Geopolitics at Play in China

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China’s problems are not entirely external and are not limited to the new Trump administration. China is now embroiled in an internal political struggle around the efforts of President Xi to make himself the most powerful Chinese leader since Mao Zedong.

In reaction to the excesses of the Mao era — including the disastrous Great Leap Forward, which caused famine in the 1950s, and the destructive Cultural Revolution of 1966–76 — China developed a new model of collective leadership under Deng Xiaoping beginning in the 1980s.

Deng himself was never president; he held a series of lesser posts. However, he was the architect of the current presidential system and was regarded as China’s “paramount leader” from 1978 to 1987. Deng held what the Chinese call the “Mandate of Heaven,” a quasi-religious concept that has bestowed legitimacy on Chinese emperors for over 3,000 years.

The new model still had a single leader, but the leader was chosen by consensus among the Central Committee members of the Communist Party. Each leader was elected to a five-year term (in rigged elections), and was permitted to serve a second five-year term (some did so, some did not).

Importantly, at the beginning of a leader’s second five-year term, he would designate one or two likely successors. Those designated successors would then jockey for position among the Central Committee members. Slowly a consensus would emerge around one figure. That individual would then be selected as president at the end of the current president’s second term.

This system ran like clockwork through the presidential terms of Li Xiannian (1983–1988), Yang Shangkun (1988–1993), Jiang Zemin (1993–2003), Hu Jintao (2003–2013), and so far in the first term of Xi Jinping (2013–2018).

President Xi’s first five-year term expires in March 2018. He is certain to be elected to a second term, but he has so far deviated from the script by not designating any potential successors for a smooth transition in 2023. At a minimum, this will make Xi more powerful after 2018 because it will eliminate the lame duck factor.

Some observers fear that Xi’s real ambition is to capture a third-term running until 2028. This would be similar to Vladimir Putin’s gymnastics in Russia where he has used various means to hold power since 2000 and is expected to remain in power at least through 2020.

Xi has also pursued an “anti-corruption campaign” that has conveniently resulted in the arrest of two of his most powerful rivals, Bo Xilai, the highly ambitious former mayor of Chongqing, and Zhou Yongkang, the head of China’s internal security apparatus. This pattern also mimics Putin’s Russia where corruption is tolerated as long as it is for personal enrichment, and does not transmute into geopolitics of political power. Those who aspire to power are brought down and arrested by the leadership.

The question of whether Xi will disrupt the two-term system and seek a third term is open for now. Xi’s actions could provoke a backlash that will cause him to lose the Mandate of Heaven. At a minimum, the political uncertainty resulting from Xi’s moves makes policy responses to Trump’s provocations more difficult to predict. Policymakers are likely to make political rather than economic calculations in their decision-making. Economic policy optimization will suffer as a result.

China also suffers from a host of internal contradictions to its global economic ambitions. Internet censorship, which I experienced first-hand during my recent visit, maintains Communist control in the short-run but stifles the creative exchange of ideas crucial to technological advances. (The internet was originally invented by the Pentagon not as a news or social media platform, but as a way for the best thinkers to exchange ideas quickly during our Cold War rivalry with Soviet scientists.)

China’s one-child policy, beginning in the early 1980s, has led to two demographic disasters. The first is that growth in the working age population is now flat, which is a headwind for economic expansion. The second is that a cultural preference for male children has led to sex-selective abortion and female infanticide. This has created a gender skew of 20 million men in their twenties and thirties with no prospect for marriage. Through adverse selection by women, the unmarried men are the least attractive and least skilled.

Many of these men are being forced into military service and sent overseas to supervise mines and industrial enterprises in Africa and South America. In any case, they are ripe for anti-social behaviors and a threat to social stability.

This mix of adverse demographics, technological bottlenecks, and political intrigue are all detriments to China’s economic development under the best of circumstances. With new challenges thrown at China by the Trump administration, internal instability may act as a force multiplier to external pressure and lead to a breakdown of social order.

Geopolitics and Instability

The tensions with China around Trump’s policies on trade, tariffs, and currency manipulation are a sideshow compared to the much larger issue of Trump’s pivot to Russia.

From 1946 to 1989, geopolitics was fundamentally a matter of managing the Russia-U.S. condominium of world power and geopolitics. China was potentially powerful (as recognized by President Nixon in 1972), but was in fact weak, poor, isolated, and chaotic. Russia and the U.S. controlled the world. All other countries were either allies, satellites, proxies or irrelevant. Flashpoints erupted in Berlin, Cuba, Vietnam, and Afghanistan, but U.S. and Soviet troops never fired on each other. The risks of escalation to nuclear war and the end of civilization were too great.

Since 1989, a tripartite world order has emerged involving Russia, China and the U.S. The strategic goal in a three-party game is to align with one of the other parties to the detriment of the third. The U.S. played this two-against-one game well from 1989 to 2009, but has failed utterly since then.

