What will China do?

Blain’s Morning Porridge 9^th March 2023: What will China do?

“Carthago Delenda Est”

This morning – Analysts and big money say it’s time to reinvest in China on the back of growth and rising prosperity. But global headlines point to rising geopolitical confrontation which could see China sanctioned, or even a hot war with the US. The real issue may be China’s rapidly declining demographics.

Despite overwhelming evidence of imminent invasion, in June 1941 Russian trains were steaming West fully loaded with oil, war materials and foodstuffs to trade with Germany, even as the Panzer spearheads were storming East across the border headed for Moscow. Stalin had deliberately ignored the signs, hoping for more time to modernise the purged Russian armed forces while boosting the economy with loot from Russia’s share of the Poland carve-up in 1939.

Today, it feels something similar is happening betwixt Occident and Orient. Trade is booming between the post-Covid reopened China economy, and the reassuringly resilient economies of the West. Advice from investment banks and hedge funds say it’s time to reinvest in China stocks to catch the coming upside….

Yet, the headlines make it feel like 1914 déjà vu all over again… China dramatically raising defence spending to 7% of GDP, considerably ahead of its targeted 5% growth rate. Chinese diplomats and American generals are warning about the inevitability of conflict.

Who should we be listening to?

The Global Economy is massively vulnerable to the threat of conflict – No Sh*t Sherlock!

The Ukraine War energy shock unleashed inflation on Western Economies, and highlighted the lack of support for the West from increasingly non-aligned (but China leaning) developed nations around the globe. What we have learnt is modern, high-tech war consumes war-stocks at a frightening rate, and how unready the West’s military-industrial complex has been to ramp up production. Apparently, it could take decades to replace the missiles Ukraine has been gifted.

A shooting war in the South China Seas would be vastly wider in scope and magnitude than Ukraine. Supply chains and global disruption would trigger an immediate market crash, forcing Western governments to scramble with new monetary and fiscal measures to keep economies open (a repeat of QE, so perhaps bonds would not be such a bad idea!), while we already know models of global chip shortages would trigger widespread closures across industry, with available supplies quickly directed towards defence production. (Look how quickly the US is trying to get new Chip foundries in place: America’s $53 Billion Pleas to Make Chips at Home Faces a Labour Shortage.)

Ukraine has become a lesson in logistics. Good logistics will beat bad generals and raw courage every time. Supply chains and logistics are much the same game – although the rules differ. Recent wargames suggest conflict over Taiwan would be enormously costly – with the Americans losing thousands of aircraft and 2-3 carrier groups. Whether Europe would join the US is also an open question.

On the other hand, wargames are notoriously what-if. Realistically no one expected Ukraine to survive more than a few days. The reality proved far different, exposing Russia’s intelligence services and unprepared forces as a busted flush. After a year, US sources say Russia lacks meaningful offensive capability, is undersupplied and will be forced to rely of external sources for war-stocks from shells to drones.. And therein lies the challenge. The most likely source will be China.

The game of geopolitics is a slippery tightrope. The world has dramatically changed – with China now embedded around the globe through debt-diplomacy and Belt and Road trade imperialism. I was recently surprised to read how deeply Argentina finds itself tied to China as trading partner and funder. Should war break out, the tip of South America, the dreaded Cape Horn, will become a major choke point to stop the US shifting carrier task groups.

However much we praise the plucky brave Ukraine forces in defence of their freedom, it’s a proxy war for dominance between East and West. NATO and the US war-stocks have effectively blunted the Red Army – there are stories of mutinies among frontline troops, and even the Wagner group bleating about supplies show just how badly Russia is hurting. However, the brutal truth is NATO has facilitated the Ukrainians to bleed on behalf of the West.

It’s clearly in China’s interest to avoid a European conflict impacting its own economy, but it has clear geopolitical goals to ensure China’s pre-eminence. China has no particular interest in Ukraine except to help Russia bleed in order to further deplete NATO war stocks. It has an enormous advantage from being able to buy deeply, deeply discounted sanctioned Russian Oil to fuel its recovery. The longer China keeps Russian in the fight, the less the US can frustrate China’s ambitions in the South China Seas, and the longer China gets cheap energy.

