Q&A with The Accidental Superpower‘s Author Peter Zeihan, Part 3: China, Japan and cyber warfare by Gavekal Capital
We recently had the pleasure of a visit by Peter Zeihan, author of The Accidental Superpower: The Next Generation of American Preeminence and the Coming Global Disorder. The article below is part 3 of our 3-part series on the discussion, in which Peter discusses the Chinese economy, Japan’s potential response to a new world order, and cyber-attacks as weapons of war. In part 1, Peter described a growing US retreat from the strategic system put in place after World War II that allowed US allies to thrive under a US security umbrella and the impact of this retreat on globalization, the shale revolution and commodities. In part 2, Peter discussed what’s next for Russia and Germany in the coming era of disorder and the refugee crisis.
GavekalCapital (GC): What are your thoughts on the Chinese economy?
Peter Zeihan: In my book, I describe China as having a subprime economy. Unfortunately, I am starting to feel like this description is too optimistic.
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GC: What is the main issue for China?
Peter Zeihan: I believe the Chinese economy is facing an over-financing issue. I believe the Chinese leadership is well aware of this problem. This is why they have started to take small steps to diversify the financial sector away from the banking sector. They know that the number of bad debts on bank balance sheets is huge, and the overall banking sector probably won’t really recover. However, the problem is they are still very concerned with top-line growth and won’t let up on the gas. So each time they try to diversify away from the banking sector through a new financial mechanism, this new avenue quickly gets corrupted by outside influences.
GC: In your book, you describe the challenging geographic endowments that China has dealt with historically. How is this affecting China today?
Peter Zeihan: In order to “fix” the banking sector, China has tried several different plans to grow its way out of trouble. As I said, the over-financing issue is one that Chinese leadership is well aware of. They have attempted to grow their way out of the issue by investing in the interior of China. The first problem is that the southern interior of China is simply too rugged for a large population to inhabit. This is why you basically only have coastal cities in southern China. In the northern interior of China, the main geographic problem is the lack of a major river to act as a source of capital. This means in order to create a sustainable inhabitable area in this region, everything must be subsidized. You have to subsidize transport links. You have to subsidize power plants. You basically have to subsidize the creation of entire cities. The main effect of this is that anything manufactured in northern China is not cost competitive with anything made on the coast. In order for these interior northern cities to remain relevant, the government must double down on the subsidy regime in place. This hasn’t worked well at all, so China has moved into another style of economic growth.
GC: And what style is that?
Peter Zeihan: China desperately wanted to copy a consumption-style model like we have in the United States. The key to the US consumption model is the US housing market. When people own their own property, they have more of a stake in the system. Also, they have to buy a lot of “stuff” to furnish their homes. This is what China has been trying to create over the last several years. From a philosophical standpoint, this was a good plan. However, the Chinese housing stock was so thin while the financial sector was so flush that you ended up having way too much money chasing too few goods. This led to unbelievable circumstances where people in Shanghai could sell a 300 square foot apartment for $3.5 million dollars. This happened so often that there is a word for the new class of flashy elite Chinese that emerged as a result. They are called “tuhao,” which roughly translates as “land-rich man.” The informal translation is Beverly Hillbilly. These are people with hardly any education that lived in a rat-infested home, and someone came in with an open checkbook, backed by easy financing, and bought the entire apartment building with the goal to level it. This is how you can get paid millions of dollars for your tiny apartment. So what are the tuhaosdoing with their economic windfall? They go and buy a Lamborghini, and they invest the rest in the stock market. Eighty percent of the overall volume in the Shanghai exchange is retail investors, and most of them are investing money cashed out from the real estate market. This helps to explain why there is so much volatility in the local stock market.
GC: So the US style of consumption didn’t work either?
Peter Zeihan: No. The way I see it, the property market, the stock market, the ghost cities, the financial market and the investment bust are all bolted together now. Each shock has piled on to an already weak banking sector. The model is officially bust, and this why you are seeing capital flight out of China.
GC: Where is the capital going?
Peter Zeihan: Primarily to the United States. China is looking at about $1 trillion in capital leaving this year alone. I think probably about 70% of that capital goes to the US. Per capita, I think Canada will actually get the biggest share. This is why Vancouver real estate is so expensive. Vancouver is a beautiful city, but it’s getting to the point where you can’t even walk down the street because it is so expensive.
GC: So if investing in the interior of the country didn’t work, and US-style consumption didn’t work, what does China do now?
Peter Zeihan: President Xi institutes Mao 2.0. They revive an authoritarian dictatorship by creating a cult of personality. Xi goes back to being the chairman with a capital C and sells a new vision of China. In this vision, you don’t have to have economic growth, you don’t even need to have a job. You just have to be a proud Chinese, and to be a proud Chinese, you just have to believe in Xi. I think this is why Xi has been putting so many high profile people in jail and in some instances, killing them off, in the recent “corruption purge.” He is consolidating power because he is fully aware that the economic model is collapsing, and he is making plans for the post-Bretton Woods world (without a US security and trade umbrella). If you look at the history of China, you either have an internationalized China that spins apart, or you have a domestic China that is under lockdown. Eventually, a domestic China that is under lockdown will probably spin apart too, just not as quickly.
GC: Over the past year, a lot has been written on whether or not foreigners would soon be able to buy Chinese A-Shares. This has many implications, not the least of which is that stock market indices, such as the MSCI All-Country World Index, would have to include A-shares. This “forced buying” is the basis for many that are bullish long-term on Chinese stocks. Do you think Chinese leadership cares about this or peripheral financial issues like getting the yuan included in the IMF’s Special Drawing Rights (SDR) basket?
