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317: The Financial Cold War with China

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Buck: Welcome back to the show, everyone. Today my guest and welfare podcast is James Fok. James is a veteran financial strategic advisor to corporations and governments. He served as a senior executive at Hong Kong Exchanges and Clearing (HKEX) during a decade of rapid internationalization in China’s capital markets. And he’s the author of Financial Cold War, which is a book which we’ll be discussing a little bit here today. James, welcome to Wealth Formula Podcast. 

James: Thank you very much for having me.

Buck: Yeah. So let’s start out with this notion, I guess, for anybody who’s following what’s going on between US and China last several years, we can understand why you would call it a financial cold war. But you want to talk about why you call it a cold war just to start? 

James: Well, first of all, when you use this phrase financial cold war, a lot of people thinking immediately jumps to sanctions, trade wars, and so forth. That’s not what I’m talking about. By the time you get to that point, I would say that you’re already in a financial hot wall. The financial cold war, as I define it in my book, is the accumulated effects of lots of individual national policies and imbalances caused by the structure of the global financial system which have contributed to tensions and conflicts between China and America. 

Buck: Got it. So the US, how is the US dollar really at the centerpiece of this financial cold war between China and the US? 

James: There are a number of elements to the financial cold war. So the dollars role in the global monetary system and the balances caused by that one. Other issues include international tax competition. It includes industrial policies, which ultimately has to do with a lot of failures to enforce antitrust policies which allowed the flourishing of monopolistic and oligopolistic practices in both countries. And then it’s also got to do with incentives both in the public sphere and in private businesses. As regards the dollar, the US dollar was lodged at the center of the global monetary system by the Bretton Woods agreement. In the time the US accounted for around about half of global GDP, dollar has been extremely useful in the globalization of trade and investment in the many decades since. But the system that Bretton was created ultimately created a fundamental imbalance at the heart of the global financial system. That being that in order to supply the rest of the world with sufficient liquidity to handle the growth in international trade and investment, the US had to keep supplying dollars to the rest of the world. In other words, it had to keep running a balance of payments deficit. And that’s all well and good while the US economy continues to grow at least as fast as the rest of the world. But for a long time now that the US has been a large, mature economy and other countries have been growing a lot faster. And so in order to allow the dollar to continue to serve in that role, the United States has had to go into higher and higher levels of debt. This has created a fundamental fragility at the center of the US financial system. And because of the US financial system, centrality to the financial system of the whole world, it’s created a fundamental fragility in global financial markets and made us, frankly, just far more prone to the types of financial crises that seem to be happening more and more often in the previous decades. The other impact of the dollar really is on the US dollar is quite often talked about as a source of exorbitant privilege in favor of the United States at the expense of other countries. Well, the reality of that really depends on where you sit in your society. So if over the last 40 years, you’ve been the wealthy shareholder of a large US Corporation who, because of the demand for dollars in international finance and international trade and the consequent structural overvaluation of the dollar, have you been able to take advantage of that by outsourcing your production to lower cost centers with undervalued currencies, then you’ve done very well. Because what’s happened is you’ve been able to bring your costs down, your profit margins have gone up, and share prices have gone through the roof. If, on the other hand, over the last 40 years you’ve been a US manufacturing worker, the story hasn’t been so rosy for you. Your experience has been one of displacement, job loss at best, long term wage stagnation. And one of the main arguments in my book is that the benefits of the dollar centric global monetary system today outweigh the benefit. The cost of the US dollar centric monetary system today outweigh the benefits, even for most people living in the United States themselves. 

Buck: This has been a complicated issue for the Chinese to consider, right, the dollar centric global economy versus their own investments into the US. How does that all play out from the Chinese perspective? 

