What in the world is going on between Japan and China these days?! Are these Asian superpowers about to engage in a full-on war? Let me give you a quick recap of what’s going on so far, what we can expect, and how we could profit from all this drama.

It’s no secret that Japan and China have been “frenemies” for the longest time. The tension started heating up recently when China had a territorial dispute with Japan when it comes to ownership of a few islands in the East China Sea. This area, which is known to Japan as the Senkakus and to China as the Diaouyu Islands, is surrounded by waters rich in oil reserves and rare minerals.

These islands have been owned and controlled by Japan ever since but it appears that China wants a piece of it, as Chinese ships and drones have been lingering nearby. Because of that, the Japanese government issued a warning that it could strike down those unmanned drones if they come too close.

In response, Chinese defense ministry spokesperson Geng Yansheng said that Japan should not underestimate the Chinese army’s determination and ability to defend their territory. ”If Japan does what it says and resorts to enforcement measures like shooting down aircraft, that is a serious provocation to us, it is an act of war,” he added. “We will surely undertake decisive action to strike back.”

History buffs say that this revived rivalry between the two nations comes at a crucial point when China is struggling to return to its glory years of double-digit economic growth and Japan is fighting to emerge from decades of deflation. Also worth noting is that China’s recent territorial claims against other Asian nations haven’t resulted in an all-out war so far and that Japan has always attempted to pursue the more peaceful alternative in resolving conflict.

However, an actual war between Japan and China is still a possibility, as neither is showing signs of yielding or coming up with a compromise. If this happens, it could spark a prolonged risk-off period, which might hurt higher-yielding assets as well as currencies from Asian nations and emerging markets.

Commodity currencies, particularly the Australian dollar and the New Zealand dollar, are already starting to weaken because of the ongoing uncertainty. After all, should China engage in a war with Japan, much of its capital would be allocated to defense, leaving less resources to shore up production and trade activity.

While the lower-yielding yen tends to strengthen during periods of risk aversion, it appears that traders are not too eager to park their money in the Japanese currency either. Better keep close tabs on any updates on this issue since it could mean more safe-haven flows to the dollar!

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