Author: Eric (Tianli) Wen, Head of Research

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Dear all:

The US mid term election started today. Because President Trump made a call with President Xi four days ago, many media in China started to speculate a forthcoming trade deal between US and China was imminent.
 

We, too, predicted short term bullishness in our last Pilgrimage 11, dated October 8^th. Since then the market has rebounded almost 20%. But I would like to remind everyone a simple fact, which is Presidents Trump and Xi will meet in Argentina late this month, which means President Trump will have the results of mid-term election fully in hand and digested when he walks up to President Xi.
 

This will make any gesture now meaningless, in our opinion. It is likely a last-ditch effort to lure some swing voters who disliked Trump’s aggressive composure. To call a trade deal forthcoming is essentially to call the result of the US mid-term election. This is not a task and risk, we confess, we have the ability to accomplish and take.

In my opinion, the US-China relation is a very small portion of consideration of the US voters, even though it is a very big portion of consideration of the Chinese mid-to-upper class. This reality is again and again lost in Chinese media because many Chinese cannot accept the reality that a relationship they esteem so much means so little on the other side.
 

But it is the reality.
 

I claim no expert to US politics surrounding mid-term elections. It appears the gust is whether or not Republicans will lose the House. But if to contain China is a bipartisan agenda endorsed by both the Republicans and the Democrats, why does Republican’s losing of the House matter? I even think if Republicans keep the house, President Trump might temporarily put China out of the hook because now that he will have a bigger plan to draw. But this temporary break will not be very long. The ensured battle will be even more breath-taking, around moving global supply chain out of China. If, however, the Democrats take the House, it is more likely that President Trump will act tough, so as to deprive one of the bargaining chips his opponent might have in the domestic battles ahead. But at least our sector investors can take a sigh of relief, as Trump will be distracted in his remaining terms, hopefully making his policy more moderate.
 

So our recommendation to our investors is to take the profit and stay aside, unless you are confident about the mid-term election result.
 

Do we hope Republicans win or lose the House? We certainly hope it loses. It will buy China more time, because the more we think about it, the more we feel the speed of China’s climbing the technology ladder will be slower than global supply chain pulling out of China. We, however, are placing out bets on the Chinese government by taking the right steps.
 

Central bank’s FX policy can change overnight

That said, China holds a short term trump card, which is the RMB. RMB deprecation is an atomic weapon that will wipe out Trump’s trade war bounties. But RMB deprecation also has huge adverse effect for China. So an RMB depreciation, if done properly, must take place swiftly so that multinationals thinking about pulling out of China do not have time to do it. And when deprecation is done, the logic reverses. It will then become very attractive to pour in new money into China because assets will be so cheap. So we saw Chinese central bank making smoke again about RMB will hold firm. The trigger will be the Presidents’ summit. If US Republicans win the house, or if US hawkish group shows no sign of relenting even if Democrats wins the house, we expect RMB depreciation to happen over perhaps a single night.
 

We were impressed by Chinese government’s about-face change

The past several weeks we saw the Chinese government finally woke up to the fact that the US policy turnaround is final, decisive and bipartisan. The resulted action is a sweeping about-face of new policies to cut taxes, spur innovation and help transitions. I will not list these policies one by one, they are almost mirror opposite of the ones rolling out several months ago, which was to tighten taxation, build national power and raise cost of doing legitimate business.
 

We have actually argued that these two vastly different policy sets aren’t that vastly different. Reform embodies pain. The overriding logic is which happens first. The end goal is competing against US for regional-dominance-to-world supremacy (which we don’t think there is any problem).  To that end, we actually find a national consensus gradually starting to come to shape. As a result, we are feeling more confident about our thesis of national focus on innovation and technology being positive to our sector. Investors, however, must be careful to select opportunities that will benefit the investors. This is not guaranteed.
 

OK, this Pilgrimage actually wants to share some thoughts on why the world (especially the west world) must put up with Chinese Authoritarianism.  We need to expand on that topic at some point to provide logic support for all our thought processes to come.
 

Chinese authoritarianism has geopolitical origins

There are many ways to define a government which all capture a moment of truth. We don’t intend to divulge this email into a political science premier. Authoritarianism vs libertarian is one, out of many angles of dividing the basic forms of government. We think one shouldn’t be overly obsessed with this division.
 

Rome changed the form of government from republic to dictatorship to better deal with threat of barbarians from the North.  Julius Caesar conquered Gaul to form a buffer zone against Germanic tribes. In this process he brought stability and peace for the Roman world in the next 400 years, until Attila came from further East. The call for a dictatorship in Rome was because the previous republic was inept in dealing with national defence. In 387 BC, barbarian Chieftain Brennus sacked the city of Rome for the first time in history.  The second sack came 800 years later also by a barbarian chieftain. The sacks of Rome had far reaching consequences in its government forms.
 