The fall of the Berlin Wall in 1989, coupled with the liberation of Eastern Europe, the 1991 collapse of the Soviet Union, Russian withdrawal from Afghanistan, and the emergence of a democracy in Russia, all resulted in close U.S.-Russia ties, to the point that U.S. “experts” designed much of Russia’s legal and financial infrastructure.

China was the odd-man-out in the aftermath of the violent suppression of the Tiananmen Square demonstrations in 1989. I made my first journeys to Red China during this period, in 1992 and 1993. I met almost no Americans and was under constant surveillance by internal security service “minders” posing as mandatory guides.

It was during this odd-man-out stage that China executed its first maxi-devaluation. The USD/CNY cross-rate went from 5.7 to 8.7 almost overnight in 1994. It was also during this period that China perfected the manufacturing juggernaut and transportation networks that led to its export success, massive reserve accumulation, and unprecedented economic growth.

Jim Rickards on the Bund in Shanghai, China. From 1900 to 1940, the Bund was called the “Wall Street of Asia,” and was the center of trade and finance in China. After 1940, it was occupied by Japan, and after 1949 it fell under Communist control. Since the 1990s the Bund has experienced a revival and its neoclassical and art deco architecture have been restored. It is now occupied mostly by Chinese banks, hotels, and high-end shopping venues.

The game changed dramatically in 2000. The U.S. pivoted away from Russia toward China. The election of Vladimir Putin in 2000 involved an assertion of Russian nationalism including territorial claims in the Russian periphery of Georgia, Ukraine, Moldova and the Baltic Republics. Putin was reassembling the old Soviet Empire into a new Russian Empire.

Meanwhile, China manufacturing prowess and willingness to buy U.S. Treasury paper made it the ideal trading partner for the U.S. The Bush administration deftly embraced China and made Russia the odd-man-out. U.S.-Russian relations hit a low in August 2008 when Russia invaded Georgia, a U.S. ally. Bush was too preoccupied with the global financial crisis and the War in Iraq to muster much of a response.

Beginning in 2009, the Obama administration failed to notice that Russia and China were playing their own version of the three-party game with the U.S. as the odd-man-out. Russian-Chinese cooperation expanded in initiatives such as the Shanghai Cooperation Organisation, the BRICS institutions, the New Silk Road initiative, and bilateral deals on currency swaps, oil and natural gas, pipeline infrastructure, and arms sales. (You can get an in depth analysis of the Russian angle in Nomi’s article.)

Obama was lulled into complacency by Chinese purchases of Treasury debt even as China’s currency manipulation, trade subsidies, and damage to U.S. manufacturing metastasized. By 2016, U.S. relations with Russia were at a post-Cold War low, while relations with China were on a downward trajectory. Russia and China had never been closer since the mid-1950s. The U.S. was the new loser in the three-party game.

With the rise of Donald Trump, the U.S. is back in the game, this time with the promise of much closer relations with Russia and confrontation with China. Putin seems willing to pursue this round with his new best friend Donald Trump. China is beginning to feel the chill of once again being the odd-man-out.

Russia and the U.S. are the two largest energy producers in the world. With cooperation from Saudi Arabia, they can dictate the global price of energy. The appointment of Rex Tillerson, former CEO of ExxonMobil, as Trump’s Secretary of State puts the use of the energy weapon in deft hands. China will be pressured for cooperation on issues such as the South China Sea, North Korea’s nuclear program, and Taiwan relations.

As is the case regarding concessions on trade and the currency, China is being asked to make concessions it cannot give. Beijing regards Taiwan as an integral part of China, a temporary “breakaway province,” not a separate political entity. China’s position on Taiwan is existential and non-negotiable.

China likewise has little room for concessions on its claim of near-complete control of the South China Sea. That arm of the Pacific Ocean is rich in fish that China needs to feed its people. China is unwilling to share the catch with Vietnam and the Philippines. Numerous boardings, collisions, and seizures have happened already. A greater armed confrontation there is just a matter of time.

China could help with regard to North Korea’s nuclear program. China has many transportation, banking, and food chokepoints it could use to stop North Korea’s bad behavior. The problem is China fears North Korea will retaliate by opening its border with China and allowing millions of desperate North Korean citizens to flood into China as destitute refugees. The result would be social and economic destabilization in Manchuria, a part of China already suffering from its rust belt status.

Given a revival of the Russian-U.S. condominium of power on friendly terms, and China’s inability to deliver concessions demanded by Trump, the prospect for U.S.-China geopolitical relations is poor.

This will only worsen the already deteriorating economic relations between the two largest economies in the world.

Thank you for reading the Daily Reckoning,

Jim Rickards
for The Daily Reckoning