The Dragon And The Eunuch: Wars, Spies And Profits In 21st Century Asia

The Quiet American is one of the most acclaimed novels of the last fifty years. Written by Graham Greene, the book deals with French colonial Vietnam in the 1950s. The story is that of Fowler, a world-weary British journalist, and Pyle, the idealistic and naïve, “quiet American” who works for an economic development organization and blindly applies his academic theories to a political situation he doesn’t quite grasp. Pyle winds up dead in the river, and Fowler is suspected of the murder.

It is a downbeat story, where the harsh realities of the war blend with passionate love and personal degradation. Toward the end of the book, a military officer admits he envies how Fowler escapes. Fowler provides more than just a simple response to the officer:

“You don’t know what I’m escaping from. It’s not from the war. That’s no concern of mine. I’m not involved…You will all be. One day…Not me.…One day something will happen. You will take a side.”

Fifty years later and those words couldn’t be more true. For a long time, people refused to look beyond the borders and understand what’s happening and why. The terrorist attacks on Sept. 11, 2001, changed this. Suddenly, people took notice. The majority looked in amazement and most were unable to explain what happened and why–and many still can’t.

For most people, the world changed that day; we were forced to look beyond our immediate world, even if only superficially.

But what makes the aforementioned developments more important is globalization. Because of globalization, the world’s geopolitical game changes more rapidly than before. Globalization has worked in multiple levels, the most important being the rise of new economic powers and consequently their quest for economic security and military independence.

The combination of globalization and geopolitical changes has created an environment where isolationist behavior–a US trait of the old–has become obsolete. For investors, understanding world changes is more important now, as the interconnection of markets and economies have proven too dangerous to ignore.

Just ask those who failed to grasp the changes globalization brought and mistakenly took the rise in oil prices from $20 to $40 per barrel as a short-term event. They decided to sell oil short, failing to realize not only that war in the Middle East would adversely affect oil prices, but, most important, that the growing economic needs of China and India would keep prices higher longer and for years to come. So they looked in amazement as oil prices climbed to $70 while losing millions of dollars.

In the future, serious investors, both domestically and internationally oriented ones, can only be successful if they understand how global political and economic changes affect their investments. Identifying and analyzing these changes is one reason I started Geopolitics & Investing Quarterly (GIQ). Another reason is to offer specific investment recommendations that will benefit from the changes we discuss.

The Economics Of Globalization

Globalization is not a new phenomenon. The growth of worldwide networks of interdependence is almost as old as human existence. During the last thirty years, the importance and reach of these networks has advanced rapidly, taking many inward looking people by surprise.

As globalization has evolved, so has its definition(s). The one used here comes from Financial Times chief economic commentator Martin Wolf:

“Globalization is defined as integration of economic activities, via markets. The driving forces are technological and policy changes–falling cost of transport and communications and greater reliance on market forces.”

In its current form, globalization has grown mainly because of money funneled by mature economies to developing ones. As the latest United Nations World Investment Report states:

“At $648 billion, world foreign direct investments (FDI) inflows were 2 percent higher in 2004 than in 2003. Inflows to developing countries surged by 40 percent, to $233 billion, but developed countries as a group experienced a 14 percent drop in their inward FDI. As a result, the share of developing countries in world FDI inflows was 36 percent, the highest level since 1997…In the case of the United States, outflows increased by over 90 percent, to $229 billion, a record high.”

Those figures demonstrate that the world economy has reached a different level of interconnectivity than in the past. This has been facilitated by the mobility of capital and the developing countries’ work toward providing the infrastructure for receiving and properly using these funds.

Previously, investments in developing economies targeted simple manufacturing and other low-end production activities. Now, however, more parts of a corporation’s functions are up for grabs. The old unwritten rule that the high-end “untreatable” functions, such as research and development (R&D), are reserved for workers of the company’s home country is fading away.

This shift has had two main effects: the gradual redistribution of income from developed to developing economies and a shift from growth- to income-oriented policies for developed economies. There are additional consequences, most notably higher resource prices, but these are the result of income redistribution and higher demand.

As things stand now, the only way globalization could slow down is through regional social unrest and protectionism. The latter has never worked, usually producing hardships, instability, and unfavorable economic environments. As a result, societies have been adversely affected, thus, leading to more problems.

The bottom line is that no one ever knows how politicians will decide to deal with constituency pressure. As Samuel Brittan noted, “Every unwise move in American economic policy has been rationalized by the protectionist fear, just as every unwise move in foreign policy has been rationalized by the fear of isolationism.”

A Dangerous World

The global geopolitical picture isn’t bright. The US continues to be involved in a complicated situation in Iraq where the outcome is anybody’s guess; few observers are currently in a position to assess the consequences for the area and the world.

Furthermore, Iran’s latest actions regarding its nuclear capabilities and the transfer of substantial amounts of its foreign exchange reserves from Europe-based banks to ones in Asia have unnerved many policy makers. At this point, you can’t seriously dismiss a potential confrontation between Iran, the US and its closest allies.

