China worries
Dissecting four of the most common pushbacks against investing in Chinese equities. Estimated reading time: 19 mins
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Summary
When I speak to investors and mention Chinese equities, I get a lot of pushback. These pushbacks tend to revolve around government crackdowns on publicly listed companies, potential sanctions on Chinese equities, and a war over Taiwan.
The clique around Xi Jinping is asserting control not only over the Chinese Communist Party (“CCP”) itself but also over the private sector. One way to deal with the risk of government crackdowns is to invest in state-owned enterprises, which enjoy the full support of the state banks and the CCP itself.
It’s also clear that the world is decoupling. One way to deal with the risks of capital controls is to invest in your own country, reducing the risk that capital will get stuck.
The CCP will have the military capabilities to annex Taiwan from 2025 onwards. Will they take action? Nobody knows. But, experts such as Ian Easton argue that we will be able to tell weeks in advance from satellite photos that troop movements have started taking place.
If pro-independence candidate Lai Ching-te wins Taiwan’s January 2024 election, there is a risk that the CCP will respond with a blockade or something similar. But I think the base case is that the election victory will be met with silence, just like in 2016.
When I talk to investors about China, they inevitably get dismissive. No one wants to own Chinese equities anymore. Just look at the performance of the Hang Seng Index - it’s been terrible.
The most common worry is about Xi Jinping － the fear that politics is moving in the wrong direction. Some also point to the possibility of an invasion of Taiwan. Russia’s war in Ukraine has made that possibility feel real.
In this post, I want to address those concerns. I want to look at Chinese politics from a neutral point of view and see how investors might ultimately be affected by the direction Xi Jinping is taking the country.
Table of contents:
1. Socialism in China
2. Global decoupling
3. A potential annexation of Taiwan
4. Taiwan's 2024 election1. Socialism in China
After Deng Xiaoping’s reforms from 1978 onwards, China opened up trade and information flows with the outside world. But after the so-called “Shanghai faction” lost power from the mid-2000s onwards, a more conservative part of the Chinese Communist Party (“CCP”) took over, with second-generation red Xi Jinping at the helm.
Outside observers have found it difficult to judge Xi Jinping. He was initially thought to be a reformer. But over time, it became clear that he was quite the opposite.
Xi is essentially a Marxist. He has called Marx “the greatest thinker in human history”. His mother taught at the Marxism-Leninism Institute. He also emphasized over and over again that "capitalism is bound to die out and socialism is bound to win". He is a socialist through and through.
So what do Marxists believe? They think societies are characterized by class struggles, particularly the ruling class, who own the means of production and exploit workers at their expense. To rectify this situation, governments need to step in and fight against the ruling class. Eventually, it will abolish private property and achieve a classless society where resources are owned by the state - not by investors like us.
Xi has ruled the People’s Republic of China (“PRC”) for ten years. He’s consolidated power over the party, and according to journalist Katsuji Nakazawa, he’s now changed his focus to the private sector:
“The crackdown on Alibaba signals that Xi Jinping is extending the tactics used in the government anti-corruption campaign to private companies.”
Over the past three years, we’ve seen similar crackdowns on other tech companies such as TikTok parent Bytedance, private property developers through the Three Red Lines policy and the banning of the private sector tuition companies.
According to the same journalist, CCP insiders have said there is “no end in sight” to the crackdowns. That would suggest that Xi’s strategy of maintaining control mirrors Joseph Stalin’s perpetual struggle - of constant revolution.
Marxists are experts at obtaining control by attacking the ruling classes in any society and maintaining control by outlawing any competing organization.
Let me explain in greater detail. In the book Homo Deus, author Yuval Noah Harari describes how Ceaușescu in Romania maintained power:
First, he placed loyal communist apparatchiks in control of all cooperation networks, such as the army, trade unions and even sports associations.
They prevented the creation of any rival organizations - political, economic or social - which might serve as a basis for anti-communist cooperation.
They relied on the support of sister communist parties in the Soviet Union and Eastern Europe.