James: The fact is, China has come from abject poverty. And it has, through opening up its economy to the rest of the world and embracing market practices, it’s seen enormous economic growth. But the way that China has grown in its early stages, we’re really reliant on a very large labor force. So it happened that a generation of baby boomers was coming into the workforce just right at the time when Dungson Ping embarked on this process of reform and opening up in 1978. You also happen to have, at that time a number of people who’d been politically marginalized under the Cultural Revolution, returning to the cities and to the workforce. And you had the one child policy, which drastically reduced the number of dependents per head of population. So the Chinese government was able to harness the savings that were generated by this growing workforce through its control of the stateowned banking sector to direct investment into government infrastructure and other development properties. And it was a model that has been extremely successful. That’s what laid the groundwork for the export boom in China that began in the 19th. The problem with that system today is that China now is facing a rapidly aging population and it can’t continue pouring concrete as a means of driving GDP growth, because ultimately that’s going to end up in massive investment and capital misallocation that is going to have severe costs and consequences for China. So a consequence of the top down, investment led economic model that China has pursued is that it has underdeveloped its domestic capital markets. That means that it is heavily reliant on the US dollar in its financial and trade interactions with the rest of the world. And as we’ve seen more recently, the United States has shown an increasing tendency to weaponize that dollar system against its strategic rivals. And as tensions have escalated between China and the US, this has become a significant source of vulnerability for China. 

Buck: Interesting. Yeah. So it is a complicated relationship ultimately. Let’s talk a little bit. Let’s go back to this idea of the financial Cold War in specifics to where we are in technology, artificial intelligence. How does this technology, in your view, how will it influence the balance of power in the coming days? 

James: Coming days, I really don’t know. But in the coming years and coming decades, I think it’s going to be one of a number of highly game changing technologies. If you look at the power balance between great powers, there’s an economic and financial dimension to that. There’s also, in very large part, a technological dimension of that. But one of the reasons why China ended up in the 19th century being essentially very poor and marginalized and frankly subject to a bit of bullying in the international sphere was the fact that in the early 1400, they had taken a decision essentially to scrap the pursuit of maritime technology. And so the Europeans raced ahead and used their lead in maritime technology to colonize large parts of the world that fueled that, provided the capital, fueled the Renaissance and the sort of technological advances that you saw in Europe through the Industrial revolution. So technology is always in great power relations a major factor. And whether it’s artificial intelligence, machine learning, or other forms of technology, if one or other gains a substantial lead over the other, then it could well shift the balance of power. Now that could be an entirely benign thing. Frankly, it’s great to have some competition because that drives human innovation and development and hopefully a better standard of living for all of humanity. But technology gives one country the power to oppress another country or to somehow subjugate them, then obviously that for the target of that oppression and subjugation is not going to be such a good thing. 

Buck: I know you’re not actually in the US right now, but right now, with the covet lockdowns coming out of covet the supply chain issues, what’s going on in the economy in China right now? Obviously, we have our own issues here that we’ve been focused on with inflation and markets are getting demolished and all that kind of thing. But what’s going on in China? 

James: Okay, it’s been pretty tough. When I left Hong Kong on the 18 April for this trip, we’d been in three months of lockdown. The kids were out of school, people working from home, and the atmosphere was pretty grim. And sadly, we’ve seen now with the spread of the Omakron variant around other parts of China, you’ve seen other cities like Shanghai, Siyan going to Angelockdown, and that obviously is causing a lot of pressure and causing a lot of social and economic harm. As regards the economic impact of that, the shutting down of factories and production and so forth will inevitably have a dramatic consequence on China’s economic growth. We now live in a rather globalized world connected not just through trade, but through the intertwining of the international capital markets. And so what’s going on in China will inevitably have knock on consequences and impacts for other parts of the world, including here in the United States. I always find it rather odd that quite often you see in some of the public commentary, a bit of Chard and Freud are being expressed at the travails that China is going through. And likewise, that happened in China in 2020 when the United States was going through a rough time. The reality is that given the extent to which the two countries are interlinked and intertwined, that the clear self interest for both countries is in the social and economic well being of the other. So as regards China right now, they’re in a tough spot. The fact is that we saw this in Hong Kong, unfortunately, a little bit over a month ago. We had some of the highest death rates in the world. And at that time, Hong Kong, you put out a survey or a study on vaccine efficacy. Hong Kong was the only place that I’m aware of in the world where you had the option between the Sinoback vaccine and the mRNA vaccine. What the study showed was that obviously people who hadn’t been vaccinated at very high levels of hospitalization, but of those who had been fully vaccinated and had to be hospitalized, 87% of those had taken the cinoback vaccine. Unfortunately, it seems that that vaccine is not as efficacious against the Armacron variant of the virus. And so if you look at it in those terms, it becomes very difficult that the Chinese government’s really between a rock and a hard place because they’re acutely aware of the economic damage of these lockdowns and frankly, the level of unhappiness and social dissatisfaction that these cause. Unfortunately, unlike here in the United States, where you have lots of doctors like yourself, almost on every street corner in China, there are two doctors or every thousand had a population, and that population is very dense. And so if they were to pursue the type of opening up that you’ve seen here in the United States, walk around the street, nobody’s wearing masks anymore, then there is a very grave risk of quite catastrophic consequences. I think rather than delighting in the travails that they face, I think all of us ought to be expressing an awful lot of sympathy at this point. 

