International | Jan 29 2021
China plays a vital role in the world economy, yet the West is taking measures to curtail its rise.
-The West to impose controls and restrictions
-China’s reaction to Western constraints
-Investors need to consider political, social and ESG pressures
By Mark Woodruff
The relationship between the US and China will be a determinant in the evolution of many key global themes. These include the nature of globalisation, the future of supply chains, information flows and the proliferation of technology.
Despite recent events suggesting the two major competing blocs are on a collision course, China’s current critical global role precludes any thoughts of the US decoupling from its current adversary. The country is a major component of global supply and value chains and the world’s third largest consumption pool, after the US and European Union.
However, the world coming into view for investors may be less concerned by efficiencies or economics and be driven by perceptions of ‘fairness and equality’. A world dominated by politics not rational economic decisions.
In Part I of this article, FNArena examines strategies the US (or the West) may deploy as an alternative to decoupling. It also considers the impact of these strategies upon investors who may be confronted with some difficult choices.
Part II of this article looks at how Chinese government expenditure plans will create tailwinds for certain industries and sectors, while at the same time providing vital clues for share investors.
Before looking forward, it may be timely to explore the history contributing toward China’s current mindset.
China’s historical self-view
China had always viewed itself as the Middle Kingdom, with surrounding lands having a subordinate tribute relationship with it. This was mostly about perception of state glory. Also the domestic standing of the Emperor had always been stronger if foreign lands accepted China’s centrality.
This demand for respect and tribute was mixed with threats of retaliation or promises of rewards. Rewards for what China would have considered as ‘appropriate behaviour’.
Unlike European states which for centuries were constantly jostling to gain an incremental advantage and/or maintain a precarious balance of power, China never had to build alliances or truly accept other people’s views.
Rather, surrounding lands were treated either as friends (i.e. those that acknowledged China’s superiority and tribute system of relationship) or enemies (those that did not).
According to Macquarie, the prevailing and incorrect view in the 1990’s and early 2000’s was that both China and Russia would ultimately become major stakeholders in an essentially western-oriented global trade and monetary system. The subsequent proliferation of internet and technology would then to lead to greater societal liberalisation.
However, the last eight years has seen the full re-integration of the state and party organisations. China has also returned to a far more ‘top-down’ model that steers and determines almost all key decisions from law and governance to prioritisation of strategic objectives.
This reliance on state-owned and controlled enterprises has significantly increased, while the private sector has been co-opted into a unified system. This blurs already unclear dividing lines between public and private assets.
This latter point is one of several perceived weaknesses from a Western standpoint, which sometimes leads to caution in trade relationships.
Western concerns about China
China has shifted towards the more illiberal end of the spectrum with an effective merger between the party and the state. Macquarie notes there is also a rising dominance of state and state-owned enterprises (SOEs) in driving strategic and capital allocation decisions. This has convinced the West that China is unlikely to be a stakeholder in the Western-designed global order.
The desirability or otherwise of allowing Chinese access to Western technology and information has also been constrained by several factors. These include China’s integration of military and civilian technologies, rising defence spending and an aggressive diplomatic and economic posture.
Finally, China continues to draw heavily on Western intellectual capital. This is shown by large deficits in semiconductors and losses in intellectual products. China has been successful in exploiting its deep pool of cheap labour, but it has not invented much, preferring to commercially innovate.
China’s reaction to Western constraints
The deepening rift with the US has led to China’s recent emphasis on a ‘dual circulation’ economy to cut the country’s dependence on overseas markets and technology. Chinese president Xi Jingping raised the idea in May 2020, and later elaborated that the country will rely mainly on “internal circulation” (the domestic cycle of production, distribution and consumption). This will be supported by innovation and upgrades in the economy. The strategy will be later supported by “external circulation”.
ANZ Bank highlights that trade tensions with the US and high competition in the global technology sector have further urged China to secure its manufacturing sector. The hollowing out of the industrial base in Japan and the US is considered to have provided a vivid lesson for Beijing.
This is simply a reflection of an implicit acceptance that a return to the status quo is impossible, in Macquarie’s view. It’s a concession the country needs to rely far more on its domestic economy. In effect, China must attain a much higher degree of independence from the West, regardless of whether this is either desirable or efficient.
China has also been the key sponsor of the Regional Comprehensive Economic Partnership (RCEP), which went ‘live’ in November 2020. This is a free trade agreement between Asia Pacific nations. There are 16 members (including Australia) that should enjoy continued growth in volume and value of trade, while becoming more closely aligned to Beijing in the geopolitical sphere.
