The economic consequences of the 2019 Japan-South Korea trade dispute are already becoming apparent. S&P Global Ratings has warned that it will disrupt global supply chains, leading to potential global economic damage. However, both countries have chosen to intensify their political campaigns against each other. In the midst of these developments, Japan signed a new trade agreement with the US on the sidelines of the United Nations General Assembly meeting in New York in September.

The US-Japan deal, though limited in scope, is significant because it shows a change in the approach adopted by Trump, who has so far been reluctant in arriving at a compromise in the US' ongoing trade war with China. It also coincides with the extension of the long-standing Japan-Korea dispute to the trade and security sectors, with South Korea recently announcing its decision to exit the General Security of Military Information Agreement (GSOMIA) in response to Japan's imposition of trade restrictions. The deal follows another important judgement: the World Trade Organisation's (WTO) ruling in favour of Japan on anti-dumping duties on pneumatic valves imposed by Seoul in 2015.

How does the Japan-South Korea dispute impact East Asian markets? What are its consequences for global technology supply chains?

Background

The WTO recognised Tokyo's stand that Japanese valves do not compete directly with locally-made products, and that South Korea’s price analyses fail to meet WTO requirements. The ruling was quickly interpreted in the scope of an already tense environment of mistrust between the two countries, leading South Korea to formally lodge a complaint with the WTO over Japan’s export restrictions.

This is but the latest in a series of developments that has further eroded the Japan-South Korea relationship. In October and November 2018, the South Korean Supreme Court's order to Mitsubishi Heavy Industries, Nachi-Fujikoshi, and Nippon Steel, to compensate South Korean families of wartime labourers, was strongly protested by Japan on the grounds that this was a violation of the 1965 Agreement on the Settlement of Problem Concerning Property and Claim and on the Economic Co-operation between Japan and the Republic of Korea. On the basis of this agreement, all outstanding issues, including the wartime labour issue, was considered settled after Japan paid US$ 500 million in economic assistance to South Korea.

By interpreting the agreement as a settlement between the two governments, and not between the corporate houses and individual people, the court’s verdict re-opened the historic agreement to new scrutiny. Following the decision, Japan undertook export control measures on essential chemicals used in South Korean electronic products, specifically those manufactured by Samsung and LG. In retaliation, the South Korean government removed Japan from its list of preferred trade partners. This further escalated with the South Korean announcement on the GSOMIA, which is an important aspect of US-Japan-South Korea trilateral security cooperation through its facilitation of information-sharing on North Korea’s nuclear and missile threats.

Trade Wars and Technology as Weapon

Japan's export control on chemicals was explained as the result of  a "loss of trust" with South Korea. It was securitised through Tokyo's accusation of Seoul improperly handling the exports of these sensitive materials, bringing into question the management of re-export controls and the chemicals' dual-use applications.

The materials in question are fluorinated polyimides, photoresists, and hydrogen fluoride. While fluorinated polyimides are used in smart phone displays, photoresists are thin layers of material used to transfer circuit patterns onto semiconductor wafers; and hydrogen fluoride is used as an etching gas in the chip-making process. Japan produces more than 80 per cent of the world’s fluorinated polyimides and photoresists, and without these raw materials, manufacturing chip and other smart phone components are impossible for Samsung or LG. The South Korean economy is technology-dependent, and stopping the supply of key components for the production of smart phones shows that beyond tariff and other fiscal policies, it is technological resources (raw materials) that determine the economic and political environment between the two countries.

Japanese officials have not yet stopped material shipments, and the companies concerned have some stockpiles. However, there is the possibility of disruptions in global supply chains–after all, in an interdependent market, a manufacturing-based economy feeds into the service-oriented markets of another country.

With Japan stripping South Korea of its ‘white list’ status under a trade control law, it could now seek an export license to countries that are suspected of using these materials in weapons-related applications. Media reports claim that some of the chemicals are finding their way into North Korea. This has prompted South Korea to not renew the military intelligence-sharing pact.

The East Asian security architecture could be in jeopardy as a result of these developments, particularly with no outcome forthcoming the US-North Korea talks. At this juncture, the Japan-South Korea rift has impacted how each country assesses its gains from the security alliances they are members of. In this light, Japanese Prime Minister Shinzo Abe and South Korean President Moon Jae-in have different approaches in dealing with North Korea. Abe has been extremely cautious of the Trump-Kim talks, and considers Moon’s policy of reconciliation with a regime that is reluctant to relinquish its nuclear weapons as dangerous. Moon, on the other hand sees economic positives in the inter-Korean economic zone and a thawing of relations on the Korean peninsula.

Economic Slowdown

In the first quarter of 2019, the South Korean Won had already witnessed a severe drop by 8 per cent against the US dollar, making it the worst performer in Asia. This slowdown was  due to the faltering demand for semiconductors and a weakened Chinese currency. It was further affected by Japan’s export controls on chemicals.

In 2018, semiconductor sales accounted for almost 92 per cent of South Korea’s export growth, giving the country a monopoly in the supply of telecommunication parts. The trade dispute has since systematically affected semiconductor prices. Samsung and Hynix together supply 70 per cent of DRAM chips and 50 per cent of NAND flash memory chips globally. With low export volumes and material shortage, making more semiconductors leads to the possibility of price rise, which, in turn, will impact global demand and supply chains. This has induced South Korea to rethink its supply chains, and look for supplier alternatives like Israel.

Just like South Korea, Japan may also experience a hit on product demand. Japanese products are currently preferred for their superior quality, but could be replaced by US or Chinese-made components if the bilateral tensions with South Korea continue. This will make it difficult for Japan to restrict exports for an extended period. In an interdependent economy, the Japan-South Korea dispute is a stark reminder of what resource monopolisation can lead to in the long-term.

Japan's export control policy has alarmed many corporate houses but has been largely supported by its conservative administration. While this is the first time the country has taken action against South Korea as a response, it will have severe economic consequences even if it fares well within domestic politics. 

For its part, South Korea has begun producing etching gas domestically. In September, Samsung announced its decision to use domestically-produced etching gas in the chip-making process to address the dependence on Japanese suppliers. The news of localised production came in August with a government proposal to increase the R&D budget by 17.3 per cent in 2020 to "strengthen the indigenous production in material sector." With South Korea as the largest buyer of Japan's technology-related chemicals, pushing Seoul to look elsewhere, or inward, will inevitably tilt Tokyo's export pattern as well.   

The Japanese restriction on imports will force South Korea to either stop production or pay much higher prices to secure crucial materials, which will impact China as well. The Japan-South Korea trade dispute, if not stemmed quickly and effectively, will have far-reaching negative implications for the global technology market.

Dr. Prakash Panneerselvam is Assistant Professor at the National Institute of Advanced Studies (NIAS), Bengaluru. Sourina Bej works on South Asian politics, foreign policy, and global political conflicts.