RGE’s Wednesday Note – Japan’s Production Shortfall Drags on EM Asia Supply Chain

The amplified shock from Japan’s March 11 earthquake, then tsunami, then nuclear crisis has rippled through the supply chain of its emerging Asia (EM Asia) neighbors. Production shutdowns and weakened demand in Japan began to register in Asia’s trade channels in the weeks following the disaster. As the extent and duration of disruptions to production in Japan become more apparent, the severity of regional supply chain interruptions and the effects on EM Asia’s industrial production and export volumes and prices through 2011 can be better anticipated.

If Japan’s infrastructure bottlenecks at roads and ports clear and power outages are resolved in Q2 2011, the impact on EM Asia’s trade will be limited. Some slowdown in global demand due to high oil prices may provide a window for firms to cater to demand by running down inventories through April or May. Nonetheless, reduced input supply and inventories will affect Asia’s industrial production in Q2 and early Q3. However, continued power outages in Japan could drag out the effects on industrial production and exports until early Q4. Asian firms have been reducing inventories since late 2010, especially in the electronics sector, suggesting that inventories won’t last beyond Q2. Permanent damage to Japanese production facilities will have the greatest impact on Asia’s trade and industrial activity. But by the second half of the year, Japanese companies will be able to relocate the production of such inputs, while Asian producers may be able to find alternate input suppliers, barring technological barriers.

In the short term, Asia will find it challenging to source inputs from alternate suppliers—domestically or from countries like China, Taiwan and South Korea—since the inputs may not be perfect substitutes for those imported from Japan. The opportunity to capitalize on increased demand for inputs is large, but it will take producers in these alternate locations a few weeks to increase production or alter the production process to produce identical inputs. The same issues will delay Japanese firms’ plans to shift input production to regions unaffected by the earthquake or outsource production to their subsidiaries in Asia.

Asia’s import exposure to Japan is higher for intermediate goods supplies for key industries like automobiles and electronics. Thailand, Taiwan and South Korea are most vulnerable to reduced imports of Japanese’ industrial supplies, electrical and semiconductor components and capital goods, including machinery equipment. Thailand, China and Malaysia are most exposed to transport equipment imports, while Thailand, China and South Korea rely on auto part and component supplies. Similarly, 50% of Taiwan’s plastic imports come from Japan as well as 40% of machinery imports and 30% of chemical, iron and steel imports. Supply-chain disruptions have already impacted Taiwan, South Korea and Singapore, which rely on importing key inputs from Japan to produce intermediate goods that China then imports. Without a Plan B, China’s re-exports and imports of complementary intermediate goods from EM Asia both could be affected.

Overall, weaker exports as well as input imports will contain trade’s negative contribution to Asia’s GDP growth in Q2 and Q3. The rundown of input and final goods inventories in Q2, and the slowdown in industrial production in Q2 and potentially Q3 will subtract from GDP growth, only to contribute to growth later as the normalization of the Asia-Japan supply chain boosts restocking and production. Countries like China, South Korea, Taiwan and Singapore will benefit from Japan’s earthquake via two channels: Asian companies unable to import from Japan may choose to source similar inputs from these countries; additionally, weaker Japanese production of automobiles, steel and electronics will help these countries increase their global market share. These channels will contain the impact of Japan’s earthquake on China’s and South Korea’s growth, but the negative effect of reduced input supply on electronics and other exports will hit growth in Hong Kong, Taiwan, Singapore, Malaysia and Thailand. The growth impact on Indonesia and Malaysia will be mitigated by their commodity exposure to Japan, though Malaysia will suffer from reduced imports of electronic inputs.

Challenges in substituting key Japanese inputs will raise global prices of those inputs and related final goods, particularly electronics and automobiles. Upstream Asian producers that compete directly with Japan will likely exercise more pricing power, commensurate with the degree of specialty of their product, provided they have adequate inventories. But the boost to their export revenues may be offset by weaker global demand and lower production relative to 2010, particularly for electronics and semiconductors. Signs of easing demand may also compel producers to absorb higher input costs.