Shared Economic Interests In A Stable Asia-Pacific Should Help Contain Geopolitical Risks

Primary Credit Analyst: KimEng Tan, Singapore (65) 6239-6350; kimeng.tan@standardandpoors.com Secondary Contact: Liang Zhong, Beijing (86) 10-6569-2938; liang.zhong@standardandpoors.com

Table Of Contents
Tensions Persist Economic Stakes In Stability Are High But Risks Have Grown Some Scenarios Could Lead To Significant Economic Damage And Asia-Pacific Sovereign Ratings May Weaken

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Shared Economic Interests In A Stable Asia-Pacific Should Help Contain Geopolitical Risks
Geopolitical tensions in the Asia-Pacific region have been rising gradually again over the past year or so and will likely persist, in Standard & Poor's Ratings Services view. The territorial dispute between China and Japan over the Diaoyu/Senkaku islands is unlikely to be resolved soon. China's new regulations relating to air traffic over East China Sea and fishing rights in the South China Sea are also likely to strain the country's relations with its neighbors for quite some time. Meanwhile, recent political infighting in the Democratic People's Republic of Korea (North Korea) continues to keep uncertainties on the Korean peninsula high. Nonetheless, Standard & Poor's believes that the region's economic importance provides an anchor for geopolitical stability. Our base-case scenario is that strong links among the major powers--especially common economic interests among China, Japan, and the U.S. (the major powers)--would prevent a serious escalation of geopolitical incidents in Asia-Pacific. In most cases, we are unlikely to see sovereign rating action when tensions flare temporarily. Overview Geopolitical tension in East Asia is unlikely to dissipate in the foreseeable future. Major powers--especially China, Japan, and the U.S.--have a strong economic interest in ensuring stability in Asia-Pacific, which should help contain geopolitical risk and limit its impact on sovereign credit quality. Still, the risk of a military miscalculation or accident exists, and such an event could trigger rating actions if the economic impact is high. However, we consider such a scenario unlikely.

Geopolitical events that can damage economic prospects and sovereign creditworthiness in the region are still possible. Such events could result from military or political miscalculations by one or more governments, especially the major powers. In an unlikely scenario, one or more of these countries could misread the situation in a potential flare-up of bilateral or multilateral tensions. This could spark a limited military conflict or a serious deterioration in international relations, even if unintentionally. In this scenario, severe disruptions in regional trade and investment flows could occur.

Tensions Persist
Geopolitical tensions in Asia-Pacific aren't dying down as some of the reasons behind the recent increase in tensions look unlikely to fade away. Moreover, unresolved historical baggage among China, Japan, and Korea can fuel geopolitical tensions when they arise. China and Korea's criticisms of Japanese Prime Minister Shinzo Abe's December 2013 visit to the Yasukuni shrine highlighted this. The historical baggage could also complicate politicians' attempts to resolve the tensions in some situations. China's growing assertiveness as it extends its security and economic interests is one persistent source of geopolitical risk. Its pursuit of these interests could create friction with neighbors and other powers with strategic interest in

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Shared Economic Interests In A Stable Asia-Pacific Should Help Contain Geopolitical Risks

Asia-Pacific. China's assertiveness and the potential for conflict could grow with its economic might. We expect China to continue its robust (if slower than in earlier years) growth of close to 7% at least for the next three to five years. The Chinese economy passed Japan to become Asia's largest in 2010. In the next few years, we expect it to narrow the gap with the U.S., another country with important interests in Asia-Pacific. Competition for natural resources in the regional seas--by many Asian countries--is a major reason for the overlapping territorial claims and presents another source of risk. Asian countries are increasingly tapping into fishery and energy resources in the disputed territories. For instance, China's recent move to get foreign fishermen to seek its approval before fishing in much of the South China Sea sparked strong objection from its neighbors. China is also one of the East Asian countries--including Malaysia, the Philippines, and Vietnam--that claim the Spratly Islands because of the rich fishing grounds and potential energy reserves in the seas around these islands. Other examples include the Dokdo/Takeshima islands disputed by Japan and Korea as well as the Paracel Islands claimed by China, Taiwan, and Vietnam.

Economic Stakes In Stability Are High

We expect the shared economic interest among Asia-Pacific countries to remain as an anchor for stability amid the sources of potential tensions. Trade and investment links among China, Japan, and the U.S. have strengthened over the years (see chart 1). All three are also important trade partners or investors in other major economies in Asia-Pacific. A serious military conflict or prolonged state of heightened international tension would likely hurt economies in the region and beyond significantly. In our view, these key countries would act to avoid this scenario by preventing an escalation of hostilities when episodes of fiery rhetoric or other provocations arise.

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Shared Economic Interests In A Stable Asia-Pacific Should Help Contain Geopolitical Risks

Chart 1

Recent experience underlines the nexus between political tensions and economic ties. In the month following the Japanese government's purchase of the Diaoyu/Senkaku islands, Guangzhou Toyota's car sales plunged 60% year on year, and Chinese visitors to Japan fell 44%, according to Japanese statistics. Japan's overall exports to China continue to remain weak long after the event (see chart 2), and Japanese investors--an important group of foreign investors in China--have become wary of expanding their activities there. A military conflict or prolonged deterioration in bilateral relations between Japan and China could exact a much higher direct economic cost on the two countries. The economic impact will also hit further afield. China and Japan are the second- and third-largest economies in the world. Their global links through trade and investment are also very strong. A rift between the two that leads to slower growth in both countries could also hurt their trade partners. This would be unwelcome news to the still-recovering developed economies and emerging economies that are facing recent market volatilities.

