The Diaoyu Islands are a group of uninhabited islands located roughly due east of mainland China, northeast of Taiwan, west of Okinawa Island, and north of the southwestern end of the Ryukyu Islands. They are currently controlled by Japan, which calls them Senkaku Islands. Both China and Taiwan claim sovereignty over the islands.
Japan counts the cost of the islands spat
As its row with China over the islands in East China Sea shows no sign of resolution, Japan faces the prospect of a prolonged recession
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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 cars in China have yet to recover, Chinese factories began to favour South Korean component suppliers, and the United States 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. "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 US$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 (HK$181.73 million) in September, a transaction Xi Jinping, the new head of the Communist Party, called "a farce".
The fallout from the sale might have cut Japan's growth in the latest quarter by about one percentage point, JP Morgan Chase estimated. That would be enough to keep the economy in recession after two quarters of contraction up to September 30. Gross domestic product may have shrunk an annualised 0.5 per cent in the final three months of last year, according to the median forecast in a survey.
The stand-off over the islands, known as Senkakus in Japan and Diaoyus in China, contributed to declines in Japan's shipments to China for six months to November. Japan's industrial output fell 1.7 per cent 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 honoured in 2005, Chinese people and politicians protested. Yet trade between the two rose more than 12 per cent 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 licences to Japan for rare-earth metals, which are necessary for the vehicle and electronics industries. The licences were resumed about a week later after Japan released the detained captain of the vessel.
The latest row had 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 has overshadowed economic ties that Jesper Koll, head of equity research at JP Morgan 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.
The latest spat began in April when then Tokyo governor Shintaro Ishihara said he planned to use public money to buy Kurihara's islands. Ishihara is a long-standing critic of China, so the national government stepped in to buy the islands instead, in a failed attempt to defuse Chinese anger.
Xinhua on December 2 criticised the US Senate's approval of an amendment to show the islands fall under a US-Japan defence 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. "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 last month, has further stoked the conflict.
"Japan is always a convenient target for the Chinese government to use to divert domestic anger," said Ding Xueliang, a professor at the University of Science and Technology. "Compared to the political values, the trade values with Japan are secondary."