Anti-Japanese protests continue to spread throughout China, some of them turning violent, with stores vandalized and Japanese flags burned. Japanese companies that trade with China are considering their options in light of growing boycotts of Japanese goods. The continued friction between the two countries hurts both of them economically, and can make for delicate political positions due to the significant amount of trade between them.

Although Japan and China have had a contentious history for centuries, the roots of the current anti-Japanese sentiment in China stem from Japan's invasion of China and massacre in Nanking in 1937. The second Sino-Japanese war lasted from 1937 to 1945, as one theater in the Second World War. Among other atrocities, Japanese medical units allegedly tested chemical weapons on Chinese civilians, and used Chinese women as sex slaves. Although Japan eventually paid war reparations to China, it has yet to offer a full apology for war crimes. At one time, Japan's prime minister suggested that there was no proof that the military was involved in the prostitution of Chinese women. Since the war, significant anti-Japanese undertones have existed in China.

The match that ignited the current flare up of anti-Japanese protests across China was lit when Japan bought a small group of uninhabited islands from a private Japanese owner. The Senkaku Islands have been claimed by both Japan and China, and Japan's decision to nationalize them brought old tensions to a head.

Economic Consequences
The recent riots have started to affect economic trade between the two countries, especially for Japanese companies selling in or to China. According to Chinese sources, Sino-Japanese bilateral trade hit an all-time high of $345 billion in 2011, making China Japan's largest trading partner, and accounting for approximately 20% of Japan's export volume.

Widespread Chinese shunning of Japanese goods is expected to seriously affect the sales volumes of large companies, such as Sharp (OTC:SHCAY), Toyota (NYSE:TM) and Nissan (OTC:NSANY). Toyota and Nissan have already planned either plant shutdowns or shift reductions in their Chinese facilities to reflect the slowing of demand. If the slowdowns continue for more than a few weeks, the automakers could be in danger of not meeting production targets and having to revise earnings estimates. Shares of major Japanese retailer Fast Retailing (OTC:FRCOY) dropped by 7% almost immediately after the company announced that it was closing some of its locations in China. The company remains depressed in the face of continuing operating uncertainty.

Both the Nikkei and Shanghai indices remain down, the depression fueled by Japanese companies with exposure to China. Although the Nikkei is up 3.9% in 2012, it is still well behind the growth in the U.S. and European markets.

The Chinese National Tourism Administration issued a travel warning in September, urging tourists to Japan to be cautious in light of safety concerns. The resulting drop in tourism could significantly hurt Japan, since tourists spent almost $2.5 billion in Japan in 2011.

The economic impact to China of the rising tensions will be more muted. Japan is only China's third-largest trading partner and represents only approximately 10% of its exports. The danger for corporations in both countries with exposure to the other is how the instability will affect rating agencies' assessments of future operations. While this most recent skirmish may die down, the tension is likely to remain in the long term.

Political Consequences
The political fallout from the recent anti-Japanese protests depends substantially on how China reacts to Japan's nationalization of the Senkaku Islands. If China reacts militarily, it could throw the two countries into a war, similar to the short-lived 1982 war between Britain and Argentina over the Falkland Islands. Unlike that military action, however, both China and Japan have significant troops and weapons at their disposal and a war could drag on for months or years, with a resulting dent in both countries' business operations. The Chinese government will be pressured to respond in some fashion in order to calm the protests.

The Bottom Line
The long-term anti-Japanese sentiment in China affects the GDP of both countries, especially during flare-ups. While it is clearly in both countries' interests to settle the current matter diplomatically, if a military response occurs, the economic fallout could create a financial crisis in both Japan and China.

At the time of writing, Angie Mohr did not own shares in any company mentioned in this article.

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