8 September 2018

Japan's Auto Sector Is Poised to Weather a U.S. Tariff Storm

Washington may unveil tariffs on vehicles and automotive parts in the next few months that could have broad repercussions for Japan's massive automotive sector. The United States has long been pushing Japan to enter bilateral talks toward a trade agreement, while Japan has been pushing for the United States to reconsider the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP). The tariff threat may change Japan's opposition. However, Japan does have some insulation from the tariff pressure given that much of its manufacturing for the U.S. market takes place in the United States itself and Tokyo has had recent success breaking down barriers to the EU, Chinese and CPTPP markets.

For more than four decades, automobile manufacturing has been a key pillar of Japan's industrial sector. And today, auto exports are a mainstay of the Japanese export economy, with exports to the United States accounting for a significant share. As with all other exporters that ship autos into the U.S. market, Japan's carmakers are facing down the threat of a tariff of up to 25 percent on their products. But unlike some other auto-exporting countries, Japan, which has car manufacturing operations spread across the continental United States, is positioned to absorb some of the damage that auto tariffs could bring.

Citing concerns about national security, the White House is considering auto tariffs in its efforts to reduce the overall trade deficit and shore up the U.S. domestic auto sector. The U.S. trade imbalance with Japan, a target of Donald Trump's ire long before he became president, totaled $72 billion in 2017, the third largest of major U.S. trading partners, just behind China and Mexico. The $54 billion trade deficit in automobiles and parts accounts for three-quarters of that overall deficit. Unlike earlier tariffs under Section 232 of the Trade Expansion Act of 1962 that targeted steel and aluminum, these new protectionist measures would target a key manufacturing sector.

The Big Picture

The Trump administration is currently deciding whether to impose steep tariffs or quotas on automotive imports as part of its efforts to insulate U.S. industries and drive down the trade deficit. Japan's automotive sector is heavily dependent on the U.S. market, meaning that such a threat could cause Tokyo to reconsider its resistance to a bilateral trade deal.

For the United States, throwing up protectionist barriers to Japanese automotive exports would in some ways serve as a means to an end: The White House has made it clear that the end it seeks would be a bilateral trade agreement with Japan. But Tokyo has maintained stalwart opposition to an exclusive trade agreement, hoping instead to lure Washington back to the multilateral Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) — although that appears to be an increasingly faint prospect. And while the new U.S. threats to the Japanese auto sector may compel it to rethink its resistance to a bilateral deal, Japan does have some insulation, given its strong auto-manufacturing presence within U.S. borders and its recent successes in breaking down trade barriers to other markets.

Growing Together
Beginning from a low post-World War II level, Japanese carmakers built themselves up on the strength of U.S. military equipment demand and foreign partnerships, initially catering to Japan's nascent consumer market. The period from the mid-1950s to the mid-1970s brought the so-called Japanese Economic Miracle: The country rode a wave of rapid growth and industrialization to become the world's No. 2 economy by 1970.

In the mid-1960s, Japan began exporting automobiles at a frenzied pace, which took the country from last place in auto export rankings in 1964 — among the six leading industrialized nations — to first by 1974 with an output of 2.6 million vehicles per year. By 1970, Japan's automotive sector was responsible for 10 percent of the country's manufacturing output, and by 1974, 40 percent of auto production was exported. The U.S. quickly became the top consumer of Japanese vehicles, and oil crises in 1973 and 1979 helped to accelerate that trend. Although the oil shocks stalled Japanese domestic demand, the country's automakers aggressively promoted their fuel-efficient vehicles in the United States, pushing sales sharply higher. At about the same time, Japan zeroed out tariffs protecting its domestic automotive sector, but it threw up steep non-tariff barriers to protect it from foreign competition. Today, Japanese carmakers command 96 percent of the domestic market.

A Critical Sector

Even after economic diversification and its so-called Lost Decades of stagnation in the Japanese economy, automotive production remained a powerhouse of its manufacturing sector and of the economy as a whole. Exports continue to drive the sector: Japan today is the world's top vehicle exporter, sending abroad 4.6 million vehicles — double that of the next largest exporter, the United States. Motor vehicle manufacturing accounted for about 3.3 percent of Japan's total gross domestic product in 2016. The impact of trade tariffs would resound through the automobile sector and related industries, which employ upwards of 5 million people, although the portion of the workforce directly exposed to the export market would be closer to 2 million maximum — or around 3 percent of the working-age population. In 2016, motor vehicles constituted nearly 22 percent of Japan's total goods exports by value, more than electronics, machinery or chemicals.

Japan's steel and aluminum industries were affected by the same Section 232 tariffs that the United States slapped on its foreign competitors (Japan was the only U.S. ally not to be granted an exception to those tariffs). But since steel and aluminum make up only 4 percent of Japanese goods exports, they did not affect its economy enough to force Japan to the bargaining table. But since Japanese carmakers are heavily reliant on exports, and the U.S. market is far and away the most important export market for them, there's no guarantee that Tokyo will view auto tariffs the same way if they are imposed.