From Caesar to the break up of the Empire into East and West Rome (27 BC – 285 AD), we count 53 emperors, of which 12 were direct hereditary (son), 8 were indirect hereditary (brother and nephew), 5 were adopted and the remaining was from power struggles. 24 emperors had reigns less than 3 years.  15 emperors had reigns less than 1 year.
 

So the idea is the necessity to consolidate power against foreign invasion necessitated the government form of dictatorship. And again the necessity to incentivize dictatorship to take up the responsibility leads to inheritance of the throne. We see that in Rome, the need to balance this incentive with meritocracy led to the compromise of indirect hereditary successors and close associates as emperor choices. But still, to have such frequent leadership reshuffling cannot be good for an empire under crisis.
 

Now imagine China facing a barbarian presence far more powerful than the Roman Empire ever faced. The so called Eurasia Steppe, the longest stretch of grassland in the world, was directly above China. The Eurasia Steppe forms a corridor which links Asia and Europe and is a home to numerous nomadic tribes and Khanates.
 

When these tribes went out to loot their fortunes, the easiest route is riding vertically down on the map, i.e., southwards. The more difficult route is riding horizontally, i.e., westwards or eastwards because the route entails the crossing of the Urals. The southward route is also much shorter than the east or westward routes.
 

The three greatest grasslands of the world: Eurasian Steppe, North American Prairie and South American Llanos

Source: Wiki
 

Historically it is well documented that there were three powerful nomadic barbarians roaming westwards to reach Europe. Let’s see how powerful they were:
· First horde is the Huns. After defeated by the Chinese Han Dynasty in 100BC, half of the Hun tribes fled westward and half surrendered to the Chinese. The surrendered half captured the opportunity to stage an uprising 400 years later (first failure of immigration policy in China’s history) to usher in an era of racial turmoil which lasted 300 years. Some believe the fled half re-emerged in Europe through Eurasia Steppe as Attila the Hun, whose adventure and brutality earned him the name The Whip of the God;
· Second horde is Turkish Khaganate. After defeated by the Chinese Sui and Tang dynasties in 500-700 AD, half of Turkish tribes fled westward and half surrendered to Chinese. The surrendered half captured the opportunity to stage an uprising in 750 AD (second failure of immigration policy) to usher in an era of warlordism which lasted  200 years. The fled half did much better, formed two great empires: the Ottoman Turkish Empire (now Turkey) and the Mughal Empire (now India), in addition to an array of more transient ones:  Seljuq,  Khorazm, Ghaznavid and Timurid Dynasties;
· Third horde is the famous Mongol Khanate. This time the Chinese ran out their luck. They, too, were conquered by the greatest of all Eurasia Steppe barbarians. The sons and grandsons of Genghis Khan formed more than a dozen empires and dynasties and left deep mark on human civilization. The Mongol Khanate successfully thrusted both southward to China and westward to reach the outskirt of Vienna.
 

We list these three powerful hordes to illustrate the point that historically China faced a far greater issue of barbaric invasion than Rome did.  These three barbarian hordes have caused great troubles to Europe and Central Asia, yet they are only a tip of iceberg of what ancient China had to encountered day in and day out.
 

From the HunLunbeier grassland southward there were three natural defense lines, none were comparable to the defense line of the Rome Empire.  The first is the Yanshan Mountain on which the Chinese built the Great Wall. Its defense value is far smaller than the Alps. The second is the Yellow River which can be crossed on surface in winter. Rhine, on the other hand, never freeze in winters. The third is the Yangtze River which successfully stopped some northern invaders in history but its defense value cannot compare to that of Bosporus Strait.
 

So this is our conclusion: The Chinese penchant for authoritarianism is a cultural DNA out of defence necessities against the nomadic tribes in the north. The Chinese version of authoritarianism has fostered a framework of human behaviour, which is Confucianism and a class of professional administrators, which is the mandarin class to alleviate the burden of governing of the dictators and balance the behaviour of the governing and the governed.  We believe Chinese authoritarianism should also be allowed to compete, in the world of diversity.
 

It is ironically to notice that the formation of China’s first empire, the Qin Dynasty, happened around 200BC, the same year when Rome starting to face its defence issues with Gaul tribes. While Julius Caesar successfully pushed out the defence frontline from the Alps Mountain to the Rhine River, the same buffer zone strategy also worked in China, only to backfire when the buffer fell to the barbarian side. While Qin was recognized as one of the original Chinese nation states, it was such a peripheral one that it almost bordered around the barbarians. So Qin’s conquest of China can be viewed as the first barbaric conquest and the subsequent tangles between the Chinese civilization with barbaric tribes were all surround the theme of conquest-absorption-rebel. Republican and democracy are simply luxuries ancient China was never able to afford. Authoritarianism persisted because it worked. To unwind China’s authoritarianism DNA, the solution should be peace, nor war.