The Asian Arms Race and the ‘Weaponization of Finance’, by Ritesh Jain

The days of Asian countries living under the US defense umbrella but enjoying the fruits of trade with China may be coming to a close. This has substantial investment implications. From Ritesh Jain at

There are those in financial markets who believe that Mike Pence’ s bellicose speech at The Hudson Institute a few weeks ago was merely sabre rattling ahead of the US mid-term elections. Sadly your analyst could not disagree more. That speech, reported in the last Solid Ground newsletter, has now been followed by the United States’ threat to withdraw from the Intermediate-Range Nuclear Forces Treaty (INF) with Russia. For those who still believe this has nothing to do with China, the US President made it clear on October 22nd that the withdrawal from the INF is as much about countering a threat from China as it is about countering a threat from Russia:

“Until people come to their senses, we will build it up…” “It’s a threat to whoever you want and it includes China, and it includes Russia, and it includes anybody else that wants to play that game. You can’t do that. You can’t play that game on me.”

This has huge geo-political implications and clearly huge investment consequences for those countries in Asia supposed to accept the new United States missiles that will stop China ‘playing that game’. Can the United States’ Asian allies accept US missiles and remain free to trade openly with China, invest in China and accept investment from China?Still unconvinced? The following is a lengthy extract from an interview between Nick Robinson of the UK Radio 4 Today Programme and Professor Matthew Kroenig. Professor Kroenig’s official biography indicates that he is well placed to explain the reasons behind the threat to scrap the INF: ‘he has served in several positions in the U.S. Department of Defence and the intelligence community, has testified before Congressional committees, and regularly consults with U.S. government entities.’ The interview begins with Professor Kroenig answering a question as to why the United States has threatened to end the INF:

Professor Kroenig:
Moreover we’ve got other issues to deal with in Asia. We have the growing Chinese threat and having more firepower, that these missiles would provide us, would allow us to better deal with the threat from China in Asia……I think the interest in the United States is really to build conventional armed missiles in this range mostly to deal with the threat in Asia. I don’t think there is any desire to deploy these systems in Europe.

You talk of the threat in Asia. Does this mean that the real new deployment is likely to be facing towards China rather than Russia?

Professor Kroenig:
I think that’s right. If you look at the balance in Asia it’s really shifted in China’s favour over the past couple of years. China has thousands of ground-based missiles within this range. I think 95% of China’s missiles would be in violation of the INF treaty… So the US is in a bad situation in Asia to compete with Chinese missiles….. being able to deploy ground-based missiles on the territory of our allies in Asia would increase our firepower and give us the ability to better counter the growing Chinese threat in that region.

Finally Mr. Koenig, there may be people who say despite your soft diplomacy the talk of an arms race with China, an arms race with Russia, and one led by Donald Trump fills them with real alarm.

Professor Kroneig:
Well, I understand that. I think the only thing worse than an arms race among the three is an arms race that the United States is sitting out. The United States and American military power has provided stability in Europe and Asia for several decades. Russia and China are becoming more assertive, building up their military capabilities so this arms race started several years ago. It’s only in the news today because the United States is finally coming up to the starting line a little bit late, so the only thing worse than the arms race would be the United States losing…

The United States’ allies in Asia will be expected to accept US missiles, conventionally armed but perhaps also including nuclear warheads, as part of the United States ‘coming up to the starting line’ in an arms race in which policy makers perceive China to be ahead. While market watchers can continue to believe that this is just more of that geo-political ‘stuff’ that really does not impact companies and their money-making abilities, it is time to think more clearly about what is going on.

The world has changed and the era of private sector determination of capital flows, trade flows and, ultimately, even pricing is ending. The Solid Ground has long argued that it ends because peoples and politicians will want some of that power back; some people like to call that populism, others prefer democracy. Now it is also clear that some of that power will be brought back to form part of the armory of the new cold war.

Many Asian countries have lived under the US defense umbrella while freely trading with and investing in China. This was a wonderful combination as defence spending could be kept low, but those same countries got to enjoy all the benefits of trading with a large and rapidly growing economic behemoth. This was a recipe for economic success that has now ended as the new Cold War, a war explicitly aimed at containing the China ‘threat’, has been declared. Before you think that this is just some macro threat of higher taxes and government spending in Asia, consider what this new policy means for trade, capital flows and technology transfers. (including India)

You don’t have to be that old to remember the last Cold War. For those of that vintage who remember the USSR and its satellites, it would have been inconceivable for either protagonist in that ‘war’ to permit capitalists to move capital freely between the chilled belligerents. From the perspective of the west, such use of private capital would have been seen as virtually treasonous in supporting the economies of ‘enemies’, while from the perspective of the USSR such private capital was unwelcome in a country where private capital existed, if at all, at the behest of the state. If capital flows between the belligerents were virtually impossible, trade flows were also almost impossible.

