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Tariff troubles and the corporate war chest

by Jesper Koll

Japan’s economy is under attack. On May 23, the U.S. Department of Commerce started investigations into whether a 25 percent tariff on auto imports from Japan should be applied on national security grounds based on Section 232 of the U.S. Trade Expansion Act. After dealing with China and Europe first, Washington is poised to move on to Japan. In fact, Team Trump is highly professional and working overtime. A decision to impose a 25 percent tariffs on Japanese autos could come before the Nov. 6 mid-term elections in the United States.

Of course, we can still hope for the best, hope that somehow Japan is special and can escape Trump’s trade attack. But hope is not a strategy. Most likely, Japan won’t be able to hide from the new “America First” trade rules. It’s time to prepare for the worst. So, how big is the threat? And what are Japan’s options to counter?

Unfortunately, it is hardly possible to exaggerate the potential negative impact of a U.S.-led trade war on Japan. Economists will happily debate nuances — clearly different amounts of tariffs will deliver damage of different size; but these debates must not distract from Japan’s extreme vulnerability to U.S.-led trade disruption. In fact, by targeting Japan’s carmakers, the U.S. leadership is aiming directly at the very heart of the nation’s economy.

Some facts: The automotive trade accounts for almost 65 percent of the U.S. trade deficit with Japan. In contrast, cars and car parts are barely 25 percent of the U.S. deficit with Germany. After decades of multilateral trade liberalization and promises of diversification, the U.S.-Japan trade relationship has remained very lopsided and centered on just one industry — cars.

This lack of diversification leaves Japan very vulnerable to Team Trump’s razor-sharp focus on bilateral trade balances. If at all, from Washington’s perspective, Japan may be the easiest target among all the major U.S. bilateral trade disputes. Fix one industry — cars — and you can claim victory.

Back in Tokyo, Japanese policymakers are held hostage to the fact that the domestic economy lives and breathes in lockstep with the health of the auto industry. This is because it has a very high multiplier effect on all other industries and services — parts suppliers, logistics, merchandising, financing, etc. Specifically, every one unit decline in auto demand pulls down total domestic economic output by 3.2 units, according to the latest METI input-output matrix (which tabulates the value of the interconnectedness of all economic sectors in Japan). The fact that Japan’s largest car company and its network of suppliers, vendors and customers may account for as much as 12 percent of the nation’s GDP must scare Japanese policymakers as much as it may delight Trump’s trade warriors.

Last but not least, Japan’s financial markets are also highly dependent on car companies’ fortunes. By stock market capitalization, the carmakers share a position of similar importance with Japan’s banks, with both sectors accounting for around 8 to 10 percent of the Topix.

However, carmakers stand out as the best creator of shareholder value and profits: Carmakers lead Japan’s dividend payout rankings and since the start of Abenomics at the end of 2012 the earnings of car companies shot up by almost 600 percent. This is almost double the value creation generated by other sectors. Banks are the most regrettable underperformer, with their profits up barely 50 percent.

Clear speak: Japan’s car and automotive parts makers alone have generated almost half of the economic value created in the past five years and their value creation has outperformed that of banks by a factor of almost 10 times in terms of profit growth since 2012.

The reason I bring up the comparison to Japan’s banks is that banks are primarily a domestic sector. Banks’ fortunes reflect the overall fortunes of the domestic economy better than any other sector. In contrast, carmakers are a global business, with their fortunes dictated primarily by factors independent of what goes on in the domestic Japanese economy.

For the current team of U.S. trade warriors, the glaring gap between only minimal growth in value creation in Japan’s domestic sectors versus very high-paced value creation for Japan’s exporters exposes a fundamental problem: It is easy to accuse Japan of being a “free rider.” Is the government somehow enforcing policies that depress domestic profitability and entrepreneurship in Japan at the expense of the U.S.?

Putting it all together, Japan is very much exposed to the U.S. tariff threat. Given the high multiplier of the car industry, GDP could be pulled down by as much as 0.5 percent to 0.8 percent initially.

The hit to corporate profits is also very significant: A 25 percent tariff amounts to approximately ¥2.7 trillion, which is about 55 percent of carmakers’ operating profit projections for the current year. So if car companies split the cost of the 25 percent tariff to between raising prices for consumers and cutting profits for producers, profits for carmakers could be forced down by as much as 40 percent. In turn, the negative profit multiplier to other listed companies is poised to very significant. My estimations suggest total Japanese profits may fall by as much as 13 percent if the U.S. imposes a 25 percent car tariff on Japan.

Then, if car company CEOs view Trump’s “America First” protectionism as not just a temporary negotiation tactics but rather as a true secular change in U.S. trade policy, they will be poised to accelerate Japan’s shift to offshore production on a large scale. This second-round “hollowing out” effect would further depress Japanese domestic fortunes. For profits, however, a structural production shift should be good news, given that typically the capital return for Japanese factories located in the U.S. is higher than the returns delivered at home in Japan.

What can Japan do to avert a U.S. trade attack? Whether we like it or not, Team Trump is fixated on bilateral deficits and focused on transactional results. Moreover, he will want to be able to declare victory. This leaves security and defense as the most impactful bargaining chip. If Japan were to raise defense spending from the current 1 percent of GDP to 2 percent, that would be about $ 50 billion, which almost exactly matches the bilateral trade deficit. Added military hardware and software spending sourced from U.S. suppliers may perhaps deliver a 20 to 30 percent reduction in the U.S.-Japan bilateral deficit.

For the trade arithmetic this may be a good solution. But it is not clear to me whether the Japanese people are ready to support such a sharp jump in defense spending while the consumption tax is going up and out-of-pocket expenses for medical and elderly care are rising. There will be an Upper House election in summer 2019.

A more creative approach would be for Japan to basically short-circuit the U.S. tariff threat by tapping into Japan’s single biggest surplus — the massive pool of retained earnings companies have accumulated over the past years. Listed companies hold almost ¥600 trillion of cash balances, with car companies holding a very comfortable ¥50 trillion. This “war chest” should be used creatively to defend Japan.

For example, the government can offer significant tax breaks if a car company taps into the retained earnings cash pool to pay for the tariff and maintain employment and production. Of course, this is not a structural solution, but it would be a very positive short-term weapon to fend off the worst.

Interestingly, both countries would actually win, with U.S. consumers benefitting from lower Japanese car prices, and Japanese workers benefitting by staying employed. In the short term, the impact may even be a net positive for Japan — prices for European cars are already rising in the U.S. because of tariffs.

In the new reality of global trade and competition, Japan should not be shy to take the lead. Mobilizing its retained-earning corporate cash war chest may actually create a competitive advantage for Japan.

Based in Tokyo, Jesper Koll is WisdomTree’s head of Japan. Researching and investing in Japan since 1986, he is consistently ranked as a top Japan strategist/economist. He publishes blogs at www.wisdomtree.com/blog .