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Why Japan Needs a 'Love Thy Neighbor' Policy

Protesters shout anti-Japan slogans near the Japanese Consulate General in Shanghai, China.
Eugene Hoshiko
Protesters shout anti-Japan slogans near the Japanese Consulate General in Shanghai, China.

While vowing to "stop the challenge" from China over the chain of islands in East China Sea, whose Japanese ownership is "non-negotiable," Japan's next Prime Minister Shinzo Abe in his first post-election press conference recognized that "China is an indispensable country for the Japanese economy to keep growing."

As a result, he went on, "we need to use some wisdom so that political problems will not develop and affect economic issues."

Beijing apparently thinks that Mr. Abe wants to square the circle.

Indeed, China claims the sovereignty of the archipelago, consisting of five islands and three reefs they call Diaoyu (Senkaku for the Japanese), as a matter of historical fact whose earliest record dates back to 1403 at the time of the Ming Dynasty. And ever since the territorial dispute erupted a few months ago, China had amply demonstrated that it would not de-link economic dealings with Japan from serious political problems in Sino-Japanese relations.

Japan has seen that already. In the first 11 months of this year, Chinese purchases of Japanese exports have been falling at an annual rate of more than 10 percent, and their decline has significantly accelerated in the last three months. Sales of Japanese cars in China were plunging in October and November at a rate of 48 percent. Japanese direct investments in China have virtually ground to a halt, and Japanese companies operating in China are complaining about increasing red tape and regulatory delays.

Japan's Strong Recession Dynamics

It is not clear how this substantial weakening of Japan's business in China can be stopped, let alone reversed, while the current standoff continues. But it is quite clear that declining sales to China are amplifying a broad-based downturn of the Japanese economy.

Recently published gross domestic product (GDP) numbers for the third quarter show that there was some life left only in public investments, a mere 4 percent of Japan's aggregate demand. The key growth engines representing 90 percent of the economy – private consumption, residential investments, business investments and exports – were either nearly stagnant or in a free fall compared with the third quarter of last year.

(Read More: What Will Save Japan's Economy?)

Japan's deepening recession is under way. The most recent business survey, published in mid-December, finds that business sentiment continued to worsen during the fourth quarter as a result of falling exports, rising yen and flagging domestic demand.

This trend is unlikely to be turned around by an 880 billion yen package to help small businesses. Even the announced fiscal stimulus of 5-10 trillion yen ($59 billion to $119 billion) may not do much to prop up an export-oriented economy with structurally weak household consumption and residential investments.

(Read More: Global Growth Woes – Here Is Where the Blame Lies)

Pushing the Bank of Japan to print more money to weaken the yen and to raise inflation target to 2 percent has an equally uncertain policy outcome.

Assuming that the Bank of Japan agrees to manipulate and debase its currency - and that Japan's trading partners acquiesce in such a move - an avalanche of yen liquidity could bring down the exchange rate. But to raise inflation from its present rate of -0.4 percent to 2 percent – and to keep it there – would require a sustained overheating of the Japanese economy, with strongly rising capacity utilization rates and demand pressures in labor and product markets.

(Read More: Is Bank of Japan Already Dancing to Abe's Tune?)

That, too, might be possible, provided there is a fundamental change in the composition of Japan's aggregate demand – a structural shift away from an export-driven economy to spending patterns dominated by domestic demand. How likely is that over any (politically) relevant policy horizon?

Economic Fallout of the Border Dispute with China

I have long argued that Japan should reduce its excessive dependence on exports, even though I understood that such a change might not seem compelling to Japanese policymakers. What is more difficult to understand though is the fact that Japan developed a veritable addiction to Chinese markets, despite thorny territorial issues and security concerns. Last year, Japanese exports to China accounted for one-fifth of its total exports, and more than one-third of its exports to Asia.

Japan will now find it very difficult to diversify export sales, and to reduce its dependence on such a huge volume of business, without serious damage to growth, employment and large segments of its industries.

And then there is a political deadlock: Mr. Abe says he wants to conduct "persistent dialogue" with China on issues - disputed islands - he considers "non-negotiable," while Beijing wants these islands back as a matter of its sovereign rights.

