The People’s Republic Of China Is Destined To Decline

Companies traded on US markets lost $700 million in value on May 13. Deutsche bank analysts immediately cried, “Investors should prepare for extended period of economic warfare!”

Really? Just because some American companies were smart enough to take advantage of lax US trade policy in the past and transferred a lot of their manufacturing capability to China are now going to have to pay the piper? They collectively made hundreds of billions in additional revenue during all those years, perhaps to the advantage of some US consumers but also to the detriment of many American workers.

The extra “tax” (effectively) imposed if tariffs remain in place on US companies that still want to manufacture, then import, from China doesn’t even equal the windfall corporations received via the most recent stimulative US tax cuts.

It was never worth risking the loss of an egalitarian and transparent society as many workers lost their jobs so a few, better off, could get bargains on their various gadgets. I like many of the products from many of these companies. However, I feel even more strongly that my dollars should not go to the construction of China’s sixth-generation fighter jet.

It was simply time to level the playing field. Now, if the elitist rulers of the masses in China are willing to stop stealing technology, patented products, copyrighted material, and other intellectual property, we can welcome them as a trading partner. If not, the People’s Republic needs the US consumer far more than the US consumer needs them.

It’s understandable that an insular autocracy would believe its own press releases. It’s insane that any intelligent investor would do so. As you read on, I will show you what desperate straits China is really in. Unless they change and play nice, this could be the People’s Republic’s zenith moment.

Understanding That, in Translation, X Means Y

There are 1.4 billion people living in what is today the People’s Republic of China (PRC.) Xi Jinping has taken the “Chinese” description further, however, and declared sovereignty over the independent nation of Taiwan and its 24 million citizens as well as the 60 million overseas Chinese in every other nation in the world, demanding fealty from them as well.

Since I don’t share Xi Jinping’s definition to include Chinese-Singaporeans, Chinese-Australians, Chinese-Americans, et al, as owing complete loyalty to the PRC, but as citizens of other nations who take well-deserved pride in being the progeny of a great world culture, I also will point out that the leaders of the PRC are not taking “the Chinese Path to Democracy” as they claim, but are instead merely the latest incarnation of the “dictatorship of the proletariat.”

There’s one real political party in the PRC – the Chinese Communist Party (CCP). There are eight other parties but they all belong to the same United Front and all vote precisely along CCP lines. If you are not a member of the CCP, you are not one of the anointed.

The intelligence communities of the United States and its fair-market allies understand this particular doublespeak. Well briefed, I believe the US negotiators in the current trade dispute understand these distinctions as well. That’s why I believe the US will be successful in curbing the PRC’s numerous transgressions against free markets. It may be a long time coming but to obsess over this is just plain stupid.

This is a Dispute Over Fair Play, Not “Trade”

Nations will always trade with each other. They will only seldom and transiently reach pure parity. But Canada doesn’t grow a whole lot of mangoes and Hawaii doesn’t have native oil and gas, so the process of fair and open trade works from the smallest example to the most massive.

The problem as I see it with the PRC and its CCP leadership is that they have no intention of playing fair. Nations that trade with the PRC must understand they are subject to theft of their patented inventions or copyrighted material and that once they have been bled dry of all proprietary knowledge with their allegedly independent joint partners, they will have made a few extra bucks for a short period of time, but their usefulness will have ended. Their success in that nation is over and they will be usurped by a PRC company, most often an SOE – state-owned enterprise, which will then compete on price with them until, in many cases, they are no more.

That would seem a dire prediction if it hadn’t already played out in just this manner so many times already.

At a more macro level, the PRC strategy has not been that different from the one Bram Stoker, the author of the book he called The Undead (later changed to Dracula,) cooked up over a century ago. You will recall that Count Dracula never drank the blood of his victims all at once. He visited at night and left two little marks so small that the patients’ doctors were befuddled as to the cause of their fatigue and listlessness. Only too late for the victim was the horrible truth understood.

