Hong Kong – THE Geopolitical Risk

What happens when Beijing loses patience with the Hong Kong demonstrators? What happens when Beijing decides ongoing trade / diplomatic conditions cannot get worse? What happens when Beijing decides it can ride out any storm? 

Hong Kong, and the ongoing protests, is now THE only geopolitical risk that matters.

22 years ago Governor Chris Patten presided over the lowering of the flag of the United Kingdom and the raising of the flag of the Special Administrative Region of Hong Kong. The 1st of July 1997 saw the end of British rule over Hong Kong, and a promise of a 50-year transition under the “One Country, Two Systems” principle. 

“In accordance with the "One country, two systems" principle agreed between the United Kingdom and the People's Republic of China, the socialist system of the People's Republic of China would not be practised in the Hong Kong Special Administrative Region (HKSAR), and Hong Kong's previous capitalist system and its way of life would remain unchanged for a period of 50 years. This would have left Hong Kong unchanged until 2047.”

Fairly obviously that was never going to happen, and the underlying rationale for agreement to the principle was to avoid the collapse of the economic golden goose and to ease the way for a potential peaceful unification with Taiwan. Well, the golden goose has done its part, but Taiwan has not budged. Furthermore, China itself was able to assimilate Hong Kong while at the same time expanding its own economy to the point that Hong Kong is no longer the entry to China. 

Fundamentally Hong Kong has become just another Chinese city, albeit a separate financial centre and vibrant port. We are continually told that the Chinese are masters at the long game and, given the current situation in Hong Kong, and the increasingly uncertain global economic status, that long game could go either way.  If they want to preserve the economic benefits, they play long; if a unified China is the prize, then it is possible that the current global situation may give Beijing confidence that with global attention diverted in so many areas including Iran, this may be their opportunity. 

So why is this THE Geopolitical Risk?

Yes, Iran is a major geopolitical risk, but nothing compared to Hong Kong right now. Iran provides focus and noise, being at the crossroads (and chokepoint) of global oil traffic. Yet the world has been through a "tanker war" once already during the Iran-Iraq war of the 1980s. 

Over the past two and a half decades the West has tied itself economically to China, to an extent that is simply frightening. Were it done as a national policy with alternative plans and capacity already in place and maintained, the West would, in theory, be able to recover quickly from the isolation that a true economic war or sanctions regime would entail. Yet across the developed world, critical national capacity and capability have been outsourced to Chinese companies and/or had production itself moved to China.


The steel industry is a good example. In search of cheaper steel (and cleaner air at home), the West has happily watched and contributed to the growth of the Chinese steel industry. Currently, over 50% of world steel production is in China. Chinese overproduction and dumping of steel on global markets has further undermined Western economies, closed steel mills and slowly built greater reliance on China. This capacity does not return overnight.

Image from Worldsteel.org

In the area of microchip production, China has set out to meet all domestic needs as well as positioning itself to be able to economically undercut and dominate international markets. In July 2017, the Wall Street Journal stated:

The U.S. views China as its biggest semiconductor challenge since Japan in the late 1980s. The U.S. triumphed then through trade sanctions and technological advances. Japanese firms couldn’t match U.S. microprocessor technology, which powered the personal computer revolution, and fell behind South Korea in low-margin memory chips.

China has advantages Japan didn’t. It is the world’s biggest chip market, consuming 58.5% of the global $354 billion semiconductor sales in 2015 according to PricewaterhouseCoopers LLP. That gives Beijing power to discriminate, if it wants, against overseas suppliers.

With these two sectors, China has positioned itself to be able to survive any attempts to isolate it or to economically undermine it. More importantly, China has positioned itself to be able to thwart any attempts at a sanctions regime, knowing that sanctions will hurt the sectioning countries more than they will hurt China. 

Imagine the impact on global trade and development if access to steel and microchips were to be curtailed or limited by sanctions or political risk?

No one should be fooled by the promise of 50 years of limited interference. Beijing has been there all along, and if Beijing has not run out of patience, it will very soon. It is also realistic to expect that in the 22 years since handover there would be changes, and there have been.

