China and Hong Kong: 'One country, two systems' becomes 'one world, two camps'
- China law on Hong Kong security bypasses its legislature and likely triggers renewed protests in HK, friction with US
- China priorities are national security, social cohesion; as economic growth fades expect reversion to more coercion
- Higher risk for China A Shares from US weaponisation of capital, and Hong Kong assets (property) from expat exodus
China is reportedly about to pass a new law, under the banner of national security, to prevent foreign interference, terror, secession, sedition, and subversion in Hong Kong. It may also be used to effectively prohibit dissent.
The passage of the law by China’s National People’s Congress (NPC) could effectively circumvent Hong Kong’s own legislature by adding it to those national laws which must be observed in Hong Kong (under Annex III of Hong Kong’s Basic Law).
Below we explore the local Hong Kong, China, global geopolitical and investment implications of this.
The local context is the following:
- Hong Kong legislature elections are due in September 2020 (the Chief Executive is not directly elected).
- Senior Chinese national government representatives were replaced earlier this year (eg the head of the Liaison Office) after 2019 saw
- Violent protests on an unprecedented scale (involving c15% of the population and sparked by opposition to a locally proposed Extradition Bill, which ultimately did not pass into law).
- Local elections in November which resulted in a resounding 90% victory for “pro-democracy, yellow” parties (compared to a 70% victory for “pro-Beijing, blue” parties in 2015) with over 70% turnout (compared to under 50% in 2015).
- A major negative impact on economic activity.
In 2003 there were also large scale protests against a locally proposed Sedition Law (Article 23 of the Basic Law, which ultimately was not passed).
The key question is whether a Tiananmen Square moment is approaching which triggers a lasting exodus of multinationals and expatriates from Hong Kong?
Modern social media makes it much more difficult to control and contain the narrative from a brutal crackdown. An expat exodus would certainly put Hong Kong real estate to another stern test but, equally, multinational corporates have shown repeatedly that moral outrage does not last long, if at all, in comparison to the pursuit of profit.
China political risk
The national Chinese context is that security is paramount in a country where the central government’s grip over its vast swathe of provinces has, over the course of the country’s history, not always been assured, and the social binding from economic growth (which has in recent decades mattered as much as coercion) is at risk from domestic debt, pressure on exports and aging demographics.
The key question is whether China can reinvigorate its economic growth model to keep social cohesion intact and the current leadership on track, or whether there is a reversion to greater reliance on political repression (ie the model of the Communist Party prior to Nixon’s detente and Deng Xiaoping’s reforms either side of Tiananmen Square)?
Given its domestic debt and demographic challenges, the marginal driver of growth may still be more dependent on external demand factors than domestic ones; ie there is a limit to how much the government, on its own, can restore growth to previous rates.
The global context is that relations with the US are perhaps at, or heading towards, their worst since the Nixon 1972 detente (which prized China away from the orbit of the USSR).
Relations under Trump have become particularly fractious (most notably in the aftermath of Covid-19 and in advance of the US election) but multiple tensions have been brewing since well before Trump’s 2016 election campaign:
- Trade (tariffs, intellectual property, rival trading blocs in Asia).
- Territory (the Nine Dash Line in the South China Sea).
- Geopolitical influence (the Belt and Road Initiative, relations with Iran and Russia).
- Technology (Huawei, ZTE, and 5G mobile).
- Influence in multilateral organizations (IMF, WB, WHO, WTO).
There is little doubt that, particularly in an election year, Trump (and Pompeo) will exploit whatever opportunity they see to pressure China (or, more accurately, deflect blame for Covid-19 deaths) and this includes Hong Kong (as much as it does Covid-19).
Democrat presidential candidate Biden also identifies China as a threat (the difference is his response is multilateral compared to the unilateralism of Trump).
The key question is whether that will have much impact on China’s leadership, which does not have to contend with elections (and the resultant short-termism it encourages in policy)?
The indications so far this year are that China is acting more assertively (provocatively, its critics would say) on several existing points of foreign friction (India, Taiwan, Vietnam) and has not hesitated to respond to new ones (Australia).
Furthermore, its leverage with countries between it and the US is arguably enhanced in a global economic environment where so many countries (not merely relatively small Frontier markets like Pakistan or Philippines, but larger Emerging ones like Brazil and South Africa, as well as Developed ones like Italy and UK) are in need of sovereign (re)finance and inbound direct investment.
