Recent leadership changes in China and Japan may put the two countries on the path to extended conflict.
Any significant conflict between Asia’s two largest economies should be a major concern for investors around the world. While U.S. investors have been distracted by the ongoing political drama around the ‘fiscal cliff’ strident nationalists have recently become leaders in both China and Japanthat significantly raises the risk of a real conflict in North Asia—just when the global economy does not need it.
Currently China and Japan are engaged in a dispute over a collection of small uninhabited islands in the East China Sea (which China calls the Diaoyu islands and Japan calls the Senkaku islands). Both countries believe the islands are part of their territory.
According to Chinese studies there are between 1 and 2 trillion cubic feet of natural gas and up to 100 billion barrels of oil in the area around the islands. The conflict over sovereignty of the island began after the release of these surveys.
New leaders in both countries are likely to exacerbate tensions. Both Shinzo Abe, head of Japan’s Liberal Democratic Party elected Prime Minister over the weekend, and Xi Jinping, expected to be appointed President of China in the coming months, are very nationalistic.
While the conflict is expected to negatively impact both countries in the long run Japan in expected to suffer more near term. The dispute has already had a severe impact on the sale of Japanese goods (especially autos) in China due to anti-Japan protests surrounding the dispute. Twenty percent of Japan’s exports go to China and China is the largest market for Japanese goods. In September exports to China from Japan plunged 14% YoY as the conflict over the islands escalated.
Due to concerns over security and the boycott of Japanese brands Japanese investment in China fell 32.4% in October.
Markets have indicated the situation may be easing as the performance of both Japanese and Chinese stocks negatively impacted by the conflict posed a strong recovery starting in late November. In late September it appeared that the turmoil surrounding the conflict peaked as Internet searches performed in China for the key word “Japan” peaked. Since then these searches have fallen but remain at elevated levels, indicating the Chinese remain very focused on the conflict.
While it is clearly not in anyone’s long-term interest to have this dispute escalate into a shooting war it is certainly possible that an accident could occur during this period of rising tensions. Global investors would be wise to keep an eye on the East China Sea in the coming weeks.