By setting up shop inside China, where some 95 percent of the world's rare earths are produced, manufacturers can obtain the metals on the cheap and then export the finished products outside the quota system.
Such a shift in production, which companies are only beginning to explore, could leave miners that are developing new sources of rare earths outside China scrambling for customers.
Analysts also expect the move to lead to a leak of technology behind Japan's strategic high-tech products, particularly sophisticated magnets used in hybrid cars, now produced by only three companies in Japan.
"China is eyeing the valuable know-how foreign companies will bring into joint ventures with Chinese firms to gain access to rare earths," said a Japanese trading company official, who asked not to be identified. "Obviously, Japan's technology to produce high-end magnets is a target."
A move into China could topple Japan's technological supremacy and further damage its manufacturing sector, already reeling in the wake of this year's earthquake, tsunami and nuclear crisis.
At the same time a crippling of the nascent rare earth sector outside China could jeopardize the long-term supply of the group of 17 technology metals.
Rare earths are used to make magnets that are smaller and more powerful than traditional magnets, making them crucial to streamlined products such as smartphones and tablet computers.
The main ingredient in these magnets is neodymium oxide, which costs $217/kg in China and $370/kg in the rest of the world. Neodymium oxide was worth just $27/kg in 2008, a near 14-fold increase in three years.
Rare earth prices have skyrocketed as China repeatedly slashed export quotas, cutting shipments outside the country to 30,184 tonnes in 2011 from about 60,000 tonnes in 2007.
That has prompted Hitachi Metals, the world's top high-powered magnet maker, to contemplate moving production of its neodymium-based magnets to China and the United States, where a massive rare earth mine is set to reopen in 2012.
Neo Material Technologies, a Canadian rare earth company that operates in China, has started up a joint venture inside China with one of its Japanese customers to produce a rare earth-based glass product.
Showa Denko KK, a top rare earth alloy producer, recently announced it would boost output at its Chinese joint venture by 50 percent to 3,000 tonnes a year, upsetting Japan's trade ministry.
"Given the soaring rare earth price, higher production in China, at least for the portion of our exports to the country, is a reasonable decision," said a Showa Denko official in defense of the move. The company will continue to produce its premium magnets, used in hybrid cars, in Japan.
Japan, grappling with the strong yen, high corporate tax, a power shortage and a shrinking population, has already seen some of its manufacturing sector shift output abroad.
With rare earth demand set to grow rapidly in the next few years as electric cars, wind turbines and smartphones gain market share, China is expected to keep a tight grip on its own supply, raising the ire of neighboring Japan.
In July, China expanded the scope of its export quotas to include low-grade rare earth alloys. Although higher-end processed alloys remained outside the export quota system, there is speculation those alloys are next.
"It would be a serious problem for manufacturers in Japan if exports of high-value alloy are squeezed," said Kaz Machida, president of rare earth consultant KAY Investment Ltd.
In an effort to keep technology manufacturers in the domestic market, Japan's Trade Ministry is spending 54 billion yen ($704 million) to encourage companies that use rare earths to set up supply chains and develop recycling technologies.
But with no significant supply of rare earths expected outside China before 2013, analysts say the production move by Hitachi and Showa Denko could indicate the beginning of a mass exodus of technology manufacturers from Japan.
"If the differential between the export price and the domestic price continues as it is, I think we're going to see a lot more people following suit," said Asian Metal analyst Brandon Tirpak. "It's like the big fish, when it starts moving then all the others follow."
At the Mountain Pass mine in the Mojave desert region of California, construction is well underway on the modernization of the historic rare earth project.
Molycorp, the Denver-based company that owns the project, plans to have the mine and new processing facilities online by 2012. It plans to eventually produce everything from separated rare earth oxides to high-powered magnets.
But Molycorp, along with Australia's Lynas Corp and Canada's Great Western Minerals, could be left hanging if their potential customers keep moving production to China at the current pace.
In order to compete with the Chinese, Western rare earth producers need to bring supply online quickly and sign deals with Asian companies to gain the critical know-how to process to end-user specification, analysts said.
On Friday, Hitachi Metals announced that it had reached a supply deal with Molycorp on materials for its neodymium-based magnets, but said it would not pursue a joint venture with the U.S. company to produce rare earth magnet alloys.
The other big hurdle for would-be miners is price.
"The Japanese want to collaborate with North America, but they don't want to do it at these prices," said Jacob Securities analyst Luisa Moreno. "The prices right now are just unrealistic."
Japan's rare earth market is expected to shrink by 30 percent in this year alone, due to the flight to China. The trend is expected to continue until prices outside China drop.
"Japanese production is moving to China faster than I've ever seen in the past," said Neo Material Chief Executive Constantine Karayannopoulos. "We may be witnessing a fundamental restructuring of the global rare earth supply chain."