China, Russia, and the West: A Game of Chess
What the prospect of China invading Taiwan might mean for Investors
Looking back a year ago, at the myriad of potential threats to the markets, the prospect of war may not have been at the top of your list. With so much geopolitical, social, and economic turmoil currently in the world, it can be a bit overwhelming for investors to keep track of all the varying risks and dangers on the horizon. An investor seeking wishing to protect their portfolio can be blindsided by an unpredictable tail event, as we have seen in some instances from the unfortunate consequences of the War in Ukraine today, and the pandemic before that. Shortly before Russia invaded Ukraine, China’s Xi Jinping and Russia’s Vladimir Putin held a summit in which they stated their friendship had “no limits.” While much of the world focuses on the current war in Ukraine, we here at Crystal seek to inform our readers so that they may stay ahead of the curve for potential market turbulence. Thus, we believe that it is prudent to analyze the threats stemming from China’s expansionist goals in Asia, in particular, the potential of China invading Taiwan and the South China Sea. So, in that vein, today we take a look at China’s geopolitical and territorial ambitions, what the consequences of China and Russia’s growing ties could mean for investors, and discuss some industries and fund strategies that could help navigate another military conflict.
China is a massive, and massively complex, nation. As the second-largest economy in the world, with the largest number of active military personnel, its decisions on the international stage have far-reaching consequences. So how did Communist China arrive to be arguably the second most important player on the world stage?
The People’s Republic of China (PRC) first emerged following the Chinese Communist Party’s (CCP) victory in the Chinese Civil War. In 1912, a revolution led to the collapse of monarchy and the ruling Qing Dynasty, and the Republic of China (RoC) rose from the ashes of two thousand years of imperial rule. While many groups jostled for power in the new republic, the Kuomintang (KMT), a conservative nationalist party led by Chiang Kai-Shek, lead a successful military campaign to defeat a coalition of warlords and unify China under one leader. Initially allied with the KMT, after a series of anti-communist purges by Chiang, the CCP launched an uprising against the nationalist government in 1927, marking the start of the Civil War. Although hostilities were paused when Japan invaded in 1937, after Japan’s defeat in 1945, the war resumed. Finally, in 1949, the KMT was defeated by the CCP, and Chiang Kai-Shek, with millions of his compatriots in tow, fled the mainland to Taiwan, proclaimed Taipei the provisional capital of the RoC, and declared martial law. Meanwhile, the Communists, with Mao Zedong as its leader, declared victory and established the People’s Republic of China, and initially held back from China invading Taiwan. Thus, the Chinese dragon was born.
Brief History of Taiwan
Source: Nikkei Asia
Both the RoC in Taiwan and the PRC on the mainland continued to lay claim over the entirety of China, and both countries professed the belief that Taiwan and mainland China can never be separated. Meanwhile, the United Nations and most of its member states continued to recognize the RoC as the legitimate government of all of China, and the Mainland found itself increasingly isolated from the world, politically and economically. The PRC subsequently experienced decades of disastrous economic experiments and sociopolitical repression under Chairman Mao. The 1960’s, however, saw a breakdown of relations between China and the USSR. This “Sino-Soviet” split, however, offered an opportunity for China and the West to foster warmer ties as a bulwark against Soviet aggression. This culminated in 1971, when most of the world came to terms with the reality that mainland China was run by the CCP, with the UN and most of the world swapping diplomatic recognition of Taiwan for China, and the United States following suit in 1978, and in turn, reduced the risk of China invading Taiwan.
What developed as a result of these maneuvers at the UN was what is commonly referred to as the “One China” policy, the central point of conflict today between China and Taiwan and the philosophy driving the prospect of war on the Island. “One China” is the official policy of both the United States and China, as well as the KMT of Taiwan, but with different meanings for all. The central idea is that Taiwan and Mainland China are one people, one nation, and must never be separated – an idea that both Taiwan and China publicly stated they believed. The reality, ever since, has been that Taiwan is a de facto independent country, but de jure, has an unresolved status.
