The London Brief - July 31st, 2021

The London Brief

July 31st, 2021

During World War I, the impact on Japan’s economy was uncertain. But it soon became apparent that it was a bonanza due to the increased demand for Japan exports. While Japan products were generally inferior to Europe’s, they could substitute for European products which were unavailable. An export-led boom followed.

By the end of the Meiji period, Japan emerged as a threat to the West (especially the U.S.) and East Asia. A foreign minister named Kijiro Shidehara pursued a diplomatic reconciliation policy. Shidehara believed a good relationship with the U.S. was important and that Japan had a responsibility to achieve global peace and prosperity. He wanted to protect Japanese interests in China by non-military means.

In a 1925 speech he said, "At present, there is clearly a global movement toward solving all international issues through understanding and cooperation among concerned powers, and not by narrowly self-serving policies, excessive use of militarism or interventionism. ... Japan is no longer permitted an isolated and independent existence in the Far East, interested only in its own affairs. As a major member of the League of Nations, Japan now bears a heavy responsibility for promoting world peace and happiness of the human race. Japan must participate in the discussion of all these important issues, even if they have only indirect influence on Japan's own interest. The fact that Japan must bear such responsibilities is beyond the question; it is necessitated by the force of history.”

Unfortunately, Shidehara’s policy of no military intervention was severely criticized by the military. Hardliners claimed that it was “coward diplomacy.” Even the mass media blamed Shidehara for being too soft. Japan sent troops to China and then the Manchurian Incident broke out in 1931 and Shidehara’s call for an immediate peace was ignored.

History Rhymes

In July, Rush Doshi published The Long Game: China’s Grand Strategy to Displace the American Order. Doshi’s thoughts are relevant as he is one of five members of the China-related National Security Council. The book makes a compelling case that China is using diplomatic, informational, military and economic strategies in a coordinated way to eventually dominate Asia by 2049, in line with the CCP’s announced plans. “A fully realized Chinese world order would involve the withdrawal of U.S. forces from Korea and Japan; the end of American regional alliances; the removal of the U.S. Navy from the Western Pacific; deference from China’s regional neighbours; unification with Taiwan; and the resolution of territorial disputes in the East and South China Seas. Chinese order would be more coercive and benefit elites at the expense of voting publics.”

Over the past year, we have seen Jack Ma disappear to Hainan for re-education, and many other reformist elements have faced corruption charges or fled the country. CNBC’s Beijing correspondent said that normally at social gatherings, people would speak freely on a non-attributed basis about Chinese policy; today everyone is too afraid to say anything. In Hong Kong, national security police arrested five teachers for conspiring to commit sedition through children’s books that portray sheep being targeted by wolves, an allusion to China’s crackdown on pro-democracy supporters in the city. Pan Shiyi, a real estate tycoon, was said to have fled to America. He is currently attempting to sell Soho China to Blackstone, and the deal is said to be encountering difficulties because of the founders. His crime is having a son who questioned the Chinese casualty count on the India/China border (Russian media said 50 and China said none at the time). According to blogs, he also has two friends who have been jailed for various crimes after one posted an essay on human rights. A Chinese activist who supported “Ink Girl”, who shared a video of herself splashing ink on a portrait of Xi Jinping, was charged with subversion and said, “So many people have left China in the past few years. We can’t have everyone leave. I think there’s more value to the struggle on the ground in China. The more dissidents leave China, the more need there is for someone to remain and persist.” Didi committed the crime of listing in the U.S., when at the last minute, China told them not to. The stock has fallen 35% below its IPO price as China has put the company under a regulatory probe. In August, Beijing plans to impose new laws in Hong Kong and Macau that would give the state broad powers for asset seizure, visa denial and deportation against those it says enable foreign sanctions. The New York times reported that an exiled expat Uighur activist had a niece who died in state custody; two of his siblings have been detained and imprisoned. Radio Free Asia reported that 50 relatives of its journalists have been detained in prison and in the camps.

