What’s in a Name?: Strategy Behind the “Indo-Pacific”

Throughout his tour of Asia in November 2017, U.S. President Donald Trump repeatedly referred to the region through which he travelled not as the “Asia-Pacific,” but rather as the “Indo-Pacific.”  While other American presidents have spoken of the “Indo Pacific” before, they did so infrequently. Trump’s continuous use of the term prompted some to speculate whether it offered a clue to the future of American strategy in the region.

Only a week later, Australia released a new white paper that embedded the term “Indo-Pacific” into its broad foreign policy objectives. The white paper made mention of the “Indo-Pacific” 74 times and the “Asia-Pacific” only four times. In contrast, Australia’s prior foreign-policy white paper, published in 2003, mentioned the “Asia-Pacific” 26 times and the “Indo-Pacific” not at all. Clearly, policymakers have intended the term to hold some deeper meaning.[1]

You Say “Asia-Pacific,” I Say “Indo-Pacific”

What does the term “Indo-Pacific” convey that the term “Asia-Pacific” does not? It conveys a wider view of the region to include the Indian subcontinent and, specifically, India. Why include India? Most likely it is because incorporating a country of India’s size and significance into the traditional conception of the Asia-Pacific region would help to balance the growing economic and military heft of China in it.

That makes sense, given that Australia, Japan, and the United States have already brought India into their Asian security discussions. Back in 2007, Japanese Prime Minister Shinzō Abe first suggested formalizing such a multilateral collaboration through what he called the Quadrilateral Security Dialogue. He hoped to bring together Asia’s four liberal democracies to promote their shared security goals. At the time, the concept fizzled for fear of alienating China. But that apparently is less of a concern today. With the rise of Chinese assertiveness, the four countries have begun to participate in joint military exercises all along Asia’s periphery. Since 2014, India, Japan, and the United States have conducted annual naval exercises from the Bay of Bengal to the Western Pacific. And, since 2015, Japan has joined the biennial Australia-U.S. military exercise called Talisman Saber.

Indo-Pacific Security Relationships

Still, for the moment the Indo-Pacific region’s only formal security alliances are the bilateral ones that link the United States with Australia, Japan, the Philippines, and South Korea in what some have described as a “hub-and-spokes” arrangement. The United States also has long-standing security relationships with Singapore, Taiwan, and until recently, Thailand. All other regional security ties are fairly nascent, including the one between Australia and Japan. Though both countries seem drawn to one another, their bond is not yet strong. Seen in that light, Australia’s recent decision to abandon a Japanese design for its future submarine fleet was probably a missed opportunity to reinforce that bond.

Meanwhile, India, which leaned towards the Soviet Union for much of the Cold War, has a relatively new security relationship with the United States. It was not until President George W. Bush orchestrated a civil nuclear deal with India, which implicitly recognized its nuclear weapons status in 2005, did that relationship really start. And even then, it did not grow quickly. Many Indians, including former National Security Council military advisor Prakash Menon and the former foreign secretary Shyam Saran, had reservations. In 2012, they, along with some notable Indian security experts, penned a strategy paper entitled Nonalignment 2.0 that downplayed the importance of stronger ties with the United States.[2]

Since then, however, China’s growing pressure on India’s borders and influence among India’s neighbors have made Indian leaders less concerned about India’s distance from the United States and more interested in finding common cause. As a reflection of that, India—once an exclusive Russian arms importer—has begun to acquire American military equipment and to consider Japanese ones, too. Australia specifically cited its interest in “much closer” ties with India in its recent foreign policy white paper.[3]

Indo-Pacific Encirclement of China?

For years, Chinese strategists have chafed at what they regarded as the geopolitical encirclement of China. But the number of such commentaries seems to have fallen over the last year or so. Perhaps that is because China has strengthened its relationship with Russia and made diplomatic headway in Southeast Asia. Or perhaps that is simply because China feels more powerful than it was. Ironically, China would have more reason to feel encircled today, if the other major Indo-Pacific powers choose to revive something akin to the Quadrilateral Security Dialogue.

What’s in the name “Indo-Pacific?” The answer, in this case, might be a strategy for balancing Chinese power in the region.


[1] Australia Department of Foreign Affairs and Trade, The Commonwealth of Australia’s 2017 Foreign Policy White Paper, Nov. 2017; and Australia Department of Foreign Affairs and Trade, Australia’s Foreign and Trade Policy White Paper, 2003.

