Security competition in the East and South China Sea (2016)

A rising China is seeking to revise the status quo in maritime North East and South East Asia,  while all other major countries in the region are eager to preserve it. Since the global financial crisis in 2008-09, China has pursued a significantly more assertive foreign policy, especially with regards to the East and South China Sea. The perception of US weakness following setbacks in Afghanistan and Iraq has encouraged Beijing to strengthen its position in the region. China claims large parts of the East and South China Sea and has sought to back these claims by building up a number of hitherto uninhabited islands and reefs, by more aggressive civilian/ non-civilian naval deployments, by fielding sophisticated military hardware and, in the case of the East China Sea, by establishing an Air Defense Identification Zone (ADIZ). This has fuelled increasingly terse disputes with many of its neighbours, especially Japan, the Philippines and Vietnam. 

Control of its near seas and access to the high seas as well as natural resources and nationalism underpin, to varying degrees, China’s more assertive stance. China is highly dependent on international trade, especially energy and increasingly food imports. By claiming the area within the so-called nine-dash line as territorial waters, China not only seeks to establish ownership of the natural resources within in it but also to gain the right to deploy military forces there in an attempt to establish effective control of the area. Strategically, China seeks to bring the seas within the first island chain under its control, before pushing more aggressively beyond it. In the mind of Chinese strategists, this represents only the first step towards safeguarding sea lines of communication and Chinese overseas interests more broadly, in addition to pushing out China’s defence perimeter. The One Belt One Road initiative similarly needs to be seen in terms Beijing’s concern over access to overseas markets. US “pivot” is meant to preserve the regional status quo.

The United States is committed to defending the territorial and political status quo. Washington is concerned about the region potentially falling under the control of an increasingly assertive China at the expense of US interests and influence. Ensuring access to Asian markets and preventing a dominant power from controlling East and South East Asia have been enduring US interests for more than a century. Even if Washington wanted to (and it does not), it would found it difficult to make concessions to a rising China as far as the regional status quo is concerned, lest it risks losing some of its actual and potential allies. From a longer-term perspective, China is also seen as a future potential peer competitor globally and Washington is unlikely to simply vacate the field - few declining great powers have done so historically – not least because the pre- conditions for maintaining the status quo are not too bad: most countries in the region are themselves eager for the status quo to be preserved. Most of them are similarly concerned about a rising, more assertive and revisionist China.

In the security realm, Washington is committed to the defence of its treaty allies and effectively opposes China’s attempt to change the territorial status quo. Washington expressed support for the recent The Hague UNCLOS ruling in favour of the Philippines and continues to insist on the principle of freedom of navigation. Strategically, the Obama administration announced the so-called “pivot to Asia”. The aim is to move 60% of US naval assets to the Pacific, up from 50% today. The US air force seeks to achieve the same distribution of forces. Washington has also acquired new basing and access rights or expanded existing rights in recent years (Australia, Philippines and Singapore). It has opened up Myanmar in order to counter Chinese influence there. It has revised US-Japanese defence guidelines giving the Japanese military greater leeway to support US military operations. It has sold and/ or is about to deploy advanced weapons systems to allies (e.g. F-25, THAAD in South Korea). It has lifted the Vietnam arms embargo. In operational terms, the Pentagon has been developing a so-called Air Sea Battle concept to counter China’s mostly land-based A2/D2 capabilities within the first island chain. All this adds up to a policy that seeks to counter-balance China’s increasing military prowess and political attempts to revise the post-WWII territorial and maritime status quo.

In the economic sphere, Washington is pursuing the Trans-Pacific Partnership (TPP). This “21st century trade agreement”, involving economic and financial that go far beyond the trade of goods, is meant to tie actual and potential US allies closer to the US economically, thereby strengthening countries in the region economically and creating common economic interests that will help complement intensifying security cooperation. In fact, the US is the economy that will benefit the least economically, suggesting that the primary purpose of TPP is indeed geo-political. After all, while Beijing recently expressed its interest in joining TPP after initially criticising the proposal heavily (and pursuing its own trade agenda with the Regional Comprehensive Economic Framework, a more traditional trade agreement), several features of the agreement have clearly been designed to prevent China from joining (e.g. SOE treatment). A more generous interpretation would be that Washington seeks to build institutions that ensure stability, lock in the commitment of other countries, guarantee US interests and prevent China from imposing its own economic regime in the region, including rules that might be potentially detrimental to US interests. (Whether TPP will get passed is another question entirely.) Again, Washington pursues a broader strategy aimed at countering rising Chinese power by defending the territorial status quo while at the same time seeking closer economic ties with the region. 

