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New World Economic Blocks

USA and China: a world divided in two blocks

Investors need to stay abreast of developments between the US and China and understand their prospects in order to identify vulnerable companies.

After four years of escalating trade challenges and almost a year since the first real global pandemic in the last 100 years, the geopolitical and economic situation looks like a roller coaster.

Beijing and Washington have very different views on how the international order should work and while the US is increasing pressure, China is not retreating one step. If the US and China cannot reach an agreement that supports the normal functioning of the international system, it is certain that they will both begin to deploy their geopolitical formations.

Many countries (such as Mexico and Pakistan), also because of their geographical proximity and deep economic ties with the two powers, will not be able to resist the call of the US and China. In the meantime, the rest of the world is in a kind of limbo, trying to remain neutral despite the pressures coming from both sides.

US strategy

It is very likely that Washington will continue to put pressure on its allies and third countries to join efforts to isolate China and continue to impose sanctions on Chinese companies.

Australia, New Zealand, Canada and the United Kingdom are members of the intelligence sharing alliance, Five Eyes, and are already committed to standing by the US. Mexico, in fact, has no alternative, such is the country’s economic dependence on the United States.

It is more difficult to persuade the European Union to take sides; Europeans, being instinctively inclined towards multilateralism, would prefer to set their own parameters for the management of relations with China. In the Indo-Pacific, the Trump administration has tried to relaunch the “Quad” (Quadrilateral Security Dialogue) as the basis of an anti-Chinese alliance, but it is not clear whether India and Australia see it the same way.

The average rate of customs duties on Chinese goods rose from 3% to 19% between January 2018 and March 2020, an increase of more than six times. There is therefore much scope for reduction, especially on intermediate goods, which penalises US companies by increasing costs and making their end products uncompetitive. Logically, a pragmatic administration would reduce these duties judiciously, using instead measures of a different nature for the more sensitive sectors.

On the financial side, the Public Company Accounting Oversight Board (PCAOB) has failed to reach an agreement with the Chinese authorities to obtain access to the audit records of Chinese companies, and in the current climate the “atomic” option has been presented: the SEC could prohibit trading in shares of companies that have not faced a PCAOB inspection for three consecutive years. In this sense, the US Senate, thanks to a bipartisan agreement, has already tabled a bill. However, Chinese law sets limits on disclosure of information and currently prohibits Chinese accounting firms (including local affiliates of international companies) from sharing audit documentation on companies for national security reasons.

In fact, this outlines the concrete prospect that China will become another country on the list of countries in which investments are restricted, such as Iran and Sudan. This would clearly limit the investment universe for US-based investors, but could potentially become a condition for trade agreements or defence pacts: i.e. a third country signing an agreement with the US would have to renege on relations with China. This is perhaps the most far-reaching impact for investors in the short term, although the investment world will quickly identify parallel mechanisms to circumvent the problem.

China strategy

In simple terms, China’s plan of action is to become richer and summarize its legitimate role as “Middle Kingdom”. Zhongnanhai, the headquarters of the leadership of the Chinese Communist Party, wants to show that communism can actually provide the structure to ensure responsible government, a clean environment and economic wealth.

On closer inspection, the process of restructuring China’s domestic economy from manufacturing to services already makes US tariffs less effective. Since 2013, China’s GDP growth has been increasingly driven by the service sector and domestic consumption.

The country’s strategy will be to redouble efforts to develop the Belt and Road Initiative.

Finally, “in the countries of Central and Eastern Europe, the economic recession will be less severe than in the EU countries, and recovery will be faster, although historically high profitability will decline due to aggressive rate cuts and lower lending growth.

(BIS) and to accelerate the recruitment of beneficiary countries within its sphere of influence. This means consolidating access to those markets, integrating Chinese companies into those economies, establishing long-term supply flows of raw materials, resources and agricultural products, while taking steps to encourage the adoption of Chinese technical and technological standards. Given the scarcity of alternatives, it would be logical to assume that the majority of countries will agree to join the initiative by integrating into Beijing’s sphere of influence.

In addition to focusing on the countries affected by the “New Silk Road”, China was also the main sponsor of the Regional Comprehensive Economic Partnership (RCEP), which became “active” in November 2020.

In commercial and geopolitical terms, this is China’s response to the Trans-Pacific Partnership (TPP). There are 16 members: Australia, Brunei, Cambodia, China, India, Indonesia, Japan, Laos, Malaysia, Myanmar, New Zealand, Philippines, Singapore, South Korea, Thailand and Vietnam. Together, they represent 25 trillion dollars of GDP. This group will enjoy continuous growth in trade volumes and value, becoming increasingly aligned with Beijing in geopolitical terms.

EU Action Plan

The EU Action Plan appears to be to try to maintain its position in multilateralism and free trade, taking advantage of its large internal market and the combination of its diplomatic and military possibilities, while strengthening its defences against cyber-warfare and the acquisition of intellectual property by China.

The blockade of the Old Continent will probably side with the United States, but it will not be willing to be fully incorporated by the Americans, jealously protecting its right to enter into independent agreements with other countries of the world.

USA vs China: implications for investment

The next decade will therefore probably see an increase in efforts to split the two largest economies in the world. Investors are well aware of the growing pressure on governments to choose sides. In developing countries, the BIS’s Chinese offer has already been accepted.

The only way to stop this process would be a sudden and corresponding financial generosity on the part of the United States, the emergence of BIS implementation problems, or a shocking political misstep on the part of Beijing.  All this seems rather unlikely at the moment, so if the dissociation between the US and China were to continue, there would be many countries in the Chinese sphere of influence.

Investors need to keep pace with developments and understand their prospects in order to identify particularly vulnerable companies. At the same time, they should plan for a future in which their geographical location will effectively determine the investment universe, as has not been the case for many decades.

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