Buck: I want to shift a little bit to the war in Ukraine. Give me Chinese your perspective on China’s. I guess lukewarm response with their perspective, and they just have to do in part with their own potential interests in taking over various places like Hong Kong in the future. What is the reason for them not being is it a balance of power issue with regard to their position on the Ukraine, Russia’s in the Ukraine?

James: I think there are two parts to your question. The first being that why is China not going along with Western financial sanctions on Russia in response to the Ukraine invasion? And then I think the second question is, is there any read across from China’s stance there to issues around Hong Kong? 

Buck: That’s basically kind of what we thought is, but yes, exactly. 

James: Okay. So I think when you look at this issue, not just from China’s perspective, but if you take a step back, it’s a complicated one. No one’s condoning Russian aggression in the Ukraine for 1 second. It’s something which is absolutely abhorrent and should stop immediately. But if you look at the English language Anglo Saxon press right now, you get this certain view of the world, which is that, oh, aren’t the Russians terrible? And why is everybody not joining into these sanctions? I’ll first say that if you look at this objectively, that the Socalled international order imposing sanctions on Russia right now includes countries representing around 10% to 15% of the world’s population. China has very specific reasons for not going along with these sanctions. One is that China is very dependent on Russia for energy and food. It’s not self sufficient in either of those commodities. And the facts is that China and its maritime environments is surrounded by the US Navy. And so in the event of any dispute with the US, there is a serious security threat to China, that access to food and energy through the very narrow Malacca straight shipping Lane could be choked off. So the geopolitical tensions between China and the US have driven China to diversify those forms of supply, and now it’s very dependent on imports of those commodities over the Russian border. The second factor is that China shares a 2600 miles land border with Russia. Russia is vital to the security and stability of a number of countries on China’s Western border. The fact is that China cannot afford for Russia to be destabilized. They don’t want to get on the wrong side of the US either. Frankly, they’re very dependent on the US dollar and the US dollar system, and so they’re forced into walking quite a tight rope at the moment. But China is not alone in not following those sanctions. And the fact is that India has chosen Brazil has chosen not to do so. Part of that has been a calculation of interest. This is a hard nosed world, and that’s a factor. Part of it, I think also, which I think is more pertinent for an American audience, is that they look at the path to this tragic conflict and they see that there are two sides to this story and so on. The moral question of whether or not they should be following along with Western sanctions at this point, irrespective of their material and sovereign interests, I think they’re very reasonable, balanced people, and I encourage people to go and read and listen to some of the views being expressed by very reasonable, level headed intellectuals in India, in China, in other parts of the world, and that then reflect on, I think, what the situation really is. 

Buck: What do you mean by that? What the situation really is, I guess from the American perspective, and what we see is an attack on a sovereign country. It was not really precipitated by anything that was not precipitated by the Ukrainians in any sort of way. It just seemed like a land grab. So what is the other perspective? 

James: The other perspective is that this was an entirely avoidable conflict. And when you say that it wasn’t precipitated, Russia had stated quite clearly that they saw NATO expansion right up to their borders and particularly into Ukraine, as a major security threat. You can debate the rights and wrongs of that and you can debate whether that’s true or not. But Russian leaders come from a long historical perspective, having been invaded a number of times by Napoleon, by Hitler, right through that sort of channel. And so I don’t think that Russian security concerns were entirely illegitimate I repeat again that I absolutely abhor violence and the aggression which they’ve resorted to. But I also believe that there have been a lot of mistakes made by a number of different actors in the lead up to this conflict. And I think the focus now must be on trying to remove Russian troops from the Ukraine and see a cessation of hostilities. And in that I look at the news and look at the pronouncements by some Western leaders, and I have to say that I hold up my hands in despair because ultimately the Ukrainians are now paying the price for what has become a proxy conflict between different actors around the world. And when Russia isn’t given room to deescalate and to exit, hopefully gracefully from their perspective, then the only result of that is a continuation of the violence and bloodshed. 

