Geopolitical Perils Prompt Investors to Rethink China Exposure

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Since the D-Day, the very onset of post war rules-based order, China has immensely benefited from the security and economic integration of the world.

The naive concept of Doux Commerce, originating from the age of enlightenment stating that commerce tends to make people less likely to resort to irrational behaviors, has been the cornerstone of West's way of interacting with China in the past 80 years, especially after the signing of 1979 Taiwan Relations Act by which the U.S. officially recognized People's Republic of China.

From that point on, China's economic ascent, epitomized by its remarkable transformation from an agrarian society to an economic juggernaut, has been profoundly influenced by strategic shifts in trade policy orchestrated by the West.

Over the past four decades, China has deftly capitalized on the evolving global economic landscape, leveraging its comparative advantages and embracing export-led growth strategies mostly thanks to change-through-trade policy sought by the West.

Enticed by the allure of China's vast consumer market, the developed world gradually softened trade barriers and fostered a symbiotic economic relationship with China, hoping that if it gets richer, it becomes a more open society to accommodate similar set of values with its trade partners.

Well, that was worth a try!

Now, it's all about choosing your D-word when it comes to China: De-Risking, Decoupling, Disentangling, Downsizing etc..

Investing in China, once considered a lucrative venture during its economic boom, has become an increasingly perilous endeavor for global investors. Geopolitical risks, once an afterthought, are now at the forefront of considerations, prompting many to reassess their exposure to Chinese stocks, bonds, and private companies.

This summer saw the U.S. impose restrictions on American investments in certain high-tech industries, coupled with export limitations on semiconductor chips pivotal for artificial intelligence—a move aimed at curbing China's military advancements. The repercussions were palpable when Alibaba shelved plans for its cloud-computing division, resulting in a staggering $20 billion loss in market value in a single day, illustrating the unpredictability of U.S.-China tensions for investors.

The spillover effects of Russia's invasion of Ukraine last year have served as a cautionary tale for investors, crystallizing the risks of over reliance on Chinese assets. The ongoing tensions surrounding Taiwan, coupled with an exodus of foreign capital from mainland China's stock markets, reflect the increasingly intricate landscape that investors navigate.

The market's response has been evident, with a notable $24 billion outflow from China A shares since August, the most significant and sustained since the inception of the Hong Kong trading link in 2014. This coincides with weakened Chinese economic data, contributing to a 10% loss in the MSCI China Index this year, signaling its potential third consecutive annual decline.

Major Wall Street banks anticipate that hedge funds and active-fund managers exiting Chinese holdings are unlikely to return until significant improvements occur in China's growth outlook and U.S.-China relations while at the same time adding a dire warning of "sustained geopolitical complexity" in 2024, an election year in both the U.S. and Taiwan.

They even outline a scenario where investors could sell an additional $170 billion in Chinese shares under harsh conditions if all get worse.

On top of that, China's economic might faces unprecedented decline, casting doubt on overtaking the U.S.

China, once hailed as the global growth powerhouse, is facing a rare setback as its share of the global economy declines for the first time since 1994. Despite frequent mentions by institutions like the International Monetary Fund as the largest contributor to global growth, a closer look reveals a more nuanced reality.

The prevalent use of "real" GDP figures, adjusted for inflation, may present an inflated view of China's economic prowess. In a world driven by nominal values, where prices reflect actual numbers on paychecks and store tags, the U.S. emerges as the most consequential economy, representing 28.4% of the planet's GDP compared to China's 20%.

Even more noteworthy is the fact that China's economic decline happened amidst a global scenario where emerging markets were growing.

This phenomenon occurred despite the U.S. Federal Reserve implementing one of the most aggressive series of interest-rate hikes in decades. Traditionally, such tightening cycles by the Fed lead to major currency depreciation in developing nations, prompting growth-destroying rate hikes. Last observed in the early 1980s, a similar scenario triggered a devastating debt crisis in Latin America.

While full-year numbers for 2023 are not yet available, an analysis of the third quarter highlights China's further descent behind the U.S. In yuan terms, China's nominal GDP increased by less than 3.5% from the previous year, and in dollars, it notably contracted due to the yuan's depreciation.

In stark contrast, the U.S. saw its GDP grow by over 6% in the last quarter, attributable in part to inflation but also fueled by sustained consumer spending and a manufacturing renaissance.

The economic and financial decoupling between the U.S. and China, accentuated since 2021, further complicates the investment landscape. Delistings of Chinese entities from U.S. stock exchanges and bans on American investments in certain Chinese firms amplify the widening rift. The repercussions of Russia's actions in Ukraine serve as a stark reminder of the risks associated with overreliance on Chinese assets.

