Japan and China’s Island Tug-of-War

Asia’s latest land dispute appeared to take an economic toll Monday, when Japan announced a -10.3% y/y drop in September exports—with exports to China, with whom Japan’s squabbling over uninhabited islets in the East China Sea, falling -14.1 % y/y.

The islets in question are the Senkakus if you’re Japanese, the Diaoyu Islands if you’re Chinese, or the Tiaoyutais if you’re from Taiwan. Japan has administered them since 1972, when the US (which had controlled them since WWII) returned control of the historically Japanese territory. But China and Taiwan have also claimed sovereignty since the early 1970s—not coincidentally, shortly after a geological survey found evidence of significant oil reserves offshore. Until September, they were owned by a private Japanese family. But after Tokyo’s mayor announced his city’s plans to purchase them earlier this year, the national government bought them to shield the capitol from a diplomatic nightmare. Of course, there was still plenty of diplomatic fallout. Taiwan and China denounced the infringement on their purported sovereignties, and the Chinese government deployed military vessels to the surrounding waters and threatened to sever all trade ties with Japan.

Now, China’s tough words and actions are most likely saber rattling. Though Japan’s a net importer of Chinese goods, and China comprises a larger share of Japan’s export market than Japan does China’s, China’s economy would hardly be insulated from the end of bilateral trade. As the world was reminded after last year’s Great Tohoku Earthquake and Fukushima Daiichi nuclear disaster, Japan is an important link in the global supply chain. Many Chinese factories utilize machinery made in Japan. Autos, computers and other high-tech electronics manufactured in China rely on Japanese components. Severing trade with Japan would make life difficult for Chinese manufacturers—and China’s government seems keenly aware of the need to support domestic industry during and after the upcoming leadership transition.

However, there’s another variable outside the government’s control: Chinese citizens, who launched anti-Japanese protests and boycotts after the islands’ nationalization. Violence erupted at Japanese auto factories, protesters vandalized, looted and marched outside Japanese auto dealerships and clothing stores, Chinese tourists cancelled trips to Japan, and consumers boycotted Japanese goods from cosmetics and clothing to electronics and cars. Hence, Japanese exports fell more than they likely otherwise would have.

In the immediate future, China’s government likely isn’t motivated to quash the protests—doing so introduces the risk protesters turn on the government, which is the opposite of what leaders want during the upcoming political transition. This mentality may be behind some of China’s more hawkish comments—taking a tough line likely curries public favor when nationalist sentiment’s riding high (just as US presidential candidates seek to capitalize on anti-China sentiment). We’ve also seen this in Japan, where the opposition Liberal Democratic Party is taking a nationalist bent to turn support against Prime Minister Yoshihiko Noda and his Democratic Party of Japan.

Looking a bit longer term though, officials have every incentive to ease diplomatic tensions and encourage protesters to settle down. China benefits heavily from investments from Japanese businesses and many of China’s auto factories are joint ventures with Japanese firms. China doesn’t want Japanese companies to take their production and investment elsewhere in Asia. As diplomatic relations thus thaw, normal consumption and trade patterns should resume—just as they did after other recent anti-Japan protests. The last decade saw annual protests over former Japanese Prime Minister Junichiro Koizumi’s visits to the Yasunuki Shrine from 2001 – 2006 (a memorial for Japanese war dead that includes WWII war criminals, including those responsible for the Nanjing massacre) and protests over other island disputes in 2004 and 2010. Yet bilateral trade grew, reaching an all-time high of $340 billion last year.

Still, Japan’s economic growth likely registers some impact from the dispute in Q3 and Q4 due to lost tourism revenue and exports. China may feel it a bit as well, if auto factories remain offline. Importantly though, the hit likely isn’t enough to much impact global economic growth.