China’s increasingly assertive attitude in the South China Sea has its neighbors worried.
Vietnam، Japan and other countries that claim parts of the region are all expanding their defense spending in an attempt to keep up with، what they perceive as، an increased threat from the regional superpower.
As a result، U.S. defense and aerospace companies have done very well recently، with record international sales in 2016. Asia-Pacific was the second largest destination of U.S. weapons، just after Europe.
The trend has continued into 2017، with South Korea announcing last September that it would spend an extra 4% on defense، hitting a record US$36.5 billion.
December then saw Japan’s Prime Minister Shinzo Abe signing an unprecedented defense budget of US$43.6 billion، indicating that his government was not going to continue its normally modest military stance in the face of a more aggressive China and North Korea.
Taiwan is taking things even further، increasing its defense spending by 50% in 2018.
The cash windfall to the U.S. defense industry is not only coming from foreign governments. The U.S. State Department itself asked for US$1.5 billion for the “Pivot to Asia” we covered last week، spending the money on securing U.S. partnerships and maintaining access to important trade routes. 2016 also saw Obama announcing the end of the embargo on U.S. arms sales to Vietnam. Along with effectively creating a new market for the U.S. defense industry، it also sent the message that the U.S. is strongly committed to countering China’s increased assertiveness in the South China Sea by providing arms to the nations that it has territorial disputes with.
While Vietnam spends relatively less on defense than other nations in the area، it still accounts for 8% of its GDP (US$4.4 billion) and is growing. According to the Stockholm International Peace Research Institute، it has expanded by more than 400% since 2005، when the nation spent just US$1 billion on its military.
We’re now going to take a look at what these increases in state defense budgets mean for investors and the companies that are set to benefit from this increased geopolitical tension.
As we explored in a previous post، six countries claim part or practically all of the South China Sea. Each of these countries، bar Brunei، has placed troops or military installations on a minimum of one of the disputed landmasses. With diplomacy seemingly reaching a stalemate، defense and arms spending has boomed.
China is a clear leader in this arms race، with a stunning expansion in military spending witnessed since the turn of millennium. The regional giant will have doubled its defense budget in only a decade، hitting an enormous US$233 billion by 2020. To grasp just how much money that is، it’s more than the whole GDP of Vietnam، and nearly the same as the US$250 billion the entire Asia Pacific region combined will spend on arms in 2020. That being said، it is also still three times less than the U.S. defense budget.
There is a simple reason China is spending so much on its military: it has serious aspirations to be a global superpower that can counter U.S. influence and curb its ability to affect regional politics and conflicts. The main arena where this contest will be either won or lost is the South China Sea.
Taiwan has plenty of reasons to fear the rising power of China. The biggest threat for the island nation is not China projecting its power in the region، but the prospect of a blockade that could severely hurt its heavily trade-dependent economy.
Taiwan is also not recognized as a sovereign country by China، which essentially views it as part of its own territory.
This situation was thrust into the spotlight in late 2016 when Taiwanese president Tsai Ing-wen made a congratulatory phone call to Donald Trump after his election. It was a clear snub to China، which was enraged at the sudden breach of a decades-old protocol، and added to the tension that has led Taiwan to increase its defense spending to 3% of its GDP (or US$11.6 billion) in 2018.
As we’ve written before، war (or at least the threat of it) can be good for growth، and this increase will likely boost Taiwan’s economy، which has been predicted to expand by 1.9 percent in 2017).
It’s even better news for Taiwan’s defense industry، with a few local companies well placed to profit from the boost. Aerospace Industrial Development (Taiwan Stock Exchange; ticker: 2634) builds aircraft for the Taiwanese Air Force، and CSBC Corp (Taiwan Stock Exchange; ticker: 2208) develops the submarines the country will need for countering an aggressive Chinese Navy. Japan
Japan has recently made the headlines for having North Korean test missiles fired over its airspace. The rogue nation’s acquisition of nuclear weapons – and unpredictability of leader Kim Jong Un - has forced Japan to revise its normally reserved approach to its military.
Defense Minister Tomomi Inada asked the state for US$44 billion in 2017 with the aim of strengthening Japan’s defensive capabilities، both in the face of an increasingly volatile North Korea and to match the huge increases in China’s spending. That was Japan’s biggest-ever defense budget and it looks to be expanding further in 2018. The majority of that budget will be channeled to realizing two objectives: shoring up defenses on the disputed Senkaku islands – which China also claims – and buying the latest U.S.-developed ballistic missile interceptors to counter North Korea’s growing threat.
Japan’s domestic arms industry has been reliant on its own state budget for decades، as its pacifist constitution prevented companies from selling weapons to foreign countries. That’s now changed، and Japanese companies can now sell to the country’s allies، presenting a huge potential for growth in that sector. North and South Korea
If any country should be really worried about a nuclear North Korea، it’s South Korea. Even though open hostilities ended with the Armistice Agreement of 1953، the war between the two sides is still officially active. Both sides have since been engaged in a never-ending arms race to keep up with one another.
North Korea has been largely reliant on China – and previously the Soviet Union – for its conventional weapons، which are mostly outdated. However، it has counterbalanced this disadvantage with a massive amount of troops and an obsessive focus on building a nuclear arsenal.
The ‘hermit kingdom’ expends over 20% of its GDP on its offensive capabilities، which it views as imperative for its survival. And even though millions of its citizens living in abject poverty، it has ten times more troops per capita than the U.S.
Its southern neighbor has meanwhile attempted to counter this threat with a focus on cutting-edge technologies. At US$38.7 billion، the 2018 defense budget announced by President Moon Jae-in is the biggest ever.
The lion’s share of this will be spent on the ambitious and controversial “Kill Chain” strike and Korean Air and Missile Defense (KAMAD)، which are intended to incapacitate North Korean attack capabilities and leadership، and to intercept any missiles it fires.
The North’s nuclear tests have also spurred the South to put in an order for advanced THAAD missile defense systems from the U.S. ASEAN
The Association of South East Asian Nations (ASEAN) is an organization of countries that includes Vietnam، Indonesia، Cambodia and Thailand. Nations of this size typically don’t possess the capital or ability to run their own military industrial complex، and therefore need to import their military hardware.
Many ASEAN countries are also on the frontline of China’s recent push into the South China Sea، and their spending amongst foreign arms manufacturers has unsurprisingly gone up as a result. While foreign defense companies have been having a bonanza from ASEAN country purchases، Japan and China have focused on increasing their ability to build their own arms at home. Make the Most of War
Rising tensions in the South China Sea have led to a massive increase in defense spending. As old treaties and alliances that have safeguarded peace in the past become more fragile، profits at defense companies will continue to rise. While the situation may lead to war، it also presents big opportunities for investors who take the time to comprehend the complex politics of the region، and where governments are going to spend their cash.