In 2003, Buffett predicted Trump by warning of the new Opium Trade.

Transcription

1 In 2003, Buffett predicted Trump by warning of the new Opium Trade. The inaugural speech of the new United States president, Donald Trump, and the speech of the Chinese leader, Xi Jinping, in Davos became strategic messages outlining each country s vision for the world s future development. It is hard to imagine two more opposite visions. If Chairman Xi was persuading the world about the advantages of globalization and cooperation, then President Trump's speech can be summarized as "America for itself." Just a year ago, this radical shift in the US s positioning from globalization toward isolationism was hard to imagine. Many observers still consider the recent developments, including the election of President Trump, as a temporary anomaly. However, Warren Buffett in his Fortune article with a self-explanatory title America s Growing Trade Deficit Is Selling the Nation Out From Under Us. Here s a Way to Fix the Problem And We Need to Do It Now. ( predicted the current situation almost 15 years ago. To see the connection between Warren Buffett s prediction and President Trump, one missing part of the puzzle is needed - a history of the US-China relationship and specifically a history of the opium trade. In this light, the logic of recent events may appear more clearly. The First and Second Opium Wars China had directly faced the Western civilization fairly recently, in the early 19th century. Prior to that, contacts with the Europeans were largely confined to occasional visits by traders and missionaries. China found itself technologically far behind the European countries that had already been going through the industrial revolution. The gap was enormous China s main weapons were still crossbows and sailing junks, while the Europeans had guns and steamships. A giant but outdated China faced small but modern and aggressive European colonizers. Europeans were interested in trade with China, as Chinese ceramics, silk, and tea being extremely popular in Paris, Lisbon, and London. However, it turned out that China was not interested in European goods. Europe had nothing to offer to selfsufficient Celestial Empire. 1

2 Britain found a solution in selling the opium grown in the British Indian colonies. Despite the death penalty for opium trafficking, the trade quickly flourished opium had become the currency of trade with China. Other countries followed, and before long a significant part of China's population was opium-addicted. In 1839, in a desperate attempt to stop the opium trade, Beijing announced an isolation from the West. The western traders responded with military actions. Thus began the First Opium War. Against the technological and military superiority of the westerners, the Chinese army was helpless. Quickly reaching Nanjing ( 南京 ), the British forced China to open its borders to the opium trade and to give away Hong Kong. After the Second Opium War, which followed shortly thereafter, western countries also received a number of ports on the east coast, including Shanghai. Thus began the European colonization of China a period known in Chinese history as the Century of National Humiliation ( 百年国耻 ). European powers, joined by Japan, began building one city after another, completely ignoring the Emperor s opinion. 2

3 DRAFT En Chine: Le gâteau des Rois et... des Empereurs Le Petit Journal Supplément Illustré, January 16, 1898 Artist: H. Meyer In this French rendering, Queen Victoria glares at the German Kaiser, while the Russian, French, and Japanese figures look pensively at China. The Kaiser stabs his knife into the German-leased territory Jiaozhou in Shandong province, acquired in 1898, while the Russian Tsar puts his fists on Port Arthur (the Chinese port of Lüshun, leased in 1897). The Chinese Emperor is helplessly observing this from behind. The caption reads: China: The cake of Kings and Emperors. 3

4 The Emperor s Mandate of Heaven was questioned, or, in other words, the authority of the central government was undermined. This led to a number of revolts against the Emperor, the main of which, the Taiping rebellion, became one of the bloodiest events in human history, claiming the lives of more than 20 million people. Opium imports have caused unprecedented capital outflow. In 1838 alone, right before the First Opium War, China spent more than 100 million taels of gold (about 3,125 tons) on opium. For comparison, the imperial government s expenses in the same year amounted to only 40 million taels 2.5 times less than the opium import. In the early days of the First Opium War, it took 23 days for 500 workers to destroy 1,200 tons of opium seized from western traders in Canton alone. After the Second Opium War in 1860, opium imports continued to grow, doubling by the 1880s. The Celestial Empire, which just shortly before then was among the richest countries in the world, by the end of the century had gone bankrupt. That was the result of China's efforts to stop the capital outflow by selfisolation. As a side note, although the United States didn t play any meaningful role in the military actions, they actively traded opium. For example, the US President Franklin Delano Roosevelt was a grandson of Warren Delano, one of the most successful opium traders in China. 4