There is not much room for dialogue there. Especially since the respective ownership claims are so strikingly different.

Writing in the French newspaper Le Monde on November 9, 2012, Ichiro Komatsu, Japan's ambassador to France, says that Japan decided to "annex Senkaku (Diaoyu) islands to the national territory in January 1895, after its investigations since 1885 proved that these islands were terra nullius (land belonging to no one)," without any sign that they were administered by China's Qing Dynasty. Historians would also say that Japan took possession of these islands after it defeated China in the first Sino-Japanese War from August 1, 1894 to April 17, 1895.

The Chinese are not denying that these islands were taken away from them by Japan, but Beijing has historical records, including Japanese maps from 1785, showing that these islands had always belonged to China. Earlier this month, China also sent to the U.N. a geological survey showing that "the continental shelf in the East China Sea is the natural prolongation of China's land territory."

Clearly, this is a tough territorial dispute where the "persistent dialogue" Mr. Abe is promising seems unlikely to produce a solution acceptable to Beijing and Tokyo.

Putin, Black Belt Judoka, Wants "Hikiwake"

Japan also has real estate issues with South Korea and Russia.

Problems with Russia involve significant economic consequences, but they are far less serious than the Japan's standoff with China, where a trade volume of $340 billion is at stake.

Referring to an 1855 agreement on trade and borders, Japan wants Russia to return four South Kuril Islands (which Tokyo calls Northern Territories) the Red Army took toward the end of WWII. Moscow has been administering these islands ever since, and maintains that they are part of its sovereign territory.

The result is that Russia and Japan never signed a peace agreement following WWII, because Japan poses the return of the four islands as a condition for such an agreement and for closer economic and political relations with Russia.

Mr. Putin wants to break the deadlock. In an interview he gave to Asahi Shimbun on March 2, 2012, he said that Russia and Japan should divide these four islands, and, with a score of 2:2, it would be just like a draw ("hikiwake") in a judo contest. He also promised that he would summon Russian and Japanese experts to a negotiating table and give them the martial arts command "hajime" (begin). True to his word, he apparently did that because there is now a Russian-Japanese working group studying the issue.

Here is also an interesting aside. In the same interview Mr. Putin mentioned that it took Russia and China 40 years to settle territorial problems along their 4000-kilometer border. Talking about that long and difficult process, he said that the more the Sino-Russian ties grew stronger, the easier it became to find solutions to seemingly intractable frontier questions. And a message to Japan: this year, he went on, the Sino-Russian trade is expected to hit $100 billion, while trade with Japan is still hardly more than one-third of that.

Love Thy Neighbor

Japan's problems with South Korea are even more complex. Not only are there territorial disputes over the Takeshima (Dokdo for Koreans) Islands in the Sea of Japan, but there are also Mr. Abe statements denying that Korean and other Asian women were forced into sexual slavery during WWII.

Similarly, South Korea, and some other countries in the region, take a dim view of Mr. Abe's stated belief that the Japanese military aggression in WWII was not a crime. A promised military buildup and a change of Japan's pacifist constitution are also being closely watched by Japan's neighbors.

South Korea's President-elect, Park Geun-hye, has reacted already. In her first major post-election speech she pledged to work for "greater reconciliation, cooperation and peace in North East Asia based on correct perception of history." Clearly, Mr. Abe's rumored move toward a more conciliatory approach to the island dispute would be well received in Seoul. That would also provide a friendlier setting for his presence at Ms. Park's inauguration on February 25.

(Read More: Can South Korea's New President Keep 'KOSPI' Pledge?)

Investors are fully aware that Japan's tensions with its neighbors have an important economic dimension. Japan's economic interests would therefore be best served by calming things down, starting with China, and seeking an acceptable modus vivendi with countries involved in its territorial disputes and perceived as presenting longer-term security threats.

Investment climate for Japanese assets would also improve if Mr. Abe wasted no time on belligerent rhetoric. His priority is to show that he has an effective plan to fix the economy – which he does not have at the moment – and that his diplomacy with China can bring that huge market back on stream for Japanese industries. Mr. Abe's first major electoral test is less than seven months away. On July 11, 2013 voters will go to the polls to elect the upper house of the Japanese parliament.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia

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