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Key points in this Outlook:
“In the middle of every difficulty lies an opportunity.” —Albert Einstein
The biggest risk to the 10-year US and global growth outlook is the rising probability of economic and geopolitical instability in Asia. The rise since 1980 of China and, more recently, Japan (see figure 1) alongside the United States as major codependent political forces in Asia and globally is by far the primary geopolitical issue of the coming decade. South Korea, Thailand, Indonesia, and Singapore are other major players in the unfolding Asian geopolitical-economic drama, but in this Outlook I will focus on the two behemoths that account for one-fifth of world gross domestic product (GDP) and 14 percent of global exports: China and Japan. (See table 1.)
Asian Economic Strains Increase
Geopolitical tensions between China and Japan are, ominously, growing alongside rising economic tensions tied to sharply slowing growth. Japan’s fourth-quarter 2014 GDP growth was reported on February 17 at an annualized pace of just 1 percent, far below expectations for a 3 percent pace. The composition was troubling as net exports fell at a 2.2 percent pace, almost offsetting the 3.2 percent pace of domestic demand growth. True, Japan wants to encourage domestic demand growth, and its quantitative-easing–Abenomics push since early 2013 has done so. But the hope was not to lose ground in the external sector. The problem, in part, is a badly timed slowing global economy, especially in China but also in Europe and the United States.
China’s closely watched HSBC Flash Manufacturing index was reported in February at 48.3, sharply below modest predictions of 49.5. China is struggling with substantial excess capacity, a legacy of its massive post–global financial crisis stimulus initiated in late 2008. Financial market instability—tied to China’s burgeoning shadow banking system that offers to produce “high” returns to yield-hungry Chinese investors on poorly vetted wealth-management products—is also destabilizing China. The yuan has been strengthening steadily over the past two years, sending a signal of confidence in China. But after the weak February manufacturing report, China’s currency experienced its largest one-week drop in more than a year. (See figure 2.) Volatility of the exchange rate also rose sharply, signaling heightened uncertainty about China’s economy. Capital is beginning to flow more rapidly out of China.
An increased need for more exports in China and Japan to finance Chinese capital outflows and boost Japanese growth would put the nations in a conflict situation. Both want weaker currencies, as does most of the rest of the world, but both cannot have them without the unlikely global acquiescence to a simultaneously weaker yuan and yen.
It is especially important for the White House to offer leadership on maintaining open trade flows in Asia and globally. The White House’s weak response to overcoming the usual congressional barriers to trade liberalization is disconcerting.
America faces some important choices in Asia that will determine the path of the global economy and political landscape in the coming decade. While trade and related economic growth problems are important, an even more critical issue involves American policy toward Japan and America’s evolving relationship with China and the United States.
Shifting Asian Geopolitics
America’s economic and geopolitical interests are far better aligned with Japan’s goals than with China’s. Japan is at an important crossroads, one highly relevant to American geopolitical and economic interests. World War II has been over for nearly 70 years—at least two full generations—and a new forward-looking generation of Japanese leadership has emerged, led by Prime Minister Shinzo¯ō Abe. Abe’s leadership has been directed at breaking new ground in economics and geopolitics.
In 2013, Abenomics signaled a new set of policies (the so-called “Three Arrows”) aimed at ending deflation (negative inflation), rationalizing Japan’s fiscal stance, and deregulating Japan’s industries and financial institutions. Deflation has already ended and the attendant 20 percent weakening of a heretofore overvalued yen has been accompanied by a world-best 57 percent rise in Japan’s stock market in 2013, the largest rise of any industrial country. Japan’s market was far ahead of China’s Shanghai index that actually fell by 5.4 percent in 2013, despite the accession of new leadership that has pledged to reform the Chinese economy by maintaining growth.
As noted already, China and Japan are both facing more challenging economic problems in 2014 than in 2013. The northeast Pacific, a “dangerous neighborhood” to recall Herman Kahn’s description, has recently seen a sharp escalation of tension between Japan and China. The proximate focus of the tension is the symbolic Senkaku (Diaoyu) Island group strategically located close to large underwater oil and natural gas reserve.
China does not possess the naval strength to prevail in any open conflict over the islands, yet it is stepping up its provocative stance in the eastern Pacific against Japan and America. In December, China radically expanded its Air Defense Identification Zone (ADIZ) to include the Senkaku Islands. On December 5, a Chinese naval vessel reportedly passed within 100 yards of a US Navy cruiser in international waters, forcing the vessel to alter course to avoid a collision. The United States waffled on open opposition to China’s cheeky ADIZ gambit while Japan openly refused to recognize it. The American response to the near-collision was somewhat passive, confined largely to a US defense secretary report on the incident and the potential dangers it entailed.
It has been suggested that China’s rising “military adventurism” is due to a Chinese perception that the 2008 global financial crisis signaled a collapse of American power. In late 2008, China moved aggressively to boost its economy with massive fiscal stimulus amounting to 14 percent of GDP and financed by easy money. The aim was to make China a bastion of economic growth in a world where financial crises had presumably weakened the world’s leading capitalist economy. That said, China continued to invest trillions of yuan in purchases of US Treasury securities with a twofold aim of storing excess savings in a safe place while simultaneously selling yuan for dollars to boost net exports with an undervalued currency.
But now, five years later, after the US economy has struggled and stabilized, America is sustaining 2 percent growth while China is confronting problems of overinvestment alongside a shaky financial system. The Chinese currency is starting to weaken again. A Chinese financial crisis sometime in the next several years based on the bursting of a real estate bubble cannot be ruled out.
In this context it is conceivable that China’s new, more aggressive geopolitical stance in Asia is aimed at distracting attention from its own considerable internal economic problems of excess capacity, labor unrest, and financial instability. In the past, China has sought to create such distractions by whipping up internal anti-Japanese sentiment. Now, with more at stake and “Japan is back” rhetoric being heard around the globe, China feels the need to turn global opinion against Japan.