All of these underscore the seismic shift in the investment landscape concerning China, a nation once considered a hotspot for global investors. The key theme centers around the rising prominence of geopolitical risks, a factor that was previously relegated to the background during China's economic boom.

Now, these risks are steering investors away from Chinese assets, impacting stocks, bonds, and private companies.

In conclusion, China's recent economic decline, coupled with the U.S.'s continued robust performance, raises questions about China's prospects of overtaking the U.S. economy. As geopolitical competitors, the economic weight of both nations plays a pivotal role in shaping global dynamics.

The rarity of China's GDP share shrinking underscores the challenges it faces on the path to economic supremacy.

Let's now carry on with putting global events in perspective.

Here are the latest developments on global trends that I believe will shape the way we do business in 2024.

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1. Boardroom Challenges in 2024:

Navigating Uncertainty - A Strategic Approach to Creative Thinking for Future Success.

In the ever-evolving landscape of business, adopting a long-term perspective can be a formidable challenge. As organizations strive to plan for an unpredictable future, the instinct to reduce uncertainty often hinders the cultivation of fresh perspectives that could unlock new possibilities.

Embracing uncertainty, however, opens the door to creative thinking, fostering a mindset that not only anticipates the unexpected but also constantly reevaluates foundational beliefs and assumptions.

Creative thinking about the future demands a nuanced approach—one that takes into account the intricate and fast-paced nature of the contemporary world.

To effectively envision the future of an organization, three essential steps must be undertaken.

Firstly, adopt an expansive, long-term view that remains open to all possibilities and is acutely aware of both internal and external dynamics. Recognizing the impact of trends is crucial, as they can significantly influence business operations and present opportunities for gaining a competitive edge.

Megatrends, encompassing substantial societal, economic, political, environmental, or technological shifts, serve as invaluable tools in sparking innovative possibilities. Notable examples include the ascendancy of alternative energy sources and the ubiquitous rise of mobile connectivity.

Identifying trends that will shape the future and questioning seemingly inconsequential ones are integral to this step.

Secondly, compile a list of issues expected to unfold over a relatively extended period, typically 5 to 10 years, with potential far-reaching impacts. These issues should open avenues for a range of strategic responses, fostering adaptability in the face of uncertainty.

Refining this list involves questioning which trends will be pivotal in shaping the organization's future and recognizing the unexpectedly critical ones.

Lastly, ponder the various ways to exploit these megatrends, creating novel opportunities for the organization. Stretching thinking involves considering the trends to which the organization might be least prepared to respond.

This prompts an exploration of overlooked trends that may lie in plain sight yet remain unaddressed. Assessing the influence of potential trends on generating new ideas for the future is paramount.

Yet, creative thinking about the future is not confined to amassing trend data but hinges on maintaining an atmosphere of doubt, as cultivated in the initial step.

The doubt-centric approach enables a fresh perspective on data—whether trends, customer research, or competitive intelligence—better preparing organizations for an uncertain future. Indeed, the essence of thinking creatively about the future lies in embracing uncertainty rather than attempting to eliminate it.

This strategic mindset not only navigates uncertainty but also serves as a foundation for innovative and resilient organizational futures.

2. Geopolitics and Investment Climate:

Walmart Mitigates China Reliance, Amplifies Indian Imports in Strategic Shift.

Walmart, the world's largest retailer, is significantly reducing its reliance on China and increasing its imports from India. Between January and August this year, one-quarter of Walmart's U.S. imports originated from India, compared to just 2% in 2018. In the same period, China's share of Walmart's shipments dropped to 60%, down from 80% in 2018. While China remains the largest source of Walmart's imports, the shift highlights the impact of rising costs and escalating political tensions between the U.S. and China, prompting major U.S. companies to explore alternative supply chain options.

Walmart's move towards diversification aligns with its strategic efforts to enhance supply chain resiliency. The retailer has recognized the importance of avoiding over-reliance on any single supplier or geography due to various factors such as natural disasters, geopolitical issues, and supply chain disruptions.

Andrea Albright, Walmart's Executive Vice President of Sourcing, emphasized the need for supply chain redundancy to ensure resiliency, stating, "I can't be reliant on any one supplier or geography for my product because we're constantly managing things from hurricanes and earthquakes to shortages in raw materials."

