The Squeeze: Reassessing the Japan/Korea/China Manufacturing Nexus

by John Longhurst of PIMCO, 2/16/13
  • ​ If the yen settles between 95 and 100 to the dollar, it could be a game changer for Japanese companies which have restructured to become profitable at 75 yen to the dollar.
  • Some Korean companies, especially those in heavy industry, may be squeezed by intensified Japanese and Chinese competition.
  • We expect Korean firms to fish in profit pools in businesses related to their core competencies, chiefly to the detriment of Asian and European competitors.

Recent and potential further weakening of the yen will likely lead not only to a recovery in Japan’s export industries but also to a new debate about the continued ability of some Korean exporters to thrive. As Chinese manufacturers rapidly move up value chains, there may be a split between Korean companies that remain as winners and others, particularly in heavy industries, which will be squeezed between Chinese and Japanese peers. In response, we see Korean companies looking to expand into profit pools in businesses related to their core competencies, to the detriment of mainly Asian and European competitors.

Until recently, the debate had been about the rise of Korean, and latterly, Chinese manufacturers at Japan’s expense. However, the demise of the Japanese semiconductor company Elpida Memory, which went bankrupt in 2012, and the near death of Japan’s shipbuilding and electronics majors last year possibly marked a low in the gradual decline of Japan’s manufacturing industries relative to their North Asian peers. With “Abenomics” – the expansionary economic policies of new Prime Minister Shinzo Abe – causing a marked weakening of the yen, we believe the “thrive vs. survive” debate will swing to Korea. Many South Korean “emerging risers” successfully undermined Japanese peers over the past decade, partly aided by a weak won.

With the yen now on a downward trajectory and many of China’s industrial companies rapidly moving up value chains and enjoying massive scale economies, a key question over the coming period is which Korean companies can continue to thrive. We believe Korean heavy capital goods and chemicals firms will face the biggest challenges.
Life of late has become much tougher for many Korean exporters because, unlike German and U.K. exporters, as an example, Asian companies tend not to hedge their currency exposures beyond a few months; the impact of currency moves is almost immediate. Clearly, on a longer term basis, the weaker yen still has not fully retraced its advance of recent years. But in our view, if a range of 95 to 100 yen were established – even more so the 100 yen/dollar level mentioned by Japanese government officials – it could be a game changer for Japanese profitability given the massive efforts by many exporters to lower costs and become profitable at 75 yen to the dollar. We believe that the Japanese industries best placed to report much stronger earnings with a yen between 95 and 100 per dollar would be industrial components, machinery and segments of the automotive industry. Many Japanese companies have become fully global producers, and thus are not as aided by the weaker yen as they were five to 10 years ago. However, the main driver of share prices for Japanese exporters this year and next will likely be the degree to which margin expansion surprises the market on the upside.
The “Battle of the Bellwethers”
Over the past five years, Samsung Electronics Co. Ltd. and Hyundai Motor Co., Korea’s two largest exporters, have far outstripped the profit and share price progression of their key Japanese peers, Sony Corp. and Toyota Motor Corp. (See Figure 2.) While the recent move up in Japanese exporter stocks and down move in Korean exporter stocks is making news, the gap remains meaningful over the longer horizon. It reflects, we believe, that in consumer electronics and automobiles, Korea’s marketing strengths and global reach may act as meaningful competitive moats as Chinese firms rise and Japanese peers attempt a revival.
What if the yen saves Japan and China pressures Korea from underneath?

When we consider how quickly many Chinese manufacturers have been moving up value chains, and the often depressing impact on profits when Chinese companies enter a global manufacturing profit pool (examples being solar panels and telecom equipment), we need to assess where the greatest competitive changes are today but, more particularly, where the greatest coming dislocations could occur, both for Korean and global profit pools more generally. Key areas include:

  • Shipbuilding. The Korean shipbuilding industry eclipsed Japan’s in deliveries to become the world’s largest in 2003. But now, Chinese companies (which together claimed the top spot briefly in 2010) are taking share using low prices. Share prices of both Hyundai Heavy Industries Co. Ltd. and China Rongsheng Heavy Industries have fallen meaningfully, driven by falling profits (see Figure 3). In the production of liquefied natural gas tankers, mass production and the cheap won have given Korean companies an advantage over Japanese and Norwegian rivals. The Japanese responded by making these complex vessels even more high tech, but the strong yen became an obstacle. Now the Japanese will be more able to resist Korean pressure.

      • Construction equipment. Despite a weak won, Korean companies such as Doosan Heavy Industries & Construction Co. Ltd. and Hyundai Heavy Industries Co. Ltd. were unable to usurp industry leader Caterpillar Inc. and runner-up Komatsu Ltd. of Japan in sales. Now they’ll face pressure from below as Chinese companies Sany Heavy Industry Co. Ltd. and Zoomlion Heavy Industry Science & Technology Development Co. Ltd. aggressively expand their lineups. Sany, now ranked sixth, will likely become number two in due course, in our view.

      • Medical equipment. Samsung Medison Co. Ltd. has already stated its intention to meaningfully expand its global share, a move that will likely depress profits for competitors including Siemens AG, Philips Electronics NV and General Electric Co.

So, what are the Koreans to do to avoid the squeeze?

What we have seen and may continue to see are chaebol conglomerates looking to disrupt global profit pools in competencies they regard as both adjacent to current core strengths and areas where they can bring their strengths in standardized mass-production techniques. For example, we have seen the Korean shipbuilders rapidly build dominance in drill ships in the oil-service sector and aggressively move into areas thus far dominated by European and Singaporean companies. To survive the China-Japan squeeze, we expect Koreans to fish in profit pools and value chains outside the traditional Asia nexus. Given their historical track record, we expect them to do to others as the Chinese are currently doing – i.e., acting as a dislocators and compressing profit margins. All else being equal, we believe it is prudent to identify these areas and mark them as “higher risk/avoid.”

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