5 "Third Opium War" One hundred years later, the situation has reversed. For most of the 20th century, China was reuniting and recovering from the Century of Humiliation. By the end of the 1990s, as a result of Deng Xiaoping s reforms, China had dramatically improved its labor productivity and had learned to produce consumer goods much more cheaply than any other country. That was the period of early globalization and trade specialization. The western world outsourced their consumer goods production to the third world. China managed to build up efficient production chains and very quickly became the world s factory. This resulted in an influx of capital into the country. According to the World Bank, in 2015 the amount of goods sold by China exceeded the amount of goods the country bought by US $330 billion. This was roughly equivalent to the inflow of 6,600 tons of gold, or two times more than the capital outflows in Since the beginning of the 2000s, when Buffett s prescient article was published, the total trade surplus received by China was approximately US $3 trillion. This is equivalent to approximately 60,000 tonnes of gold, or about a third of all the gold mined in human history. In the 19th century, the western world used China's opium addiction. In the early 21st century, China used the western societies addiction to consumer goods. Today, consumer goods play the role of opium. 5

6 450 China's trade balance ( ) USD dollars, billion Chart: China's trade balance. Source: World Bank Until recently, despite Buffett s efforts, capital outflow was mostly unnoticed. However, in 2016, American society reacted the influence of workers who lost their jobs to a globalized world has reached its critical mass, leading to the election of President Trump. In his inaugural speech Trump announced a strategy to stop capital outflows and preserve jobs. Remarkably, this strategy sounded virtually identical to the strategy that Beijing tried to use in 1839 to protect against the "globalists" a strategy of isolation and trade barriers. 6

7 An Imperial Commissioner Lin Zixu's letter to Queen Victoria the beginning of the First Opium War (1839) there are barbarian ships that strive to come here for trade for the purpose of making a great profit. The wealth of China is used to profit the barbarians. That is to say, the great profit made by barbarians is all taken from the rightful share of China. By what right do they then in return use the poisonous drug to injure the Chinese people? President Trump's inaugural speech (2017) We have made other countries rich, while wealth, strength and confidence of our country has dissipated over the horizon. One by one the factories shuttered and left our shores. Of course, the world has become much more complex over the past two centuries. Nowadays, international relations are driven by more than just capital flows. Nevertheless, this historical analogy shows how ineffective and counterproductive an isolation strategy can be as a defense against globalization. In the 19th century, China s isolation strategy was defeated by the technological and military superiority of the West. Nowadays, the American isolation strategy is likely to be defeated by two other forces. Force 1: Isolation from the world's consumer market The American consumer market has ceased to dominate in the world and is no longer the world s largest market. Official figures are not yet available, but in 2016 the Chinese consumer market is likely to have become the world s largest (see 7

8 Retail Sales (in USD trillion) China US Chart: Retail sales in China and the US. Source: National Bureau of Statistics of China; U.S. Bureau of the Census Moreover, in the last five years, China has been deliberately accumulating pent-up demand in its own domestic market. Consumption was actively discouraged by the austerity, anti-luxury, and anti-graft campaigns. Consumer lending was also artificially restrained. The main purpose of accumulating pent-up demand was to use it as an offset in case of a possible decrease of demand for Chinese consumer goods in the western markets. (for more detail see It is likely that using this pent-up demand will allow China to double its domestic consumption, if necessary. More importantly, over the past decade, consumer markets of many other developing countries apart from China have also grown much faster than the US market. If the American consumer market previously dominated the world, it is no longer the case. If the isolationist logic of the Third Opium War" eventually prevails, then the US will not protect its market from foreign products, but instead will isolate American companies from the world s consumer market. 8