Peter Zeihan: No, I don’t think the upper echelon of the politburo cares too much about being part of the global stock market. I don’t think there is a single person in the politburo that cares much at all about the SDR. I do, however, think that the People’s Bank of China cares a lot about the SDR. And I agree that inclusion into the SDR is a watermark that emerging countries should aim for. However, from the politburo’s perspective, they are just trying to hold on to this current version of China as long as possible. They couldn’t care less about international financial institutions.
GC: So what does China gain from a currency devaluation?
Peter Zeihan: Time…
GC: Time for what?
Peter Zeihan: To keep the current export model going as long as they can. They know that the US is backing away from trade. They know that demand in Europe isn’t recovering. They know that demand in Japan isn’t recovering, and they know that emerging market demand is at best flat and not growing as strongly as it did in the prior decade. If they devalue, they buy some time to keep exports going, but it’s not an end game because a big devaluation will trigger a currency war that they are bound to lose.
GC: How large of a devaluation do you predict?
Peter Zeihan: I think a 35% devaluation is certainly in play. The last time they did a large devaluation that is what it was. China has spent the last decade trying to move away from an export model, but they ended up getting themselves into an investment-led model which produced even worse results. They know that everything they have tried over the last decade just complicated things, and they are running out of tools to deal with their domestic situation. When they devalue, this will lead to imports becoming very expensive, and instead of dealing with large imported inflation, the government may just shut off all imports. This will drive consumers to lower quality Chinese goods, and it will also lead to shortages across the country. However, if there is one thing China can deal with it is shortages. This is not a new problem in China.
GC: How do you expect Japan to react to this new world order?
Peter Zeihan: The irony of the outcome of World War II was Japan basically got everything they were trying to win, even though they lost the war. As an island nation, Japan is always on the lookout for energy access and trade partners. Once the US put in place the Bretton Woods system, Japan gained greater access to global energy markets and the largest consumer base in the world (the US), all while dismantling their military complex. The result of this after 70 years is that pacifism is very popular in Japan. However, like in Germany, this pacifism is artificial thanks to Bretton Woods. The Japanese leaders know they will have to take a more aggressive stance once the US retreats from the global scene.
GC: Is Japan ready to take on a more aggressive stance?
Peter Zeihan: Militarily, yes. Culturally, not yet. The military is fully capable of fighting wars. The problem is that culturally, the military path is not socially accepted. Japan needs to convince the local culture that if you join the military, it doesn’t mean you are a psychopath. They will gradually increase the number of people enlisted in the armed forces by showing that the military is not a place where one’s career goes to die, but it is in fact an honorable institution to be part of. I think one quick war will change the minds of the local culture. In fact, I see quite a few similarities with the current state of the Japanese military and the US military before the Gulf War in the early 1990s. After the military failure of the Vietnam War, the social acceptance of the military in the US was very low. It wasn’t until the shock and awe of the Gulf War that the US population was reminded that a military career was something worth pursuing. I see a similar situation playing out soon in Japan to change the cultural mindset there. And lastly, since Japan is a naval power, it should be able to pick its first fight to ensure an easy victory and a change in the cultural mindset.
GC: Do you envision much of a US naval presence in Asia going forward?
Peter Zeihan: No I don’t think so. I think the US will continue to support its allies in the region with weapons, especially the Philippines, in order to keep China locked in its sphere of influence. Overall, right now the US Navy is undergoing quite a dramatic overhaul of its carrier forces that will affect how we patrol the oceans. We already have retired two aircraft carriers as a prelude to replacement, with the others being updated and digitized. The US is digitizing all of its vessels so that we will see a 50% increase in carrier strength without any increase in the number of vessels. The goal for the US Navy is not to have 500 outdated ships, but to have 80 “best-in-class” vessels. This overhaul has affected our international footprint. Once we are out of Afghanistan, we won’t have an aircraft carrier in the Persian Gulf anymore. The US already has sailed home the carrier that was in the Mediterranean Sea. Overall, the US Army’s international footprint has shrunk to about 5% of what it was seven years ago.
GC: Cyber-attacks are increasingly in the news. If a war breaks out among major countries, do you see cyber-attacks being used broadly as a weapon and would this change your forecasts?
Peter Zeihan: A major cyber-attack could accelerate my predictions. We have already seen a major shift among US corporations’ attitudes in regards to intellectual property rights, specifically toward China. China’s position on intellectual property over the last decade or so has been to poke the US as much as they can, and steal as much information as they can, but never to cross a line which could have the US launching cruise missiles over stolen information. Large US corporations had been advocating for China in Congress, but as China has been showing more and more US companies the door out of the country, we’ve seen less of that advocacy. If you take the US business community out of China’s corner, there aren’t a lot of people in China’s corner anymore. In regards specifically to cyber-attacks as part of an overall strategic warfare plan, there is no doubt cyber-attacks will be a heavily used weapon. The US is a “first strike” country, and cyber will be used in that first strike attack. If a war breaks out, cyber-attacks will happen within the first six hours. While you may hear a lot about hacks originating in China and Russia in the news, the US actually has the most advanced offensive cyber capabilities in the world, by far. If for some reason we came to blows with China, they could use a cyber offensive to create minor nuisances for Americans. On the other hand, we could use cyber-attacks to completely wipe out China’s electrical grid. This is the scale of the US offensive abilities. The US government has been pooling talent over the past thirty years –pretty much every hacker that has been caught by the Feds now works for the NSA.