“Trump risk” notwithstanding, Washington is highly unlikely to withdraw from the region or let down its allies. While Washington would be loath to be pulled into an armed conflict on the back of excessively provocative behaviour by its allies, it will be equally loath to risk letting East and South East Asia fall under Chinese domination. As long as the US remains committed to the region, China’s more assertive policies will only help to push countries in the region closer to Washington: countries will seek to balance China (with US support) rather than bandwagon. Washington will rely on the existing hub-and-spokes model in the region and it will cooperate and coordinate very closely with its two most important allies in the region: Japan and Korea.

Major regional powers also eager to preserve the status quo Japan feels the most threatened by China’s rise due to geo-political and historical reasons. Like China, Japan is heavily dependent on overseas trade and especially commodity imports. Territorial disputes surrounding the Senkaku/ Diaoyu islands in the East China have intensified. Japan has no treaty allies except the United States. The alliance with the US is considered absolutely vital by Tokyo, but policy-makers are worried whether Washington would really be willing to fight a war with China rather than abandon Tokyo if push came to shove. Last but not least, historical issues related to WWII and wide-spread anti-Japanese sentiment in China make Tokyo even more concerned about China’s increasing assertiveness. 

Not surprisingly, Tokyo has been beefing up its military and reforming its defence policy, including a revision of US-Japanese defence guidelines, the re-interpretation of Japan’s pacifist constitution as well as the development of new weapons systems (e.g. “helicopter” carriers, tactical ballistic missiles). The Abe government will continue to push in this direction, especially following its recent electoral success. Bilateral disputes have in the past led to Chinese economic retaliation (e.g. ban on rare earth exports, targeting of Japanese firms in China). This is one reason why Japanese companies are seeking to diversify their supply chains in the region and especially towards countries similarly concerned about China’s territorial claims (esp. Vietnam). It has also led the Abe government to strengthen political, economic and financial ties with countries in the region. 

South Korea is in a more difficult position vis-a-vis China, geographically, politically and economically, and has therefore exhibited greater ambiguity in its relations with both Beijing and Washington. The ROK is aware that alienating Beijing would be negative as far as ROK-DPRK relations are concerned. The ROK is also increasingly dependent on China in terms of trade and, especially, investment, even if there is also increasing commercial competition. On the flipside, the ROK relies on the US for its security vis-a-vis the DPRK.

Combined with far less intense competing territorial disagreements, this makes Seoul more reluctant than, for example, Japan or Vietnam, to take a firmer stance vis-a-vis China. If push came to shove, Seoul would very likely side with Washington. The only possible exception might be a scenario where the DPRK collapses and Beijing offers Seoul reunification in exchange for neutrality (a la Stalin note). Nonetheless, with the ROK depending on the US for its security, Washington will in the end have more leverage than Beijing and the ROK is very likely to throw its lot with Washington rather than Beijing. The ROK ultimately has no interest in allowing China to change the regional status quo if this risks translating into Chinese hegemony. As long as the US sticks around, this risk is remote and ROK can afford to focus on the DPRK and will seek to maintain reasonable relations with Beijing as long as possible.

Virtually all other countries in the region also support the territorial and maritime status quo. Their willingness to take back up their stance with action is largely a function of the severity and complexity of territorial disputes, economic dependence on and geographic proximity to China as well as intensity of security relationship with the United States. Vietnam and the Philippines are more wary of China than Malaysia, Indonesia and Brunei. Washington has many actual and potential allies in the region, as the countries prefer the status quo to a more uncertain future determined by an assertive China. While not eager to irritate China unnecessarily, they welcome US efforts to counter-balance China’s rise and are extremely reluctant to yield to Chinese territorial demands.

By contrast, China has no effective allies in the region, but has territorial disputes with most of them. Only Cambodia and Laos, countries with populations of 15m and 7m and per capita incomes of USD 1,000 and USD 1,600, respectively. Nonetheless, China’s economic importance and rapidly rising defence expenditure, not to mention its increasingly advanced weapons systems mean that in the long run Beijing may feel it does not really need allies other than for diplomatic or symbolic purposes – and even here Beijing could probably resort to the middle kingdom narrative if necessary – in order to prevail in the region.

