Originally published July 2021.

“Let China Sleep. When she awakes, she will shake the world…”

This Morning: The media is full of China noise – does the rising tension mean it may become un-investible? The Chinese economy is very different, but recognisably similar. Investment into China boils down to how effectively a capitalist economy can succeed in the face of government diktat, bureaucracy, and intervention – and on that basis it’s a proceed with caution market.  

I started with a quote from Napoleon this morning, but it feels it’s August 1914 all over again as sabres are sharpened for a new cold war.

Building a new US-led Global Alliance against China has emerged as one of Joe Biden’s primary presidential themes. He’s identified it plays well domestically and it gives him something to engage on internationally after his predecessor alienated the USA’s Western Alliance. It stresses the same themes as the last cold war: our inclusive multicultural free society is diametrically opposed to the lack of perceived freedom and personal liberty under Chinese rule which threatens our way of life…

At present, there is no desire in the US to resume discussions on a trade deal or reopen bilateral talks about economic growth – a previous Democrat initiative. US businesses are being told to stay clear of Hong Kong. Janet Yellen has gone political, accusing China of “unfair economic practices, malign behaviour and human rights abuses”.

China is the dragon in the room. When its wings flap, the world takes notice

China is the dragon in the room. When its wings flap, the world takes notice and prospects for global trade, supply chains, demand and growth all change.

For markets the question is whether to invest in China. Well-known names like Ray Dalio say China is just too big to miss. Others say the Occidental economies are now hopelessly mired in distortion, that it’s worth exploring China for better external opportunities. On the other hand, there is a large number of analysts who see China as so different it can never meet Western investment parameters. Over $800b of foreign cash is now invested in China – over $300m in the past 18 months. (For the record, Blain’s rainy-day fund is modestly playing the paddy field.) Increasingly, folk are buying China bonds.

Investment into China is increasingly painted on social media and news wires as semi-treacherous and a big fail on the S and G of ESG (Environment, Social and Governance) provisos of ‘woke’ investment.

Is investment into China smart or stupid money?

It’s not as binary or simple as saying China is a huge market, therefore you must invest. It’s more nuanced and complex.

There are clearly massive social issues to consider about investing in China: the treatment of ethnic and religious minorities – not just the Uyghurs, their bellicosity over Taiwan (which, for the record, never was part of China), the theft of intellectual property over many decades or the disavowal of treaties in terms of the subjugation of Hong Kong (80 years ago how different was Europe?) We suspect them of covering up the release of Covid, massaging their economic data to make the Party look strong, of hiding environmental cheating and generally believe the worst of them.

On the other hand, China has now become a massive part of the whole global economy and about a fifth of its consumption base. In historical terms, what we are seeing is a new era with a new superpower challenging the old incumbent. There is plenty of historical evidence about the inevitability of two cultures in pursuit of dominance ending up in conflict – but that doesn’t have to be the outcome. It would certainly not be an optimal one.

Occidental and Oriental economies have zero to gain from conflict or trade wars

Ultimately, all wars are about economics and markets. Does it turn hot or can a global accommodation be found? Occidental and Oriental economies have zero to gain from conflict or trade wars. If China has got its growth and development strategies wrong, then we will see that reflected in increasing economic slowdown, rising domestic tension and the Middle Kingdom getting old before it gets rich. If they have got it right, start learning Mandarin.

If we consider China is terms of global markets, the reality is China is the new reality.

Global growth is no longer simply a function of the strength of the US economy. Anyone who spends their investment career focused entirely on US Treasury, Corporate and Junk Yields, deciphering Fed-speak, slavishly following every step of the various US equity indices or scanning every US data release for clues on how the US and therefore global economy is going to perform has missed the bus. In the next 20 years – which should be a heart-beat in terms of investment parameters – China and India will have pushed the US into third place in GDP terms. Europe? Don’t ask.

If current trends continue, China’s growth will increasingly set global flows and it’s therefore critical to understand what makes its economy tick. Understanding exactly how the Chinese central bank, The Peoples Bank of China (PBOC), operates and pulls policy levers is just as informative as what the Fed, ECB, BoJ and BoE are up to. In this world turned upside down (by Covid), its curious right-wing Western governments went all-in socialist with bail-out, stimulus, furloughs and spending programmes, while the market-Communist orientated PBOC stood by as the economy locked down and then rapidly reopened.

PBOC has not engaged in QE infinity and some economists say it has headroom to vary interest rates in response to changing monetary conditions. Yet last week it flooded the economy with capital by cutting its bank minimum reserve requirements to stimulate lending. That was cash into an economy already flush with capital – but is now struggling with a nascent and potentially metastasising debt crisis.