Investments: weaponisation of capital by the US, China A shares outperformance at risk
A separate key question is to what degree the US will expand its weaponisation of trade policy to a weaponisation of capital; eg are ever greater restrictions likely on the listed securities of Chinese corporates (not merely investment by US government-related pension assets in funds with Chinese exposure and de-listing of Chinese ADRs but also restrictions on private sector funds’ investments in all Chinese listed securities, restrictions on US corporates’ direct investments in China or Hong Kong, or restrictions on Chinese investments in the US)?
In turn, in the style of tit-for-tat tariffs, does this ultimately lead to a sell-down of the Chinese government’s holdings in US treasuries (although the absence of reserve currency alternatives to the US Dollar may limit this)?
We may see those draconian, previously unimaginable scenarios, appear on the horizon before this new Cold War de-escalates. From the perspectives of Hong Kong and China, the risk of disruption is going to get worse and from the perspective of international relations, the neutral space in between the US and China will continue to contract.
That is a bleak conclusion for emerging market investors. Year to date the performance in equities suggests that those risks are reflected much more in equities across EM than in (outperforming) China A-shares. There appears to be an implicit assumption that Covid-19 has been conquered in China and economic activity will return to the old normal, even though the world China faces looks ever less like the old normal.
National People's Congress (NPC) footnote
The annual NPC starts on 22 May, has 2,980 members (70% of whom are Communist Party members), lasts for a couple of weeks, debates new laws drafted by it standing committee (where 70% of its 175 members are Communist Party members), and tends to act as a forum for balancing the views of different factions of the Communist Party rather than for enabling substantive debate over the essence of new legislation (this is done in the drafting stage).
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China and India: Himalayan friction matters
- China-India skirmishes and tension across Asia much more likely than an all-out war (economic costs too high for both)
- India needs China's trade more than the other way round and higher military spend may eat into its fiscal stimulus
- But overall costs for China ratchet up if the US adds this to its list of pretexts for capital restrictions on China
As military friction renews between China and India in the Himalayan region separating the two countries, we offer the following context and tentative conclusions:
(1) Skirmishes and tension, not war – An extensive, full-blown war is extremely unlikely: both sides have far more to lose (economically) than to gain (in terms of territory). Nationalism plays a big role in the rhetoric of the leaders of both China and India, and both have demonstrated their ability to forcibly quell domestic dissent, but their political legitimacy is ultimately dependent on delivering economic growth. Nevertheless, both sides have crept closer to each other's territory as the buffer-zones around their land border (left behind after the British withdrawal from the region over seven decades ago) have effectively shrunk (because of greater infrastructure development on both sides) and as their rivalry extends across the region (with both competing for influence and control in Afghanistan, Bangladesh, Iran, Maldives, Myanmar, Pakistan, Sri Lanka, and Vietnam).
(2) India needs China trade more than China needs India trade – Exports to China account for a much larger share of India's global exports (9%) than exports to India do for China's global exports (3%). Arguably, India has more to lose from any spillover of military tension to trade tension. (Foreign direct investment flows between the two are comparatively trivial.)
(3) Catalyst for higher military budget in India – India spends substantially less on military defence, both in absolute US$ terms and as a percentage of GDP, than China. Similar to domestic political pressure in India seen after previous episodes of tension with China, there may be calls to raise military expenditure significantly.
(4) Another potential trigger for US capital restrictions on China – The US is obviously much more closely aligned with India and tension between China and India is yet another node of broader US-China conflict (trade tariffs and blocs, technology standards and access, influence in multilateral organisations, restrictions on capital flows, Covid-19 responsibility, independence of Hong Kong and Taiwan, 9-Dash line territorial disputes with Malaysia-Philippines-Vietnam, and the treatment of Uighurs). If China-India tensions escalate, they could act as a catalyst for US policies that target trade and capital flows to China.
The world – and China and India's roles – have completely changed since 1987
A generation ago in 1987, China and India squared up to each other across their Himalayan border, two and a half decades after a full-blown but brief war. Those same tensions, left unresolved after 1962, 1987, and 2017, are flaring up yet again.
In 1987 the total military spending of both countries was similar. The US was relatively more aligned with China than with India (and the USSR was aligned in the opposite direction). China and India were similarly sized economies and collectively accounted for less than 4% of global GDP. As such, their friction in 1987 was far less important, on a global scale, compared to the Perestroika and Glasnost policies underway in the USSR under Gorbachev. And to the degree that a group of investors identified themselves as emerging market investors, it hardly mattered at all. The MSCI Emerging Markets index was created a year later in 1988 with no place for either India or China (because they were not sufficiently accessible for foreign investors until 1994 and 1996, respectively).
