A fiery diplomatic clash last month over Japans arrest of a Chinese fishing boat captain near islands both Japan and China claim as their own, threatened to sour relations between the Asian rivals. But the spat is just the latest episode of rising tensions, both economic and political, between the two countries, as Japans economic dominance over Asia continues to ebb.
In August, news broke that China had overtaken Japan as the worlds second-largest economy behind the US in terms of nominal GDP, seeming to mark one more stage in what some see as Chinas inevitable ascent toward the number one position, and to reinforce Japans decline into relative economic obscurity.
Even though China won the accolade on the basis of just one quarters GDP, and even though Chinas GDP has outstripped Japans on occasion in the past, Japans chances of regaining second place are slim, given dramatic differences in growth rates between the two countries.
Japans nominal GDP (before adjustment for price and seasonal variations) amounted to $1.29 trillion in the second quarter, compared with $1.34 trillion for China, according to Japanese government data. Since China is expected to grow at a rate of around 10% in 2010 compared with 23% for Japan, China appears set to stay ahead of Japan on an annual basis too for the first time.
This is a shock for Japan, which has held the number two spot in the global economic league table since 1968, when it became a global manufacturing power and overtook Germany as the second-largest economy behind the US. China then moved into third place in 2007 and has now leapfrogged Japan too (although in purchasing power parity, or PPP, terms it has been ahead of Japan for some time).
Japanese policy-makers sought to appear stoic at the news, with some, such as finance minister Yoshihiko Noda, noting that Japan is still way ahead of China in terms of per-head national income. Japans per head GDP was $37,800 in 2009 compared with just $3,687 for China 103rd position in the world, according to the World Bank.
This may signal Chinas rise, Japans decline, and Chinas continuing rise to overtake the US by 2030, according to Goldman Sachs, Masahiro Kawai, a former senior official in Japans finance ministry and now dean of the Tokyo-based Asian Development Bank Institute, tells Emerging Markets. Japan can benefit from Chinas growth if Japan can integrate itself more with China (and other Asian emerging economies) through trade with and investment in China, and transfers of technology related to energy efficiency and environmental improvement.
Kawai adds: Healthy competition between the two countries will be useful, for example in the area of promoting international financial centres (Tokyo and Shanghai), currency credibility (related to the role of the yen and yuan), etc. If Japan wakes up and focuses on domestic reforms, like agriculture and the labour market (foreign workers, old-age caretakers), then the country can be more competitive, and integrate itself with Asia and other emerging market economies.
Reaction in China to news of its own success was restrained, with Gu Yuanyang, economist with the Chinese Academy of Social Sciences, acknowledging that the quality of Chinas growth has still to match its quantity. China lags far behind in the ability to transform technical progress into economic benefits, and our weight of research and development to GDP is very low, Gu told China Daily.
China had been expecting this, and it is not a key milestone that is being set, but it has happened a little bit faster than expected, Harvey Chen, an economic adviser to Chinas State Council and president of the First Light Academy of Economics and Management in Shanghai, tells Emerging Markets. The key thing is to make sure that this fast-running train does not derail, he adds.
After the financial crisis, a lot of countries are still troubled, while China is much stronger than before. So there is more self-confidence in China, but everyone is aware of the reality that on a per capita basis, China still has a lot of work to do. The Chinese government is principally concerned about stability of growth. If current growth continues for another 10 years, China will be in a much stronger position [to close income gaps].
But while China refrained from crowing, and Japan showed little outward sign of resentment over the economic achievement of its rapidly emerging neighbour, Tokyos actions in subsequent weeks with regard to relations with China appeared strangely defensive and, in the eyes of some, aggressive.
Diplomatic tensions flared when Japanese coastguard vessels arrested a Chinese trawler, which they claimed was fishing illegally in waters near the Senkaku islands (whose ownership is disputed among Japan, China and Taiwan), and which they claimed had rammed one of the coastguard vessels as it attempted to escape.
The vessel and its crew were brought back to Japan where its captain remained in detention a highly unusual situation in what are regular incursions by Chinese fishing vessels. The dispute went right up to the prime ministers office in Japan and to the highest levels in China, which protested vehemently at the events and demanded that Japan back off.
Even as Beijing was cancelling planned treaty talks with Japan on sharing gas and other mineral rights in other disputed areas of the East China Sea, Japans annual Defence White Paper called attention to what it claims were Chinas growing military activities in the region.
Adding fuel to the sudden outbreak of tension between the two east Asian powers, Tokyo is demanding to know what motives lie behind Chinas sharply increased purchases of Japanese government bonds (JGBs), and complaining that it does not have similar access to the Chinese government bond market.
It remains unclear what suddenly prompted Japan to take actions that would set back the improving relations which both governments have striven for, with some success, after the departure of former Japanese prime minister Junichiro Koizumi, who brought them to a low ebb. Some, such as chief economist Richard Jerram at Macquarie Securities in Tokyo, sense growing frustration in Japan at its seeming inability to restore growth, while China continues to move forward smoothly.
Japanese political veteran Ichiro Ozawa, who challenged prime minister Naoto Kan for the leadership of the Democratic Party of Japan (and thus also for the premiership), has long pushed for a much closer relationship between Japan and China, even at the expense of loosening Japan-US ties.
Ozawa argues that an ageing Japan can fulfil its potential only in the context of a common economic community in east Asia, where people, as well as trade and investment, can move freely across borders, and that big shifts in Japans diplomatic stance are needed to bring this about.
Ozawa was defeated in the election, however, leaving Japans affairs of state in the hands of Kan, who is widely regarded as far more cautious, and less inclined to push Japan in bold new directions that could restore not only its economic growth but also its sense of national purpose.
Adding to Japans sense of diminishing economic clout, in September India usurped Japan as Asias second-largest importer of oil. Japan fell to third, with South Korea occupying fourth position.
Japans apparent decline in terms of national industrial output reflects in part a continuing shift of Japanese manufacturing production to offshore locations in Asia not least to China and India. This process is accelerating, with the yen recently reaching a 15-year high against the dollar and a nine-year high versus the euro. The Federation of Japanese Economic Organizations (Nippon Keidanren) warned recently that Japan is in danger of further hollowing out from companies moving production (and jobs) offshore, unless Japanese authorities counter yen strength or endaka.
Goaded by such statements, and by his rival Ozawas promise of muscular action on the yen, Prime Minister Kan finally went into action on the foreign exchange front on September 15, ordering the Bank of Japan (which acts as agent for the finance ministry in such matters) to intervene, and sending the yen at least temporarily lower.
But endaka is only one of many problems confronting Japan, including chronic deflation, slowing domestic and external demand, a government debt to GDP ratio approaching 200% and a declining population.
Japans population is on track to drop from 127 million to just 90 million in the next 45 years, by which time almost 40% would be aged over 65, according to official estimates.
The symbolism of dropping to third place in the global economic league table might be the wake-up call that Japanese leaders need to focus on reviving growth, says Martin Schulz, senior economist at Fujitsu Research Institute in Tokyo. But not everyone is betting on it.