Economic ties between China and Japan have flourished for years despite their on-and-off cold political relations. Their relationship used to be characterized as "politically cold but economically warm". But that is not the case anymore. The farce of "purchasing" the Diaoyu Islands played out by Japan has sparked outrage and protests across China.

Many Chinese have spontaneously boycotted Japanese goods and canceled their trips to Japan. A latest J.P. Morgan report says Japanese auto exports to China would fall by 70 percent in the October-December period. Obviously, bilateral economic and trade relations are under tremendous strain.

China and Japan established diplomatic relations 40 years ago. Since then the two countries' leaders, entrepreneurs and general citizens have made efforts to promote bilateral economic ties, and the two sides have become highly interdependent on the economic front. China is now Japan's largest trading partner and top export destination, while Japan remains China's fourth largest trading partner after the European Union, the United States and the Association of Southeast Asian Nations.

In 2011, Sino-Japanese trade volume was more than $340 billion, accounting for 20.6 percent of Japan's gross foreign trade volume, and Japan's exports to China made up 19.7 percent of its total exports. Although last year China's trade with Japan accounted for only 9.4 percent of its total foreign trade, Japan remained one of the largest sources of China's foreign direct investment. Japanese FDI in China is more than $85 billion. Last year alone, Japanese FDI hit $6.35 billion, a year-on-year increase of 49.7 percent.

Besides, China held short- and long-term Japanese government bonds worth 18 trillion yen ($230 billion) at the end of last year, and earlier this year, Japan got the approval to buy 65 billion yuan ($10.3 billion) worth of Chinese government bonds. In June, the two sides began direct trading in Chinese yuan and Japanese yen and were expected to increase the holdings of each other's bonds.

Such a hard-earned and mutually beneficial relationship should be cherished, but Japan's unilateral moves on the Diaoyu Islands now threaten to freeze bilateral economic ties. In fact, even before the islands row triggered a boycott of Japanese goods in China, bilateral trade had shown signs of decline this year. In the first eight months of the year, it fell by 1.4 percent year-on-year to $218.7 billion, and in August, Japan's exports to China dropped by 9.9 percent. China's economic slowdown and a shrinking demand for Japan-made machinery, steel and other products are the main reasons for the decrease in bilateral trade. The problem has been compounded by the simmering tension over the Diaoyu Islands.

Although Japanese investment in China increased by 16.2 percent year-on-year in the first eight months of this year, it was much less than the 50 percent increase in 2011. The intensifying islands row will probably cause a further drop in Japanese FDI flow into China in the following months. Predictably, bilateral economic ties, especially mutual bond holdings and direct yuan-yen trading, will suffer further setbacks. Even the efforts made to establish a tripartite free trade zone among China, Japan and the Republic of Korea will be compromised, if the islands dispute persists.

The islands row has taken a toll on bilateral economic and trade relations, and Japan has to bear the brunt of the loss. Japan's economic bubble began deflating in the early 1990s, driving the country into a litany of economic woes. As things stand today, Japan has little room to stimulate its economic activities and create jobs by increasing public investment. Consumer spending, which accounts for almost 60 percent of Japan's GDP, remains anemic with Japan grappling with long-term deflation.

Exports, therefore, could be the proverbial life-saving straw for the Japanese economy. But Japan continues to experience economic stagnation, because the global financial crisis has curbed demands in the US and the EU. Besides, after the Fukushima nuclear disaster, Japan has been forced to increase imports of natural gas and crude oil, which have ballooned its trade deficit.

Expecting the economy to be driven by post-quake reconstruction spending, the Japanese government has projected economic growth in real terms at 2 percent for fiscal 2012, but its economic ailment persists. Japan's economy grew by only 0.7 percent in the second quarter of this year, half the expected rate, and a drop in the country's key economic gauge in July and August indicates that the economic contraction will continue in the third quarter.

At this point, Japan's falling exports to China will have a damaging effect on its economy. The Daiwa Institute of Research, a Tokyo-based think tank, estimates that suspension of Japanese exports to China for one month would reduce manufacturing output value by 2.2 trillion yen, a drop in real GDP of almost 0.2 percent. Japan's weak exports, especially declining exports to China, will cause a fall in production, increase unemployment, and reduce income and consumer spending, which will further exacerbate the country's ailing economy.

Japan cannot afford to lose the Chinese market, and it is in its fundamental interest to admit there is a dispute over the Diaoyu Islands and hold negotiations with China to resolve it and prevent paying an even heavier price for its follies.

The author is a researcher in Japanese economy at the Chinese Academy of Social Sciences.

(China Daily 10/16/2012 page9)