Hollow ring

Japanese firms are moving more production and even research to China, now that they see consumers. But they have also taken work back home. Inevitably more work will go to China, but Japan's innovation prowess will keep their factories busy.

Between 1985 and 2002 Japanese companies invested 3. 5 times more in Southeast Asia, than in China, reports the Japan External Trade Organization (Jetro), though Japan's investment in dollars is similar to Korea or Taiwan. Investment now favors China over Southeast Asia. "

Over the last 12 months there has been a very important shift in Japanese corporations' attitude to the People's Republic of China," says Jesper Koll, Merrill Lynch's chief economist in Tokyo.

China's free-spending middle class is irresistible, comprising over 10% of China's 400m urbanites, reckons Jetro. By 2009 households earning over RMB80,000 (US$9,666) will together spend RMB692bn annually, Asian Demographics forecasts conservatively.

Bathroom fittings maker Toto is ramping up Chinese production, as apartments mushroom by the million. Electronics giants, like NEC and Mitsubishi, are chasing Chinese consumers.

Carmaking jumps
Car manufacturers are investing heavily. Toyota will make the hybrid-engine Prius, a runaway success worldwide, outside Japan for the first time with First Auto Works in Changchun. "The value-add has been increasing as the [Japanese] domestic value add has been increasing," says Richard Jerram, Macquarie Equities' chief economist in Tokyo.

However, most production remains Japanbound. "Of the non-food export items, about 72% is manufactured for export to Japan. Of that, the bulk is components," says Koll.

Chinese technicians earn a quarter what their peers in Japan make. That is compelling: Nissan's RMB330m R&D center opens later this year. Toyota began hybrid-engine R&D with Tianjin's China Automobile Technology Research Institute, which opened two years ago. Toshiba and Matsushita opened local labs in 2001. NEC, Oki and Index are writing software in China.

But the R&D comes down to mostly tweaking products for the local market, though that may change as scientists and engineers get better. Indeed, it would change a lot faster if China stopped copyright theft, a major concern because Japan's only resources are its people and their ideas. "The Japanese have taken a ruthless approach towards IP and technology transfer with regard to China. A lot of Japanese companies got severely burned," says Koll.

Notes JP Morgan China Economist Ben Simpfendorfer: "Very few manufacturers have patents or intellectual property rights. That was cited as a major barrier to growth in Shenzhen."

Although Chinese factory hands earn around 5% of their Japanese counterparts, high land prices in Japan make China look cheap, too. Chinese tax breaks favor R&D. Software firms, for example, pay low taxes (rates vary according to location). But that advantage may not last with India's warming welcome for foreign firms.

Falling population
Japan's population begins to fall rapidly from 2007, which means fewer workers. Their productivity must go up to support an aging population, which means importing labor or exporting work that earns low-margins at home. China is the obvious destination.

But China is also graying fast, which may mean fast-rising wages. Asian Demographics forecasts by 2024 under-40s will fall by 250m, from around 800m now, while over-40s will grow 270m, accounting for 58% of China's 1.3bn people.

Indeed the tide may be turning, briefly at least, against China. Canon has replaced humans making some exports in China, reckoning robots in Japan are cheaper. Canon built its first new Japanese factory in 12 years last year. Between 2004 and 2009, 80% of its capital spending is slated for Japan, reversing the previous decade's position.

Some Japanese firms found that shorter product cycles and speed-to-market favor manufacturing in Japan. Sony brought high-end camcorder and digital camera production for the US back to Japan from China in late 2002. "People have been talking about the hollowing out of Japanese industry for 15-20 years, but output is approaching record levels," says Jerram.

Chinese are also developing appetites for Japanese pop culture and the country itself. Chinese accounted for 10.2% of visitors in 2004, up 27% on 2003.

All told this suggests Japanese investment will continue rising as Chinese spend more, but manufacturing at home is far from over, because their management, processes and ideas lead the world by wide margins. Only Japan can make 82% of parts for Apple's iPod music player.

"In terms of applications of technology, no one does it like the Japanese," says Koll. "You wanna see the future in terms of gadgetry, you're not going to Shanghai or New York, you're going to Japan."