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ESG Focus: China – Thucydidean Trap or ESG bid

ESG Focus | Jun 08 2022

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: China: Thucydidean Trap or ESG Pitch 

Growing geopolitical tension with China has many investors scratching their heads given Western and Eastern policy responses to the threat of regional conflict align so closely with ESG thematics.

-Preparations for economic war or hot war
-Taiwan could prove a flashpoint
-Domestic discord in China is in the mix
-ESG themes of onshoring and social cohesion align with conflict themes
-S&P Global adopts a sanguine view of China
-Actions speak louder than words

By Sarah Mills

Escalating tension between China and the US, combined with domestic ructions within China arising from lockdowns, are wreaking havoc on global trade.

And both the domestic and global challenges have one common denominator  – the green and circular transitions.

Much has been written about the possibility of war with China should Taiwan, the world’s largest semiconductor manufacturer, prove a flashpoint (if so, pundits such as Simon Hunt Strategic Services are tipping 2024).

The narrative being promoted by those beating the drums of war is that of the Theucydides Trap – a term used to describe the high probability of war when an emerging power threatens to displace an existing greater power as a regional or international hegemon.

At this point in history, however, two global narratives are running in tandem with the emerging power theme – the green and circular transition; and the fourth industrial revolution.

ESG goals and activities align so closely with those typically used for conflict preparation (such as on-shoring of manufacturing), that many analysts are struggling to determine whether ESG goals are being driven in part by threat of conflict between two major powers; whether talk of conflict is a screen for ESG execution; or whether ESG is being used as a screen for war preparation. 

All positions could be well argued and it is also possible that all three elements are in play independently.

Meanwhile, China’s economic growth is falling, boding ill for the global economy, another potential historical trigger for global conflict. All the indicators are pointing to a (potential) US recession as well. 

Macquarie now estimates a 60% probability of a mild recession in Australia.

Economic War Or Hot War

Economic war is par for the course, and China has certainly been exercising its muscles on this front, issuing tariffs on Australian goods and other countries.

But the question for most of the world is will this escalate into a hot war or can we relax into the promise of global investment in ESG objectives – a bumpy but more palatable option – in which the economic competition/war continues uninterrupted.

It is always possible to kill two birds with one stone. And while there is an uncanny alignment of actions, there is nothing precluding the two running in tandem.

Some observers are taking an Orwellian tack, hoping both governments are just keeping the populations on their toes heading into the Fourth Industrial Revolution (which doesn’t preclude conflict either).

Few doubt that the growing tension between the US and China is real, as underscored by the Thucydidean dynamic. 

An In-Depth Examination Of The China Subject

This article is the first in a series of five articles.

It examines the political situation: China’s positioning on ESG, the challenges this poses to its domestic stability, and to what extent its surprise policy shifts in the past year can be interpreted as a response partly driven by ESG and domestic factors, or disguised global aggression.

It also examines China’s campaign to unseat the hegemony of the US dollar by 2025 and the implications this may have for global conflict (it is not surprising then that pundits are tipping 2024 as a potential flashpoint in Taiwan). 

Some observers ask whether we are witnessing a race to disengage global economies ahead of such an event?

The second article quickly outlines China’s six-point Common Prosperity Plan (which we refer to below) and compares these six points with the United Nations’ Sustainable Development Goals (SDGs). It also examines how below-the-headline execution points may diverge from the West’s preferred narrative, digging down to the core points of dissent

The third article provides an economic outlook for China and discusses the affect of the Prosperity plan on various industries and sectors.

The fourth is a hats-off to Australia and checks out the implications for the metals and resources sectors.

The fifth looks at industries that are likely to prosper regardless of whether or not conflict emerges between the US and China (rare earths being one example).

China’s Common Prosperity Plan – Friend Or Foe

As a quick backgrounder, the Chinese Government announced its Common Prosperity Plan in 2021, which represented a sharp departure from business as usual.

