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Geopolitical risk: Iran is out, China and Japan are in

Photo taken on October 23, 2013 shows Chinese People's Liberation Army fighter jets leaving their base in Shanghai.
Mark Ralston | AFP | Getty Images
Photo taken on October 23, 2013 shows Chinese People's Liberation Army fighter jets leaving their base in Shanghai.

Just as geopolitical risk showed signs of abating after Sunday's nuclear weapons deal with Iran, tensions between China and Japan over disputed islands have re-surfaced.

And at a time when risk appetite in global markets is running strong, strategists say renewed strain between two of the top three world economies is something that should not be taken lightly by financial markets.

(Read more: Asian airlines to give flight plans to China after airspace zone created)

"At the moment if you look at the world, one of the striking features is that there aren't many tail risks out there, especially if the U.S. and Iran are now talking," said Bank of Singapore Chief Economist Richard Jerram, referring to a deal between Iran and six world powers to curb Iran's nuclear program. "But with the China and Japan dispute, both sides are stubborn and this is one of the bigger geopolitical risks the world still faces."

(Read more: Iran oil, energy sanction still in force after nuclear deal: US)

Beijing at the weekend declared an "Air Defense Identification Zone" that covers most of the East China Sea and a group of uninhabited islands that have been the subject of heightened tensions between China and Japan in recent years.

The move has been criticized by Tokyo and Washington. The U.S. has warned that Beijing's military claim to airspace raises the risk of "misunderstanding and miscalculations," according to media reports.

"It seemed that things had calmed down a bit, so latest developments represent a re-escalation of the tensions," said Tim Condon, head of research, Asia, at ING Financial Markets. "We agree with the official U.S. reaction that the potential for a misstep has gone up as a consequence and that means a higher risk premium for Asia as a whole."

(Read more: US, Japan slam China airspace rules on islands)

Déjà vu?

China- Japan tensions flared up in the second half of last year after a row over the disputed islands, known as Senkaku in Japan and Diaoyu in China, led to violent anti-Japan protests in China and prompted locals to shun branded products such as Japanese cars.

(Read more: Adapt Now: Japan firms heed message in China dispute)

"We're watching this situation very closely and it is something that worries me," said Bank of Singapore's Jerram. "Trade relations between the two countries are essential for the operation of many global manufacturers and so anything that would threaten that is potentially a problem."

Japanese trade data released last week, for instance, showed that China was the second biggest market for Japanese exports in October after the U.S. Exports to China rose 21.3 percent from a year earlier.

(Read more: More evidence of rebound in Japan: Exports soar)

Jerram said another concern is that Beijing may use tensions with Japan to distract attention from worries about a slowing Chinese economy.

Sean Callow, a senior currency strategist at Westpac Bank in Sydney, said that if tensions between Tokyo and Beijing persist, jittery investors could push the safe-haven yen higher.

"The market at the moment does have a high level of tolerance for this kind of noise. And U.S. stocks are doing well so risk appetite is high, but if there is continued trouble over the islands, the yen will move up," he said.

A weak yen, which is down about 18 percent against the U.S. dollar this year, is viewed as key to Tokyo's plans to revive the economy. It was trading at about 101.50 to the dollar on Tuesday, hovering near six-month lows hit a day earlier.

—By CNBC.Com's Dhara Ranasinghe; Follow her on Twitter

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