This is exactly the playbook that Xi is using. He’s afraid of the private sector since organizations such as Jack Ma’s Alibaba could potentially be used to challenge party supremacy.
Since Xi came to power in 2012, he has presided over an economy that has redirected lending from private enterprises to state-owned enterprises under his control. You can see that trend clearly from the following chart, showing how much of China’s total lending went to the private sector vs the state sector. Chinese banks used to lend 57% to the private sector, but by 2016, that proportion had fallen to just 11%.
The Party has also introduced communist party committees across most large private companies. The government insists that these party branches should be given control over personnel decisions, including who to hire as CEO.
A booklet by the Party’s Organization Department explicitly said that:
“The non-state economy is taking up an ever bigger share of the national economy… If party organisations don’t go and control it, other political forces will exploit [our] weakness.”
So, the Party wants control over private companies, and this opens up the possibility that the state will eventually control a greater and greater share of the country’s resources.
Key takeaways: I believe that investors are right to worry about the slow encroachment of the Communist Party across all parts of Chinese society, including the private sector. One way to deal with that threat is to avoid investing in private enterprises altogether in favor of companies that are already owned by the state and already enjoy full support from China’s state-owned banks.
2. Global decoupling
Xi’s “perpetual struggle” is not limited to the country’s private enterprises. He’s also seeking to control organizations in the country’s trade partners. These include religious organizations within China and beyond and competing political parties in Taiwan and beyond.
Xi’s overseas ambitions should not come as a surprise. After the Russian Revolution in 1917, the Bolsheviks Communist International (ComIntern) movement. Its goal was to spread communism globally. Mao also tried to export revolution by igniting civil wars in countries such as Indonesia, Nepal, Zimbabwe and Peru.
Ian Easton’s book The Final Struggle explains Xi’s mindset. He believes that the goal of the CCP is to export communism to every country in the world. In Xi’s own words:
“The fundamental mission and aspiration of a Marxist political party is achieving [international] communism.”
And in a 2019 speech, Xi emphasized that he thinks international communism is within reach and can be realized soon:
“We will be master of the world! This is the final struggle. Unite together. Soon international communism will be realized.”
This attempt to achieve international communism is done under the flag of the so-called “community of a common destiny for all mankind”. But make no mistake, this “community of common destiny” is just a rebranding of Marx’s concept of a unified international proletariat.
So why is Xi obsessed with international communism? Probably the same reason he’s obsessed with Taiwan. Democratic systems show the Chinese people that there are alternative systems of governance, thus threatening China’s single-party rule.
According to Xi’s 2020 New Year speech, he emphasized that he wants to “ensure justice and equality for the world” by building an alternative set of institutions that take the Communist Party’s best interests into account.
In some ways, we’re simply going to the Cold War era. During that time, an Iron Curtain rose between the communist states of Eastern Europe and the West.
And in Asia, we had the so-called “Bamboo Curtain” that separated the communist nations of the USSR, Mongolia, North Korea, the PRC, North Vietnam and the rest of Asia.
Here is what the Bamboo Curtain looked like during the first Cold War, with the non-aligned nations painted with blue color:
I think we’re probably going to see a new Bamboo Curtain arise. China is trying to gain allies across Asia, converting other countries to its cause. In Xi’s own words:
"China maintains that all countries should make the correct choice for the future destiny of all mankind and the well-being of future generations by embracing the Community of Common Destiny for All Mankind.”
In practice, the CCP has started a number of initiatives to further its goal of international communism - or, as it’s now known, this “Community of Common Destiny for All Mankind” (人类命运共同体). These include the Belt-and-Road Initiative, the Global Security Initiative, the Global Development Initiative and the Global Civilization Initiative. Most plans that pushing for this community use the words ”Shared Future”. The “Community of Common Destiny for All Mankind” is meant to be completed by 2049 - the 100-year anniversary of the People’s Republic of China.
According to analyst Dan Blumenthal, in each of these friendly countries, the CCP aims to control manufacturing, currency exchange policies, trade, security, food, resources, immigration, the Internet, and human rights policies. Trade will occur whereby China sells manufactured goods, and they sell natural resources to China in return. That is the vision - for the countries to become deeply intertwined:
"They are assimilated into us, and us into them. We are becoming deeply fused together in a Community of Common Destiny."