The situation is becoming more complex because the US is trying to gain a foothold in Central Asia–which is traditionally under Russia’s, and to a lesser degree China’s, influence–about which Moscow and Beijing are upset. Hence, astute observers aren’t surprised by Iran’s purchase, from Russia, of Tor-M1 defense systems, to be delivered in 2006, worth more than $1 billion. China’s support for Iran has also been clearly conveyed to European Union (EU) and US representatives.

Russia and China don’t necessarily want to see Iran armed with nuclear weapons, yet the two countries seem to be using the situation as a countermeasure to what they believe is a threatening hegemonic attitude by the US.

North Korea remains an uncertain spot on the political world map. That’s in part because six party talks haven’t proved successful, with Russia, China and South Korea adopting a different position than their more hard-line partners, the US and Japan.

As an aside, the changes in Latin America’s political map (e.g., socialist-oriented governments being elected) and the deteriorating situation in most of Africa are not small developments. Yet, the situations in the Middle East and Asia appear to be more pressing.

One of the world’s most important geo-strategic puzzles is the future of the Sino-Japanese relationship. The issue has multiple dimensions, including China’s rise as an important economic and political power, the future of Taiwan and Japan’s efforts to have a significant presence in the global political arena. To do so, Japan is focusing on increasing its defense capabilities to shed its post-World War II geopolitical eunuch status.

The US’ status as the sole superpower, its involvement in a number of the world’s hotpots, such as the Middle East, and its role in guaranteeing stability in East Asia during the past sixty years makes the Sino-Japanese relationship’s evolution even more relevant to investors. If correctly positioned and patient, you have the opportunity for outstanding profits.

China’s and India’s economic growth during the past decade has been the focus of every investor for the past three years. (Note: India’s rising geo-strategic status will be the theme of an upcoming report.) As these economies grow stronger, so does their need for a better defense and power projection capabilities. Add to this the needs of a former imperial power (i.e., Japan) that boasts the second biggest economy in the world, and you can appreciate the magnitude of the change that will take place in the not-so-distant future.

Asia’s rearmament has already started and will continue for years to come. Its consequences will be far reaching and change the global balance of power forever.

The Baseball Diamond

In 2003, then-Deputy Secretary of State Richard Armitage, while commenting on Japan’s decision to send Self-Defense Forces (Japan’s military forces; JSDF) to Iraq, said: “It’s not necessary to be the pitcher or the catcher and be involved in every single play of the game. But you cannot play at all unless you are on the baseball diamond.”

Three years earlier he had led a study group of heavy hitters from the fields of international relations, government and security that prepared a study for the Institute for National Studies of the National Defense University (“The United States and Japan: Advancing Toward a Mature Partnership,” INSS special report, October 2000).

Many observers consider this report one of the most important on the subject, especially since quite a few of the authors later held important government positions (while some served in previous administrations), as newly elected President Bush was appointing his policy team a few months after the report was published.

In the report the research team explicitly acknowledged the importance of the US-Japan security relationship:

“If the United States can exercise leadership–that is to say, excellence without arrogance–in its relations with Japan, the two countries will be better able to realize the full potential for cooperation nurtured during the past 50 years. If the changes underway in Japan ultimately produce a stronger, more responsive political and economic system, the synergy in US-Japan relations will enhance our abilities to play an engaged, mutually supportive and fundamentally constructive role in regional and global arenas in the years to come.”

And later:

“Because the stakes are so high in Asia, it is urgent that the United States and Japan develop a common perception and approach regarding their relationship in the 21st century. The potential for conflict in Asia is lowered dramatically by a visible and ‘real’ US-Japan defense relationship. The use of bases granted by Japan allows the US to affect the security environment from the Pacific to the Persian Gulf. The revised Guidelines for US-Japan Defense Cooperation, the basis for joint defense planning, should be regarded as the floor–not the ceiling–for an expanded Japanese role in the transpacific alliance, and the uncertainties of the post-Cold War regional setting require a more dynamic approach to bilateral defense planning…We see the special relationship between the United States and Great Britain as a model for the alliance.”

Although this is the best-known paper on the subject, there are countless studies available from both the US and Japanese sides that draw similar conclusions regarding the importance of the US-Japanese defense alliance to the two parties and the region’s overall stability.

To understand why this relationship is such an important piece of the geopolitical puzzle, we need to refresh our memory of Japan’s Constitution. The constitution was crafted by the US under the guidance of General Douglas MacArthur. Article 9 of the document ensured Japan remained a geopolitical eunuch during the past sixty years.

More specifically, Article 9 states:

“Aspiring sincerely to an international peace based on justice and order, the Japanese people forever renounce war as a sovereign right of the nation and the threat or use of force as means of settling international disputes. In order to accomplish the aim of the preceding paragraph, land, sea, and air forces, as well as other war potential, will never be maintained. The right of belligerency of the state will not be recognized.”

