The Question without an Answer

Wednesday, 25 November 2020
Wollongong, Australia
By Greg Canavan

[3 min read]

What is going on with China, and what does it mean for Australia and you as an investor?

They’re the question I’ll seek to answer today. Although, I really don’t think there is one.

The Australian’s Paul Kelly sums up the issues pretty well today:

The China that Australia must manage is a profoundly dysfunctional entity riddled with contradictions — an economic powerhouse but a Communist Party autocracy, arrogant yet vulnerable, projecting strength yet betraying weakness, exploiting Western openness but addicted to internal tyranny, a leadership obsessed with gaining international legitimacy whose behaviour casts a permanent shadow over that aspiration.

Beijing seeks to punish Australia and to teach Australia a lesson — that Beijing will dictate the terms of this relationship and that Australia is guilty of a grievous blunder in not grasping this reality, a blunder for which Australia will pay an unspecified price for an unknown period. What China gains from this project is highly dubious.

Indeed it is.

So what is China playing at? What does it have to gain by playing the schoolyard bully? Australia isn’t the only country it’s having a go at. Relations are at a low with neighbouring India. And they’re hardly on cosy terms with Japan, Canada or the US.

Although if Biden does win the presidency, things will be much different between the two superpowers. You’re already getting a taste of the leniency the US will show China via Twitter, which is effectively a part of the Democrats’ Ministry of Propaganda.

Twitter, as you probably know, had no problem leaving the doctored image of an Australian soldier holding a knife to a child’s throat up for the world to see. It was posted by Chinese ‘Wolf Warrior’ Lijian Zhao. They only belatedly added a ‘sensitive content’ warning.

But prior to the election, Twitter did see fit to remove a factual story from the New York Post detailing Hunter Biden’s dodgy dealings in the Ukraine, using his father’s name and position to enrich himself.

That gives you some idea of whose ‘side’ Twitter is on.

But let’s get back to China and why is it behaving so aggressively?

There is always the risk when analysing a situation like this that you tend to see the situation through the lens that you choose to, rather than the lens that you should.

So keep in mind that I have been bearish on China’s long-term economic outlook this year. I think the virus that emerged from Wuhan late last year, which was deliberately released into the world (or certainly not stopped until too late), has done untold long-term damage to China.

Having said that, it’s done greater short-term damage to the ‘developed’ world.

Hold that thought…

One of China’s problems is financial. They are a totalitarian State locked into a capitalist (or crony capitalist) system via their link to the US dollar. They’re sitting on around US$3 trillion of reserves, most of which are US government bonds.

These ‘reserves’ form the foundation of their own domestic financial system. The reserves are an asset. On the other side of that coin, so to speak, are yuan denominated domestic bank liabilities.

It is these US dollar reserves that have allowed China to grow its economy so quickly over the past two decades.

But the reserve pile has stopped growing. It stopped in 2014. China can still inflate its economy through State-directed lending, but doing so without an increase in the (US dollar reserves) asset base increases the leverage and risk within the financial system.

This is where we are now. The Chinese banking system is dangerously leveraged.

So if you’re an authoritarian regime focused on total control, what do you do when you’re locked into a global financial system that you can’t control, and it threatens to blow your economy up if it continues?


Maybe allow a highly contagious virus to escape into the world and cause havoc in Western economies? Then watch as Western governments panic and plunge themselves further into debt and ruin their economies via lockdowns.

A plausible story?

Too far-fetched?

No one knows the truth of the matter. But it wouldn’t surprise me.

Consider this:

While the virus was spreading around the world, China first made mention of what it called its ‘dual circulation’ strategy. The South China Morning Post explains it:

The so-called dual circulation strategy was first mentioned at a meeting of the Politburo, China’s 25-member policymaking committee, in mid-May.

The plan places a greater focus on the domestic market, or internal circulation, and is China’s strategic approach to adapting to an increasingly unstable and hostile outside world.

It is expected to see China place less reliance on its export-oriented development strategy, or external circulation, without abandoning it altogether.

President Xi Jinping later added that China would “gradually form a new development model in which domestic circulation plays a dominant role”.

Dual circulation is also included in China’s 14th five-year plan, for 2021-25.

What better way to encourage a focus on the domestic market than by demonising ‘external’ suppliers and cutting off the product. Remember, to pay for exports China must use its precious US dollars. The more it can satisfy domestic demand with domestic product, the less potential long-term strain on its financial system.

With this in mind, Australia could well be a test case for a strategy that will be rolled out around the world in the years to come.

Putting it all together then, China’s behaviour is coming from a position of weakness, not strength. It realises it is trapped inside the global monetary system and wants to reduce the risk of blowing up down the track.

While the risk for Australia is not immediate, the writing is on the wall. Over the next five years, China will not be the customer it has been in the past.

I don’t think the market will really care until iron ore exports start to take a hit. China is developing massive reserves in Africa, which will replace a lot of Australia’s product, but that reality is still years away.

It’s coming though. That means weaker economic growth, lower national income and a weaker currency. It also means interest rates will likely remain locked at near zero for a loooong time.

And now Scomo realises he can spend like a socialist and still pretend to be a conservative, fiscal deficits will be with us for years to come too.

In this environment, if you can handle the inevitable volatility, stocks are the only place to be.