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Squabbling Asia is compromising its growth potential

Sunday, 19 Jan 2014 | 9:50 PM ET

Largely unaffected by the Great Recession, Asia is now in danger of seeing its entirely manageable security problems play havoc with nearly a quarter of the world economy.

The results of the poll conducted jointly by the Chinese, Japanese and South Korean media, published on January 8, 2014, show that almost two-thirds of Chinese executives said they could not do business with Japan because of the worsening political tensions. About the same number of Korean businessmen reported that they were keeping their transactions with Japan to a minimum.

(Read more: Can China contain its high government debt?)

Prospects for any dialog to address these problems look as remote as ever. In fact, according to media reports, Japan is on a mission to counter and contain China's broadening economic and political influence in Asia. That dueling is now spreading to Africa. Japan was openly critical of China's business dealings on the continent during Prime Minister Abe's visit to Ethiopia, Ivory Coast and Mozambique last week.

Shubiya district, Tokyo, Japan
Getty Images
Shubiya district, Tokyo, Japan

Seoul won't play with Tokyo

Wisely, South Korea wants no part of the Sino-Japanese brawling, and is not interested in joining any designs of competing with China. But Seoul is also steadfastly refusing to soften its attitude toward Japan, because it sees no change in Tokyo's reluctance to atone for its misdeeds during the three decades of Korea's occupation.

Expectations that South Korea would participate in Japan's anti-Chinese agenda are overlooking important economic and strategic interests. South Korea is directly and fiercely competing with Japan in all of its major industries, while China remains its largest and most lucrative market whose importance will be further enhanced as Seoul and Beijing finalize their pending free-trade agreement.

In addition to economics, China also holds the key to peace, security and inter-Korean relations on the divided Peninsula through the influence it wields with North Korea. South Korean President Park Geun-hye says that she sees the reunification as "a dream" and an opportunity for the Korean economy to take a "fresh leap forward."

(Read more: South Korea ramps up forex reserves to record high)

The Asian economy, however, cannot leap forward unless China and Japan step back from the looming military confrontation in the South China Sea.

At the moment, that does not seem likely, but it is encouraging that they appear to have stepped back from the ruinous economic warfare. Their bilateral trade has picked up vigorously since last summer, indicating a radical change from China's anti-Japanese public demonstrations and widespread boycotts of Japanese goods as tensions escalated early last year about their disputed maritime borders.

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Trading and feuding

Last November, for example, Japanese exports to China were soaring at an annual rate of 33 percent, with China's surplus for that month nearly doubling from the monthly average recorded in the first half of 2013.

This is an interesting case of managing an adversarial relationship: While continuing to trade, the two countries seem unwilling to establish a meaningful high-level dialog to diffuse tensions, partly because Japan apparently refuses to recognize that it has a border dispute with China.

A whiff of Oriental wisdom? We shall see.

Meanwhile, China is seeking to control the contested areas through the newly established air defense identification zone (ADIZ), matching a similar measure maintained by Japan and South Korea. Effective January 1, 2014 China also requires prior approval for foreign fishing vessels to enter the disputed waters in the South China Sea. Chinese and Japanese air and naval assets are also present in the areas that both countries claim as their own sovereign territory.

(Read more: IMF planning to raise growth forecasts: Lagarde)

Until there is an incident – by accident or by design – both countries seem to be preparing for.

That is not what Chinese Prime Minister Chu En-lai and his Japanese counterpart Kakuei Tanaka had in mind when China and Japan restored their diplomatic relations in September 1972. To the question Mr. Tanaka raised about the disputed islands in the South China Sea, the Chinese leader responded to leave the issue aside and to talk about it sometime in the future. That agreement was upheld during the discussions China's President Deng Xiaoping held in Tokyo with Japanese Prime Minister Takeo Fukuda when the two countries signed the Treaty of Peace and Friendship in October 1978.

Both of these events are remembered as decisions to find a peaceful solution to the territorial issue Chu En-lai did not want to be an obstacle to restoring the diplomatic ties, and Deng Xiaoping did not want to be a spoiler of the solemn occasion that was expected to put an end to deadly enmities. They obviously counted on the wisdom of future generations to do better than they could do at the time when the wounds of war were still festering.

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I don't see that this generation of politicians on either side is ready to compromise on an issue that transcends the disputed real estate, with its apparently rich fishing areas and oil and gas reserves. Arguably, the contested South China Sea boundaries are the world's most sensitive strategic sea lanes whose navigation will require a modus vivendi with China – which has yet to be found.

China is forcing that search by putting down the markers with ADIZ and the new fishing rules. Further events will be driven by China's growing economic and military clout. That will determine how Beijing will exercise its presence in the sea it claims as part of its own ancient territory.

Japan is more interesting than Fed "tapering"

Investors would do well to think of this instead of being consumed by the impact the unfolding monetary tightening in the United States may, or may not, have on East Asian economies.

(Read more: Emerging markets may become new force in euro rally: Goldman Sachs)

Japan might be a good place to start that reflection. In addition to its military standoff with China, Japan's quantitative easing is facing a moment of truth. There is no exit strategy – the Bank of Japan says it is "too early" for that – and the extent of an incipient financial crisis is illustrated by the fact that the Japanese bond yields are unresponsive to rising inflation.

Here is that interesting detail. Inflation in Japan went from minus 0.9 percent at the time the quantitative easing started to 1.6 percent in November 2013. In spite of that, the 0.66 percent yield on Japan's government ten-year bond last Friday was still a few basis points below its year-earlier level.

That glaring anomaly cannot continue, even allowing for the fact that the Japanese bond market is controlled by domestic investors and by the proverbial "iron fist" of its financial regulator.

What will happen on the way out of the labyrinthine quantitative easing? Who and what will provide the Ariadne's thread to lead the country out of this uncharted territory?

(Read more: Global economy at a turning point: World Bank)

And what would happen if the escalation of military tensions with China were to shut off one-fifth of Japanese exports?

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9

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