That said, Japan–during the past 10 years—has put 1 percent of its gross domestic product (GDP) toward defense-related expenditures. For the second biggest economy in the world, this is serious money. Consider this: If the Japanese decided to raise spending to about 4 percent of GDP, which is what the US currently spends, the dollar amount would reach almost half of what the US spends—and that’s the largest amount any one country spends on defense, by far. As an aside, Japan started its defense buildup during the ‘70s.

During the past two to three years, Japan has made changes to its defense operations that would have been unimaginable not long ago. It has (1) sent JSDF troops to Iraq, (2) begun maintaining a regular presence in the Indian Ocean and the Arabian Sea, (3) decided to implement a sea-based missile defense and (4) become more direct regarding its defense needs toward China.

Japan’s 2005 defense policy overview reflects the seriousness with which it treats these priority shifts:

“In order to deal with new threats such as the rapid proliferation of WMD [weapons of mass destruction] and ballistic missiles as their means of delivery after the end of the Cold War, the Japanese government officially decided to introduce a ballistic missile defense (BMD) system in December 2003.

“A BMD system is an inherently defensive measure and the only one available to protect the lives and property of the people against ballistic missile attacks. The government determined that BMD system was appropriate for Japan’s exclusively defense-oriented defense policy and that rapid advances in BMD-related technologies in recent years had made it technically feasible for Japan to develop such a system.

“The BMD system being deployed by Japan is a multi-tier defense system comprising upgraded Aegis vessels and Patriot PAC-3 missiles, and current equipment is being utilized as much as possible to make the introduction of the system as efficient as possible. In addition, in order for the BMD system to function effectively, BMD legislation to enable a quick response to missile attacks without undermining the principle of civilian control is being considered.”

“…In order to build and enhance the capability of the BMD system, it is necessary for Japan to continue with cooperative research with the United States, and promoting BMD cooperation with the United States will be of great help to the defense of Japan. In this context, Japan entered into a memorandum of understanding on creating a general cooperation framework concerning BMD in December 2004. As for operational matters, Japan is considering creating a framework which enables Japan and the United States to cooperate in the operation of the BMD system.”

Recently, Japan announced it will develop, with the US, a sea-based ballistic BMD capability against possible regional threats, including North Korea and China. Prime Minister Junichiro Koizumi signed off a budget that will set aside more than JPY3 billion ($25 million) for the initial stages of the program in 2006.

According to industry sources, “Indications that Japan and the US were preparing to expand their BMD co-operation were evident throughout 2005, as the US Defense Security Cooperation Agency (DSCA) reported to Congress a series of Foreign Military Sales requests for SM-3 missiles to Japan totaling more than $1 billion.”

Although Japan has been constrained when it comes to military capabilities and its use, a potential change in the constitution and a reorientation of attitudes toward the military point toward a significant shift from the status quo.

In order to implement a “sea-based, mid-course anti ballistic missile defense,” it takes a defense platform of Aegis destroyers, as can be seen from the diagram below.

It’s important to understand these ships’ capabilities. GlobalSecurity.org, a respected name for information about the defense industry, offers interesting details:

“Japan was the first state (outside the United States) to acquire the superlative Aegis fleet defense system, fitted in the Kongo-class destroyers. The Aegis system’s maximum detection distance, the number of simultaneously tracked targets, reaction time and missile range is superior in all points by comparison with the former Tartar system. The ASROC anti-submarine rocket, which is the anti-submarine weapon, along with the Standard anti-aircraft missile, are launched from the VLS (vertical launch system), which is imbedded in the front and back section decks.

Source: Japan Defense Agency

“The Kongo is an improved version of the US Navy’s Arleigh Burke class, displacing 9,485 tons (full load). It is a substantial departure for Japan in terms of size and capability in its surface fleet. There also are qualitative differences between Japan’s modern ships with their well-trained crews and the older, less capable ships of other East and Southeast Asian navies.

“Although derived from American Arleigh Burke class, numerous changes include a far longer helicopter deck aft, less horsepower and a slightly different weapon suite. Some of the differences between the JMSDF Kongo’s and the USN Burkes are that the Kongos employ a separate fire-control system for the 127-mm gun, which has a faster firing rate than the USN standard Mk 45 127-mm gun, a back-up surface/air search radar, a more elaborate EW system and while they have the capability to act as a helicopter platform they do not have a haul down system. Full displacement on the Kongos is larger, 9,485 tons to 8,500 tons and is some 78 feet longer and 2 feet wider.”

The Kongo Class is the 4th generation Guided Missile Destroyer (DDG).
Source: Japan Defense Agency

Although Japan has some time until it’s able to create a fully functional military, its weapons systems are the most technologically advanced in the region, not including the US.

It must be understood, though, that the US role has been to provide security for Japan, and there may be a day where one or both of these parties decide to stop. This opens the door for Japan to create its own military policy, which it hasn’t done since the end of WWII. It makes sense, therefore, that many Chinese Japan specialists appreciate the stability the US’ presence offers the region.

