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The emptying of shelves in Chinese grocery stores as consumers stocked up on iodized salt on March 17 was just one example of many unanticipated repercussions from the magnitude 9.0 earthquake and tsunami that hit Japan's northeastern coast a week earlier. The panic buying of salt, apparently triggered by rumors that a radioactive cloud from the damaged Fukushima Dai-ichi nuclear power plant in Japan was about to drift over China, was based on the false assumption that consuming large quantities of iodine provides protection against radiation. But while the radiation scare was short-lived, the impact to China's economy, including its manufacturing growth engines, is likely to play out for months, perhaps even years, to come.

Although the earthquake and tsunami on March 11 struck what has traditionally been a relatively isolated part of Japan, the country's northeastern region is home to many factories manufacturing semiconductors, auto parts and other components for export. Not long after the disaster, a number of Chinese manufacturers reported production cuts as parts inventories shrank.

For everything from computer chips to ball-bearings and pigments to plastics, March 11 drove home the critical role that Japanese factories play in supply chains, not just in China but around the world. More than 40% of the flash memory chips that go into such products as iPhones and iPads, and 15% of DRAM chips are made in Japan. A plant owned by Merck of Germany in Onahama, near the Fukushima nuclear power plant that was damaged by the March 11 tsunami, is the only source of a particular metallic paint pigment for autos. With that factory shut, Ford Motor, Chrysler and other automakers have been forced to hold back on some of their orders.

Opinions vary as to how supply chains will adapt to this unprecedented disruption. Of course, any losses within China are likely to pale in comparison with the damages that Japan must bear, which could reach as much as US$300 billion, but they will add up, says Patrick Chovanec, a professor at Tsinghua University School of Management and Economics in Beijing.

In terms of how -- or whether -- recent events will have a significant impact on trade flow between the two countries, Chovanec predicts that "as the Japanese economy suffers, demand for imported goods from China will fall." The concern then is whether there will be a reversal of the recent positive pace of trade between the two countries -- even despite many unresolved tensions over, among other things, China's recent "rare earth" export embargo that has affected Japan's high-tech firms. According to the Japan External Trade Organization (Jetro), bilateral trade was a record US$30.3 billion in 2010, up 30% from 2009. China is Japan's largest trading partner and biggest export market -- Japan's exports to China rose 36% year on year to US$14.9 billion in 2010, while imports from China totaled US$15.27 billion in 2010, up 24.7%.

In terms of the types of goods that are in demand, electrical equipment, including semiconductor chips, electronics parts, and audio and telecoms equipment, account for 23.5% of China's imports from Japan, followed by machinery at 22.4%, chemical products at 14.5%, autos and auto parts at 10%, and steel at 5.3%. Meanwhile, Japan's main imports from China include electrical equipment -- the largest category, accounting for 25.9% of the total -- followed by machinery at 16.8% and textiles at 14.3%.

As for foreign direct investment from Japan into China in 2010, Jetro says, it reached US$4.24 billion in 2010, an increase of 3% from 2009. It's the forth-largest direct investor, after Hong Kong, Taiwan and Singapore.

Calling All Parts

South Korean, Taiwanese and German manufacturers are likely to step in as alternative suppliers for many items. But in the automobile sector, for example, each substitution involves recalibrating machinery to precise specifications and safety requirements. In the short term, this presents difficulties. "For six months to a year, there will be serious disruptions for supply chains. But I would be surprised if the Koreans could not do what the Japanese are doing now," says Franklin Allen, Nippon Life professor of finance and economics at Wharton.

Xianfang Ren, Beijing-based China economist for IHS Global Insight, a research and information company, views the problem as more intractable, given the unique technology involved in making some components. "Chinese manufacturers may find alternative sources for general parts, but that may be impossible for parts that only one or two Japanese companies can make and there is no one to fall back on," she says. The fact that even a US$5 part can affect the manufacturing of a product is a sign of just how competitive and advanced Japanese companies are, leaving little room for alternative manufacturers to step in and take over.

The March 11 earthquake and its aftermath are indeed driving home the vulnerability of Chinese manufacturers of high-value products using imported components, notes Andy Xie, an independent Shanghai-based economist. "For example, the iPhone is made in China, but Apple will not tell people which components are made in Japan and which in China. If a touch screen is made in Japan and it is not available, you cannot make the iPhones even if all the other components are available in China."

That means the blow could be very hard for companies like Taiwan's Foxconn, based in Shenzhen in southern China, which assembles products like Apple's iPhones and iPads, Sony PlayStations and Dell computers from its various factories in China. IHS says its analysis of the iPad2 identified five sources for parts, including flash memory chips from Toshiba, an electronics compass from AKM Semiconductor and the touch screen overlay glass from Asahi Glass. Apple declined to comment on the impact but a month after the first quake, its online shop was showing delays of up to three weeks for shipments to markets around the world selling the iPad2. "There are over 300,000 people working for Foxconn and the news will come out if there is a serious impact. We will know this soon," Xie says.

The auto industry is also being watched Japan closely. Nissan Motor expects April output at its China joint venture, Dongfeng Nissan Passenger Vehicle Company, to fall about 10% below target due to difficulties procuring engine parts from Hitachi Automotive Electronics, located in Hitachi, Japan, an area that suffered significant quake damage. Dongfeng Nissan is slashing production by idling plants on weekends until mid-April, and is holding back on setting a production schedule for beyond mid-month.