People’s Liberation Army (“PLA”) documents quoted by Easton also show that PLA peacekeeping units will be placed in each of these countries to maintain stable political environments.
Foreign leaders will be trained by Chinese party officials in the realms of building a bureaucracy, lending them security forces, and generally instilling them in China’s quasi-socialist practices.
So, which countries are likely to become part of this Chinese-led trading system? Party documents have stated an alliance with Russia, Iran and the BRI countries. Other party documents suggest an alliance between BRICS countries, including Brazil and India.
I believe trade route considerations will decide this new Bamboo Curtain. For example, Pakistan and Myanmar offer China direct access to the Indian Ocean without passing through the Strait of Malacca. Other Asian allies include North Korea, Cambodia, Sri Lanka, Vanuatu, the Maldives, the Solomon Islands and Fiji.
Japan, Taiwan, South Korea and Australia have leaned towards the Western trading bloc. Southeast Asian countries such as Malaysia and Thailand seem neutral in this new power conflict.
The key question is what China’s “Community of Common Destiny for All Mankind” will mean for investors in its partner countries. The book "Fundamentals of Xi Jinping Thought" states that the state should control the global economy and markets. And that the market and the state will be “organically unified”, whatever that means. It seems pretty clear to me that the vision is for state-controlled markets in each of these countries.
Other implications include greater control over each country’s Internet, as we now see across 35 countries globally. Free trade agreements such as the RCEP will probably incentivise intra-bloc trade. Some have hoped that a Chinese Central Bank Digital Currency could be used as a payment method in partner countries, with the PBoC taking direct deposits and then controlling lending decisions.
What I fear most, though, is capital controls. There is a case to be made not to invest in the opposite bloc, as many European investors in Russian equities learned the hard way. I agree with Swen Lorenz that countries are moving in that direction.
Key takeaways: Decoupling remains ongoing, initiated by both the China-Iran-China bloc and Western governments. I think there’s a strong case to be made for avoiding investing in countries of the bloc, as capital controls could one day be imposed. But there could be broader implications if CCP-allied countries shift towards state ownership and control systems.
3. A potential annexation of Taiwan
Another constant worry is a potential communist invasion of Taiwan. This worry seems to come back every few years. However, I do think there are legitimate reasons to be concerned.
The Chinese Civil War never ended. The Republic of China's government fled to Taiwan, where it now rules over the island of Taiwan, along with the much smaller islands of Penghu, Kinmen, Matsu and Dongsha. In 1949, the CCP attacked Kinmen but failed to take over the island. There were further plans to attack the main island of Taiwan in 1951, but the CCP was distracted by the Korean War and had weak Naval capabilities at the time.
But today, the CCP is no longer lagging - quite the contrary. The PLA has 2 million active servicemen compared to Taiwan’s 200,000. Also, the CCP’s military spending is on the order of 15x higher than that of Taiwan. The PLA finally has a fighting chance.
When could Taiwan eventually fall under communist control? These are the clues that I have gathered so far:
At the 18th National Congress in 2012, newly elected General Secretary Xi Jinping promised to build up operational capabilities to use force against Taiwan’s government sometime around 2020.
Meanwhile, the director-general of Taiwan’s National Security Bureau Chen Ming-tong (陳明通) has said that the CCP will reach full military capability by 2023.
Taiwan's Minister of National Defense Chiu Kuo-cheng (邱國正) warned that China will be militarily capable of launching a full-scale invasion of Taiwan by 2025.
A leaked memo from US general Mike Minihan suggests that 2025 might be when the CCP feels ready to make a move:
“I hope I am wrong. My gut tells me we will fight in 2025… Xi’s team, reason, and opportunity are all aligned for 2025.”
In 2021, US admiral Philip Davidson said that the Communist threat to Taiwan would “manifest” within six years, i.e. by 2027.
More recently, Xi instructed the PLA to gain the capabilities to fight and win a “regional conflict” by 2027. He’s also set a target is for the PLA to become a world-class military by 2035.
