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Sino-Japanese tensions over some tiny islands in the East China Sea are a salutary reminder that fast-growing Asia’s many geopolitical flashpoints can erupt suddenly and with meaningful economic impact. Daniel Ben-Ami delineates the risks – but finds them difficult to manage

Asia has more actual and potential flashpoints than a public fireworks display.
 Simply listing them all would take up a large part of this article. They range from long-standing military enmities, such as the conflict between the two Koreas, to angry disputes over islands that few could find on a map.

Military spending in the region is also rising. According to The Military Balance 2012, a definitive study by London’s International Institute for Strategic Studies, it is likely to have exceeded that of Europe during 2012. To underline China’s surging military expenditure, the US Department of Defense has published its annual report to Congress on the subject for over a decade.

Yet such facts and figures should be put in their proper context. East Asia and South Asia combined account for over a half of the world’s population and more than a quarter of its economic output. It includes demographic giants such as India, Indonesia, Pakistan and Bangladesh as well as economic behemoths such as Japan. China clearly fits into both categories. Military spending is still well below European levels when measured per head of population – and, moreover, the parties involved are also well aware that outright conflict would bring high costs.

To develop a balanced view of this topic this article will start by examining the recent dispute between Japan and China over the Senkaku/Diaoyu/Tiaoyutai islands in the East China Sea. They are given these different names in Japan, mainland China and Taiwan, respectively. It will then go on to examine other disputes in the region, including some that are active and others that are dormant but could reignite. In conclusion it will assess the likely economic and investment impact of these tensions.

Buyers’ strike
The Senkaku/Diaoyu dispute was at the forefront of the minds of all the Asia experts IPE spoke to for this article. It involves both of the largest economies in the region as well as raising the question of how the US relates to such conflicts.

Its effect is also actual rather than hypothetical. Japanese exports to China have plummeted in recent months as a result of the row. Maarten-Jan Bakkum, an emerging markets strategist at ING Investment Management, says that this is  “clearly a buyers’ strike that has hit Japanese industry very hard”. Peter Elston, the Singapore-based head of Asia-Pacific strategy at Aberdeen Asset Management, notes that Japanese consumer brands such as Canon have been hit particularly hard by the row – but he adds that such impact “never tends to be that big or that lasting”, contrasting the spike in crude oil prices in response to the latest Gaza flare-up in the Middle East.

Examining the dispute can also help to develop a framework for examining many of the other conflicts in the region. China’s rising power is central to understanding the geopolitics, as are America’s reactions to it. Even when China is not in the forefront of regional disputes, it is often, as in the case of the Korean peninsula, in the background.

The Senkakus/Diaoyus dispute dates back at least as far as the early 1970s when the administration of the islands was transferred from the US to Japan. They had come under American control at the end of the Second World War, while Japan had formally annexed them in the late nineteenth century. The recent spat began in April. Shintaro Ishihara, a hawkish nationalist who was then governor of Tokyo, gave a speech saying he wanted the Tokyo metropolitan government to buy three of the islands that are privately owned. As the dispute escalated, the Japanese government, in an apparent attempt to calm the dispute, decided to purchase the islands itself.

China reacted furiously. There were street demonstrations as well as diplomatic protests.
The Chinese authorities encouraged a boycott of Japanese goods while also sending warships into the Japanese waters around the islands.

For many commentators this was just part of the normal to-and-fro of turbulent Sino-Japanese relations – the sort of thing that blows up when senior Japanese leaders visit the Yasukuni shrine that honours Japan’s war dead, for example. But other experts see the latest spat as representing a serious escalation in tensions.

Disaffection
Duncan Innes-Ker, a Mandarin-speaking Asia economist at the Economist Intelligence Unit, argues that China has consciously moved its position on the issue. “A lot of people in the Japanese government probably didn’t realise China would take this as such a strong provocation,” he says. “The Japanese government has, in many ways, dug itself into a hole that it is difficult to get out of.”

In broad terms, there are two ways in which the dispute is generally explained. One points to the existence of large oil and gas reserves in nearby waters. Innes-Ker thinks this is overstated. “We live in a global word where resources are traded,” he observes. “In practical terms, ownership is not that important.”

The other view is to see the conflict as a reversion to a form of pre-war nationalism. Innes-Ker points out that in China there is a strong “sense of righting historic wrongs”.

However, although such disputes often refer to history, they are rooted in contemporary developments. John Swenson-Wright, a senior lecturer in Japanese studies at Cambridge University, says that Japan sees China’s intervention as “part of a larger process to challenge the limits of Japan’s maritime sovereignty”.

In his view, the gap between more nationalistic politicians, such as Ishihara, and the moderate mainstream has compounded the problem. Ishihara acted as “a lightning rod for public disaffection with mainstream politics”. Although Ishihara’s views only represent a minority, there is a widespread sense that central government is ineffectual. So political tensions in Japan have inadvertently spilled over into bilateral relations with China.

Despite these tensions, both the Chinese and Japanese governments recognise the dangers of the conflict escalating too far. Both are led by governments that ultimately tend to put practical considerations to the fore.

Pivot
The conflict between Japan and China, in turn, raises questions about the US role in the region. America is obliged to come to the defence of Japan under a mutual security treaty. However, the US has taken a slightly ambivalent stance on the disputed islands.

America is keen to retain its role as an important player in the region. Indeed, for the past two years the Obama administration has talked of a ‘pivot’ to Asia in which its foreign and security policy puts more emphasis on the region. It is playing a delicate balancing act. On the one hand it wants to stop Chinese power becoming, in its view, excessive. At the same time, it does not want to unnecessarily antagonise an important economic power that also has growing political clout.

