The Group of Seven’s Ise-Shima gathering in Mie Prefecture last month was the summit that fell in the woods, generating few global headlines. For China, though, it was a geopolitical game-changer that could reverberate loudly through the world economy in the months ahead.

Buried in the middle of typically bland G-7 economic assessments and cooperation pledges was a pointed warning over maritime provocations. “We are concerned about the situation in the East and South China Seas, and emphasize the fundamental importance of peaceful management and settlement of disputes,” the May 27 communique said. “We reaffirm the importance of states’ making and clarifying their claims based on international law, refraining from unilateral actions which could increase tensions and not using force or coercion in trying to drive their claims.”

While it didn’t mention China specifically, Asia’s biggest economy was written between the lines in bold typeface. The word “reaffirm,” meanwhile, is typical G-7 passive aggression. In Beijing’s reading, this is an escalation of efforts to contain its rise — and do Tokyo’s bidding in the process. China’s anger is partly about timing, as we’re just months away from a potentially explosive ruling that will probably go against China by an international court in The Hague.

That case was brought by the Philippines, and an unfavorable result would be both humiliating and damaging to China’s claims to more than 80 percent of the South China Sea. And the question is how it might play out in President Xi Jinping’s perceived orbit, one which Japanese and U.S. vessels are increasingly challenging. Not well, considering China’s irate reactions to a U.S. destroyer coming within 12 nautical miles of an island it claimed last month or the G-7’s communique. Beijing accused the G-7 of “hyping up” tensions and is “extremely dissatisfied” by the tone of discussions at the summit.

For global markets, though, nothing about this is hyped up. If anything, complacency reigns as investors assume (wrongly) that commercial interests in Asia will prevail over brinksmanship — or even armed conflict.

It’s hardly news that the South China Sea is the site of a proxy Cold War between Beijing on one side and Washington and Tokyo on the other. China’s territorial ambitions gave Prime Minister Shinzo Abe political cover to “reinterpret” the war-renouncing Constitution to deploy troops abroad. “Let’s remember,” says Tomohiko Taniguchi, special Abe adviser and Keio University professor, “who started these problems in the seas — it wasn’t Japan.”

China disputes that view, of course. But last month’s U.S. naval sail-by marked a more strident stance toward China’s ever-expanding claims. It means President Barack Obama will be adding significant naval resources. Fighter jet sorties — and mid-air confrontations — between China and Japanese pilots are already occurring with bewildering frequency. It doesn’t require much imagination to see how an accident or miscommunication could instantly escalate into a regional crisis. This surge of military hardware in such close proximity is a clear and present danger to stability.

Enter Rodrigo Duterte, the president-elect of the Philippines and a huge wildcard. The tough-talking mayor from Davao City made his bones okaying the assassination of criminals and taking crap from no one. How might this Donald Trump of the Philippines react to a Chinese provocation? On the campaign trail, Duterte even pledged to ride a Jet Ski to a disputed island occupied by China and stake Manila’s claims.

China is already making it clear it views the Hague ruling as a sideshow. It’s lobbying nations to offer pre-emptive support for its “nine-dash map” of “indisputable sovereignty” over more than 100 islands, atolls and reefs. It claims about 3.6 million sq. km amid overlapping claims from Brunei, Malaysia, the Philippines, Taiwan and Vietnam — on top of disputes with Tokyo. Beijing’s public-relations blitz is garnering support from a disparate band from Belarus to Gambia to Kazakhstan to Russia. Chinese ambassadors the world over are publishing op-eds backing Xi’s posture.

Chinese construction companies, meanwhile, are scrambling to reclaim vast swaths of sea to build artificial islands so Beijing can plant flags and people on them. So far, they’ve created land masses more than three times the size of New York’s Central Park. That includes airfields and resorts to turn some of China’s claimed islands into Maldives-style tourist draws.

Bottom line, China has zero inclination to respect rulings against it, putting the onus on tough-guy Duterte to save face. His military capacities, as powerful as they may be in Southeast Asia, are little match for China’s, not that this fact will necessarily stop him. Any confrontation might pull the United States, a staunch ally of the Philippines, into the fray. Add in the wildcard of a Trump presidency and global markets have a recipe for massive uncertainty.

Vietnam, too, is increasingly facing off with China in disputed waters. During Obama’s recent Hanoi visit, the U.S. lifted its decades-old arms embargo. That means Hanoi may reopen Cam Ranh Bay, a deepwater harbor, to U.S. warships — much to Beijing’s disapproval.

With communist governments and similar economic structures, Beijing and Hanoi should be solid comrades. But China’s land claims and provocations — including a fishing boat flotilla trolling Vietnamese vessels — are driving Hanoi toward Washington. Here again, how might the U.S. respond if a miscalculation in the seas brings Beijing and Hanoi to fisticuffs?

There’s another casualty from this proxy war worth considering. One of the planet’s most diverse maritime ecosystems, the South China Sea boasts more than seven times the coral reef species as the Caribbean.

“Building new manmade islands on top of shallow reefs is smothering them with sediment, and turning clear water muddy — the environmental damage is substantial and unprecedented in scale,” coral specialist Terry Hughes told The Guardian. “What we need,” Hughes said, “is a breakthrough in cooperation aimed at protecting fragile reef ecosystems rather than destroying them.” Good luck with that as Asia’s infrastructure arms race has nations dredging sand on reefs to construct military outposts, runways and small towns.

The military arms race is the more immediate risk. In a new report, consultancy IHS Jane predicts South China Sea tensions will fuel a roughly 23 percent surge in Asia-Pacific defense spending by 2020. That would raise last year’s $435 billion to $533 billion, accelerating the shift in weapons spending from West to East. “A number of the South China Sea’s littoral states appear to be responding to China’s more assertive stance in the region and there is no sign of this trend coming to an end,” says IHS Jane analyst, Craig Caffrey.

What are the odds this megatrend will end well for world markets? Quite low as a rapidly increasing number of ships, submarines, fighter jets and drones armed with state-of-the-art firepower, guidance systems and nationalistic impulses come in daily contact.

In 2014, economist Nouriel Roubini, known as “Dr. Doom,” ranked China bullying smaller Asian nations over territory a bigger threat to stability than North Korea, Iran’s nuclear program or Russia’s Ukraine adventure. It was around that time that Northrop Grumman, Raytheon and the rest of the U.S. military-industrial complex were rushing to expand Asia offices.

The threat has only grown. It doesn’t mean Asia is spiraling toward World War III. But economic pragmatism could swing toward confrontation rapidly and unpredictably, making life as difficult for the G-7 as investors.

William Pesek, executive editor of Barron’s Asia, is based in Tokyo and writes on Asian economics, markets and politics. www.barronsasia.com

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