From Russian rain to Chinese storm

“I kind of look at Russia as the hurricane. It comes in fast and hard. China, on the other hand, is climate change: long, slow, pervasive.”

Rob Joyce, director of the Cybersecurity Directorate of the National Security Agency (NSA) in 2019.

By the end of 2020, the director general of the British Security Service MI5 Ken McCallum used similar terms as he described Russian actions as “bursts of bad weather, while China is changing the climate.”

Joyce and McCallum were on the money with their assessment that Moscow would probably shake up the geopolitical situation in the shorter term. However, China is currently also creating considerable turmoil for the world economy. Not because of foreign adventures, but via coronavirus and the actions of the government to contain the pandemic.

Xi Jinping and those around him seem to have doubts about the best approach. At any rate, and at any cost, Xi wants to avoid too much unrest ahead of his appointment to an unprecedented third term by the end of this year. The consensus among analysts was therefore that Beijing would stick to its zero-COVID policy at least until the autumn. The major question is whether this can be maintained with the more contagious COVID variants.

In any event, officials also differ on how to absorb the economic impact of the coronavirus revival. For example, a number of highly placed men — because they are all men — want to boost the property market, further reduce the reserve requirements for banks and provide monetary support.

On the other hand, there are policymakers who believe that, in view of the nature of the economic blow, there is not much that can be done about it now, and who moreover warn of the dangers of blowing even more bubbles in property prices, for example.

Team Boost has won the battle for now because, among other stimulus measures, another large-scale infrastructure initiative was announced. In a sense, this is not surprising, because little power can be expected from the other potential growth engines. Chinese growth can basically be attributed to three sources: corporate investment, consumption by households and the government and trade surpluses.

Exports are suffering as a result of weakening global growth due to the Ukraine war and high inflation. At the same time, the so-called terms of trade have deteriorated for China. Moreover, Chinese consumer confidence is eroding, and consumer expenditure is fraught with difficulty due to the lockdowns. Companies are becoming increasingly reluctant to invest due to the deteriorating economic climate. This is particularly unpleasant, as investment activity normally makes up a disproportionally large share of Chinese growth. The property market has accounted for roughly half of these investments in recent years. If this is to remain that way, the property bubble will become even bigger.

Propping up the property market even further and pumping ever more money into infrastructure projects means that there is an increasing reliance on future growth to justify the current investments. However, long-term challenges point to lower growth. Demographic developments are far from favorable. While the population previously grew by approximately 10 million people a year, population growth has declined considerably since 2015 and is now roughly at zero. The population is even expected to shrink. In addition, China will greatly rely on technological advances for future growth. In recent decades, China has made huge strides by largely leaning on Western technological innovations. As a result of shifting geopolitical relations, China will increasingly have to go it alone. It is doubtful whether this will work. Also, because, under Xi, China is taking on more and more of the traits of a planned economy.   

This changing international political climate is largely prompted by China’s enormous economic, diplomatic, technological and military rise. However, this upsurge is starting to partially turn against Beijing because the West was rudely awakened from the dream that China would also democratize as it became more prosperous. China is therefore increasingly being actively obstructed. And the country may be a giant, but it remains highly dependent on the rest of the world. It still relies on Western expertise in many areas, it requires foreign exchange reserves (especially dollars and euros) as well as foreign capital.

These three factors are currently at risk. Before the invasion of Ukraine, Western countries had already grown far more concerned about the transfer of advanced technology to China, but the war has forced the West to face the facts in terms of intentions and the potential of autocracies. The West has since taken a far more critical look at which technological applications and products are shared.

As for currency reserves, China will become more cautious about holding dollars, euros and possibly yens and Swiss francs, as it has witnessed the risks involved in a scenario whereby Europe and the U.S. really decide to put the screws on an opponent: Roughly half of the reserves of the Russian central bank have been frozen.

The influx of foreign investment will also decrease. In light of environmental, social and governance enterprise initiatives, Western companies are becoming more cautious about investing in countries with authoritarian regimes. Moreover, the lockdown in Shanghai has made it crystal clear that — in the words of China expert Fraser Howie — “Shanghai has always been a state-owned enterprise creation.” There is no free movement of capital and information and this now includes people.

It is nowhere near clear-cut, as China has certainly taken steps in recent years to open up its economy further, but it has become perfectly clear that the yuan will not be freely tradable for the time being, the legal system will remain an instrument of the Communist Party, and supervisory authorities and stock exchanges intervene arbitrarily if certain market movements do not please them. In short, China is not becoming any more appealing.

At any rate, uncertainty is increasing for companies and investors. The US — combined with many allies and partners — wants to make things tougher for China, in a political, military and economic sense. This is achieved by, for example, refusing to transfer knowledge and technology, a greater military presence in the region around China and partnerships and organizations such as the Australia, United Kingdom, United States partnership (AUKUS), the Quad and the new Indo-Pacific Economic Framework (IPEF).

Tensions in the region are rising considerably. Developments surrounding the strategically located Solomon Islands — with a population of 700,000 — are telling: After the archipelago had signed a security pact with Beijing, top U.S. diplomats rushed aboard a plane to change the view of the government of the Solomon Islands. In short, tough battles for influence are being fought by great powers in every corner of the world.

Reference is often made to a decoupling between the West and China in order to be able to win the geopolitical battle. The Russian example has been pointed out. However, decoupling from China is of an essentially different order. Western economies and China are intertwined in many ways and massive ways:

• Two-thirds of China’s foreign exchange reserves are held in Western government bonds and so on.
• By the end of 2021, foreign parties owned $3.6 trillion in direct investments in China and $2.2 trillion in shares, bonds and the like.
• Four of the 40 systemically important banks in the world are Chinese.        
• Only a fifth of China’s trade is conducted in yuan.
• China is the most important trading partner for over 120 countries.
• Chinese products account for 18 percent of U.S. imports and 22 percent of EU imports. 

In short, a decoupling between China and the U.S. and its allies may not be an impossible task, but the consequences will be of an entirely different order than the already very considerable consequences of the struggle with Russia.

For the time being, a steady form of bloc formation is more likely, in which China and its partners on the one hand and America and its associates on the other gradually reduce their mutual dependence. In recent years, this has been evident in China’s reduction of dollar reserves (in 2005, dollars constituted 79 percent of China’s foreign reserves compared to 58 percent in 2019).

Andy Langenkamp is a senior political analyst at ECR Research which offers independent research on asset allocation, global financial markets, politics and FX & interest rates.