China and Japan are edging closer to a significant conflict, ostensibly over a small set of rocky islands known as the Senkaku Islands in Japan and the Diaoyu Islands in China. Both nations lay claim to the uninhabited islands. This dispute began to escalate in 2012 and reached a new high with China’s imposition of an Air Defense Identification Zone (ADIZ) that includes the islands and overlaps Japan’s defense zone.
While the islands are the flashpoint, there are further undercurrents of tension with economic and military overtones – China is not pleased with what it sees as increasingly nationalistic and militaristic goals of Japanese Prime Minister Shinzo Abe, and Japan resists the increased economic power and territorial expansion from China.
At this point, the tension between the two nations has not had as much impact on the global economy as it has on the respective economies of the two nations. Japanese stocks have been disappointing in 2014, ensnaring some investors who expected the astonishing 57% gains of 2013 to continue. Chinese stocks have been on a slow decline since a minor recovery at the beginning of 2010, and the Chinese economy has been slowing overall.
Economically, both countries need each other. China is Japan’s key trading partner. 2014 year to date numbers show $90 billion in imports from China – more than from any other single nation – and exports of $61.7 billion, second only to the $63 billion exported to the US.
For the moment, the tension has limited effect on the US stock market, except to produce general jitters. But what if things escalate to the point of armed conflict?
The US is obligated to defend Japan should hostilities break out, and President Obama reiterated this during his trip to Japan earlier this year. Yet he stressed that America does not take a position on the sovereignty of the disputed islands and that this is Japan and China’s dispute to work out through dialogue, not through military actions.
Undoubtedly, this is to avoid pushing China into economic retaliation, which could be considerably damaging to our own economy. In 2013, the US imported $440 billion of Chinese goods, and exported $121 billion in goods to China. Chinese production facilities of US companies provide another leverage point, and raw materials for US companies are a further concern. For example, China produces the vast majority of the world’s rare earth metals, used in everything from high tech batteries and magnets to weapons-guidance systems and night vision goggles to fundamental catalysts for chemical reactions. Interruption in supply of raw materials, intermediates, or products for affected companies will drive down income and earnings – and therefore, the stock.
Boycotts, tariffs, and supply disruptions are not the only economic weapons available. Consider the staggering amount of American debt that both countries hold. Foreign countries hold slightly under $6 trillion of our $17+ trillion national debt. As of May 2014, China held $1.27 trillion and Japan held $1.22 trillion – over 40% of the combined total.
Either side – or perhaps both – could try to use this debt as economic leverage against American positions by dumping off their Treasury holdings. They would damage their own economies in doing so – especially China, since the Yuan is linked to the dollar – so this would more likely be used as a threat than as a policy.
In summary, the effect on investors is limited now to specific stocks that depend on China or Japan for significant production, sales and distribution, or raw materials – but escalation could produce bad news for investors in unpredictable ways, depending on how China and/or Japan gauge our response and react to it. Results could be anything from a collapse in the dollar to a manufacturing and trade crunch leading to overall recession.
With overlapping defense zones and increased maritime encounters, it is increasingly likely that an unfortunate mistake or misunderstanding could spark a conflict that could rapidly escalate, resulting in worldwide economic damage. Let’s hope that our leaders have the dexterity to keep navigating the current diplomatic tightrope, and eventually lead China and Japan away from conflict and toward a mutually beneficial economic relationship – for our sake as well as theirs.