India has emerged as a crucial component of Walmart's strategy to diversify its supply chain. Walmart has accelerated its growth in India since 2018, following its acquisition of a 77% stake in Indian e-commerce firm Flipkart. The retail giant is committed to importing $10 billion worth of goods from India annually by 2027.

Currently, Walmart is importing around $3 billion worth of goods from India each year. The rising cost of importing from China, coupled with India's rapidly growing workforce and technological advancements, has made the country an attractive option for Walmart.

Walmart CEO Doug McMillon's meeting with Indian Prime Minister Narendra Modi in May 2023 reflects the company's commitment to supporting India's manufacturing growth. India's strategic importance has been underscored by the rising demand for critical minerals and the need for a resilient and diversified supply chain.

Walmart's move aligns with the broader trend among companies seeking alternatives to China, with other countries like Thailand and Vietnam also benefiting from this shift.

The COVID-19 pandemic exposed vulnerabilities in global supply chains, prompting companies to reevaluate and diversify sourcing strategies. In addition to India, Walmart has also expanded its sourcing from countries like Pakistan and Bangladesh.

The shift in Walmart's sourcing strategy is a response to the changing dynamics of global trade, emphasizing the importance of agility, redundancy, and resilience in supply chains.

3. Friendshoring and Supply Chains:

EU and Mercosur Edging Closer to Culminating Historic Trade Pact.

The European Union (EU) and Mercosur, the South American customs union consisting of Argentina, Brazil, Uruguay, and Paraguay, are on the verge of finalizing a major trade agreement after over two decades of negotiations. This potential deal, one of the largest in the history of the EU, is anticipated to create an integrated market comprising 780 million consumers.

The agreement is seen as a significant economic and geopolitical milestone for both regions, offering extensive opportunities for trade, economic cooperation, and market integration.

The leaders driving the negotiations, European Commission President Ursula von der Leyen and Brazilian President Luiz Inacio Lula da Silva, are set to meet on the sidelines of the United Nations' COP28 climate summit in Dubai. This meeting, expected to take place on Saturday, will serve as a crucial political push to bring the deal closer to fruition.

The technical negotiations between the EU and Mercosur have reportedly made notable progress, especially in addressing environmental concerns that had been a major stumbling block in previous iterations of the agreement.

The potential agreement would lead to the elimination of import tariffs, providing substantial benefits to European exporters and offering South American industries increased access to European markets. With a focus on creating an integrated market, the agreement is particularly significant for sectors related to green and digital technologies, securing essential materials for the development of these industries.

The geopolitical implications of the EU-Mercosur agreement are also noteworthy. In the backdrop of global competition for influence, where countries like China and Russia are seeking to enhance their presence in resource-rich nations across the Americas, a successful deal would strengthen ties between the EU and Mercosur.

Additionally, the trade agreement could contribute to fostering closer cooperation between the two regions, aligning their responses to global challenges.

The negotiations between the EU and Mercosur initially concluded in 2019 after more than two decades of technical discussions. However, the agreement faced hurdles as concerns were raised about deforestation rates in the Amazon rainforest under the leadership of former Brazilian President Jair Bolsonaro. These environmental issues have continued to be a challenge, but recent reports indicate that both sides are making progress in addressing outstanding technical issues.

Despite optimism surrounding the negotiations, officials remain cautious as the agreement enters a critical phase. Several important issues, including environmental concerns, compensatory mechanisms, and the phasing out of tariffs on certain products, still require resolution.

The process received a serious setback, for instance, after French President Emmanuel Macron said that the environmental concessions obtained by the bloc fall short of what’s needed.

Products imported from Mercosur — comprised of Argentina, Brazil, Uruguay and Paraguay — would have “a disgusting carbon footprint,” Macron told reporters Saturday after meeting with his Brazilian counterpart, Luiz Inacio Lula da Silva, in Dubai at the COP28 climate conference.

Still, the EU and Mercosur are keen to build on the momentum generated by recent advances in technical negotiations and secure a comprehensive agreement that benefits both regions economically and strategically.

The successful conclusion of the EU-Mercosur agreement would represent a significant trade achievement for the EU and mark a new chapter in the economic relations between the two blocs.

4. Energy Security and Diversification:

EastMed Pipeline Secured in European Commission's Roster of Key Priority Projects.

The European Commission has decided to retain a proposed gas pipeline that would connect Eastern Mediterranean gas reserves to Greece via Cyprus and Crete on its updated list of Projects of Common Interest (PCI).

The PCI list grants projects access to a fast-track permitting process and special funding.

