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A China-Japan conflict fits our scenario of global economic catastrophe

When China recently declared a new “air defence identification zone” covering some small islands in the East China Sea claimed by Japan, it raised the possibility of an outbreak of hostilities between…

Senkaku. Or is it Diaoyu? Al Jazeera English

When China recently declared a new “air defence identification zone” covering some small islands in the East China Sea claimed by Japan, it raised the possibility of an outbreak of hostilities between the two countries.

We are right to be concerned. At Cambridge’s Centre for Risk Studies we model hypothetical chains of events that lead to global economic catastrophe, and a conflict over the barren rocks of the Senkaku Islands (or the Diaoyu Islands as the Chinese call them) closely fits one of our scenarios.

This is not to say that war will break out any time soon, or even that it is especially likely to. But conflict is entirely plausible, and its impact would be felt in economies around the world. Global firms, most of whom rely on Southeast Asia at some point in their business model, should recognise the possibility.

The economic importance of both China and Japan is obvious. They are the world’s second and third largest economies and the US$120 billion worth of exports they pass back and forth represents one of the major engines of global growth.

Just south of the disputed islands, the South China Sea is a bottleneck in one of the main arteries of global commercial trade. It serves six of the world’s largest ports, and half of the world’s container traffic passes through it. Air traffic is similarly important, with China and Japan containing five of the world’s top 20 airports, handling 8% of world passenger traffic and 46% of air freight.

Extreme scenario

This isn’t just armchair war gaming; these models have a practical use. The hypothetical extreme scenario that we have developed is intended for businesses to test how they would cope with future geopolitical conflict, combining likely macroeconomic consequences with impacts on the investment market. Knowing how your business would fare in a Sino-Japanese war gives a good sense of overall resilience to sudden global shocks.

The scenario envisions the provocations escalating to military exchanges leading to both China and Japan suffering destructive attacks on mainland targets. It envisions shipping exclusion zones and restricted air space that would curtail exports from the region for the duration of hostilities.

Open-source military war gaming for a conflict of this type expects to see extensive naval interchanges, long-range missile attacks targeted on power supply and manufacturing, cyber warfare inflicted on Japan and its allies and a resurgence of nationalism and social unrest in both protagonists’ populations.

The conflict would affect the region’s outsourced manufacturing, and increased transport time and risks would have a knock-on effect. Businesses would also face an exodus of expatriate personnel from a number of affected countries and maintaining continuity would be tough.

Insurance companies have standard exclusions on policies that protect them from major payouts. But this does not mean they’ll be entirely safe. The conflict could trigger non-excluded claims in other lines of business and regions, with indirect liability claims, political interference and knock-on effects on defaults from trade credit.

There could be unexpected vulnerabilities that might increase the likelihood of other types of insurance loss. To take one example: what if a backlog of shipping waiting outside the conflict zone causes ships to be concentrated in the typhoon belt?

Economic damage

Conflict would damage the economies of both China and Japan. Past wars have typically caused higher energy prices, increased government expenditure and public debt, inflation hikes, and lengthy periods of trade disruption for the protagonists. Foreign money tends to flee out of the country, causing governments to impose currency restrictions and asset freezes.

The volume of international economic interactions mean that the effects would not be confined to the countries fighting. Our model suggests that the impacts would be almost as bad to the national economies of Europe, for example, as they are to China and Japan.

Conflict would lead to a global recession lasting between 18 months and four years, depending on the duration of hostilities and how hard it would be to continue trading. Either way, we would lose tens of trillions of dollars of global output.

The financial markets would be badly affected by an event of this magnitude. The traders’ adage of “sell on the trumpets, buy on the cannons” (stockmarkets fall when it looks like war, but rally once war is underway) would amplify volatility and severity of the financial shock.

During a severe financial crisis, as seen in 2008, a domino effect can take hold. Ripples of defaults and liquidity shortages, together with fire-sales of devalued assets by over-exposed institutions, can escalate into “crisis correlation”, where stocks move up and down together and market movements are exaggerated.

Investment managers would see significant losses. Even the safest of bonds would be affected by the volatility, inflation and capital flight, that could be expected. Estimates by the Risk Centre suggest that a standardised high-quality portfolio could see poor performance for years, with immediate returns up to a third lower than expected. This isn’t just a problem for top bankers; your pension is probably managed in this way too.

Facing the future

Global businesses need to be ready to face a wide range of future crises; the better prepared ones will plan for a severe shock or challenge every few years, and will recognise the imperative of riding out crises better than competitors.

By their nature, shocks are unexpected and largely unpredictable, so it is more important to be resilient across a number of scenarios than exactly prepared for any specific one. Holding inventory at various points on the supply chain rather than in one spot can help, as will diversifying suppliers. The key idea is to not leave your business too exposed in one particular region or sector.

China and Japan have been to war twice before, and a third major conflict between the countries is unlikely, but plausible. Businesses should act. The smart ones will have contingencies for a wide range of scenarios, including this one.

The ripples that are caused by a territorial dispute over remote islands in the China Sea may seem unimportant. But then so did the assassination of an Archduke in Bosnia in 1914.