Professor Thomas Christensen of Massachussetts Institute of Technology once quoted a leading Chinese expert on Japan as saying “the US presence in Japan can be seen either as a ‘bottle cap,’ keeping the Japanese genie in the bottle, or as an ‘egg shell,’ fostering the growth of Japanese military power under US protection until it one day hatches onto the regional scene.”

Many Chinese security analysts believe Japan will be a great military power, again, within 20 years. At that point, their thinking goes, the US will play a lesser role in the region, as a self-assured Japan will feel more comfortable deciding its own future.

This may prove correct, given that China’s rise has prompted discussions regarding a potential change in the regional status quo–making some (e.g., Japan) nervous. With the geo-strategic picture in Asia changing, Japan’s main reason for military reform becomes clearer.

As Tomohiko Taniguchi, Japan’s Deputy Press Secretary for the Foreign Ministry, wrote in an excellent paper (“Whither Japan? New Constitution and Defense Buildup,” The Brookings Institution, May 2005) on the subject: “While Japan has been preoccupied with the often-discussed threat from North Korea, the administrators of the missile defense program and other defense initiatives have obtained latitude to secure funding. However, in the run-up to finalizing the report, it is obvious that the Council [of security and defense capabilities], in fact, gave more attention to China than to North Korea. As a matter of fact, North Korea provided a convenient façade behind which Japan was able to slowly but steadily sharpen its focus vis-à-vis China.”

Dragon Tales

Although China’s emergence as a serious player in the economic and geopolitical arena has global consequences, it is its relations to the rest of Asia that are of special interest here.

This suggests a strong China-centric perspective, but the Sino-American relationship and US involvement in the area are of paramount importance because of the high level of economic interdependence. Despite this, China’s military power and its potential threat are often the focal points in discussions regarding security issues in Asia and the world. And this perspective is gaining ground, as many US political analysts agree that a unipolar world–a world where one country’s power and capabilities are so great that the creation of a balancing coalition against it is not possible–benefits the US.

In China’s 2004 white paper on national defense, the government notes that:

“China persists in taking the road of peaceful development and unswervingly pursues a national defense policy defensive in nature; China’s national defense is the security guarantee for the survival and development of the nation…The current international situation continues to undergo profound and complex changes. Peace and development remain the dominating themes of the times. Although the international situation as a whole tends to be stable, factors of uncertainty, instability and insecurity are on the increase.”

These sentiments reflect China’s opinion that it behaves like any other peaceful legitimate state. The report also suggests China views the world political environment in a way that’s similar to the US. China has supported the US in its war on terror and carefully avoided a confrontation regarding its opposition to the war in Iraq.

At the same time, though, China has worked on becoming a source of stability and cooperation in the region, i.e., a responsible great power. Furthermore, China has resolved most of the territorial disputes with its neighbors, which have been a source of instability for the past fifty years.

As the country continues to improve its economic standing, China has tried to enhance its security by increasing its military capabilities while engaging the world. One way it has done so is by joining a number of international organizations, including almost all the key security regimes (e.g., the Nuclear Non-Proliferation Treaty and the Chemical Weapons Convention). China has worked hard to gain visibility in the world stage, not only as a regional power but also as a good intentioned and caring member of the global community.

Jane’s Defence Weekly, the most authoritative journal on the world’s defense developments, finds that:

“China’s military modernisation is a development of global consequence. The People’s Liberation Army’s (PLA’s) launch in 2006 of its 11th Five-Year Defence Plan covering 2006-10 represents the next phase. Details of this plan remain a closely guarded secret but emphasis is likely to continue in several broad areas. These include further troop reductions, particularly among ground forces, together with promotion of joint operations, building ‘informationised’ capabilities and construction of an effective civil-military defense mobilization system.”

Part of that effort, as well as improving its regional relations, has been cooperating with Russia, a relationship that has come a long way from the 1962 Sino-Soviet split, which was the culmination of a long-simmering feud regarding relations with the West, military and industrial developments and how the Cuban Missile Crisis was handled. One result of its recently revived cooperation has been an improvement in China’s naval and air capabilities.

The best plane China’s air force, the PLAAF, is the Russia-made Sukhoi-27 Flanker and the Su-30 MKK. The Su-27, of which China is believed to have 100, is a high performance fighter, primarily useful for high-altitude interception, and is often compared favorably to the US F-15C. It has a 930-mile range, can refuel in the air, flies at Mach 2.35 and can climb to nearly 60,000 feet. Plus, its sophisticated avionics systems and 6,000 kilograms of ordnance make it a deadly foe. Military observers, however, have pointed out that its air-to-air missiles and fire control systems aren’t as good as those of the F-15C, F-16, or Mirage 2000 fighters.

The Su-30 MKK–see the picture below–is PLAAF’s most advanced plane; it’s believed they have about 60 of them. The fighter has all the air combat capability of the Su-27 but also has a secondary all-weather ground attack capability. It has a range of 1,800 miles without refueling and has more advanced avionics and radar than the Su-27. The Su-30 carries a dozen air-to-air and air-to-ground missiles, as well as 6,000 kg of precision-guided smart bombs.

