A New World Order
Lots of very interesting moves are being made in the markets at the moment: 1) The Chinese government devalued their currency, the yuan. 2) Ukraine imposed capital controls, unsurprisingly given the conflict, but from a crypto perspective, the Ukrainian central bank banned bitcoin purchases with the national fiat currency (to curb capital outflows). In addition to cryptocurrency buys, the new rules also target electronic wallet deposits, FX transactions, and travel payments. We start with point 2, and while the Ukrainian central bank move is to be expected given the situation, we would also argue that this form of financial repression is not going to be unusual and why we need a portable store of value (such as FIXOO and its future offerings) and to be very careful where we invest and domicile our investments. For more on why we are entering a new regime in terms of world order and financial markets we refer readers to an article posted by Russell Napier in the Toronto Star earlier in April: A new world order is coming and it cannot cope with the flexibility of capitalism (https://www.thestar.com/business/opinion/2022/04/11/a-new-world-order-is-coming-and-it-cannot-cope-with-the-flexibility-of-capitalism.html) "Most saver’s funds are invested in financial securities. These securities are legal contracts giving their owners rights to future income streams and assets. We take for granted that these will be paid and the assets available as per the terms of the contract that govern that particular security. All of this of course assumes there is a strong civil legal system that allows an investor to assert their contractual rights. Most of the time we simply do not think about the importance of these legal rights. Often we invest in countries where we assume such rights will be enforceable without doing research. Some of the greatest investment mistakes in history are the result of a failure to fully understand that legal rights, as expressed in contract, are meaningless unless they can be enforced, not just under the current legal system, but under likely future legal systems. Today’s changing world order means that investors now have to consider such basic considerations when they invest. There is a growing likelihood investors will not be able to enforce such rights in China and that the value of investments there will effectively fall to zero. However the so-called Russian “oligarchs” made their money, they brought it to London in pursuit of protection under the rule of law. It turns out that no such protection existed when the political climate changed. This is not to say that their assets should not have been sequestered. It is to point out that even in a country with a long history of protecting property rights, one can lose everything when a major political shift occurs. Foreign investors in Russia also find themselves with local currency denominated assets that cannot be turned into foreign currency. The political divide rapidly developing in the world, that will change the rest of this century, is between China and the developed world. Investors now have to consider which side of this political divide they are on. If they live, work and ultimately hope to retire on one side of that divide will they be able to liquidate their investments on the other side of that divide? On numerous occasions throughout history, investors have found themselves in this position. Savings so trapped have effectively no value as they cannot buy the goods and services of everyday life that support a quality of life and retirement to which we all aspire. This divide between the developed world and China has been growing at least since former U.S. vice-president Mike Pence’s speech at The Hudson Institute in October 2018 when he drew the ideological battle lines between the U.S. and China. At the time these very strong words were seen as the idiosyncratic views of the Trump administration. However, the new Biden administration has not backed down from the confrontational relationship with China. The war in Europe has done something very important as it has brought the EU to a realization that it has become too reliant upon Russia for energy but also that it has become too reliant on China for almost everything else. The European version of the Pence speech came on March 19 when German Finance Minister Christian Lindner stated that China represented an opposed ideology that had become an “enormous risk” to Europe and the rest of the developed world. He went on to be more specific. “Our trade relationship with China is almost a concentration risk for our economy. It may be a trading partner, but it’s also a systemic rival.” We are now in a rush to reduce our China risk and this will focus on massive investment in the developed world to reduce our reliance on China for so many products. This comes at a time when labour is already in short supply and inflation is high. This need for massive investment creates an opportunity for investors in developed world equities where those companies that benefit from much higher levels of capital expenditure are listed. However, it also represents a massive risk to developed world investors who continue to believe that investing in China can bring positive long-term returns. In 2010, I wrote a piece called “Buy Chaos, Sell Order” for my institutional investor clients comparing China and India. That was a very confrontational title but it argued that from the seeming chaos of India an order was forming in which the world’s largest democracy would create very good opportunities for investors. It argued that China had created a much more brittle system that was then producing much higher economic growth but it would not ultimately produce good returns for investors. The then seeming chaos of India was a reflection of its ability to bend and change, as it has, while the rigidity of China suggested that it could not bend and might break. This problem for China was exacerbated with the ascendancy to power in 2012 of President Xi Jinping. Xi has made no secret of his wish for the Chinese Communist Party (CCP) to have more power over almost all areas of life in China and he has thus enforced the rigidity of the system. The difference in returns from the Chinese and India stock markets have been instructive. From its speculative peak in October 2007, the Chinese stock market has now declined. Over the same period the Indian