So perhaps we are not going back to an era when jeans and recordings of The Beatles traded only through the black market but free trade between Cold War belligerents is highly unlikely – we have already entered such a deteriorating relationship with Russia, and China is next.

This is not a spat with China about trade; it’s about the unwillingness of the US to concede influence in Asia to China or as Mike Pence put it more bluntly on October 4th at The Hudson Institute, “China wants nothing less than to push the United States of America from the Western Pacific and attempt to prevent us from coming to the aid of our allies. But they will fail.” This is not an environment in which economic relationships remain unchanged.

One practical example of how this relationship is changing is technology. In Pence’s speech he made it clear that technology transfer was one of the key areas in which the United States administration was pressuring US CEOs to consider when investing in China. The technology that flows freely between countries will no longer flow so freely between those involved in the new cold war – Russia, China and the United States of America. While there are many reasons why technology stocks are falling, the dawning of this new relationship between business and the state is a key driver for lower share prices.

For those seeking a tangible example of such restrictions, the following from Mike Pence’s speech should serve as a warning – “For example, Google should immediately end development of the Dragonfly app that will strengthen Communist Party censorship and compromise the privacy of Chinese customers.” That’s a fairly broad definition of the technology that can be used by a Cold War enemy in pursuing their victory. Many, if not most, companies can find their activities in China construed as supporting the Communist Party given that the Party’s influence extends widely through the Chinese economy.

Investors simply cannot reasonably expect to continue to have the freedom to play their game while the United States of America seeks to stop China from playing what President Trump considers to be ‘that game’ – a missile build up in Asia. Mark Carney (Governor of the Bank of England), speaking in Bali on October 14th at the Group of 30 Conference, tried to spell out the consequences from the new Cold War when he referred to the growing “weaponization of finance.” Carney was careful not to use the phrase weaponizing the US dollar, a phrase that most readers of  The Solid Ground seem to accept represents the new normal.

What Carney talked about, ‘Weaponizing finance’, is something much broader than weaponizing the US dollar. ‘Weaponizing finance’ is weaponizing you! Your analyst finds that those on the front line of this new Cold War with financial assets as a key weapon still don’t even know they are on the front line. Their ‘game’ continues to be to guess whether the next quarter’s corporate earnings will be higher or lower than the level management had previously suggested. That’s a ‘game’ in its own right, but in an age of the ‘ weaponization of finance’ one can’t help thinking that it’s more of a parlour game than the key game in which fiduciaries seek to protect and grow the wealth of savers.

Asset prices are acting to reflect the new Cold War and the weaponization of financial assets. While other factors are operating to cause the collapse of financials share prices (The Solid Ground has been highlighting these for the past few years) the newly accelerated collapse recognizes that such companies are increasingly in the front line of the new Cold War. In a world where the state plays a much bigger role in the allocation of capital, whether under the guise of macro prudential regulation or to support a cold war, it is not realistic to expect private sector corporations to be paid a high fee to accept those state directions.(absolutely)

Capital so directed by the state has more of the features of a utility, and management fees for utilities are never high and are often regulated. While standard analysis sees the ETF as the key enemy of the active manager, it is a shift to more state-directed capital flows that is a bigger risk for the capital management business. Investors should continue to avoid investing in both commercial banks and investment management companies while the market fully digests the scale of this structural change.

So, apart from avoiding investing in financial service companies, what is an investor to do if he/she wants to keep managing money in the new Cold War? Well, it begins by avoiding those countries where the free lunch is being withdrawn. It is unrealistic to expect the countries of Asia under the US defence umbrella to continue to get the use of that umbrella while trading freely with China. The end of that relationship means not just lower growth but higher risk premiums as any Cold War inevitably entails some hotter episodes where those pursuing the conflict meet. (does it ring any bell)

In terms of shorter-term financial implications, your analyst continues to believe in a strong USD, exacerbated by further weakness in the RMB and de-leveraging in EM – well covered in quarterlies from 4Q 2017 to 3Q 2018. At some stage that squeeze creates an illiquidity crisis, particularly in the bond funds that have swelled in size during a primary issuance boom but now find themselves with insufficiently liquid holdings to meet redemptions. If this is correct, the short-term implications continue to be much more deflationary than inflationary for the world, and portfolios should be constructed accordingly.

As we enter the new Cold War none of us can know how hot it might become. Those of us old enough to remember the last one can remember some sleepless nights in Europe, and in some parts of the world real wars were very hot and deadly indeed. All of us hope that we won’t have to read that book again, for as Gordon Lightfoot reminded us, at the height of the last century’s Cold War, when relationships sour it’s a world of heartaches, few if any heroes and it’s more than the endings that are just too hard to take.



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