China vs. Japan: The Loser Could Be the Global Economy

A deepening dispute between China and Japan over a cluster of tiny uninhabited islands, some no bigger than rocks jutting out of the East China Sea, threatens to throw one more (big) monkey wrench into the slowing machinery of the global economy.

Senkaku Island, Japan
Senkaku Island, Japan

The origins of the dispute date back centuries but came to a head last month after Japan nationalized the tiny islands, called Senkaku in Japan, the world's No. 3 economy, and Diaoyu in China, the world's No. 2 economy. The move set off violent protests in at least two dozen Chinese cities. Angry mobs torched a Panasonic factory, looted several Japanese retail outlets and burned Toyota and Honda car dealerships.

The resulting boycott of Japanese goods has brought a sharp contraction in Japanese exports to mainland China as the gunboat confrontation on the high seas has morphed into a wider economic front. On Tuesday, Japanese carmakers reported sales cratered in September –- Toyota's numbers were cut in half –- in what some analysts warn is just a preview of the looming fallout from the high-stakes confrontation.

As the Asia-Pacific economy has become increasingly interdependent, other countries could soon feel the blowback, including Europe and the U.S., both of which have economic woes of their own.

“The fallout is increasing and it’s not the way forward for the region,” said Rajiv Biswas, Asia-Pacific chief economist at IHS Global Insight. “The impact on the region could be significant.”

The impact of a Chinese boycott would fall hardest on Japan, where economic growth slowed sharply in the second quarter and is expected to continue to decline. China represents an important market for Japan’s export-reliant economy. Last year, roughly 20 percent of Japanese semiconductor exports were sold to Chinese manufacturers.

“This (economic conflict) can and will cost the woebegone Japanese economy dearly it the form of export,” said Carl Weinberg, chief economist at High Frequency Economics.

Chinese visitors have also become an increasingly important part of the Japanese tourism industry, according to Parag Khanna, an economist and senior researcher at the New America Foundation.

“A large part of the increase in tourism to Japan in recent years has been from China because of diminished visa restrictions,” he said. “If that goes down, it’s really a double whammy for Japan at a time when they don’t really need that.”

Beyond the long-standing political hostilities, the fight over these barren islands is about more than a tiny patch of remote real estate. The battle for control includes the international rights to develop substantial underwater oil and natural gas, which are critical resources to both countries’ energy-hungry economies.

Natural resources could also become a weapon for the Chinese, who control an estimated 90 percent of a series of so-called rare earth elements – minerals with almost-unpronounceable names that are critical to the production of everything from hybrid cars to flat-panel TVs. (Related: How Are Rare Earth Elements Used?)

Last month, the Chinese government cut the number of mining permits for rare earth elements by a third. By tightening exports of those materials, China could leave Japanese manufacturers scrambling to head off shortages, or paying higher prices.

But an economic strike against Japan’s supply chain could quickly backfire on Beijing and reverberate throughout the Chinese economy, according to Biswas.

“The bigger concern is the longer term impact on supply chains,” he said. “A lot of Japanese investment -- about $80 billion -- has gone into China in the last 15 years and a lot of that is supply chain for their big multinationals.”

“If they decide to move away from China, that’s going to hurt Chinese jobs as well,” he added.

No matter who comes out on top in this Asian economic slugfest, the global economy can ill-afford any further slowdown in trade, especially one involving two of the world’s largest economies. Last month, the World Trade Organization said global trade will grow by just 2.5 percent this year, dragged down by Europe to less than half of the previous 20-year average. That’s down from a prior estimate of 3.7 percent made in April. The WTO also cut its growth forecast for 2013 global trade to 4.5 percent growth from 5.6 percent.

With the global engine of trade slowing, the outlook for the overall economy is also darkening. On Tuesday, officials at the International Monetary Fund, meeting in Tokyo, said the global economic slowdown is worsening and cut their growth forecasts for the second time since April. The IMF warned both U.S. and European policymakers that failure to fix their economic ills would prolong the slump. What little momentum exists is coming primarily from central banks, the IMF said in its World Economic Outlook

The IMF cut its forecast for world GDP growth this year to 3.3 percent, down from 3.5 percent in April.

Some private economists think those numbers will likely come down even further.

“While the IMF has reduced its forecast for next year, we believe it is still over-optimistic about the chances of a global recovery,” said Andrew Kenningham, senior global economist at Capital Economics.