The escalating territorial dispute between China and Japan over a small group of islands in the East China Sea is testing the bilateral economic and political relationship between the northern Asian neighbours, with wide-reaching consequences.
The latest territorial tussle between China and Japan over the ownership of the uninhabited islands, known as the Senkaku in Japan and Diaoyu in China, has sparked violent anti-Japan protests in China after its neighbour bought several of the islands from a private landlord.
Negative Chinese sentiment has led to boycotts against certain Japanese products, and forced some Japanese companies to close several of their operations in China. Japanese electronics companies Panasonic and Canon have been forced to close several of their outlets, while car manufacturer Toyota and Nissan have temporarily closed dealerships throughout the country.
However, both countries stand to lose if the dispute continues. China is Japan's largest export partner, accounting for nearly 18% of Japan’s total exports, and bilateral trade has tripled during the past decade to reach more than $340 billion.
According to S&P, the Chinese market accounts for 10% to 15% of the total revenues in Japan's automobile sector, and leading manufacturers generate 8% to 14% of their consolidated revenues from the Chinese market in the consumer electronics sector.
If political tensions were to intensify, the profitability of these sectors in Japan will be hit. Indeed, Japan’s export-driven economy will find no economic refuge in Europe, as the eurozone continues to grapple with the sovereign debt crisis. Japan is also still grappling with the fallout of the earthquake and tsunami in 2011, which has had a serious affect on the country’s real economy.
At the same time, a halt in trade with Japan will hamper ambitions for China to re-boot the economy as GDP growth falters. And as China undergoes its first political leadership handover in a decade, it would be in Beijing‘s best interest to resolve the territorial dispute peacefully.
Fears are also growing over the outlook for cross-border financial relations. Jin Baisong, a member of the Ministry of Commerce-affiliated Chinese Academy of International Trade, called on China last month to use its power as Japan’s biggest creditor, with $230 billion (£141 billion) of bonds, to impose sanctions on its neighbour.
More recently, several leading Chinese banks reportedly announced they would no longer attend the high-profile annual meeting of the World Bank and International Monetary Fund, which will take place in Tokyo next week. No formal reason was given for the withdrawal.
According to S&P, if the political confrontation intensifies, Japan's macro-economy could be hurt and the credit quality of rated Japanese companies could be affected on a large scale.
If the “diplomatic spat leads to trade restrictions between both countries and political tension lingers for more than a year, dragging down Japan's economic growth, our sovereign ratings on Japan, as well as ratings on Japanese issuers, including industrial and corporate entities and financial institutions, may be affected,” says the report.
S&P’s outlook on the long-term sovereign rating on Japan is negative ((AA-/Negative/A-1+).