Geopolitical struggles impact investment outcomes
Four years into an escalating confrontation and nearly a year into the first truly global pandemic in a century, the world is poised for a geopolitical and economic rollercoaster ride. Investors and asset owners are greatly impacted, so we need to track a variety of issues: historical context provides the motivation; economic heft provides the arguments; ideology appears to be driving policy and the result is a significant challenge for investors.
The reality is that Beijing and Washington, DC hold very different views of how the international order ought to work and as the US ratchets up the pressure, Beijing digs in. Bluntly, if the US and China cannot find a workable arrangement that supports the normal functioning of the international system, they will each line up their respective teams. Many countries will not be able to resist the call, because of their geographical proximity and economic linkages, like Mexico or Pakistan. Meanwhile the rest of the world is in limbo, pressured by both sides and trying to remain neutral.
The historical context
History matters. And China’s long history is marred by over 110 years of humiliation by foreign powers who occupied and exploited the country. Mao brought the reassertion of sovereignty. Deng Xiaoping brought the pragmatic and often painful reforms that launched modernisation. He counselled caution, advising famously that China should “hide your strength, bide your time, maintain a low profile and never claim leadership”. This was the result of a pragmatic assessment of the world’s power balance at the time.
For most observers, Xi Jinping changed all that in his October 2017 speech to the Chinese Communist Party Congress. In a three-and-a-half-hour speech, he set out his “Xi Jinping thought”, telling Chinese that “It is time for us to take centre stage in the world and to make a greater contribution to humankind. China stands tall and firm in the east”. But in fact, the turning point came earlier, in the aftermath of the 2008 Global Financial Crisis. For the elites in Zhongnanhai, the equivalent of the White House, 2008 signalled not only the unstable nature of western capitalism, but also the evidence that “bide your time” was no longer necessary. Xi Jinping’s vision is an alternative to western style capitalism, called “socialism with Chinese characteristics”.
The Party’s credibility is tied to its personification with homeland and the fact that it was present in the struggle to independence. Led by Mao, it was there when “the people stood up”, in Mao’s words, defeating the US-backed nationalists and became a sovereign nation.
The US game plan
Washington, DC has actively dismantled the historic accommodation of ‘sceptical cooperation’ with China. The one view that now enjoys bipartisan support is that China is a ‘bad actor’. Regardless of the economic cost, the US has consistently sought to block the development of Chinese technology hardware and software, and invested significant political capital in pushing third countries to follow suit. Even with a new administration, this route now looks to be the way forward.
The economic links between China and the US look to be reduced to exporting ‘plain vanilla’ commodities, such as soybeans, as virtually any technological or industrial export could potentially be labelled as ‘sensitive for national security reasons’.
Further, Washington, DC is highly likely to continue to press allies and third countries to join the effort to isolate China and continue to levy sanctions on Chinese companies. Australia, New Zealand, Canada and the UK are members of the Five Eyes intelligence sharing alliance and are already committed to the US camp. For Mexico, it is a done deal, such is the country’s economic dependence on the US. It is harder to persuade the EU to fall in line, as the Europeans are predominantly instinctive multilateralists that would prefer to set their own parameters on their relations with China. In the Indo-Pacific, the Trump administration tried to relaunch the ‘Quad’, a loose (until now) ‘security dialogue’ as a fledgling anti-China alliance, but it is not clear that the will exists in India and Australia. The only common element they all share is their concern about China and that is simply not enough. The group will continue to meet at a ministerial level and make noises about freedom of navigation in the Indo-Pacific, but this is not another NATO in the making.
Trade weighted average tariffs on Chinese godos have gone from 3% to 19% between January 2018 and March 2020, a more than six-fold increase. There is a lot of room to reduce tariffs, especially those on intermediate goods, which penalise US firms by raising their costs and making their final products uncompetitive as a result. Logically, a pragmatic administration would judiciously reduce those tariffs and use non-tariff measures in sensitive areas instead.
Block access to US capital markets
The Public Company Accounting Oversight Board (PCAOB) has been unsuccessful at obtaining agreement with the Chinese authorities to secure access to the audit records of Chinese companies and in the current climate, the nuclear option has been presented: the Securities and Exchange Commission (SEC) will prohibit trading in any shares where the company’s auditor has not faced a PCAOB inspection for three consecutive years. This exercise would require the companies to disclose whether they are owned or controlled by a governmental entity. The Senate has presented Congress legislation to write this into law, with bipartisan support. Chinese law sets limits to disclosure and currently prohibits Chinese accounting firms (including local affiliates of international firms) from sharing audit documentation on companies, on the grounds of national security.