In 2013, Xi Jinping said that the question of Taiwanese independence could not be “passed on from generation to generation”. He’s said this many times over the past decade. This language seems to imply that the annexation of Taiwan will take place under his tenure. Xi himself is 70 years old today and can probably rule for at least another ten years. That has caused some analysts to think that 2035 is the year.
The CCP has made it clear that it wants to deal with the “Taiwan issue” sooner or later. As I mentioned above, both the “China Dream” of national rejuvenation and the ambition to build a Community of Shared Future for the Benefit of Mankind have deadlines of 2049 at the latest. In the eyes of the CCP, by 2049, the “Taiwan issue” must have been dealt with.
In contrast, the top US military official General Charles Brown thinks that an amphibious landing remains a remote possibility and that the CCP would use more subversive methods to gain control over Taiwan’s government:
“I do think that [Chinese president] Xi Jinping doesn’t actually want to take Taiwan by force. He will try to use other ways to do this.”
But these are broad estimates. There are several reasons to think that an invasion will take place sooner rather than later.
For example, China has been stockpiling commodities at a rapid rate from 2020 onwards: crude oil, meat, rice and wheat, copper, aluminium, cobalt, semiconductor chips, etc. It’s not clear whether this stockpiling was due to COVID-19 or plans for other contingencies.
On 1 January 2021, Xi Jinping took full control over the military with a new defence law that took powers away from the State Council into his own hands.
The number of PLA aircraft crossing the median line has increased significantly over the past few years. And since mid-2022, these aircraft sorties have been continuous. This suggests that the PLA is either trying to wear out the Taiwanese pilots or engage in practice for an actual campaign.
In late 2022, the Politburo was updated with new members. Out of the 24 people on the standing committee, four comes from the defense industry. There are also two former generals and one intelligence analyst. There have not been this many representatives from the military in at least 50 years, signalling a break from the past.
So we’re definitely getting closer to the point of an actual campaign, whether it will materialize through a blockade, amphibious landing or something else.
As an outside observer, it’s probably impossible to know exactly what goes through the minds of the key decision-makers in Zhongnanhai. But if a campaign does go ahead, we will be able to tell 1-2 weeks in advance by observing reserves and militia units moving towards the Fujian and Zhejiang provinces, by seeing fighter jets flying low across cities like Shanghai practising for their missions, by the Taiwanese Internet being cut off, a greater number of civilian boats encroaching Taiwanese waters, etc.
I think it’s also important to note that the Russia-Iran-China bloc has now initiated conflicts across several battlefields: Russia invaded Ukraine, Hamas attacked Israeli civilians, Venezuela is threatening to invade Guyana, and the Chinese Communist Party is no longer precluding the use of force to take control over Taiwan. American defense expert Elbridge Colby believes that this is part of a Russia-Iran-China axis strategy to overstretch America’s ability to handle multiple conflicts at once. If war breaks out across multiple locations at once, America’s chances of helping Taiwan’s government in fending off an invasion will be much lower.
I believe that Xi Jinping is a conservative individual. A failed campaign would risk his entire career and perhaps even his life. Much safer to annex, say, Matsu Islands or Kinmen, and use that success to demonstrate how the party is getting closer to solving the “Taiwan issue”.
Key takeaways: Experts agree that the CCP will have the military capabilities to annex Taiwan from 2025 onwards. Presumably, it will happen during Xi’s tenure in the next ten years or so. But precise predictions can only be made weeks in advance as troop movements show up in satellite data. That’s what I will be watching.
4. Taiwan’s January 2024 election
In my latest portfolio update, I mentioned being shocked seeing Wigram Capital’s Rodney Jones believing in a non-zero probability of a communist blockade of Taiwan if the pro-independence party Democratic Progressive Party (“DPP”) wins Taiwan’s January 2024 election. Such a blockade would have important ramifications not just for Taiwanese equities but for global stock markets overall. Just think of the impact a blockade would have on global supply chains.
