The economic incentives in the South China Sea

One of the hot spots of geopolitical tensions is the South China Sea. If you read publications from military and political think tanks it is hotly debated and one of the core topics that will define the relationship between China and Western industrialised nations in the coming decade.

Yet, if you are an investor or an economist the tensions in the South China Sea hardly feature on people’s radar screen. If at all, they get mentioned as a risk somewhere in the East that investors in Europe and the United States don’t really need to pay attention to.

This is probably true in the short-term but once you realise the economic incentive structure, you start worrying a lot more, because the incentives are so lopsided that it seems almost inevitable that China will eventually assert its power over the South China Sea – if necessary, with military force.

Two researchers from the University of Virginia have tried to simulate what a blockade of the shipping routes around Singapore and the South China Sea would mean for world trade. They assumed that the area marked in red in the map below would become impossible to cross for cargo ships and oil tankers. This would force ships going from East Asia to Europe or from the United States to India to make a huge detour around the southern tip of Australia and increase transport costs and times.

Assumed blockade in South East Asia

Source: Cosar and Thomas (2020).

That may not sound like much, but the 2020 pandemic has shown us what happens if global supply chains get interrupted in Asia. According to the simulation, countries like Taiwan and Singapore would effectively be blocked from almost all their imports and exports. The economic costs in terms of lost GDP would be devastating. Countries like Japan and South Korea meanwhile would experience a significant shock in the region of several percentage points of lost GDP and likely drop into recession.

The estimated cost to GDP from a blockade

Source: Cosar and Thomas (2020).

But here is the scary part: The economic costs to China would be practically zero. This means that China has little to lose from taking an aggressive stance in the South China Sea as long as they can avoid outright military action. At the same time, they can basically ruin Taiwan and Singapore, forcing them to make political concessions to lift the blockade.

The crucial question is how would the United States react in such a scenario? Japan and South Korea are in a defence alliance with the United States, but that would only kick in if these countries were attacked militarily. If it’s just a blockade enforced by the Chinese navy the question is if this would be considered as an act of war? Note that the economic costs of the blockade to the United States would be minimal, so the only reason for the United States to consider it an act of military aggression would be to ensure their influence in the region. 

Under President Trump, nobody in China and in the United States would have known the outcome of such a confrontation, but under President Biden, it becomes a bit more calculable. A war-weary President in the United States might try to resolve the conflict with other means effectively handing China more regional influence. And the Chinese rulers probably know that.

Does that mean that we are going to see the conflict in the South China Sea escalate in 2021? I don’t think so. But China is working towards greater technological independence with its Made in China 2025 programme and its Belt and Road Initiative is creating important global transport corridors and supply chains that end in China. As we approach the end of Biden’s first term as President in 2024 and 2025, it could be an opportune moment for China to trigger a conflict that makes Biden look weak and help to create a change of government in the United States like the Iranian hostage crisis did for Carter in 1980.

Geopolitics matters and will matter even more in the coming decade than it did in the past.