Effectively this places all Chinese companies with ADRs on notice, with the real prospect of China becoming another country on the long-established Iran – Sudan list. This would clearly limit the investable universe for US-based asset owners, but it could potentially be made a condition of trade deals or defence pacts, that the third country signing with the US must disavow relations with China. This is perhaps the most far-reaching impact for investors in the short term, although the investment world will quickly identify parallel mechanisms to get around the problem.
China’s game plan
Put simply, China’s game plan is to grow wealthier and assume its rightful role as the ‘Middle Kingdom’ it once was. Zhongnanhai, the seat of the leadership of the Chinese Communist Party, particularly wants to prove that its brand of communism can and does provide the structure to deliver a responsive government, a clean environment and economic wealth. The words ‘social justice’ appear to mean ‘stability’ and this can be enforced, if necessary.
In some ways, the restructuring of the domestic Chinese economy away from a manufacturing industry and towards services renders the US tariffs less effective. Since 2013, Chinese GDP growth has increasingly been driven by the services sector and domestic consumption. That move to urbanise and raise the living standards of the rural population is set in place and this confrontation with the US will not derail it.
The bruising trade wars have served to silence the moderate factions in Zhongnanhai, leaving the podium to the strident nationalists who advocate a harder-line policy stance with the US that has been dubbed ‘Wolf Warrior diplomacy’.
Belt and Road
The country’s game plan will be to double down on the buildout of the Belt and Road Initiative (BRI) and to accelerate the recruitment of beneficiary countries to the Chinese side. That means cementing access to those markets, integrating Chinese companies into those economies, establishing secure long-term supplies of raw materials, resources and agricultural products, while taking steps to encourage adoption of Chinese technical and technological standards. Given the paucity of alternatives for many of these countries and the promise of reflected glory for governments seen to be bringing in investments, it would be logical to assume the majority accept and become integrated into Beijing’s sphere of influence. There are currently 126 countries on that list, but the most compelling example is Pakistan, a strategically located nuclear power.
The China-Pakistan Economic Corridor (CPEC)
The CPEC commitment covers energy, transport & logistics, health, education and water supply. So far, 5,320 MW of generating capacity (31% of target) and 2,548 km of highways (36% of target) have been delivered at a cost of US$10.8 billion. There are a myriad of projects including 4,122 km of railways and a series of industrial zones on the plans which, if delivered, will transform the country by 2030.
But one of the more interesting subplots of CPEC is an attempt to increase the use of the renminbi (RMB) as an international currency. This is a push from Islamabad, not Beijing – it stems from IMF constraints, dwindling US dollar reserves and persistent current account deficits. China has recently doubled its RMB Currency Swap Agreement with Pakistan to 40 billion yuan. It has been reported that this arrangement has been replicated for 19 other countries on the BRI. It is not clear at this point how successful this effort might be, as most private businesses prefer dollars or euros and there is a limit to the amount of goods that countries like Pakistan can buy from China.
Pakistan and the CPEC have proved to be the shop window used by Beijing to demonstrate what it can do to help countries that sign up to the Belt & Road Initiative.
The European Union
The EU’s game plan appears to be to try to hold its ground in multilateralism and free trade, leveraging its large internal market and its combined diplomatic and military projection, while tightening its defences against cyberwarfare and potential Chinese intellectual property acquisition. The bloc will probably side with the US, but will be wary of becoming too ensconced, jealously guarding its right to strike its own deals in the world.
The experience of the Brexit negotiations since 2016 has demonstrated a new steeliness to the EU; it has been able to resist all attempts by the UK to create fissures in the block, with impressive discipline among the twenty-eight members. The agreement on the EU’s Recovery Fund, to help member countries deal with the damage wrought by COVID-19 represents an ability to find common ground that in the past was sorely lacking. The 28 have overwhelmingly got in line over the EU Green Deal, a highly ambitious plan to transform the member states into sustainable economies, leading the world in clean technologies and climate-friendly industries. This cohesion bodes very well for the EU’s fortunes in a more Hobbesian world.
The first big test will come in the next round of trade negotiations with the US. Even with a more orthodox Biden administration, these will likely be tough and uncompromising. There are significant challenges in the areas of taxation of big technology companies, then on the issue of international standards, where the EU has become a setter of specifications on a global level.
In 2012, China proclaimed a spectacular opportunity for Central and Eastern European countries to benefit from the Belt and Road Initiative. The ‘Visegrad Four’, as Hungary, Slovakia, Poland and Czechia became known, were giddy acolytes. That inevitably led to tensions with Brussels and the other EU members. The experience since then has disappointed. Chinese Foreign Direct Investment (FDI) into Europe focused on France, Germany and the UK with the Visegrad Four receiving much lower-than-expected amounts. Meanwhile, their trade deficits with China continued growing. So, there is a degree of disenchantment which makes it much more likely that ultimately the EU will line up on the side of the United States – NATO will become a more European-led organisation and potentially pivot further East.
