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* Stock lending in big Japanese companies on the rise
* Eight of top 10 Asia Pacific funds cutting Japan exposure
By Sinead Cruise and Chris Vellacott
LONDON, Oct 1 (Reuters) - Nervous overseas funds are starting to pull money out of Japan, spooked by a territorial spat with China that has prompted talk of corporate boycotts, weakened trade and even military action.
Political commentators have played down the significance of the latest flare-up in a long-running feud between Asia's largest economic powerhouses over the ownership of a handful of small islands in the East China Sea.
The dispute, however, has stirred unprecedented levels of anti-Japanese protest in China, forcing companies that export to the region, such as Toyota Motor Corp, to rein in production and sales targets until the tensions dissipate.
As both governments grapple with imminent shake-ups in their governments, foreign investors are allocating away from Japan amid fears that a lasting reconciliation could be some way off.
"It's yet another headwind that neither of these two markets can afford. It could definitely get ugly," said one New York-based fund manager who specialises in Japanese equities.
Data from Lipper, a Thomson Reuters company that tracks the funds industry, shows net outflows of money from 1,500 Japan equity funds during the first eight months of 2012 totalled about $1.2 billion. Total assets in these funds amounted to $91 billion at the end of August.
The figures also show the biggest Asia-Pacific funds that include Japan in their portfolios are starting to back out of the country. Eight of the top 10 funds where full data is available have cut exposure to Japan since the end of last year.
Besides the spat with China, overseas investors may also be trimming exposure to Japan because concerns over recession and the weakness of the yen abound.
And while long-term investors are leaving, the short-sellers - investors who seek to profit from asset prices going down - are circling vulnerable companies with most to lose from a prolonged quarrel.
Data from Sungard Astec Analytics shows the volume of stock out on loan - a proxy for short-selling interest - in names such as Nissan, Honda and Canon has surged in recent weeks.
September is prime dividend season for many Japanese quoted companies, which might account for some, but not all, of the uncharacteristically high interest, David Lewis, Astec's senior vice-president, said.
"The activity at Nissan, for instance, doesn't correspond with the dividend dates. If you look at a European stock like Royal Dutch Shell or Siemens, you can see exactly when the dividend is being paid because of the peaks in on-loan balances," Lewis said.
Nissan is due to pay a dividend on Sept. 30, but on Sept. 27 there were 105 million Nissan shares out on loan, against 83 million shares in September 2011.
"There's clearly some negative sentiment expressed against Japanese stocks and positions being taken that do not fit with normal dividend arbitrage activity," Lewis said.
While most experts agree that the chances of a military clash remain slim, some investors see signs of permanent damage to ties linking Asia's two biggest economies.
Even Japanese fund managers who insist that the country's long-term prospects remain undiminished by the spat are bracing for uncertainty in the near term.
"In the short term, it may be hard for us to say that the Chinese economy and the Japanese economy and the relationship between the two countries will get better," Shigeru Oshita, senior investment officer at Sumitomo Mitsui Trust Group, told Reuters through an interpreter.
Economically, the war of words between Japan and China over the East China Sea islets, is undoubtedly having an impact.
A Reuters Poll conducted between Aug. 31 and Sept. 14 found that 41 percent of Japanese companies saw the conflict upsetting their businesses, with some weighing up exiting China completely.
Talks to set up a free-trade zone between China, Japan and neighbour South Korea also stalled this week, delaying an initiative to insulate the region from the global downturn.
Fund managers familiar with investment in the region have learnt to live with routine squabbles between Asia Pacific powers, but this episode feels more parlous than most.
"You could argue that you can't price in this kind of risk, but nor can you price the risk of North Korea sending a nuke into South Korea tomorrow," the U.S. fund manager who specialises in Japanese equities said.
"The markets have learnt to shake this off. But this feels new and we haven't become immune to this yet."
Not everyone is preparing for the worst. Other investors said that China is unlikely to escalate the dispute because it would hurt its economy just as deeply.
Mike Turner, head of strategy and asset allocation at Aberdeen Asset Management, said that his concerns about Japan stem more from unfavourable demographic trends and a slowing global economy than any risk of war.
"I doubt they would go that far because of the state of the global economy and global trade. It would be cutting off the nose to spite the face," Turner said.