20 Sept 2024
Global Geo-political and Macro-economic Update
Introduction
In this newsletter after a brief update on geo-political events we will focus on China. Why? Because China is now dominating the global economy even though it may have challenges in its domestic property and consumer spending markets. The so-called strategy of containment articulated by the western media is nonsense. China’s population is 1.4 billion, including a middle class of over 500 million and growing which is larger than the entire US population. China has the second largest economy in the world with a Gross Domestic Product (GDP) of around USD19 trillion and has the 2nd “strongest” military in the world after the US.
Geo-political analysis
Geo-political events continue to move quickly. Since our last newsletter, the war in the Middle East has continued to lurch toward a major regional conflict with the assassination of the Hamas leader and chief negotiator, Haniyeh that Iran has vowed to retaliate too, even though all the major players say they do not want a war.
For many years, BRICS countries notably China and Russia have adopted a neutral position on Israel and Palestine; however, this appears to be changing with Palestinian President Abbas being invited to attend the next BRICS summit. Israeli Prime Minister, Netanyahu has not received an invitation. China is also highly offended by Israel’s assassination of Haniyeh whom only weeks before had visited China on the invitation of President Xi Jinping.
In the Ukraine/Russia war, the surprise attack by Ukraine on Russian territory and the NATO supplying Ukraine with F35 fighters and locating missiles in Sweden are further examples of escalatory steps. Again, all parties say they do not want a wider war, so hopefully wiser heads will prevail. We are less hopeful about Israel/Palestine as that conflict has been going on for 75 years.
BRICS: Stampede
We have been reporting on developments around BRICS for many years now, e.g., trading in local currencies rather than US dollars, and the impacts these changes are having across the global economy. In the last 12 months, there has been a stampede to join BRICS with 40 countries expressing interest even though two of the last round of invitees have changed their minds on joining. Saudi Arabia is sitting on the fence mostly from US pressure because of their security arrangement, while a change in government in Argentina saw it backflip on joining BRICS. Turkey, a NATO member has applied to join BRICS. In response to the significant interest to join, it is reported that BRICS has suspended new membership while it works on its mission, membership framework and governance.
BRICS: New Development Bank v International Monetary Fund
The BRICS, New Development Bank (NDB) is a competitor to the International Monetary Fund (IMF). The NDB has adopted two important different features to IMF loans:
The NDB lends in the borrowing country’s local currency which means it is not exposed to fluctuations in the value of the US dollar. This is unlike IMF loans that are in US dollars which means the borrowing country is subject to foreign exchange risk, so as the value of the dollar rises the borrowing countries interest payments increase, placing additional strain on the countries financial position.
The NDB loan conditions are less stringent without harsh austerity requirements. IMF loan conditions normally involve austerity measures, i.e., reducing government spending and privatisation of government assets, which generally lead to a recession and a currency devaluation, which in turn increases interest payments on the IMF loans. A self-fulfilling downward spiral which Greece is the good example of the impact of austerity measures under IMF loan conditions.
Japan joins China in reducing its US Treasury holdings
Japan that has been a major buyer of US treasuries, thus funding the US budget and national debt. It has changed course and is now selling down its US treasury portfolio, as it seeks to address its own economic problems, e.g. reducing its 250% debt to GDP ratio and because of the negative real returns on the US treasuries it holds.
US Interest Rates
The US Federal Reserve (US Fed) has lowered its Federal Funds Rate target by 0.50%. This has again sparked a rally in US share prices. We have discussed in newsletters (See Newsletter dated 27 October 2023) how equity markets have continually been front running the US Fed in anticipation of a rate reduction. In contrast, the Governor of the Reserve Bank of Australia (RBA), Michelle Bullock recently indicated that interest rates would remain on hold for some time in Australia. Consumer Price Index (CPI), unemployment and GDP figures and our global trading partners interest rate moves will determine, the RBA’s next step.
Despite the Federal Funds Rate cut, we do not see long term rates also falling, rather we see them remaining as is or increasing for many reasons. Specifically, the US budget deficit (USD3 trillion) and national debt (USD35 trillion) must be funded and with China and Japan reducing their holdings, the US must either increase taxes (politically not possible), monetarise the debt (print money which increases inflationary pressures and ultimately higher yields) or increase bond yields to attract investors. Bond markets will force yields to rise, the question is when? Higher bond yields mean higher costs of corporate debt and mortgages which flows through into lower corporate earnings and household disposable income, respectively.