Demographic & economic trends in the EU-4 & Japan (2016)

Rising risk of conflict in North-East Asia (2016)

The DPRK under Kim III has intensified efforts to develop long-range nuclear missiles. The DPRK is committed to becoming an official nuclear weapons state under the 2012 constitution, a commitment it reaffirmed very recently at the party congress. Internationally, the DPRK today rejects the goal of denuclearisation agreed upon during the six-party talks in 2005. Obtaining long-range nuclear weapons helps strengthen Kim III’s domestic political position. Internationally, it helps increase the DPRK’s deterrence potential, given the DPRK’s increasing conventional inferiority. It might also create a future bargaining chip. The present programme is the continuation of the so-called military first policy. The DPRK will be extremely reluctant to agree to anything resembling denuclearisation, but it might be more willing to trade away its long- range missile programme in exchange for a peace treaty. It will refuse to trade away its nuclear weapons. Pyongyang seeks a long-range nuclear capability as a means to deter US military aggression. The DPRK has stated repeatedly that it would only use nuclear weapons if attacked. While US intelligence officials believe that Pyongyang would use nuclear weapons only “under very narrow circumstances” (James Clapper, Director of National Intelligence), the next US president is unlikely to set much store by DPRK declarations, if only out of domestic political considerations.

Under Kim III’s leadership, Pyongyang has stepped up efforts to develop inter- continental ballistic missiles (ICBMs) and miniaturised nuclear war heads as well as SLBMs. The DPRK claims to have successfully tested an engine designed for ICBMs. It has successfully launched a missile into space. It claims to have developed and tested a miniaturised nuclear warhead. US intelligence and military officials have publicly said that they believed that the DPRK was capable of miniaturising a nuclear weapons and putting it on missiles (General Scaparrotti, commander of USFK). Uncertainty nonetheless exists as regards the reliability of miniaturised nuclear warheads and the range and accuracy of its long-range missiles. Several long-range missile flight tests have failed and the DPRK would require re-entry vehicles to make ICBMs effective. It is clear though that the DPRK is making intense efforts to develop nuclear-capable ICMBs of a sufficient range to reach the continental United States. US intelligence sources estimate that it will take the DPRK 2-3 years to master the necessary technology to build such a capability. Naturally, such predictions are inherently difficult to make with much confidence. What matters though is that the US government is working with this timeline in terms of its policy towards the DPRK.

If left unchecked, the DPRK will eventually build and field nuclear-capable ICBMs. Some US defence officials sound reasonably confident that they will be able to deal with a limited number of ICBMs launched against the US. Washington has an operational missile defence system in place allowing it to destroy a limited number of incoming intermediate and long-range ballistic missiles in space. But the reliability of the missiles defence system is less than a 100%. Washington would not want to run the risk of becoming the target of nuclear extortion by a so-called rogue state, however irrational such a policy might appear to be and however unlikely that might be. US diplomacy towards DPRK

The Obama administration has largely been pursuing a policy of strategic patience towards the DPRK. The next US president will be under heavy pressure to prevent the DPRK from developing nuclear-capable ICBMs. Anxiety in Washington is already rising. After all, Iraq’s WMD programme was an important driver of US policy - even if somewhat less important than claimed at the time. Even if deterrence is a workable policy, US domestic political dynamics will make it difficult for the next US president not to take increasingly forceful action to prevent the DPRK from developing ICMBs. The rogue state narrative combined with opaque and non-collegial DPRK decision-making structure will leave the US president with no choice but to resort to more forceful, coercive diplomacy. Recent statements by Hillary Clinton also support this view. Washington has already begun to tighten sanctions, multilaterally and bilaterally.

At the multilateral level, UNSC Resolution 2270 (March 2016) took sanctions to a new level with (1) mandatory cargo inspections of all North Korean ships, (2) sanctions on trade in natural resources and (3) sanctions targeting DPRK banks and assets. At the bilateral level, Washington adopted a new measure (Section 312 of the Patriot Act) that cuts off (Chinese) banks’ access to the US banks if they do business with the DPRK banks linked to the nuclear or missile programme. Washington has also helped the ROK to upgrade its military capabilities (e.g. F-35 fighters) and Seoul has just approved the deployment of the THAAD missile defence system. The economic, financial, military and diplomatic pressure on the DPRK is already being ratcheted up. Regional diplomatic backdrop

The regional diplomatic context matters in terms what future scenarios will look like. China, historically a key ally of the DPRK, is in a difficult position. Relations between DPRK and the PRC have worsened since Kim III’s ascension. Beijing is not pleased with its neighbour’s nuclear missile programme, not least because it risks upsetting the strategic balance in North-East Asia. Pyongyang’s stepped-up missile development and nuclear test efforts have put strain on PRC-ROK relations and is indirectly responsible for the deployment of THAAD system that Beijing fears is aimed at its own strategic forces. Even so, China remains reluctant to push the DPRK too hard in terms of sanctions in order not trigger a regime collapse. A collapse might not only cause a humanitarian crisis.