China has also been proactive with the One Belt, One Road (OBOR) initiative, so as to bind together a broader Sinosphere. This strategy was adopted by the Chinese government in 2013 to invest in nearly 126 countries and international organisations. This potentially provides the country with greater security as well as an economic cushion.
Splitting into spheres
UK asset manager Martin Currie suggests China and the US will continue to line up their own teams. Many countries (like Pakistan and Mexico) won’t be able to resist the call because of geographical proximity and economic linkages.
Australia, New Zealand, Canada and the UK are members of the Five Eyes intelligence sharing alliance and are already committed to the US camp.
It is not surprising to Macquarie the separation into effective zones of interest (i.e. Sinosphere versus Anglosphere) is progressing rapidly. This is due to both China’s strategy and the Western reaction to it.
With a large domestic market and a significant nearby periphery, the Sinosphere is likely to encompass at least 25% of the global economy, with China alone accounting for 20%.
China’s critical global role
Currently, China has become an indispensable link in the global economy, and is home to a significant share of global manufacturing capacity in almost every product.
China’s contribution to the global value-add is approaching US$2 trillion (broadly on par with the US), and more than three times the contribution of Japan.
The country controls around 13-14% of global exports. This shows a pace of increase that has been much faster than either Germany or Japan had achieved at a similar stage of evolution. China is now the world’s second largest global trader, only behind the EU.
Similarly, China today accounts for around 16% of global GDP and it should be closer to 20% by 2025, according to Macquarie. While still lagging the US, China should overtake the EU-plus-UK share of the global economy.
Alternatives to decoupling
China is just far too competitive and systemic to be ignored or quarantined, explains Macquarie, even as some factories move and supply chains duplicate. In fact, ANZ Bank strategists believe China and foreign companies will deepen their engagement over the longer term. Some mergers and acquisitions are considered possible, giving birth to truly global brands.
Nonetheless, the investment bank expects the West to impose ever more stringent controls on technology transfers, information, education and acquisitions. Already, the US has slowed down China’s drive towards leadership in the key area of AI, quantum computing and other cutting edge technologies. In addition, the US is trying to force the broader West to adopt its definition of ‘clean networks’ that are less vulnerable to China’s interference (eg 5G and the recent example of TikTok).
Over the next decade it’s likely that the flow of trade, goods, services, technology and information will continue to tighten as would acquisitions and the flow of capital. Macquarie considers it unlikely trade and links would be completely severed. However, whatever crosses the borders between the blocs will be closely scrutinised and assessed for its potentially malignant impact.
This would particularly apply to information flow. At present, China has unfettered access to the relatively free global internet, technology transfers, and education and skilling. Additionally, there is access to joint scientific experiments, cross-border acquisitions and open capital markets.
In some instances, there is a high probability that duplicate supply and value would need to be created (e.g. technology).
Macquarie also considers it likely there will be restrictions on capital flows and on the ability to access markets.
Investors are likely to be confronted with the difficult choice of potentially scaling back investment in the world’s second-largest economy. In some instances any decision will be taken out of the individual investors hands.
An increasing number of stocks would be likely blacklisted, not by government, but by investment managers. The reasons would not just stem from the US or EU, but rather a potentially very powerful mix of political, social and ESG pressures.
Macquarie believes US regulations will likely reduce the ability of the US investors to hold China’s financial instruments. Additionally, investors and fund managers are considered likely to start self-censoring by anticipating problems and potentially highly negative headlines.
Investors are likely to remain cautious regarding polluters such as coal, tobacco, steel and cement and potential ‘abusers’ such as security, military and surveillance. In addition, there are US and EU restriction lists.
Chinese law sets limits to disclosure and currently prohibits Chinese accounting firms from sharing audit documentation on companies, on the grounds of national security. According to Martin Currie, this places all Chinese companies listed in the US on notice. This would limit the investable universe for US-based asset owners.
Going forward the US could potentially make it a condition of trade deals or defence pacts, that the third country signing with the US must disavow relations with China. The investment manager considers this could be the most far-reaching impact for investors in the short term.
As evidenced by a high relative weighting of Chinese technology and intangible companies in Macquarie’s Asian and global portfolios, the investment bank is at present comfortable investing in the region.
The size and scope of the Sinosphere is still one of the most attractive globally and opportunities in China are considered to remain strong for those that are willing and/or able to invest.
With such prospects it’s unfortunate that investors need to monitor the progress of separation between the Sinosphere and the West. While full decoupling is not feasible, containment and lower intensity is likely.
A situation that hasn’t been contemplated for decades is aptly summarised by Martin Currie. Investors should be planning for a future where an asset owner’s geography effectively determines the investment universe.
Part II looks at how Chinese government expenditure plans will create tailwinds for certain industries and sectors, while at the same time providing vital clues for share investors.
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