Geopolitical risk: US-China among flashpoints with highest probability of escalation

This insight is part of our Political Risk Outlook 2021, which explores five key themes we’re tracking for our clients this year. You can find the other themes at our #PRO21 hub, as well as related webinars.

The geopolitical situation Joe Biden inherits at the dawn of his presidency is significantly different to when he last held high office in 2017. Great power competition between the US and China – the world’s two geopolitical heavyweights – has accelerated and is now a defining characteristic of the international arena. How Biden squares up to the challenge posed by China will shape the geopolitical risk landscape for corporates and investors over the coming year and beyond.

Yet the 46^th US president faces various obstacles at home and abroad to reasserting American influence on the global stage, and he may find his ability to have a strong bearing on the trajectory of other geopolitical flashpoints much diminished.

Against this backdrop, we’ve used our Interstate Tensions Model to identify the key geopolitical rivalries that have the potential to spill over into a military confrontation in the year ahead, and that should be on the radars of strategic decision-makers (see Figure 1).

Countering Chinese assertiveness will top new administration’s foreign policy agenda

Biden’s top foreign policy priority will be managing escalating great power competition with China. Our Interstate Tensions Model identifies the US-China pairing as having one of the highest risks globally of tipping over into some form of military confrontation, with a 58% probability of such a scenario occurring in the next 12 months – an increase of 19% over the last year (see Figure 1).

While neither side will want to resort to force to resolve their many differences, there is an increasing likelihood that both sides will use military threats and posturing to project power. Reports that Chinese bombers conducted a simulated strike against a US Navy carrier group in the South China Sea in January 2021 is one such example and likely a sign of things to come. The danger is that such muscle flexing, through a combination of miscommunication, misunderstanding and miscalculation, will inadvertently result in the actual use of force in theatres such as the South China Sea or the Taiwan Strait.

Biden faces pressure from both sides of the Congressional aisle to maintain a tough policy towards Beijing, and his characterisation of China as America’s “most serious competitor” during his first foreign policy speech suggests hopes for a détente are wide of the mark. The rebound in verbal conflicts chalked up between Beijing and Washington in January 2021 supports this assertion (see Figure 2).

China stepping up pressure against US partners

Following military skirmishes along the disputed Himalayan border in 2020-Q2 and Q3, our data also captures the rise in tensions between China and India – the latter is viewed by Washington as an important counterbalance to Beijing in the Indo-Pacific. A scuffle between Chinese and Indian forces broke out in a disputed border area in late January 2021 and we put the chance of further military confrontations over the next 12 months at 41%.

The sharp deterioration in relations reflects a broader trend, where Beijing has doubled down on a more aggressive foreign policy following international criticism of how it managed the original outbreak of Covid. Australia, a key US ally, is also on the frontline of Beijing’s ‘Wolf Warrior’ diplomacy and coercive foreign policy, although our model suggests there is only a remote prospect for escalating diplomatic and trade tensions to tip over into a military confrontation in 2021.

our model flags the Greece-Turkey pairing as another likely geopolitical flashpoint, with a 54% chance of a military confrontation.

Biden takes reins as US influence on the wane

With the rules-based global order fraying in the wake of the Trump administration’s disregard for international norms and its haphazard foreign policy-making, ‘strongmen’ such as Erdogan and Putin have profited from the resulting power vacuum. Biden will find reining in the actions of these newly invigorated geopolitical power brokers a tricky prospect. The storming of the US Capitol building by Trump supporters on 6 January and the domestic divisions it exposed will likely only embolden Washington’s international rivals further.

Within this context, our model flags the Greece-Turkey pairing as another likely geopolitical flashpoint, with a 54% chance of a military confrontation – such as a naval encounter over disputed hydrocarbon resources in the Eastern Mediterranean – over the next 12 months. An increasingly autocratic President Erdogan has adopted a much more muscular foreign policy over recent years, which has seen Turkey deploy military assets to multiple theatres in its near abroad. Striking a balance between wooing and cajoling this strategic NATO member back into line is another key foreign policy challenge on Biden’s plate.

An outlier within our Interstate Tensions Model is the US-Russia pairing. Trump’s repeated reluctance to challenge President Putin’s provocative foreign policies – from interfering in the 2016 US election to the 2020 SolarWinds cyber hack – is reflected in the very low probability of a military clash. However, Biden has warned that the days of the US “rolling over” for Russia are done, and we expect this tougher rhetoric to be reflected in future iterations of the model.

Separately, our model flagged escalating bilateral tensions that led to the outbreak of conflicts in the South Caucasus. While tensions between Azerbaijan and Armenia will remain high in 2021, the presence of Russian peacekeepers on the ground reduces the likelihood of a return to full-scale war. Two traditional flashpoints – the Korean Peninsula and India-Pakistan – round out the geopolitical hotspots and shouldn’t be overlooked.

Middle East as a silver lining?

One positive for President Biden is the decline in geopolitical tensions in the Gulf, which has created the diplomatic space for Saudi Arabia and its allies to end the three-year blockade against Qatar. While multiple friction points remain, lifting the embargo adds salve to a sore that has undermined unity among Washington’s Middle Eastern allies. One driver is Riyadh’s realisation that it will have less leeway under the new US administration, as underscored by Biden’s decision to pull US support for the Saudi-led war in Yemen. Our model indicates that the prospect of Saudi Arabia and Iran engaging in a military clash in the coming months has also eased somewhat, although the regional rivalry will remain fierce.

US-China relations is unsurprisingly the geopolitical trend that is set to have the greatest impact on global markets.

Market impact

The trajectory of US-China relations is unsurprisingly the geopolitical trend that is set to have the greatest impact on global markets. Bilateral tensions between the world’s two largest economies have been on the rise over the past decade, but a spillover into a military confrontation would likely trigger an aggressive tit-for-tat policy response.

Under such a scenario, Washington would likely tighten export controls and other sanctions against firms with links to China’s military, further curb the ability of Chinese SOEs and domestic champions to access American capital, and double down on efforts to reduce America’s reliance on China as a source of critical minerals. Beijing’s retaliatory playbook would probably feature import restrictions on US LNG, crude, coal and agricultural goods, politicised regulatory probes against US firms operating in China, cyber-attacks and potentially the arbitrary arrest and detention of an American citizen or two. US partners and allies are also likely to remain on the front line of any backlash from Beijing, as Australian exporters of wine, barley, cotton and coal can attest.

More broadly, the corporate sector is increasingly viewed as a legitimate target by sparring strategic rivals, and the unwary risk getting caught in the crossfire of one of the world’s various geopolitical flashpoints. Tracking the signals is therefore a crucial first step towards navigating a year likely to be defined by geopolitical jostling.