2018 second-quarter forecast

Asia-Pacific

The Asia-Pacific is home to more people than any other region. Centered on the western rim of the Pacific Ocean, this region includes the easternmost countries of continental Asia as well as the archipelagos that punctuate the coast. Several of these countries, most notably China, experienced rapid economic growth in the second half of the 20th century, giving the region a new sense of global economic relevance that continues today. That relevance, however, depends largely on China, a power in transition whose rise is testing the network of U.S. alliances that have long dominated the region. How effectively Beijing manages its transition will shape the regional balance of power in the decades to come.

16 MINS READMar 8, 2018 | 20:57 GMT
Centered on the western rim of the Pacific Ocean, the Asia-Pacific region includes the easternmost countries of continental Asia as well as the archipelagos that punctuate the coast.
(Thoyod Pisanu/Shutterstock.com)

Centered on the western rim of the Pacific Ocean, the Asia-Pacific region includes the easternmost countries of continental Asia as well as the archipelagos that punctuate the coast.

section Highlights
  • As the United States imposes new trade restrictions on China, Beijing will respond in kind, engaging in a tit for tat that could delay China's plans for economic reform.
  • At home Chinese President Xi Jinping will focus on solidifying control over local governments to ensure that they comply with his attempts to overhaul the economy and redistribute national resources.
  • South Korea will struggle to balance between neighbor and ally as tension mounts between North Korea and the United States.
  • Intent on halting China's rise, the United States will forge deeper diplomatic and defense ties with Taiwan -- pushing China and Russia even closer together in the process.
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The Bell Heard 'Round the World

For months, the nuclear threat rising from the Korean Peninsula has transfixed the globe, but during this quarter, a different issue will take center stage in Asia: China's brewing trade spat with the United States. With Washington determined to bring Beijing's behavior in line with its own agenda, it will ratchet up pressure by targeting China's economy and strategic interests in the region — including its claim to sovereignty over Taiwan. Rather than take these measures lying down, China will retaliate, sounding the bell for a boxing match that will determine the moves and countermoves of smaller nations caught between the sparring giants.

The impending showdown has loomed for over a year. Throughout 2017, China parried most of the United States' jabs by answering Washington's calls to ramp up economic pressure on North Korea. To that end, Beijing scaled back its trade ties and severed its lingering financial connections with Pyongyang. But as North Korea accelerated its weapons development, China's ability to shape events on the peninsula waned, eroding its ability to link trade matters to security issues in the process. No longer able to fend off the United States' blows, and faced with the maturation of several U.S. punitive trade measures against it, China could respond in kind by slapping tariffs on U.S. exports, including on agricultural and chemical products; by challenging U.S. measures at the World Trade Organization (WTO); and by pressuring American firms operating in China. All the while, Beijing will try to create room for negotiation with Washington by offering to open up Chinese markets and boost its imports of U.S. goods. Despite its best efforts, however, the United States will keep its sights trained on Chinese trade practices.

The timing of this feud couldn't be worse for Beijing. On the heels of a crucial quinquennial transition in political leadership, China's elite face the daunting task of pushing through a raft of delayed socio-economic reforms. Over the past few months, the country has taken advantage of its robust economic growth and stable trade ties to advance important aspects of a plan to shift its economic model away from credit-based investment and toward domestic consumption. Among these steps are deleveraging China's financial system and deeply indebted state-owned enterprises, eliminating overcapacity in resource-intensive industries, and increasing the enforcement of environmental regulations.

As Beijing expands its reforms in the months ahead, the central government will concentrate on making sure that local governments and industries effectively enforce them. So far China's attempts to curb informal lending and overhaul the bloated state-run companies at the heart of the nation's debt crisis have fallen short at the local level; governments and companies there collectively hold debt equal to about 80 percent of China's gross domestic product. Likewise, the implementation of environmental laws has been lackluster across the southern provinces and among a handful of industries, including steel and coal. Beijing will try to rectify these problems by stressing the importance of compliance, but doing so will carry the risk of widespread failure caused by overly hasty implementation or by local resistance stemming from a desire to preserve economic growth and jobs.

