China Tensions Could Kill This Bullish Recovery

Posted on May 28, 2020 in Economics

China Tensions Could Kill This Bullish Recovery

The world’s second-largest economy suspended guidance on its gross domestic product for the first time in 25 years, citing pressures from the coronavirus and trade tensions.

For China’s leaders, the economic uncertainty creates political vulnerability. Given that the legitimacy of the Chinese Communist Party comes from the twin pillars of unbridled economic growth and fierce defense of China’s national interests, nationalism grows as economic clouds gather.

The National People’s Congress (China’s rubber-stamp parliament) advanced new laws for Hong Kong that outlaws subversion, sedition and foreign interference. This is a further tightening of Chinese control over a global business and financial hub that has prospered in large part because of its Western-style quasi-independence and rule of law. If enacted, and it likely will be, it will drastically change the promise of “one country, two systems” on which Hong Kong’s capitalistic, free-market economy was built.

Beijing’s policies and rhetoric can put either oil or sand into the gears economic growth. Ideally, oil would be added as conditions begin to slow and perhaps add some sand to slow conditions when they risk overheating. As the global economy moves deeper into recession, even with an ongoing pandemic shutdown, tightened control over Hong Kong and increasingly combative rhetoric with the U.S. and others seem ill-advised if economic stability and a return to growth is the goal.

The United States is experiencing a similar economic contraction that despite a slow national re-opening is still contracting. President Trump has said that he holds China responsible for the spread of the coronavirus pandemic based on their secretive, non-disclosure of critical health data. Continued measures to restrict Chinese firms’ access to U.S. advanced technology raises the prospects of decoupling. Moreover, he expects continued compliance with trade negotiations and agreements to date.

While China’s leaders don’t face the pressure of running for re-election, the Covid-19 pandemic has shifted the electoral winds in the United States. Where the president and his team once lauded their dealmaking with China as accomplishments on the economic agenda, now the administration seeks to hold China accountable for the pandemic. Thus, on both sides of the Pacific, the voices that would follow the old path of Kissingerian engagement and fostering economic and commercial ties now take a backseat to nationalists and hawks.

The pressures are not coming solely from the administration. A new bill just passed in the U.S. Senate would require compliance with U.S. listing regulations or result in delisting from U.S. stock exchanges. This would severely restrict corporate China’s access to capital and put further pressure on the Chinese economy. (As a side note, I’ve never understood why we need a new law in order to enforce an old law.)

In the wake (think funeral, not boat) of the Luckin’ Coffee fraud, the share price plunged 95% and will be wiped out. The company, that was incorporated in 2017 and grew to 2,370 stores, is accused of fabricating $310 million in transactions. The drop from $51.38 to $1.43 erased billions of dollars of shareholders’ value (many of the U.S. shareholders including retirement plans.)

Luckin’ shares along with a range of other Chinese companies have long failed to comply with the accounting disclosure requirements for listing on U.S. stock exchanges. The U.S. requires adherence to GAAP accounting standards and regular financial examinations and audits. 95% of Chinese companies listed on U.S. markets use Chinese accounting firms and provide little if any transparency to their financial records.

The Luckin’ fraud and delisting threat is an additional headwind to struggling economies everywhere. China’s need to exert greater control over Hong Kong looks like a classic example of “It ain’t broke, so let’s fix it!”

There is a clear, fair and plausible path for a profitable and prosperous business relationship with China and the rest of the world. It is based on a model of transparency, contract and property laws, and free markets with which the rest of the developed world already complies. The rub is that such disclosure and accountability are almost antithetical to China’s cultural and governing history. It is long past time for China to evolve past its protectionist, chip-on-the-shoulder hubris and practice the collaborative decorum expected of the world’s second-largest economy and become a good and reliable global business partner.

On February 13, on CNBC’s Halftime Report, I suggested that the shutdown in Wuhan Province was causing a disruption in the global supply chain that raised the risk of recession for the U.S. The comment was met with polite dismissal from my fellow panelists and a flurry of tweets to guest-host Brian Sullivan asking if Farr had lost his mind, among other things that were even less flattering. While I had a clear view of a huge threat to the global economy, I never imagined the scope of this pandemic-wrought recession.

The economic devastation working its way around the globe is robust. Argentina has just defaulted on a payment of its national debt. Central banks the world over are adding money and suppressing interest rates in hopes of fending off a depression and stimulating a recovery. This struggle is hard enough without China adding to the steepness of the incline. All the significant domestic and foreign headlines haven’t dissuaded resilient U.S. markets, but historically markets fall prey to a “last straw” effect of just one more bad story that suddenly causes all the bad news to matter. It hasn’t happened yet. God willing it won’t, but if China continues its tone-deaf, aggressive policies, the positive road to economic recovery could take an ugly and very expensive turn.