China’s new leadership, while struggling to stabilize the country’s financial sector and provide more attractive wealth-accumulation vehicles (besides empty apartments), has been caught off guard by Abe’s aggressive “Japan is back” stance. President Xi Jinping and his politburo colleagues have not yet factored into their long-run planning Abe’s push to reestablish Japan as a major power in Asia and the world. Hence the aggressive posturing on China’s much-enlarged ADIZ, on the Senkaku Islands, and on the challenging of American naval vessels in the Pacific. Who would have predicted, as recently as two years ago, that Japan’s stance against—or refusal to recognize—China’s expanded ADIZ would be more aggressive than the Obama administration’s tepid “we wish you wouldn’t” stance. Abe is providing President Obama with an objective lesson in how to provide true leadership.
The time has come for the Obama administration to remind China that it has a treaty with Japan that obliges it to come to Japan’s defense in the event of attack by any sovereign power. Presently, there are those in Japan who doubt that the United States would promptly honor its treaty obligation in the event of an outbreak of hostilities with an economic and military power as large as China. Emboldened perhaps by Obama’s waffling on opposing Syria’s use of chemical weapons, Chinese leadership holds the same view; otherwise, why make provocative threats against American naval vessels in the Pacific and against Japan’s newfound expanded geopolitical goals?
The Chinese have been further emboldened by the 2013–14 replay of the annual flap over the Japanese prime minister’s visit to the Yasukuni Shrine dedicated to the souls of nearly 2.5 million Japanese men, women, and children—including those of the 14 Class A World War II criminals—who have died for their country since its establishment by Emperor Meiji in 1869. The American response to the Yasukuni visit was muted, expressing concern that the shrine visits could elevate tensions between Japan and its Asian neighbors. The American statement might have pointed out that the rise of such tensions has been exacerbated by China’s recent provocations and its somewhat hyperbolic response to Abe’s visit to the shrine.
Japan’s Economic Potential Is Intact
Meanwhile, in view of its still-tepid pace of growth, Japan’s fiscal consolidation is proceeding slowly, as it should while aggressive monetary policy is aimed at permanently ending deflation and boosting growth. Japan’s move toward restructuring its economy through deregulation and by welcoming foreign investment is termed “too little, too late” by its critics both inside and outside of Japan, but progress is being made. Also, wages will be boosted in the “spring wage offensive”—Japan’s annual wage negotiation between the enterprise unions and employers—and that will further support growth of domestic demand.
Japanese companies are beginning to streamline in ways that are attracting heretofore absent interest among foreign investors. American investors and even some high-profile fund managers such as Dan Loeb, activist founder of the hedge fund Third Point LLC, are beginning to invest in Japanese companies. Perhaps more important, some American investors are beginning to work cooperatively with low-profile Japanese managers to invest in newly promising individual companies while others are placing larger macro bets on Japan’s economy. Japan is back in play for global investors.
Japan’s overall growth rate—including a return to persistent, positive nominal growth important to boosting profits and wages—has been stagnant for nearly two decades. By the fourth quarter of 2013, Japan’s year-over-year nominal growth rate had recovered 2.4 percent, well above the 1 percent contraction in the first quarter. This outcome is encouraging, as it happened when the fourth quarter’s pace of growth had dropped to just 1 percent. Part of the rise came from an end to Japan’s dangerous and heretofore persistent deflation.
And, just as important, the allocation of capital and labor within Japan is improving with the help of focused Japanese and foreign investors. It surely is fair to suggest that Japan’s medium-to-long-term growth outlook has improved relative to that in the United States where policy uncertainty remains high and regulation in the financial and industrial sectors, not to mention the troubled health care sector, is rising.
Under Abe’s leadership, Japan is clearly moving toward the full nationhood that it relinquished during the American protectorate of Japan and the era of passive Liberal Democratic Party (LDP) leadership in the decades after World War II. During the 1970s and the 1980s, Japan’s renaissance was by design economic, not political. After a flirtation with a shrinking economic and political role under the weak leadership of the Democratic Party of Japan, the new Abe LDP is signaling that Japan’s economy is back and so is Japan as a major industrial nation that is ready and able to defend itself as a truly sovereign nation. Japan’s movement toward full sovereignty should include symmetric defense treaties with the United States whereby Japan pledges to support American interests in the event of conflict, just as America pledges to protect Japan.
Opportunity for America in Asia
America’s primary task in the Pacific is straightforward: pick a winner. The new winner in Asia is Japan, which is developing a strong economy alongside a new geopolitical role as an autonomous, sovereign nation that will be an equal partner with the United States as a guarantor of a peaceful Asia. A stronger, more clearly articulated US-Japan alliance (a symmetric version of what Senator Mike Mansfield once described as “the most important bilateral relationship in the world, bar none”) need not threaten China, which continues to develop as an economic-geopolitical world power. It only needs to remind China that economic and geopolitical initiatives that advance Chinese interests at the expense of American-Japanese interests will not be tolerated.
President Obama’s late April trip to Asia, including visits to Japan and South Korea, presents him with an opportunity to encourage Japan’s progress toward fully symmetric sovereignty while helping stabilize Asia and promote the faltering Trans-Pacific Partnership Agreement. Toward that end, adding a presidential visit to China would be a constructive step.
1. Herman Kahn, Thinking about the Unthinkable (New York: Horizon Press, 1962).
2. See Edward N. Luttwak, “China’s Risky Flirtation with Military Adventurism,” Wall Street Journal, January 2, 2014.
3. Mike Mansfield: My Recollections (Tokyo: Nihon Keizai Shimbun Inc., 1999), 89–92.
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