[2] Sunil Khilnani, Rajiv Kumar, Pratap Bhanu Mehta, Prakash Menon, Nandan Nilekani, Srinath Raghavan, Shyam Saran, and Siddharth Varadarajan, Nonalignment 2.0: A Foreign and Strategic Policy for India in the Twenty First Century (New Delhi: Centre for Policy Research, 2012).

[3] Australia Department of Foreign Affairs and Trade, The Commonwealth of Australia’s 2017 Foreign Policy White Paper, Nov. 2017, p. 42.

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China’s Encirclement Concerns

For almost two decades, Chinese strategists have worried about what they regard as the geopolitical encirclement of China. At various times, they have attributed that encirclement to the United States, then India, and most recently Japan.[1] No doubt last week’s large-scale naval exercise in the western Pacific did little to dispel their concerns. For the first time warships from India, Japan, and the United States jointly conducted anti-air and anti-submarine drills in the Philippine Sea, an area directly adjacent to the Chinese-claimed waters of the East and South China Seas.

China's Encirclement Concerns
China’s Encirclement Concerns

Events over the past month likely added to China’s concerns. Last Friday, Indian Prime Minister Narendra Modi visited Bangkok in part to expand his country’s defense and maritime security cooperation with Thailand. A week earlier, he met with President Barack Obama at the White House, highlighting India’s closer ties with the United States. At a summit in late May, the United States and Japan, along with other Group of Seven countries, openly voiced their concern over China’s maritime actions. Days before the summit, Obama flew to Hanoi where he lifted the long-standing U.S. arms embargo against Vietnam, one of China’s South China Sea antagonists. Then after the summit, Japanese Prime Minister Shinzō Abe welcomed a Vietnamese delegation to discuss how they could enhance their military cooperation.

Certainly Chinese concerns over encirclement are not new. During the Cold War, China worried about the Soviet Union pursuing a similar geopolitical strategy. Even earlier, the Chinese Communist Party faced several all too real “encirclement campaigns” during China’s long civil war. Those experiences could have left an imprint may have left their imprint on China’s strategic thinking ever since.

What is clear is that Asia-Pacific countries have begun to prepare for what could be an era of heightened tensions. Such hedging has recently accelerated, as Chinese behavior in the East China Sea, South China Sea, and on its border with India has grown increasingly muscular. The United States has pursued its “pivot” or “rebalance” toward Asia, which shifted the bulk of American naval might to the Pacific. India and Japan have boosted their diplomatic and economic engagement in Southeast Asia and strengthened their military postures. Other countries have begun to do the same. As Australia’s 2016 defense white paper warned, “competing claims for territory and natural resources [in the region]… could undermine stability.”[2] But does such hedging constitute an encirclement of China?

Imagined Encirclements

In the early 2000s, China agonized over a possible American encirclement on its western border as U.S. forces streamed into Afghanistan and Central Asia. But a decade later, a persistent insurgency had worn down the United States and its allies. U.S. military bases in Kyrgyzstan and Uzbekistan were closed; America’s once-close relationship with Pakistan became acrimonious; and U.S. forces began their long withdrawal. China’s concern never materialized.

Now Beijing fears an even wider encirclement by the countries along the Asia-Pacific periphery, as they hedge against China’s assertive behavior. But most of them are still in the early stages of building up their strength. Although Australia has launched an ambitious military modernization program, its forces remain small. India’s defense bureaucracy continues to frustrate its military’s modernization and expansion plans. While Japan fields highly capable forces, its fragile economy constrains its military’s ability to grow. Even America’s “pivot” toward Asia may not be as weighty as it sounds, as the Obama administration has trimmed the overall size of the U.S. Navy. Hence, one could argue that China’s concern over an encirclement is, at least for the moment, not wholly warranted.

Undermine the Encirclement

Besides, the countries that China fears will encircle it are not yet a cohesive bunch. Officially non-aligned, India remains skittish about is relationship with the United States. And while Australia and Japan have security treaties with the United States, they do not have strong ties with each other. That was evident when Australia, at the last minute, chose to purchase France’s Scorpene-class submarine over Japan’s Sōryū-class submarine for its next-generation submarine fleet. India’s security relationships with Australia and Japan are equally tenuous. China could use bilateral deals to weaken those relationships and hinder a nascent encirclement from coalescing any further.

