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Rare Earths Could Be Pawn in Island Spat... Again

As China and Japan continue to ratchet up tensions over a group of disputed islands in the East China Sea, many investors may be wondering how the dispute could affect the marketplace. One potential area for fallout is the market for rare earth elements (REEs): the futuristic sounding group of 17 minerals with unpronounceable names that play a critical role in everything from hybrid cars to flat screen TVs. As discussed in our October edition of the Euro Pacific Capital Global Investor Newsletter, these minerals have shown particular sensitivity to the diplomatic relationship between the two Asian giants. If the current situation deteriorates (as it has this week when several major Chinese banks pulled out of International Monetary Fund events in Tokyo), the REE market may come under intense pressure.

As of now, China controls over 90 percent of the world's rare earth mining concerns. In the past, this near monopoly has allowed them to exert a significant influence over both price and supply. In 2010 and 2011, China used its position to send prices on a roller coaster ride. The catalyst was a dispute over the same islands that are causing tensions to rise today.

Though currently uninhabited, many believe that the Diaoyu Islands (called the Senkaku Islands by Japan) sit on top of valuable oil and gas reserves. But even if the islands are nothing but worthless rocks, they have simply become flash points in a long-running rivalry between the biggest powers in East Asia. Viewed through that lens, symbolism is everything.

In September of 2010, Japan arrested a Chinese fishing crew whose boat had collided with two Japanese Coast Guard vessels near the islands. The boat captain's 16-day incarceration ignited long simmering tensions between the two Asian powers. Over the course of the dispute, China took the gloves off and hit Japan where it hurts: It halted shipments of REE's to Japan, the world's largest importer. Japan had traditionally bought 60% of China's rare mineral supply for its high tech manufacturing industries. The embargo even spread briefly to the United States and Europe after US officials announced plans to investigate China for possible World Trade Organization violations.

Through it all, China claimed that no countries were being targeted but, rather, the shipment slowdowns were a result of increased regulation in the rare earths industry. But as many experts have suggested, China's unofficial embargo served as an effective means to strike at Japan.

After simmering down for a year or so, tensions over the islands have flared up again. This time around, things could get worse. In mid-August of this year, Japan arrested 14 Chinese activists for planting a flag on the disputed islands. To make matters even more volatile the Japanese government subsequently announced plans to buy the islands, which had previously been held by private interests. That development has produced a stronger reaction from China than the arrest of its citizens.

China's news organization, Xinhua, reacted to the decision by saying, "that Tokyo had thrown bilateral relations into the scalding pot" and warned that Japan's actions would have "serious consequences." A new crop of Chinese leaders is currently taking the helm in Beijing, and taking a tough line with Japan may be seen as a rite of passage. Last week leaders in Beijing described the islands as "sacred Chinese territories," while chastising Japan for its "insulting" failure to take responsibility for its aggressions during the Second World War. Not surprisingly, anti-Japanese demonstrations have erupted across China. For its part, Tokyo has dug in its heels and seems prepared to face down its larger rival.

Given the situation, it is wise to keep in mind what happened the last time this road was traveled. Price spikes in 2010 and 2011 benefited REE producers with deposits outside of China, However, when the crisis subsided in the second half of 2011, the subsequent flood of Chinese exports led to significant price drops in the minerals and a sell off in the shares of REE producers. For most investors, that degree of volatility may be too hard to tolerate, especially given the enormous power to manipulate the market that is concentrated in a few politically motivated hands in Beijing. But for those less concerned with such risk, this crisis may provide an opportunity.

In the wake of the last crisis various rare earth consumers scrambled to set up new mining operations in places like Australia, the US, and Malaysia. In August of this year, Japanese technology concern Toshiba announced that a new motor it had designed would no longer utilize a rare earth element that is found primarily in China but instead would rely on a different element found in Australia and the United States.

The renewal of the island spat should create similar opportunities. For more on this and other developments in the global economic landscape, download the latest version of the Euro Pacific Global Investor.


Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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