Following the death of Chairman Mao and the re-establishment of diplomatic ties with most of the world, the 1978 ascension of Deng Xiaoping as leader of China, a man known as the “Architect of Modern China”, China began the process of politically and economically modernization that has led it to its position as a global superpower today. As China gradually evolved into a slightly freer society and substantially more market-oriented economy, coupled with a large population of low-paid workers, China developed into the manufacturing powerhouse it is today.
China’s trade balance with selected regions/economies
Source: The Diplomat
While highly controversial within China at the time, these political and market reforms may have helped unleash the economic power of China and its reach to nearly all corners of the globe. The rise of the Dragon as we know it today can largely be depicted in its trade balance with the world (see chart to the left). Though the building blocks had been laid near the turn of the century, when, in 2001, China was admitted to the World Trade Organization (WTO), we can see a real inflection point in 2012, where China had accrued a massive trade balance from foreign partners. By this time, China had already become the largest trading partner of 124 countries, well exceeding that of the United States.
As the Diplomat puts it, “As trade remade China, in the process China also remade world trade”.
In 2013, the nation’s thirst for economic, political, and social growth was backed by a massive program of foreign direct investment and loans in infrastructure, known as the Belt and Road initiatives. Colloquially referred to as China’s “new Silk Road”, the belt, referring to land trade routes connecting Europe and Asia, and the road, a maritime trade route, further connecting China with Southeast Asia, Africa, and Europe. In essence, this was a plan for China to spread its tentacles, acquire resources, and build China’s massive infrastructure ambitions (both hard and soft). Funding for the program has totaled roughly $50-100 billion per year. The motivation of the plan is rather straightforward. That is secure trade routes, and build interdependence with China, thereby building both economic and political influence and thwarting western power (US). And while investment in pariah states like Iran has received the bulk of attention from foreign press, in an attempt to maximize its influence across the globe, China’s financing has been uncorrelated with measures of democracy, with countries like Kenya, Indonesia, and the Netherlands, traditionally allied with the West, receiving money as well.
China's Belt and Road Initiative
While its trade ties have deepened with much of the world, more nations have found their economic success reliant upon their trade ties with China, giving them an immense amount of “soft” power to achieve the international and territorial goals they reportedly care about. And as China’s economic prowess has grown though, so have its geopolitical ambitions. Immediately after World War II, before the birth of Communist China, the RoC published a map that made a number of claims to islands in the South China Sea, recaptured from Japan, that China had at various points in history controlled. The so-called “Nine-Dash Line” is largely considered invalid under international law, however, both Taiwan and China have continued to profess their rightful control over the territory within these lines.
China's "Nine-Dash Line"
Source: Radio Free Asia
While China has become a progressively bigger and more integral player on the world stage, it has asserted with increasing aggression its claims to Taiwan and the islands of the South China Sea, which hold nationalistic, economic, and military significance. The islands of the South China Sea generally fall within the territory of the Philippines, Malaysia, and Vietnam, countries that historically have had closer ties with China. As China’s aggression has escalated, these relationships with China have also soured. As such, China has in recent years turned increasingly to Russia to establish a unified front against American and Western concerns about their expansionism. Many diplomats and foreign policy buffs believe these closer ties are about establishing a rival axis of power, that for China, will facilitate its capture of Taiwan, particularly as President Xi has escalated its rhetoric towards Taiwan. The recent capstone of these efforts was the joint statement by Putin and Xi on Feb 4th, shortly before the Olympics in Beijing began, that Russia and China’s friendship has “no limits.” This statement, at the time a bit bewildering, seemed much more sinister following Russia’s invasion of Ukraine.
As we recently discussed in our piece on the War in Ukraine, the West has responded with steep economic sanctions on Russia and military support to Ukraine. China, however, seems to have been caught off guard by the unified Western response and is now walking the tightrope of diplomacy, seeking to maintain its economic ties with the West, while continuing its political support of Russia. Given their close ties with Russia, the West has been suspicious that China will seek to assist Russia in evading sanctions, and as such, many world leaders have preemptively warned China of sometimes vague and sometimes quite specific punishments for helping Russia.