Breakout of the Encirclement

But even if China’s fear was to manifest itself, Beijing is already developing the means to break out of it. In late 2013, China turned heads across Asia with its “One Belt, One Road” initiative. Among the many infrastructure projects it has financed in Southeast Asia are a special economic zone in Cambodia, hydroelectric dams in Laos, and energy and railway projects in Malaysia. While China’s “yuan diplomacy” has not always been successful, it has had an impact. Cambodia and Laos have become reliable advocates for China within ASEAN. Malaysia largely remains on the sidelines of the South China Sea dispute, despite a rising number of Chinese infringements of its exclusive economic zone. China’s initiative may prove useful even in the Philippines, which has been a thorn in Beijing’s side. The Philippines’ new president, Rodridgo Duterte, has indicated that he would undertake the bilateral dialogue that China has long sought in exchange for Chinese economic development assistance.

Benefit of the Encirclement

Still, Beijing may have reason to play up its fears of encirclement. Despite its remarkable economic achievements, China faces a host of problems. Today, Chinese leaders must manage their country’s difficult transition from investment-led growth to expansion by private consumption, while dealing with its various debt-fueled bubbles. Even under the best conditions, those challenges are bound to be volatile. So some may see fears of encirclement as a way to rally public sentiment and maintain the “social stability” needed to ensure the longevity of communist rule. In any case, whether the “encirclement of China” is imagined or real, effective or not, one can expect the phrase to remain in Beijing’s lexicon for years to come.

NOTES

[1] Zhang Yunbi, “Tokyo urged not to stir tension in the South China Sea,” China Daily, Mar. 10, 2016, http://www.chinadaily.com.cn/world/2016-03/10/content_23806572.htm; “Tokyo’s move to encircle China will lead nowhere,” Global Times, Nov. 23, 2015, www.globaltimes.cn/content/954471.shtml; Hu Qingyun, “US to increase troops stationed in Australia: Deal seen as move to ‘encircle’ China,” Global Times, Aug. 13, 2014, http://www.globaltimes.cn/content/875836.shtml; Li Hongmei, “India’s ‘Look East Policy’ means to encircle China,” People’s Daily Online, Oct. 27, 2010, http://en.people.cn/90002/96417/7179404.html; Dai Xu, “U.S. building ‘Asian NATO’ to encircle China,” China.org.cn, Aug. 11, 2010, http://www.china.org.cn/opinion/2010-08/11/content_20687335.htm; “China feels encircled,” Economist, Jun. 6, 2002.

[2] Australian Department of Defence, 2016 Defence White Paper (Canberra: Commonwealth of Australia, 2016), p. 57.

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China’s New Missiles and U.S. Alliances in the Asia-Pacific: The Impact of Weakening Extended Deterrence

Two weeks ago, Chinese President Xi Jinping attended a nuclear security cooperation summit in Washington. At the same time, China has been busily preparing its next generation of nuclear weapons. It has made steady progress on its new DF-41 intercontinental ballistic missile (ICBM). Last December, China conducted two more tests on the missile, including one that confirmed the DF-41’s ability to be launched from a mobile platform. The DF-41 will be China’s first solid-fueled missile with the range to reach the entire continental United States. The new missile’s range will likely exceed that of China’s older liquid-fueled DF-5 (or CSS-4 according to its NATO designation) ICBM. As a mobile, solid-fueled missile, the DF-41 will be hard to track and able to quickly launch, improving China’s nuclear deterrent. Some believe that China might deploy the DF-41 as early as this year.[1]

China has also been developing a sea-based ICBM, the JL-2. Though the JL-2 has a shorter range than the DF-41, China has built four Jin-class nuclear-powered ballistic missile submarines to carry JL-2 missiles closer to their targets. While those submarines are unlikely for the moment to venture far from their base at Yalong Bay on Hainan Island, American officials confirmed that one of them conducted a patrol late last year. [2] Whether or not JL-2 missiles were on board the submarine is unknown. But if they were, that would make the JL-2 even more elusive than the DF-41, again strengthening China’s nuclear deterrent.

Chinese Ballistic Missile RangesChinese Ballistic Missile Ranges

While China’s nuclear arsenal is small when compared to those of Russia or the United States, there is little doubt as to its enduring importance to Beijing. That much is clear in the special status its nuclear weapons program has held over the last half century. As part of its wide-ranging military reorganization early this year, Beijing elevated its land-based nuclear forces, once a component of the army, to a full-fledged service on par with the army called the Rocket Force.