I believe the DPP will win the election. But I doubt that there would be a forceful reaction from the CCP, such as a full blockade or an invasion. Let me clarify why.
Taiwan’s presidential election will take place on 13 January 2024. There are currently three main candidates for the position:
The currently ruling party DPP’s Lai Ching-Te (賴清德), who believes in Taiwanese independence from mainland China and a continuation of the status quo. He belongs to the “green camp”. The DPP is overtly anti-communist and wants Taiwan to maintain its independence from CCP-controlled mainland China.
Also on the ballot are Kuomintang’s (“KMTs”) Hou Yu-ih (侯友宜), who has the support and is the preferred candidate of the Chinese Communist Party. KMT is known as the “blue camp”.
Finally, you have former medical doctor Ko Wen-je (柯文哲) of the newly formed Taiwan People's Party (“TPP”), belonging to what’s known as the “white camp”. The TPP also wants a closer relationship with mainland China.
This election might determine the future of Taiwan as an independently governed nation. In 2014, the Taiwanese legislature nearly passed the Cross-Strait Trade and Service Agreement, which would have given the CCP full control of logistics and trade flows to and from mainland China. This law was only discarded after heavy protests that came to be known as the Sunflower Movement.
If the TPP or the KMT wins the January 2024 election, the legislative process for the Cross-Strait Trade and Service Agreement will probably restart, tilting the scales in the CCP’s favor, as it will allow mainland entities to buy Taiwanese banks, healthcare companies, tourism agencies, film studios, telecommunication and publishing houses. So, this election is important for the CCP.
On Xi Jinping’s mid-November trip to the United States, he expressed his wish for the United States not to interfere in the Taiwanese election:
“Xi aggressively warned Biden against arming Taiwan and also urged him not to support Taiwanese Vice President Lai Ching-te in his presidential bid ahead of elections in January”
Behind the scenes, the CCP has used its United Front Works Department to influence Taiwanese politics through grassroots organizations and social media apps such as Douyin. It also opened a tax probe on independent candidate Terry Gou’s company, Foxconn, the largest supplier to iPhone maker Apple, to get him to resign. And up until mid-November, TPP and KMT candidates Ko Wen-Je and Hou Yu-ih have slowly gained ground on the DPP’s Lai Ching-te.
However, I believe that this data is no longer that relevant. On the presidential candidacy registration date of 24 November, Lai Ching-te announced he was teaming up with highly regarded diplomat Hsiao Bi-khim as his running mate. Hsiao speaks perfect English and has strong connections in Washington, DC. The “Vote for Taiwan” campaign sends a message that the pair will safeguard Taiwan's security in the next presidential term. I can tell that this message resonates among voters.
Another reason to think that Lai Ching-te will win is the failed coalition between the KMT and TPP. The CCP allegedly tried to mediate a collaboration between the two candidates, whereby the KMT leader would become the president and the TPP would assume some subordinate role. But on 24 November, the coalition announced it had broken up. So Lai Ching-te only needs to get the highest number of votes in absolute terms.
What does the DPP’s Lai Ching-te’s likely victory mean for geopolitics? It's difficult to say, but January is a terrible time to organize a blockade or an amphibious landing. The weather conditions are tough, with waves over 10 metres high. There’s also not much sign of a conflict in the very near term. For what it’s worth when the DPP’s Tsai Ing-wen was elected in 2016, there wasn’t much of a response from the CCP. I expect a repeat of that scenario in 2024.
Key takeaways: Polls suggest that the DPP’s candidate Lai Ching-te, is in a narrow lead, though the failure of the KMT-TPP coalition probably means that he will win. The base is that there might be some sabre-rattling right after the election. But a full blockade in January seems unlikely, in my view.
Conclusions
There’s a good case to be made that one should have too much exposure to Greater China equities, given Xi’s ambitions regarding state control and ownership and the decoupling that’s taking place globally.
At the same time, Chinese equities are incredibly cheap right now. Perhaps investors are over-emphasizing the above risks, just as they ignored them in early 2021. With an almost 40% exposure to Hong Kong-listed equities in my Asia-focused portfolio, I’m implicitly making that bet.