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Following the recent escalation of tension between Japan and China, FXstreet.com Analyst Gus Farrow has taken a look at the history of the conflict, the underlying causes of the recent chapter, and what implications it may hold for the FX markets.

손바닥으로 하늘을 가리려한다 Don't try to cover the whole sky with the palm of your hand - Korean proverb

So where are we now?

So, elections have passed and transitions have taken place but the drum is still beating.  What gives? It could well be the case that once you let the cat out of the bag, it takes careful and delicate negotiation to get it back in. Asian culture is steeped in concepts of honour and pride. After the Chinese Government stoked the mob protests which led to the blockading of Japanese products and the violent targeting of Japanese businesses, exports to China (20% of exports) plunged, thus pushing Japan towards recession and it became politically impossible for an incoming Japanese leader to appear to let the issue lie. Conversely, a new administration has taken over in China and as the new leaders of the world’s up-and-coming superpower, they cannot appear to be dictated to by a fading old enemy. They say that pride comes before a fall, and it is not that outlandish to assume that on this issue at least, both Japanese and Chinese tanks are currently running on pride.

Outside factors too are most certainly playing a role. The US and many of its regional allies are keen to prevent Chinese aims of a unipolar Asia. Further, recent US support for Japan on the issue may have irked Beijing but encouraged them to step back. A likely consideration is that the US position is also being made in reaction to China’s stance over Syria. Furthermore, there have been reports in German newspaper Spiegel that North Korea is taking its first steps towards economic reform with the assistance of German businesses and economic advisor’s. No matter how distant and improbable, the prospect of a unified Korea would worry China on the basis that Korea has historical claims to the Manchuria region, is highly developed, extremely militarized and has the backing of the US. Opportunities to show strength to those reading between the lines, on a world stage nonetheless, do not present themselves often and are duly taken when given.

"The Senkaku/Diaoyu Islands disputes look to be just one part of a larger and more complex game of chess in the region."

Continuing with the North Korean wild card theme, reports have circulated in which the hermit kingdom claims to be conducting Nuclear missile testing with the aim of being able to launch attacks that can target the US. Considering that just days previously the islands issue looks to have reached an uncomfortable truce, the timing is uncanny. Educated in the West, leader Kim Jong-Un is said to favour economic reform but it is believed that an internal struggle is taking place where the Chinese backed military, fearful of having to justify its dominant role in a freer country, is proving to be an obstacle to further progress. From this perspective, the Senkaku/Diaoyu Islands disputes look to be just one part of a larger and more complex game of chess in the region. 

Implications for FX?

The reports of peaceful overtures from the Chinese, followed by reciprocal moves from the Japanese, indicate that the status quo will remain for now but short of ultimate resolution through armed conflict, the issue looks like it will continue to resurface whenever convenient domestically and/or provoked internationally. In terms of what to watch for, it should be noted that on two occasions since 2010, the Chinese government has encouraged mob protests that have targeted Japanese businesses and boycotted Japanese goods. 20% of Japanese exports go to Mainland China and as such, the nation is sensitively exposed in such events.

"...future tensions could be seen as an opportunity to short JPY on peaks."

With Abenomics in full swing, the trigger-happy Aso in place as Finance Minister and a new dovish regime expected in the BoJ shortly, future tensions could be seen as an opportunity to short JPY on peaks, in anticipation of easing measures following hits to Japanese exports to and businesses in China. Likewise, similar positions in KRW and other regional exporters could be targeted in anticipation of retaliatory measures. As seen of late, aggressive easing by major central banks has left many emerging nations planning to take action themselves. In a tit-for-tat central banking environment where everybody is taking action but nobody is “manipulating” their currency, excuses to print are actively sought after, and four years after the financial crisis of 2008, easy monetary policy and its subsequent trends look to be here to stay, in the medium term at very least.