Although all the conflicts in the region have their peculiarities, many of the themes and trends apparent in the Senkakus/Diaoyus dispute recur. Most obviously, there is the impact of China’s rise as a substantial power on Asia’s geopolitical balance; and the counterbalancing influence of the US in the region.

China has benefited immensely from the current set-up in international relations. In addition to China’s growing economic clout, its capacity to project its influence when it desires is increasing. If it decides to dispatch warships, for instance, it has an increasingly powerful navy at its disposal. It has even recently acquired an ex-Soviet aircraft carrier that it has extensively refitted.

In many respects, other countries in the region can be seen as caught between the two powers. China is typically their most important economic partner, while the US remains the pre-eminent global military force. Much foreign policy in the region is therefore directed at trying to find the right balance between these two potentially awkward giants.

As June Teufel Dreyer, a professor of political science at the University of Miami, Coral Gables, told a recent webinar organised by the Foreign Policy Research Institute: “Asian countries [are] playing a very unproductive hedging game because, on the one hand, they want the United States to defend their security. On the other hand, they depend on China for a fair amount of their prosperity.”

Of the other disputes in the region, the one that most closely resembles the Senkakus/Diaoyus row is the conflict over several other groups of islands in the South China Sea. Although claimants to these nominally include Brunei, Indonesia, Malaysia and Taiwan, the tensest disputes are between China, on the one hand, and Philippines and Vietnam on the other.

Amicable
Once again, many countries in the region seem to fear and resent China’s rising power. Vincent Wang, a professor of political science at the University of Richmond in Virginia, even argues that a “low intensity conflict” between the Vietnamese and Chinese navies cannot be ruled out.

And then, of course, there is the divided Korean peninsula. At first sight, the conflict between the two Koreas seems a world away from the island disputes, but there are some similarities. It is certainly true that since the bloody war of the early 1950s the two sides have faced each other with considerable military forces. The US has maintained close ties with South Korea, which has grown into a prosperous market economy, while China has maintained links with the North.

For the time being, the peninsula is relatively quiet. North Korea, under its new ruler Kim Jong-un, the latest in the Kim dynasty, is facing severe internal economic dislocation.
Meanwhile, the US State Department has removed North Korea from its list of state sponsors of terrorism and China is trying to push North Korea to accept Chinese-style market reforms. The hope is that by becoming more market-oriented it will become less prone to erratic actions.

Moving further west, even events in South Asia can be largely set against the context of US-China relations. As far back as the George W Bush administration, the US was actively courting India as a counterweight to Chinese power. However, the drive to strengthen American relations with India also clearly relates to the South Asian giant’s western flank. Pakistan is widely viewed as highly unstable both by foreign policy experts and by fund managers. It is also closely bound up with the conflict in neighbouring Afghanistan.

While Pakistan represents one of the worst trouble spots in the region, there is also some good news. In particular, relations between mainland China and Taiwan – which in the region are referred to as ‘cross-strait relations’ – have become more amicable as economic and financial ties improve. “China is melting Taiwan into its system,” as Anthony Chan, an Asian sovereign strategist at AllianceBernstein in Hong Kong, puts it. By this he means that the trajectory seems to be towards peaceful cooperation.

This survey is far from a comprehensive account of all the tensions in the region. Among others are piracy in the Strait of Malacca, an Islamic insurgency in the Philippines, as well as a recent dispute between Japan and Russia over the Kuril islands. There are also questions over Indonesia’s rising power and on how Australia should relate to Asia.

Nevertheless, it is now possible to sketch the likely economic and investment impact of such tensions. Clearly these will depend on the extent to which conflicts are contained.
Top-down fund managers are also likely to focus more on such questions than those who take a bottom-up approach.

Wrong-footed
One thing that is certain is that Asia has become far more important in the world economy over the years. Not only does it have a much larger share of global output but it is also more closely integrated with the global economy. Asia’s share of global trade almost doubled between 1980 and 2010. Asian countries also hold a substantial proportion of US federal debt, with mainland China and Japan together, the two largest investors, amassing over $2trn.

It should also be remembered that there are some beneficiaries from regional tensions as well as losers. “Indonesia and Thailand can get more Japanese investment if Japan does not sort out its relationship with China”, as INGIM’s Bakkum points out.

Elston at Aberdeen is sceptical about the ability of fund managers to play these trends. He accepts that geopolitical developments can affect portfolios by hitting both markets and individual stocks, but says that by their nature they are highly unpredictable. “It’s just not worth trying to factor these things into portfolio strategy,” he argues.

However, he also notes that even bottom-up fund managers can sometimes take advantage of geopolitical developments when markets over-react to conflicts. “In our experience, when you get these mini-panics in markets that are a result of political unrest they tend to be good buying opportunities,” he says.

He concedes that, in the case of the Senkaku/Diaoyu islands, for instance, this has meant at least taking an implicit view that the situation will improve. In many, probably most, such cases those optimistic assumptions are likely to be proved right and while in the event of a concerted flare-up there is always the possibility of being caught wrong-footed, even the best-informed top-down managers are likely to struggle to predict such developments accurately: how many investors who were focused on South China Sea tensions were caught off-guard by the sudden and economically damaging Senkakus/Diaoyus dispute, for example?

From an investment perspective there are no easy ways to respond to the multiplicity of Asian tensions. Perhaps the best approach for most investors is to be aware of the broad contours of geopolitics while avoiding over-reacting to short-term trends. In most cases, conflicts will be contained as there is a strong shared interest in international co-operation. But there is always the possibility that disputes will occasionally get out of hand.

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