Is China Burning?

Chinese streets were quiet today after anti-Japan protests, many of them violent, rocked more than a 100 cities last week.  Large demonstrations continued through Tuesday, the 81^st anniversary of Japan’s invasion of Manchuria.

The disturbances, triggered by a territorial dispute over the Senkaku Islands in the East China Sea, are commonly described as the worst anti-Japan riots to hit the country since at least 2005, and they may have even been more destructive than that.

In any event, the damage to Japan’s business interests in China was substantial.  More than a dozen Japanese companies halted operations in the country as fire bombings, sabotage, and looting took their toll.  Manufacturers Honda, Nissan, Toyota, Mazda, Mitsubishi, Yamaha, Komatsu, Hitachi, andCanon shuttered plants.  Panasonic locked the doors of a factory after employees broke windows, ruined equipment, and set fires.  Retailers Aeon, Fast Retailing, Ryohin Keikaku, and Seven & I closed stores.

Japanese tourists are canceling trips to China, and hard-hit Panasonic is, not surprisingly, reducing business trips from Japan to the country.  As a result, Japan Airlines reduced flights to and from Chinese destinations.  It halved Tokyo-Beijing and Osaka-Shanghai flights, for example.  All Nippon Airways reported an increase in cancellations on its flights from China to Japan.  And it is not only Japanese carriers that have been hurt.  China Eastern, China’s second-biggest airline, is delaying the October 18 start of its Shanghai-Sendai route due to insufficient bookings.

With the streets calm for the time being, Japanese businesses are getting back to work.  Toyota, for instance, restarted its China operations today.  Most Japanese stores have reopened by now.  Aeon has resumed selling at all but two China locations.

The short-term effect of the rioting, therefore, should be limited.  Moody’s says the longer-term consequences will be “difficult to determine,” but they could prove to be detrimental to China’s economy for three principal reasons.

First, China today is no longer in its upward supercycle.  When it was in that phase, demonstrations did not noticeably affect growth.  Even the disruptions in the nearly 190 cities during the Beijing Spring of 1989, which ended in the horrific massacre in the Chinese capital in early June of that year, did not result in a downturn.  A few foreign businesses built backup manufacturing facilities in nearby countries, but they quickly transferred all production back to China when Deng Xiaoping restored order.

Then, almost nothing could derail momentum.  And that remained true even as the number of protests increased last decade.  The 2005 demonstrations, for example, had no apparent long-term effect on Japanese business interests.

Today, however, the Chinese economy is in obvious distress, with fewer analysts buying Beijing’s claims that the country is growing in the high single digits.  Charles Dumas of Lombard Street Research, for example, thinks China’s growth rate is only 1.6%, and it could even be lower than that.  In this environment, even minor disruptions could have a “tipping point” effect.

Japanese companies were, even before the recent disturbances, thinking of reducing their China exposure.  As Kyohei Morita of Barclays told theWall Street Journal, “Growing anti-Japan sentiment could become a catalyst for Japanese companies’ further shift of focus toward Southeast Asia from China.”

Economic fundamentals are already driving companies to look south.  Quickly rising wage rates makes the Chinese export belt increasingly uncompetitive for low-end manufacturing as does the stricter enforcement of environmental rules demanded by the Chinese public.  China’s interior is benefiting from migration away from coastal export areas, but so are Vietnam and even the U.S.

In the long run, other countries will be the big winners from the exodus away from China’s coastal factory cities.  Why?  The big draw for manufacturers, China’s consumer market, is not panning out as many expected.  Consumption is already low—in no country does consumer spending contribute less to GDP—and retailing is already being adversely affected by the accelerating downturn.

Moreover, the prospects for Japanese companies will be even worse than it is for others.  Who in China is going to buy a Toyota when last Saturday, in an incident now well-known throughout the country, a 51-year-old Chinese man in Xian was savagely beaten—he is now paralyzed and mostly unable to speak—because he was driving a white Corolla?  And don’t think this affects only Japanese companies.  China’s new ultra-nationalism, on display this past week, can also affect brands from other countries.

Second, Beijing is making itself an unreliable member of global supply chains.  It took a big step down that road in late 2010, when, in clear violation of its World Trade Organization obligations, it imposed a ban on exports of rare earths to Japan as a means of punishing Tokyo over the Senkakus, which the Chinese call the Diaoyus.  China, at the time, also imposed such bans on the European Union and the United States.

In recent days, China has again attempted to use its economic muscle.  It is not issuing visas to Japanese companies and not inspecting in a timely manner Japanese goods as they enter the country.  One Japanese transport machinery firm was prevented from bidding on a project.

About 41% of Japanese companies polled by Reuters admit recent tensions in China are affecting their business plans.  Some of them say the unstable situation may force them out of China.  Reuters states that relations between the two countries—the first and second largest economies in Asia—“have hit their lowest point in decades.”

And economic ties could get worse.  Last Monday, a Chinese Ministry of Commerce official, Jin Baisong, wrote in the official China Daily that Beijing should take “strong countermeasures, especially economic sanctions” against Japan.  And on the same day People’s Daily, the Communist Party’s chief propaganda organ, said it could use economic sanctions to force Japan into one or more “lost decades.”

Threats like these may work in the immediate term—as they did in 2010 when Tokyo was pressured to release a Chinese captain who rammed two Japanese coast guard vessels—but in our just-in-time world they inevitably erode confidence in China.  The last thing Beijing should be doing at this moment is reminding the global business community that it cannot be trusted.

And that brings us to the third reason why the disturbances last week could have long-term adverse consequences for China.  By now, it’s apparent the Communist Party has been promoting anti-Japan sentiment.  There were virtually no anti-Japan protests in the early years of the People’s Republic, when two strongmen, Mao Zedong and Deng Xiaoping, ruled the country.  Now, however, two weak leaders, Jiang Zemin and Hu Jintao, have resorted to whipping up nationalist sentiment to bolster the Party’s faltering legitimacy.

Because senior Party leaders are failing to maintain unity at home, it’s likely they will continue to press Tokyo over their claims to the Senkakus.  In recent weeks, Beijing has upped the stakes by sending patrol vessels and threatening to flood the disputed area with “more than 1,000” craft.

Unfortunately, Beijing in recent years has lost its ability to compromise its territorial claims, some of which are outlandish.  Beijing has laid down a marker for itself and cannot yield an inch.  This makes each claim a flashpoint.

And Tokyo is beginning to realize there is no appeasing Chinese leaders.  On the 14th, the official China Daily, by making a reference to Kume in the Ryukyus, laid the historical groundwork for raising a claim on that Japanese island chain, which is near the Senkakus.  Said Hissho Yanai, a Japanese activist, to the New York Times, “If we let them have the Senkaku Islands, they’ll come after all of Okinawa next.”

In fact, Beijing officials have talked about taking the Ryukyus after they get the Senkakus.  And we should not think the Chinese are limiting their anger to the Japanese.  Last week’s events have been compared, in their intensity and their aims, to the anti-foreigner Boxer Rebellion, which began just at the end of the 19^th century.

That, unfortunately, is a historical parallel we should remember.  Rioters on Tuesday attacked and damaged the car of American ambassador Gary Locke while he was in it.

China at the moment is unstable, and that puts foreign businesses there—not to mention the Chinese economy—at risk.