China
Many Global North (“the West”) folks are understandably concerned about the rise of China because it is not a democracy, and they have only ever known US hegemony which has served their interests. It is important to consider Chinese history. Specifically, in China’s thousands of years history, there is no record of it having a democratic period, as we know it in western civilisation. Therefore, it is naïve to think China will switch to being a democracy soon, so rather than talk about containment, “the West” needs to consider a more objective approach to its relationship with China. We recognise there is a difficult balancing act between appeasement and confrontation; however, “the West” talking of containment does not sit well with the Chinese given its economic strength, population size, and increasing military presence and capability, thus its actual and perceived position in the world.
Putting aside Taiwan, China across the globe has pursued an expansionist policy based on friendship and mutual interest, rather than adoption of the 19th century colonialists’ model, e.g., the US has 750 military bases in 80 countries compared to China’s 1. As part of this policy, China has also been positioning itself as an independent mediator, e.g., Iran and Saudi Arabia rapprochement and peace between Palestinian factions, where the US has disqualified itself because of its bias.
Unlike the US, China does not have the natural resources to be self-sufficient. Therefore, its foreign relations policy is aimed at ensuring there is sufficient energy and food for its population, as it does not have enough of either to meet its needs. The Belt and Road initiative is fundamental to this policy and is now 13 years old and is no longer just an idea.
Over the last 40 years China has become an economic powerhouse, and its growth is continuing despite US efforts. In July 2024, China recorded a record trade surplus of USD100 billion for the month of July, despite US tariffs and sanctions. This places China economically in a very strong position as it also now controls many of the supply chains across the globe, e.g., solar panels, semi-conductors, rare earths, etc., and it is the manufacturing centre of the world. The Belt and Road initiative reduces its reliance on “the West” that will become suppliers of last resort.
China: US dollars and Yuan
In our newsletters, we have explored the future of the US dollar as the world’s reserve currency, including examining BRICS initiatives around de-dollarisation. Many commentators have speculated that the Chinese Yuan will eventually takeover as the world’s reserve currency, or that a product similar to the IMF’s Special Drawing Rights (SDRs) would evolve or that a gold type standard would be re-instated. However, closer consideration of China’s actions reveals that China seems content for the US dollar to continue as the world’s reserve currency. Why? Because it now trades in both US dollars and Yuan and has major surpluses in both currencies. With respect to US dollar surpluses, rather than investing the funds in US treasuries and then being caught within the US controlled Society for Worldwide Interbank Financial Telecommunications (SWIFT) system, it is now lending those US dollars directly to “friendlies” outside the SWIFT system. These “friendlies” need US dollars and China is happy to oblige without the risks of US confiscation, as occurred to Russia. Equally, it is earning Yuan which Chinese banks can also either lend to “friendlies”, thus assisting in the Yuan becoming a reserve currency, or use the funds domestically.
As part of the global trend to de-dollarise (defined as using non-US banks to do business) we see two trends are emerging:
Heavily US sanctioned and Global South countries are now trading commodities and products in Yuan, e.g., India is buying oil from Russia in Yuan.
Global South countries and companies are using crypto currencies to trade. Notably, Tether developed in Venezuela in response to US sanctions is a stable coin where 1 tether equals 1USD and uses blockchain technology to trade in the private markets outside the US controlled SWIFT/Banking system. Tether is doing more business than the Visa credit card network and is making more profits than BlackRock, the largest asset manager in the world, with only 100 employees making a profit of USD6.2 billion with 300 million users.
BRICS is introducing a new trading system so that BRICS countries do not need to trade and settle in US dollars. Over many years folks have observed that trade for instance between Australia and New Zealand is effectively in US dollars (AUD to USD then USD to NZD) with settlement controlled by SWIFT provides US banks the opportunity to take a clip. There is understandable push back against US banks earning a fee for a transaction that does not involve the US. Why should an Australian farmer selling wheat to New Zealand need to use an American bank as part of the transaction?
A second important aspect of the SWIFT model is price discovery. These transactions are US centric as they are based on template US contracts, involve US exchanges, e.g. Chicago Board of Trade, and US banking system, it means that the US government, traders, analysts, etc., can see the volumes/prices and the buyers and sellers. Built into the current system is a feedback loop where data is collected and analysed which is important for understanding world trade movements and product pricing. This loop disappears with the BRICS platform as it is said that it will use blockchain technology and be a private, not public platform. If this is correct, it means that as the buyers/sellers effectively trade secretly as the trades are not reported in global trade figures which will then have significant gaps.
China: Price maker not taker
Earlier this year China cancelled huge wheat orders from the US (500,000 tonnes) and Australia (1million tonnes). At that time folks were guessing as to why? In hindsight (months later not days as under the old system no longer used by BRICS), it has been revealed that the orders were filled by China from its record harvest, while Russia and Brazil sold at cheaper prices at the time unbeknown to the Australia and the US sellers.