A PLAAF 3rd Air Division Su-30MKK (serial number 11140) in the “Peace Mission 2005” China-Russian joint military exercise.
Source: Chinese Defence Today

On the sea, China’s best are the Russia-made Sovremenny-class destroyers, built principally to counter Aegis-equipped destroyers (see above) and cruisers (aircraft carrier escorts) and the on-board defense of US carriers.

The most formidable weapons onboard the Sovremenny-class destroyer are the eight 120 km-range ramjet-powered 3M-80E Moskit (SS-N-22 Sunburn) supersonic anti-ship cruise missiles–in the picture below, they are highlighted by a red circle. The PLA Navy received at least 40 3M-80E missiles in 2000 and conducted the first test launch in 2001.

The Sunburn is among the most advanced anti-ship missiles deployed in the world today and against which there are limited countermeasures. It has been specifically designed to penetrate the defenses of carrier battle groups. It has a velocity of Mach 2.5, and can avoid radar by flying 4.3 feet above water.

 

A project 956 Sovremenny class destroyer.
Source: Chinese Defence Today

According to industry sources, the missile is armed with a conventional 300 kg penetrating warhead, containing 150 kg of high explosive, or, as in Russia’s Navy, a 200 kiloton nuclear warhead. Even with a conventional warhead, the SS-N-22 Sunburn missile is large enough to seriously damage or even sink a major US Navy surface combatant. A US Navy aircraft carrier could probably withstand hits from a few Sunburns, but would not be able to withstand a hit from a nuclear-armed SS-N-22 Sunburn, even if the warhead detonates at some distance from the carrier.

Jane’s Defence Weekly’s correspondent for Taiwan, Wendell Minnick, has noted “the Sunburn is three times as fast as the US Harpoon, [and] does not slam into the side of a ship like the Harpoon; instead, as it nears the target it rises above it and then dives straight down through the deck of the ship. The speed and angle of the attack make it nearly impossible to shoot down or to disable by electronic countermeasures or jamming” (“The year to fear for Taiwan: 2006,” Asia Times, April 2004).

The most modern segment of the PLA is its ballistic missiles capabilities (it’s no wonder the Japanese have developed such a sophisticated BMD program). This suite includes a new generation of short-, intermediate- and intercontinental-range missiles (ICBMs). The short-range ballistic missiles receive most of the attention, as about 700 of them are deployed near the Taiwan Strait.

China has had the ability to hit the continental US with ICBMs since the 1980s. Currently, the most advanced ICBM in China’s arsenal is the DF-31, also known as CSS, China’s first true strategic nuclear deterrent.

According to industry sources, the DF-31 is a three-stage, solid-propellant ICBM. The basic variant DF-31 has a range of about 5,000 miles, which places Alaska, Hawaii and the northwestern continental US in range. The upgraded version can strike up to about 7,500 miles away.

The missile reportedly uses an inertial guidance system with a stellar update system. Stellar- or star-guidance systems compare computerized star maps with photos taken of the galaxy from the missile. Discrepancies, which reflect trajectory inaccuracies, are then corrected. A combined inertial/stellar system would enhance accuracy.

There’s no denying China has come a long way in modernizing its military. But given its limited access to Western technologies, it’s having a tough time closing the gap with the US and other advanced military powers. As I’ve written before, “in a potential conflict, the US will emerge victorious” (see Growth Engines, “China and Taiwan – 27 October 2005”). This is why a US presence in the region is welcomed by Japan and Taiwan.

The Straits

China’s major security issue is Taiwan’s possible declaration of independence and China’s efforts to prevent such a move. China, in its 2004 white paper on defense, takes a hardline position when it comes to a move toward independence:

“We will never allow anyone to split Taiwan from China through whatever means. Should the Taiwan authorities go so far as to make a reckless attempt that constitutes a major incident of ‘Taiwan independence,’ the Chinese people and armed forces will resolutely and thoroughly crush it at any cost.

“…The United States has on many occasions reaffirmed adherence to the one-China policy, observance of the three joint communiques and opposition to ‘Taiwan independence.’ However, it continues to increase, quantitatively and qualitatively, its arms sales to Taiwan, sending a wrong signal to the Taiwan authorities. The US action does not serve a stable situation across the Taiwan Straits.”

Unsurprisingly, a long history of events and tensions has contributed to the current situation. Knowing that, an understanding of history is necessary if you’re to profit from the region’s realignment. Our goal, therefore, is not to pass judgment on territorial claims, but to properly understand and position for the coming changes.

Taiwan became a “problem” during China’s ’40s Civil War. The existing nationalist government fled to the island after losing power to Mao Tse-tung’s communist forces. Popular support for Mao was in large part because the Nationalists were responsible for disastrous economic policies that lead to hyperinflation in the late ’40s, when in three years Shanghai wholesale prices rose 7.5 million times.

