Why will Japan and China avoid conflict? They need each other.

Despite dark allusions to Germany and Britain in 1914, the two powers' economies are deeply intertwined, and Japanese doing business in China are guardedly optimistic.

One of the most striking warnings that Sino-Japanese tensions could descend into conflict came from none other than Japan’s prime minister, Shinzo Abe.

Speaking at the recent World Economic Forum in Davos, Abe suggested that Japan’s relationship with China was in a “similar situation” to that between Britain and Germany before the outbreak of World War I in 1914. The most common interpretation: that close economic ties between nations are not always enough to prevent them from going to war with each other.

Japanese officials insisted that Mr. Abe’s comments, as reported by some foreign media, had been taken out of context. But his analogy raises an important question about the ongoing territorial dispute between Japan and China: whether strong bilateral trade will be enough to pull them back from the brink or, at the very least, help them weather the current diplomatic storm. The answer – at least for now – is yes, according to the consensus emerging among the myriad Japanese companies with business interests in China.

That guarded optimism contrasts with the autumn of 2012, when Japan’s decision effectively to nationalize the Senkaku islands – East China Sea territories also claimed by China, where they are known as the Diaoyu – sparked riots in several Chinese cities and forced Japanese businesses in the country to temporarily close amid calls for boycotts of Japanese products.

“We suffered a downturn, just like every Japanese company that has business interests in China,” says a spokesman for the automaker Nissan. “But 2013 ended up being our best-ever year for sales,” he adds.  Between January and December last year, Nissan's new vehicle sales in China, which accounts for a quarter of the firm's global sales, totaled 1.27 million units, up 17 percent from a year earlier. “We fully expect that sales there will continue to grow in 2014,” the spokesman adds.

The broader picture tells a similar story. Exactly a year after the riots in China, sales were returning to near pre-crisis levels, with Japan’s exports to China rising more than 11 percent in September 2013 from a year earlier; Japan's imports from China, its biggest trading partner, increased by more than 30 percent over the same period.

Interdependent economies

Economically, Japan and China need each other. Trade between the two countries has tripled over the past decade to more than $340 billion in 2012. China offers Japanese firms an affordable manufacturing base and a vast export market. Between 1995 and 2011, for example, shipments to China accounted for 45 percent of the overall growth in Japanese exports.

China, in turn, depends on Japanese investment and the jobs that come with it, while its own export industry would struggle without Japanese technology. About 60-70 percent of the goods China imports from Japan comprises the machinery and parts it needs to make its own products. And for every 1 percent of growth China sees in global exports, imports from Japan rise by 1.2 percent, according to 2012 calculations by the International Monetary Fund.

Given that backdrop, any military confrontation in the East China Sea would have profound implications for the global economy. It could also suck in the US, which is treaty-bound to come to Japan’s aid if it is attacked.

Japanese firms can take some comfort from the absence of violent protests in China or boycotts of Japanese goods since Abe visited a controversial war shrine in Tokyo at the end of last year.

Richard Bush, director of the Center for East Asia Policy Studies at the Brookings Institution in Washington, says China has come to realize that a repeat of the officially sanctioned mass protests of 2012 would only strengthen the hand of Japanese right-wingers.

Mr. Bush suggests that the benefits China accrues from strong economic ties with Japan will trump any desire to raise the stakes over territorial and historical disputes.

“But Beijing’s motivation is probably more strategic than economic,” he adds. “It doesn’t want to have the US get drawn into whatever might happen in the security realm with Japan. What I think they are doing is low-risk, and may work, whereas a more aggressive approach carries greater risks.”

Provocations

Not all analysts share the view that China has responded with restraint. They point to its declaration last November of an air-defense identification zone, which requires even civilian aircraft to notify Chinese authorities of their flight paths, and frequent sightings of Chinese surveillance ships and aircraft in the disputed area.

“China still rejects any peaceful means to overcome the different claims to the islands, and is sticking to coercion," says Tetsuo Kotani, a research fellow at the Japan Institute of International Affairs in Tokyo. “But China is losing the diplomatic cards with which to pressure Japan, since Prime Minister Abe has made it clear that he is determined not to compromise in the face of Chinese pressure.”

Mr. Kotani is not convinced that economic considerations and fear of the terrible consequences of war will always guide Beijing’s thinking. “Economic ties are not a primary reason for avoiding war, since no one has proved that economic interdependence prevents war,” he says.

Tension, not conflict, is uppermost in the minds of Japanese firms in the wake of Abe’s Yasukuni pilgrimage. The shrine honors 14 class-A war criminals among 2.5 million Japanese war dead, and is viewed by China and South Korea as a symbol of Japan’s past militarism.

While Japanese companies saw exports to China recover to pre-2102 crisis levels at the end of last year, the Yasukuni visit could dent their prospects for the coming year. ”We believe everything will work out for the best, but we are closely monitoring the situation in China,” says a source at a Japanese exporter who asked not to be named.

"China-plus-one" strategy

While few believe that war is a realistic concern, Japanese companies appear to be making contingency plans in case the diplomatic climate deteriorates.

Their direct investments in China fell by almost 37 percent the first nine months of 2013. By contrast, Japanese direct investment in the 10 ASEAN nations rose more than 55 percent in the first half of that year from the same period in 2012 to a record high of USD10.2 billion, according to the Japan External Trade Organization.

"Economically, China and Japan are a perfect match," says Martin Schulz, chief economist at the Fujitsu Research Institute in Tokyo. "A big, young market in China for Japan's ageing industry and capital, and an overflow well of technology and depressed capital in Japan for China's development.

"Politically, however, things will remain difficult. So companies in Japan are looking for "China-plus-one" strategies that connect the wider Asian market with China's strong economy, while Chinese companies are heading towards investment opportunities in Southeast Asia, too."

But he adds: “While the political situation has clearly not improved, the business environment for corporations on both sides has almost normalized.”

There was evidence of that as recently as November, when more than 100 executives took part in the biggest Japanese business mission to Beijing for more than a year.

Their hosts, including Chinese Vice Premier Wang Yang, did not mention the Senkaku islands, while the local media reported encouraging words from China’s former ambassador to Japan, Xu Dunxin, who told the delegation: "We hope the communication between high-profile business entrepreneurs will help result in a turnaround of the strained China-Japan relationship."

A month earlier, executives from ten leading Chinese companies in Guangdong Province visited Japan in search of more investment. They met Yoshihide Suga, the chief cabinet secretary and close Abe ally.

"We were able to feel a positive attitude toward cooperation between Japan and China," Hiromasa Yonekura, the outgoing chairman of the Japan Business Federation, told reporters after the trip to Beijing. "I believe we have taken one step forward."