Sensex equity index has almost tripled. This cost to investors in China from running a rigid economic, financial, social and political system may be about to significantly increase. German’s Lindner has made it clear that the developed world needs to reduce its reliance on China for trade. On March 17, French President Emmanuel Macron also outlined a new industrial policy for his country aimed at reducing its reliance on China. This structural shift in the flow of goods will have negative impacts for key Chinese producers. More importantly for investors is what this acceleration in our new Cold War means for the free flow of capital between China and the developed world. Those who thought the Trump tariffs on trade were the limit to the disengagement between the two countries have been very wrong. The disengagement has already spread to the sphere of capital. The U.S. is seeking to reduce the access to U.S. capital markets for Chinese corporations. China’s Xi, in line with his long-professed ideology, is seeking to increase the power of the CCP by taking greater control over key corporate assets. Investors have been caught in the cross hairs of these political shifts in the growing Cold War. Capital is in the front line of this Cold War and foreign investors hold Renminbi denominated securities to the value of $2 trillion (U.S.). There is a lot to lose when, probably not if, we reach the full expression of a Cold War with China — the end to the free movement of capital between the two opposing systems. History is replete with examples of where legal rights were changed by political realities. Foreigners holding Russian assets and Russian “oligarchs” owning non-Russian assets have just lived through such a shift. A bigger shift is coming. If you are a resident in the developed world you can no longer rely upon the ability of your savings in Chinese assets to be of any value. We are just a few headlines away from such a reality. One of those headlines might be that China has taken strategic stakes in Russian commodity producers, a move that seems likely given the German Finance Minister’s declaration that threatens the supply of commodities to China. An even more dramatic headline would be confirmation that Chinese military material is flowing to Russia. These acts would result in years of friction between two different ideologies suddenly producing that sudden shift which generates a political and economic earthquake. It may not come soon but with the EU also committed to severing its reliance upon China, it is coming. A greater order is being imposed upon the world and it is an order that cannot cope with the flexibility that the free movement of capital imposes upon it." Ok let's then talk about the Chinese devaluation of the yuan. It's a positive right? It will mean yet another deflationary wave being unleashed on the West, the death of inflation and yet more money printing, etc. We've seen this before, therefore, it's a case of wash, rinse, repeat. Not so fast, and we refer you to an interview Russell Napier did with Schroders at the tail end of last year, to explain why in this instance Sir John Templton might be wrong: "The four most dangerous words in investing are, it’s different this time.” So here is the excerpt from the Russell Napier (RN) Schroders interview with Vera German (VG), in which he gives the rationale why a China devaluation is happening in a different time and will cause different outcomes:
"TD: It sounds from that that, potentially, China is the area we should be looking at as the subject for a future Russell Napier book. At the present time, do you have a view to how China might seek to resolve the growing debt crisis it has? RN: Absolutely. So what is the lesson from that period? You have read the book so you know it begins in Southeast Asia on 2 July  with a devaluation of the [Thai] baht? Now, as an analyst who had got some sort of recognition for getting that right, let me tell you the bit I got wrong. We were looking at Taiwan and saying, we do not have to worry that this spreads to Taiwan – Taiwan had a current account surplus, which I think was 2.5% of GDP and it had some of the biggest foreign exchange reserves in the world. So you just think, well, there is a rock-solid balance sheet – there is nothing that country is going to be affected by. This is fine. So that was true for July and it was true for August and it was true for September – and then the new Taiwanese dollar devalued by 14% in October and there was just complete shock. What on earth is going on? Why did they do that? And this is germane for China because you can see the parallel. China has a current account surplus. China has the biggest foreign exchange reserves in the world. Most people just look at that and say, well, that is a currency that is not going to move. So why did Taiwan do that? And the answer is there was enough capital leaving Taiwan – in that case, it was the inability to roll over short-term dollar debt that was impacting that – that it sent interest rates higher. Bottom line: they were trying to defend the exchange rate as capital was leaving and that sends your interest rates higher – and people of a certain vintage will remember the UK being in that position as well in 1992. And that is the way it works. So going back to China, my opinion – and it has been an opinion long before COVID – is China is running far too tight a monetary policy. That is now manifesting itself in its property market – and, let’s face it, we have seen this story before. And we have also seen the answer before. How does China fix it? You slash interest rates and you print money. Now the question is, is that compatible with a stable exchange rate? Remember, China – like Asia back in the 1990s – is managing its exchange rate. It is not a free float. So, in my opinion, the answer is a flexible exchange rate. So what now is on the front page of the newspapers is a property crisis – as it was in Thailand in 1996: “This is a property crisis.” It is not a property crisis. It is an exchange rate ... I do not want to use the word ‘crisis’ because there is nothing wrong with letting your currency float. But the ultimate end goal here for Xi Jinping is lower interest rates, print money and you need a flexible exchange rate to do it. TD: The conventional thought would be that would lead to a deflationary depreciation environment for China. How does that align to your