In recent days, China has flown a large squadron of military aircraft in the Taiwan Strait and a US aircraft carrier group sailed into the South China Sea. This is not the first time that tensions have flared in the region, nor will it be the last.
These military manoeuvres occur in the context of recent diplomatic (eg Hong Kong opposition resignation, Taiwan invited to Biden inauguration) and rhetorical jabs (eg Xi Jinping at virtual Davos, Antony Blinken at his secretary of state confirmation meeting) as both sides size each other up in the early days of the Biden administration.
Predicting the tipping point or the catalyst for when tension between the US and China becomes a material driver of financial markets with any useful precision is beyond us. But, below, we lay out our thinking on the context and investment risks associated with China's 'Nine-Dash Line'.
Hot conflict and cold war are unlikely in the near term: China's naval inferiority means it cannot overreach. A full-blown cold war between the US and China, in the manner of the US-USSR, is also unlikely given the existing trade and investment links and the gap between US and EU attitudes to China.
China territorial tension is not going away: China's Nine-Dash Line territorial claims stem partly from historical and legal interpretation and entirely from economic necessity (whether guaranteeing access of its manufactured exports or raw material inputs through various choke points in the region or securing access to offshore hydrocarbon exploration).
US regional naval superiority may be in question at the end of the decade: The inferiority of Chinese military spend and naval capability relative to the US limits its appetite for hot military conflict (whether involving, at the geographic extremes of the region, Taiwan, the Philippines or Vietnam). But, after another decade, this equilibrium may not be so stable: China is already narrowing the gap on spending and naval assets, and the economic base (from which it finances military spending), potentially will match that of the US on this timeframe.
The rest of Asia therefore has to prepare: The tacit underpinning of the export-led economic growth of Asia (from post-war Japan to, most recently, Vietnam, and potentially next, India) has been both low tariff access to the US market and the secure access to sea transit provided by the US navy. All of these Asia exporters now need to either beef up their own military spend and capability, navigate to neutral diplomatic ground between the US and China (an approach, perhaps exemplified by the Philippines and Singapore, which might frustrate US President Biden's efforts to assemble a multilateral front against China) or choose more clearly one side with which to align (eg Vietnam or India with the US or Pakistan with China).
Long-term risk in asset valuation: Investors have correctly largely ignored these geopolitical risks in Asia for years. Like most long-term geopolitical concerns, when they escalate they may do so very quickly and the past will not be a reliable guide to the future. One of the trickiest issues for investors in emerging markets is that countries across Asia generally offer a much more compelling higher-growth, lower-risk growth story (clearer path to job-creating manufacturing exports, younger demographic bias, improving governance, more stable domestic politics) than peers in LatAm, Wider Europe, the Middle East and Africa. However, this assessment, across the entire emerging market portion of the region, is vulnerable to any change in the current geopolitical equilibrium between China and the US.
1. China's 'Nine-Dash Line'
2. Exports: South China Sea nexus
3. Oil choke points in South China Sea
4. LNG choke points in South China Sea
5. Taiwan's TSMC choke point for Technology
6.US's globally unrivalled military spend
7. China's larger military spend than all Asia
8. US's current naval superiority
9. China may have a competitive navy in a decade
EU-China deal follows a year of friction, prepares for Biden (January 2021)
Hong Kong opposition resigns; likely that Biden supports (November 2020)
US weaponises all Tech regulation in China friction (August 2020)