More importantly, it would also risk causing strategic instability in the region, possibly leading to the emergence of a united Korea allied to the US. Current DPRK policies are pushing Seoul into a closer relationship with Washington and it is also pulling Washington further into North-East Asia, undermining Beijing’s strategic position and slowing its ascendancy. But for an Iran-style approach to work, Washington will need to obtain the co-operation of Beijing. This being very difficult, but not impossible, to achieve, Washington may resort to or threaten to use military force against the DPRK.

North-East Asia is a large and critical part of the global economy as far economic size, trade and FDI are concerned. Geo-political instability, let alone a regional military confrontation, might lead to a severe disruption of the global supply chains running through the region. This would have very adverse global financial and economic consequences. The severity would depend on the type, length and intensity of a military confrontation.

Scenario 1 - Status quo => Gradual tightening of sanctions & slow DPRK technological progress

The DPRK continues to face significant obstacles in developing operational nuclear-capable ICBMs. Washington with some support from Beijing continues to tighten sanctions. Diplomatically things do not come to a head within the next 2-3 years. The DPRK economy is being squeezed, but not to the point of economic-political collapse. Wider economic and financial impact is negligible. This scenario remains the most likely scenario over the next 2-3, given the likely difficulties the DPRK’s missile programme will encounter. Even if it manages to master the technology, it needs to get to the stage of reliably deploying ICBMs in sufficient quantities in order for Washington to opt for scenario 3 (see below). Scenario 2 also looks less likely for reasons spelled out below.

Scenario 2 - Iran-style sanctions successful => DPRK curtails its ICBM programme 

DPRK continues with stepped-up nuclear missile development efforts, prompting Washington to step up bilateral and multilateral sanctions very aggressively. Washington also succeeds in persuading Beijing that it is in its interest to prevent the DPRK from acquiring operational ICBMs by joining the US-led stepped-up sanctions regime, perhaps in exchange for concessions in other areas, perhaps because Beijing fears a significant strengthening of the US-Japanese-Korea alliance. A combination of Iran-style sanctions, after some back and forth, persuades the DPRK to fold for fear of an economic and regime collapse and to put on hold its missile programme in exchange for sanction relief and perhaps some sort of multilateral/ bilateral security guarantee/ peace treaty.

The question is how likely the DPRK would be to make such concessions. China is unlikely to push Pyongyang so hard as to trigger a collapse. Pyongyang knows this. If a military first policy prevails, this scenario will not materialise because Washington is highly unlikely to reward the DPRK with a peace treaty as long as the latter remains a de facto nuclear weapons state. If Iran-style sanctions prove successful, the international economic and financial impact will be limited, even if the path leading up to such an agreement could see increased diplomatic and military tensions on the peninsula.

Scenario 3 – DPRK fields a significant number of nuclear-capable ICBMs => US airstrikes

During the 1994-95 stand-off over the DPRK’s nuclear programme, the Clinton administration considered air strikes against DPRK nuclear sites. This is clearly a high-risk, last-resort type policy. It is complicated by the fact that two major US allies could suffer significant collateral damage if Pyongyang retaliated (ROK, Japan). It would deeply upset Beijing and it may turn out to be not very effective in terms of preventing the DPRK from acquiring a long-range nuclear capability. The economic, political and financial consequences would be severe and could have several difficult-to-predict second-round effects (e.g. Sino-US relations, DPRK military retaliation against US and US- allied targets in the region). However, should DPRK capabilities become a significant threat to US security and China fails to help rein in the DPRK, this scenario would become more likely over time/ by the end of the decade. After all, the threat from long-range nuclear missiles to US security is significantly greater than the DPRK’s nuclear programme in the nineties.

