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

GPSBLOG_2014_09_17

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.

We Read (And Liked)… China Goes Global: The Partial Power

Investors are faced with disparate conclusions about whether China is a truly global power.

According to David Shambaugh’s comprehensive look at Chinese power and its current role in the international system,* China remains a partial power that will continue to struggle advancing its foreign policy preferences within the existing global order.** Shambaugh uses the term partial power to explain that while China’s importance in areas such as global commerce and energy markets is very large, it remains a limited power in terms of its diplomatic reach, cultural influence, role in global governance, and security presence on the global stage. We agree with this nuanced take on the rise of China.

Shambaugh’s most important finding is that Chinese policymakers are being forced to advance the country’s domestic and foreign policy priorities within a global system that is based on liberal rules and norms designed by America in the post-Cold War era. This is a problem because Chinese cultural and political beliefs are opposed to many of the current rules and norms of the game. China is also suspicious of today’s architecture because it was designed by Western powers when China was weak and incapable of influencing outcomes. The stage is therefore set for a revanchist power to take on the declining hegemon.

As a result, China will continue to engage with other states and international organizations only if the result of their engagement directly impacts their strategic interests. As China grows more powerful, it could become more resistant to the institutions and practices that have underpinned the global economy for the past few decades – such as the World Trade Organization or the IMF. In fact, Beijing is likely to attempt to erode those institutions actively whenever the opportunity is at hand. This will create more uncertainty for global investors, as well as opportunities to profit from changes in geopolitical landscape.

Some analyses contend that Chinese power is understated and that the international system will be increasingly shaped by Beijing in the near future. Others argue the opposite, that China is years away from seriously influencing global affairs. Which view is correct? Does it matter?

The second source of uncertainty investors will need to grapple with comes from within China itself. Shambaugh does a good job describing the inconsistencies and opaqueness of the Chinese foreign policymaking process. For instance, after explaining the various actors and bureaucracies that influence Chinese foreign policy, Shambaugh contends that China’s national security decision-making process is “unclear, uninstitutionalized, and unregulated.” This is concerning.

The growing presence of the U.S. military in the region, along with the multitude of calls coming from China’s neighbors for a more assertive American footprint in Asia, will increase the importance of understanding if, how, and when China will react. Unfortunately an opaque policymaking process makes that exercise very difficult. The result is, as we have been arguing at the Geopolitical Strategy for some time, a growing probability that investors are caught off-guard by Chinese response to American strategy of containment.

* Shambaugh, David (2013). China Goes Global: A Partial Power. New York: Oxford University Press.
** David Shambaugh is an international authority on Chinese domestic politics, foreign policy, and international relations in Asia. He is currently the Director of the China Policy Program at George Washington University.