East Asia Blues: South China Sea Is Not Going Away Folks

A poll of BCA Research Investment Conference attendees suggested that most investors are worried about Russia and the Islamic State, but investment-relevant risk remains in East and Southeast Asia.

I just got back to our Montreal HQ after two days at the BCA Research Investment Conference in New York. It is always great to catch up with old friends and make new ones at our annual event. It is also always an honor to share the same stage as our invited guests and my colleagues.

It is a tradition at our conference to ask the audience a few questions before we begin each panel. I began my Geopolitical Update presentation with two simple questions: which geographical region do you expect to produce the most investment-relevant risk in 2015; and do you think geopolitical risk will increase, decrease, or stay the same in 2015?

Unsurprisingly, a majority of the audience expected geopolitical risk to increase in 2015. No arguments there. But when it came to selecting the source of that risk, most of our clients and invitees expected it to come from Russia (first choice) or the Middle East (second choice). Only 14% respondents thought that East Asia would produce market-relevant geopolitical risk next year.

Here I respectfully – and considerably – disagree with our clients. While the probability of more tensions and noise from Russia and the Middle East remains high, the market impact of the two regional crises will likely remain muted. Meanwhile, East Asian geopolitical tensions continue to mount. The more investors ignore this region, the greater the likelihood that the market will be blindsided by a crisis.

Take this New York Times article from September 13 which reported that Malaysia had offered the U.S. a base from which to fly surveillance aircraft over South China Sea. The claim remains unconfirmed by Kuala Lumpur, but fits the pattern we have come to expect in the region where China’s neighbors are increasing military cooperation with the U.S.

The airplane in question, the P-8 Poseidon, is currently flown out of the American Kadena Air Base in Okinawa, Japan. A P-8 was recently ‘buzzed’ by a Chinese Shenyang J-11B Flanker B air-superiority fighter, causing a minor incident. Chinese officials went on the offensive soon after, publically warning the U.S. national security adviser Susan E. Rice, while she was visiting Beijing, that the Obama Administration should stop the “close-in” surveillance flights. The warning is unlikely to alter American planes to deploy (a lot) more P-8s to the region, with Boeing set to produce approximately another 100 planes for the U.S. Navy.

The U.S. uses the P-8 Poseidon aircraft to spy on China, and its submarine fleet in particular, from international waters. Washington’s claim is that its aircraft can operate within international waters beyond the immediate 12-mile territorial line. China, on the other hand, claims that foreign aircraft are not allowed to fly within the 200-mile exclusive economic zone without permission. The difference in views is further accentuated by China’s claim to nearly all of South China Sea.

The reason I am highlighting this news item is because Malaysia is not an obvious candidate to join America’s containment of China. Kuala Lumpur does have a territorial dispute with China – James Shoal, only 22 miles off the coast of Malaysian state of Sarawak (Borneo) – but the issue has not soured relations between Beijing and Kuala Lumpur thus far. Malaysian public also has the most unfavorable views of the U.S. out of the major East Asian countries (Chart 1), suggesting that there could be a domestic political constraint to closer military relations with Washington.

 

Malaysia: Not An Obvious U.S. Ally

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Malaysia is a ‘litmus test’ for our Geopolitical Strategy theme that East Asia geopolitical tensions are rising. In other words, if even Malaysia is joining the anti-China coalition that America is building in East Asia, then our view that things will get worse in the region is probably right. Russia and Iraq are certain to continue to make noise in 2015, but it is difficult to see how either produces major, and global, market-moving risks other than in a few unlikely scenarios. East Asia, on the other hand, could blindside investors precisely because nobody is paying attention to it.

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