Make no mistake: America and China are on a collision course and the battleground is Asia. The China-Japan dispute has little to do with a small group of islands in the South China Sea. It's about a new world power, China, wanting to assert its authority in Asia. And it's about the U.S being threatened by China's increasing power and wanting to contain it. That's what makes the current dispute so dangerous. Even if the fight dies down, the battle for dominance in Asia between the U.S. and China will continue.

For investors, the implications from this are not only the potential for increased trade disputes between the U.S and China. But also, the likelihood of rising friction between Asian countries themselves. In fact, we're already seeing it as these countries are being forced to side with either America or China. Intra-Asian trade will be impacted too. Welcome to the new Cold War.

Asia is the new battleground

I have an abiding love for history. I put it down to a combination of great high school history teacher and a realisation that if you don't understand history, you can't possibly understand the present or the future. Anyhow, I got thinking about how we've been lucky to have lived through a remarkably peaceful period since the fall of communism in 1989.

The fall spurred much self-congratulation about how liberal democracies had won the day and communism was dead for good. Francis Fukuyama's 1992 bestseller, The End of History, reflected this sentiment:

"What we may be witnessing is not only the end of the Cold War, or the passing of a particular period of post-war history, but the end of history as such: that is, the end point of mankind's ideological evolution and the universalization of Western liberal democracy as the final form of human government."

The book was not only silly in theory but totally ignored the rise of communist China too.

Now some of you may say that we haven't lived through a peaceful period since 1989 at all. Two wars in Iraq, a war in Afghanistan, a terrorist attack on the U.S., ongoing bloodshed in Palestine, to name but a few of the fights since that time.

Not to belittle these conflicts in any way, but they were relatively small fry compared to what happened prior to 1989. The latest Iraqi war and occupation is estimated to have had around 172,000 casualties. The September 11 terrorist attacks had casualties numbering 9,000 including 3,000 dead.

These were not total wars though. The number of countries involved was far greater in World Wars I and II, as well as the Cold War. The casualties also dwarfed those of recent conflicts. For instance, casualties during World War I numbered 22.5 million. It's hard for many people to fathom these numbers and the destruction involved.

Which brings me to the present day. I can't help but thinking that we're entering a new period of rising tensions between countries. As well as a Cold War in Asia. The 2008 financial crisis and subsequent economic downturn, as well as rising food inflation, have led to the fall of several, once-considered impregnable governments in the Middle East. The installation of new governments in their place is proving problematic.

By contrast, increasing tensions in Asia have nothing to do with the economic downturn or food inflation. Instead, they've come about from the rise of China as a new world power. China is staking its claims as a world power both economically and politically, focusing particularly on its own neighbourhood, Asia. And other nations are increasingly concerned about it.

China-Japan dispute: appearances deceive

The current conflict between China and Japan is supposedly over five tiny, uninhabited islands, Senkaku or Diaoyu islands, in the South China Sea. And the abundant natural gas in the area. China has been challenging Japan's claims over the Senkaku islands and its control of them. The situation has become increasingly tense and in late January there was almost a shoot-out. Japan claims that China beamed fire control radar at a destroyer owned by the Japanese Navy - a first step to potentially firing a missile at it.

The dangers of the conflict lay with politicians on all sides wanting to prove their military credentials by appearing tougher than the one another, with little regard for the consequences. This kind of behaviour is similar to that which almost led to catastrophic consequences during the Cuban missile crisis in 1962.

Stepping back from the minutiae of the dispute though, it's ultimately about the changing balance of power in Asia. China has already become an economic power, now being the world's second largest economy. It's Asia's largest trading partner in both exports and imports. It's seeking the political power to match its economic might. And it's aggressively building military capabilities to achieve this goal.

Japan, on the other hand, is angry over China's economic prowess and wary of its political ambitions in the region. Japan has watched its share of imports in all markets shrink while China's share has rapidly expanded. Japanese companies have been forced to shift the production of manufactured goods to China and other low-cost countries, which has contributed to the country's depressed economic activity. The current dispute is effectively Japan's way of saying: "enough is enough".

Of course, Japan's principle ally in Asia is America. The U.S. has publicly remained neutral over the disputed islands, but privately there's little doubt that it's siding with Japan.

The backdrop is that the U.S. has historically been Asia's most influential political power but the dynamics are changing with the rise of China. That's why official American foreign policy has been to "pivot" towards Asia and away from area such as the Middle East. China believes that this pivot is about the U.S. containing its power and it's right. Of course, America denies this but logic dictates otherwise.

In a previous note, I suggested that it was no coincidence that The New York Times ran arguably anti-China stories U.S. election. I love the Times and some of the stories, such as Premier Wen's family secret fortune, were fantastic pieces of journalism. But I've got no doubt that the sources feeding these anti-China articles were mostly from the Obama administration. It's part of a toughened stance towards China.

Asia is splintering

Thus far, the U.S. has played its hand well in Asia. It's strengthened relationships with Vietnam and the Philippines by subtly backing their own claims against China to territories in the South China Seas. It's also strengthened military alliances with South Korea, Singapore, Indonesia and Australia. And it's managed to become a key ally to Myanmar, a country with immense potential that is starting to open up to the world, and where China arguably has blundered.

Asia itself has splintered. Countries are being forced to ally with the U.S. or China. "You're either with us or against us" in military speak. This trend is most apparent at the 10-member, Association of South-East Asian Nations (Asean). Asean has practically stopped functioning because of the bickering over China's territorial claims in the South China Sea.

Last year, Cambodia chaired the association and as an ally to China, pressed its friend's territorial claims. Vietnam and the Philippines strongly objected, and the various arguments became public at Asean meetings. With Brunei now chairing the association, it's hoped these arguments will die down.

But I wouldn't count on it. Asean is pushing for a collective agreement over China's claims while China itself only wants discussions and/or agreements with the countries directly impacted by the claims. In short, expect more diplomatic posturing and possibly open hostility.

Why it matters for investors

There are several implications from this new Cold War. In any war, cold or otherwise, trade usually suffers. You're likely to see the U.S. and China introduce new trade tariffs and sanctions between the two countries. The U.S. will also start pressuring Asian allies to align their investment policies with it. From China's side, you're already seeing work to move away from the dollar as the world's reserve currency.

Of course, the elephant in the room is China being the second-largest holder of U.S. government debt. For economic reasons, China's already started to reduce its holdings due to reduced foreign currency reserve growth (which we've talked about recently).

The implications of this new war spread much further than just the U.S.-China relationship though. Intra-Asian trade will be impacted too. Consider that exports within Asia account for around 56% of total Asian exports. In other words, Asia matters more than the rest of the world. Consider also that intra-Asia trade grew 3.5x over the past decade, or a 15% Cagr. Tidy.

Hat tip: Joshua Saldanha.

China's export trade share in Asia though has fallen from 51% in 2002 to 44% now. It's become more export dependent on the rest of the world and less on Asia.

On the other hand, Asean has benefited greatly from intra-Asian trade. As a percentage of total exports, Asia accounts for 69% of Asean exports, up from 60% a decade ago. It's not hard to see that Asean could be a big loser from increased trade frictions.

Source: http://asiaconf.com