If Ulrike Schaede is right — and I wouldn’t bet against her — then the decision last year to tighten export control vis-a-vis South Korea is a disastrous move that could do far greater damage to Japan than it will to that country.

Regardless of whether it was driven by genuine concerns about trade diversion and the proliferation of weapons of mass destruction, or pique at court rulings in Seoul on the issue of wartime labor, the Japanese government’s decision last summer to require approval for each export of three specialty chemicals to South Korea and remove it from the "whitelist" of countries entitled to preferential trade treatment threatens Japan’s most visionary companies.

Every government needs to assess the tension between the satisfaction (geopolitical and emotional) that follows the imposition of sanctions and the potential for blowback as the target attempts to reduce the pressure and the pain. In this case, South Korea is reacting as should have been anticipated — and as studies of sanctions predicted — by creating domestic substitutes, undercutting not only the intended impact of the sanctions but damaging some of Japanese most cutting-edge businesses as well.

Schaede, a professor at the University of California San Diego, is an astute observer of Japanese business and she is convinced that the doomsayers are wrong about Japan and that the country, and especially its businesses, are more relevant than ever as the world transitions to the digital economy.

In “The Business Reinvention of Japan,” she argues that Japanese companies have been engaged in relentless restructuring since the slowdown and stagnation of the 1990s. This two-stage process began in the first decade of the new century. Then, companies made the hard and often unpopular decision to winnow out underperforming operations and focus on core competencies with the best prospects. As Schaede notes, between 2000 and 2006, 75 percent of Japan’s largest 500 companies conducted at least one measure of reorganization and 34 percent reported at least one business exit. (Schaede explored that evolution in her last book, “Choose and Focus.”)

A second wave of restructuring is underway as Japanese businesses reinvent themselves to deal with the intensifying competition of the digital era. The best Japanese companies aren’t just slimming down; more importantly, they have identified the most valuable niches in global production chains and are filling them. They have created virtual monopolies in critical categories and are making themselves indispensable to the global economy.

This isn’t easy. To succeed, those companies must become “ambidextrous,” maintaining “their traditional strength in monozukuri — of making things well, consistently, reliably with continuous improvement” (kaizen). At the same time, they have to develop “deep technologies, inventions on the frontier of technological breakthrough.” In other words, companies have to marry a careful and meticulous approach to production with speedy, risk-taking, creative research and business development. It may sound simple, but these are two very different business cultures (and the latter is alien to traditional business practice in Japan).

This new business landscape was exposed after the 2011 Great East Japan Earthquake and nuclear accident. While Tohoku is generally considered something of an economic backwater, it quickly became apparent that the shutdown of the region would have profound impacts on the global economy. Economists had bemoaned the shrinkage of Japanese manufacturing to just 10 percent of global capacity, but they soon realized that in some products Japanese companies had a combined 100 percent global market share.

Tohoku is no special case. Schaede highlights a regular Ministry of Economy, Trade and Industry survey of global market share to demonstrate how widespread that approach is. The 2017 report showed that of the 931 industries surveyed, Japanese companies had over 50 percent of global market share in 309 products, over 75 percent in 112 products and 100 percent in 57 products. Japanese businesses dominated at least 478 distinct global high-technology product markets.

It’s a profitable strategy. The average size of the 900 global markets that METI examined was about $4 billion. Japan’s combined average market share across those products was about 50 percent, or about $2 billion per niche. Not bad.

Schaede is quick to note that this “aggregate niche strategy” evolved naturally. It wasn’t directed by the Japanese government and she is not trying to resurrect the myth of METI’s prescience or infallibility. “The strategy was not planned or organized but emerged slowly and methodically as companies moved to technology niches.”

Which brings us to last year’s decision to tighten control on certain exports to South Korea. The measures were clearly intended to stun and sober the government in Seoul. The three specialty chemicals — fluorinated polyimide, hydrogen fluoride and photoresist — are vital to the production of semiconductors and other high-end products such as smartphone displays by some of South Korea’s largest companies. The pain that those businesses are feeling is a sign of the success of the aggregate niche strategy: Japanese companies account for about 80 percent of the global market share of the three chemicals and 100 percent of top-end supplies.

Satisfaction could be short-lived, however. South Korean consumers of the chemicals have switched to imports from overseas plants of Japanese suppliers, undercutting Tokyo’s leverage. But more significant have been efforts to boost domestic capacity. Soon after the tighter export controls were announced, South Korean President Moon Jae-in launched an initiative to assist companies producing 100 strategic materials.

Earlier this month, Seoul expanded that list to 338 items and promised 2 trillion won ($1.67 billion) per year in additional research and development funds. Moon pledged to “turn the crisis into an opportunity and emerge as a manufacturing powerhouse in advanced materials, parts and facilities.” Cynics note that versions of this plan have long existed in Seoul and have been regularly pulled off the shelf in crises.

Still, South Korea now aims to have homemade etching gas meet 70 percent of demand from domestic chipmakers by 2023. Reportedly, SK Materials has achieved 99.999 percent purity for its etching gas. While that is considerably short of the purity of the Japanese competition, some Korean users say it is good enough.

South Korean executives know that the previous division of labor made sense for all parties, but they now worry about the reliability of Japanese suppliers. Japanese executives acknowledge that new mindset and fear that it will be difficult to regain business if and when the tightened regulations are lifted. (And to be clear: Exports haven’t been banned; they are just subject to additional scrutiny.)

An official at the Korea Semiconductor Industry Association told the Nikkei that that “even if Japanese restrictions revert to what they were before July 2019, companies that have decided to use something else are not going to switch back.” Kim Sang-jo, Moon's chief policy secretary, crowed that “one day, our materials industry will have developed and we'll be able to say, 'Thank you Mr. Abe!'”

Every study of sanctions warns that target governments will respond by trying to reduce dependence and vulnerability. The Japanese government must recalculate the costs and benefits of such actions because that natural inclination to remove pressure points undermines the strategy of Japan’s most successful businesses. Nothing would seem to be further from promoting Japan’s real national security.

Brad Glosserman is deputy director of and visiting professor at the Center for Rule Making Strategies at Tama University as well as senior adviser (nonresident) at Pacific Forum. He is the author of "Peak Japan: The End of Great Ambitions."

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