Many Chinese analysts believe that by creating a more robust nuclear retaliatory capability they can ensure that no country would threaten China with nuclear coercion should a crisis erupt over one of its “core interests,” like Taiwan. As one Chinese official once famously quipped in the 1990s, the United States would never trade “Los Angeles for Taipei.” Hence, China has opposed any proposal that might blunt the effectiveness of its nuclear missiles, even indirect ones, like America’s recent effort to deploy its Theater High-Altitude Air Defense system to protect South Korea and Japan from a possible North Korean missile attack. While Beijing may contend that a state of mutual vulnerability would lead to a more stable security environment between China and the United States, it also complicates a key feature of U.S. alliances in the Asia-Pacific.

Since the Cold War, U.S. allies, like Australia, Japan, and South Korea, have enjoyed what is called “extended deterrence”—a security guarantee that the United States would be willing to use its nuclear forces to deter aggression against them. But that guarantee is dependent on the credibility of the United States to act. Naturally, the United States is more likely to act if potential adversaries are unable to retaliate against it. Once fully operational, China’s new missiles, which can directly threaten the United States, will complicate the credibility of America’s security guarantee to its allies, weakening extended deterrence.

Already American credibility to act has been questioned over the last half decade, due to the Obama administration’s repeated hesitancy in foreign crises. The reliability of America’s security commitments concerns many of its allies in the Asia-Pacific, as China’s military capabilities continue to grow. That has led some U.S. allies to reevaluate their own military postures. Japan has even taken steps to change its constitution to enable its military to take on a more “normal” role to safeguard Japanese interests in the region.

Australia has begun to do the same. Since the early 2000s, several Australian policymakers have argued for a more self-reliant defense. In its 2009 defense planning document Australia stated “in terms of military power… we must have the capacity to act independently where we have unique strategic interests at stake.”[3] Then, its defense white paper this year, Australia indicated that it could only assume American military dominance in the Asia-Pacific for the next two decades, rather than for the “foreseeable future” as it had in the past. [4] As a result, Australia is pressing ahead with a defense review that will culminate in the purchase of a raft of new military hardware. Australia is now considering the purchase of Japanese submarines for its navy. A few Australian analysts have even begun to openly wonder whether nuclear weapons should in Australia’s future.

Some American policymakers have welcomed the change that weaker extended deterrence has brought. Long-time issues of burden-sharing have eased. They believe that a web of militarily stronger allies can deter China from upsetting Asia’s regional order and do so at a lower cost to the United States. If they are correct, it may usher in a new era of stability. But it also means that the United States will be less able to manage crises in Asia-Pacific, as regional countries will have greater ability to act without it. Should American allies do so, they could draw the United States into a crisis that it would have rather avoided. For those who are concerned about that prospect, it provides an added incentive to pursue ever stronger anti-ballistic missile defenses.

[1]China’s top new long-range missile ‘may be deployed this year’, putting US in striking distance,” South China Morning Post, Mar. 29, 2016; Bill Gertz, “Chinese Defense Ministry Confirms Rail-Mobile ICBM Test,” Washington Free Beacon, Dec. 31, 2015; Bill Gertz, “China Tests New ICBM from Railroad Car,” Washington Free Beacon, Dec. 21, 2015; Keither Bradsheraug, “China Said to Bolster Missile Capabilities,” New York Times, Aug. 25, 2012, p. A5.

[2] Bill Gertz, “Pentagon confirms patrols of Chinese nuclear missile submarines,” Washington Times, Dec. 9, 2015.

[3] Australian Department of Defence, Defending Australia in the Asia Pacific Century: Force 2030 (Canberra: Department of Defence, 2009), p. 48.

[4] Australian Department of Defence, 2016 Defence White Paper (Canberra: Department of Defence, 2016), p. 41.

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The Almost-Normal Country: Japan and the Use of Force

The enactment of Japan’s new national security bills was a long time in the making.  The bills, already passed by the lower house of the Japanese Diet in July, were approved by its upper house last week.  But ever since Shinzō Abe became Japan’s prime minister in 2012, he had sought legislation that would enable Japan to engage in “collective self-defense,” the ability to aid friendly countries under attack.  While that may seem routine in most countries, it has been anything but in Japan.  Many were unhappy with the legislation’s passage.  Those who opposed it feared that it would lead the country into war; and even some of those who supported it grumbled that it did not go far enough to make Japan a truly “normal” country, one where the use of force is considered as a legitimate tool of international politics.

