Australia, Japan and the Arms Race in the Asia-Pacific

Today’s Daily Reckoning continues your tour of the ‘rim of fire’ with a special stop at the island nation of Japan. You’ll have a front row seat to ancient enmities in northern Asia (which could draw Australia into a regional war). You’ll also explore Australia’s options for a building a new submarine capable of patrolling one of the largest exclusive economic zones (EEZs in the world). If you’re a pacifist or have an irrational fear of hydrocarbons, you’re not going to like today’s DR.

And that brings us to Japan. 63% of Japanese coal imports come from Australia, according to Shiro Armstrong in yesterday’s Australian Financial Review. Japan imports 62% of its iron ore from Australia. Australia supplies Japan with one-fifth of its LNG, and is the largest supplier of ‘energy fuels’ to Japan, when you include thermal coal.

All of those raw materials must pass through a body of water being hotly contested by no less than seven nations: Japan, China, Malaysia, Vietnam, Taiwan, the Philippines, and Brunei. Over $5.3 trillion in goods pass through the Straits of Malacca alone, each year. Nearly 13 million barrels of oil per day (mbpd) — 10.4 million of it from the Middle East, transit through to Japan, Taiwan, Korea, and China, with China (5.4mbpd) nearly as thirsty as Japan and Korea combined (5.6mbpd). Check out the image below from Bloomberg.

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Source: Bloomberg visual data

Now can you see why submarines are so important to patrolling and keeping open the sea lanes connecting China and Japan with the Middle East, and Australia with the rest of the world? The South China Sea itself — with an estimated 11 billion barrels of oil, 190 trillion cubic feet of gas, and some of the world’s richest fishing rounds — is an economic prize at the centre of future conflict.

What are Japan and Australia going to do about all this? We’ll find out later today when Japanese Prime Minister Shinzo Abe addresses the Australian Parliament. But it comes down to three basic issues: food security, national security, energy security. Or in even simpler terms: grain, gas, and guns.

I say guns. But what I really mean is submarines. When Abe’s cabinet reinterpreted Article 9 of Japan’s 1947 constitution last week, it allowed for ‘collective self-defence’. That might sound like soldiers from the Japanese Self-Defence Forces can come to Australia’s aid in a future conflict (or vice versa), which may be true. And if it is true, Australia may be agreeing to be part of any future conflict in North Asia, which is why China is following events so closely.

But practically, the reinterpretation of the pacifist constitutions means Japan can now legally sell top-shelf defence technology and weapons to Australia, which is exactly what will happen. It now looks like Australia and Japan are planning a joint venture to replace Australia’s six Collins-class diesel-electric subs with technology from Japan’s Soryu, or ‘Blue Dragon’ submarine.

The ‘Blue Dragon’ is said to be one of the world’s best conventional submarines for patrolling large off-shore areas. It’s a 4,200 tonne boat, whereas the Collins-class is 3,400 tonnes. German designs are being considered as well. The American-made Virginia-class submarines would be perfect for Australia’s massive patrolling needs. But they’re nuclear (not conventional), and thus not being considered.

Patrolling the EEZ is a big job

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Source: Geoscience Australia

Whether Australia builds them or buys them, it’s going to spend close to $35 billion on a new submarine fleet. That tells you how urgent and expensive the matter is. It’s urgent because recent reports from Defence Minister David Johnston showed there were periods in the last five years — whole months — where Australia didn’t have a sea-worthy Collins-class boat to deploy. Technical and crewing issues left the fleet in port.

It’s expensive. But if you haven’t gathered it already, the world is in a new arms race. Japan is selling. Australia’s buying. But US defence companies are doing a booming trade as well. Australia agreed to buy $8 billion worth of Boeing’s P-8A Poseidon anti-submarine surveillance craft. It also agreed to buy up to $4 billion worth of Northrup Grumman’s MQ-4C Triton high-altitude surveillance drones.

You can see a three part strategy. $30 billion worth of new submarines that can patrol further north, launch cruise missiles if need be, or insert Special Forces teams. $4b worth of anti-submarine surveillance plans. And a fleet of ‘persistent surveillance’ drones that can monitor Australia’s vast coastline and provide round-the-clock surveillance of the most important shipping lanes in the world.

