Considering China
Published 1.18.2016LWRAS has long avoided all China based stocks because reading through their financial disclosures is too often reading fiction. That, however, is simple fraud. Behind the risks of emerging market disclosure, which is much broader than China, there is and has always been the danger of the Chinese government action.
China is so large a market that US companies chose to ignore the risks of intellectual property theft, bribery or fraud, and government crack down. Depending on when and where you start reading, the hope was that as the Chinese got a taste of (somewhat) free market benefits that the government would stay out of it. This was folly, but no one could predict when the Communist Party (CP) would feel threatened enough to begin to reassert itself.
As the Chinese economy began to feel the effects of the recession and growth slowed (as growth always does), this has clearly begun to happen as evidenced by the unexplained and continuing disappearance of wealthy Chinese businessmen. It should be noted however, that slower Chinese growth is still more rapid than the growth rate here in the US. However, 4% pales in comparison to China's previously reported growth rate.
George Friedman, formerly of Stratfor, wrote up a very nice discussion of various aspects of China. I wish this version of Chinese geography and demographics had been taught to my children in school. What follows draws upon Friedman's article.
The Han Chinese, who represent the majority and the power, are surrounded by “essentially” different nations— actually other regions of China. It’s basically the Soviet model, before it collapsed, in that there are other people at the front lines in case of invasion. China is well protected by geographical features, except along its pacific east coast.
There is occasional talk about Chinese military operations in Central Asia. First, this would have to take place through the hostile territory of Tibet or Xinjiang. The major forces and supplies would have to be transported over 1,000 miles from the industrial base in Han China to the Chinese border. The supply lines would pass through desert and mountains. An invasion of Astana in Kazakhstan would require travelling a distance of at least 700 miles through mountains and near desert grasslands. Fighting in these ranges is as unlikely as invading over the Himalayas.
In effect, China is an island in Eurasia. It can move money around and sometimes technology, but not large modern armies. Therefore, China is not a threat to its neighbors, nor are they a threat to China. China’s primary strategic interest is maintaining the territorial integrity of China from internal threats. If it lost control of Tibet or Xinjiang, the PRC’s borders would move far east, the buffer for Han China would disappear, and then China would face a strategic crisis. Therefore, its goal is to prevent that crisis by suppressing any independence movement in Tibet or Xinjiang.
So when China speaks of the “interior” it's really talking about the lands still in Han country just not by the coast. The populated part of China is the area to the east of the isohyet line which marks where at least 15 inches of rain falls each year. That’s the amount of precipitation that’s needed to support a population.
In the seas, China has a problem because it doesn’t control the shipping lanes, the US Navy does. We could blockade China, and so they are trying to find a way to offset or get around that. To listen to certain Republican politicians, the Chinese are powerful and basically beating us across the board. However, China is a long way from challenging our navy. Building and training a naval fleet takes time and money. They have anti-ship missiles, but we know where they are, and can and would take them out. So China is pretending to be stronger than it is, which includes it's shenanigans in the East China Sea. Friedman estimates that it will take a generation in the best of conditions to fix the sea problem, and China has multiple internal issues.
China, therefore, has three strategic imperatives, two of them internal and one unattainable in any meaningful time frame. First, it must maintain control over Xinjiang and Tibet. Second, it must preserve the regime and prevent regionalism through repressive actions and purges. Third, it must find a solution to its enclosure in the East and South China Seas. In the meantime, it must assert a naval capability in the region without triggering an American response that the Chinese are not ready to deal with.
If this analysis is correct, then Trump's overstatement of China's capabilities are particularly foolhardy.
John Mauldin offered newsletter readers Gary Schilling's take on China. Money is fleeing China as the government can no longer pretend the economy is surging by building ghost cities. In addition, the CP is finding it difficult to manage market moves against the yuan. All the talk of the US dollar being replaced as the World's reserved currency seems to have ended. China is still buying oil, however, taking advantage of low prices to build its strategic reserve.
In different words, Schilling reaches a conclusion similar to Friedman, which is that China has quite enough to deal with internally, it will not want to tangle on the broader world stage. The comparison is to Japan, which has yet to recover from its own real estate collapse. Just like Japan, China's birthrate is below replacement rate, meaning that the younger generation will be stuck supporting a much larger aging one.
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