The Senkaku/Diaoyu islands, which are administered by Japan but which have been claimed by China (and Taiwan) since 1971, are again the object of fierce tensions between East Asia’s two regional leaders. The Japanese government’s decision to buy three islands from their Japanese private owner rekindled the dispute and triggered widespread protests throughout China against Japan and Japanese factories. After a few days, calm was restored but tensions remained high: China is keeping a firm position and demands Japan’s acknowledgment of China’s claim on the islands whereas Japan refuses to yield and calls for China’s restraint.

Impact on country risk

The largest and most violent national demonstrations in years are symptoms of instable Sino-Japanese relations and proximity of a political transition happening during an economic slowdown. Protests in China were exacerbated by Beijing’s nationalist stance that helps to underpin the Communist party’s legitimacy and is still fed by what is perceived as past humiliation by the hands of the Japanese. Any risk of a trade war between the region’s two largest economies is mitigated by their economic complementarity and interdependence - Japan for FDI and supply of high-tech products, China notably for its exports of rare earth elements while being Japan’s first export market. Japan has the most to lose and it is not excluded that China takes detrimental measures to harm Japan’s economy, such as the one which hit exports of rare earth elements in 2010, while Japanese businesses operating in China might be affected by anti- Japanese consumer choices in the short-term. However, based on previous similar anti-Japanese movements, they are unlikely to last especially in a difficult economic context.

The most fundamental risk comes from potential clashes between Japanese and Chinese vessels that might eventually culminate in a military conflict in the future. The political transition outlook in both countries, the unlikelihood of a Japanese concession on the sovereignty issue, incursions of Chinese fishing boats in disputed areas and landing of activists on the islands as witnessed recently are indeed likely to keep tensions high, with the risk of confrontation. This conflict highlights a wider threat posed by China’s many sovereignty claims in South East China Sea and East China Sea that risk turning the areas the future hotspots of political tension in the region. Since 2009, there have been multiple clashes between China and other Asian countries (e.g. the Philippines, Vietnam…) over unresolved islands claims, and they are likely to intensify in the context of a regional leadership battle that is at stake, well beyond the mere potential of fish, oil and gas resources in the areas. At the same time, the US are enhancing military co-operation with other South-East and Eastern Asian countries which are planning to develop further their military capacities in coming years. This is also the case with Japan, particularly if opposition leader and nationalist Shizo Abe succeeds incumbent PM Noda after next year’s elections as expected. In this slowly deteriorating security environment, war risk is likely to increase over time, although it will remain strongly mitigated by economic pragmatism.

Analyst: Raphaël Cecchi, r.cecchi@credendogroup.com