Japan Collective Self-Defense

Unsurprisingly, China was quick to condemn the legislation’s passage.  China’s Ministry of National Defense declared that Japan’s new security laws ran “counter to the trend of the times that upholds peace, development and cooperation.”  The ministry chastised “Japan’s war mentality, its reinforcement of military alliances and attempts to send more troops abroad.”  Chinese media was less charitable.  Xinhua carried the headlines: “China Voice: Is Japan bound up to battle chariot?” and “News Analysis: Japan’s pacifist ideals stripped as Abe steps closer to resurrecting old war machine.”  One commentator at The People’s Daily blamed the “unyielding spirit of militarism” of Japanese leaders who were “breaking [Japan’s] pacifist promise and getting ready to send its troops to battles again.”[1]

Of course, China rarely passes up an opportunity to remind Japan of its imperial aggression.  Thirty-six years of Japanese economic aid to China—now nearly $1.2 billion per year—has yet to restrain its reflex.  In part, that is because the Chinese Communist Party (CCP) has often used anti-Japanese sentiment to buttress its own political legitimacy.  (Only recently did the CCP even credit its longtime Chinese rival, the Kuomintang on Taiwan, for its contribution—arguably larger than the CCP’s—to resisting Japan in World War II.)

That it took so long for Japan to pass this sort of legislation is a testament to the strength of Japan’s postwar pacifist sentiment.  While militarist elements may still lurk in Japan, most Japanese are decidedly uncomfortable with the use of force in international politics.  That was clear during Japan’s negotiations with Russia over the Northern Territories (or southern Kuril Islands in Russia) in the 1990s.  Though Japan had already begun its long economic stagnation, its military and political might was still near its peak.  In contrast, Russia, following the fall of the Soviet Union, was at its nadir.  Things were so bad in the Russian Far East that it was questionable whether Moscow could provide enough food or heat for its population on Sakhalin Island, let alone defend it.

Yet, Japan did not try to use its military or political capital to pressure Russia into a settlement.  Rather, Japan solely relied on the persuasive power of its economic assistance.  That tactic ultimately came to nothing.  After Russia’s economy recovered, Japan’s window of opportunity to settle the dispute on favorable terms closed.  Today, Russian leaders act without concern over Japanese reaction.  They cavalierly flout Japanese interests.  This year, a series of senior Russian officials visited the four disputed islands, despite repeated protests from Tokyo.  Russian Prime Minister Dmitry even toured one of them in August.  While there, he underlined that the Kuril Islands “are part of Russia… That is how it is and how it will be.”[2]

Japan’s self-imposed limitation on its use of force has also impacted its ability to secure its place in a changing East Asian geopolitical environment.  China’s economic rise has drawn other Asian countries closer to its orbit, while its seemingly relentless military rise has upset the regional balance of power.  Without the ability to form true security partnerships, Japan has risked becoming isolated.  Hence, Abe has eagerly cultivated new political and economic ties across the Asia-Pacific, from Australia and India to the countries of Southeast Asia.  Japan has certainly become more sensitive to changes in Asia’s geopolitical balance.  Last year, after Thailand’s relations with the United States soured, offering China an opening, Tokyo leapt into the breach with pledges of economic engagement with Bangkok.

Surely, the most immediate beneficiary of Japan’s new security laws is the United States.  For the past half century, the United States has borne the entire security burden of the alliance between the two countries—if Japan is attacked, the United States is obligated to defend Japan; but if the United States is attacked, Japan has no such reciprocal obligation.  Even during the Cold War, that uneven arrangement rankled some Americans.  To make it more equitable, Japan accepted the lion’s share of the financial burden to host American forces in Japan.  But with the end of the Cold War and the withdrawal of a substantial portion of American forces from Japan (to Guam and elsewhere), the relationship was about to tilt again.  Thus, it was hardly surprising that Washington welcomed the legislation’s passage.