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Shared Economic Interests In A Stable Asia-Pacific Should Help Contain Geopolitical Risks

Chart 2

In order to avoid the heavy economic costs of this scenario, we believe that major powers will continue to be cautious in dealing with new instances of heightened tensions. The U.S. response to China's declaration of the new air defense identification zone (ADIZ) in November 2013 is an example. The U.S. flew two bombers within the zone without providing the advance notice that China's new regulation requires, but subsequently advised American commercial airlines to adhere to the requirements. We believe that the distinction the U.S. government made between military and commercial flights represents its effort to register opposition to the new ADIZ without escalating tension.

But Risks Have Grown

Nevertheless, the risk of a miscalculation that could materially weaken sovereign creditworthiness is not negligible. The major powers have no intention to destabilize the region. However, each party also seeks to maximize its own national interest, for instance, by staking its claim on potential energy reserves. In this balancing act, politicians cannot know with certainty what reactions from other countries their actions may trigger. It is possible that one or more actions by the parties concerned lead to unexpected responses that escalate tensions to serious levels. The recent deterioration of international relations among the major powers increases the

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Shared Economic Interests In A Stable Asia-Pacific Should Help Contain Geopolitical Risks

likelihood of such miscalculations. The increased military presence near disputed territories also magnifies the risks of unintended military contact and miscalculated political responses. Around the Diaoyu/Senkaku islands within the new Chinese ADIZ, military equipment and personnel on both sides have operated in close proximity over the past year or so. According to Chinese authorities, Chinese fighter jets scrambled to monitor American and Japanese military planes flying in its ADIZ in late 2013. In turn, Japanese fighters rushed to intercept a Chinese government plane that flew into Japan's ADIZ in mid-January 2014. We believe that the parties involved are exercising caution to minimize unintentional military contact. The U.S., for instance, said early February 2014 that the Chinese air force had continued to engage the U.S. and Japanese military in a "professional" manner near the disputed islands following the creation of the Chinese ADIZ. Nevertheless, mistakes and misunderstandings are still possible.

Some Scenarios Could Lead To Significant Economic Damage

The risks highlighted above could severely strain international economic relations, even if we believe the likelihood is relatively low for now. One such possible scenario is that a government acts in a manner that others consider to have "crossed the line" and required forceful responses. Despite economic considerations, this may happen if public sentiment at home forces a government involved in a dispute to assert its national interests in a provocative manner. In another unlikely scenario, an accidental military contact elicits a quick reaction by ground commanders before the government leaders can be consulted. The military conflict may escalate as a result. Even in these scenarios, we do not see a broad and sustained military confrontation as likely. We believe that both the heavy economic costs and lack of popular support for war in all major powers make such a confrontation exceedingly unlikely. Nevertheless, lower levels of tensions could already severely damage trade and investment links. In a less serious scenario of trade disruption, nationalistic reactions may cause the public and private sectors to voluntarily boycott goods and services from the offending nation. If the governments involved also impose trade sanctions on one another or set unfavorable regulations for businesses from rival countries operating in their territory, disruptions are likely to be more severe. International investment flows are likely to drop significantly in any of these scenarios. The indirect economic effects could also be sizable. A spike in geopolitical tensions in Asia-Pacific would likely rock the global financial markets, cause large swings in commodity prices, and slow investment and trade flows in the region and beyond. The total economic cost would depend on the severity and duration of the situation.

And Asia-Pacific Sovereign Ratings May Weaken

In these unlikely scenarios, the damage to sovereign creditworthiness in Asia-Pacific could cause Standard & Poor's to take rating actions on one or more sovereigns. Because we believe military conflicts--if they were to arise--would be limited, the pressure on ratings would likely come from reduced policy effectiveness in the countries directly involved.

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Shared Economic Interests In A Stable Asia-Pacific Should Help Contain Geopolitical Risks

For instance, the governments may have little choice but to increase public spending substantially for a prolonged period to offset the drag of weak international trade on the economy. The resulting economic slowdown in the affected countries and their economic partners could also exert further downward rating pressure. In addition to reduced trade, investor confidence would likely weaken and financing costs would rise, which would also hurt growth. Economies that depend significantly on external financing, such as Australia and New Zealand, may also face capital outflows. Overall, we may lower the ratings on the sovereigns directly involved in a dispute by one or more notches, depending on the scenario. Other sovereigns might see less severe rating actions than those directly affected or not at all. Standard & Poor's is likely to take rating actions only when it assesses that a persistent state of high tension is probable. However, if we believe the governments involved are still in control of the situation, we are likely to view the likelihood of tension remaining high as modest, given our assumptions above. However, if we believe that one or more of the major governments involved has lost significant ability to shape the course of events--for instance, if we believe military leaders are influential enough to impose their views on foreign policy--we may assess the threat to sovereign creditworthiness in one or more countries to have risen sufficiently to justify rating actions. At this time, however, we believe the occasional episodes of heightened geopolitical tension will most likely continue to be temporary and won't create uncertainties that have a serious economic or credit impact.

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