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  • Writer's pictureConor O'Donoghue

Silk Purse from a Pig's Ear

Silk was the most sought after luxury item of the middle ages across Eurasia. In the pre-industrial age, the silk road linking China to Europe was the world’s most lucrative trade route. The centre of the trading world ran through Persia (modern day Iran). All of the territory either side of Iran that makes up, modern day Iraq, Afghanistan, Kazakhstan and Pakistan all straddle the multiple overlapping silk routes. Incredible civilizations and cities dotted the commercial path, enriched by transcontinental trade routes and dominated by the movement of silk and other goods from China.

Eventually Genghis Khan and his Mongol heirs would destroy almost every civilisation along the route right up to the heart of Europe, killing millions of people along the way. The trade continued however and extended into the then much more backward European continent, living through its own ‘dark ages’. Italian city states, like Venice dominated the silk trade and curiosity about how silk was created eventually led to the knowledge seeping out from China. Silk was the intellectual property (IP) of its day. Nobody except the Chinese knew how to cultivate silk worms. Despite its secret being protected for a thousand years, the trading cities of Italy were able not only to trade but now manufacture silk. The long held secret of silk production was out. Global industrial espionage was born.

Much the same intellectual property seepage, from the source of sought after technologies to new trading powerhouses, is happening now. The moment ground breaking new technologies are created, countries, companies and individuals are trying to steal and learn the new secrets. China is more interested in Western technology secrets than any other country.

Tchinaaa. You cannot hear the word anymore without an image of Donald Trump at a podium, smug orange face, shining white veneered teeth, gripping the podium in that strange shoulder forward pose, whipping up a crowd to hate someone or something. “Who controls the Democrats?, Tchinaaa”

However it would be a mistake to consider faltering US China relations, a creation of Donald Trump. The US is at the opening stages of long cold war with China, less focused on military might, although that may not be unimportant, indeed it will not be a battle of ideas, despite the communist/capitalist backdrop. Instead we are entering a great power struggle with the battleground based on control of infrastructure, economics, trade, financial systems and markets.

There is oft told anecdote that when US president, Richard Nixon made peace with the Chinese in the belief that it would allow him to close out the Vietnam war, he casually asked a Chinese official what he thought of the 1789 French Revolution, to which the official replied, “It’s too early to tell”. It is doubtful any such exchange took place but it is supposed to illustrate how the Chinese think in centuries whilst the US thinks in election cycles. In the end, the Chinese surprised the US and went to war with the Vietnamese, supposed Chinese allies, demonstrating the never ending problem of muddled US strategic thought, confusing tactical convenience for the multi century vision of the Chinese.

The US is all in on the new economic cold war now. Chinese GDP has ballooned out, driven by exports and a globalised economy. China has set up its own vast infrastructure through economic vassals to cart commodities back to the mainland from all around the world. The infrastructure, known as the Belt and Road is comprised of ports, telecommunication networks, roads and railways through third countries, including some western countries like Israel. It shuttles raw materials on a mass scale back to the factories of China, which in turn rolls out goods of increasing sophistication to global markets back through the new silk road. Chinese savings through bonds fund African airports, European docking facilities and Asian motorways but there is no free lunch. Chinese interests come first and when payments are missed, control shifts to Chinese state owned enterprises. (SOE). Much of the infrastructure is of dubious value to the hosts. Some emerging countries are now in permanent hock to the Chinese.

That vassal system is about to come under pressure. The world is moving towards a system of three massive global economies, the US, China and the EU and two financial systems, the Sino and Western systems, around which every other economy will orbit. We are moving away from a single globalised system of trade. The Biden administration has spent the first year of its presidency shoring up Europe, particularly the Germans. Germany has enjoyed a cosy relationship with China selling lots and lots of cars and high end engineering, mechanical and chemical goods and services, to China. China nearly got an EU China deal across the line before the new US administration got their feet under the table, instead the rug was pulled from under the trade deal. In May this year the deal was frozen by the European parliament under massive pressure from the US. It will never be revisited in its current form.