China also conducted a major crackdown on the education sector. New Oriental Education plunged 40%. Koolearn Technology tumbled 35%. China said the education sector had been “hijacked by capital.” The new regulations prevent firms that teach school curriculums from making profit, raising capital or going public. JPM said, “The worst-case became a reality. It’s unclear what level of restructuring the companies should undergo with a new regime and, in our view, this makes stocks virtually un-investable.”

Earlier in the year, there were concerns that China was about to invade Taiwan. This past weekend, Xi Jinping released a policy statement, asking the military to make resolute efforts to become the world’s best army by 2027, on par with the U.S. 2027 marks the centennial of the founding of the People’s Liberation Army (PLA). He stressed that the PLA must function under the party leadership (ie – him). “On the path of completely building a modern socialist country and realizing the second centennial goal, national defence and the military must be placed in a more important position, and the consolidation of national defence and a strong military must be accelerated.”

Nationalist trends are not just Chinese. Vladimir Putin wrote a 5,000-word essay about the ‘historical unity’ of Russians and Ukrainians. But China’s ambitions seem much more audacious. Russia’s growing ties with China are a bit short-sighted. A year ago, Chinese ‘netizens’, who seem to have a lot of influence on the leadership, claimed Vladivostok used to be a part of China. They claim it was Qing’s Manchurian homeland but was annexed by the Russian empire in 1860 after China was defeated by the British and French during the Second Opium War. The netizens were also not very enthusiastic about Britain’s warship vacationing through the South China Sea. Chinese state media said, “If the UK wants to play the role to coerce China in the South China Sea, then it is being a bitch. If it has any substantial move, it is asking for a beating.”

That said, many China watchers view the recent events as a buying opportunity. Ray Dalio, for instance, says:

“I understand that it’s confusing to people who are not close to what’s happening. Since I started going to China 36 years ago, I have found that most Western observers who do not have direct contact with policy makers’ and don’t follow in detail the patterns of the changes have tended to not believe that the Chinese Communist Party’s usage of capital markets to foster development is real. They interpret moves like these two recent ones as the Communist Party leaders showing their true anti-capitalist stripes even though the trend over the last 40 years has clearly been so strongly toward developing a market economy with capital markets, with entrepreneurs and capitalists becoming rich. As a result, they’ve missed out on what’s going on in China and probably will continue to miss out. In this case the policy makers signalled to DiDi that it might not be best to go ahead with the listing and they understandably want to deal with the data privacy issue. In the case of the educational tutoring companies, they want to reduce the educational inequality and the financial burden on those who are desperate to have their children have these services but can’t afford them by making them broadly available. They believe that these things are better for the country even if the shareholders don’t like it.

I remember a number of such analogous misinterpretations. For example, I remember how the Chinese retail investor bubble bursting led to government stock buying and then the government trying to manipulate the market for a while. Also, I remember the Chinese currency plunge in 2015-16 resulting from the PBoC widening the band and how that led to many investors pointing to these developments as evidence that policy makers were turning away from developing capital markets. Some skeptical investors looked at these moves as inappropriate anti-free market interventions even though these same moves happened many times in many capitalist markets and even though the fiscal and monetary policy interventions in the U.S. and other developed markets dwarf the Chinese government interventions in its markets. Through it all Chinese policy makers successfully managed the fallout and pursued their goals; i.e., the direction of their actions never changed. It has been in support of a fast and steady development of capital markets, entrepreneurship, and openness to investment to foreign investors. So, I encourage you to look at the trends and not misunderstand and over-focus on the wiggles.

To understand what’s going on you need to understand that China is a state capitalist system which means that the state runs capitalism to serve the interests of most people and that policy makers won’t let the sensitivities of those in the capital markets and rich capitalists stand in the way of doing what they believe is best for the most people of the country. Rather, those in the capital markets and capitalists have to understand their subordinate places in the system or they will suffer the consequences of their mistakes. For example, they need to not mistake their having riches for having power for determining how things will go.