I’ll get back to those shipping lanes and all the grain and grass that go through them in a moment. But I’ve left out the Joint Strike Fighter (JSF)! The F-35, as it’s also called, is being built at a cost of $400 billion and counting by Lockheed Martin. It’s a key pillar of Australia’s defence strategy. It’s a 5th generation fighter reputed to have some of the world’s most advanced surveillance and detection systems. It runs on over 8 million lines of computer code, making it a very powerful, very lethal kind of airborne smart-phone.

The Gillard government had already signed up to buy 12 of them. The Abbot government upped that order by an additional 58 earlier this year, with plans to buy another 24. It’s the lynchpin of Australia’s future air-combat capabilities. At $100 million a plane, plus weapons, training, and facilities, that’s another $12.3 billion.

By the way, the US Air Force has grounded all flights of the F-35A version of the JSF after an engine fire on take-off did severe damage to a plane on June 24th. It was bad timing, given one of the Air Force planes was scheduled to show off for prospective buyers at the Farnsborugh Air Show later this month.

It’s also bad timing if Australia’s prize air asset turns out to be a lemon. But we’ll see. In the meantime, the Abbott government is also considering the purchase of F-35B variant operated by the US Marine Corp. That’s a JSF that could stage a vertical take-off from a ship like the HMAS Canberra, currently being outfitted in Williamstown. Did somebody say ‘Australian aircraft carrier?’

All of this ‘arming up’ is designed to protect the sea lanes. Mitsubishi Chairman Yorihiko Kojima explains in yesterday’s Australian, with my own emphasis added:

‘Australia remains one of the world’s major suppliers of resources and has potential for growth in other areas as well, including agri-industry…As one of the world’s largest wheat producing countries and the largest exporter of wheat to the Southeast Asian market, this [free trade agreement] will bolster our capacity to forge a stronger and more stable procurement system in Australia’s competitive grain market…Australia is among the world’s most resource-rich countries and represents a veritable lifeline for the Japanese economy.’

But as important as food security is, energy security is at the heart of Australian-Japanese trade. Aussie LNG exports account for 20% of Japan’s total LNG imports. But Japanese power companies buy up nearly 80% of Aussie LNG exports. This from Rick Wallace in today’s Australian:

‘Japan is striving to boost LNG exports from Australia and Papua New Guinea — where Mr Abe travels to next — amid soaring concern about conflict in the South China Sea and delays in restarting nuclear plants. Reports from Japan say Tokyo has adopted a policy of doubling gas volumes from Australia and PNG from 18 million tonnes per annum to 36 million tonnes to -diversify risk; Mr Abe is expected to raise the issue of securing extra supply in talks with Tony Abbott.’

Do you start to see the picture? Australia has resources. Japan has been a long-time and willing buyer and partner, contributing large amounts of capital to Australian projects. The ‘lifeline’ connecting Aussie wheat and gas with Japanese markets runs right through the South China Sea, which China considers part of its territorial waters. Anticipating future conflict, Australia and Japan are planning closer defence and technology ties.

If you were China, how would you take all this? Are the American-aligned powers in the region trying to ‘contain’ you with new alliances and trade deals? Is the military escalation a threat? What about China’s relationship with Australia? I’ll get to all that in our next stop on the ‘rim of fire’ tour.

Today I’ll close with two important ideas. First, history shows that a financial crisis can become a political crisis. A political crisis can become a military crisis. If we are approaching another 2007-style day of reckoning for markets, then the time to prepare for the geopolitical fall out is now, hence the ‘rim of fire’ series and my controversial ‘Invasion’ report.

The second point is that, most of the time, you have absolutely no influence on the course of human events, other than the life you choose to lead. Your decisions aren’t going to change the arc of history. Whether Asia-Pacific is headed to peace and prosperity or strife and conflict is beyond your control.

What IS in your control is your financial strength and future. The best thing you can do for yourself as Australia’s neighbourhood gets more contentious is to improve your financial strength. Everything I’ve discussed above is ‘investable’. Food, energy, defence…these are all ‘big picture’ ideas you can connect with specific investments. That’s what I’ve been doing for the last three years in The Denning Report. Tomorrow, we go to China.