The project is sponsored by energy group Edison and Greece's DEPA International Projects through their joint venture IGI Poseidon.

However, a final investment decision (FID) on the pipeline is still pending, with delays attributed in part to geopolitical tensions in the Middle East. Originally, the FID was expected to be made by the end of this year.

In a separate document published on the same day, Italy's energy authority ARERA, in collaboration with counterparts in Greece and Cyprus, ruled out the inclusion of the costs associated with building the EastMed pipeline in the national tariffs of the three countries.

Additionally, the authorities dismissed the notion that gas grid operators in Italy, Greece, and Cyprus should compensate for the construction of the infrastructure.

The EastMed pipeline has strategic significance as it aims to connect gas fields in the Eastern Mediterranean, including offshore fields in Israel, to Greece. Projects like these play a crucial role in enhancing energy security and diversification of energy sources in the European Union.

The European Commission's decision to keep the project on the PCI list reflects its importance in the broader energy landscape and the European Union's efforts to ensure a secure and diverse energy supply.

5. Sanctions and Trade Restrictions:

EU Floats Proposal for Windfall Tax on Frozen Russian Assets in Solidarity with Ukraine.

The European Union (EU) is moving forward with a proposal to tax profits from more than €200 billion ($218 billion) of frozen Russian central bank assets, with the aim of supporting Ukraine's reconstruction efforts. The proposal involves imposing a windfall tax on profits generated by the frozen assets, and the European Commission is tentatively planning to unveil the legislative proposal on December 12.

However, there are concerns from several EU member nations, including Belgium, Germany, France, Italy, and Luxembourg, which have expressed caution and called for a more gradual approach.

The EU has been debating the option of applying a windfall tax on the profits generated by Russia's sanctioned sovereign assets, with estimates indicating that more than €200 billion of such assets are in the EU, primarily at the Belgium-based Euroclear clearinghouse.

Sanctioned Russian assets frozen at Euroclear have reportedly generated nearly €3 billion in profits from the time they were frozen through the third quarter of this year. The proposed windfall tax aims to tap into these proceeds to contribute to Ukraine's reconstruction.

The issue has divided the 27-nation EU, and while some member states advocate for a more cautious and gradual approach, the European Commission contends that EU leaders have urged an acceleration in the development of the proposal. The EU leaders are expected to consider the proposal during a summit in Brussels later in December.

The EU's decision on this matter will likely be influenced by factors such as political considerations, economic interests, and the ongoing geopolitical situation.

The windfall tax proposal reflects the EU's efforts to respond to the conflict between Russia and Ukraine and contribute to the reconstruction and stability of the region. The EU's decision-making process on this matter is complex, involving negotiations and discussions among member states, the European Commission, and other stakeholders.

6. Decarbonization and E-Mobility:

US Implements Stringent Measures on Chinese Content for EV Tax Credits.

The Biden administration has unveiled a set of regulations aimed at restricting electric vehicle (EV) manufacturers from sourcing battery materials from China and other geopolitical adversaries.

These long-awaited rules, mandated as part of a broader initiative linked to the extension of the $7,500 tax credit under President Biden’s climate law, introduce a 25% ownership threshold for entities categorized as Foreign Entities of Concern (FEOCs). The term refers to businesses or groups with ownership or control ties to US geopolitical rivals.

Initially, the restrictions will be applied to battery components starting next year, with an expansion to include suppliers of critical battery raw materials, such as nickel and lithium, scheduled for 2025. The impact of this definition is significant, as from 2024 onward, vehicles containing any battery components manufactured or assembled by FEOCs will be disqualified from the tax credit.

The Biden administration faces the challenging task of striking a balance between reducing reliance on low-cost Chinese materials dominating current supply chains and promoting EV adoption as a means to combat climate change.

The delay in outlining these requirements has created uncertainty in the mining, auto, and battery industries, with the impending implementation just weeks away. The release of these guidelines provides automakers and suppliers with some clarity for project planning.

While most automakers are still analyzing the rules, Ford Motor Co. has indicated that its Mustang Mach-E EV may no longer qualify for federal tax credits under the new guidelines. The criteria stipulate that any company subject to the jurisdiction of China’s government or controlled by the government, including those with at least 25% ownership by a Chinese government authority, will be classified as an FEOC. These restrictions will also extend to all production within China.

However, there is a nuanced aspect to the regulations, allowing foreign subsidiaries of privately-owned Chinese companies in non-FEOC countries to operate freely, provided they are not under the control of the Chinese government.