In Australia, local media is reporting the drop off in Chinese demand for iron ore is because of a slowdown in the Chinese property and infrastructure market, however this is not the full story. If China is buying iron ore through the BRICS platform or in local currency of alternative suppliers as outlined above, then these transactions are not captured by SWIFT, and not reported.
Simply, China has moved from a price taker to a price maker.
China: Common Prosperity Policy v Highly competitive market
China has a Common Prosperity policy which appears to be at odds with its highly competitive economy where companies are allowed to fail, e.g., Evergrande property giant was allowed to fail without a Chinese government bailout, unlike in the US where a too big to fail policy has evolved following the collapse Lehman Bros. US regulators have identified certain major US banks as too large to fail and have created policies in respect to these institutions, ironically the US approach is not consistent with capitalistic values of allowing companies to fail.
This Common Prosperity policy appears to be working, as China is now focussing on increasing the wealth of its regions, as factories are moving out of the major cities to cheaper regional and country areas, thus driving down costs which is deflationary. Whereas, the “reshoring” and "friendshoring” of US companies is inflationary as the costs of doing business in the US is much greater than in China.
Financialisaton: US v China
There are 2 important points:
China is the world’s largest creditor country, and the US is the world’s largest debtor. We are not aware of any time in history when the world’s largest creditor country (China) has lent the currency of the world’s largest debtor’s country, i.e., USD. China earns USD2 billion every day and lends/invests it, particularly to Global South countries on infrastructure activities and the Belt and Road initiatives, e.g., ports, to guarantee supply chains for its energy and food requirements.
The days of saying “Wall Street” does not reflect “Main Street” are over in the US, as 90% of Americans own stocks either directly or through their pension funds. US companies Nvidia, Apple, Microsoft, Alphabet Amazon, Meta, Berkshire Hathaway and Eli Lilly combined have a market capitalisation of more than USD25 trillion, which equates to the US GDP of USD25 trillion. Does this mean that the S&P 500 index and US economy are one and the same? Whereas, only 10% of Chinese own stocks which reflects that old adage “Wall Street” does not represent “Main Street” applies in China.
China leading the world
China is leading the world in many areas:
China is now considered easier to do business than the US according to international surveys on business competitiveness. For the 1st time ever there are reports that show the US is outside the top 10 for easy of doing business. For many years the US ranked in the top 3 now it ranks 12th.
China is now leading the world in nuclear energy. It has achieved 1st mover advantage in nuclear fusion through Energy Singularity, a Shanghai based company that became the 1st company in the world to build and operate a Tokenmac nuclear reactor. It uses high energy super conductor materials. Energy Singularity owns the patents and will likely set the standards that others will need to adopt.
In the last 20 years, China has built 55,000 miles of “bullet” train tracks compared to the US that in the same timeframe built 100 miles.
Two major developments are occurring in the education sector. The first being fewer Chinese students are studying in western countries, and secondly Chinese students that studied abroad with the intention of staying there are now returning to China as the work opportunities are better and the standard of living is much higher than when they left. Chinese universities are producing more scholarly papers than US universities. Half of the Artificial Intelligence (AI) scientists in the US are either Chinese, Indian or Iranian.
In 6 years, China has become the largest car producer in the world. Build Your Dreams (BYD) is the largest producer of Electronic Vehicles (EVs) in the world and can sell them at USD11k or less than half the price of the Tesla base model which is why the US has introduced 100% tariffs on Chinese vehicles.
The above provides a snapshot of the changes occurring which will impact all of us in the coming years.
Key take aways
In summary:
We are not aware of any time in history when the world’s largest creditor country (China) lends the currency of the world’s largest debtor’s country (USA).
China is starting to lead the world in innovation.
China continues to be the manufacturer to the world.
China is no longer a price taker as reflected in commodity prices.
China controls the major supply chains.
China lower costs structures are deflationary whereas “the West” is still under inflationary pressures.
China continues to have record trade surpluses as its earning USD2 billion per day in both US dollars and Yuan, thus positioning it as a provider of investment capital.
Both US Democrats and Republicans are pursuing an anti-China policy and China is pushing back which will hurt the US and its allies.
A re-think of “the Wests” approach to China is required.
Postscript: We have been anticipating a reduction in dividends by Australian companies, especially the miners, because of the fall in commodity prices. BHP, Woodside etc., recent dividend announcements confirm this to be the case.
General Advice Warning: Any advice or information provided is general advice only and has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any General Advice provided, you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs. If you wish to discuss the contents of this newsletter, please do not hesitate to contact us.