Pacific Tensions: Potential Tinder Box

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

The Trade Card
This is different than the 2012 "nationalization" of the Senkakus/Dianoyus 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, rathera response 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 is a move by China to take back Zhongye Island (Thitu), which is the second largest of the Spratly Islands, occupied by the Philippines. The Philippines 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 on Qianzhan.com, which spoke of a "Sudden major move of Chinese troops this year to recover Zhongye by force". The report says 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 that a Chinese move would quickly escalate.

Nothing Is Certain
Nor is the veracity of the reports certain in an environment that may simply be more of the same: posturing. That said, 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 navel 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 non-status quo power makes for a potential tinder box of momentous proportions.