Industry Trend Analysis - EU - Japan Free Trade Agreement: Political Dividends Precede Economic Windfalls - SEPT 2017


BMI View: The immediate impact from the EU-Japan FTA Political Level Agreement signed on July 6 th is the political benefits to each side. Specifically, the agreement enables Japan and the EU to head into the G20 meeting with a tangible commitment to free trade creating a counter-weight to the US ' more interventionist stance . Looking at long-term impacts of the deal , implementation by Q3 2018 ( in our estimate ) will benefit most European pharmaceuticals, winemakers and luxury a utos , as well as Japanese car m anufacturers , while the consumer e lectronics sector will - surprisingly perhaps- see little impact .

The agreement signed on July 6 th is a Political Level Agreement, the highest level of political endorsement ahead of finalising the free trade agreement (FTA).

The FTA is still under negotiation, with the vast majority of the agreement eliminating direct tariff and non-tariff barriers. The European Commission aims to have it finalised by end of the year. It must then be sent to the EU Parliament for ratification and potentially the EU-28 National Parliaments depending on the scope of the FTA (EU only, or, Mixed Agreement) and the Japanese Upper and Lower Houses of Parliament. Assuming full ratification by June 2018, it is possible that the FTA comes fully into effect by Q3 2018.

(Note: The FTA also covers the services sector, but our analysis will focus only on the impact on the trade on goods)

Political Gains Imminent

The most immediate benefit of the FTA for the two sides is the strong political statement this agreement has made ahead the G20 meeting on July 7-8. It enables Japan and the EU to head into the G20 meeting with a tangible commitment to furthering free trade. Overall, we identify five political impacts from this move:

First, it is a tangible commitment that Japan and the EU will be assuming a leadership role when it comes to free trade globally.

Second, it is diametrically opposed to the narrative coming from the US administration, creating a counter-narrative and spearheading efforts to rebuild consensus around greater free trade proliferation.

Third, it increases EU leverage in Brexit negotiations, as the UK will have to walk away from this FTA as well as other external EU trade agreements should the UK decide to leave the EU Single Market.

Fourth, it steals a march to China's growing appetite to lead free trade, as was expressed in the World Economic Forum speech by President Xi Jinping in January 2017.

Fifth, for President Abe this comes at a difficult time for him politically on the domestic front. This FTA shows his initiative to open up Japan to the world and sends a progressive message for the domestic audience.

EU Pharma, Agriculture And Japanese Carmakers Main Beneficiaries

While the political dividends come immediately, the economic dividends will not start materialising until late 2018, if we assume that the agreement will be enacted from Q3 2018.

While the focus of our analysis below is on the largest multinationals with capacity to push for bigger sales and expansion in the EU and Japanese markets, we note European SMEs across sectors would also benefit, especially on the supply chains for heavy industries and manufacturing by lower tariff and non-tariff barriers. The German industrial competitive landscape is dominated by export-oriented SMEs (Mittelstand), which we believe would be at the forefront to flex their muscles in the Japanese market.

Throughout the negotiations there has been a special role for agriculture and autos as the two most prominent sectors for the negotiating parties. European Pharmaceuticals will also stand at the forefront to benefit from this FTA. The sector is currently is one of the largest EU exporters to Japan, with significant scope for expansion.

The high income profile of the Japanese consumers makes them particularly attractive for the highest value EU products, whether that is Pharmaceuticals, Agri-food or Autos.

Flow Of Trade To Intensify
EU 28 - Japan Trade in Goods Flows, EURmn, 2016
Source: European Commission, DG Trade

Pharmaceuticals - Major Opportunity For European Innovative Drugmakers

The European pharmaceutical industry will be one of (if not the) biggest beneficiary from this agreement.

The reduction and abolition of trade barriers between the EU and Japan will considerably improve access for EU exporting firms to the Japanese pharmaceutical market as well as enable regulatory harmonisation.

Japan has an ideal market profile for European drugmakers' innovative medicines, combining high income and an ageing population. Their forays into Japan have been capped thus far by (a) a dominant domestic sector, with majors like Takeda and Astellas dominating the Japanese market, and (b) high regulatory requirements, including strict domestic clinical trial requirements. While there are no tariffs to pharmaceuticals products trade, the non-tariff barriers are particularly prohibitive.

Looking For A Major New Opportunity
European Drugmakers - Japan % Share in 2016 Total Revenues
*Includes South Korea. Source: 2016 Annual Results

EU countries already dominate Japanese pharmaceutical imports. EU markets (plus Switzerland) export more than USD9.2bn of pharmaceuticals to Japan. This is more than half of all pharmaceutical imports and approximately 1/12 of total pharmaceutical demand (Japan's pharmaceutical market was worth USD108bn in 2016). This dominance is likely to increase as easier access will help EU firms take market share from domestic Japanese players ( See also ' EU-Japan Free Trade Agreement: European Pharmaceutical Industry To Be Major Beneficiary ' , 7 July 2017 ).

High Incomes and Aeging Population Favour Patented Drug Sales
Japan Pharmaceuticals Market Forecast, USD
f=forecast. Pharmaceuticals and Medical Devices Agency (PDMA), Japan Self-Medication Industry (JSMI), The Association of the European Self-Medication Industry (AESGP), BMI. USD/JPY FX based on BMI Forecast.