On April 18, Toyota -- the world's largest auto maker, with 8.42 million units sold in 2010 – resumed production at all its 18 Japanese plants, though at half capacity, after shortages of power and parts forced closures after March 11. The company said production from May 10 to June 3 will run at about half of its normal capacity, after which it will decide how to adjust production pending an assessment of its suppliers, although much of its mainauto parts network is located near the company's headquarters in Aichi, in central Japan, a relatively safe distance from the initial disaster zone. The disruption will have a limited, if any, impact on China's auto buyers. With three joint ventures in China selling around 900,000 vehicles a year locally, Toyota exports less than 50,000 vehicles to China annually.

But on April 20, Toyota announced that it will cut production at its joint venture China plants until early June due to supply disruptions. In a statement posted on the website of its China units, it said its plants will run at 50% of their normal capacity until another review on June 6. A company spokesperson says the production cut will result in a shortfall of 80,000 Toyota cars during that period, about 8% of its total output in China.

Wait and See

Given the lack of clarity about the actual extent of overall supply chain disruptions, however, economists are playing a guessing game when forecasting the disaster's impact on manufacturing output. "We have seen some supply problems in Jiangsu and Guangdong provinces, but other provinces are not affected at all," says IHS's Ren. "We will have to see the scope of the disruptions and how widespread they will be." In the Yangtze River delta region west of Shanghai, a major electronics production hub where over 7,000 Japanese companies operate, local commerce officials in Jiangsu say Japanese-invested Chinese electronics companies have reported delays of up to 10 weeks for components deliveries from Japan. Such companies operating in the region, including Suzhou Cannon, Hitachi Display and Fuji Film, are keeping their cards close to their chests and have declined to make any public announcements.

Meanwhile, Ren says. "our Japan economist said Japanese supplies will come back in June. Chinese makers are relying on their inventories and those will be falling by mid-April, though they will not disclose the level of their inventories."

If supply disruptions last for another 12 months, China's overall economic growth could be affected, although the situation involves many variables -- including potential gains for some suppliers of steel and other construction material as Japan begins rebuilding cities razed by the quake and tsunami. Shares inChinese steel companies such as Baosteel Group gained following the earthquake on expectations of a surge in demand for its products.

Still, Chinese officials are anything but sanguine. The National Development and Reform Commission's Institute for International Economic Research, a government think tank, has said that the supply difficulties could cut China's GDP by 0.5 of a percentage point. "If the recovery of the Japanese production line is delayed, the negative impact on China could be much bigger," Zhang Yansheng, director of the institute, told a conference on March 20 at Tsinghua University.

Isaac Meng, a China economist at BNP Paribas, expects downward pressure on second-quarter economic growth, due to the supply disruptions for electronics, IT and auto components from Japan. "As a consequence of the earthquake, nuclear calamity and sustained power outages, we should see a profound impact on China’s exports to Japan in the second quarter and a slowdown of exports to the global market due to the disruption of integrated supply chains," Meng wrote in a report.

Many Western economists are refraining from changing their forecasts for GDP growth in China, given the lack of current visibility into many Japanese companies and the potential for China to make adjustments to compensate for lost production. China's central bank could ease inflation-fighting monetary tightening, for example, says Wharton's Allen. However, he adds, "in the end, there would not be much effect at all [on the Chinese economy]." On April 5, the bank raised interest rates, the fourth increase since October, as concerns about China's growing inflation continued.

Some economists warn that strong Japanese demand for oil to replace the huge energy supply lost with the nuclear plant disaster could accelerate the global rise of oil and other commodity prices. "With several of its nuclear plants shut down, Japan is going to have to fire up oil-fueled power plants to make up the difference," says Chovanec. However, he says, if the Japanese economy goes into a large, protracted decline that hits global growth, it could drive down overall energy demand and prices.

Despite the massive scale of the Japanese disaster, other factors could have far more influence on China's growth -- and supply chains -- in the months to come. That includes the price of oil, broke two-and-a-half year highs of to US$127 a barrel in mid-April as unrest in the Middle East continues. "There is a much bigger risk from the situation in the Middle East," says Allen. "If demonstrations spread to Saudi Arabia [China's largest supplier of oil], who knows what will happen to oil prices."

All the same, barring a catastrophe that unleashes significant amounts of radiation in China, the leadership in Beijing is unlikely to give up their ambitions for a huge increase in nuclear power capacity. "It's hard to see China walking away from its nuclear plans," says Chovanec. "There's just too much need for more energy and alternative sources of energy in China, which already relies far too much on coal."

Certainly, the catastrophe is a wake-up call for globalizing manufacturers. It's not just Chinese firms that need to reassess their risk calculations and make greater allowances for potential disruptions by natural disasters. "There has been this issue of myopia, where people pay great attention to risk management right after a catastrophe and put in motion a set of mitigation approaches that then, sadly, fall by the wayside as time progresses," says Howard Kunreuther, professor of decision sciences and business and public policy at Wharton. "Another crisis rears and the earlier crisis is essentially forgotten."

Erwann Michel-Kerjan managing director of the Wharton Risk Management and Decision Processes Center, notes that many companies tend to ignore factors outside their core business. "But more are realizing that we live and operate in a world now that is much more interdependent." he says. "As a CEO, you have to be fully aware of risks emerging a continent away, and have in place a system to see these risks coming from afar." The Japanese situation is driving home the need for more careful calculations, and one that companies are beginning to take to heart.