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In early September, Yoshihiko Noda passed the one-year mark as Japanese prime minister. That’s no small accomplishment—the country is on its sixth premier since 2006. Noda has seen his approval rating drop to 34 percent after doubling a sales tax to 10 percent, however, and he has reshuffled his Cabinet three times. If he’s going to make it another year, he’ll need to defuse a tricky foreign policy crisis: Japan and China’s quarrel over ownership of a group of uninhabited islands in a potentially energy-rich section of the East China Sea.
The Japanese government’s decision last month to nationalize part of the islands (called the Senkaku in Japanese and the Diaoyu in Chinese) triggered protests in dozens of Chinese cities. It is also hurting Japan’s economy. In September, Toyota (TM) and Nissan (NSANY) suffered their biggest monthly drop in Chinese car sales since the financial crisis in late 2008. JPMorgan Chase (JPM) is predicting a 0.8 percentage-point hit to Japan’s gross domestic product from the China dispute in the fourth quarter. The International Monetary Fund, which held its annual meeting in Tokyo from Oct. 12 to 14, said the tension may crimp growth worldwide.
Noda has called for talks with China, and diplomats from both sides have agreed to hold a meeting soon to resolve the crisis. “These are the second- and third-largest economies in the world, and our interdependence is deepening,” Noda, 55, said in an Oct. 10 interview in his office in Tokyo. “If our ties cool, particularly economic ones, then it isn’t a question of one or the other country suffering. Both countries lose out.”
The Japanese premier says his government won’t compromise on its ownership claim on the islands, situated on a continental shelf which is home to between 1 and 2 trillion cubic feet of natural gas and as many as 100 billion barrels of oil, according to Chinese studies cited by the U.S. Energy Information Administration. Japan imports virtually all of its petroleum. “There is no doubt that the Senkaku islands are Japan’s inherent territory in terms of history and international law,” Noda said. “There is no problem of sovereignty.” Japan argues that it took control of the islands in 1895 and that while it lost authority over them after World War II, the U.S. returned them along with Okinawa in 1972.
China, the world’s largest energy consumer, maintains that it’s owned the islands for centuries and has dispatched patrol boats to the area. Japan should “correct its wrongdoing of violating China’s sovereignty and return to the track of solving the issue through dialogue and negotiation,” Chinese Foreign Ministry spokesman Hong Lei told reporters in Beijing.
The conflict contributed to a drop in Japanese stocks in the past month, with the Nikkei 225 Stock Average down 3.8 percent since Sept. 10, when Noda’s administration announced the deal to buy the uninhabited islands from Japanese real estate developer Kunioki Kurihara. The spat has added to Japan’s economic woes: Exports have been hurt by Europe’s crisis, and reconstruction spending from last year’s earthquake and tsunami disaster has wound down. “This is the last thing Japan needs right now, given the overseas slowdown and the sluggish economy,” says Junko Nishioka, chief economist at RBS Securities Japan (RBS) in Tokyo. “The dispute has become much more serious than we initially expected.”
While the public supports the prime minister’s handling of the crisis so far, according to opinion polls, Noda and his ruling Democratic Party of Japan have a far lower overall approval rating than the rival Liberal Democratic Party. Noda inherited a weak economy following the 2011 earthquake, and his own party is divided over his tax plan to cope with Japan’s gargantuan government debt load, which is on track to hit 223 percent of GDP in 2013—the highest in the developed world. Noda must call new parliamentary elections by August 2013. If the China crisis isn’t resolved soon, a bunch of rocks in the East China Sea will weigh heavily on his reelection prospects.
The bottom line: Japan’s territorial dispute with China, its biggest trading partner, will shave nearly 1 percentage point off fourth-quarter GDP.