China Lockdown Could Just Be The Beginning Of Larger Trouble

Date: 7/12/2022
Author: Mr. X

President Joe Biden may feel he’s not getting enough credit. Gas prices have declined for three weeks straight. The latest jobs report was expected to show 250,000 new jobs were added. Instead, it showed 372,000. Commodities are all falling in price compared to just a few months ago – including corn, wheat, copper, and other essential goods and raw materials.

Inflation, the experts say, may have peaked. A recession, some say, may really just be the public being irrational.

Today’s inflation report will tell the real story. Yet as the Fed itself has repeatedly admitted, what is truly driving events is entirely outside the central bank’s control.

So while Wall Street is focused on inflation, I’m thinking about Beijing – and the horrifying prospect of more lockdowns and what they could lead to.

China’s “Zero-COVID” policy may be one of the greatest own goals in the history of geopolitics. Early in the pandemic, the country looked competent, efficient, and unified compared to the United States. Today, despite all its problems, there can be no question about which country faces economic ruin. China’s political elite draws its very legitimacy from delivering economic growth. China’s growth target for the year is 5.5% – something that most experts were saying was out of reach just a few weeks ago.

With current news, I’m just going to put myself out there. China will miss this target. And it will miss because of COVID policies.

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This is not to say that China is taking the wrong approach from a purely utilitarian point of view. Bloomberg has reported that China suffered relatively few deaths per capita compared to the United States and its economy performed better in previous years. Even if one were ruthlessly focused on the economy instead of human lives, small outbreaks controlled with authoritarian lockdown policies and mass testing could be less costly than a more decentralized approach. Disrupting production schedules may prove far less damaging in the long run than letting the virus run wild.

Yet as even the fully vaccinated are getting repeatedly infected with new COVID-19 variants and cases of “long-COVID” are spreading, the West could be looking at a ruinous health care crisis. China may actually have it right…  but it doesn’t matter.

I’m not granting China does, but assuming, arguendo, that it does, its political system is far less able to handle outbreaks of public disorder than the American system. The United States has seen vast riots and crime increases over the last few years – yet none of it really poses a threat to the state. At worst, the Biden Administration’s party may lose the House, and that’s no danger to the Republic. Yet China must tamp down dissent or risk political elites using disorder to challenge the system from the inside while rioters challenge it from without.

President Xi Jinping admitted for the first time in March that the country needed to balance the economic costs with health care considerations. However, this didn’t represent a meaningful break with the zero-COVID strategy. The lockdowns continue. The government can’t be perceived as failing in its mission to achieve (using Xi Jinping’s phrase) “the maximum prevention and control effect.” That could be said of its approach to government, not just the economy.

During the recent lockdown in Shanghai, there were positively nightmarish reports of people essentially locked in their own homes. Videos emerged of scuffles with local police. At night, one video showed people screaming out their apartment windows into the darkness.

And those screams were heard, in some way, by the United States. Elon Musk blamed the supply chain disruptions in China for destroying Tesla’s production schedule. Even leaving aside American companies operating in China, America alone consumes more than 17% of China’s exports. Any major economic disruption or political conflicts would have a major negative impact on the United States, especially as China would have less ability to buy American treasury bonds.

China’s economy was already looking shaky before now. The crisis of China Evergrande, the massive real estate company, is still ongoing. Chinese real estate companies are highly leveraged and vulnerable to lockdowns and the knockoff effects that disrupt sales.

There are also signs of trouble hitting the financial sector. Local banks are reportedly not letting customers withdraw their money in some areas. In Henan, protests ultimately led to violence by the security forces. The government resorted to blaming the situation on “criminal gangs” who supposedly took over the bank in 2011. Even Chinese social media, which generally takes a nationalist tone, wasn’t buying it. Videos of the incident also circulated widely even behind the Great Firewall. Western media has also been heavily promoting the story, which is interesting in itself.

Bank runs are of far more political importance than simple street crime. The level of Chinese debt (projected as a percentage of GDP) is projected to reach 275% this year. And that’s from an analyst who works with the Chinese central bank, not a worst-case scenario from a hostile foreigner. The bond market is also in turmoil as investors flee from banks that lent heavily to Russia.

In this environment, the political costs of enforcing lockdowns are increasing for the Chinese government. That translates into greater economic costs as well, especially as the chain of reinfections and lockdowns has no end in sight. This has a greater psychological impact than what we are suffering in the United States.

Therefore, it’s extremely ominous that China is going through a whole series of new restrictions and lockdowns right now. The New York Times reports that Haikou, Langzhou, and Xi’an are all operating under limited lockdowns. Macau is under full lockdown – the first time China has done that in two years. This had a massive impact on the entire gaming sector, including on Wall Street, where it contributed to the larger bear market.

What is the solution for China? What concerns me is that there may not be one. They have chosen a highly confrontational and overt method of controlling COVID-19 that guarantees more confrontations. Each shutdown puts more pressure on banks and real estate companies that are already on the verge of breaking. The supply chain disruptions have a massive impact on the American economy. Worst, there is no end in sight. As a new variant of COVID-19 continues to spread around the world, it seems that COVID will be with us forever, much like the flu.

The question is what the Chinese government will do as it faces a credibility test at home. Rather than admit failure, China may seek to rally the nation around a foreign enemy. The key will be whether it openly defies American warnings to stop aiding Russia economically.

In the recent meeting between Secretary of State Antony Blinken and Foreign Minister Wang Yi, the United States government was very frank about accusing China of aiding Russia’s war. “More than four months now into this brutal invasion, the PRC still stands by Russia,” Secretary Blinken told the media. Meanwhile, China blasted what it called American “threat inflation,” which it said would lead to a “dead end.”

Perhaps the most eloquent words were those that were not said. Removing the tariffs on Chinese goods placed by President Donald Trump reportedly did not even come up in the meeting. This was a crude geopolitical test of strength. That’s a very bad sign for investors.

Some have suggested American diplomatic actions against Russia have painted the Kremlin into a corner, where it cannot but escalate without losing credibility at home. I’d argue the same may be happening in China. If China cannot meet its economic targets thanks to the continuing effects of COVID and is repeatedly being challenged by America, it is naïve to think the that Beijing won’t choose danger abroad than disgrace at home.

In a multipolar world, we can no longer rule out military actions by great powers in their near abroad as something unusual. Few predicted that Russia would invade Ukraine, but the signs were all there for those with eyes to see. Now, the same sorts of forces are assembling in China. It’s not too late for China to change tack. However, if America continues to pressure China, policymakers should not be surprised if Beijing responds not with less aid for Moscow, but more.

Mr. X is an investment analyst working in the Washington DC area who specializes in the intersection of business and public policy. After fifteen years working in politics, he writes on a classified basis for to bring you news on what those with power are debating, planning, and doing.

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