You also need to understand that in this rapidly developing capital markets environment Chinese regulators are figuring out appropriate regulations so, when they are changing fast and aren’t clear, that causes these sorts of confusions, which can be misconstrued to be anti-capitalist moves.

Also, you need to understand that the global geopolitical environment changing leads to some changes. You can see that reflected in the U.S. governments’ policy shifts such as a) changing its policies about Chinese companies’ listings in the United States and b) threats to prohibit American pension funds from investing in China.

Assume such things will happen in the future and invest accordingly. But don’t misinterpret these wiggles as changes in trends, and don’t expect this Chinese state-run capitalism to be exactly like Western capitalism.”

But I disagree with Dalio. I’ve been following China for several decades and while China made policy mistakes, and would take ad hoc decisions, they generally left their entrepreneurs and private sector alone. Most of the people Dalio has met has been from this class. The party officials who meet with foreigners are quite urbane, but they are people like Cai Esheng, formerly of the CBRC, who was just arrested. The ultranationalists and the military tend to not meet foreigners, and certainly wouldn’t meet a hedge fund manager. Under Xi, in alliance with these groups, there has been a trend towards state ownership and absolute control including countless hours studying Xi Jinping thought. In some respects, this is similar to the Russian transition in 2007 as Putin forced all the oligarchs to report to him and created a mafia sort of state. This was negative for foreign investment into Russia and the old adage, “Never invest in Russia” has saved money for many investors over the years. But in Russia’s case, much of the general population is just living life. Outside of the Ukraine and dreams of greater Russia from immediately surrounding states, there doesn’t seem to be a dream to recreate the ambitions of the Soviets.

In China, the ultranationalists are scarier. In the Olympics, when the Japan team won in mixed double table tennis against its Chinese opponents, ultranationalists wrote a torrent of abuse. "Got tons of DM from a country telling me to 'Go to hell! P*ss off!', but I'm totally OK as I'm used to such comments. I'm just happy that I got the whole world excited. All messages from Japanese are cheering me, thank you!" he wrote in the tweet. More abuse followed for Daiki Hashimoto, who narrowly won against a Chinese opponent in gymnastics:

“The anger, first set off on Chinese social media, soon spilled over to platforms typically censored in China. Chinese nationalist trolls circumvented the Great Firewall and descended on Hashimoto's Instagram account, inundating his feed with angry comments and tagging him in insulting posts. Many called Hashimoto Japan's "national humiliation," while others accused him of stealing China's gold medal. Some even tagged him in photos of the atomic bombings of Hiroshima and Nagasaki. Some of the accounts attacking Hashimoto appeared to be created specifically for this purpose, with their entire feeds filled with posts targeting the Japanese gymnast. Hashimoto later changed the privacy settings on Instagram, so he could no longer be tagged on the platform -- but angry comments have kept pouring in under his posts. The attacks and harassment are emblematic of the rising tide of ultranationalism sweeping through social media in China, which has silenced many of the country's more liberal and moderate voices online. The nationalist sentiment against Japan has often flared, due to deep-rooted rancor against Japan's invasion of China in World War II. Other Chinese netizens criticized the online abuse and called for an end to it, but they were also attacked.”

This brings us back to Shidehara. Clearly if reform elements had prevailed in Japan, history might have been very different. Unfortunately, it doesn’t always go that way.

End Note

The Economist had an interesting article on drug dealer wages. One American study found that lower-ranking dealer averages a mere $5.80 an hour. With the hot labour market, drug syndicates are facing huge wage inflation pressures. Furthermore, with GPS tracking, location tags and demands from bosses from frequent on-line check-ins, workplace stress is rising, particularly since the penalties tend to be physical. Drug dealers are now calling on the Fed to raise rates. I’m also glad I have trouble with small boats and seasickness, otherwise I’d be very unhappy about the yacht shortage that’s plaguing the U.S. coasts.

Cobham, Surrey

July 31st, 2021