The United States, or any other country looking for a fair deal from the People’s Republic, like the scores suckered by the Belt & Road Initiative will discover, to update Sen. Everett Dirksen, that “a hundred billion deficit this quarter and another and another, pretty soon you’re talking real money.” Better to upset the applecart of global trade in a dramatic way right now than continue to be sucked dry any longer.

I would rather see the Chinese people able to reform the CCP’s way of doing business, for their own sake as well as the rest of the world’s sake. Why do I say this? Because the People’s Republic has massive problems which are known to them but swept under the rug by their repressive masters. These autocrats believe they must continue their current bluff or the country’s massive problems will become obvious to everyone.

Without Change, the CCP/PRC Will Fall Of Its Own Weight

Most analysts see this economic adversary as 10-feet tall. They also are guilty of the linear thinking that, because the People’s Republic has made such strides in the last 30 years, it will continue to proceed at the same rate of climb in the next 30.

Nonsense.

The problems of the Mainland are many and monstrous. Here are just a few, condensed from a longer report I wrote for a think tank.

Demographics. After Mao devastated the agricultural base that grew the nation’s food by forcing the farmers into steel-making collectives, the Great Famine took the lives of some 45 million men, women and children. Then began the 10 years of the Cultural Revolution, in which many or most of the best and the brightest in the land were sent to be “reformed through labor.”

Salvation came in the form of realpolitik. In 1971, first Kissinger, then Nixon, began direct negotiations to help China. Why? Because if they had not, then the Soviet Union would have stepped in and come away far more powerful with nearly unlimited human resources beholden to them. The idea was to split China away from the Soviets, talk nice, provide assistance, and keep them from forming a united front. It worked. Be careful what you wish for – you may get it.

The next hit seemed to make sense at the time. Too many mouths to feed? Stop the growth in the number of mouths. Hence the one-child policy, which prevailed from 1979 to 2015. (For 30 of these years families were allowed a second child if the first was a girl.) The result of this policy, and the ensuing infanticide of many baby girls, is that today there are 52 men for every 48 women. I expect to see a diaspora of males for at least the next 20 years.

Worse, the Mainlanders are growing old – within 30 years 330 million or more will be 65 or older, usually without the benefit of social welfare protection. As they ask “Who will take care of me in my old age?” when healthcare is most needed, they now realize that a young Chinese man and woman with two children of their own will likely have four parents to provide for. That would be two incomes for eight people! Heaven forbid if any grandparents are still alive. That would mean as many as 16 people depending on the income of two workers.

Source: United Nations Department of Economic and Social Affairs

You will notice in the UN chart above that China’s growth is reaching its zenith now and will likely begin a steady decline within the next five years as the country ages beyond the fertile years of their lives.

Homogeneity: The CCP leadership wants obedient foot soldiers, not free thinkers. This is the hallmark of all tyrannical police states, though few have carried it so far in surveillance and recording the activities of an entire nation. The “social credit” score all citizens now have is based on many things. If you smoke, you will likely create more healthcare expense so that gets you downgraded for consideration for a promotion, for instance. If you are a Han Chinese (92% of the population) you get an upgrade for not being, say, a Tibetan.

Immigrants from anywhere else, who could provide youthful energy to support those 330 million Chinese without enough income to live on, are not welcomed. For all the slings and arrows directed at the US, the United States has 44.7 million first-generation immigrants living there and in 2016 welcomed more than a million of these. Even Japan, notorious for keeping its culture homogenic, allows about 10,000 immigrants per year. According to the latest PRC census, there are 1,500 immigrants registered in the entire country. Not 1,500 per year – 1,500. Some of those may be the “illegal” wives that frustrated Chinese men married, mostly from Southeast Asia, and brought home. They are, the regime has dictated, “dilutive” to the nation.

