​China Under Pressure

Guild Investment Management  |


Last week, as the country was riveted by the drama and controversy surrounding Supreme Court nominee Brett Kavanaugh, a substantive policy speech made by Vice President Mike Pence went largely unnoticed and uncommented on by the media. Pence’s speech was at a Washington think tank, the Hudson Institute. It consisted of a summary and critique of all the ways in which China is pursuing technological, economic, military, and diplomatic hegemony, both regionally and globally.

Pence levelled extensive and harsh criticism at the Chinese government for the ways in which it has abused the openness shown by the global community since its accession to the World Trade Organization 17 years ago. China had expanded its economy ninefold, he said, while persisting in unfair and manipulative trade practices; engaging in politically and socially repressive behavior at home; employing “debt diplomacy” to secure influence abroad; and using all the resources of government to both overtly and covertly acquire critical U.S. technological know-how. He also claimed that U.S. intelligence services have direct knowledge of Chinese government attempts to influence the outcome of the upcoming midterm elections. Beijing, he said, had targeted tariff actions to disproportionately hurt areas that were friendly to the current U.S. administration in 2016 and currently have close House and Senate races, and also engaged in social media manipulation to further inflame political divisions among Americans. (China rejected the claims.)

Mr Pence then summarized: “Now these are only a few of the ways that China has sought to advance its strategic interests across the world, with growing intensity and sophistication. Yet previous administrations all but ignored China’s actions. And in many cases, they abetted them. But those days are over.

“New Cold War”? More Likely, Negotiation As Usual

Some analysts are calling this speech the manifesto of a “new cold war” with China, and on the face of it, that is a plausible interpretation -- but one that we think is premature. We believe this because of the broader context, which we’ll outline below.

First, the U.S. administration has consistently shown that its negotiating strategy is to apply intense pressure with little regard for diplomatic niceties. Rather than the muted and publicly cordial style of previous administrations, this one uses public forums to dole out both condemnation and praise on the path to making a deal. Sometimes the move between good cop and bad cop comes with great speed -- which is probably calculated to wrong-foot the people on the other side of the table.

Mr. Pence’s remarks came at the same time as a testy exchange between U.S. Secretary of State Mike Pompeo and Chinese foreign minister Wang Yi. But soon thereafter Mr. Pompeo was upbeat on the progress of talks with North Korea -- certainly not a development happening without the knowledge and assistance of the Chinese. And a Chinese official on the sidelines of World Bank and International Monetary Fund meetings in Indonesia emphasized his optimism about trade talks with the U.S., pointing out that official top-level talks are only one venue -- and that other communication continued to go on under the radar.

This leads us to believe that the U.S. ratcheting up public pressure is from the normal playbook of the Trump administration; we’ve seen it many times before. Indeed, given the dramatic nature of trade and diplomatic developments in the past, we wouldn’t be surprised if this is part of a push to secure a deal, or at least a dramatic progress report, before the U.S. midterm elections.

Second, when the heat is on, the U.S. administration likes to lean on its adversaries’ pain points -- and China currently has a lot of those.

In his speech, Mr. Pence made a pointed remark about the negative impact that the trade conflict has had on the Chinese stock market, down about 25% on the year. But that is a small difficulty compared to others that the Chinese economy is currently experiencing.

The pressure on the Chinese economy from the ongoing trade conflict is real, and the U.S. administration accurately perceives that China has more to lose in this conflict than the U.S.

China, as we’ve often written, is in a tough economic and financial position. The fundamental underlying reality for the Chinese government is that they must maintain growth. The Chinese Communist Party has maintained power because it has successfully created two decades of economic growth -- growth that has lifted hundreds of millions of Chinese citizens out of poverty. The coastal regions of China and the major cities have been transformed. Many of them are essentially “developed world” according to standard economic measures of development.

However, there are hundreds of millions more Chinese who are waiting to reap the benefits of this development. They live in the interior of the country, in second- and third-tier cities. The Communist Party knows that should it fail to extend the benefits of development to them, it will face their anger, and the security of its rule could be endangered.

In China, as in every economy, a long period of fast growth has led to corruption and excesses in the financial system. China has seen the accumulation of a great deal of debt, some in its mainstream banking sector, but more in the so-called “shadow banking” sector and in local governments which have borne the brunt of central government mandates while not getting the direct funding they need to fulfill those mandates.

Seeing that this debt buildup has increased the risk of financial instability, and wanting to ward off such a crisis risk, the central government has gradually begun ratcheting it back -- while attempting not to derail the continued growth that will keep the Chinese population happy. It’s a tough balance.

It is also a tough balance because the central government’s financial tightening hits China’s private sector and small businesses disproportionately hard. The private sector and small businesses are the strongest engines of economic growth and job creation, and this is as true in China as it is in every other economy. The significance of the private sector in China can be summarized as “56789” -- the private sector provides 50% of tax revenue, 60% of GDP, 70% of capital expenditures, 80% of total employment, and 90% of the total number of enterprises. It is also responsible for virtually 100% of new job creation.

The private sector has been hit especially hard by the government’s efforts to rein in the overall debt levels because these companies typically do not have easy access to credit in the “official” banking system. They resort to the unofficial, or shadow banking, sector -- so pressure to ratchet back leverage in that sector means that private businesses will be even more challenged in getting the funding they need to keep expanding, growing the economy and creating jobs.

The Chinese private sector is also first to receive fallout from trade conflict with the U.S. -- lacking as it does the kind of subsidization, protection, patronage, and favorable treatment received by state-owned enterprises. The U.S. administration is surely well aware that its trade actions will disproportionately affect the private companies that are the real engine for China’s continued growth -- and therefore that are critical to the Communist Party’s ability to deliver on its promise to improve living standards and therefore avoid public anger, resentment, and rebellion.

In short, U.S. actions and rhetoric are obviously calculated to apply maximum pressure to the Chinese government’s “pain points” as the U.S. presses for progress in a trade deal. There is certainly a long-term thought process at work both in China and the U.S., and the conflict will probably continue for some time. But we believe that setting up such a long-term conflict is not the U.S. administration’s immediate goal -- and that high-pressure tactics are likely intended to secure a nearer-term breakthrough.

Investment implications: The U.S. is obviously determined at this point to apply economic and diplomatic pressure to secure a trade deal with China, or significant progress towards a deal. With China facing many economic and financial pressures, and the U.S. acting to use those to its negotiating advantage, we believe that even after this year’s declines, it is not yet time for investors to look for an entry point into the Chinese market. There is also the risk that China’s response to U.S. pressures could include a significant devaluation of the yuan, which would also argue against any exposure to Chinese equities at this juncture. We regard China as territory for traders and speculators only at the present time.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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