Matthew Nimetz, an eminent scholar, lawyer, venture capital executive, and former senior US/UN diplomat, recently presented a thought-provoking paper at a joint meeting the National Committee on American Foreign Policy and the China Institute of Contemporary International Relations. Nimetz was asked to address the future of US/China relations from a US perspective. The paper, which will be published by the National Committee on American Foreign Policy, concludes we should expect a somewhat rocky but hopefully manageable period in relations between China and the US over the next few years. Admittedly, the conclusion is not headline material, but Nimetz raised some interesting points that I comment on below.
I have also asked Alexander Wilmerding to offer his thoughts. Alex has spent much of his professional career working in China. He is currently based in Hong Kong where he is a principal at Pantheon, a firm that provides private equity advisory services related to funds in Asia.
Nimetz’s comments are identified by MN, Wilmerding by AW, and mine by EM.
Human Rights/Democracy
MN: But more and more it appears, sadly, that those who lead China have set a firm red line as to permissible individual behavior, as well as political, cultural and social activities, which red line puts China so far from Western standards that they shock the conscience of most Americans and others who share a Western civil/human rights political culture.
EM: I am not so sure. Things are changing in China. So called permissible behavior has changed dramatically and rapidly over the last several years. The point should be the trend line….whether or not the standards are getting closer to the West … and not the standard at this point in time. And this first point really involves governance – what is the government going to allow its individuals and institutions to do? I ask: How do you think the Chinese felt about the US letting its banks gamble, fail, and cause global recession? The Chinese government would not have allowed this to happen. And why did it happen in the US? It was the result of what is wrong with US democracy – special interest groups getting the US government to get rid of regulations controlling banks. As I have written, the control these special interest groups exercise is the uniquely American form of corruption.
AW: Arguably the Chinese government has been quite deliberate in prioritizing support for a lot of State Owned Enterprises through lending practices. The reality is that both the US and China have found it difficult to “let go” at points; some entities might best be left to markets to decide whether they survive or should be let fail. In both countries, this is sometimes not an outcome in part because of fear of public reprisals and the instability that would follow.
Minorities
MN: Along with political liberalization, there is the issue of minority rights — what most Westerners consider harsh and uncompromising treatment by the Chinese Government of certain ethnic groups.
EM: I don’t have all my facts together on this. But when I drove from Kunming to the Vietnam border, my sense was that minorities, at least in that region, were treated quite well. For example, the one child policy was not being enforced on them. My sense is the government is worried about these minorities “disturbing the peace” and wants to insure they do not.
AW: Many Chinese are quite proud of their contribution to economic development of minority areas. The fact is that a great deal of government support in areas like infrastructure is directed toward minority regions. The trade-off is that linkages increase and in some areas inflows of Han Chinese through migration will over time introduce greater Han presence and influence.
WTO Rules
MN: On the whole, policies designed to maintain high growth are admirable, but more questionable methods need to be calibrated or totally abandoned to conform to WTO standards and accepted global practices.
EM: We hear a lot about Chinese pirating of intellectual property. An interesting point here: The US quota keeping Chinese clothing out is the largest trade barrier in the world (as measured by the value of clothing kept out) and is illegal under WTO rules. But somehow, it continues. We don’t hear much about this.
AW: Curiously, Chinese patent issuances have increased dramatically and are one statistic that could point to China’s focus on developing intellectual property at a faster rate than often recognized. I am not convinced the pace of Chinese innovation will reach the pace necessary in order to create needed efficiencies in China’s economy and to make up for the dramatic fall-off in population growth and increasing pressure on wages and aging population.
EM: Ten years ago, I developed a project with Chinese partners that involved the Shanghai Huashan Hospital, one of the leading hospitals in China. I was struck that while its doctors were on the forefront in medical research, they had no way to convert their findings into commercial ventures – so different than in the US.
US Middle East Policy
EM: China probably views the US as the most militant nation in world. I further believe that China sees the US’s unending promotion of democracy/human rights as inappropriate meddling in a country’s domestic affairs that can and often does lead to dangerous regional instability. In all likelihood, China views US promotion of democracy as hypocritical, given the dictatorships that the US has supported and now supports – e.g., Saudi Arabia and Bahrain.
The “Asian Spring” as seen from a Chinese perspective? Extremely dangerous. And of course, China stands with the rest of the world in viewing US “coddling” of Israel as totally inappropriate and a key reason for the rise of terrorism worldwide.
AW: Democracy in the US has shown itself to be increasingly ineffective in balancing social policy needs with fiscal realities and likely is seen by the Chinese as inefficient. Whatever your politics, even if taxes are to be raised on the wealthy, the outcome of the recent presidential election and standstill in the Congress are a result of pressure from a large group of Americans. These Americans are themselves paying less into systems like government healthcare programs than they are receiving with the result being obstruction or delays to restructuring in areas where restructuring is necessary to right the country’s finances. I suspect that the Chinese leaders, albeit running a communist/socialist state, are wise to this.
Taiwan
MN: The fact is that the Taiwan issue is nowhere near solution, and China-U.S. relations will never be fully benign until it is solved.
EM: This certainly creates a tension between the US and China. But Taiwan and China have become so interlocked economically that investors in both countries will work very hard to keep things stable.
AW: Agreed – Taiwan is not as great an issue as it is made out to be. 10% of its population lives in China, and its linkages continue to grow closer.
Growing Military
MN: The growth and assertiveness of the Chinese military, particularly its navy and missile technology, will make these points of potential competition more dangerous. Add to this our rivalry in space and in cyber technology, including so-called cyber warfare, and we can see how many profound areas of security confrontation are possible during the next five or 10 years.
