Global Trend

Cutting China’s Financial Lifeline
 

In 1982, the Soviet Union controlled an empire stretching from Havana to Hanoi, but their hard currency revenue totaled only about $32 billion a year; that was roughly one-third the annual revenue of General Motors, at the time.  More importantly, they were spending about $16 billion more annually than they were making.  Ironically, this funding gap was being financed by Western governments and banks, which acted as the USSR’s life support system.

But this status quo, which had been in place for decades, was about to change.

President Reagan had long believed that the Soviet Union was economically vulnerable; he knew it lacked the entrepreneurship, technological dynamism, and freedom that are the prerequisites of a strong modern economy.  And when he learned that we in the West were financing this brutal regime, he committed to slowing and ultimately terminating, that flow of discretionary cash.

Our European allies had a completely different approach.  Their belief in Ostpolitik, as the Germans called it, presupposed that commercial bridge-building would lead to geopolitical cooperation.  If the West would offer financing and trade to the Soviets, peace and prosperity would result.  Meanwhile, the Soviets were using the proceeds from Western loans, hard currency revenue streams, and technological support to build up their military, expand their empire, and engage in anti-Western activities.

The Reagan administration drew the line on a project called the Siberian Gas Pipeline, a 3,600-mile twin-strand pipeline that stretched from Siberia into the Western European gas grid.  If completed, not only would it become the centerpiece of the Soviets’ hard currency earnings structure, but Western Europe would become dependent on the USSR for over 70 percent of its natural gas, weakening Western Europe’s ties to the U.S. and leaving the continent open to Kremlin extortion.  Moreover, the pipeline was being financed on taxpayer-subsidized terms, since France and Germany viewed the USSR as a “less developed country” (or LDC) worthy of below-market interest rates.

At the time, the U.S. had a monopoly on the oil and gas technology we had developed for Alaska’s North Slope which was needed to drill efficiently through permafrost.  We imposed oil and gas equipment sanctions on the USSR and any European companies that were helping them build the Siberian pipeline.  At one point, despite the strain it placed on relations with our NATO allies, we closed the U.S. market entirely to companies that continued to supply the pipeline project over our objections.  Four of the six companies affected went bankrupt within six months, and the Europeans woke up to the fact that they could do business with us or with the Soviets, but not both.

As a result of these efforts, the United States

-  capped Soviet gas deliveries to Western Europe at 30 percent of total supplies,

-  delayed the first strand of the Siberian pipeline by years and killed the second strand, and

-  eventually helped dry up the bulk of Western investment credit to the USSR.

In a secret deal, we also persuaded the Saudis to pump an additional two million barrels of oil per day while we decontrolled prices at the wellhead in the United States; this knocked oil prices down to about $10 a barrel.  That’s significant because, for every dollar decrease in the price of a barrel, the Soviets lost between $500 million and one billion dollars.  In short, the Soviet Union never recovered from these economic and financial blows.   And, as a result, it defaulted on some $96 billion in Western hard currency debt shortly before the total collapse of the Soviet empire.

Why is this story so important?  Because the situation today with China has many similarities.  But there is one big difference: the U.S. has been playing the role of the naive Europeans.  Since adopting the Kissinger policy of engaging with China in the 1970s, our government has operated on the assumption that economic and financial relations with China would lead Beijing to liberalize politically.  And since 2001, when we backed China’s entry into the World Trade Organization, the pace at which we have given China access to our best technology, capital and markets have accelerated.  Yet China has shown no signs of:

-  embracing individual freedoms,

-  becoming a positive force in building a stable world or

-  reliably enforcing the rule of law.

Instead, with our support, the Chinese have launched a massive campaign to become the world’s leading superpower with the clear intention of displacing the United States.  Consider just of few of the facts:

-  We know about the “Belt and Road Initiative,” a strategic undertaking to place huge segments of the world under China’s influence or outright control.

-  We know about “Made in China 2025,” a strategy designed to dominate key technology sectors - from artificial intelligence and quantum computing to hypersonic missiles and 5G.

-  We know about China’s practice of forced technology transfers: requiring American companies to share their trade secrets and R&D in order to do business in China. And,

-  We know about China’s predatory trade practices.

