Jan. 9 (Bloomberg) -- The last time a dispute between Japan and China blew up in 2010 over eight uninhabited islands, the economic fallout lasted less than a month. This time, the spat is prolonging a recession in the world’s third-largest economy.
Four months after Chinese consumers staged a boycott of Japanese products over the islands in the East China Sea, sales of Japanese autos in China have yet to recover, Chinese factories began to favor South Korean component suppliers, and the U.S. has displaced China as Japan’s largest export market.
“The spats have become increasingly costly as Japan’s dependence on China as an export market has risen,” said Tony Nash, a Singapore-based managing director at IHS Inc., which provides research and analytics for industries including financial companies. “Nationalism around the issue has resulted in lower demand for Japanese products in China and even Chinese firms sourcing products from Korean suppliers.”
As China’s confidence in asserting its territorial claims has grown, and trade between the two nations has tripled since 2000 to more than $300 billion, the commercial cost of failing to resolve the dispute keeps rising. The latest flare-up came after property developer Kunioki Kurihara sold three of the islands to the Japanese government for 2.05 billion yen ($23 million) in September, a transaction Xi Jinping, the new head of the Chinese Communist Party, called “a farce.”
The fallout from the sale may have cut Japan’s growth in the latest quarter by about one percentage point, JPMorgan Chase & Co. estimated. That would be enough to keep the economy in recession after two quarters of contraction up to Sept. 30. Gross domestic product may have shrunk an annualized 0.5 percent in the final three months of 2012, according to the median forecast in a Bloomberg News survey.
The standoff over the islands known as Senkaku in Japan and Diaoyu in China contributed to declines in Japan’s shipments to China for six months through November. Japan’s industrial output fell 1.7 percent in November, to the lowest level since the aftermath of the 2011 earthquake.
With each round of political disputes, the economic effect has grown. When then-Japanese Prime Minister Junichiro Koizumi visited a Tokyo shrine where war criminals are among those honored in 2005, Chinese people and politicians protested. Yet trade between the two rose more than 12 percent that year.
Things got worse in 2010, when a Chinese fishing boat and a Japanese Coast Guard vessel collided in contested waters. China stopped granting export licenses to Japan for rare earth metals, necessary for automobile and electronics industries. The licenses were resumed about a week later after Japan released the detained captain of the vessel.
This year’s row has had the biggest effect so far, said Professor June Teufel Dreyer, a specialist in Chinese politics at the University of Miami in Florida. After the Japanese government bought the three islands, angry Chinese boycotted Japanese products and smashed Japanese shops in China.
“This has really changed things, unquestionably; it is not a blip,” said Dreyer. “China will continue to push its claims to sovereignty until Beijing gets what it wants.”
The islands offer the prospect of rich fishing grounds, potential oil reserves and a strategic military outpost in the sea between China, Japan and Taiwan. That’s overshadowed economic ties that Jesper Koll, head of equity research at JPMorgan in Tokyo, called “a match made in heaven.”
“Japan has intellectual property, brands and capital, while China has people, markets and purchasing power,” said Koll, in an interview.
The latest spat began in April when then-Tokyo Governor Shintaro Ishihara said he planned to use public money to purchase Kurihara’s islands. Ishihara, 80, is a longstanding critic of China, so the national government stepped in to buy the islands instead, in a failed attempt to defuse Chinese anger.
China’s official Xinhua news agency on Dec. 2 criticized the U.S. Senate’s approval of an amendment to show the islands fall under a U.S.-Japan defense treaty, calling it a “disturbing message” to the world that the Senate is seeking an escalation of tensions between China and Japan.
“The row has changed the landscape of China-Japan relations,” said Taylor Fravel, a professor at Massachusetts Institute of Technology who specializes in Chinese politics. “As a territory dispute, it’s prone to spirals of escalation.”
The election victory of Shinzo Abe’s Liberal Democratic Party, which returned to power in a landslide victory in December, has further stoked the conflict. In its manifesto, the LDP proposed strengthening the nation’s military and said it would consider stationing officials on the islands, prompting an editorial in the China Daily newspaper on Nov. 26 that described the manifesto as “dangerous.”
Two days before the election, China sent an 11-page report to the United Nations arguing that the geology of the continental shelf makes the islands a natural part of China.
Japan yesterday said the government summoned the Chinese ambassador to protest the presence of four surveillance ships near the islands. China responded that the ships were conducting normal duties around Chinese territory, Foreign Ministry spokesman Hong Lei said at a briefing in Beijing.
Japan’s Defense Ministry made a budget request Jan. 7 for extra PAC-3 missile interceptors and upgrades for F-15 fighter planes, and will seek to raise next fiscal year’s defense budget by about 120 billion yen, reversing the downward trend of the last decade.
“As Japan’s politics turn decisively to the right, more and frequent spats between Japan and China are expected,” said Liu Li-Gang, chief economist for Greater China at Australia and New Zealand Banking Group Ltd. who used to work for the World Bank. “Both economies will lose in the end. Japan will lose a big market, and China will not be able to leverage on Japan’s technology and investment for growth.”