In January 1950, President Truman announced the US would not become involved in the Taiwan Strait dispute. On June 25, 1950, though, the Korean War broke out, leading President Truman to impose a “neutralization of the Straits of Formosa” two days later. The Seventh Fleet moved into the Straits to prevent an attack on Taiwan and to stop Kuomintang (KMT), the remains of the Nationalist government, forces from attacking China’s mainland. In 1954, the US and Taiwan signed a mutual defense treaty that isolated the US and communist China from each other, until President Nixon re-established relations with China in 1972.

Beginning Jan. 1, 1979, President Carter ended diplomatic relations with the Republic of China on Taiwan and recognized the government in Beijing as the sole legal government of China. In March 1979, the US embassy in Taipei was renamed the American Institute in Taiwan.

Given the history of the issue and the strong language the Mainland has used, there’s been speculation China will eventually invade Taiwan, triggering a US response and an all out war. There’s a lot of truth to this line of thinking, and China has built its military with the aim of being prepared for a confrontation in the Straits with Taiwan and US forces.

As a consequence, there’s been a plethora of scenarios regarding the timing and manner of the invasion. The most interesting was suggested by Minnick in the 2004 Asia Times article mentioned earlier. In it, he speculated that if China invaded Taiwan, it wouldn’t take place through an amphibious assault, but by a decapitation strategy:

“Decapitation strategies short circuit command and control systems, wipe out nationwide nerve centers and leave the opponent hopelessly lost…China’s deployment of its special forces and rapid-deployment forces, combined with air power and missile strikes, is the most likely formula for successfully taking Taiwan with the least amount of effort and damage.” The article makes for a breathtaking reading and was received positively when first published.

Invasion or no invasion, Taiwan remains important to both China and the US. For the former, Taiwan represents a final “unification of the motherland,” a newfound control of trade routes to and from Japan and Korea and the ability to dominate the South China Sea–although China doesn’t yet have the naval capability to exercise that control. For the US, China’s capture of Taiwan makes it harder to collect intelligence on and from the Mainland, as it has agreements with Taiwan to share intelligence.

This US signal intelligence base at Pingtung Lee on Yangmingshan Mountain just north of Taipei has operated for at least 15 years.
Source: Asia Times

Despite the hype and endless scenarios regarding Taiwan’s potential declaration, there’s been progress toward a peaceful solution. That’s in part because the number of Taiwan citizens who are against independence, even if a Hong Kong-style one-country two-systems arrangement isn’t supported either.

Polls suggest that the opposition and pro-China party Kuomintang (KMT) has increased popular support, which translated into elector success in last year’s local government elections where the ruling party DPP suffered its worse election setback since it took office in 2000. The DPP won six of 23 posts, while the KMT won 14. Furthermore, the economic ties between Taiwan and the Mainland have become extremely large, with huge amounts of Taiwan investments going to the Mainland with a large number of Taiwanese workers and businessmen.

However, direct links between the two are still inflexible, costing Taiwan’s economy billions of dollars. The sovereignty issue, though, must be resolved for further economic gains to be realized.

The Chinese term for security, anquan, means complete stability. This is China’s main goal for the foreseeable future. The country will wait and try to influence the Taiwanese people to think positively about the issue. There’s an increasing probability that an arrangement where both sides agree on the one-China concept can eventually occur. The Mainland can surely wait.

The US Factor

As mentioned above, the US remains the stabilizing factor in the region. Even Chinese experts aren’t comfortable with a complete withdrawal of US forces, because of concerns that Japan’s military instincts would become uncontrollable.

Of the countries involved in this region’s most tense political and military standoff, Japan holds the most difficult position, as it must decide which country to support in a conflict.

If Japan avoids helping the US, then the countries relationship would be dealt a serious setback and could, depending on the magnitude of the crisis, lead to a problematic shift in the guarantor, the US, of stability in the area. This is why it’s possible the US won’t request Japan’s explicit assistance in a potential security scare or minor conflict.

If Japan does decide to help the US, the results could be worse because of strong anti-Japan feelings in China and the fact that China has been and will be Japan’s neighbor for ever. These factors, for the time being at least, do not undermine Japan’s commitment to the US because China isn’t expected to create major regional problems during the immediate future–it recognizes that it’s not in its best interest to do so.

Consider, though, what David Shambaugh, an eminent scholar on China’s military, has written:

“The anti-Japanese sentiment one encounters among PLA at all levels is palpable. Distrust of Japan runs deep, transcends generations, and is virulent among the generation of PLA officers in their forties and fifties. Japan stimulates an emotional reaction not evident even in anti-American diatribes. In conversation with PLA personnel, Americans are regularly subjected to the view that the Unites States is naïve to consider Japan as an ally or partner, and they often counsel the United States to be wary of Japanese intentions and military ambitions” (David Shambaugh, Modernizing China’s Military, University of California Press, 2002).

In the meantime, Japan diligently works toward a more visible and influential force in world politics. For example, Japan’s Foreigner Minister presented, at the foreign correspondents’ club of Japan on December 7, 2005, the notion that Japan has become a “thought leader” in Asia, explaining that:

“[S]ince the mid-19th century, and at an earlier date than the other countries of Asia, Japan has been experiencing a modernization of its politics, economy and its society. With regard to the establishment of both democracy and a market economy, Japan has amassed a wealth of experiences without comparison anywhere else in the countries of Asia.”

