How A Land Dispute Between Japan And Korea Could Be Sparked All Thanks To Low Market Volatility

bank of japan boj shirakawa

[credit provider=”AP”]

Japan and Korea have a longstanding history of political disputes.One disagreement the two countries have never been able to resolve is who controls the Liancourt Rocks, a tiny group of islands that lie between Japan and South Korea.

However, such arguments have taken a backseat in recent years to economic considerations between the two countries, but they could spark up again soon if Japan is not careful, according to JPMorgan strategist Hajime Kitano.

First, bear in mind that territorial disputes are a growing issue in the region. Japan and China have gotten the headlines, but this Liancourt Rocks issue is bubbling.

Back to the financial angle…

Korea, an export-dependent nation, has since the global financial crisis relied on currency swap lines from the Bank of Japan in order to secure foreign currency reserves that stop growing when other countries stop purchasing Korean exports.

Kitano says these swap agreements – notwithstanding political disputes between Japan and Korea – are an easy sell for both nations because they give stock markets in both countries a boost. The value of the Japanese yen is inversely correlated with Japanese stocks – typically when the yen depreciates, stocks rise. In Korea, the correlation tends to be the opposite – when the Korean won rises, so do stocks. Thus, the swaps, which have the effect of depreciating the yen and increasing the value of the won, are a political no-brainer.

The currency swap agreement has been modified three times since the crisis broke in late 2008. It was increased from $13bn to $30bn in December, 2008 before being reduced back down to $13bn in April, 2010. Then, in October of 2011, it was increased to $70bn.

Following the drastic increase in October of 2011, a Nikkei editorial cited by Kitano explained that “The territorial dispute over [Liancourt Rocks] and historical perspectives are the cause of smouldering resentment between Japan and Korea. The only way to prevent this problem from seriously harming relations is to deepen mutual trust by stepping up economic and diplomatic cooperation.”

However, global financial market tensions have eased drastically, making the swap lines less useful. Kitano cites a recent newspaper report that “the Japanese government and the BoJ have been quietly and internally considering returning the swap limit to its original level following the expansion in October 2011.”

According to Kitano, “if handled badly, even such administrative procedures could be viewed as retaliation for the territorial dispute and thus lead to political problems, however.”

Here’s a chart plotting the currency swap modifications against market volatility. When volatility is high, the BoJ has increased the currency swaps. When volatility was low in April 2010, the central bank wound down the swaps:

VIX Index and Currency Swap Agreement between Japan and Korea

[credit provider=”JPMorgan”]

Kitano concludes that there is an “inverse correlation between Japan-Korea political tension and global financial market tension” and warns that political trouble between Japan and Korea may arise now that markets have been calmed.