Having cemented his grip on power, President Xi Jinping will have few excuses left for such failures. He will rely in part on the new National Supervision Commission to keep a sharp eye on local officials' performance and ensure that they don't botch the job. One issue will draw particularly close attention from Beijing: easing China's massive local debt burden by correcting an imbalance between the fiscal responsibilities of the central and local governments. Since the start of the year, Beijing has made significant headway on its long-delayed tax reforms, in part by shoring up local tax bases. Though its centerpiece property tax likely won't emerge until 2020, the Chinese government will continue to enact fiscal reforms, encourage domestic consumption, reallocate resources to underdeveloped regions and lighten corporate debt loads in the coming months — all with the aim of setting the Chinese economy down a more sustainable path.

Of course, a deepening trade dispute with the United States will present a formidable obstacle on the road to reform. On March 23, Washington will impose high tariffs on U.S. steel and aluminum imports to protect itself from what it deems to be unfair trade practices by other countries, including China. Because only about 2 percent of U.S. steel imports come from China, the volume of these imports will remain fairly steady. But China, which accounts for roughly half of the world's steel production, will still be hit hard as steel prices tumble and major exporters divert their supplies from the United States, snatching up a portion of China's market share along the way. To make matters worse, Washington's actions could inspire European countries and Japan to erect their own trade barriers against China to protect producers at home. Each new source of strain could damage China's steel industry, potentially reducing employment in the sector and undermining Beijing's ability to address stubborn overcapacity issues.

U.S. Steel Imports

Steel and aluminum tariffs aren't the only weapon at the United States' disposal, either. Washington could opt to establish tariffs or import quotas on major Chinese exports, such as electronics. It may also charge hefty fines intended to alter China's market restrictions and intellectual property practices. Each of these tactics would become even more effective if the United States were to join forces with the European Union and Japan — a scenario China is undoubtedly eager to avoid. But try as it might, Beijing's efforts to open up its services, finance and manufacturing industries to the rest of the world won't satisfy Washington's demands or discourage its scrutiny of Chinese investment in the high-tech sector.  

Chinese FDI

Regardless of which means the United States uses to achieve its ends, China will have to expend more and more resources to prop up its precarious economy. And as its funds run low, Beijing will be forced to compromise on some of its key economic objectives. For instance, should Washington's measures chip away at China's growth or employment figures, Beijing may back off its planned production cuts and environmental reforms, or it may use lines of credit to buoy the economy. In the direst circumstances, the central government could even bolster the real estate market, potentially creating a real estate bubble and, in the long run, the heightened risk of a national debt default. 

Coping With a Nuclear North Korea

While the consequences of the United States' trade tiff with China could spread across the global economy, its attempts to contain North Korea — and to enlist China in its campaign — will have an only marginally narrower impact. Ahead of the 2018 Winter Olympics, North Korea's relationship with the South appeared to warm as Washington and Seoul delayed their joint military exercises and Pyongyang continued to postpone its controversial missile tests. But preserving the peninsular detente was an uphill battle from the start, thanks to the United States' refusal to accept North Korea's acquisition of a nuclear deterrent.

The second quarter will thus be marked by South Korea's attempt to manage its relationships with the United States and North Korea as Pyongyang relies on its tried-and-true tactic of using outreach to Seoul and Washington to break the U.S. pressure campaign against it. At the center of this approach will be the promised meeting between Trump and North Korean leader Kim Jong Un. Seoul, for its part, will seek tangible steps toward confidence-building measures with Pyongyang. However, because the United States will refuse to ease up on the North until it makes notable strides in abandoning its nuclear weapons program, the window for outreach between the two Koreas will be narrow. Though the United States may take North Korea up on its offer of so-called "talks about talks," they might not get far in the face of Washington's persistent offensive against Pyongyang's nuclear program and North Korea's insistence on the easing back of U.S. defense architecture in the region. At the end of the day, ensuring North Korea's denuclearization will be a tall order, fraught with American suspicions of Pyongyang's duplicity and challenges in verifying its compliance.

As it attempts to balance between neighbor and ally, South Korea will carefully consider its long-term reliance on U.S. security guarantees — even if it means risking the North's ire, which could take the form of sudden cancellations in negotiations, reversals of agreements and preconditions for further concessions. Pyongyang will alternate punishment and outreach to Seoul in hopes of maintaining leverage over Washington. Keen to signal that North Korea cannot dictate its behavior, the United States will press for the quick resumption of its military exercises with South Korea.