Debt: If you are in awe of China’s ability to finance everything from Russian LNG plants in the Arctic to entire ports in Djibouti and Pakistan, hold your applause. Thanks to the United States’ sponsorship of the People’s Republic into the World Trade Organization, the PRC has access to lending from the World Bank and many other sources. But like a teenager with a credit card, here’s the result:

The People's Republic Of China Is Destined To Decline

At first glance at this chart you might think, “well, at least the government and the banks are judicious in not taking on too much debt.” You would be wrong. Unlike in the US, Australia, Europe and other places where the government is a different animal than private enterprise, most of the debt compiled by “corporations” in the above chart are from the state-owned companies. Lumbering and indebted they may be, but they are also the way the elites get most of their billions in the People’s Republic.

Those of us who view the United States’ total debt are alarmed and disgusted that it is now above 100% of our GDP. In China it’s approaching 300%. When this bubble bursts, no one knows what the consequences will be. We just know they won’t be pretty.

The System Itself: The PRC’s big problem is that it must remain the cheapest labor provider or the most-efficient producer. Education and opportunity may not be equally distributed around the world but intelligence and street smarts are distributed equally. The ruling elite is now discovering this: There are other regions with people just as smart, willing to work for less than China’s now-more-demanding home population.

The People’s Republic is no more communist than the Soviet Union was. In both cases, a noble ideology simply masked a totalitarian police state. But today’s China is no capitalist nation, either, no matter how tortured the headlines about China’s “version” of capitalist.

I would best describe the current political system in China as plutocratic mercantilism. It’s plutocratic (or kleptocratic) in that everyone who can is chasing the money (and squirreling it away offshore if they can.) But it’s also mercantilist. If, a very big if, China can grow its own consumer base at home, it may be able to become less of a mercantilist nation. But so many of the CCP’s policies work at cross purposes. For instance, the country needs consumers at home so they don’t have to depend on selling to others, but they are racing headlong into artificial intelligence and robotics so they don’t need pesky human workers. They really can’t have it both ways.

Until then, BRI (or OBOR – One Belt, One Road, if you prefer) is not some saintly way to bring peace and love to the whole world. It’s the only way to ensure the supply chain is strong. If your current reality is to take in raw materials and via cheap abundant labor turn those raw materials into something else that other nations will pay for (a rather oversimplified view of mercantilism,) you cannot ever allow your supply chain to be disrupted.

Viewed this way, one could argue the seeming lunacy of aggressively placing its military on every strategic reef or island within another nation’s exclusive economic zone is a defensive, rather than offensive, move. (And as any military strategist will tell you, it does nothing for them in the event of a war. In the military, we call such places “stationary Day 1 targets.”)

Finally, a central statist autocracy is “efficient” but not always effective. It likes to see things done the same way in all places – that makes it inflexible. The hurly burly of entrepreneurialism is most unsettling to such a government.

In addition, the system is easily gamed. You want to shoot for 6.2% growth this year? Amazingly, each village that rolls up all the way to the provincial level comes in at 6.16%, 6.23%, etc. No one, within China or without, really knows what the real numbers are. As they say in the hinterlands, “The mountains are high, and Beijing is far away.”

The Leadership Itself: The combination of intellectual, property and technology theft, forcing recipient nations of PRC largesse to use PRC managers and sometimes laborers as a condition of loans, forcing “partners” to divulge proprietary information, and grandiose statements like calling the BRI “a community of common destiny” as Xi recently did, create significant resentment and animosity among other nations and cultures.

The PRC leaders may be able to fool starved-for-real-information Chinese at home with calling Russia’s Northern Route “the Arctic Silk Road, a partnership between China and Russia,” or claiming to be a “near-Polar state,” but others don’t fall for either the flowery phrases or the high-handedness.

Further evidence of this dawning realization on the part of many erstwhile partner nations abounds. The PRC decided to blast the Pakistan-China Economic Corridor through lands disputed by Pakistan and India. They were on the Pakistan side of the always-contested Line of Control but still – for people who like to think of themselves as terribly clever and cunning, how tone deaf could this have been?