As a result, experts believe that China now faces two very different choices for its future: an alliance with Russia and its accompanying support for China’s territorial aims; or maintaining ties with the West, the driver of its economic power.
As the recent market volatility has shown, military aggression by a nuclear state can have chilling effects on various assets and aspects of the economy. Regardless of the result of the war in Ukraine, the world will likely look very different than it did prior to Russia’s invasion. Since China’s rise as a military and economic force, the West has pushed China to become a “responsible stakeholder”. China choosing the West would likely, for obvious reasons, necessitate weaker political and economic ties with Russia. Sanctions on Russia have made economic trade between China and Russia much more difficult, and with the prophylactic threats that the West has made against China intervening, the economic relationships that have enriched China may become untenable. But as the saying goes, with great power comes great responsibility. The West would likely look to China to tone down its expansionist rhetoric, and in its industry and global trade, expect China to more clearly respect human and labor rights. The consequence of all this though could largely be a continuation of the status quo for China – a large and growing economy, that on the international stage will still largely project to play second fiddle to the demands and ideologies of the West.
Russia’s most important Import partners
The effects of closer ties with Russia, however, might result in a dramatic shakeup of the world order. A Ukrainian defeat could embolden and strengthen Russia, demonstrating that even when the West is completely unified, they could slow, but not stop, their ambitions, and therefore demonstrating the influence and power a Chinese-Russian juggernaut could have. A military powerhouse, coupled with stronger trade ties between the two countries to counter Western sanctions, would give China the geopolitical and economic latitude to get away with any number of expansionist actions in the Pacific, and given Xi’s harsh rhetoric towards Taiwanese independence, could likely include China invading Taiwan. Such a scenario would lead to increased isolation of China from the West, and the world could impose crushing sanctions on China similar to those imposed on Russia. However, the economic impact on the global economy would be massive.
While it is impossible to predict if any of these narratives will actually occur, with so much world trade passing through China, even a small contraction of trade could push both China and the United States into turmoil.
Most Traded Goods Between U.S. & China
Regardless of whether we see “One China” come to fruition, with China invading Taiwan, or if they choose a path to better relations with the developed world, as we have been acutely reminded of in the last several weeks, the world is a complex place, and situations on the ground are unpredictable and can shift at any moment. Russia’s invasion of Ukraine has opened a world of uncertainty, and prudent investors seeking to get ahead of more market volatility, may wish to analyze the potential threats lurking ahead in Asia.
Some investors who wish to protect their portfolios in advance of potentially worsening relations with China may seek allocations to industries less tied to the global supply chain, such as tech services, domestic middle-market manufacturers, retail, health care, and others; and may choose to avoid investments in industries tied to China and Taiwan, like automobiles, semiconductors, and energy. In the alternative asset space, Private Equity funds focused on companies with little foreign exposure, such as in earlier stage Venture Capital, may be better able to weather another geopolitical storm; while on the hedge fund side, experienced global macro, multi-strategy, and distressed debt managers may be skilled at navigating these complicated geopolitical dynamics. While there is no assurance that the investment objectives or information discussed will be achieved, we believe it is important to stay abreast of potential further geopolitical turmoil and learn how some investors view the world during volatile times.
Carnegie Endowment for International Peace, Apr 2022. “China’s Ukraine Calculus Is Coming Into Focus”
Chatham House, Apr 2022. “Ukraine: Xi may come to rue his ties with Putin”
The Hill, Mar 2022. “Beijing is hardly a responsible stakeholder”
Bloomberg, Mar 2022. “U.S. Threat to Sanction China Is Spooking Other Nations in Asia”
CNBC, Mar 2022. “Russia sees China as a lifeline against sanctions, but U.S. threatens ‘consequences if Beijing helps”
Politico, Mar 2022. “China finds itself in a tricky position – stuck between the White House and the Kremlin”
BBC, May 2021. “What's behind the China-Taiwan divide?”
Foreign Policy, Dec 2020. “Washington Still Wants China to Be a Responsible Stakeholder”
Brookings, Oct 2020. “Seven years into China’s Belt and Road”
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