China has issued a warning of significant economic repercussions against Japan if Tokyo continues to impose restrictions on the sale and servicing of chipmaking equipment to Chinese companies.

This situation complicates the efforts led by the United States to limit the access of the world's second-largest economy to advanced technologies. Senior officials from China have consistently communicated this stance during recent discussions with their Japanese counterparts, as reported by sources familiar with the situation.

A particular concern for Japan, as conveyed by Toyota Motor Corp. to officials in Tokyo, is the possibility that Beijing might respond to new semiconductor regulations by restricting Japan's access to vital minerals necessary for automotive manufacturing, according to unnamed sources discussing confidential matters.

Toyota, a key player in Japan's economy and heavily involved in the nation's chip policy, has invested in a new chip facility being developed by Taiwan Semiconductor Manufacturing Co. in Kumamoto.

This involvement amplifies its concerns, making them a significant factor for Japanese officials, alongside those of Tokyo Electron Ltd., the semiconductor equipment manufacturer that would be most directly impacted by any new export controls from Japan.

The United States has been urging Japan to implement further restrictions on companies like Tokyo Electron regarding the sale of advanced chipmaking equipment to China, as part of a broader initiative to hinder China's advancements in the semiconductor sector.

In conjunction with these discussions, senior U.S. officials have been collaborating with their Japanese counterparts to devise a strategy that ensures a stable supply of critical minerals, particularly in light of China's recent export restrictions on gallium, germanium, and graphite.

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Concerns regarding Toyota have historical context. In 2010, China briefly halted rare earth exports to Japan following a maritime dispute in the East China Sea, an area claimed by both nations. This action significantly impacted Japan’s electronics industry and posed a risk to the global supply of high-power magnets, which rely on rare earth materials sourced from China. Since then, Japan has made efforts, with varying degrees of success, to lessen its dependence on rare earth imports from China.

Following Bloomberg’s report on the China-Japan incident, shares of Japanese semiconductor companies experienced declines. Tokyo Electron saw a drop of up to 1.9%, while Lasertec Corp. and Disco Corp. fell by as much as 2.8% and 3.3%, respectively.

Some voices in Japan have expressed opposition to the notion that the Tokyo government should align itself with the latest geopolitical strategies proposed by Washington.

“Japan should not impose stricter export controls merely at the behest of the US,” stated Akira Minamikawa, an analyst at the research firm Omdia. “Japan needs to establish its own principles, determine what is in its best interest, and maintain its stance.”

The Biden administration is optimistic about alleviating Tokyo’s concerns and hopes to finalize an agreement with Japan by the end of the year, according to several sources.

However, there are more assertive measures available: The US has been utilizing a regulation known as the foreign direct product rule (FDPR). This rule enables Washington to oversee the sale of products manufactured globally, as long as they incorporate even a minimal amount of American technology.

During the ongoing discussions, US officials have so far chosen not to apply this authority against Japan and other crucial allies, who view the rule as excessively harsh. A senior administration official indicated that while the US prefers a diplomatic resolution, it has not dismissed the potential use of the FDPR.

The complexity of any potential agreement is heightened by the upcoming US presidential election in November and the anticipated resignation of Japanese Prime Minister Fumio Kishida this month. However, a senior administration official indicated that Kishida's departure is unlikely to affect the ongoing negotiations for additional restrictions, as there is already a consensus on the policy within the Japanese government.

Japan’s Ministry of Economy, Trade and Industry did not provide an immediate response when approached by Bloomberg News. Tokyo Electron also refrained from commenting. A representative from Toyota stated that the company is continuously evaluating optimal procurement strategies, which extend beyond mineral resources, to fulfill customer demands.

The Bureau of Industry and Security within the US Commerce Department, responsible for export controls, chose not to comment.

In a statement, the Chinese Foreign Ministry expressed its opposition to any nation attempting to politicize standard trade practices or to persuade other countries to participate in a technology blockade against China.

The US initially introduced extensive chip export controls in October 2022, targeting both equipment and advanced processors. Subsequently, Japan and the Netherlands implemented their own, albeit less stringent, measures. Since then, Washington has been working to persuade its allies to fully adopt the original US controls, particularly by restricting Dutch supplier ASML Holding NV and Tokyo Electron from servicing restricted machines already in China—an action prohibited for US companies. Reports indicate that The Hague is set to introduce some servicing limitations.

The United States is considering implementing further restrictions on high-bandwidth memory chips, which are crucial for artificial intelligence, along with additional tools for chip manufacturing. This move also includes measures aimed at specific Chinese companies. As a result, a new round of discussions has commenced with officials from Japan and the Netherlands, as Washington urges these nations to align with the anticipated US actions, which currently exempt allies. The Biden administration faces pressure from domestic industry stakeholders and some members of Congress to finalize an agreement with key partners before proceeding with its own initiatives.

In a letter dated August 13 to senior officials at the Commerce Department, California Democrats Representative Zoe Lofgren and Senator Alex Padilla expressed significant concern over the detrimental effects of unilateral export controls on US companies and the nation's semiconductor innovation leadership, questioning the national security benefits of such measures. They also voiced heightened apprehension regarding the potential for additional unilateral controls in the near future.

Both ASML and Tokyo Electron have reported substantial sales growth in China since the US enacted its regulations. American companies like Applied Materials Inc., Lam Research Corp., and KLA Corp. have also maintained significant sales of equipment to China, as businesses there accumulate less advanced machinery in anticipation of possible new US restrictions. A senior official from the Biden administration minimized the significance of this stockpiling, asserting that it pertains only to older technology and that Beijing's capacity for innovation has been significantly restricted due to limited access to state-of-the-art tools.

Andrew Jackson, head of Japan equity strategy at Ortus Advisors Pte., indicated that this situation likely foreshadows new US restrictions, particularly in light of the tensions between Japan and China. He advised his clients to continue shorting stocks with substantial exposure to the Chinese market.

US legislators have called on the administration to utilize "all available leverage" to ensure the cooperation of allies. They indicated that they would be open to supporting tariffs on chipmaking equipment from allied nations that compete directly with American companies for market share.

Frustrated by the situation, US firms previously proposed that allies be informed of potential additional export licensing requirements for companies that continue to serve customers in China, which American firms are prohibited from engaging with.

South Korea's trade minister, Cheong Inkyo, emphasized that the US should provide incentives and greater flexibility to foster collaboration among allies regarding chip controls related to China.

"Incentives should be offered to countries or companies that are genuinely trying to comply with US regulations," Cheong stated in his first media interview since assuming office in January. "This approach would facilitate a smoother acceptance of US policy."