My Report from East Asia

This week, Elisabeth and I are in Tokyo, visiting our son Anthony who’s been working here for the past five years.

Japan is 8,000 miles and 13 time zones from our home in Florida. But whenever we ask Anthony why he must live so far away, his tongue-in-cheek response is always: "It’s your fault. You’re the one who got me here."

True. Back in 1989, soon after we founded an elementary school in Palm Beach County, we decided to teach Japanese as the main foreign language. Anthony was our first student and he later chose Japanese as his major in college. And now if we get to see Anthony twice a year, we feel fortunate.

This particular voyage, however, has been fruitful in many other ways as well. It gave me the opportunity to explore, directly and on site, some of the possible black swan events that could be striking around the world, including …

• a banking disaster waiting to happen in Italy (click here for the video or here for the transcript)
• the millennial conflicts now converging in Turkey (video, transcript) and
• hidden instabilities on the Arabian Peninsula.

But in terms of their potential impact on investors, those disputes are no larger than the simmering conflicts here in East Asia; and I’m certainly not the first one to warn our readers about them.

Indeed, for many years, Money and Markets editor Larry Edelson has written that they are volcanos waiting to erupt, with multiple countries in East Asia making conflicting and overlapping territorial claims.

How serious is it? I’ve traveled extensively to nearly every one of those countries — especially China, Vietnam, the Philippines, Taiwan, where I was last week, and Japan, where I am now. And I can tell you with a high degree of confidence: Some of those eruptions are now closer than they’ve ever been since World War II.

Like the Middle East and North Africa, this region is riddled by overlapping conflicts in multiple areas, on multiple dimensions and with a wide diversity of players — all posing real threats to the global economy.

• In the South China Sea, serious territorial conflicts are brewing between China and other Asian nations over the Spratly and Paracel Islands.
• In the East China Sea, the primary protagonists are China and Japan, sparring over the Senkaku Islands (Diaoyutai in Chinese).
• And on the Korean Peninsula, the emergence of the North as a serious nuclear power is bursting into the headlines with shock and awe.

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But anyone who sees these disputes as strictly territorial or political is missing the forest for the trees. In reality, the disputes are just symptoms of three underlying megatrends:

Megatrend #1. Military Resurgence

In China, the People’s Liberation Army, with about one million more service members than the U.S. military, is being upgraded in one of the largest modernization drives of all time.

According to the U.S. Department of Defense, as recently as 2000, less than 10% of China’s army, navy, air force and air defense services was "modern," i.e, "multi-mission platforms with significant capabilities in at least two warfare areas." Today, that modernization metric ranges from 30% to 60%, depending on the service.

North Korea, despite its small population, has the largest miltary/paramilitary force on Earth — a total of 7.7 million, or more than double China’s. And even in terms of active military personnel, North Korea ranks fourth in the world, surpassing Russia.

In recent years, while the U.S. and its allies were busily negotiating a deal with Iran to delay the development of its nuclear capabilities, North Korea was busily building its nuclear stockpile with no effective response from the West.

And now, with its recent successful tests of nuclear warheads and medium-range ballistic missles, it already has the capability to wipe out Seoul or Tokyo.

In response, Japan is moving as swiftly as it can toward shedding every one of its postwar restrictions on militarization. And we see similar trends throughout Southeast Asia.

Megatrend #2. Hardening of Alliances

East and Southeast Asian countries are now scrambling to build stronger alliances and draw deeper lines in the sand. We see …

• Vietnam aligning itself more closely to Japan to counter China …
• China holding major joint miltary operations with Russia to showcase its defiance of the U.S. and …
• The U.S. seeking to tighten its knots with South Korea, Japan and even Vietnam.

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Megatrend #3: Looming Economic Battles

First and foremost, the disputes in the South and East China Seas could threaten one of the world’s largest shipping routes.

This is where a massive $5 trillion in goods are transported every year. It’s responsible for 80% of China’s crude oil imports plus nearly 60% of the energy supplies used by Japan and Taiwan.

Why does this matter to you?

Because China and Japan would be directly impacted. Because China and Japan are the second- and third-largest economies of the world. And because their troubles could do two things: (1) immediately drive more flight capital to U.S. markets and (2) ultimately drag down the global economy.