The protests started over the extradition law that would have allowed the Hong Kong government to extradite individuals to be tried in China proper. The protests managed to force the Hong Kong government to back down. All well and good, to that point.

It was time for the protesters to go back to university, back to work, and back home. A little local difference that we can all learn from.

But having forced the local government to back down, like so many “protest” movements, they did not see that their primary goal was all that they could actually gain in concessions. They are pushing further, and they may have pushed too far. The current general strike and protest actions such as blocking the subways, roads, and painting over street lights to block traffic are bad enough. To call for “revolution” will probably push Beijing over the line.

“Restore Hong Kong. Revolution of our time,” protesters chanted in a demonstration on Monday at a temple in Wong Tai Sin, a working-class neighborhood that was the site of weekend clashes in which enraged residents went into the streets in flip-flops and shorts to drive out police.

In a broader geopolitical context, Hong Kong is now a proxy that is never should have been, and that it really does not want to be. It is a bastion of Western Liberalism deep in the heart of China. Protests are acceptable when they are local only. But when China is facing off against the United States, loyalties are being examined. 

The breakdown in relations with the West (the United States anyway) make any overt and internationally extravagant protest a form of disloyalty, and that is not acceptable to Beijing. 

There have been reports of Chinese forces (vague reports) on the Chinese side of the border between China and Hong Kong. I expect we will see more such reports. It will be interesting to see what units are included, both by name and by type of units. Those forces will not stay there indefinitely.

Late last week (1st August) the Hong Kong element of the PLA (People’s Liberation Army) released a video showing the unit practising anti-riot exercises “showing its soldiers dressed in riot gear and riding in tanks in scenes that bore striking similarities to the Tiananmen Square protests in 1989”. It is not possible to see this as anything other than a warning that what was done 31 years ago, to protect China and more importantly the Communist Party, will be visited on the people of Hong Kong if they continue to protest.

With no end in sight to the protests, Beijing may well have come to the conclusion that now is the time to end two systems. “The PLA can help restore peace in Hong Kong if necessary: Hong Kong lawmaker Junius Ho Kwan-yiu”. It might not be the 27th Group Army (responsible for Tiananmen Square, and disbanded in 2017), but that will not stop them from being equally brutal and effective.

If they have, Hong Kong will be crushed, and we will see an impotent West rush to the UN Security Council fully aware that China will veto any resolution.

Tiananmen Square may be visited on all of Hong Kong. If this happens, the bloodshed will be terrible, and it will be broadcast to the world. The outrage will be both real and impotent. But within China, the message will be two-fold; Hong Kong is now fully integrated into China, and internal dissent will be tolerated only as long as the role of the Communist Party is not questioned.

The West (and Beijing) will discover if it is possible to engage in urban warfare in a modern mega-city. What better place and time to test doctrine, in a place where they control all physical access, and where, eventually, they can control all communications (though that one will take some time). Beijing will also be watching closely to see what lessons they can learn in relation to Taiwan. 

It will not be fast, but it will be effective. Professionals will be "spared" though families may be invited to visit the countryside. After all, the financial systems and global trade must continue.

By the time the international community is able to respond meaningfully, Hong Kong will be subjugated. China (and the rest of the world) knows full well that Hong Kong is not Kuwait, and Xi Jinping is not Saddam. The United States will not be pushing the PLA out of Hong Kong.

What will happen to global markets? From China’s perspective, nothing that they are not willing to allow anyway, in their trade fight with the United States. In Asia “Face” is all-important, and to allow insults of the leader and the country is to lose face.

So anyone who thinks that China will not “invade” and “pacify” Hong Kong should be careful with their assumptions. Geopolitical risk is exceptionally high, and unless both China and the United States have a way to convince the protesters to end their protests and calm their slogans, there will be major trouble.

China has positioned itself to be able to survive any sanctions regime, or at least to impose a greater cost on sanctioning countries. This limits the ability to use threats of sanctions to influence China. This also means that China may feel that they will be given a "free hand" to suppress Hong Kong. 

There is a very significant danger of miscalculation. We already know that words alone will move markets. A Chinese "Tiananmen" style suppression of Hong Kong could generate global market chaos.