In itself, it aligned quite closely with the UN’s SDGs but it was accompanied by a series of actions (and policy actions) that sent global markets reeling in 2021 and 2022 and angered the nation’s own east-coast power brokers.

Most notable of these was the bid to bring an “unruly” tech sector back into line (the sector had been operating in, and lobbying for, grey regulatory zones for some time), and its most confronting action involved the arrest of Alibaba Group’s Jack Ma, and the halt to Ant Group’s initial public offering.

Uber rival Didi fell foul of the government just two days after its listing, and the Chinese government also took aim at online food delivery and private education services.

The Chinese crackdown also included potential changes to tax structures that many in the West (not to mention domestically) considered to be antithetical to capitalist doctrine and detrimental to the advancement of Western interests in China and globally.

Asian shares went into a tailspin lopping trillions off global capital markets.

While some such as Brookings have viewed these policy shifts through a “communist lens”, claiming China is pivoting toward greater state control of society and the economy, others are viewing it through an ESG lens, believing the Chinese government is attempting to raise its “social” quotient in a bid to better compete in an ESG world.

The government’s policy to end the 996 working-hour system – 9am to 9pm six days a week – is one example of this.

It is completely within the spirit of ESG, and yet this was one of the most strongly criticised policies, particularly domestically.

Domestic Politics Also In the Mix

The Common Prosperity Plan has also generated significant domestic angst and this is also entangled in the plot.

Much of the Chinese Government’s actions can be viewed from the lens of domestic policy as President Xi seeks re-election as China’s leader for a third five-year term later this year.

On the one hand, the theme of Common Prosperity appeals to a disenchanted populace that has been largely disenfranchised through an unequal distribution of wealth. 

While the government announced it had eliminated extreme poverty in 2021, nearly 600m people still live on less than US$154 a month, according to Brookings.

The policy is a commitment to build a middle class capable of driving domestic consumption (in line with ESG imprimaturs) and reducing reliance on debt-fuelled housing development, which is impacting housing affordability (and the industry is riddled with corruption through local government kickbacks, which in turn has been weakening the central party).

The Common Prosperity plan is as much about reducing corruption and bolstering the weakened power structures of Chinese Communist Party as any other imprimatur. 

Another key bone of contention is President Xi’s plan to switch some growth to the poorer west from the wealthy coast. 

Brookings notes that six coastal cities account for 49% of GDP, while the 15 poorer ones account for just 21%. (It is also common for countries to shift industrial bases into more defendable areas when preparing for war, as Stalin did prior to Hitler’s invasion. The West is also onshoring manufacturing.)

President Xi’s Common Prosperity policy is understood to have the support of the Peoples Liberation Army, the security forces and nearly all 540m rural population and 290m ex-rurals who have left for urban areas.

It is considered an important step in raising living standards (not to mention better defend the country), but steps to address the wealth imbalance have angered the country’s wealthy east-coast power brokers, particularly in the port city of Shanghai.

This casts the recent covid lockdowns in Shanghai in a new light. Brookings reports President Xi sent Beijing troops into Shanghai to secure the lockdown rather than rely on the Shanghai police, which tends to support the agendas of local power brokers and business interests.

Still, the power brokers appear to have had some sway, aided by a sharp slowdown in the Chinese economy in response to the crackdown. 

China recently publicly abandoned the Common Prosperity plan, and President Xi’s rhetoric shifted from “Prosperity” to “Stability”, in a bid to placate domestic business interests and assure international investors it is open to business.

The government has said it is wishes to expand the pie and divide the pie, rather than adopt a Robin Hood approach to wealth redistribution.

But most observers consider this to be more of a tactical retreat. 

S&P Global, for one, believes that while the prosperity campaign has been wound down, the imprimatur remains intact.

This is not surprising. If China is to compete as an economic power in a post-ESG world, it needs to raise the living standards of its workers: prosper or perish. 

It also highlights the complexity of the Chinese situation: to what extent are ESG imprimaturs driving domestic discord in China? 

