Trading Places

Russia’s invasion of Ukraine is clearly straining China’s relations with the West. What is less clear is what the implications of this will be for China’s trade and economic policies and, by extension, on the development and interactions of Asia’s markets. These are common questions that I get from investors these days and they are hard to answer without a great deal of speculation. However, there are some trends that are already in place and the conflict in the Ukraine may accelerate some of these trends.

First, China has been searching for more self-sufficiency and its “dual circulation” strategy is all about increasing self-sufficiency whilst remaining part of global markets. Things like self-sufficiency in food are going to be impossible to achieve as China has little arable land relative to its population. Relying on food imports means that it needs to retain good relations with the US and also Russia. Southeast Asia could also be a source of food and agricultural imports from Africa may continue to increase. So, the One Belt One Road initiative that seeks to increase economic ties and transportation routes through Southeast Asia and to Europe and the East coast of Africa is an important part of their economic diplomacy, particularly if the relationship with the US sours further.

China wants also to be self-sufficient in technology. At the moment that is hard to do when China is almost entirely reliant on the outside world for semiconductors—the building blocks of hardware. Even the equipment bought by China’s suppliers of semiconductors to make the chips is predominantly made by the U.S. and European Union (EU) countries. This reliance leaves China with a need for huge investment at home in the factories needed to make the chips but also the intermediate goods and raw materials required to be able to manufacture at home. This is a long-term project and surely the invasion of the Ukraine comes at an inopportune time for China as relations with the West are strained even as it is just embarking on this initiative.

Finally, there is the need for financial self-sufficiency. The threat of sanctions with the U.S. and the potential for being locked out of the U.S. dollar trading system means that China has been eager to set up its own renminbi (RMB)-based payments systems and to try and internationalize its treasury market. This is all part of a desire to have long-term financial interrelations through the RMB, much as the U.S. does with the dollar. It has had some success attracting investment from the EU and more latterly (and more significantly) Russia. Also, pricing of oil in RMB. But these are still early steps—the system is still nascent. However, as we know with the experience of the dollar post World War One, things can change rapidly.

An inward pivot?

Do these trends mean China is turning inwards and moving away from globalization? I think it would be a mistake to look at it that way. China sees these goals as a response to provocation from the U.S. The imposition of trade tariffs from the recent administration and the West’s consternation at advances in Chinese technology is an example. However, transitions in China’s economy, too, mean that it will continue to rely on cooperation with other countries to maintain economic progress. The aging and shrinking of its workforce means that it will continue to relocate some of its industrial base outside its borders—Southeast Asia a major beneficiary but also parts of Latin America and maybe Eastern Europe, too. It will enable China to make use of younger and cheaper workforces abroad whilst its own population focusses more on higher-end manufacturing and services jobs.

These trends also argue for a greater role from government. Tax and spend! China knows the value of a capitalist economy to create wealth but it will also have a need for government to continue to build up the physical infrastructure of its economic diplomacy. Whilst it does so, it will continue to spend more heavily on the production and utilization in service sectors of IT capital to support productivity growth at home.

In addition, China will continue to spend to deal with “developed economy” issues that arise from having largely solved the problem of extreme poverty. That is to say: How do we achieve a more equal share in consumption? A better quality of life and environment? Prevent monopolistic corporate power? The list is familiar to any Western government. China is struggling with how to achieve these aims and with how it can better support public discussion and involvement in the debate, without springing surprises on the capital markets.

What about the markets?

China does not want to spook the capital markets because it sees them as important for maintaining the highest possible levels of return on investment. As investment share in GDP gradually declines towards more developed economy levels, achieving better pricing and use of capital will be crucial in maintaining the rates of productivity growth needed to maintain the fast pace of wage growth that has cemented the Party’s legitimacy in the eyes of the Chinese population.

In my view this has several implications for the markets. Whilst this is certainly not anti-globalization, it does suggest that the overall quality of China’s domestic A share market is set to improve gradually. Also, the domestic market will be more influenced by local monetary policy, local sentiment and the local financial system. Perhaps it will be less correlated with global markets and less susceptible to the shocks of the U.S. dollar system. We have long thought that China was on the way to becoming its own asset class—perhaps recent events may accelerate this.

However, even if the world were to split into two spheres of influence—one around the U.S. and one around China—China is not interested in retreating into its shell. So there will still be a process of “globalization” within the Chinese sphere of influence at least and this has to be positive for the countries of Southeast Asia as they are able to build up their manufacturing base, their infrastructure and maintain fast rates of wage growth to support consumption. This will have the added advantage for China of helping it clean up its environment at home. However, this is another long-term project—the scale of the manufacturing capital stock in China is huge relative to these nations’ GDPs.

These trends suggest that consumption markets around Asia will continue to grow. That China will favour technology spending and will have a lighter regulatory touch on areas of the greatest innovation and research and development expense. That it will seek to promote and support businesses that offer at the lowest cost access to, for example, health care. That there will be growing markets for health care of convenience rather than survival (orthopedics is one example.) And there will be continued regulatory costs around pollution and other issues such as equal access to education and financial speculation in real assets that are seen as antithetical to China’s mandate of Common Prosperity—the drive to narrow the wealth gap and strengthen and enlarge its middle class. But it is a China that does want to work with its neighbors and the capital markets to achieve these outcomes.

No doubt other markets will benefit in other ways. The U.S. may push to diversify its supply chains within its own sphere of influence, to Mexico for example. India, a long-time ally of the U.S. and China skeptic, has had some recent success in building up its own manufacturing in automobiles and smartphones. And there remains the issue of Europe, where China had been making such progress in its investment, economic and diplomatic outreach.

So the impact of Russia’s invasion of the Ukraine has indeed put some of these relationships to the test—particularly concerning must be the wariness of Europe. Given that China’s long-term plans are many years away from realization, there should be an incentive for China to play a more constructive role in the conflict. We shall see. However, as much as it feels that we have somehow turned a corner and are heading down the path of a world divided into two spheres of influence, it seems that this will simply confirm trends in investment and opportunity that were already in place.


Robert Horrocks, PhD
Chief Investment Officer
Matthews Asia