But beyond the United States, the legislation also enables Japan to more effectively cooperate with other countries on security matters.  If Japan’s relationships with Australia, India, the Philippines, and recently Vietnam mature into security partnerships, those countries can now count on Japan as a full partner.  In fact, in the days before the upper house vote on the national security bills, Abe met with Vietnam’s communist party secretary to discuss stronger security ties, in light of Vietnam’s dispute with China in the South China Sea.  Abe pledged more patrol boats for Vietnam.  Such promises is partly what worries Japanese opponents of the bills.  Getting Japan entangled in the disputes of other countries could pull it into a conflict, perhaps with China.  On the other hand, the possibility of facing a regional network of security partners might restrain China’s aggressiveness.  After all, China’s own economic prosperity (tenuous as it has become this year) requires peace and stability.

Even with the enactment of its new national security bills, Japan seems unlikely to seek the active use of military force far from home.  After all, Japan’s debt-laden government is in no position to rapidly expand its self-defense forces without hurting its still-weak economy.  Moreover, the conditions under which Japan can use force to support American expeditionary efforts abroad are still narrowly circumscribed.  The new legislation may be a step toward a Japan that is more comfortable with the idea of the use of force.  But the road to an actual use of force remains a long one.  Ironically, China may be the one country that could propel Japan faster down that road.

[1] “China Voice: Is Japan bound up to battle chariot?” Xinhua, Sep. 19, 2015; “News Analysis: Japan’s pacifist ideals stripped as Abe steps closer to resurrecting old war machine,” Xinhua, Sep. 19, 2015; “Japan’s new security bills against trend of the times: defense ministry,” Xinhua, Sep. 19, 2015; Wen Zongduo, “Abe’s win is Japan’s loss,” Chinadaily.com, Sep. 19, 2015.

[2] “Moscow officials ‘have always and will continue to’ visit Russian Kuril Islands – PM,” RT.com, Aug. 23, 2015.

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Decline in Oil Prices, Currency Pairs, and National Power

Last autumn, headlines began to declare national “winners and losers” from the precipitous drop in oil prices over the second half of the year.[1]  They contended that the United States and its friends would benefit from the fall in oil prices; and that its most strident adversaries would not.  While largely true, the headlines did not capture the whole story.

Since international prices for oil are quoted in U.S. dollars, the exchange rate between the U.S. dollar and another country’s currency (a currency pair) also matters when calculating the real impact of a change in oil prices on that country.  Take Russia for example.  Much has been made of the fact that half of Russia’s government budget is based on revenues from oil.  One might suppose, because oil prices have fallen about 50 percent over the last six months, that Russia’s government budget would be pinched by about 25 percent (reflecting the 50 percent fall in oil revenues on half its budget).  Such a contraction would be catastrophic for the Russian government and Russia’s economy, given its high dependence on government spending.  That might lead Western policymakers to believe they can easily wait out Russian President Vladimir Putin’s aggressive designs.

But one must remember that the Russian government does not pay for domestic goods and services in U.S. dollars, but rather in Russian rubles.  Any drop in the value of the Russian ruble against the U.S. dollar allows Russia to reap more rubles for its dollar-based oil revenues.  (Even so, a sudden devaluation in a country’s currency can still wreak havoc on that country’s wider economy, because it fails to let people adjust to the benefits of devaluation, before they feel its negative impacts.)  Given the devaluation in the Russian ruble (which has fallen in tandem with oil prices), the real impact of the fall in oil prices is closer to only 8 percent, rather than 25 percent. While that is still a big challenge for the Russian government’s budget, it is a lower hurdle for Putin to surmount.

Similarly, one might expect that Japan, a key American ally in Asia, to unreservedly benefit from the decline in oil prices.  As a country completely dependent on oil imports, any decline in oil prices should boost its economy.  Given that oil prices have fallen about 50 percent over the last six months and that Japan imported about 1.6 billion barrels of oil in 2014, one may naturally assume that Japan is now saving a vast sum that would act as a fiscal stimulus to its economy, making it a stronger country and one better prepared to cope with a rising China.

That has happened, but not to the degree that the halving of oil prices would suggest.  That is because the value of the Japanese yen against the U.S. dollar has fallen too.  During the second half of 2014, the yen devalued about 15 percent, as a result of the Japanese central bank’s quantitative easing policy.   That shaved one-fifth off the benefit from the decrease in oil prices to 40 percent in yen terms.  Ironically, the lower energy input prices had made it more difficult for the Japanese government to achieve its 2 percent inflation target, which Tokyo believes will help lift the country out of its decades-long deflationary economic stagnation. 

As the cases of Russia and Japan have shown, changes in currency exchange rates can make a real difference on the impact that changes in oil prices have on a national economy, whether they are net oil importers (those shaded in blue in the chart below) or net oil exporters (those shaded in red).

