—Japan Cabinet to hold meeting Tuesday to discuss response to territorial dispute with South Korea

—Possible steps include scaling back currency swap arrangement, suspension of plans to buy South Korean government debt

—Analysts doubt there will be any big practical impact on the economies of the two countries from such steps

 
   By Takashi Nakamichi 
 

TOKYO—Japan may take steps to roll back an emergency financial lifeline with South Korea in response to the latest territorial dispute between the two countries, in what would be a departure from the Asian neighbors’ tradition of keeping economic affairs separate from territorial disagreements.

Japanese Prime Minister Yoshihiko Noda could make a decision on such measures as early as Tuesday, when members of his Cabinet meet to discuss a response to the recent flare-up with Seoul over contested islands in waters between the two countries.

“Before tomorrow’s Cabinet meeting, we will hold a ministerial discussion the Takeshima issue,” Chief Cabinet Secretary Osaku Fujimura told reporters Monday, using the Japanese name for the disputed islands, also known as the Liancourt Rocks.

The meeting comes as Mr. Noda is trying to diffuse a separate territorial spat with China, on which he has been slammed by opposition parties for being too soft.

Anti-Japanese protests erupted across China after Japanese activists landed on one of the disputed islands Sunday, with Chinese media keeping up the rhetoric Monday.

“The national strength of China, as long as its growth continues, will become the bargaining chips that force Japan to back off,” wrote the Global Times, a popular tabloid with nationalist leanings, in an English editorial.

The Japanese activists landed on the Japanese-controlled Senkaku islands after activists from Hong Kong landed there last week, later to be deported by Japan.

The territorial spat between Tokyo and Seoul began earlier this month when South Korean President Lee Myung-bak visited the Liancourt Rocks, effectively controlled by South Korea, which calls them the Dokdo Islands. Japan refers to them as Takeshima.

But even if Mr. Noda decides to shrink the currency swap line with Seoul—which was expanded to cope with the European debt crisis—analysts say the impact on the two economies would likely be limited.

The two countries agreed last October to expand the swap line—an agreement to temporarily lend each other dollars—to $70 billion from $13 billion for one year. The increase had been requested by South Korea, which was concerned about potential capital outflows resulting from the European debt crisis, another Japanese official said.

Further offending many Japanese last week, after visiting the islands, Mr. Lee made remarks interpreted as being disrespectful to Japan’s emperor, whom many Japanese hold in high esteem.

The comments “really raised the hurdle” for the finance ministry to keep financial cooperation separate from politics, a Japanese official said.

On Friday, Finance Minister Jun Azumi signaled that Japan might let the expansion expire at the end of October.

Other potential steps Tokyo could take include indefinitely postponing planned purchases of South Korean government debt, Japanese officials said.

But some analysts say the financial steps being considered by the two nations are mostly symbolic. Even if Japan rolls back the swap agreement, South Korea wouldn’t suffer much because it has plenty of its own foreign-reserves—$314.35 billion at the end of July, the world’s seventh-largest. It can also rely on swap deals with other nations as well as Asia’s regional firewall mechanism, they say.

They also say a decision by Japan not buy Korean government bonds would actually help Seoul, which is worried about foreign buying of such debt pushing up the value of the Korean won. Rises in the won hurt Korean exporters by making their products more expensive abroad.

And while South Korea is the third-biggest importer of Japanese goods after China and the U.S., economists in Tokyo said a potential drop in Korean purchases won’t have much impact on Japan’s economy.

Many of South Korea’s imports from Japan are intermediate items used by Japanese factories to build finished products for export elsewhere. Thus, even if South Korean demand for Japanese exports shrinks, it may have no meaningful effect on Japan’s economy, said Toshihiro Nagahama, chief economist at Dai-Ichi Life Research Institute.

“The impact would be much bigger if the same happened in China,” Mr. Nagahama said, as China is steadily becoming a consumer of Japanese items from being a mere factory base for Japanese makers.

Another Japanese official said putting the Japan-South Korean financial cooperation back on track might be difficult until after Mr. Lee steps down later this year.

Mr. Lee’s Conservative Party faces a presidential election in December, but he is constitutionally barred from a second term.

In-Soo Nam and Alexander Martin contributed to this article.

Write to Takashi Nakamichi at takashi.nakamichi@dowjones.com

“Japan May Trim Financial Lifeline With South Korea Over Island Spat,” published at 1136 GMT, misstated the name of Japan’s Chief Cabinet Secretary in the third paragraph. He is Osamu Fujimura, not Osaku Fujimura.

http://online.wsj.com/article/BT-CO-20120820-704605.html