view that the world will be looking for financial repression built on inflation and low interest rates outside of China, if you have, effectively, a deflationary force coming in from East Asia? RN: There is no doubt the markets would initially move to price in deflation for a very good reason – because they will have read my book and they will know that is what happened the last time. That is what happened in 1994 – it not only produced very cheap products coming out of China, it kind of bankrupted lots of their competitors. So it would be obvious that the first step the market would take would be to say, this is going to be highly deflationary as China will be selling lots of products a lot more cheaply in in dollar terms. So let me tell you why they are wrong. The first thing that has to be said about China’s devaluation is it was against the background of the mass mobilisation of resources – and I think we can honestly say the biggest in history. I mean, the only competitor is America after the Civil War, when the railroads went into the interior. And that was mobilising people because it was dragging them across the Atlantic and it was accessing new lands and new productive lands. But there has been nothing like this thing that happened in China. So one of the reasons was not just the exchange rate – it was also the mass mobilisation of what people call Chinese peasants but I prefer to call ‘farmers’. It sounds less derisory. So that is over – it is done. You are not going to do that again. That was done once. But the most important reason it is not deflationary is because of tariffs. The world cannot live with China devaluing its exchange rate if the result is selling goods much, much, much more cheaply – they just simply could not cope with that, given where we are in the global economic recovery, given where we are with inequality of wealth, etc, etc. So if the response to China’s float – I prefer float to devaluation – if it is beginning to become lower Chinese product prices, then it will be hit with tariffs. And then finally, remember – the reason he is doing this is to inflate away debt. So, ultimately, it means much higher levels of inflation in China itself. So finally, I think, it also triggers a massive capital expenditure boom in the West because we are going to have to build a lot of the stuff that was previously built in China. So that is a combination of reasons. You know, the easiest thing in the world is to go back into financial history and say, China devalued last time, therefore, it means deflation next time. But I think the reason and the way we use financial history is to understand mechanisms – that is what we have to do. And there was a very different mechanism in place back then. And nobody cared about China – it was a tiny economy. It turned out they should have cared about China, because it was growing very quickly. But things are very different now. TD: Does that mean, in your role as a financial historian, you are increasingly interested in political relationships and how they might determine the pace and future of globalisation? And what does that mean for how you think about those political realities in various countries? RN: Absolutely. So my career has been marked by, if you like, governments stepping away and letting markets determine prices. And that was launched by Thatcher and Reagan, it spread to Europe, and even the British Labour Party, as New Labour, were endorsing it. And we have already been stepping away from that for some time now. Now, almost nobody is educated in what that means. Because certainly, if you have been to business school or studied economics, they do not talk about it. They talk about how economics works in a free market. But how does it work in a non-free market? Maybe we could ask the head of the IMF because she was educated in Bulgaria, at the Karl Marx University, so maybe she might understand how it works. Anyway, the point is – we do know how it works because the history books are full of how non-market systems work. And I do not mean by that a communist society – I mean, the type of financial system we had after World War Two, where politicians decided to tell us the right prices of short-term rates, long-term interest rates. But we had price controls, we had wage controls, we had credit controls, we had capital controls. You know, it is hard for people who have been brought up in the current system to imagine that we can go back to that system and what it looks like but, ultimately, that is why politicians are important. And I associate the word ‘politician’ with the word ‘control’ – and we are going to see a lot more controls coming in. So you have to understand the nature of what drives politicians. Now, it is not ideology, it is pragmatism – debts have to be inflated away and the market system has, let’s just say, not been very good at that, because the debt-to-GDP ratio was soaring up, so there will be active means to do this. You raise the subject of globalisation – and that is important in terms of this wealth-inequality issue – but I think it is much, much bigger than that. It is where we are in the continuum – if one extreme is a laissez-faire market economy and the other extreme is a command economy, we are moving from the market economy towards the command economy. Not ‘to’ it, but ‘towards’ it. And that is 100% about politics. And if all your economics is based on market economics, and you want to invest money based on that, then I will be choosing a different fund manager." We would recommend you read the whole interview transcript, and here is a link to that: https://www.schroders.com/en/uk/the-value-perspective/blog/all-blogs/podcast-transcript-russell-napier/ Despite being apocryphal the "Chinese curse" has relevance to our conclusion today. "May you live in interesting times" is an English expression that is claimed to be a translation of a traditional Chinese curse. While seemingly a blessing, the expression is normally used ironically; life is better in "uninteresting times" of peace and tranquility than in "interesting" ones, which are usually times of trouble. So our conclusion is simple - bE Prepared; keep your financial independence because we are (sadly) living in "interesting times" and we need to protect ourselves - FIX00 and its future offerings should be a part of your defensive financial armor.
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