This provision seems to endorse licensing arrangements, exemplified by Ford’s battery plant in Michigan, which licenses technology from China’s battery giant, Contemporary Amperex Technology Ltd. (CATL).

Tesla Inc. explored a similar structure with CATL earlier this year, although the current status of those negotiations remains unclear.

The unveiling of these regulations sets the stage for a recalibration of the EV industry landscape, as companies navigate the intricate terrain of geopolitical considerations and climate imperatives.

7. Rare Earths and Commodities:

Saudi Arabia Explores Entry into Critical Minerals Market with Commodity Trading Platform Initiative.

Saudi Arabia is actively exploring the possibility of launching a new commodity trading platform that would focus on battery materials, including graphite and rare earths, according to Khalid bin Saleh Al-Mudaifer, the Vice Minister of Industry and Mineral Resources.

This initiative is part of Saudi Arabia's broader strategy to diversify its economy and tap into its substantial mineral resources, which are estimated to be worth around $1.33 trillion.

The country aims to become a minerals hub, shifting away from its traditional dependence on oil.

The proposed trading platform would cover critical materials such as lithium and cobalt, which play a crucial role in the production of electric vehicles and are integral to the global transition towards renewable energy.

While lithium and cobalt are already traded on established exchanges like the London Metal Exchange and Chicago Mercantile Exchange (CME), graphite and rare earth metals currently lack efficient commodity exchange platforms and price-finding mechanisms.

The Kingdom has been studying the feasibility of this initiative over the past three months. However, a decision is not expected before the next six months. Al-Mudaifer highlighted the complexity of establishing a commodity exchange for these specific minerals, as quantities are relatively small, and specifications differ. He emphasized that the process is more challenging compared to commodities like aluminum or crude oil.

To facilitate the development of this initiative, Saudi Arabia is collaborating with consultants and individuals with expertise in commodity trading. The move aligns with the country's broader efforts to transform its economy and leverage its mineral wealth for economic growth.

The investment fund Manara Minerals, a joint venture between state-owned miner Ma'aden and the Public Investment Fund (PIF), was established in January. This fund prioritizes overseas acquisitions, focusing on minerals such as copper, nickel, iron ore, and lithium.

Manara Minerals made a significant investment by becoming a 10% shareholder in Vale's $26 billion copper and nickel unit in July 2023, marking its initial foray into overseas ventures.

While the potential commodity exchange is still in the study phase, its successful implementation could contribute to Saudi Arabia's ambition of establishing itself as a prominent player in the global mineral markets, aligning with the ongoing global shift towards renewable energy and electric mobility.

8. Aerospace and Defense:

Finland Inks €317 Million Accord with Israel for Acquisition of David's Sling Air Defense Systems.

Israel's Defense Ministry has secured a historic agreement for the sale of the David's Sling air defense system to Finland, marking a groundbreaking deal estimated at 317 million euros (NIS 1.3 billion).

The agreement, signed at a ceremony attended by officials from both nations, is regarded as a significant achievement and underscores Israel's prowess in the defense industry. Developed by Rafael Advanced Defense Systems, the David's Sling system is renowned for its advanced capabilities in intercepting a variety of threats, including ballistic missiles, cruise missiles, aircraft, and drones.

The Defense Ministry characterized the David's Sling system as one of the world's most advanced, showcasing high-performance capabilities in real-world scenarios.

Operational in Israel since 2017, the system has been a critical component of Israel's multi-layered missile defense capabilities, which also include the Iron Dome for short-range threats and the Arrow systems designed to engage long-range ballistic missiles.

The sale of the David's Sling system to Finland marks a significant milestone as it represents the first foreign sale of this advanced air defense technology. Finland, having joined the NATO military alliance, announced its intention to purchase the system in April of this year, emphasizing its desire to extend the operational range of its ground-based air defense capabilities significantly.

The Defense Minister of Finland, Antti Kaikkonen, expressed that the acquisition of the David's Sling system would provide Finland's defense forces with a new capability to intercept targets at high altitudes.

The sale of this defense system to a NATO member reinforces Israel's position as a global leader in defense technology, with its cutting-edge solutions meeting the security needs of nations worldwide.

While the deal with Finland signifies a significant step in Israel's defense exports, it also underscores the global demand for advanced missile defense systems. The success of the David's Sling system in real-world scenarios and its adoption by a NATO member highlight Israel's contribution to enhancing international security and the effectiveness of its defense industry in meeting the evolving challenges of the modern battlefield.?

That's all for now and hope to see you again in the next edition.

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