The Chinese Communist Party has publicly stated its goal to be the largest economy in the world by 2035, taking over from the United States. In 1960 the Chinese economy was about 1/10th the size of the US economy. It is now about 75% of the size today and the 2035 target is achievable, indeed probable. The United States became the world’s largest economy around the start of the 20th century overtaking the British Empire. The combined economies of Britain, France and Germany were ultimately ravaged by two world wars, meaning the US was the pre-eminent global power after World War II. The US shaped the global financial order through the Bretton Woods agreement that effectively made the US dollar, the world’s reserve currency. That is an extraordinary privilege. It means the US can borrow from the world at rates that it decides and that others, such as oil producers buy and sell their produce in dollars which acts as a global financial subsidy to the US. China covets the global lender of last resort status.

This is where the comments above about the French revolution being too early to tell start to reveal something much larger happening. China does not think in quarterly GDP numbers but in centuries and dynasties. China views the US dynasty as beginning its end. When it looks at itself, it sees a vast, pre industrial, trading based, economic history where China was the largest economy in the world with the deepest culture and philosophies such as Confucianism that influenced civilizations for millennia. In 1820, before Britain became the workshop of the world, China was the largest economy in the world but the decadent Qing dynasty was on its last legs. The Taiping Rebellion of 1850 led to the death of up to 50 million people. It was an attempt by a messianic cult to recreate society but they fell short of toppling the regime, instead they crippled the state. It is a war completely unknown outside China and was the most serious in a series of wars in which Chinese society essentially devoured itself. The 19th century is known in China as the ‘the Century of Humiliation’, as the world’s then most powerful nation ended up collapsing before falling prey to colonialism and local rivals like Japan. The 20th century saw China recover its status and autonomy. The 21st century is about China once again leading and dominating.

The country is no longer interested in year zero communist notions of recreating a global social order but instead is looking to restore China’s position as the greatest power on earth. The US stands in the way and is focused on isolating China, a previous period of acceptance and tolerance for China’s growing economic strength is giving way to containment and isolation. Europe, through the EU is the third economic pole. The EU has no meaningful collective military presence. Germany has no external military footprint, France and Britain are mid-size powers at best. Europe’s influence is overwhelmingly economic and the US wants to pull the EU into a connected economic bloc that gradually cuts China off from supply chains, segregates financial systems and pulls vulnerable countries towards the US and the EU and pushes China away.

The US and China are no longer working together, nor beside each other but are now increasingly working against each other. So an unstoppable economic force in China is meeting an immoveable object in the US and EU. What does that mean for investors. A former colleague of mine who has much greater knowledge than I on matters fixed income is excited by the growing Chinese bond market that may ultimately topple the US dollar from the world’s reserve currency status. He feels investors will come to see Chinese sovereign bonds as comparable to US treasuries. (US treasuries are seen as a proxy for the risk free rate against which any other investments should be compared). I am not so sure. You will get better yields than US treasuries but the risk of capital controls or, as yet know, unknown restrictions from Washington or Beijing is high. What can you do?

Capture growth through companies that are exposed to Asia but tread carefully with any securities registered in China or Hong Kong. VPL, the Asia Pacific ETF has no direct Chinese exposure and looks fit for purpose. Blue Oak use VPL as part of our Global portfolio suite to get exposure to Asian productivity and consumer growth.

Supply chains from China may not be sustainable particularly if there is any intellectual property required. Be careful about your supply chains and begin to seek viable alternatives to China. High end manufacturing on the ground in China will be more and more difficult for western companies to execute.

2019 was the year of the pig in China, the pig is associated with wealth. In May 2019, the US government banned US companies from dealing with Huawei, the first time US rhetoric moved to action. Huawei was accused of cyber espionage through its burgeoning 5G networks that were being rolled out across western telecommunications. Huawei’s global network ambitions lie in tatters and their experience is a forerunner for future Chinese plans. The future Global order is difficult to anticipate but investors and companies need to be prepared for change. Making a Chinese silk purse from a pig’s ear might be a lot harder than it was.

Blue Oak Counsel offer Wealth Management and Financial Planning advice to Professionals


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