Buck: We talked a little bit about the Chinese perspective on Hong Kong. Do you see any parallels on what’s going on with Ukraine and the Russians and how China sees the situation with Hong Kong and how they may be reacting to it influenced by that perspective? 

James: Do you mean Hong Kong or Taiwan? 

Buck: Taiwan. Sorry, Taiwan. 

James: Taiwan. Well, I’m not sure that there’s any direct read across. I’m certain that Chinese policy makers will be paying very close attention to the financial sanctions that the west has placed on Russia in the wake of the Ukraine conflict. Unfortunately, with Taiwan, history has left us with the current status quo. I think my best advice would anyone that we should probably follow the Ping’s prescription on that and allow that situation to be handled by later and hopefully far wiser generations. And I think that generally that will happen unless there is a particular catalyst that forces the hands of leaders either in China or in the United States. 

Buck: I want to finish up with a question a little bit. I know you have an interest in digital currencies and Bitcoin and that sort of thing as it relates to China. China seems to have had sort of a tricky relationship with the digital currencies, having at various times banned mining, Bitcoin, attacks on Bitcoin, etc. But then there’s also a recent I believe you could clarify this for me, but recently launched their own digital currency. Can you explain sort of China’s perspective, perhaps, on digital currencies and what you see the role of it in the future potentially. 

James: So you’re right. China is a leader in the drive towards creating a central bank digital currency. And I think the reason why they’re pursuing that is that in China, China has, frankly, some of the most advanced kind of payment technology, mobile payment technologies in the world. Even if you’re on the street paying a busker, you’re doing it over your phone, through the alleypay, or WeChat pay app. The problem that China faces is that in many cases, that the technological advances has run far ahead of the regulatory frameworks to support it and to govern that. And I see the central bank digital currency as part of an effort to essentially create a level playing field for all financial services companies and fintech actors, so that dominant monopoly or oligopoly platforms aren’t able to abuse their position of dominance, to stifle competition and to prevent the emergence of newer and more innovative technologies. As regards the attitude towards cryptocurrencies, that’s a bit of a distinct issue. And I think that there what you’re seeing is that China worries deeply about those cryptocurrencies being used as tools for speculation, and they’re very concerned about formation of speculative bubbles and the consequences, both economic and social, even when those burst. But you’ve also got to understand that in China, the social contract between the state and its citizens has dramatically changed in the past ten to twenty years. Previously held US health of growth had really ignored environmental issues. China at one point, was the largest center for Bitcoin mining. That’s obviously a very energy consumptive activity. China still relies heavily on coal for electricity generation. And so the proliferation of Bitcoin miners was having a material impact on the environment. So I think the issues of investor protection and avoiding the environmental damage involved in cryptocurrency mining were major factors in the Chinese government’s decision to crack down. 

Buck: That’s interesting. So your perspective is that the crackdown on Bitcoin was more of an environmental perspective? I think that’s sort of unique. You don’t feel that there was a fear of in a very centralized society like China, to have a distributed technology and distributed ledger type currency seems like a good reason to be against it. But you feel like it was a bigger that the environmental issues were really what drove…?

James: Environmental and the avoidance of speculative bubbles. I think we’re major drivers. There’s no doubt that there are also concerns about non state issued currencies proliferating. It’s not just China is sensitive about that. China happens to still have a semi closed capital account. And certainly I think that the People’s Bank of China wouldn’t want to see cryptocurrencies being a channel for large scale capital flight. But in that China is not unique. If you look at other governments around the world and the way they’ve responded to cryptocurrencies, and particularly Western government’s response to Facebook’s proposal to create Libra or DM, and the way that they strangled that to death, that’s not something that’s unique to China. 

Buck: Well, this has been very interesting. James, thank you for your time. Again, the book is Financial Cold War, A View of US Relations from the Financial Markets. I assume that that’s available in all the usual outlets?

James: It is available from the usual outlets, Amazon.com. And if you want to find out more about it, you can go to my website, which is jamesafok.com, that’s jamesafok.com

Buck: That’s great. Thank you very much, James. It’s been really interesting to talk to you and would love to have you back again sometime in the near future. 

James: Thank you, Buck. It’s been a pleasure. 

Buck: We’ll be right back.