International pensions adviser at PRIME bv, Peter Kraneveld, looks at how different China scenarios could impact portfolios.

Investing in emerging markets is becoming popular again and China is a vital part of an emerging market portfolio. However, it is difficult to understand the long-term projections for China. Its statistics are unreliable, its governments unstable through the strong link between economy and policy, yet its policies are inflexible as economic development is subservient to government politics. In this article, I will use a simple scenario analysis that investors can use to monitor China’s developments and update the assumptions behind their emerging market portfolios from time to time.

Don’t predict the future

The future is too complicated to predict with many more variables than equations. Moreover, the judgment of those who predict is normally clouded by such factors as education, culture, experience, constraints of time and access to data. In principle, all predictions of the future beyond the very short term should be considered with very considerable care. At best they represent only one-way things might develop. More often, they are an expression of a combination of fear, wishful thinking, marketing imperatives and other factors that should not have played a role.
As an alternative, after a short inventory of the present situation, I will develop two polar scenarios (whether the one or the other is positive depends on the eye of the beholder), assuming that the real future will play out somewhere in between. The major advantage of this approach is that it allows for easy updating: throw out what has not happened and has become highly unlikely to happen. Keep what is still possible and add newly surfaced imponderables. This updating process has value in itself, as it forces the reviewer to reconsider yesterday’s easy assumptions.

Today’s economic issues

China, like every country in the world, is dependent on foreign trade. It needs it for know-how, capital, energy and basic materials that are not found in sufficient quantity in China, but also as a back-up to smooth domestic economic problems. In principle, China’s size allows it to play an important role in international trade. In practice, China’s role in international trade is restricted by political considerations. First among those are the real and perceived enemies of China, including Taiwan, Russia and the US. Second are military strategic considerations. In addition, trade suffers from over-regulation that gets in the way of flexibility.
When China was poised to join the World Trade Organisation, it fought hard to retain all kinds of mechanisms to control imports and incoming capital and to undermine industrial and intellectual property rights. This backfired into a deep distrust from its trading partners and a lack of domestic economic discipline. Typical examples are food safety problems and fake Chinese banknotes and coins circulating within China, but also judiciary blackmail on foreign direct investors.
China’s trade policy includes efforts to corner markets. The country will engage with developing countries, offering physical, non-financial development aid with financial and economic strings attached. China tends to seek out countries with highly corrupt economies, ruled by dictators or the military. These countries are not reliable political or economic allies. The policy is backfiring into painfully ruptured relations, especially after a change of regime. China’s project execution, often a closed compound with Chinese workers only, does not provide employment or education for the local population, so that the projects tend to create resentment, rather than goodwill locally.
Using economics and trade as a tool of political goals, China has made itself vulnerable to pressure from the US particularly. With China’s historic background of attempts at colonisation (“unequal treaties” in Chinese parlance) it is unlikely that the government wants to, or even can, make economic concessions in trade disputes.

The “all goes well for China” scenario

In this scenario, the world develops China’s way and China becomes the world’s largest economy. That means next to nothing, as GDP figures can be compared only when related to population. But as the US media and financial markets attach emotional value to the US no longer being in ‘first place’ it will have a psychological effect.
China increasingly gets influence on trade and basic materials and uses it to create favourable conditions for itself. Several developing countries lose the possibility to trade without China’s permission. The big prize, the oil market, eludes China, because of major production in the US and Russia. However, Saudi Arabia, the world’s largest producer may feel increasingly attracted to China as a counterweight to the US. Venezuela, another large producer, may be in the Russian or Chinese orbit, but it is not in the US sphere of influence. Meanwhile, green pressure diminishes the importance of oil.
Politically, China succeeds in silencing all countries on its borders, apart from Russia and it will awaken the military aspirations of Japan. Trade disputes are a running war that hollows out the liberal trading system and replaces it with bilateral relations, where China’s influence looms large. Investments into China go from private to government induced.
Perhaps China’s greatest success is in international bulk transport. Its shadowy companies buy up harbour front service industries and airports, making sure that Chinese trade flows get preferential treatment. This is also another way to keep other nations in line. In principle, Chinese internet companies could take over domination from their US competitors. In practice, China lags so much behind in privacy legislation, good behaviour (hacking, trolling, spamming) and consumer trust that, while it would be likely to grow in importance, any chance of domination would be countered by legislation. For the same reason, Chinese computers and software would be unable to convince the security conscious.
The obvious problem with this scenario is that it is in the interest of only one country. China will see the world turning against it and attempts to isolate it further. Other countries will restrict their R&D information and its practical results, as happened to the Soviet Union during the cold war. The question arises whether, in the event China can even reach a state of affairs where it dominates distribution, the situation can be maintained for long.

The “all goes badly for China” scenario

Now, the most important threat to China seems the trade war, induced by the US. However, it may well all be over by the next US presidential election. What will still be there are the major domestic imbalances. One is the distribution of the population. China’s population is concentrated along the Eastern coastal provinces. That goes for the largest population group, the Han Chinese. By its inability to tolerate other cultures, religions and opinions, the Han have already created several tensions. In the North, the Uighur, a Muslim population with a distinctive culture, is discriminated against and in the South, Tibetans chafe under an oppressive Chinese regime. The inevitable death of the current Dalai Lama will not change that.
In addition, the repression of China’s rural population in favour of huge, uncontrollable cities can quickly become another source of instability that may find ready allies among intellectuals and students. In the shorter, but more durable run, a culture that rewards “who do you know”, rather than “what can you do” promotes graft, decisions driven by the wrong consideration and exclusion.
China’s political and economic isolation would deepen as new alliances are born, none of which trust China. Its AI efforts would be a domestic success at most and its internet policy would hamper creativity and flexibility to the point where it is constantly running behind innovation, cannot compete on quality and must compete on price, to the detriment of domestic growth and the development of the middle class.
The weak point of this scenario is that it presumes implicitly that China cannot change. The transformation from Maoism to the current proves that it can. The real question is therefore if it can change quickly enough. The higher the level of flexibility, tolerance and growth that can be introduced, the more this scenario is unlikely.

From this analysis, it becomes clear that the strength of China lies in its size. Just like its major competitors, it is a large economic presence. The challenge is to use this strength well. China’s greatest weakness is its view of economic policy as a political tool. This restricts its flexibility and makes China suspect in the eyes of the rest of the world, keeping it in isolation. China’s major opportunity is growing its domestic economy and thereby meeting the aspiration of its population, increasing stability and its influence in world affairs. This ought to be China’s priority. The major threats to China are if the rest of the world unites against it, and increased divisions in its own population, against each other, and the state.

Peter Kraneveld is international pensions adviser at PRIME bv

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