Employees of Japan's microprocessor maker Renesas Electronics work at the company's Naka wafer fabrication factory in Hitachinaka, Ibaraki prefecture. A new survey by the Japanese central bank has found sagging confidence among manufacturers as the nation continues a territorial dispute with China. - 

The Bank of Japan's annual Tankan survey reveals that Japanese business sentiment is growing more pessimistic among manufacturers. Non-manufacturers -- those in the service and retail sectors -- are feeling a bit more buoyant.

"Manufacturing output here fell by 1.3 percent in August, that's much more than was expected," says Rupert Wingfield-Hayes, the BBC's correspondent in Tokyo. "Japan's economy -- certainly its famous manufacturing economy -- is seeing quite a dramatic slowdown. There are fears here that Japan could fall into recession."

The manufacturing slowdown in Japan comes as the nation continues to feud with China over who owns the uninhabited Senkaku Islands.

"In the last few years, China has become Japan's No. 1 export market, so political fallout -- if it continues to be serious -- could have really big knock-on effects for the Japanese economy. Chinese people at the moment simply don't want to go out and buy Japanese products," says Wingfield-Hayes. "There's a real potential for a problem for Japan from this island dispute."

Follow Jeff Horwich at @jeffhorwich