He also discussed Japan as having a stabilizing effect on the region and explicitly noted that the US-Japan alliance allows his country to do so. If this region hadn’t been one of peace and stability, the development of Asia’s economies wouldn’t have been possible. A major reason for that peace and stability is the US and its regional presence.

That presence has largely been made possible by Japan, which has continuously provided a secure place for the forward deployment of US military forces. The recent announcement regarding a realignment of US forces in Japan should be viewed with this in mind.

It’s important for the US to facilitate good relations between China and Japan. Doing so allows both countries, but especially China, to adjust to the new realities in the region: China’s and India’s rise and Japan reclaiming its “normal state” status (i.e., rearmament).

The above arrangement will also be good for the US, as it comes to grips with the rise of China as an international economic and political power. Given today’s geopolitical environment, the words of Joseph S. Nye, while an Assistant Secretary of State in 1995, should be remembered: “If you treat China as [an] enemy then you will have an enemy.”

The Investment Angle

The most speculative but most rewarding investment you could make in the context of these changes is Taiwan. Depending on the way the Straits issue works out, Taiwan’s economy and stock market will either soar or remain a laggard.

So far, Taiwan has been unable to make the move from an almost purely manufacturing-based economy like South Korea where companies create brand-name products and compete successfully in the global marketplace.

This has, among other things, hurt the economy and stock market performance, including a massive underperformance of Taiwan’s stock market during the past five years.

But a positive resolution of the sovereignty issue can change this; Taiwanese businessmen will be able to more freely profit from investments in the Mainland, which can then easily flow back to Taiwan. In addition, direct links will help tourism and other related industries, thus, further boosting Taiwan’s economy. Investments from the Mainland shouldn’t be ruled out either, given that Chinese companies aren’t allowed to invest in Taiwan–mainly because of Taiwanese restrictions. Buy the iShares MSCI Taiwan Index Fund (NYSE: EWT).

When it comes to Japan’s economic revival and potential increase in military expenditures, there are two Japan-based companies that will benefit tremendously. Once Japan decides its industries can increase weapons production, there will be nothing preventing them from selling arms outside Japan, including the rest of Asia.

Mitsubishi Heavy Industries (OTC: MHVYF) isn’t to be confused with Mitsubishi Motors, the automobile manufacturing company. MHI doesn’t build cars, but is a diversified manufacturing and construction company with operations in a bevy of fast-growing businesses.

That includes power plants, both nuclear and conventional. Japan relies on nuclear power for its electricity needs. MHI is a leading builder of nuclear plants within Japan, and the company also builds plants outside Japan, including in China.

Even more compelling, though, is the company’s aerospace and defense business. MHI manufactures the Patriot Advanced Capability 3 (PAC-3) missiles that are used to intercept and destroy incoming missiles. Orders have also been growing for terrestrial launch facilities of the missiles as well. PAC-3s are manufactured under license from Lockheed-Martin.

The company also builds airplanes, such as Japan’s F-2 fighters, and ships, including destroyers. Sales to JSDF amount to more than $2 billion annually.

MHI also works closely with several foreign defense companies, including Lockheed. A change in Japan’s arms export laws allow MHI to export missile nose cones and command and control systems to countries like the US.

Kawasaki Heavy Industries (OTC: KWHIY) is another diversified manufacturer with a large aerospace and defense operation. Like MHI, Kawasaki is strong in aerospace, manufacturing key airplane parts such as wings for Boeing and Embraer commercial aircraft.

On the military front, Kawasaki Heavy produces Japan’s P-X patrol airplane and C-X military cargo planes. The company is also a key supplier of parts for and co-producer of F-2 fighter aircrafts. In addition, Kawasaki produces several different light helicopters used by JSDF.

Lockheed-Martin (NYSE: LMT) is the largest player in the US defense industry, and, by far, the world’s largest private defense contractor. Right now, the company’s highest profile projects include the F-35 Joint Strike Fighter and the F/A-22 jet; the company came to dominate the US fighter aircraft industry with the older F-16 aircraft. In the future, international demand for these fighters will be equally impressive.

The company is also considered a technological leader in missile designs. Lockheed makes the PAC-3 defense missiles and the Trident submarine-launched missiles. The company is also one of the main beneficiaries on spending related to the Aegis Weapons System. It continues to be one of the big contactors in Japan and is expected to strongly capitalize in Japan’s increase arming efforts.

Raytheon (NYSE:RTN) is particularly strong in missile guidance, sensor, radar and electronics systems. Primary examples include the Tomahawk cruise missile, which has been widely deployed since the first Iraq war and electronic systems for the US Navy’s new DD (X) destroyer.