Today, next to China and Hong Kong, all other geopolitical risk pales. 

Is the Baltic Dry Canary telling us something?

The US economy continues to grow at a cracking pace, or so we are told again and again. Unemployment is down to record lows, and the stock market is back to record highs. Corporate profits are at record highs, and the (US) economy grew at 4.2% in the second quarter of 2018. Europe continues to grow, at least that is the message, Brexit or not. Not one month ago, the Baltic Exchange Dry Index (BDIY), a key measure of the cost of transport and a bellwether of international trade volumes, was at an annual high of $1774.

Is there anything to suggest that all is not well?

Officially, all is good in Economy-Land. Unless you are in the Emerging Markets (EM) where all is going to hell in a handcart. And if you do watch the BDIY as I suggested last month, you may have reason to worry.

https://www.bloomberg.com/quote/BDIY:IND

Years of Growth Ahead?

Some time ago (18 August 2017) I asked if the collapse of the employment participation rate during and after the Great Recession of 2008 had actually set the US up for years of economic growth as ejected labour re-entered the market, creating a multi-year pool of “new” labor. Was the unemployment rate artificially low due to the definitions used to define “unemployed”, and was there, in fact, a giant pool of untapped labour just waiting to be absorbed?

Certainly, European economies have had a chronic underemployment problem for the past twenty years, so there should be no shortage of labour, unless your production is in Germany (a problem that was supposed to be solved through the importation of millions of ‘refugee’ migrants to provide the new working underclass). 

Or black Swans a swimming?

Or, as I pointed out last month (6 August 2018) are there too many Black Swans flocking, ready for the first to set off a global contagion? Some are pointing to the ongoing EM route and collapse of so many international currencies (Turkish Lira, Argentine Peso to name two) as the “Black Swan de jour” that may cause contagion in developed markets. Are the US markets being kept artificially buoyant with cash fleeing EM countries? 

Or, are tariffs actually beginning to impact? Or, the EM route simply an indicator of the level of international uncertainty, with tariffs being one re-enforcing element?

If tariffs and the EM markets are all part of the same flock of Black Swans, then we should be able to see the rot in international trade. 

On the 6th of August I wrote:

"We need to keep watching indicators from around the world, and look for specific activities. The Baltic Dry Index provides a good indicator for us to watch. In the past moths, the Index has risen from $1250 to over $1700 now. The Baltic Dry Index provides a reliable surrogate for global trade volatility, with higher trade volumes increasing the cost of freight, and falling freight volumes driving down the BDIY."

And so I have been watching the Baltic Dry Index, and it has not been pretty. In the month since I wrote the above, the BDIY has fallen from an annual high of $1774 down to $1477 today (6 September 2018), representing a 16% fall in that month.

As a reminder, the BDIY is a measure of the cost of freight, and as such is an indicator of volumes of international trade in terms of shipping. It is reasonable to expect the BDIY to rise and fall over time due to total shipping capacity, with fleets expanding too quickly for anticipated growth in trade resulting in a slowly lowering BDIY, and fleets falling as uneconomic ships are retired from the fleets and scrapped resulting a slowly gaining BDIY. But that is for the long-term trend line only.

What we have seen this year is the BDIY increase significantly in the second quarter, just as tariffs were being mooted, but before they were actually brought into force. As I speculated in early August, the robust second-quarter GDP print could have been a factor of forward-purchasing and inventory padding to ride-out any transitory tariff impact. If that were the case, I suggested that we would see a fall in trade volumes in the third quarter, with the BDIY providing an early warning sign of such a fall in trade.

We are now seeing that fall, and while one month and a 16% fall could be a transitory fluctuation, it could also be an indicator that trade volumes are being hit, and we should expect a must worse third quarter GDP print.

If the BDIY continues to fall, it will be the clearest sign yet that the tariffs are biting, and that trade volumes are indeed falling.

Even as the BDIY was increasing through July, the Netherlands Bureau for Economic Policy Analysis was reporting that global trade volumes fell in June (I await the July figures).

As I said in early August, I will continue to watch the BDIY, as this may be one of our best canaries in the global trade coal mine.