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South Korea-Japan trade fight risks 'further escalation'

Key Points
  • In an escalation of trade tensions, Japan moved to impose trade restrictions on exports of three high-tech materials to South Korea, which are critical for manufacturing semiconductors.
  • "I think that unfortunately ... the probability of further escalation, you know, I think is quite likely," Jesper Koll, senior advisor at WisdomTree Investments told CNBC last week.
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Japan-South Korea relations could see further escalation: WisdomTree

As the trade battle between South Korea and Japan drags on, Seoul announced it will cut down its economic dependence on Japanese industries.

South Korea's Finance Minister Hong Nam-ki said at a regular briefing Wednesday that his government was "working on comprehensive plans to reduce the country's dependence on Japan's materials, components and equipment industries."

Relations between the two countries deteriorated on July 1, when Tokyo imposed restrictions on exports of three high-tech materials to South Korea, which are critical for manufacturing semiconductors. Japan also removed South Korea from its "white country" list — nations deemed to have trustworthy export control systems.

One of those materials, hydrogen fluoride, was reportedly shipped to North Korea after it was exported to the South. Seoul has denied those allegations.

"I think that unfortunately ... the probability of further escalation, you know, I think is quite likely," Jesper Koll, senior advisor at WisdomTree Investments told CNBC last Thursday.

South Korean President Moon Jae-in
Antonio Masiello | Getty Images News | Getty Images

Koll said that the tensions are a build-up of years of discontent and "the latest rulings by the supreme courts in Korea really just tipped things over."

He was referring to a South Korea Supreme Court ruling last year, which ordered Japanese company Mitsubishi to compensate forced labor victims during Japan's colonial occupation. The ruling drew a strong rebuke from Japan, which said the matter was already settled under a 1965 treaty.

Seoul has asked Tokyo to scrap the curbs on chemical materials used in making semiconductors, but that request was rejected. South Korea's trade ministry said Sunday it plans to raise the issue at the World Trade Organization's general council meeting on July 23 to 24, according to a Reuters report.

US mediation?

Washington has also been pulled into the trade battle between the North Asian neighbors, and it remains to be seen if the U.S. will weigh in on the situation. Japan and South Korea are two of Washington's biggest allies in the region.

David Stilwell, the top U.S. diplomat for East Asia policy, met South Korean officials in Seoul on Wednesday, according to Reuters. He said Washington will "engage in all issues that are related to South Korea and the United States," but avoided responding directly to questions on what role the U.S. will play in the conflict.

Stilwell reportedly told Japan's NHK broadcaster last week that the U.S. will not intervene in the dispute.

Experts are not sure if the Trump administration will actually get involved in the Korea-Japan dispute or not.

"Prior (U.S.) administrations would have tried to work behind the scenes to de-escalate tensions between the two countries," said Troy Stangarone, senior director of congressional affairs and trade at the Korea Economic Institute of America.

"However, it is unclear how the Trump administration will be involved. Ideally, they would encourage both governments to engage in dialogue to find a reasonable solution to the current dispute," Stangarone told CNBC via email.

Last Wednesday, South Korea's Foreign Minister Kang Kyung-wha told U.S. Secretary of State Mike Pompeo that Japan's restrictions may not only damage South Korean companies, but could also disrupt the global supply chain and hurt U.S. firms, according to Reuters.

The U.S. State Department later issued a statement noting the importance of U.S.-Japan-South Korea trilateral cooperation, and agreed to continue working closely to address common challenges in the region.

Koll said the probability of the U.S. stepping in as an active mediator is very low.

"The Trump administration is not afraid to weaponize trade," he said, adding that using trade to settle political disagreements may seem reasonable to the current U.S. administration.

In Trump's world, it's America first, Koll pointed out — as for the rest of world, "that's (their) problem."

Impact on businesses

The bad blood between the two Asian powerhouses is nothing new and dates back to Japan's colonization of South Korea in the early 20th century. Bilateral ties further deteriorated during the World War II, over the many Korean woman forced into sex work in military brothels.

Koll said that trade regulations imposed are not due to a short term "political ploy" by Japanese Prime Minister Shinzo Abe, rather a long awaited "strategic" move.

The trade conflict between the two countries "has been in the planning for quite a while," Koll said, adding that there's been "growing distrust" between Japan and South Korea in the last two years.

Samsung Semiconductors are seen on a circuit board.
Justin Sullivan | Getty Images

Korean and Japanese firms have historically been insulated from political tensions, said Kristin Vekasi, a professor at the School of Policy and International Affairs in the University of Maine.

She said business are well positioned to call on their respective governments to soften their positions, and expects the Japan Business Federation might take steps along that line.

"They are aligned with the Abe government in that they would like the issue to be settled by the terms of the 1965 treaty," Vekasi told CNBC in an email. But the business community in Japan does not seem to "favor Abe's approach making normal trading relations more difficult/putting barriers in place."

South Korean businesses are also worried, said Stangarone. The Federation of Korean Industries has called on the Seoul government not to retaliate, which could exacerbate tensions.

Citing the retaliation tactics used in the ongoing U.S. and China trade fight, Stangarone said that "restrictions of this nature hurt firms in both countries and there is a strong incentive in both business communities to see the tensions deescalate."

Ultimately, the trade rift will affect businesses from both nations and potentially chip-makers' global supply chain, he added.

— Reuters contributed to this report.