Right now, the most critical geopolitical risk to the financial markets remains Europe, with the Persian Gulf probably the second most important concern.  However, there is value in analyzing situations which may become problematic, even if it is in the distant future.  By doing so, it allows investors to become aware of potential situations long before they become issues.  We believe it is better to have some familiarity with geopolitical concerns in advance of any major problems.

The South China Sea is a particular area of concern.  China has made somewhat opaque claims of control in this sea for a long time.  These claims have come under occasional dispute over the past 20 years.  So far, none has sparked a major conflict but, as we will show, the potential exists for a major war to develop in this area.  In this report, we will explain China’s claims in the region, why the myriad of local and national paramilitary bodies raise the risk of a confrontation and explore how rising nationalism increases that risk.  A short discussion of regional geopolitics follows where we will note how China is a rising nation which seemingly plans to eventually project its maritime power.  Finally, as always, we will conclude with a discussion of how this issue will affect financial and commodity markets. 

China’s Claims in the South China Sea

China has claimed virtually all of the South China Sea as its own.  These claims originate from 15^th century surveys and fishing logs.  Chinese cartographers have included this area in Chinese territory since 1914.  The map below shows its claims.

The red line on the chart shows China’s traditional claims.  Initially shown as nine dashes on a map, the claim became known as the “nine dash line.”  The blue lines on the chart represent the U.N. customary sea boundaries that show regional nations’ exclusive economic zones.  As the map indicates, China’s claimed territorial waters essentially give it control of a substantial swath of ocean.

Why does China claim so much area which clearly contravenes the most accepted rules of the sea?  When China made this official claim in 1947, most of the other countries in the region were not independent.   For example, the Philippines only became independent on July 4, 1946. 

Vietnam was still a French colony and Malaysia was part of the British Empire.  After WWII, the European empires were beginning to break apart, meaning France and Britain were busy with managing that process.  In addition, the U.S. was occupied with rebuilding Europe and Japan.  Thus, when China announced its claim to the South China Sea, the major powers mostly ignored it.

To some extent, China’s claim is similar to the Monroe Doctrine.  At the time the Monroe Doctrine was announced, the U.S. did not have the military power to implement it.  The claim was useful to Britain insofar as it denied claims by other European powers.  However, it was unlikely that the small U.S. Navy could have enforced the Monroe Doctrine any more than China’s Navy could have defended its claim. 

Despite the fact that the U.S. and other major nations didn’t acknowledge China’s claim to the South China Sea, China’s citizens are taught from an early age that the map above is their rightful territory.  China could not militarily defend its claim until the 1990s, although this didn’t prevent it from trying in the past.  As far back as 1974, China and Vietnam had a skirmish over the Paracel Islands.  The same countries again had a quarrel over the Spratly Islands in 1988.  But, over the past fifteen years, there have been a rising number of incidents between Chinese vessels and the U.S., the Philippines, Vietnam and Japan.  The defense of China’s self-proclaimed region in the South China Sea has become intertwined with nationalistic sentiment.  As such, the dangers to this region are increasing.

In international negotiations, China has never fully defined what its “nine dash line” claim fully entails.  It has, on occasion, indicated that it has a “special interest” in the region, which might suggest it is willing to use force to protect its claim.  However, in other circumstances, China has shown a desire for joint ventures and negotiations.  It should be noted that China continues to use Deng Xiaoping’s “peaceful rise” foreign policy.  This thesis warned against China being overly aggressive and causing fear among other nations to its increasing economic and military power.  Although the policy of peaceful rise remains the mainstream one, there are growing nationalistic voices suggesting that China has reached sufficient size to force its will.  Two years ago, China’s foreign minister, Yang Jiechi, hearing a barrage of complaints about China’s behavior, said that “China is a big country and other countries are small countries and that is just a fact.”  Although Yang probably regretted the comment, it does suggest that the peaceful rise policy may be slowly jettisoned.   

The Tinderbox

What makes the current situation unusually dangerous is the large number of government and quasi-government bodies operating in the South China Sea.  Called the “nine dragons,” the bodies include the Fisheries Administration, Maritime Surveillance (part of China’s ocean management bureau), local government police forces, environmental protection offices, the Coast Guard, Chinese state energy companies and, of course, the People’s Liberation Army Navy (PLAN), China’s naval forces.

With so many governmental bodies “swimming” in the South China Sea, supporting fishing rights, protecting the environment, fighting smuggling, gathering intelligence and projecting military power, the potential for confrontation is high.  Complicating matters is the fact that most of these organizations compete for budget yuan.  Aggressive actions against foreign fishermen or navies improve the odds that funding will be increased.  With the exception of the PLAN, these groups have a vested interest in acting aggressively to boost funding.

The Geopolitics

The Chinese government clearly allows this situation to exist because it lends a degree of plausible deniability.  If the PLAN isn’t engaging in an aggressive action, but the Fisheries Ministry is instead, the government can enforce its claim without official military action.  

At the same time, this plethora of Chinese authorities acting in the South China Sea increases the odds of a conflict.  An overly aggressive fisheries flotilla could prompt an international incident by attacking foreign fishermen in the region, who may be acting within their respective economic zone. 

