Geopolitics and the Dollar

The confrontation with Iran is widely perceived as the most worrisome geopolitical event on the horizon. It is difficult to assess the odds of overt action. Intrade.com shows about a 29% chance of a US or Israeli strike before the end of the year. The general perception is that nothing happens before the US elections. The odds of a strike before the end of next year are just above 50%.

While this is indeed worrisome, there is another geopolitical issue that is increasingly problematic and that is the face-off between Japan and China over the disputed islands. It has spoiled the 40th anniversary of the celebration of the normalization of relations (Sept 29) and is having an economic fallout.

A military threat lurks just below the surface. Intrade.com has not developed a contract for this (yet?). Japanese press played up the fact that the islands are covered by the US-Japanese security pact. However, the US position is for a peaceful negotiated resolution.

However, the domestic situation in both countries seems to make it difficult for compromise. China's once in a decade transition of power appears not to be going as smooth as hoped/expected. Moreover, China faces numerous similar disputes with others in the region and any softening of its stance vis a vis Japan would be seen as weakening its negotiating hand with the others.

Japan is also in the middle of a transition of sorts and the resignation today of Finance Minister Azumi to take a senior position within the ruling DPJ, which may be part of a larger cabinet reshuffle, reinforces the sense that an election announcement is coming.

The DPJ appears to have exhausted its political capital on the insistence of the controversial retail sales tax increase (first step will be in 2014). The polls suggest the LDP may be returned to power and the coalition government it leads may be even more nationalistic than the current one. The Noda's government hand was forced when the governor of Tokyo bought a couple of the contested islands from a Japanese family that has "owned" them for decades. It is the nationalization of the islands that is the precipitating factor to current intensification of tensions.

There has already been some economic fallout. A Reuters poll found 41% of Japanese firms claiming that this confrontation is effecting their business. Some Japanese companies have threatened to shift operations out of China. Last week, a Japanese auto factory cut output by 14k vehicles at a cost of some $250 mln. Fitch, the rating agency, warned that Japanese corporate sales and reputations with Chinese consumers would likely be impacted. A few investment houses have lower outlook for Japanese listed companies. There have been reports of administrative trade frictions and some reduction of Chinese flights to Japan.

This is not meant to be alarmist and it is difficult to see a direct general market impact. However, it should be understood as a confrontation that may have a low probability of escalating, but whose risks, should it materialize, be highly significant.