Key 2017 North Korea Missile Tests

North Korea, in turn, will have the chance to conduct more weapons tests as the weather gets warmer. Whether it will actually do so, however, is unclear, since such tests would risk undermining Pyongyang's attempts to relieve the strain it is under. For its part, the United States will continue to weigh the option of launching a full military strike against the North, but it is unlikely to conduct one in light of the costs associated with the operation. Instead, Washington will keep up the economic and diplomatic pressure on Pyongyang while eyeing the attractive option of the limited strike, which could take many forms — including covert action. This approach, if selected, would aim to delay or disrupt North Korea's nuclear program in an effort to avoid a policy of perpetual containment and the threat of war. Yet even the limited strike would be tough for the United States to pursue amid North Korea's diplomatic overtures.

For all its bluster, North Korea will proceed with caution as well. As it nears the finish line in its race toward a nuclear deterrent, North Korea will try to break the resolve of the international community and the United States' allies to adhere to the crippling sanctions regime against it. Pyongyang's recent good behavior and high-profile outreach to Seoul, coupled with Washington's aggressive rhetoric, have only supported China and Russia's argument in the United Nations that the United States is needlessly provocative and should show more restraint. If the United States rejects North Korea's advances or keeps its harsh measures in place before entering into talks with Pyongyang, China and Russia will have an opportunity to weaken the sanctions regime against the North. Moreover, Beijing, driven by the need to avert a complete collapse in governance on its doorstep, will use any opening in the dialogue between Washington and Pyongyang to assert its influence once more. Even if the United States manages to secure more sanctions against North Korea, the penalties won't deter Pyongyang's pursuit of the nuclear ambitions it has long held dear. 

Globalization

Despite the tension running high on the Korean Peninsula, the top two U.S. allies in Asia — South Korea and Japan — have been unable to escape its wrath in the realm of trade. Like China, they have become the targets of a White House bent on reducing U.S. trade deficits and increasing its access to foreign markets.

The United States dealt a blow to South Korea during the first quarter of the year by introducing new global safeguards on washing machines and solar panels. Now South Korea is staring down the barrel of steel tariffs that will hurt its own producers, in addition to those of China and Japan. During ongoing talks on the United States-Korea Free Trade Agreement (KORUS), Washington will likely keep insisting on concessions from Seoul in the automobile and agricultural sectors, too. That said, the United States will be more focused on China and on negotiations on the North American Free Trade Agreement in the coming months, as long as those talks aren't suspended in the runup to the U.S. midterm and Mexican presidential elections. South Korea — nearing local electoral contests of its own in June — will seize the chance to push back against Washington's demands where it can. But faced with a flagging economy and stagnating Chinese trade ties, South Korea will have every reason to compromise to prevent the United States' withdrawal from KORUS.

Japan's automobile, agricultural and pharmaceutical industries have come under fire from the United States as well. So far Tokyo has eased Washington's concerns somewhat with concessions and promises of big-ticket purchases in the U.S. energy and defense sectors. However, Japan will do what it can to sidestep the United States' calls for a bilateral trade deal. With Australia's help, it will instead urge the United States to rejoin the Trans-Pacific Partnership, where Tokyo could count on having more leverage against Washington. But the current U.S. administration is unlikely to give in. With or without U.S. participation, Japan will concentrate on the revived version of the pact — the Comprehensive and Progressive Agreement for Trans-Pacific Partnership — as a way to lead the charge toward free trade in Asia. Once the fledgling bloc's remaining members have signed the deal in March, they will embark on the legislative process of approving the agreement, an undertaking that is poised to go smoothly.

Trade Within the CPTPP

Asia-Pacific: Among Great Powers

While scrambling to respond to U.S. trade tactics, China will have to protect its interests on a second front as well: its own backyard.

