One world two systems
October 26, 2020
Since the Global Financial Crisis, the west has slowly woken up to the fact that China does not intend to play entirely by their rules. It has adapted its centralised approach to allow for market prices to send signals about where the state should allocate resources and public goods, it has extended its infrastructure projects into the One Belt One Road project and it has invested heavily in technology and financial innovation. However, it has not allowed the west access to its strategic assets and consumers in the way the west demanded and this is the true source of the anti China bias we now see.
The western system can not suppress Covid, because it is designed not to be able to repress and control individuals. It should stay that way.
Meanwhile, ironically, the west has become more like China in centralising power, first in repressing the financial market pricing mechanism with QE and now, under Covid, by attempting to adopt command and control policies backed by a surveillance state and a suspension of civil liberties. They are failing because they do not have the people or the systems to successfully apply this approach. But nor in our opinion should they. The west has jumped from too much liberty to not enough and needs to return back to its version of the middle. There is no need for one system, there is room for two different approaches.
Investors need to be aware to the opportunities available as the Chinese system presents access to capital – such as the Ant Financial IPO, the issuance of debt with positive real yields – while being wary of the threats represented by the western system denying access to capital.
In a week after the final US Presidential debate barely touched on the economic agenda, the Chinese government sits down to work on its next five year economic plan. We should not expect anything particularly surprising, since the plans are evolutionary rather than revolutionary, although perhaps of most interest will be any announcements on how China is going to adjust to the spoiler tactics the US is using to try and disrupt its Technology plans. In particular how it plan to develop its Chip manufacturing sector, an issue fleshed out somewhat in an interesting piece in the FT at the weekend.
However, even though the plans may not be radically new, many investors don’t seem to be aware that they exist at all, mainly because of what Ray Dalio (also in the FT), refers to as “anti China bias’. He goes on to discuss many structural developments in Chia that would be familiar to readers of Market Thinking but also puts in a punchy statement (which we would agree with) that :
In the long run, timeless and universal truths determine why countries succeed or fail. In brief, empires rise when they are productive, financially sound, earn more than they spend, and increase assets faster than their liabilities. This tends to happen when their people are well educated, work hard and behave civilly. Objectively compare China with the US on these measures, as I chronicle in an ongoing study, and the fundamentals clearly favour China.Ray Dalio. FT October 2020
The hundreds of comments below the article were, as ever interesting, particularly as this is one of the more ‘balanced’ forums. While there were many agreeing with his logic and common sense there were many more running the standard Pompeo/Pentagon line on repressive regimes etc, as well as ad-Hom attacks on the author. Not one of them however (as far as we could tell) challenged the point brought up in the above quote.
China was never an “Emerging Market”
There is of course another, broader issue about the anti China bias however, and this is that it comes in part from a frustration that the largest economy by population and also by GDP (certainly on a PPP basis) has come from nowhere without fully adopting the western ‘system’. In the initial stages it appeared to, but certainly since Xi assuming the top job in 2012, it has evolved a variation that used to be referred to as Capitalism with Chinese characteristics, but is now routinely referred to by Washington and others simply as authoritarian and repressive. It was not supposed to be like this after the fall of the Soviet Union, ‘The end of History” was supposed to deliver a One World Government modelled on the US. However, that didn’t happen. We now have One World, two systems.
The failures of the Washington Consensus went from a bug to a feature
As previously discussed, China was ‘supposed’ to be the world’s biggest emerging market and the ultimate prize for Global (read US) corporations. It was supposed to follow the rules of the Washington Consensus and open up its capital markets to Wall Street, industrialise its agricultural sector to provide plantation crops to the west while importing staples from the US farmers. It was then supposed to use the cheap labour from the farms to man the new (foreign owned) factories, providing cheap manufacturing bases for multi nationals to sell back to the west. Then, using consumer credit lines provided by local banks funding in offshore $s, those new industrial labourers could buy higher value added products like autos and household goods that would be imported from the west. This was a template applied throughout Central and South America and South East Asia and many parts of the Middle East and Africa. While outside observers pointed out that thanks to this system the so called emerging markets never actually emerged, they failed to recognise that what started as a bug had become a feature. The system had evolved to a US centric oligarchy in pursuit of cheap labour and access to consumers, with the inevitable boom/bust cycle transferring former state assets into the hands of western owners.
China however, has not played along and this is the source of the frustration and ultimately the reason for the change in trade policy. The big US corporations that drive US foreign policy have now largely given up on this previous strategy and indeed find now themselves in competition with China. Not only can they not access Chinese consumers, Chinese owned and Chinese manufactured products are now competing for western consumers, particularly in the areas covered under Made in China 2025 of 5G, AI and the internet of thing. The attacks on Huawei, Hikvision, ZTE and Tik Tok are all part of this competition strategy dressed up as National Security. This is why, regardless of who wins the Election that the trade war with China will persist. Meanwhile, as Ray Dalio points out, Tesla’s model 3 for China will be made entirely in China – and the structure is that Tesla doesn’t actually own anything in China. Moreover, as we have noted previously, the Tesla truck promises to be the big game changer in Chinese logistics as around 50% of China’s transportation fuel is consumed by the truck fleet. Replace those strategically important imports with home produced electricity from wind, solar and particularly nuclear and you add a further significant boost to the economy. For investors then we can add cheap, reliable, pollution free transportation to Ray Dalio’s list of virtues.
This then is the opportunity-set for investors to think about. The Chinese consumer will mainly be served by domestic/Asian produced goods and services. In particular the lack of legacy systems in telecoms and banking has allowed the spread of Fintech as well as health tech, encouraged by government and now manifesting itself through the IPO mechanisms into growth portfolio opportunities. Meanwhile the US sanctions are forcing investment to remain ‘at home’ offering the prospects of major competitive threats to existing western corporations. It is worth noting perhaps, that of aside from Tesla, all the big FAANG companies except Apple have little or no prospect of accessing the China market, whereas the ability of the US to restrict the growth of their Chinese competitors, such as AliBaba, Ant, Tencent or Baidu is clearly limited, certainly outside of the US itself.
On the opposite side of the equation, there is the increasing attempt to centralise and control western economies that manifested itself after the GFC with QE and also subsequently under the Climate umbrella where an attempt to have a single world ‘system’ to deal with the projected Climate Emergency has also run into Chinese unwillingness to comply with western ideals. This has distorted capital market pricing dramatically and whether it is in negative real interest rates or in carbon credits, the west is now fixing prices and misallocating capital.
A further important aspect of this has been the response to Covid. With extra-ordinary levels of irony, the west, with the notable exception of Sweden, has largely adopted the Chinese approach of lockdown and surveillance in response to Covid, but have now discovered that it simply doesn’t have the ‘systems’ in place to make it work. In particular the things that the west (rightly) values, such as a free press, democratic accountability of politician, personal responsibility and so on mean that the centralised approaches to suppressing the virus do not work. Nor will they work without changing the system. This is not to say that the west should indeed become like China – the ability to suppress the population should not be a policy objective! Not that some more efficiency amongst the necessary bureaucracies wouldn’t help. As would some reining in of Crony Capitalism.
Unfortunately the longer the western politicians continue to try and apply system inappropriate policies, the more damage they will do. While western politicians are still trying to impose a single system, investors are recognising that One World Two Systems is the new reality and that the Chinese are currently the ones adapting their system in a way better suited to capital returns. Asset Allocations are starting to reflect this.