A memory module by Samsung Electronics. SeongJoon Cho | Bloomberg | Getty Images

The latest escalation in tensions between Japan and South Korea has ignited fears that the important global manufacturing supply chain for semiconductors could be disrupted — and that's adding to worries on an already slowing world economy. The neighboring countries are part of a complex and tightly linked network of economies that contribute to the production of electronic goods such as smartphones and laptops. But earlier in this month, Tokyo unexpectedly imposed tighter controls on one portion of that network: The supply of certain chemicals from Japan to South Korea. Those chemicals are used by Korean manufacturers to produce semiconductors, and are crucial for making components — including memory chips, microprocessors and integrated circuits — that can be found in many modern-day electronic products. Given the widespread use of semiconductors, companies that test and make them are often seen as a barometer for the health of the global economy. Global sales of semiconductors grew 12.5% to reach $474.6 billion in 2018, according to research firm Gartner. Signs are pointing to falling sales this year with several large semiconductor companies slashing earnings estimates amid deteriorating demand. Already, the U.S. and China are locked in a year-long trade war that has dampened the global growth outlook. Now with tensions between Japan and South Korea also heating up, it could make things worse. "The ongoing trade dispute between Japan and South Korea could have serious consequences to the global semiconductor industry if a resolution cannot be identified in the near term," Rajiv Biswas, Asia-Pacific chief economist at consultancy IHS Markit, wrote in a note last week.

Japan's moves

Japan announced on July 1 it would restrict exports of three chemicals to South Korea: fluorinated polyimide, resist and hydrogen fluoride. Those high-tech materials are used in the production of semiconductors and display screens. Tokyo cited "inadequate management" of the chemicals — which some reports said could be diverted for military use — as a reason to impose restrictions. The curbs came into effect on July 4 and Japanese exporters must now seek permission each time they want to ship any of the three chemicals to South Korea. That process takes about 90 days.

If supply constraints arise in South Korean memory chip production, the price of memory components could significantly increase... Rajiv Biswas Asia-Pacific chief economist, IHS Markit

In addition, Tokyo said it plans to strip South Korea off some preferential treatment in its trade ties with Japan. Such a move, which is expected by August, would involve removing South Korea from a "white list" of countries deemed trustworthy by Japan. If Tokyo goes ahead with its plan, Japanese exporters will need licenses to ship to South Korea some 850 items that could be used in weapons-related applications, according to IHS Markit.

The consequences

Japan produces around 90% of the world's supply of fluorinated polyimide and resists, and about 70% of hydrogen fluoride. Japan's global dominance of those chemicals will make it difficult for South Korean companies to source for alternatives when their supplies are disrupted by Tokyo's exports curbs. Even if they manage to find alternative sources, the companies "may either encounter quality issues or fail to get adequate supplies to fulfill their production orders," according to a report last week by Lloyd Chan and Shigeto Nagai, economists at consultancy Oxford Economics. South Korea is home to semiconductor giants Samsung Electronics and SK Hynix, which supplied 61% of components used in memory chips globally in 2018, IHS Markit said. Any production disruption would be bad news for their customers, which include major tech companies Apple and Huawei. For now, the two South Korean suppliers have "high" levels of semiconductor inventories that they can rely on, according to analysts from Citi. But when that's drawn down, the chipmakers could have trouble meeting production deadlines if they fail to find alternative suppliers of the three chemicals in time. Citi's analysts estimated that at Samsung Electronics, inventories of the chemicals restricted by Japan could last the company 20-30 days. They didn't provide inventory figures for SK Hynix, but cited a local media report as saying the company told customers "the current situation is manageable near-term." Still, any prolonged disruption of Japanese exports of the crucial chemicals to South Korea could cause a global shortfall in memory chips supply, and as a result, push up prices, warned Biswas from IHS Markit. There could be a contagion effect, and the U.S. and China might also feel the pain given that both countries rely on supplies from South Korea, the economist noted. American electronics firms with production sites in both the U.S. and China, or either one of the two countries, are especially vulnerable, he said. "If supply constraints arise in South Korean memory chip production, the price of memory components could significantly increase due to the inability of the other memory suppliers to meet global demand," said Biswas. "End products, including servers, mobile handsets, PCs and a variety of consumer electronics would be impacted," he added. As a result, consumers from all over the world may have to pay a higher price for those products.

The trigger

Relations between Japan and South Korea have not always been warm. The Asian neighbors share a bitter history dating back to the Japanese colonization of the Korean peninsula from 1910 to 1945 during the World War II period. The two countries signed a treaty in 1965 to restore diplomatic ties. But disagreements over what was settled in the treaty continued to strain their relationship in the decades that followed, with sticking points including the use of forced labor by Japanese companies and sexual slavery in wartime brothels. Japan has not given much detail behind its trade actions against South Korea. But media reports suggest that Tokyo's moves were in retaliation against a dispute about wartime forced labor.

Lose-lose situation

The Japan-South Korea trade dispute comes at a time when lingering tensions between the U.S. and China continue to dampen economic activity worldwide. The downturn has already hit many trade-reliant economies and those along the electronics supply chain, including Japan and South Korea. That's one reason why some analysts said they don't expect the two countries to escalate the conflict and harm their respective economies even more.

We do not expect trade tensions to escalate to such an extent that businesses are severely affected, as Korea and Japan should have enough economic incentives to minimise the potential fallout. Lloyd Chan and Shigeto Nagai Oxford Economics

In addition, because of how closely linked their economies are, Japan's measures against South Korea "will lead to mutually assured destruction," said Waqas Adenwala, Asia analyst at consultancy The Economist Intelligence Unit. "South Korea is an important export market for Japan. The producers of materials used in manufacturing of semiconductor devices will struggle to find new buyers," Adenwala said in a note earlier this month.