Determined to check China's rising power, the United States will increasingly challenge Beijing's claim to sovereignty over Taiwan. Over the past few months, two bills have advanced in the U.S. Congress that would permit official visits between U.S. and Taiwanese leaders while lobbying to enhance the island's status in international organizations. In the months ahead, Taiwan will be an observer at U.S. military exercises in March and June, will host a defense conference with the United States in May for the first time, and will make politically sensitive requests for purchases of military equipment such as F-16 and F-18 fighter jets. Each of these moves will only widen the diplomatic chasm between the United States and China, prompting Beijing to isolate Taipei, threaten the Taiwan Strait and perhaps even downgrade its military exchanges with Washington. However, none of these responses will dissuade Washington and Taipei from deepening ties.

To hedge against external meddling elsewhere in the region, China will forge ahead with negotiations on a code of conduct for the South China Sea, which began in March. Distracted by constitutional reforms and Islamist militancy this quarter, the Philippines can't afford to end its detente with China over the disputed waters. But Washington may still throw a wrench in Beijing's plans as some countries, such as Vietnam, grow bolder in their foreign policies because of their strengthening partnerships with the United States. At the same time, the members of the Quadrilateral Security Dialogue — the United States, Japan, Australia and India — will focus on using regional infrastructure development and diplomatic gestures to smaller Asian powers to contain China's maritime expansionism.

Faced with the tricky problem of juggling their relationships with China and the United States, and vulnerable to the secondary effects of the two countries' trade spat, Indonesia and Malaysia will hold elections this quarter. Economic issues will feature prominently in both races as opposition parties criticize the unequal distribution of economic wealth. In Indonesia, whose local elections in June will set the stage for national races in 2019, the opposition has also censured the ruling party for outreach to the United States and Australia that it deems overly eager. The opposition in Malaysia has directed similar accusations — but about the government's ties with China — toward the long-ruling Barisan Nasional coalition, whose parliamentary majority will be on the line in the next general elections. Neither race is likely to end in an upset, but both will give critics of the government a platform and will force the ruling parties to react accordingly.

With the shared goal of insulating themselves from U.S. encroachment on their peripheries, China and Russia will place an even greater premium on cooperation, rather than competition, in areas of mutual interest. During the first quarter, the two powers made notable progress on several joint energy projects, including the Arctic Yamal natural gas project and the Eastern Siberia-Pacific Ocean oil pipeline. They will build on these gains in June when China hosts the Shanghai Cooperation Organization (SCO) summit. There, both countries will demonstrate their common goals of stabilizing Central Asia and Afghanistan and spurring deeper integration among the bloc's members, perhaps even raising the oft-discussed proposal of establishing SCO banks and a free trade zone. Meanwhile, Beijing will use its sizable coffers to outstrip Japanese financing of projects in Russia's Far East and Arctic regions in hopes of driving a wedge between Moscow and Tokyo. 

Russia's Next Strategic Energy Projects

Japan's Prime Minister Protects His Position

Japan will try its best to foil China's plans, and on economic matters it will have some success. Japanese Prime Minister Shinzo Abe will likely meet with Russian President Vladimir Putin in May. That visit will yield progress on more energy, infrastructure and information technology deals centered on the Russian mainland. Though the two leaders will also discuss their nations' territorial dispute over the Kuril Islands, they probably won't make a breakthrough on the issue because of Russia's determination to maintain sovereignty there.

The South Kuril Islands

Back home, Abe will spend most of his energy trying to advance his legislative agenda ahead of Liberal Democratic Party (LDP) elections in September. The prime minister has set the ambitious goal of passing a raft of constitutional amendments this year, including the alteration of Article 9, which enshrines the principle of pacifism by outlawing the use of force in foreign policy. He will take care not to pursue this goal too aggressively (and risk a dip in the polls) or too timidly (and risk empowering hard-line critics in the LDP) as Japanese lawmakers work to finalize the defense budget in April. The ruling party will also seek out reforms on income, inheritance and pension taxes to offset the pain of a consumption tax hike planned for October 2019, which will amount to double the rate it was in 2014. In addition, Japanese officials will formalize a long-debated immigration policy in a bid to alleviate the country's looming demographic crisis.

Japan's Diet Session Priorities

As it stands, Abe is well-positioned to secure another appointment to his post at the head of the LDP that would extend his tenure through 2021. But he will use the September leadership race as an opportunity to check any political rivals rising within the party ranks.

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