How things have changed compared to 1987! Now, total military spending of China in US$ is almost four times larger than that of India. The US is now much more aligned with India than with China (and Russia is tilted in the opposite direction). China's economy is now almost five times the size of India's and collectively they account for c20% of the global economy. China and India account for 40% and 8% of the MSCI EM equity index, respectively. In global geopolitics and emerging market investment hardly anything seems to matter as much as China. And if China is rendered offside at some point in the future as the US potentially weaponises capital flows (eg imposes sanctions or restricts portfolio capital inflow to China) then little will matter to emerging market investors as much as India. This conflict clearly merits attention.
US-China: an ugly turn at a bad time
- US-China friction: eg coronavirus name and origin, journalist expulsions, Taiwan jets, Kudlow on US corporate relocation
- Risks increase for Phase 1 trade deal, Hong Kong, credibility of China virus data, and, ultimately, a drift to cold war
- Risks (proxy conflict) and opportunities (competing capital inflow) for EM caught in the middle
Escalating tensions at a time that calls for cooperation; the cold war end-game
Tensions between the US and China have clearly escalated in recent days: the 17 March effective expulsion of leading US journalists from China (and Hong Kong), which follows US restrictions on Chinese journalists earlier this month, is merely one example. In the context of the global coronavirus crisis, during which one would expect such geopolitical tensions to moderate, this increased friction is noteworthy and concerning.
The end game for this trajectory of events is a full-blown cold war between the US and China, with, for example, the abandonment of phase one of the trade deal, US corporate relocation from China back home, further erosion of the "one country, two systems" constitutional principle for Hong Kong, more territorial challenges in the South China Sea among the staging posts on this path.
For countries caught in the middle, which include all of the emerging markets, the implications are mixed: on the one hand, steady-state global growth (trade) falls in the event of sustained US-China friction and, on the other, that rivalry may create a competitive tension in flow of capital into or trade access for these countries (as components in the strategy of these global powers to build geopolitical allies).
It may be premature to consider such an extrapolation and the pressures for more global cooperation may prevail but, either way, the sense is building that so many aspects of the world will not simply revert back to how they were prior to the coronavirus.
Risk of less confidence in China's coronavirus data
A separate risk resulting from the specific measure of expelling journalists from some of the most followed newspapers in the US is that foreign investors start to cast greater doubt the veracity of data from China on the number of coronavirus infections, recoveries and deaths. This would have repercussions for estimates of the length of global disruption related to the virus.
Given the context of the coronavirus crisis, this is more than mere mud-slinging
- US and China tit-for-tat effective expulsion of journalists;
- US President Trump's pointed reference to the "Chinese virus";
- US national security adviser O'Brien criticising China for suppressing coronavirus data;
- US economic adviser Kudlow's comment that US firms may receive tax write-offs for expenses related to relocation back to the US from China;
- Taiwan air force jets scrambled to warn of Chinese counterparts;
- China foreign ministry spokesperson Zhao questioning if the US was the origin of the virus;
- Serbia president's highly critical remarks on the EU and complimentary ones on China;
- China's very public show of international medical assistance to countries where there is a sense of disappointment with international efforts (e.g. Iran, Italy, Spain) or where the coronavirus has presented China with an opportunity to reaffirm close relations (e.g. Ethiopia, Namibia).
Vietnam: Comparing government intervention policies
- In this special report, we focus on government intervention policies implemented by Vietnam in response to Covid-19...
- ...and compare it to policies during the global financial crisis as well current polices in neighbouring countries
- Vietnam’s current policies are supportive of a remarkable rebound in H2 20
In this special report, we focus on government intervention policies implemented by Vietnam in response to the Covid-19 outbreak and compare it to policies during the global financial crisis as well as to current polices in place in other regional Asian countries.
We examine the Vietnamese government’s point of view, the benefit-takers and the room for more upcoming intervention. In our opinion, the government has played an active role in flattening the curve and has meticulously designed its intervention policies. At end-April, the scale of the fiscal stimulus is estimated at VND266tn, equivalent to 4.1% of GDP, and tax deferral at 2.8% of GDP. Currently, the government has also delivered indirect support to corporates such as contribution to social security and pension funds in order to minimise unemployment. The government does not prefer to offer direct support to corporates.
Meanwhile, low-income households or informal labour that have been hit by the pandemic, are qualified to receive cash aids, which should boost aggregate demand. In addition, the government is keen to accelerate public investment disbursement via transforming the PPP parts of the North-South expressway into public investment projects and extending the timeline of 2019 disbursements. We believe that those stimulus policies will significantly cover the losses of FDI and exports.
In general, the size and approach of the intervention policies are parallel to Vietnam’s economic and coronavirus outbreak conditions. In the base case scenario that Western countries start reopening in May, Vietnam’s current policies are supportive of a remarkable rebound in H2 20.