And to what extent do the covid lockdowns reflect domestic concerns (there are rumours the CCP is fracturing), or are they a form of disguised economic aggression?

Coinciding as they do with rising oil prices and the Ukraine war, the rest of the world has found itself in the economic crossfire, underscoring China’s growing economic might.

“Prosperity” a soft rhetoric for ESG; or Theucydidean Trap

The ESG and fourth-industrial revolution pitch

President Xi has been warning of changes unseen in a century, most likely referring to the green transition, technology and geopolitical tension; and as a result, the central government wishes to exert greater control over the allocation of resources.

Brookings says the government wants to enhance China’s competitive position in key strategic sectors such as high-end manufacturing, green technology, semiconductor production, electric vehicles and other national priorities identified in the Made In China Initiative and the 14th five-year plan.

Many of the events of the past two years can be viewed through this lens, and the lens of domestic discord, rather than international aggression.

S&P Global conducted a webinar last week: What Last Year’s China Policy Surprises Mean For The Future.

Panelists at the webinar took a sanguine approach to China’s recent policy shifts, attributing them largely to domestic issues rather than global geopolitical concerns.

FNArena asked the panel to what degree ESG considerations were affecting domestic policy and whether they were being used as an economic lever.

“Certainly we do see ESG issues in these policies,” said S&P Global.

“In China’s internet sector, all ESG credit indicators score at a very minimum a 3 (only one company scored a 4) … hence the push behind social regulations.”

S&P said that as the government builds more positives ESG scores, its “S” score could progress to an S2.

Responding to another question asking whether Western economies were migrating their supply chains away from China, S&P was again relatively sanguine.

The agency says it has not witnessed a sharp shift as yet (which is what you would expect if conflict were brewing). 

The panel said the degree of migration differs by industry and is generally “not happening in a major way, and not quickly”. 

Such a shift, says S&P, is challenging for manufacturers given China is well entrenched into supply chains, and the agency believes the process of leaving China will take the West decades.

That gives President Xi plenty of time to build the nation’s “S” manufacturing scores to a competitive level.

But geopolitics cannot be discounted.

The Thucydidean Trap

A quick Google search reveals the prospect of a Theucydidean Trap gains far more interest than the role of ESG in explaining China’s domestic policy initiatives, although this could easily reflect the human proclivity to focus on threats.

The Theucydidean Trap refers to the severe structural stress caused when a rising power threatens to unseat a ruling power, which heightens the probability of war and the chances of even ordinary flashpoints sparking a major conflict.

China is rising. According to Statista, China accounted for 18.62% of global GDP in 2021, compared with the US’s 15.86%.

The hawks in the West are looking beyond the soft ESG rhetoric of the Common Prosperity theme to the government’s strong-arm actions.

Asia Society says the Common Prosperity policy “aims to promote the rhetorical, moral, material and institutional advantages of the Chinese socialist authoritarian system over that of Western liberal-democratic capitalism, with the ambition to disseminate the “China Model” worldwide as a tool to further China’s superiority in Global politics”.

Simon Hunt Strategic Services (SHSS) notes a key bone of contention is Russian and Chinese efforts to create a new trade and currency platform to end the 77-year hegemony of the US dollar.

The platform is already quite advanced, as evidenced by the attempt to impose economic sanctions in the Ukraine. Over the past decade, the two countries have been switching US$ denominated trade to that denominated in yuan and roubles, and such trade now stands at roughly 30%.

SHSS expects the currency platform is scheduled for lift off in 2025, which may be why 2024 is being mooted as the most likely year for a potential flashpoint with Taiwan.

The research service says that China and Russia are not alone in this endeavour and that global policy is “pivoting from the West to those who share China’s view of a multilateral world, free of one-country domination”. 

Many countries have been liquidating asset and portfolio investments in Western alliance countries.

“Exports will focus on BRICS and Eurasian Economic Union which includes establishing Iran as a new manufacturing and export hub for Chinese goods made in Iran,” says SHSS.