Agribusiness - Wine and Pork To See Strongest Upside

The EU agricultural industry would also be a prime beneficiary of the FTA as agricultural trade flows between the EU and Japan essentially go one way: the EU exports agri-food products to Japan.

EU agri-food exports to Japan amounted to USD6.7bn in 2016. Japanese agri-food imports into the EU were below EUR1bn.

Open access to Japan would give EU products exposure to high-income consumers that might be interested in paying a premium for quality and traditional food products; cheese, wine, olive oil would be at the forefront of this.

Of the three, we see most opportunities for Europe's biggest wine-producing nations - notably France, Italy and Spain. We forecast strong growth in Japan's underdeveloped wine market over the long term, driven by rising incomes and increasingly sophisticated drinking preferences (see also ' EU-Japan Free Trade Agreement: Opportunities For European Wine Industry ' , 28 December 2016).

The FTA also presents strong upside to the growth trajectory of our EU pork and cheese production forecasts, with the latter being the largest agri-food currently exported to Japan.

It would also help EU exporters gain some market share from competing exporters, mainly the United States as well as Canada, Australia, New Zealand and China ( See also ' E U-Japan Free Trade Agreement: Initial Thoughts For Agriculture ' , 18 January 2017 ).

Upside To EU Agri-food Production From FTA
EU Cheese and Pork Production Forecasts, 000's tonnes
f=forecast. Source: Ministries of Agriculture, USDA

Autos - FTA Can Change The Calculus For Manufacturing Strategy

The FTA would increase the dominance of European brands in Japan's imported car segment and bolster the prospects of the premium car segments especially, where they can hope to take some market share away from US carmakers. The EU exported EUR8.9bn worth of Automotive products to Japan in 2016.

Crucially, it will also give Japanese brands an alternative to their current manufacturing strategy in Europe. The EU imposes a 10% tariff on certain cars imported from Japan, which Japanese firms have thus far circumvented by producing cars in the UK. Currently, the UK is the largest manufacturing base for Japanese carmakers, with France being a distant second; Brexit has complicated the outlook, but this FTA can change the calculus for the sector, certainly by offering more options in what is a highly uncertain outlook.

UK Dominant Base For Japanese Manufacturing In Europe
Autos - Japanese Production Facilities In EU, % of Total (Total = 1.49mn units)
Source: JAMA

Having tariff-free access to the European market could lead to Japanese carmakers rethinking their localised manufacturing strategy if exporting becomes more cost effective. This would be a bold move given that Japanese brands are well established in Europe and proximity to the end market plays a big part in their strategy, but it is an option that cannot be ruled out and would have a knock-on effect for the supply chain.

It also provides another element of uncertainty for the UK facilities of Japanese carmakers as the details of the UK's withdrawal from the EU are still to be decided. While Nissan Motor has already signalled its intent to stay in the country, Honda Motor, with a plant in Swindon, and Toyota Motor with plants in Burnaston and Deeside, are yet to commit. Of the two, Toyota's facilities have the biggest exposure to the EU, with 75% of output destined for the bloc, compared with 40% for Hond ( See also ' EU-Japan Free Trade Agreement: Potential Implications For Autos ' , 16 December 2016 ).

More Upside For Imports As Tariffs Are Eliminated
Japanese Car Makers EU Production And Imports, 000's units
Source: JAMA

Consumer Electronics - Little Upside For Japanese In The EU Market

We expect little impact on this sector. Tariffs for importing into the EU are already very low for many consumer electronics products. They are non-existent for the broad computer hardware categories and mobile handsets, but they exist for cameras and TV sets, standing at 4.0% and 8.2%, respectively. The Japanese electronics majors have lost a significant amount of market share since the early 2000s to South Korean, American and Chinese rivals.

Furthermore, many of western European markets are now in decline owing to saturation and technology developments, and the arrival of a free trade agreement and the possibility of lower prices are unlikely to boost to demand. For example, digital cameras demand has been cannibalised by smartphones, and no price differential will reverse this trend (see also ' EU-Japan Free Trade Agreement: Little Upside For Consumer Electronics ' , 20 December 2016 ).

Japan No Longer A Major CE Exporter
Japan Consumer Electronics Exports To Europe, 2006-2015
Source: BMI, Intracen

Are There Risks To T his FTA Falling T hrough?

One the final FTA is agreed, it will be sent to the relevant legislatures for voting and ratification.

In Japan it is the Lower and Upper Houses of the Japanese Diet that must approve the agreement.

We believe the FTA will pass through both houses. President Abe's ruling coalition has 2/3 majority in the Upper and Lower houses. The Agricultural lobby is not in favour of the agreement, so pressure may mount against it that may cause some dissent, but not loss of majority in the vote.

It is still to be decided whether this FTA will be a 'Mixed' or 'EU-only' agreement, the latter only needing the approval of EU Parliament. Under the terms of the Lisbon Treaty, the EU Parliament has to ratify all FTAs. We expect the EU Parliament would pass this. Risks rise if however in the case this becomes a 'Mixed Agreement' like CETA, in which case it has to go through 28 National Parliaments, plus state parliaments, which raises the risks of opposition to the agreement.