Or when The Philippines took China to the World Court over its military buildup on Scarborough Shoal and both parties agreed to abide by the court’s ruling. When it came down in favor of The Philippines, the PRC simply sent additional warships to take the shoals by force. Tone deaf. (Of course, the US showed itself to be an unreliable ally back then, an attack on even this piece of rock 222 miles from Manila legally triggered the mutual defense treaty between the US and The Philippines. The US did nothing. That was then. The best time to plant a tree was 20 years ago. The next best time is now, today.)

The new reality of the BRI and PRC “assistance” is increasingly seen as hegemony and blackmail by many. As a result Chinese firms have now been disinvited from previous areas where the PRC rulers thought they had deals sewn up – in Malaysia, Pakistan, The Maldives, Sri Lanka, Burma (Myanmar) and many African nations.

What Are the Investment Implications?

You already are most likely an investor in China whether you want to be or not. If you look at any emerging market fund, unless its charter specifically says “ex China,” China will be anywhere between 20% and 60% of an emerging markets fund or ETF. That’s where the performance has been, so that’s where the portfolio managers invest. If it’s an EM index fund, that is where the valuations are high so, again, that is where the funds’ funds go.

But you say you don’t own any EM funds. Do you have a pension or 401k at work? If so I guarantee that the pension fund managers or advisors selected for the 401k are invested in China. Even if you have none of these, China Mainland shares are now part of the MSCI indexes. Almost every single endowment, pension fund or administered 401k invests in these global indexes.

I need to re-emphasize that tariffs are not directly assessed on an adversary nation. They are assessed on the products coming in from that nation. By making it more expensive for US manufacturers to have items built in China then shipped to the US, those manufacturers must either raise their prices, find a place like China was when labor was cheap (pretty easy to do these days), accept lower earnings, or bring the jobs back to the US – where it will likely cost more in labor costs.

Which matters most to the citizens of the United States – whether Apple (NASDAQ:AAPL), a favorite of mine, loses some sales or is forced to relocate some manufacturing? Or whether the PRC can continue to steamroll its neighbors and US allies in the region into compromise and compliance?

Which matters most to the citizens of the United States – whether Qualcomm (NASDAQ:QCOM), another favorite of mine, will continue to allow its technology to be stolen in the name of profitability? Or whether the PRC has US consumer dollars to continue its headlong rush to develop its next aircraft carrier?

I answer this with my portfolio decisions. You may have a different take. But the big investment implications for me are that I own no Chinese mainland stocks (unless I buy an EM ETF in the future and even then, I will seek a no- or very low percentage of mainland holdings.)

I own no money center US or European banks. This is not only because these banks will be the ones most likely to lend to PRC state-owned enterprises, but because long experience has shown me that these banks always will find a way to shoot themselves in the foot, or more likely the head. They will lend to Argentina, or to subprime borrowers, or to Russia, then come running to the US government (or their European government) claiming no one could have seen x or y or z coming. My government’s only money comes from tax revenue so I figure I’m already supporting enough of these dodos with my taxes. No need to buy more.

I would, however, be a buyer of the companies most likely to fall temporarily as investors panic, even if tariffs mean less employment by these US blue chips in mainland China (it will) and higher costs for these firms (it will). Apple, Qualcomm, Corning (GLW), Albemarle (ALB) and 3M (MMM) all come to mind. All are highly adaptable firms that I’m certain, after a bit of hunting, will find new and less onerous partner nations to relocate to. As the song says, “I got along without you before I met you, Gonna get along without you now.”

The panic pendulum always swings too far, just like the exuberance pendulum. When that happens, these will be among the first to leave page 1 of my watch list and into my Growth & Value Portfolio.

“Specialization is for insects.” — Robert Heinlein. 

I agree.  I don’t “specialize” in REITs or Dividend Aristocrats or bonds or tech or energy or health care or growth or value or any other sector, industry or single asset class.  Value is where you find it, and I cover the waterfront seeking the best ideas for *this* particular time.  Six months from now a different asset class may be more favorable and I’ll be there instead.  Take a look at a truly universal portfolio… at Investors Edge® 

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in QCOM, MMM, GLW over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.