9 Force 2: The United States and China the mutual dependence The second reason why an isolationist policy could be destructive is that the mutual dependency between China and the US is stronger than commonly believed. Until recently, in return for its consumer products, China received not only money, but also American debt. By 2015, China had accumulated US Treasury securities worth $1.3 trillion. China depends on the US the same way, as a creditor is dependent on its largest borrower. It is believed that because China owns only 5% of the American debt, the US does not depend on China in a strong way. However, China is not just the largest lender. Since 2003, the US government debt more than tripled from $6 trillion to a record-high $20 trillion. The main reason why the US has been able to service its debt were record-low interest rates. If the interest rates go up by just 1%, the interest payments would increase by $200 billion. If the rates return to their historical average range of 5% 6%, then the US would have to pay an additional half a trillion dollars in interest payments, which is comparable with the entire US military budget. The main reason for zero interest rates, besides the second Mississippi inflation tax program implemented by the Fed (see more has been the flow of cheap goods from China, which kept inflation at record-low levels. If the US can no longer do the trade with China, a shortage of cheap Chinese products will cause inflation, triggering interest rate increases, which in turn will escalate the cost of servicing $20 trillion debt and further increase the deficit. Once the higher inflation - higher interest rate higher deficit vicious cycle is activated, the financial system may quickly become out of balance. The new administration s isolationist policies are likely to trigger this cycle. 9

10 The process of financial isolation has already begun. Since mid-2016, China has been selling US government debt Beijing s ownership decreased from $1.25 trillion dollars to about $ 1 trillion, presently. Recently, debt sales have intensified further, and have reached a magnitude of $50 billion per month. If the trend continues, by the end of this year, China's ownership of US debt will become insignificant. However, this fundamental shift is still largely ignored or misunderstood by the US markets because of Beijing s tactical maneuver. Chart: The US treasuries owned by China (in billion US dollars). Source: U.S. Department of the Treasury The sales began in May 2016, when candidate Trump, in an interview with CNBC, invited "to negotiate the US debt discounting ( sb trump_debt_default). 10

11 In order to sell a large amount of US debt without causing panic and a premature fall in the debt s value, China needed a compelling reason. Following the principles of the "The Art of War" book by Sun Tzu, China explained the sales of the US debt using internal problems the economic slowdown and the fall of the yuan. The going out of business stores commonly apply this efficient sales tactic. Directly following the plan outlined by Buffett in his article, Beijing converts US government bonds into real assets. This is done by lending the proceeds from US debt sales to Chinese companies and individuals, which use the money to buy foreign companies and real estate abroad ( made-in-chinato-owned-by-china-chinese-enterprises-buying-up-western-companies-at-recordpace / - 4f41fd6e1387). In the case that the new US president will try to discount or inflate the US debt, such assets would not be affected and would retain their value. Most governments find it much harder morally to seize foreign-owned property than they do to dilute the purchasing power of claim checks foreigners hold. Theft by stealth is preferred to theft by force. Warren Buffett Fortune, November 10, 2003 The media has interpreted the purchase of foreign assets as a sign of a slowing Chinese economy - Chinese companies could not find a profitable investment in the country and were forced to look for investment opportunities abroad. Beijing s move has led to a decrease in foreign exchange reserves, the growth of credit, and capital outflows from China. These processes fit perfectly into the overall paradigm of the Chinese slowdown: the debt growth in China gave a new reason to talk about the Chinese credit bubble. The outflow of capital and reduction of reserves were explained in the media by ordinary Chinese, who panicked because of the fall of the yuan and purchased dollars. As a result of this tactic, China s sale of US debt remains largely ignored by the outside world. In sum, in response to Trump s threat to discount debt, China is selling it. The danger of this process is that it starts a vicious cycle of isolation, which is likely to destabilize the US debt market. 11

12 What's next? It is Trump s turn to make a move. At first glance, it may appear that going further down the isolation path is a sound strategy. However, as the historical analogies of the first two Opium Wars indicate, it can lead to disastrous results. Isolation would mean increased difficulty for American companies to access the international consumer markets, which already significantly exceed the size of the US consumer market. Isolation is also likely to lead to the destabilization of US debt and a reduction in the China US interdependence. However, if Trump eventually decides to keep the US s course toward globalization, he will have to find answers to the following critical questions: How do we stop the outflow of capital without losing the benefits of globalization? How do we compete with China without succumbing to "the Third Opium War" logic? This could be a good title for Buffett s next article. V. Yuzhakov 12