Meanwhile, in September the EU and China reached an agreement on their discussions around state-owned enterprises, forced technology transfer, and subsides to press ahead with efforts to complete their Comprehensive Agreement on Investment (CAI). The EU also revealed China would extend to EU businesses the benefits granted to US companies under the US-China phase one trade deal. This seems to indicate a willingness by Xi to meet some European demands, but sticking points remain. The EU stressed securing broader market access and removing non-tariff barriers in areas including automotive and emerging digital technologies – industries where China has been recalibrating its policies and pushing for more market mechanisms. The EU focused specifically on the need for Beijing to lift market barriers for EU firms in China in telecommunications, biotech, and sustainable mobility. China is also asking for its own concessions from the EU – potentially a lifting of investment restrictions or support for Beijing’s Belt and Road Initiative – that looks unrealistic at this point.
Japan and South Korea
These neighbours share an awkward history that has never been satisfactorily resolved and also common economic and military threats. It does not seem likely that Tokyo will prioritise a complete climbdown from its tensions with the South Korean government, with only two years to go till the next Presidential elections, will settle for a pragmatic accommodation which will allow for the ‘normalisation’ of trade relations. This would clearly be in the interests of both economies and provides the base case going forward.
What could hasten a tighter rapprochement between the two would be the resumption of North Korean missile tests, a reminder of the nuclear-armed and unfriendly neighbour they share. What could create a more damaging split between Japan and South Korea could be an incident between fishing or coastguard vessels in the Sea of Japan or a move by Pyongyang to offer improved relations with Seoul. That would place the South Korean government in a difficult situation as it has historically responded positively to such moves.
They both view China through a jaundiced lens and are already advanced in plans to reduce their supply chains’ dependency on their giant neighbour. Prime Minister Yoshihido Suga chose to make his first overseas trips to Vietnam and Indonesia, to prioritise an alliance with ASEAN to check China’s advances and where he declared increased support (half the cost) for businesses relocating supply lines away from China.
Former Prime Minister Abe’s long-held ambition to formalise Japan’s Self Defence Forces into a regular army is not rejected by Yoshihido Suga, but his priorities currently lie in COVID-19 and economic growth.
Even more exposed to the deterioration in relations between China and the US, Taipei is slightly different in that the game is more nuanced – a re-elected government with a clear mandate for continued independence, working hard to persuade its companies to relocate back home and yet economically extremely dependent on China. Further, it has a unique handicap of not having any official recognition and being excluded from multilateral organisations such as the World Bank and the World Health Organisation. Recognition by Washington, DC is a card that can only be played once and would almost certainly constitute an irreversible red line for Beijing.
Militarily, an invasion is not beyond the capabilities of the People’s Liberation Army, but any US involvement would almost certainly involve bombing the mainland, which would lead very quickly to the threat of nuclear war. The recognition of this scenario appears to be holding both sides back. The room to move diplomatically is narrowing all the time and it is becoming harder to envisage a way that its leading technology companies can continue to operate unhindered in both China and the US. It all depends on the two heavyweights reaching an accommodation. Meanwhile, Taipei looks ill-equipped to help defend its tech champions like Taiwan Semi-Conductor Company (TSMC) in this version of the ‘Great Game’. Expect Taipei to gradually fall into line with the US on the technology confrontation, even at considerable economic cost of disengagement from China. Any sign of formal recognition by the US, however, could trigger an aggressive reaction from Beijing, as the leadership will feel they have no alternative.
The next decade will likely see increasing efforts to disassociate the two largest economies in the world. Investors are well aware of the mounting pressure on governments to take sides. In the developing countries, China’s offer of the BRI has already been accepted. The only issues that could potentially derail this development are a sudden and commensurate generosity of finance from the US, evidence of poor-quality execution in the BRI, or a particularly shocking political misstep by Beijing. All seem unlikely at this point, thus underlining that should the US-China decoupling continue, there are many countries already committed to the Chinese sphere of influence. The aggressive moves against specific companies by the Trump administration, however, have set dangerous precedents. It is not just a question of adverse publicity being driven by an unguarded tweet, it can impact the revenues and profitability of third-country companies, as has been demonstrated by the pressure campaign on Taiwanese TSMC in order to get at Chinese Huawei. In this case, TSMC enjoys a leading position in the industry, so the company has options that others would not. Investors need to stay abreast of developments and understand the perspective to identify companies that are particularly vulnerable. At the same time, investors should be planning for a future where an asset owner’s geography effectively determines the investment universe – something we have not considered for decades.