The Trump Dump: war-gaming the next move against China
2 June 2019
Both sides in the US-China trade war appear to be digging in for a long-term battle of ideologies - the US battling for capitalism and open markets, China battling for socialism, central planning and protectionism, baulking at the idea that it should commit to free and fair trade by opening its markets to foreign competition and ownership on a level playing field. The Chinese position is entirely to be expected, because it's right there in the PRC Constitution:
"7. The State-owned economy, namely, the socialist economy under ownership by the whole people, is the leading force in the national economy. The State ensures the consolidation and growth of the State-owned economy."
And although the constitution since a 2004 amendment allows for the private sector, it is very much an appendage to the state-led approach:
"11. The non-public sectors of the economy such as the individual and private sectors of the economy, operating within the limits prescribed by law, constitute an important component of the socialist market economy.
The State protects the lawful rights and interests of the non-public sectors of the economy such as the individual and private sectors of the economy. The State encourages, supports and guides the development of the non-public sectors of the economy and, in accordance with law, exercises supervision and control over the non-public sectors of the economy."
No large-scale economy on Earth has delivered enduring prosperity to its citizens without giving them all the rights and liberties of open society and divesting the state of large-scale involvement in the allocation of capital. China, by relaxing basic controls since 1979, has raised GDP per capita to around a quarter of OECD levels, but it simply cannot centrally-plan its way to OECD levels of prosperity. Unfortunately, the current leadership, with Xi Jinping as the "Core" and surrounded by yes-men, does not recognise that, and believes it can steer China to a socialist "completely developed country" by 2049, the 100th anniversary of the Communist takeover of China, masterfully allocating capital as only the Party knows how. It may still take years of economic stagnation before they discover that they are wrong.
The capital threat
So far, all of the Trump Administration's economic actions against China (with the exception of actions against particular companies for alleged sanctions-busting), have been focused on the trade account: imports of Chinese goods to the US, with escalating tariffs now threatening to add 25% to the cost of all Chinese goods entering the USA. Forgive us for pointing this out and waving a Chinese red flag at this US bull, but Mr Trump and his advisers have so far ignored another huge potential area of sanctions, namely the capital account.
How long will it be before they realise that hundreds of billions of dollars of US pension funds, mutual funds, foundations, endowments and 401(k) retirement plans are invested in the stocks and bonds of Chinese companies listed in the US, HK and the mainland, many of which are either state-controlled or heavily influenced or protected by the Chinese government? Not only that, but some of the world's biggest asset managers are also US-headquartered - the likes of Fidelity, Blackrock and Capital Group manage not just the assets of US citizens but of other citizens around the world, investing their money in Chinese securities.
In the opposite direction, China applies very strict controls to the outflow of its citizens' capital, restricting them to contrived schemes like the Southbound HKEX "Stock Connect" (mostly investing in Chinese companies) and limiting foreign exchange purchases to USD50k per citizen per year and overseas cash withdrawals to CNY100k (about USD15k) per citizen per year. It's one way that the Chinese Yuan is propped up against overseas currencies, and if you need any evidence of the over-valuation of the CNY and the way capital is trapped, then look at the premium at which mainland A-shares trade to the H-shares of the same company. The shares are economically equal but, at current exchange rates, the A-shares are priced at a 26% premium to their HK counterparts.
When each side has exhausted the potential for trade-damage by tariffs (and the US has inflicted all the self-harm it can bear), if not sooner, we would not be surprised to see Mr Trump apply capital sanctions and force US Persons to dump their holdings of Chinese equities and bonds. They have potentially wide scope to do this, using the US Treasury's Office of Foreign Assets Control (OFAC). According to its web site:
"[OFAC] administers and enforces economic and trade sanctions based on US foreign policy and national security goals against targeted foreign countries and regimes, terrorists, international narcotics traffickers, those engaged in activities related to the proliferation of weapons of mass destruction, and other threats to the national security, foreign policy or economy of the United States."
OFAC's powers were demonstrated in Apr-2018 when it ordered US Persons to divest, and stop dealing with, Russian aluminium firm United Company Rusal plc, on the grounds that it was controlled by a man who is close to the Russian regime. OFAC cited the regime's occupation of Crimea, support of President Assad's regime in Syria, and attempts to subvert Western democracies. US Persons were ordered to divest Rusal within a month. The HK-listed shares plunged, and for a while it was even impossible to get a stock price from US-based information providers, who were prohibited from dealing with the firm. Index-providers and credit-ratings agencies also had to drop coverage. Eventually the sanctions were lifted following a rearrangement of directors and shareholdings.
We have some distance still to go on the tariff front, but we would be amazed if the economic war-gaming in the US Treasury Department has not already begun to consider capital sanctions, and could introduce them either in parallel or after the next round of tariffs. OFAC might first be used to order US Persons to divest from all PRC state-controlled companies such as those in the banking, petroleum and petrochemicals sectors, before moving on to target private sector companies which have established Communist Party Committees within their Articles of Association, embedding the Party in the company. Such entities are not as "private-sector" as they claim to be.
After all, it is somewhat inconsistent for the US on the one hand to complain that the PRC Government directs the allocation of capital and subsidies to state-controlled enterprises and favoured sectors and protects them from foreign competitors, while at the same time allowing US persons to fund the same enterprises via the international stock and debt markets, whether in HK, the mainland or overseas.
Apart from the price-impact of such a large-scale dump (which depends partly on the timeframe), the direct impact on US funds from depriving them of the ability to invest more cash in Chinese equities and bonds (particularly those which are government-controlled) would be relatively minor, as they have other global opportunities for their capital. It might even improve their portfolio performance in the long run, if we are right that the centrally-planned economy will fail to deliver sustainable growth in its present form.
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