This possibility puts the U.S. and China in a generally unrecognized difficult spot.  As China has become more aggressive, other governments have become supportive of a U.S. Naval presence in their countries.  This state is a reversal of trends since the end of the Cold War, where many Asian nations “encouraged” the U.S. to move its bases away.  For example, the Philippines have recently contracted for American made naval vessels and have been pressing the U.S. for overt protection.  Last week, Secretary of Defense Panetta visited the Cam Ranh Bay, the first visit by a U.S. Defense Secretary to this Vietnam War-era port in over 30 years. 

Even more critical was the recent decision by the U.S. to “pivot” towards Asia in its defense focus (see WGR, 1/23/2012, The Obama Doctrine).  In a period of fiscal constraints, the U.S. has decided to increase its focus on Asia and consequently reduce its attention to the rest of the world.  This decision to “pivot” could embolden smaller states in the South China Sea, making them feel they are protected by the U.S. and thus inspire them to stand up to Chinese incursions.

At the same time, if the U.S. fails to stand up to China, there is a risk that other regional powers will conclude the U.S. cannot defend them and will opt to accommodate China’s rise.  This would likely lead to these nations refusing to allow American military bases or ports of call on their soil. 

In fact, if one buys into the concept that the U.S. is a waning power and China a rising one, regional powers have an incentive to move quickly before China’s navy builds substantially.  The U.S. must tread carefully; on the one hand, it wants to assure the regional powers that it is there to offer protection.  However, on the other, the U.S. cannot offer blanket protection that might encourage a smaller power to provoke a conflict.  Thus, the protection must be conditional. 

China is, no doubt, a rising power.  It has indicated that it would like to eventually move from a “brown water navy” to “blue water navy,” one which would project power.  The map below shows the goals as discussed by various Chinese military strategists indicating the nation’s eventual naval goals.  China wants to first control the “first island chain” as shown on the map and, over time, expand this power to the “second island chain.”  It should be noted that the U.S. has numerous naval and air force facilities inside both.  This goal suggests that China wants to, at some point, replace the U.S. as the sole naval superpower in the region.

  

(Source:  University of Texas)

Needless to say, the U.S. does not support this thesis.  Under the peaceful rise policy, China officially suggests that this goal isn’t imminent and there may be room for two large powers in the region.  History would suggest such an arrangement between an authoritarian state and a democracy would be exceedingly rare.  Studies by Rand suggest that by 2020 China will be able to prevent American aircraft carriers and aircraft from operating in the first island chain.  Once this occurs, Taiwan will become indefensible.  Losing Taiwan would be a major blow to U.S. power in the region.  Although China and the U.S. have a “strategic ambiguity” about Taiwan, the U.S. wants the island to remain anchored with the U.S., as holding this island gives the ability to project power in the region. 

It should be noted that the South China Sea is rich in resources; not only are the fisheries rich, but there may be as much as 55 billion tons of oil and 20 trillion cubic meters of natural gas available offshore.  Vietnam has been drilling for oil and gas for some time and these activities have led to conflicts with China.  In addition, the sea lanes are also critical; about $5.3 trillion of trade passes through these waters annually, with the U.S. accounting for about 22% of that trade.  The U.S., like the British before it, operates on the notion that the world works best with open sea lanes.  China may not maintain that standard if it becomes the regional hegemon.

This situation is also playing out in the field of diplomacy as well.  When disputes arise, China tends to want bilateral negotiations.  The U.S. has been offering its services as a mediator, which China deeply resents.  China wants to resolve these disputes unilaterally because it usually has the upper hand.  For example, China and the Philippines recently had a dispute over fishing in the region.  As the Philippines escalated the situation, China refused to allow Philippine bananas to clear its customs, allowing them to rot on the docks.  Due to its relative economic size, China can dominate bilateral talks.  On the other hand, multilateral talks tend to lead to less favorable outcomes for China.  This pattern is indicative of the broader pattern of tensions in the region.

Ramifications

The current international focus is on Europe, as it should be.  The problems in Europe, in our opinion, are geopolitical; unifying the continent under one government is the only way to guarantee another major war won’t be fought there and the Eurozone is a prime component of that process.  The real discussion in Europe is now about who will run the place.  Germany is making it clear that the cost of using its balance sheet will come in the form of dominating the EU structure and forcing other nations to forego sovereignty.  Needless to say, other Eurozone nations oppose this outcome.  This issue will likely dominate the coming week’s news flow.

   

However, the situation in the South China Sea will likely become a major issue in the coming years.  Barring a collapse in China’s economy, over the next five to eight years, the U.S. will likely face a significant competitor in the region.  President Obama’s decision to pivot towards Asia may be the most profound of his administration. 

This issue also highlights the cost to the world of the U.S. moving towards isolationism.  Globalization rests on the U.S. Navy maintaining open sea lanes; if regional powers prevent open sailing, shipping costs rise, inventory management becomes less efficient and the likelihood of regional wars increase.  To a great extent, the potential for conflict in the South China Sea makes clear the strategic case for holding hard assets in portfolios.  The potential for trade disruption could very easily lead to “just in case” inventory accumulation which will boost the prices for key commodities.

Overall, we don’t expect this issue to be an imminent problem.  However, we think investors should be aware of the growing dangers in the region, allowing time to develop strategies to protect their portfolios.

Bill O’Grady

June 11, 2012

 

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

 

 

(c) Confluence Investment Management

www.confluenceinvestment.com