China has 40,000 kilo-tonnes of gold for reserves to back its currency, suggesting a return to a gold standard, and SHSS expects the country to launch a digital currency within two years. 

Meanwhile, President Xi has stated publicly that: “China is tightening international production chains’ dependence on China to form a powerful countermeasure, and a deterrent capability against foreigners who would artificially cut off supply to China.” 

Recent lockdowns are timely reminders to the West of their dependency on China.

SHSS reports that China has also been stockpiling critical imports – agricultural, commodities and technology imports. But again, this can also be explained away through the ESG imperative.

It has also been sourcing imports from Asia, South America, Argentina, Brazil, Chile and Peru.

S&P Global Says It’s About Moving Up the Value Chain

S&P Global had a few more points to make at its China policy webinar.

The agency says much of policy shifts of the past year have been aimed at moving China up the value chain and driving supportive growth.

Viewed from this angle, the Chinese government continues to support industries higher up the value chain such as high-tech, despite the recent crackdown on certain companies.

Observers say this reflects the country’s desire to upgrade its manufacturing base to be competitive for the fourth industrial revolution.

It involves the integration of information technology to improve productivity, increase the local content of higher end technology products, reduce reliance on foreign inputs, and become technologically more self-sufficient.

Dual Circulation Strategy Reinforces This View

Last year, the Asia Society notes, the NPC endorsed a new “Dual Circulation” strategy comprising domestic circulation and international circulation, which, if successful should “have profound implications for global economics and geopolitics”.

Li Keqiang declared in his work report to the NPC:

We will give priority to domestic circulation, and work to build a strong domestic market and turn China into a trader of quality. We will leverage the flows of the domestic economy to make China a major magnet for global production factors and resources, thereby promoting positive interplay between domestic circulation and international circulation.

The policy aims to establish China as the main source of critical technologies and industrial outputs of the future, across the value chain in high priority sectors such as as robotics, high-speed rail, Internet of Things, biopharma and new materials. 

This sounds more like the government is preparing for economic war rather than conventional war, although again the self-sufficiency theme remains a typical conflict theme. 

Asia Society says the implications of the Common Prosperity policy are enormous, and could enable China to break through the “middle income trap” which has stymied the advance of emerging economies in the past (and again is a critical ESG requirement). 

The society says the policy is particularly designed to avoid the threats of decoupling of economies driven by deteriorating US-Chinese relations.

Like the US, China is highly dependent on foreign technologies and market-access and is likely to build more onshore semiconductor foundries. 

Again, such actions appear designed to sidestep economic aggression from the United States, and to buttress its economy, while simultaneously building self-sufficiency in the event of conflict.

Actions Speak Louder Than Words

ESG pitch or Thucydidean trap – only time will tell.

At least publicly, China appears committed to the current global economic culture, and says it will “unswervingly promote high-level opening up, protect property and intellectual property rights, and enhance policy transparency and predictability” (Russia’s recent abolition of IP rights is a salutary lesson to the West of what might happen in the event of a hot war). 

In the meantime, a slowdown in global business activity as the world shifts to an ESG era and into the fourth industrial revolution will hurt exports, worsen geopolitical tensions and potentially trigger an asset crash (not to mention the affects of the covid-debt trap). 

Most commentators expect China’s stellar GDP will slow to 3% in 2022, and peg 2%-4% as the outside parameters.

But it is fair to say that neither the US, China or Russia are prepared for War, with China and the West still deeply co-dependent.

SHSS notes food is a particular problem for China, the country suffering from a lack of arable land compared to its population. This puts the Ukraine invasion into a whole new light.

It expects Chinese agricultural production to rise threefold by 2030 to US$3.27trn, which SHSS says will have significant affect on the global agricultural market.

All up, untangling the soft rhetoric of ESG and hawkish commentary of power plays is tough. 

The US Administration has labelled China “America’s No.1 enemy”.

To my mind, them’s fighting words.

The West will be keeping a very close eye peeled to China’s actions, not words.

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