Third rock from the sun: Japan, China and the land of rising tension (Part 1)

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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. In the first of three installments, Farrow looks at the history behind the conflict.

時間過得就像流水 Time passes like water – Chinese Proverb

The start of 2013 has seen a shift in risk sentiment across global markets. Improving US economic data and Eurozone optimism, despite wobbling numbers, seems to have stablised investor concerns for now. However, there is a wild card issue that had threatened to overshadow market perceptions, that of the Senkaku/Diaoyu Islands dispute between China and Japan. While the issue had seemingly calmed from the heights that saw mobs across the Chinese mainland target Japanese businesses, tensions resurfaced with a vengeance in early 2013, with reports that Japanese and Chinese fighter aircrafts were shadowing each other around the disputed islands.

The investment community and the blogosphere alike have raised questions over whether tensions were just those… tensions, or if there was any potential for armed conflict. Asian Second World War scars have not healed as smoothly as those in Europe, a fact that can be seen on the Seoul subway where full wall adverts in English are placed to educate visitors of the crimes committed by the Japanese Imperial Army during its occupation of mainland Asia.

"Asian Second World War scars have not healed as smoothly as those in Europe."

There is little love lost across the water in Tokyo, where new Prime Minister Shinzo Abe has caused controversy by visiting the controversial Yasukuni war memorial. The LDP has even hinted interest in re-writing an apology for its aggressive colonization of East Asia. However, despite the anti-Japanese sentiment in the region, there appears to be an understanding that the counterbalance to the growing tide of Chinese influence in the region needs to be strengthened, a point highlighted by the recent Philippine Government’s call for a comprehensive Japanese rearmament.

The point however, raises an interesting observation on the nature of the tension between Japan and China. Japan is not fully armed and on its own, completely unable to take part in any form of sustained conflict against Chinese military forces. Any action would require direct American support and approval and be almost completely unthinkable at this juncture. Conversely, China has marched straight to the top of the regional food chain via rapid economic development and ever-deepening trade relationships with its neighbors. China, Japan and South Korea are estimated to account for close to 20% of global GDP at recent estimates. So, with this being the case, why were Japanese and Chinese leaders being so brazen in stoking tensions over a small collection of islands?

The History

The Senkaku/Diaoyu Islands are seen as being strategically important. They are tactically positioned between Japan, China and Taiwan, have rich fishing waters and are believed to hold significant oil reserves. They have been administered by Japan since 1895, and owned by private Japanese owners over the period. At the point of nationalisation, Japan stated that they had observed the islands for ten years to ensure that they were uninhabited before taking action.

After the end of the Second World War, Japan was forced to renounce a collection of territories and islands under the Treaty of San Francisco in 1951 which transferred the islands to under US trusteeship. In 1971, the islands were returned to Japan. A key foundation of Japan´s argument is that China had no objections to the Treaty of San Francisco, but only took interest in the islands when the prospect of oil reserves was revealed. Conversely, China claims that over the long stretch of pre-colonial history, the islands have historically been theirs. Further, China claims that under the “Cairo Declaration” of 1943 and the subsequent “Potsdam Declaration” of 1945, the Senkaku Islands, as islands appertaining to Taiwan, reverted to China along with Taiwan.

"Japan's argument is that China had no objections to the Treaty of San Francisco, but only took interest in the islands when the prospect of oil reserves was revealed."

Tensions started to surface in the mid 1990’s when Chinese activists made attempts to land on the island. These moves were swiftly met by Japanese authorities who arrested and then evicted them. The conflict took a new turn in the early noughties when the Chinese Government is reported to have concluded exploration agreements with leading oil development companies for the exploration and production of gas projects in the East China Sea in 2003. The Japanese Government is said to expressed concern that the areas in question overlapped with Japan’s exclusive economic zone. Requests for information from Beijing were rejected and in 2004, the Japanese government confirmed that China had started drilling just 4km from Japanese waters.

After a period of relative calm, the issue flared up again in 2010 when a Chinese fishing boat was caught in Japanese waters and violently resisted arrest from the Japanese coastal patrol. Eventually the Chinese captain was taken into custody, stirring up the diplomatic issue once again and leading to a tit-for-tat diplomatic response by the Chinese. The Japanese eventually released the Chinese fisherman following the reported arrest of four Japanese men who had been working on a Government funded project in China on contentious charges. Since then, tensions calmed until mid 2012 when the Japanese Government officially purchased three of the islands from their private Japanese owners.

However, the end of 2012 saw both the Japanese General Election and the transition of power in the Chinese Communist Party. As both dates drew closer, tensions soared to unprecedented levels. Further, both nations have been experiencing times of economic uncertainty, albeit with differing levels of severity and instability.


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