Most saver’s funds are invested in financial securities. These securities are legal contracts giving their owners rights to future income streams and assets. We take for granted that these will be paid and the assets available as per the terms of the contract that govern that particular security.
All of this of course assumes there is a strong civil legal system that allows an investor to assert their contractual rights. Most of the time we simply do not think about the importance of these legal rights. Often we invest in countries where we assume such rights will be enforceable without doing research.
Some of the greatest investment mistakes in history are the result of a failure to fully understand that legal rights, as expressed in contract, are meaningless unless they can be enforced, not just under the current legal system, but under likely future legal systems. Today’s changing world order means that investors now have to consider such basic considerations when they invest. There is a growing likelihood investors will not be able to enforce such rights in China and that the value of investments there will effectively fall to zero.
However the so-called Russian “oligarchs” made their money, they brought it to London in pursuit of protection under the rule of law. It turns out that no such protection existed when the political climate changed.
This is not to say that their assets should not have been sequestered. It is to point out that even in a country with a long history of protecting property rights, one can lose everything when a major political shift occurs. Foreign investors in Russia also find themselves with local currency denominated assets that cannot be turned into foreign currency.
The political divide rapidly developing in the world, that will change the rest of this century, is between China and the developed world. Investors now have to consider which side of this political divide they are on. If they live, work and ultimately hope to retire on one side of that divide will they be able to liquidate their investments on the other side of that divide?
On numerous occasions throughout history, investors have found themselves in this position. Savings so trapped have effectively no value as they cannot buy the goods and services of everyday life that support a quality of life and retirement to which we all aspire.
This divide between the developed world and China has been growing at least since former U.S. vice-president Mike Pence’s speech at The Hudson Institute in October 2018 when he drew the ideological battle lines between the U.S. and China.
At the time these very strong words were seen as the idiosyncratic views of the Trump administration. However, the new Biden administration has not backed down from the confrontational relationship with China. The war in Europe has done something very important as it has brought the EU to a realization that it has become too reliant upon Russia for energy but also that it has become too reliant on China for almost everything else.
The European version of the Pence speech came on March 19 when German Finance Minister Christian Lindner stated that China represented an opposed ideology that had become an “enormous risk” to Europe and the rest of the developed world. He went on to be more specific.
“Our trade relationship with China is almost a concentration risk for our economy. It may be a trading partner, but it’s also a systemic rival.”
We are now in a rush to reduce our China risk and this will focus on massive investment in the developed world to reduce our reliance on China for so many products.
This comes at a time when labour is already in short supply and inflation is high. This need for massive investment creates an opportunity for investors in developed world equities where those companies that benefit from much higher levels of capital expenditure are listed. However, it also represents a massive risk to developed world investors who continue to believe that investing in China can bring positive long-term returns.
In 2010, I wrote a piece called “Buy Chaos, Sell Order” for my institutional investor clients comparing China and India. That was a very confrontational title but it argued that from the seeming chaos of India an order was forming in which the world’s largest democracy would create very good opportunities for investors. It argued that China had created a much more brittle system that was then producing much higher economic growth but it would not ultimately produce good returns for investors.
The then seeming chaos of India was a reflection of its ability to bend and change, as it has, while the rigidity of China suggested that it could not bend and might break. This problem for China was exacerbated with the ascendancy to power in 2012 of President Xi Jinping. Xi has made no secret of his wish for the Chinese Communist Party (CCP) to have more power over almost all areas of life in China and he has thus enforced the rigidity of the system.
The difference in returns from the Chinese and India stock markets have been instructive. From its speculative peak in October 2007, the Chinese stock market has now declined. Over the same period the Indian Sensex equity index has almost tripled. This cost to investors in China from running a rigid economic, financial, social and political system may be about to significantly increase.
German’s Lindner has made it clear that the developed world needs to reduce its reliance on China for trade. On March 17, French President Emmanuel Macron also outlined a new industrial policy for his country aimed at reducing its reliance on China.
This structural shift in the flow of goods will have negative impacts for key Chinese producers. More importantly for investors is what this acceleration in our new Cold War means for the free flow of capital between China and the developed world.
Those who thought the Trump tariffs on trade were the limit to the disengagement between the two countries have been very wrong. The disengagement has already spread to the sphere of capital. The U.S. is seeking to reduce the access to U.S. capital markets for Chinese corporations.
China’s Xi, in line with his long-professed ideology, is seeking to increase the power of the CCP by taking greater control over key corporate assets. Investors have been caught in the cross hairs of these political shifts in the growing Cold War. Capital is in the front line of this Cold War and foreign investors hold Renminbi denominated securities to the value of $2 trillion (U.S.). There is a lot to lose when, probably not if, we reach the full expression of a Cold War with China — the end to the free movement of capital between the two opposing systems.
History is replete with examples of where legal rights were changed by political realities. Foreigners holding Russian assets and Russian “oligarchs” owning non-Russian assets have just lived through such a shift.
A bigger shift is coming. If you are a resident in the developed world you can no longer rely upon the ability of your savings in Chinese assets to be of any value. We are just a few headlines away from such a reality.
One of those headlines might be that China has taken strategic stakes in Russian commodity producers, a move that seems likely given the German Finance Minister’s declaration that threatens the supply of commodities to China. An even more dramatic headline would be confirmation that Chinese military material is flowing to Russia. These acts would result in years of friction between two different ideologies suddenly producing that sudden shift which generates a political and economic earthquake. It may not come soon but with the EU also committed to severing its reliance upon China, it is coming.
A greater order is being imposed upon the world and it is an order that cannot cope with the flexibility that the free movement of capital imposes upon it.
Russell Napier is an adviser on asset allocation to institutional investors. He is a freelance contributing columnist for the Star. Reach him via email: [email protected]
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