Second, a stronger Sino-Russian alliance poses new threats to the United States — not only militarily, but also via cyber espionage, cyber warfare and other vehicles to achieve dominance in technology and global trade.

And never forget the third economic weapon in China’s arsenal: money. China has more cash in the bank in the form of foreign currency reserves (mostly in U.S. dollars) than any other nation.

Precisely how it will wield this power remains to be seen. But it’s well recognized, both on Wall Street and in the White House, that just minor shifts in China’s portfolio of U.S. government securities could drive U.S. bond yields skyward.

Conclusion: No matter how we may want to ignore them, deny them, or simply wish them away, all three of these megatrends are, without a doubt, exactly what Larry has called them:

Winds of War

How aggressive might China be? For a hint at the answer, let’s take a closer look at its recent actions in just one of the disputes we’re talking about — the South China Sea and the Spratly Islands (see map below).

Among all five countries involved in the dispute, China is claiming the largest area, as defined by its "nine-dash line." In fact, China’s demarcations encompass almost the entire South China Sea.

China insists that both the Paracels and the Spratlys are — and have been — an integral part of China. What’s equally surprising is that, despite decades of conflict with the mainland, Taiwan now agrees.

Vietnam vehemently disputes China’s claims. The Vietnamese authorities argue that China didn’t claim the islands until the 1940s, while Vietnam has claimed both the Paracels and the Spratlys since the 17th century.

Complicating the picture, the Philippines and Malaysia also say that some of the Spratly Islands are theirs, while both Malaysia and Brunei argue that portions of the South China Sea fall within their economic exclusion zones — not China’s.

It’s a miserable mess, which even the Permanent Court of Arbitration in The Hague has been unable to unravel. And believe me, they tried. The court has:

• Declared that China’s so-called "nine-dash line" is absolutely invalid …
• Ruled that none of the Spratly Islands are large enough to create an Exclusive Economic Zone (EEZ) or continental shelf of their own, and
• Flatly rejected every argument that China has made, drastically reducing China’s maritime rights in the Spratly chain of the South China Sea.

International observers unanimously describe the ruling as an overwhelming defeat for Beijing; a game changer for Asian maritime disputes.

But ironically, precisly because the ruling was so sweeping, it’s unlikely to have any real impact. To understand why, consider China’s immediate reaction:

It explicitly declared it’s going to totally ignore the ruling.

It reinforced its aircraft hangars in the Spratlys, each tailored to accommodate at least 24 fighter aircraft and up to about a half dozen larger aircraft on a permanent basis.

Its Supreme Courtannounced that fishermen caught in "Chinese waters" could be jailed for up to a year.

Its defense minister said China should prepare for a "people’s war at sea" to protect national sovereignty.

It has conducted new air patrols over the disputed areas.

As I mentioned earlier, it has undertaken major joint operations in the area with Russia.

In sum, China has unabashedly demonstrated its willingness to use military force against virtually any other country in the region and beyond.

One of those countries is the Philippines. Although the recent ruling from The Hague handed the Philippines a major legal victory, Manila is doing absolutey nothing to capitalize on it.

Quite to the contrary, newly elected Philippine President Rodrigo Duterte is deliberately adopting a softer approach in resolving the long-simmering disputes with China in the South China Sea.

The country that’s not backing down is Vietnam, emboldened by its new alliances with Japan and the U.S. Instead, Vietnam has apparently responded by placing new mobile rocket launchers on five bases in the Spratly Islands.

How serious is this dispute? I’ve told you about the threats to $5 trillion in trade. I’ve told you about the potential impact on global trade. But I’m not the only one issuing these warnings.

Fitch Ratings says that shifts in regional balance of power in the South China Sea entail long-term risks, which might cause significant economic and political instability. Their own words:

"Major geopolitical risks have largely been contained in Asia in recent years, but the potential economic implications could be severe in the event of a sudden escalation."

Don’t turn a blind eye to this brewing battle. Don’t ignore its potential impact on investment markets, especially the immediate possibility of more flight capital rushing to the U.S. And be sure to stay tuned to Larry’s continuing updates on what’s most likely to happen next.

Good luck and God bless!

Martin