Effect of Exchange Rate Movements on the Decline in Oil Prices in Local Currencies

 

As a region, Asia has benefited from the drop in oil prices.  Almost every country in the region is a net oil importer.  Chief among them is China, whose slightly appreciating yuan against the U.S. dollar, has allowed it to fully benefit from the lower oil prices.  In fact, Beijing has taken advantage of them to less expensively fill its strategic petroleum reserve.[2]  But not far behind have been India and Indonesia.  The currencies of neither country have devalued by more than 6 percent, allowing them to realize almost all of the benefit from the decline in oil prices.  That, in turn, has allowed their central banks to cut their interest rates to spur their economies without having to worry as much about inflation.  Lower oil prices have also enabled Indian Prime Minister Narendra Modi and Indonesian President Joko “Jokowi” Widodo to slash fuel subsidies, which had been draining government coffers in the past, without a public outcry.  That has freed up resources that they can devote to infrastructure and defense, as both national leaders have promised.

However, the fall in oil prices has also pinched some American allies.  One such country is Australia.  Though it is a net importer of oil, Australia has ambitions to become among the world’s leading exporters of liquefied natural gas (LNG).  But LNG prices, which are often linked to those of oil, have followed oil’s prices downward.  That has put into jeopardy Australia’s new round of offshore LNG development.  According to the Australian government, it will likely miss out on about AUS$750 million in petroleum resource rent tax over the next four years—about the cost for one of the new diesel-electric submarines that its navy wants.  The situation would have been even worse had the Australian dollar not devalued by 13 percent against the U.S. dollar.[3]

Finally, some countries, like Venezuela, whose currencies are effectively pegged to the U.S. dollar, have felt the full impact of the decline in oil prices.  Unfortunately for Venezuela, it imports most of its consumer and industrial goods—including food, clothing, machinery, vehicles, etc.—and it holds debts mainly denominated in U.S. dollars.  Thus, any devaluation of the Venezuelan bolívar to temper the impact of lower oil prices would also cause the costs of goods to soar and make its U.S.-dollar debts crushing.  To avoid a financial crisis, Venezuelan President Nicolas Maduro has travelled to China this week.  In the past China has agreed to oil-for-loan agreements, in which China provides immediate financing to Venezuela in exchange for future deliveries of Venezuelan oil.  Already existing deals with China have begun to squeeze out Venezuela’s ability to use its oil to bring Latin American countries into its orbit.  Rather, new deals are more likely to move Venezuela close to China’s orbit.[4]

By the first week of January 2015, the benchmark prices for Brent and West Texas Intermediate crude oil had fallen to $51 and $48 per barrel, respectively.  As long as these conditions persist, oil-exporting countries will suffer and oil-importing ones will benefit.  But to really understand whether these countries are weakening or strengthening to the extent that the decline in oil prices suggest, one would be wise to also consider the trajectories of their national currencies.

[1] “Winners and Losers,” Economist, Oct. 25, 2014.

[2] Abheek Bhattacharya, “China’s Petroleum Reserve Builds Shaky Floor for Oil,” Wall Street Journal, Sep. 3, 2014.

[3] Australia is considering a Japanese submarine design for its next-generation submarine fleet.  The most recently launched Japanese Sōryū-class submarine cost $540 million and AUS$750 million converts to $615 million at today’s exchange rate.  John Hofilena, “Japan launches newest submarine Kokuryu amid party atmosphere,” Japan Daily Press, Nov. 04, 2013, Eric Yep, “Falling Oil Spells Boon for Most of Asia’s Economies,” Wall Street Journal, Jan. 4, 2015; Max Mason, “Oil price plunge sends petrol to four-year lows as Australia feels it at the pumps,” Sydney Morning Herald, Dec. 22, 2014; James Paton, “Plunging Oil Threatens to Spoil Australia’s Next Gas Boon,” Bloomberg News, Nov 27, 2014.

[4] Eyanir Chinea and Brian Ellsworth, “Venezuela’s Maduro to visit China, OPEC nations amid cash crunch,” Reuters, Jan. 5, 2015; Nicole Hong and Kejal Vyas, “Oil Shakes Venezuelan Debt to Its Foundations,” Wall Street Journal, Dec. 22, 2014; “Inside U.S. Oil,” Thomson Reuters, Aug. 22, 2014, pp. 7-8.

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