All things considered, scenario 1 looks more likely than scenario 2 over a 2-3 year horizon. How quickly the DPRK makes progress towards nuclear ICBMs will be the most important scenario driver. US missile defence capabilities and the limited amount of missiles the DPRK will be able to field at the very beginning will buy time and will make a military escalation less imminent than otherwise. But if scenario 1 falls by the wayside because the DPRK deploys long-range nuclear missiles and a diplomatic solution remains out of reach due to diverging US, Chinese and DPRK interests, then scenario 3 will become significantly more likely over time.

The long view in EM – middle-income trap, demographics and economic growth (2016)

A number of factors, including the decline in commodity prices, sizeable corporate foreign-currency debt, a strengthening dollar and the prospect of higher US interest rates, are weighing on the economic and financial outlook in the emerging markets (EM). The relative lack of reform combined with a weakening of some of the structural factors that underpin growth has raised concern about the medium-term outlook in many, but not all EM.

If the IMF is to be believed, the economic growth gap between the major Asian EM and the rest will remain significant. The gap has always existed, but – leaving aside China – it seems to be widening. In part, this is due to the economic slump in Brazil and Russia, two countries hit particularly hard by the commodity slump. But broader structural trends are at work, too. Per capita income levels and demographic trends favour India and Indonesia over all other major EM. Here is why and how.

First, per capita incomes in India and Indonesia remain low, compared to the other major EM. According to the conditional income convergence hypothesis, poorer economies have a greater growth potential than richer ones due to their ability to generate productivity gains more easily by way of capital accumulation and total factor productivity increases. Convergence is of course conditional in the sense that it relies on countries pursuing reasonable economic policies. The fit between per capita income and economic growth (past and future) is pretty good in the case of the larger EM.

Second, all the major EM – with the exception of India and Indonesia – have reached per capita income levels associated with the so-called middle-income trap. According to Eichengreen & al (2013), there are two income levels at which significant growth decelerations tend to occur. Viewed from this perspective, China may indeed be facing a tricky next few years. Similarly, Brazil, Mexico and Turkey may also hit speed bumps as they approach the second, higher income threshold. Interestingly, if the data are to be believed, Russia may already have passed the critical thresholds. Or, more likely, the commodity boom helped mask until recently the decline in Russia’s underlying growth potential due to the middle-income trap.

Third, the demographic outlook also varies greatly across the EM, but is most favourable in India and Indonesia, in addition to Mexico, where dependency ratios are falling and the working age population is expanding rapidly in absolute terms. This contrasts sharply with what China and Russia are experiencing. Not only have dependency ratios bottomed out there, but the working age population is declining in absolute terms in both countries. In Brazil and Turkey demographic trends are somewhat more favourable, but even here the so-called demographic window will be closing within the next decade or so.    

Admittedly, growth accounting suggests that rapid economic growth is primarily due to capital accumulation and an increase in total factor productivity rather than labour supply growth. In this sense, demographic trends would seem to have little to do with an economy’s growth momentum. However, research suggests that the demographic dividend (falling dependency ratios) explains around 1/3 of East Asia’s (per capita) economic growth in 1965-2000, mostly via their impact on savings and investment. Viewed from this perspective, the near- and medium-term deterioration of the demographic outlook in the EM is bound to matter.

Neither the middle-income trap nor demographic drag will be constraining economic growth in India and Indonesia for the foreseeable future. Unlike China, where adjusting to slowing productivity growth and unfavourable demographic trends is proving challenging, not least due to its economy’s global systemic importance, India and Indonesia are facing a much simpler task, policy-wise. A combination of macro-stability and moderately supportive policies aimed at raising the physical capital stock, including infrastructure, should suffice to maintain high economic growth rates.

Naturally, this does not mean that concerted reform efforts would not help raise economic growth in the other EM. It certainly would, at least in the medium- to long-term. Interestingly, Eichengreen et al. (2011) also find that it is education that allows EM to overcome the middle-income trap. This makes intuitive sense. Building a reasonably productive capital stock is easier (though not necessarily easy) and less time-consuming than building a quality educational system and human capital. Again, this is not meant to suggest that, for example, infrastructure in places like Brazil is not a major growth constraint. It undoubtedly is. But it is far less of a problem in places like China, Mexico or Turkey. In this respect, at least, China would seem far better positioned to deal with the middle-income trap than Brazil, Mexico or Turkey, countries that have seen much more limited progress in terms of human capital accumulation than China in recent decades. None of this is meant to suggest that broader, productivity-enhancing reform would not be desirable in terms of raising potential growth in the EM – just that important structural factors will favour India and Indonesia over the other EM for the time being.