The general public knows many of these things only because the Trump Administration has brought them to the forefront of national attention.  And, contrary to conventional wisdom, the ongoing tariff war is already paying off in the sense that the United States has finally begun to take a stand for its own best interests.  As Trends predicted even prior to Trump’s inauguration, the Americans have been able to exploit enormous and growing bi-lateral advantages.  As a result, China is being forced to work around constraints created by U.S. tariffs and this has seriously slowed its rise.

What would hurt them immeasurably more would be meaningful restrictions on their access to our investment dollars.  The Chinese are estimated to have attracted nearly two trillion dollars of American investment in equities alone.  Beyond that, we do not really know the extent of our true exposure to China, because it has issued dollar-denominated bonds elsewhere in the world that is ending up in Americans’ bond portfolios.  Our investment banks buy them overseas utilizing a loophole in our regulatory structure.

What are the implications?  Over 700 Chinese companies are funded via our stock, bond or other capital markets.  As of September 1, China had 86 companies listed on the New York Stock Exchange, 62 on the NASDAQ, and over 500 in the murky, poorly regulated over-the-counter market.  Among these companies are some egregiously bad actors. Hikvision, for example, is responsible for facial recognition technology that identifies and monitors the movement of ethnic Uyghurs.  It also produces the surveillance cameras placed atop the walls of Chinese concentration camps holding as many as two million Uyghurs in Xinjiang.  Both its parent company and Hikvision itself are on the U.S. Commerce Department’s “Entity List,” which experts refer to as the “Blacklist.”

Notably, Hikvision is far from an isolated case.  While it may be difficult to believe, it’s an empirical fact that the majority of American investors are unwittingly funding Chinese concentration camps, weapons systems for the People’s Liberation Army (or PLA), and more.  This is because U.S. capital markets, which have roughly $35 trillion under management, have no national-security screening mechanism.

When it comes to screening Chinese investments in U.S. companies, we do have the Committee on Foreign Investment in the United States (or CFIUS), which was recently empowered due to the enactment of the Foreign Investment Risk Review Modernization Act of 2018.  Thereby, Congress expanded its reach to reflect the administrations justified worries about China undermining our security and stealing our technology.

On the other hand, our capital markets, are completely unprotected.  Consider the facts:

-  There are serial violators of U.S. sanctions operating in our capital markets today.

-  There are companies using our capital markets that are responsible for proliferating advanced ballistic missiles to our adversaries.

-  There are Chinese companies accessing U.S. capital, which manufacture sophisticated weapons systems for China’s aggressive PLA.

-  There are companies in our capital markets that are responsible for militarizing the illegal islands in the South China Sea.

-  There are also companies helping maintain the North Korean nuclear threat. And,

-  There are Chinese companies accessing U.S. capital markets that have been indicted, whose employees have been arrested for espionage, or are associated with known cyber-criminals.

Notably, U.S. investors find disclosures of none of these “material risk factors” in our prospectuses for these offerings.  Neither do we hear about these concerns from our financial planners or fund managers.  Nor has there even once been hearings on this topic in Congress.  Almost everyone remains quite willing to let the status quo persist.

As mentioned earlier, the trade war is already hurting China.  And, given China’s unwillingness to play by the international rules, this is a positive result that is long overdue.  So, whether we’re talking about the reshoring of manufacturing industries or the rise of more trustworthy regional trading partners, these developments make Americans wealthier and more secure in the long run.

These changes in the world system mean that Global supply chains are being rerouted in an effort to decouple multi-national enterprises from China-based trade risks.  But China is not simply sitting idly by as the United States and its allies isolate and marginalize its economy.  Specifically, China-based enterprises are busy gaining allies in the United States through closer financial relationships.  To put it simply, China knows that investors who own Chinese equities and bonds will increasingly see their interests as tied to China’s success.  Letting that trend play out would mean that the U. S. investor-class would have significant incentives for undermining U.S. and multi-lateral policies designed to impede China’s aggressive rise.

Already, China’s so-called “business lobby” within the U.S. is large and formidable.  But that’s nothing compared to where things are headed if Americans become more heavily invested in China.  Yet, most policymakers remain largely blind to this development, much as we were blind to the extensive financing of the Soviet Union by the West, prior to Reagan’s election in 1980.  Today, China is playing the role of the authoritarian villain, waging economic and financial warfare against the United States and its allies; they are simply more aggressive and capable than the Soviets.  And just as before, the hostile regime is using investments from western Democracies to keep its system going.

