Asian Security Issues May Undermine Japan

Japan's DPJ government has been forced to back down on its campaign pledge regarding the moving of the US Marine Corp base in Okinawa. Prime Minister Hatayama's retreat may come at a high political cost. It appears to have weakened his already poor standing in opinion polls and appears to be undermining his governing coalition. In sum, it adds to the odds that the DPJ will lose the upper house election in July.

Hatayama's decision came before the latest tensions on the Korean peninsula, but likely reinforce the decision that now is not the best time to reassess the US-Japanese security relationship.

However much the tensions in Korea are unsettling, what investors do not seem to fully appreciate is that China's recent actions may an even greater cause of concern.

Last month there were two incidents that were under-reported by the press. In both cases, Chinese military harassed Japanese defense forces. In early April, a Chinese military helicopters flew within 100 yards of a Japanese defense forces escort ship in international waters. Japanese protests were dismissed by Chinese officials. In late April, Chinese naval vessels sailed between Okinawa and other Japanese islands and conducted military exercises in waters Japanese defense forces usually patrol. Again a Chinese military helicopter buzzed a Japanese escort ship.

Separately, the tensions between the two countries was also aired in the middle of May. At a diplomatic conference, Japan's foreign minister called on China to reduce its nuclear arsenal. China's foreign minister became irate and claimed that Japanese forces had killed his parents and reportedly stormed out of the meeting.

There are several important take aways for investors:

First, security issues in the region extend beyond the Korean peninsula.

Second, the tension between China and Japan,suggests that China cannot be counted on to reign in North Korea. Japan supports South Korea's initiatives.

Third, China is projecting its naval power in a way that it hadn't before. This warns that security issues may surpass the exchange rate policy and trade issues in terms of saliency for US policy makers.

Fourth, handling of the Okinawa base decision, even if correct from a realist or realpolitik point of view, was poorly handled and this raises the odds that the DPJ lose their majority in the upper house. Weak political leadership makes bold decision making less likely. And this is important in terms of what kind of structural budget adjustments that the DPJ government will unveil next month, which S&P has indicated is an important factor in its decision whether to cut Japan's sovereign rating after putting it on negative watch earlier this year.