In 2016, the United States accounted for 1.73 million units — nearly 40 percent of Japan's vehicle exports and 5 percent of total exports. This compares to the approximately 1.41 million units shipped to all of Asia and Europe combined. For the United States, Japan is the second-largest source of automotive exports (parts and vehicles included) by value, just behind Canada. This heavy reliance leaves Japan vulnerable to tremors in the U.S. market and trends toward protectionism. Preserving this access will be a priority for the Japanese automotive sector, which will become only more reliant on external demand as demographic decline shrinks the Japanese domestic consumer market. Even as global automotive demand rose 4.7 percent overall in 2016 to 93.86 million units, Japanese domestic sales contracted 1.5 percent overall to fall below 5 million units. And Japan is bracing for the effects of a long-delayed domestic consumption tax hike that is now expected to take effect in 2019, bringing with it immediate impacts on the economy and making external markets, particularly the United States, an even more critical part of its economy.

Japan's Built-in Resistance to Pressure

Past protectionist pushes by the United States prompted Japan to build up a degree of insulation that could help it weather the current tariff threat. Even as it pursued its Cold War-era strategy to build up the Japanese economy as a U.S. bulwark in the Pacific, the United States moved to protect the U.S. domestic sector from Japanese competition. In the 1970s, the United States piled pressure on Japan, which ultimately agreed to self-imposed voluntary export restrictions on automobiles, which lasted from 1981 to 1994. This squeeze on Japanese automakers spurred a flurry of joint ventures and the movement of Japanese production onto U.S. shores.

Between 1978 and 1989, the top seven Japanese carmakers each set up production in the United States — an acceleration that gathered momentum with production of Japanese cars climbing from 620,000 units in 1986 to 2.15 million by 1994. This trend of increased Japanese manufacturing in the United States has continued to strengthen. The number of vehicles manufactured by Japanese carmakers in the U.S. rose from 3.3 million to nearly 4 million between 2006 and 2016. And of the 20 most popular light-duty vehicles sold on the U.S. market, five were Japanese models containing upwards of 50 percent of components produced in the United States.

The strong onshore presence of Japanese production facilities will partly blunt the effectiveness of the tariff tactics as the United States presses Japan to enter a bilateral dialogue. Japan still holds out hope that it can persuade the United States to reverse course on its abandonment of the CPTPP. This trade agreement fits more into Japan's overall strategy in the Asia-Pacific to counter China's rise by pulling the Asia-Pacific region's economy more closely into both the U.S. and Japanese orbits. During the most recent high-level meeting of U.S. and Japanese trade officials on Aug. 9 — more than two months after the auto tariff threat — Japan continued to seek a U.S. return to the CPTPP, and the United States continued to push for bilateral talks. Instead of caving to U.S. pressure, Japan has offered up expanded investment, increased purchases of U.S. natural gas and large-scale military procurements in hopes of mollifying Washington by chipping away at the trade deficit.

While Japan is not irrevocably opposed to a bilateral trade deal, Tokyo does not want to lose its leverage as it continues to try to lure the United States back to the CPTPP. But that has become an ever more unlikely prospect. Now, the multilateral trade structure faces opposition not only from the Trump administration but also a likely insistence by Washington to renegotiate much higher automobile rules of origin with all CPTPP members — a proposal few would entertain. Even if Japanese-U.S. bilateral trade talks did begin, they would take up to a year, giving Japan a great deal of room to negotiate terms that would protect the flow of automobiles into the U.S. market.

At the same time, the trend toward U.S. protectionism may spur Japan to build on current efforts to knock down export barriers to other economies. While the United States holds the preeminent position for Japanese car exports (35 percent by value), the combined markets in China (8.4 percent), the European Union (10.4 percent) and CPTPP members (12.2 percent) come close.

While Japan is far from curbing its reliance on the United States, tariffs in other markets are trending lower. The CPTPP stipulates that its members lower their automotive tariffs to zero over the next four years — further opening up markets in Mexico, Canada, Australia and in other Pacific countries, not to mention potential future members. Additionally, the economic partnership agreement Japan signed in July with the European Union requires that auto tariffs drop from 10 percent to zero over the next seven years.

Tokyo's overall strategy in the Asia-Pacific is to counter China's rise by drawing the region's economy closer to the United States and Japan.

And China, under its own massive U.S. trade pressure, decided to raise its tariffs on U.S. autos to 40 percent in July while lowering tariffs from other destinations from 25 percent to 15 percent — opening more room for Japanese imports. The burgeoning Chinese middle class has fueled massive demand for automobiles right on Japan's doorstep, with overall passenger vehicle purchases in China hitting nearly 24 million in 2016, as compared to 17.5 million in the United States. And while new car registrations in the United States essentially flatlined in 2016, new vehicle registrations in China rose nearly 14 percent.

China has become an increasingly important market for Japan's big three automakers. In 2017, Toyota sold 2.43 million vehicles in the United States and 1.29 million in China; Nissan's U.S. sales totaled 1.59 million, with 1.52 million sold in China; Honda's sales in both markets were also nearly on par (30 percent of all export sales in the United States; 28 percent in China). All have plans to increase production capacity and sales in China. In fact, on Aug. 15, reports emerged that Toyota is planning to ramp up its annual production in Tianjin, China, by almost a quarter — 120,000 vehicles — and has set a goal of doubling its sales there to 2 million a year.

While Japan's reliance on access to the U.S. market puts it at moderate risk if U.S. tariffs do go into force, its previous adaptations to U.S. protectionist pushes gives it some degree of leeway. Ultimately, the unintended consequence of U.S. protectionism might be to more closely knit the Pacific economies together — with China's growing consumer class as a major component.

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