Notably, the set of investors pulled into China’s financial orbit is both broad and diverse.  This American financial exposure to China takes the form of public equities, private equities, and debt.  This exposure ranges from small startups to industry giants, to sovereign debt.  And, it involves institutional investors as well as individuals with few truly appreciating the magnitude of the financial or geopolitical risks involved.

Let’s consider a few examples:

Americans are unexpectedly investing in China’s sovereign bonds.  These are issued directly by the Chinese government, with the proceeds used at its sole discretion.  According to the Prague Security Studies Institute, “Americans are buying Chinese sovereign bonds to finance our own potential destruction.  Today, this category is still small; the California State Teachers’ Retirement System, for example, owns Chinese sovereign bonds valued at just over $4 million.  However, we are finding examples like this throughout our state public employee retirement systems and elsewhere.”

Now, consider university endowments.  The University of Michigan has 44 percent of its $12.2 billion in assets in private equity and venture capital; of the venture capital portion, one-third of the investments are in China. And the University of Michigan’s investment portfolio is quite typical of what exists at other universities.

Given the fiduciary responsibility of financial managers at retirement plans and endowment funds, this raises some serious questions about prudence and risk management.  For example, “Where is the disclosure related to these Chinese investments?” and “Where is the due diligence on the part of fund managers and index providers?”

There are all kinds of existing investment policies and standards that prohibit the financing of concentration camps, human rights abuses, organizations engaged in espionage, and violators of U.S. sanctions as well as specific prohibitions on aiding the People’s Liberation Army of China.  But those are currently being ignored.

So far, we’ve talked mostly about private capital.  But what about our tax dollars? The Federal Thrift Savings Plan (or TSP); the contributory retirement system for all federal employees - totals roughly $578 billion.  It is the largest retirement fund in the country, with 5.7 million enrollees - including U.S. military personnel.  Until recently, TSP managers used a specific index for TSP’s $50 billion international portfolios.  Specifically, TSP was using a Morgan Stanley Capital Investment (or MSCI) index containing only companies in industrialized democracies.  But in November 2017, the TSP Board had the idea of changing its index to capture yields from emerging markets.  In response, a Wall Street consulting firm introduced TSP to the MSCI All Country World Index, which includes China.  For instance, it includes companies such as AVIC (which makes fighter aircraft and ballistic missiles for the PLA) and China Mobile (which has been barred from U.S. government procurement for national security reasons.)  As of this writing, the decision has been made to begin moving the TSP international fund to the MSCI All Country World Index beginning in 2020.

What’s the bottom line?

As documented in prior issues of Trends, China is waging economic and financial warfare against the United States every day.  As we’ve also explained, the United States is in a position to prevail.  But as with the Franco-Anglo-American advantage vis a vis Germany and Japan in 1936-to-1938, this advantage is fleeting. In the case of trade, we’ve only recently “taken the field.”  In terms of our capital markets, we’re not even at the stadium.

Today, as in 1982, the United States has the leverage needed to peacefully undermine and marginalize a potentially existential challenge to our way of life.  As outlined in prior issues, the growing threat is undeniable.  The question is whether we’re willing to exploit our strategic advantages to protect our wealth, national security, and cultural values.  When weighed against America’s other means of responding to China’s aggression, access to U.S. capital markets is by far the most powerful and invulnerable to retaliation.

Given this trend, we offer the following forecasts for your consideration.

First, early in 2021, the United States will act decisively to cut off China’s access to U.S. capital markets, likely using a violation of an interim trade agreement as a pretext.

For domestic political reasons, both the U.S. and Chinese governments are likely to sign a set of interim trade agreements in the near future.  As a result of this and other factors, stock indexes in both the U.S. and China will soar by 20%+.  However, China will not be able to live up to the agreement and the United States has no long-term rationale for expecting them to do so.  This set of interim agreements could be signed almost any time in 2020.

Second, a key objective of America’s multi-faceted capital markets strategy will be disentangling the vested interests of the U.S. “investor class” from those of China.

Other than private equity and hedge funds, U.S. exposure to financial risk in China is still relatively small.  But, according to experts, if nothing is done, in the next 36 months, our exposure will be two to three trillion dollars more than it is today.  The Chinese are moving as fast as they can into the investment portfolios of the American people because they are in desperate need of our dollars. ? But it’s not just a matter of dollars: roughly 150 to 180 million Americans have investments in our capital markets.  If these Americans wake up one morning and discover that 15, 18, or 22 percent of their retirement accounts are in Chinese securities, those scores of millions of Americans will have a vested financial interest in opposing any future sanctions or other penalties against China, irrespective of the severity of China’s offenses or the overall threat it poses to America’s national security.  More than anything else, that’s what China is knowingly working towards and what the administration must stop.