China’s calculus now is about sustaining the Ukraine war while minimising damage to itself. How much it can afford to risk sanctions and the destabilisation of its economy vs supplying warstocks to Russia? How can it enhance its reputation with other states by mouthing platitudes about peaceful resolution, while fuelling the conflict? How much can it learn from Ukraine? The Russian Red Army and Chinese People’s Liberation Army share similar weaponry and doctrine, but unlike Russia, Chinese forces have not been tested since the late 1970s.

China and Russia are very different nations. The Chinese approach is not mass human waves, but victory through guile – the last thing they want is a hot war with the US, but to persuade the US and the world it’s not worth fighting….

The problem is…. the run up to war takes on a momentum of its own. Hence my Carthago Delenda Est quote this morning. In the US I detect a clear sense the expectation of a hot war is rising and an equivalency to Cato the Elder is emerging (*). Many Americans increasingly perceive China in the terms their last President described them; stealing American jobs, theft of intellectual property and unfair competition. They fear Chinese weapons – a common theme of all cold wars is the fear the other side is better armed so we must smash them now.

What do the Chinese think? (I bet they are not as impressed with us as we are of ourselves.)

The Chinese are acutely aware there are other factors at work. Demographics are working against China – at speed. China is running out of time to fulfil its manifest destiny as the Middle Kingdom.. The population is already in decline – something Western analysts did not expect till later this century. It’s a trend that prefigures Covid. China’s birth rate peaked in 2016 at 18 mm babies. In 2022 it had crashed to 9.6mm! That’s a staggering tumble – and will lead to dramatic consequences.

China itself is changing with a large and prosperous middle class emerging. When Covid protests broke out earlier this year, it was surprising how quickly the government unravelled the Covid surveillance state – almost making it look planned, rather than a reaction to an increasingly hostile population.

For some further insights on the consequences of China’s demographic challenges, I’d recommend this report from Professor Nicholas Eberstadt and Ashton Verdery from the American Enterprise Institute, China’s Revolution in Family Structure: A Huge Demographic Blind Spot with Surprises Ahead.

Their report argues China’s success and growth came on the back of the strength of family links and a “kin-explosion” based on how closely large expanding families remained aligned – assisting other family members. That allowed a wide “guanxi” network – the way in which success in China is based upon access to an individual’s network of personal and business relationships, which was dramatically enhanced though large family groups, leading to reduced business uncertainty and lower financing costs.

That is all now set to contract as these close family links start to break down as the population declines and families are spread. Over half of Chinese men of military age will be single children in the next few decades – meaning there will be no one to care for the parents if they are lost in overseas “adventures”. The Chinese state faces a rising financial obligation to improve social welfare as family care breaks down as fewer young workers will be supporting increasingly aged family hierarchies – at a time when labour will be increasingly scarce!

The global economy thrives under conditions conducive the trade – if war between the US and China becomes a reality, it will create a global systemic shock far greater than Covid or the GFC in 2008. The question is… can conflict be avoided. China may make the decision it has to act now before the demographics make it impossible.

Place your bets accordingly…

Five Things To Read This Morning

FT                    China is right about US containment

FT                    Citi warns clients about risks of Russia “weaponizing” metals

BBerg              Mobius Says Chip Stocks Are Top Bets Amid US, China Investments

WSJ                 China’s New Way to Control Its Biggest Companies: Golden Shares

The Drive        B-21 Raider Seen From Above in New Image

Out of time, and back to the day job…

Bill Blain

Strategist – Shard Capital

(*) Carthago Delenda Est: “And furthermore, I conclude Carthage Must Be Destroyed” is how Roman politician Cato the Elder concluded every speech to the Senate and People of Rome. Eventually he got his way. There are parallels between the Punic wars of the second century BC and the present impasse between China and the US.