Japanese automakers’ share of the Chinese market slumped to 14 percent in November from about 23 percent before September, Xu Changming, a director at China’s State Information Center, said on Nov. 29. Toyota Motor Corp., Japan’s biggest carmaker, said in November that output in China fell the most in at least a decade, while Nissan Motor Co. reported the biggest output decline since at least 2009.
All Nippon Airways Co., Japan’s largest airline, had 46,000 seat cancellations on flights between September and November because of the dispute, spokesman Ryosei Nomura said. The carrier forecast the row will cut sales by about 10 billion yen.
Fearing attacks from anti-Japan protesters, Fast Retailing Co., seller of the Uniqlo casual wear brand, temporarily shut 60 of its 169 stores in China from Sept. 14-24, according to spokeswoman Yukie Sakaguchi.
“We closed stores in areas that could have been dangerous, such as near the Japanese embassy in Beijing,” she said.
Anti-Japan protesters attacked three department stores in Hunan province run by Heiwado Co., a supermarket operator based in Shiga prefecture, central Japan, forcing the company to close its stores there for more than a month and incur losses of around 500 million yen, according to spokesman Tomoharu Tsuda.
“They smashed windows, broke shutters and wrecked products in the stores,” Tsuda said. “This could well happen again.”
While Japan has administrative control over the islands, they were largely ignored from the end of World War II until 1969, when a United Nations commission said the surrounding seabed may be “extremely rich” in oil. That brought sovereignty claims in the following years by China, Japan and Taiwan.
“As existing resources are exhausted, the importance of oil and gas resources in the South China Sea will increase and that’s one of the key reasons why this issue is not going away,” said Hao Hong, managing director of research at Bank of Communications Co., China’s fifth-largest lender by assets. China is “stronger than Japan militarily and economically.”
Underlying the border dispute is a history of strained diplomatic ties between the two countries dating back to the Japanese invasion of China in 1937 and atrocities carried out in the country by some Japanese troops.
With political capital to be gained by both sides from courting nationalist fervor -- Abe visited the same shrine as Koizumi in October -- lawmakers may manipulate the row to fit their agendas despite the economic costs, said Ding Xueliang, a professor at Hong Kong University of Science and Technology, who teaches contemporary Chinese politics.
“Japan is always a convenient target for the Chinese government to use to divert domestic anger,” Ding said. “Compared to the political values, the trade values with Japan are secondary.”
China would be willing to accept a 30 percent reduction in trade with Japan before it would back down, whereas Japan’s pain threshold is about 20 percent, Ding estimated.
One possible course follows the policy proposed by the late Chinese leader Deng Xiaoping, said Martin Schulz, a senior economist at Fujitsu Research Institute in Tokyo.
“China knows it will never get the islands, and Japan knows that China will never let go,” said Schulz, who has done research for the Bank of Japan. “Deng Xiaoping’s stance from the 1970s, to keep it quiet until joint economic cooperation in the area becomes possible, remains the only solution.”
As the current stand-off pushes Japan and China to reduce reliance on each other, U.S. relations with both sides could benefit, according to Liu at ANZ Bank.
“The U.S. will become more important to both China and Japan and will play a big balancing role between Japan and China,” Liu said. “Japan may increase its investment in Vietnam and other economies” in the Association of Southeast Asian Nations.
Exports from Japan to 10-member Asean grew nearly 50 percent in the decade through 2011, according to finance ministry data.
“Japanese investors will accelerate their strategy of diversifying investments to the rest of Asia,” said Tao Dong, head of Asia economics excluding Japan at Credit Suisse Group AG in Hong Kong. “We see increased cases of Japanese investment in Vietnam and the Philippines and there’s lots more to come.”
Japanese companies have spent or plan to spend more than $10 billion since January 2011 on acquisitions in the Asean bloc, data compiled by Bloomberg show. In November, Kirin Holdings Co. bid $2.2 billion for Singapore-based Fraser & Neave Ltd.’s food and beverages unit.
China, which also has disagreements with Asean nations over islands in the South China Sea, was warned last month by Vietnam not to apply economic force to settle disputes.
“Japanese business influence in China will start to decline” as China invites more European and U.S. investment, ANZ’s Liu said in an interview in Tokyo. “Japanese firms’ space in China could be limited in the future.”
Still, the legacy of decades of investment in China make it unlikely that Japanese companies will withdraw, said Nash at IHS.
“This is not an either-or issue,” Nash wrote in an e-mail. “Firms will stay in China and they will invest in Southeast Asia and other places. It’s hard for Japanese exports to move totally away from China and it’s hard for Chinese OEMs to move totally away from Japanese components.”
Japanese companies such as Nissan employed 1.6 million people at subsidiaries in China in the fiscal year ended March 2011, according to the Japanese trade ministry.
As Richard Koo, chief economist at Nomura Research Institute Ltd., wrote in a Dec. 11 report: “No matter how unpardonable China’s behavior over the issue of Senkaku Islands may be, as a practical matter Japan needs to proceed carefully given the magnitude of its Japanese investments in the country.”
To contact the editor responsible for this story: Paul Panckhurst at email@example.com