Raytheon’s approach–referred to as platform agnostic–to the industry is somewhat different from other major defense contractors. Specifically, Raytheon tends not to bid as the primary contractor on the giant, high profile defense deals. Raytheon’s products are used in a wide variety of defense applications, with the company acting as a key subcontractor. The advantage is Raytheon isn’t dependant on any one program–more than 10,000 active defense contracts employ some version of Raytheon technology, the largest of these is only worth about 4 percent of Raytheon’s total sales.

Also interesting is Raytheon’s international sales momentum. Of the US defense majors, Raytheon has the highest exposure to sales overseas–roughly a fifth of total revenues. This, too, is thanks to the wide applicability of Raytheon technology.

The company has been one of the chief beneficiaries of Japan’s missile defense program. Raytheon manufactures two-thirds of the PAC-3 Land-Based System and the accompanying sea-based SM-3 program.

But exposure in Japan isn’t the only positive-looking area for Raytheon. Taiwan continues to show interest in BMD equipment, which will be mainly handled by Raytheon. If the Taiwan orders come through, the company could receive Asia-based BMD orders of more than $2 billion this year.

There’s also a probability that China would be allowed to purchase weapons–although not extremely advanced ones–from US companies. There are US defense companies that have sold to China, but restrictions prevent them from following up on those orders (e.g., providing spare parts). China has indicated it would be interested in buying helicopters, aircraft and ship engines, transport aircraft, AWAC aircraft, radars, avionics and surface-to-air missiles from the US.

A side note is worth making here: China views its military exchanges with other countries as a component of a broader diplomatic foreign policy to advance China’s national security interests, not as a simple exchange between military establishments.

If the status quo, which prevents a large amount of military sales to China, changes even slightly, the following companies will benefit.

United Technologies (NYSE: UTX) is a diversified manufacturer behind some of the world’s best-recognized brand names, such as Otis elevators, Pratt & Whitney engines and Carrier heating and air conditioning units. But United Technologies is also a major supplier of defense systems products.

For example, the company is a major manufacturer of military helicopters through its Sikorsky division. Helicopters, such as the Black Hawk, Sea Hawk and H-92 SuperHawk, have been sold to about 40 countries, including China. For now, China is prohibited from directly buying spare helicopter parts from United Technologies but that’s likely to change. When it does, United Technologies will see benefit.

General Electric (NYSE: GE) is one of the world’s best-known corporations. But when most investors think of GE, they think of white goods like refrigerators or power turbines; GE is also a major supplier to the defense industry, though. Specifically, GE makes jet engines, which are used in all sorts of military aircraft, and specialized engines used in ships and ground vehicles.

Of particular interest is GE’s LM-2500 gas turbine engine, which is capable of generating nearly 40,000 horsepower. The US Navy is already using the engine to power several of its ships. China is also interested in these advanced engines but is prohibited from importing the engines or spare parts for the other engines it has due to a US weapons ban. When the ban is lifted, China is likely to order the engines for use in its own ships.

The European Aeronautic Defense and Space Company (OTC: EADSF) is best-known as the company behind Airbus, the commercial aircraft manufacturer that competes with US-based Boeing.

The company makes a variety of defense products and electronic systems. The list includes Europe’s fighter aircraft the Eurofighter and its military helicopter the Eurocopter. EADS also manufactures missiles and naval defense systems. Like US defense companies, EADS is currently barred from exporting key technologies to China; the stock would likely get a huge lift off any change to that policy.

Conclusions

The main idea for this report was Japan’s return to normality and the implications of that return on investors. As presented in our book The Silk Road to Riches (FT/Prentice Hall, 2006), don’t expect material changes in Asia’s status quo until the end of the decade. Until then, though, Japan will still move forward and lead Asia’s rearmament efforts.

Notice that Japan’s newfound defense efforts are taking place while the economy comes out of its long economic slowdown. This will almost certainly contribute to the country’s military buildup and make its leaders more comfortable in moving ahead with their plans.

Furthermore, the country’s changing relationship with the rest of Asia, especially regarding trade, will play a significant role. Consider the following: Japan is heavily dependent on the rest of the Asia market. Its power within that market has begun to grow dramatically. Roughly 40 percent of Japan’s exports and 40 percent of Japan’s imports are to or from Asia, compared to only 20 percent of Japan’s imports coming from the US and 30 percent of Japan’s exports going to the US.

Although no one knows what the final outcome will be, there are a couple of things GIQ is comfortable forecasting. First, economic cooperation among countries in Asia will continue to increase and, in the process, political differences will be smoothed out–although tensions will always exist.

Second, China won’t jeopardize its economic development and destroy the goodwill it’s been building in the region, unless provoked by senseless ultimatums from other countries. But the US has demonstrated its ability to project power and resolve without simultaneously undermining the regional stability. It is to be expected that it can do it again.

As the British legendary Permanent Under-Secretary of State Lord Thomas Sanderson counseled in 1907:

“It has sometimes seemed to me, that to a foreigner reading our press the British Empire must appear in the light of some huge giant sprawling over the globe, with gouty fingers and toes stretching in every direction, which cannot be approached without eliciting a scream.”

This is what modern superpowers need to avoid.