 3 U.S.T. 3169. 3 The State Department officials included: Robert Starr, Acting Assistant Legal Adviser for East Asian and Pacific Affairs; Harrison Symmes, Acting Assistant Secretary of State for Congressional Relations; and Howard McElroy, Country Officer for Japan. 4 The Chinese Near Year falls in January in some years and February in others. During this time, factories stop production; migrant workers return home and financial markets are closed. The seasonal disruption of the Chinese New Year to the economy is visible in all of the import data series. 5 We used the 2013 data to determine the top 10 trading partners of China, which are, in descending order, United States, Hong Kong, Japan, South Korea, Taiwan, Germany, Australia, Malaysia, Brazil, and Russia. 6 Results for the other sectors can be found in the Online Appendix. 7 China believed that the THAAD system, which has a powerful radar capable of penetrating the interior of China’s territory, could reduce China’s strategic leverage over other military powers in the region. 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