Pacific Tensions Set to Intensify

The simmering tension in the South China Sea may intensify in the coming weeks, and although this is no immediate market reaction, there could be going forward.  Last week Japan indicated that it will formally register 280 islands it claims as part of its territory. Many of these are very small islands and some don’t even have names. Nevertheless, China, Taiwan and others have conflicting claims.

This is different than the 2012 “nationalization” of the Senkaku/Diaoyu islands, but China is unlikely to let this pass without responding.   During this dispute, China’s responses have been asymmetrical in the sense that its reaction is not so much a direct offset, but responds on a different front. For example, China has played its trade card, first in rare earths, then in the sale of Japanese goods in China. It countered Japanese patrol ships with claiming an air defense notification zone.

 

Among the asymmetrical responses being considered reportedly is for China to take back Zhongye Island (Thitu), which is the second largest of the Spratly Islands, occupied by the Philippines.  The Philippines have recently announced a military build-up on the island with new air force troops.  Local press has quoted Chinese officials saying that the Philippines are demonstrating “intolerable” arrogance, relying on US support.

 

The China Daily Mail translated a report from Qianzhan.com: “Sudden major move of Chinese troops this year to recover Zhongye by force”.   The report says that officials indicating that the Chinese army has drawn up detailed plans to take the island.  Officials quoted suggest a limited campaign that would not include the Philippines itself.    It is not clear a Chinese move would not quickly escalate.

 

It is not immediately clear the veracity of the reports and what is simply posturing, but investors should monitor developments closely.     Chinese President Xi Jinping has launched reform of military and a recent op-ed piece put it in the context of strengthening China’s ability to respond to US “aggression” in Asia-Pacific.  Last October, China sent a surveillance ship into Hawaiian waters for the first time.  This was seen a retaliation for US naval presence in the East China Sea, according to reports.

 

From a macro-economic point of view, we see the Philippines as somewhat better positioned within emerging Asia. In terms of security, the US and the Philippines have a mutual defense treaty.  Over the past few months, Japan and the Philippines have strengthened military ties.  Separately, last week  India and Japan announced plans to consolidate and strengthen their strategic military ties.  Some observers are comparing 2014 to 1914.  While we are generally skeptical, the numerous and conflicting territorial claims in the East and South China Seas and the rise of a non-status quo power  makes for a potential tinder box of momentous proportions.

 

This piece is cross-posted from Marc to Market with permission.