EM: All true. But let’s keep things in perspective. Today, the Chinese defense budget is 2% of its GDP, or $146 billion. The US defense budget is 4.7% of US GDP, or $705 billion. And yes, the US has been waging two wars and China’s GDP is growing more rapidly than the US. But given the differences in the size of the two budgets, US military superiority should continue for some time.
AW: Agreed. Imagine if the US military were to use its spending more efficiently.
China: A Resource Poor Country
EM: China is a resource poor country right across the board. Iron ore is good example. Unlike the US that makes all the new steel it needs from scrap, China needs to import iron ore to make steel. Latin America is a major beneficiary of China’s need for food and other natural resources.
Energy is a special problem for China. I quote from a recent paper:
As the following table indicates, 81% of India’s energy imports are for oil and 53% for China. In both countries, coal is the primary energy source with very little coming from natural gas and renewables.
Energy Sources in China and India, 2009
* Renewables include nuclear, hydro, solar, wind, and geothermal.
China consumes more coal than any country in the world. And there is a problem. China is running out of coal. As the table below indicates, China only has 35 years of coal left at current production rates. In contrast, the US has 270 years left and India 77. The Chinese authorities are very aware of their coal predicament and are doing all they can to find new energy sources and cut down on coal consumption. But it will be a slow process.
Coal Consumption and Reserves (mil. tonnes)
AW: What is overlooked is that China is actually quite intent on becoming energy independent if at all possible. So they are hell bent on trying to find ways of leveraging alternatives and while the effect on global warming will still be large their incentives and interest in advocating and using energy efficient practices is large.
EM: There is no question that is working hard on energy. But the challenge is daunting, as the following table suggests. I know China is working hard on renewables and is constructing more than 20 new nuclear plants. But with a growing energy demand, I see China needing all its coal and oil for the indefinite future. I doubt these numbers change much when we get more current data. 
The Future
- China
MN did not get into details on China’s alleged exchange rate manipulation. Good. Certainly some its US Treasuries purchases were to accomplish that goal. But something that most people missed: then and now, US government paper is viewed as one of the safest assets in the world. It was quite reasonable for Chinese government authorities to purchase this debt for that reason alone.
MN: The volume of world trade appears stagnant or even in decline; at any rate, it is certainly not in a rapid growth cycle. This is due primarily to the financial crisis in Europe and low growth in the United States, China’s two largest markets. This risks a reduction in China’s exports, certain in its rate of growth. We do not know what is going to happen in this respect, but I personally believe the era of sustained high economic growth in the global environment is over for a while, and we have to content ourselves with a somewhat more sober world economy. In this context, the political forces pressing for protectionism will become stronger everywhere.
Chinese leaders understand this and are attempting a transition from an export-led economy to one more domestically focused, with emphasis on services and retail sales. But this is not an easy process.
EM: I agree. Looking ahead in China, I see an emerging middle class wanting goods that Western middle classes already have. And this includes autos. At the same time, China, unlike Russia and the US, is running out of coal. The net of all this is I see China going from a huge trade surplus to a deficit.
AW: Agreed. This is an important theme in successful investment strategies focused on China. Portfolios that have been repositioning away from export-led growth and toward consumer led growth themes in private equity have recently been more successful in outpacing the MSCI.
EM: But now look more closely at the last 5 years: GDP growth has continued buoyed up by China government investment/stimulus outlays and the increasing demands from the Chinese burgeoning middle class. But look at what is happening to the current account balance. It is certainly falling in part because of the Western recessions, but I wonder if will go negative. 
AW: Rising wages in China is putting huge pressure on margins and will force businesses to become more efficient or the country’s growth will slow down.
United States
MN: If all goes well, as I am suggesting it will, the United States can look forward to a positive economic trajectory.
EM: I agree. US labor costs were falling even before the recession due to global competitive pressures. They are now falling even more rapidly. As you have suggested, the US is becoming competitive again globally.
AW: Recent studies by the Boston Consulting Group point to how the US is likely to insource 2/3 of what it outsourced as efficiencies from outsourcing cost savings are squeezed and the US becomes more attractive. As a practical matter though, a large amount of offshore manufacturing in piece goods that require manual finishing will stay offshore. But the US will increasingly outperform many OECD countries, e.g. Japan, as well as developing countries in more automated businesses where US labor and automation abilities excel.
MN: Because of new oil and gas technologies relating mostly to extraction of oil and gas from shale, plus real investment in fuel savings and environmental protection (not noticed as much as it should be), the United States is becoming more self-reliant in energy supplies, with the prospect of relatively inexpensive energy in our future.
EM: I am not so sure here. Energy transitions are very difficult to scope out. The US has already wasted a lot of money subsidizing solar panels (recent China dumping of solar panels happened they realized the next generation of panels will be two to four times more efficient), inland windmills and electric autos (natural gas autos far more energy efficient). Now, if we can only find a way to store electricity…. You are positive about new technologies to extract oil and natural gas. But keep in mind it will only take one extraction “incident” threatening water supplies to slow things down quite abruptly. Look at what happened with nuclear because of Fukushima.
Global Warming
EM: If MN is right on fossil fuels, the US will be putting global warming concerns on the back burner. It might as well. Whatever the US does, global warming is here to stay and will get worse because of demands from the middle classes of China and India. As I have pointed out, all we can do is prepare for more severe weather.
AW: See my earlier comment about China being focused on being energy independent which will force adoption of energy sources other than coal.
Investment Implications
For the last decade, I have been recommending investments in emerging market countries, both equities, e.g., iShares (EEMV) and debt, e.g., WisdomTree (ELD). But the pendulum seems to be turning. The US economy is recovering, while US labor costs continue to fall. Probably the best US bet is real estate. It is hard to see how you can lose if you purchase a real estate fund/ETF with a high yield such as Fidelity Real Estate Income (FRIFX).