It would be a mistake to think the Chinese economy is simply a copy of the West

As the old banking saying goes: “the only thing worse than too little capital is too much”. It’s a problem the Chinese are solving in their own way – by providing more capital. It would be a mistake to think the Chinese economy is simply a copy of the West. It’s ‘capitalist’, but the banks are there to deliver state goals of growth and job creation. That’s why we call them policy banks.

There are massive inconsistencies about how the Chinese have juiced the economy with easy money, creating a host of over-indebted junk nightmares like Evergrande. Some investors are still betting the Chinese state will bail Evergrande, the largest Chinese junk issuer whose bonds are trading around 60 cents. 

In some ways the PBOC ain’t that different from any other central bank, cleaning up the consequences of over-levered corporates, but the debt crisis in China is as much a consequence of the state as it was banks in the West.

China has recently demonstrated an interventionist streak that has shocked and confused the West. A series of draconian applications of tech, financial and banking rules and regulations have been used to crush corporate doubleplusungoodwrongthink. Ride hailing service Didi was pimp slapped for its US IPO, while the defenestration of Jack Ma was punishment for his criticisms of the party appointed regulator and ‘disturbing’ lack of faith in the Party’s infallibility. (He won’t make that mistake again – no. He really won’t ever get the chance to do so). Didi’s swift punishment has put other China firms back on the straight and narrow – cancelling US listings and going to Hong Kong instead.

Party membership is now obligatory for businessmen/entrepreneurs with dreams of advancement

China clearly wants a strong corporate sector, but one that remains very closely aligned and functional with Party aims and objectives. Party membership is now obligatory for businessmen/entrepreneurs with dreams of advancement, and in return they are expected to work on behalf of the party and its objectives.

The question is whether the Party keeping corporates on tight leads constrains or improves profitability? That is the key question for global investors putting cash into China.

Any measure of state bureaucracy and intervention is bound to reduce the effectiveness of commerce. Can China figure out how to solve for entrepreneurial motivation, profits and light-touch alignment with Party goals? To be frank – that looks an unsolvable three-body problem.

Chinese policy is going to keep changing to meet the needs of the economy. While the economy may soon be the world’s largest, it is by no means the richest. To balance growth and standard of living – thus demonstrating the Party delivers – China needs to match its manufacturing capacity with its innovative output. That means developing Chinese tech and applications for the global and domestic markets. Does that sound a little like the USSR in 1986?

Or is it more like Europe? A large economy hamstrung with regulation and controlled by unelected bodies from the centre? At least China has the advantage of being homogenous.

History has a way of repeating itself. Faced with ongoing Mongol invasion threats, dynastic strife and the escalating costs of rebuilding the Wall and armies, China was forced to de-emphasise trade in the 1450s and focus internally on threats. (There probably never was an edict to completely close the economy.) Famously, the Chinese saw little value in what the rest of the world had to trade with them. (I thoroughly recommend Imperial Twilight by Stephen Platt, the story of how the British tried to prise open Chinese markets in the 1830s, and when ignored, this led to the Opium Wars – an experience China is unlikely to forgive or forget.)

With the largest internal market in the world, there is plenty of domestic demand in China today to provide markets for indigenous Chinese tech and products – but such a course would simply doom China to a repeat of the 1800-1950s when it was left behind by the industrial age in the West, left backward, repressed and vulnerable to imperial powers that had overtaken it across all aspects of tech in terms of weapons, transport, social mobility and growth drivers.

As the world goes into the fourth (or is it fifth) industrial revolution in AI, robotics, and the rest of disruptive tech, betting on American tech takes the gamble they can retain their global dominance by excluding China – which China clearly can’t afford.

China has little choice but to keep up technologically with the US and build its global markets – a policy it’s pursuing with limited success. It’s been accused of debt imperialism across Africa, its attempts to build belt and road supply chains globally are perceived as quasi-colonial, while its ‘wolf-warrior’ aggressive diplomacy has proved counter-productive, shunting nations back towards traditional alliances with the US.

The bottom line is China is very different – and a clear challenge to the West. The reality is it will likely struggle to create strong corporates that parallel the West because of the role of the state, but it will create successful companies – and these will offer investment opportunities. It is also going to struggle in the face of the current global superpower trying to retain its dominance.

China is not a slam-dunk as some suggest, but neither is it un-investible! Proceed with caution, I suggest.

Reprinted from Blain’s Morning Porridge and published here with permission.