Third, the Administration will reverse the TSP Board decision before it is implemented.

As with the recent legislation supporting the Hong Kong protestors, this should not be a partisan issue.  Even leaving aside China’s brutal repression of its own people, does anyone in America, Democrat or Republican, want to fund the production of weapons designed to kill American soldiers, sailors, and marines?  Does any American want to underwrite the Chinese militarization of the South China Sea?  Do they want to finance U.S. sanctions violators benefiting Iran and North Korea?  And do Americans want to finance the destruction of their own liberty and the ruin of everything they hold dear?  We think most Americans will react with outrage, once they knew the facts.

Fourth, beginning in 2020 the Department of Justice will increasingly use the Foreign Corrupt Practices Act to cut-off individual Chinese companies from U.S. capital markets.

Obviously, it is urgent that Chinese bad actors be excluded from accessing U.S. markets or at least be forced to disclose their malevolent past activities because of the “material risks” involved.  And, when it comes to China, there is a question of whether there are any good actors.  Article 7 of China’s National Intelligence Law allows every commercial entity to be instantly weaponized by order of the government to commit espionage, technology theft, or whatever else is deemed to be in China’s national interest.  That’s a matter of public record.

Fifth, by late 2021, expect to see a mass exodus of prudent fund managers and investors from China.

Any entities subject to the so-called “prudent man rule” will have to ask themselves some key questions.  Failure to disclose material risks is illegal. And although the SEC apparently doesn’t consider egregious corporate human rights and national security abuses to be “material risks,” the fact is that a company’s stock will likely decline when it becomes known that the company is providing, surveillance cameras for concentration camps or producing ICBMs targeting American cities.  And that kind of revelation does represent a real material risk which the plaintiff’s lawyers will not ignore.  Right now, this disclosure is objectionable because China would be offended.  However new legislation is working its way through Congress requiring the same audit coverage and transparency for both American and Chinese companies.  This will be a game-changer.  Don’t get caught in the stampede.  Late 2020 is likely to be the best time for investors to exit China.  And,

Sixth, for private equity funds heavily committed to China, its likely too late to get out.

As the U.S. government implements its plan, the Chinese banking system will face an existential crisis.  It’s already becoming very difficult to get money out of China.  It will only become tougher as the dollar-starved Chinese government puts more restrictions in place to prevent the capital fight.  Investors with large commitments to joint ventures should already be planning for massive write-downs.

References
1. Oct. 17, 2019.  Jeffrey Snider.  Chinas Dollar Problem Puts The Sync In Globally Synchronized Downturn. 

https://www.reuters.com/article/idUSSeekingAlpha429699820191017

2. The Wall Street Journal. April 23, 2019  Mike Bird.  China’s Banks Are Running Out of Dollars. 

https://www.wsj.com/articles/chinas-banks-are-running-out-of-dollars-11556012442

 
3. October 2019.  Roger W. Robinson, Jr.  Why and How the U.S. Should Stop Financing China’s Bad Actors. 

https://imprimis.hillsdale.edu/roger-w-robinson-stop-financing-china/

 
4. The Wall Street Journal. June 4, 2019.  Marco Rubio.  You Can’t Trust a Chinese Audit.

https://www.wsj.com/articles/you-cant-trust-a-chinese-audit-11559687739

 
5. Accounting Today. October 11, 2019.  Ben Bain.  China’s resistance to a U.S. investor audit safeguard riles Team Trump. 

https://www.accountingtoday.com/articles/chinas-resistance-to-a-u-s-investor-audit-safeguard-riles-team-trump

6. June 20, 2019.  Claude Barfield.  China and US capital markets: For once, ‘leveling the playing field’ is not a protectionist cover. 

https://www.aei.org/economics/china-and-us-capital-markets-for-once-leveling-the-playing-field-is-not-a-protectionist-cover/

 
7. JUNE 5, 2019.  David Alexander.  U.S. lawmakers push U.S.-listed Chinese firms to comply with financial oversight. 

https://www.reuters.com/article/usa-congress-china-exchanges/us-lawmakers-push-us-listed-chinese-firms-to-comply-with-financial-oversight-idUSL2N23D01Z