Echoes from the 1940s – China and the US Squaring Off

China has big plans for Gwadar.

An airport, a hospital, five star hotels…

There are also reports that China is building a city for half a million Chinese that will be living behind a gated complex and working in the financial district.

Free report: Aussie dollar crunch coming (find out why)

Yet the interesting part about this is that Gwadar isn’t in China, but bang in the middle of coastal Pakistan.

China is looking to transform this fishing village into an international thriving port city.

Pakistan partnered with China to develop the port and in 2015, Pakistan leased the port to China for the next 43 years.

The project is part of the China-Pakistan Economic Corridor (CPEC) and part of the solution to China’s ‘Malacca Dilemma’.

You see, China is quite dependent on other countries for energy, and oil in particular. In fact, China is today the largest oil importer in the world.

Much of the oil they import — about 80% —passes through the Strait of Malacca. The Malacca Strait is a narrow sliver of sea between Sumatra and the Malay Peninsula.

It is also a chokepoint. That is, it would be quite easy to block it, cutting off China’s oil supply.

It’s why China has been grappling to solve this dilemma to secure its energy supply.

It has built gas and oil pipelines through Myanmar.

And the Gwadar port in Pakistan together with a Gwadar-Xinjiang pipeline would give China another alternative.

As you can see below, Gwadar is quite well positioned.

It is close to oil producing countries and near the Strait of Hormuz. It would also save China a lot of time. The journey for tankers would shorten to 10 days instead of the 40-plus days it now takes to go through the Strait of Malacca.

The Rum Rebellion - 5-09-19

Source: Gwadar Central

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The corridor would give China another access to the sea. All the oil tankers would need to do is get to Gwadar and unload the oil, which would then travel to China through the pipeline.

There are reports this week that the port will be fully functional by next month.

Truth is China has hogged much of the news this week.

The media has centred in the celebrations. 1 October marked 70 years since Mao Zedong stood in Tiananmen Square and unified the country by proclaiming the People’s Republic of China.

But earlier this week too, an article from Bloomberg rattled markets.

They reported on a discussion going on in the White House about stepping up the trade war by imposing capital controls.

Here is what they wrote:

What unnerved markets about the internal deliberations, first reported by Bloomberg News, was that they seemed like an extreme departure from the U.S.’s longstanding free-market orthodoxy. U.S. officials have for decades advocated opening financial markets around the world to capital. That the discussion is even taking place, therefore, is eye-popping for many in the world of international finance…

Another bipartisan bill pushed by Senator Marco Rubio, the Florida Republican and China hawk , would force Chinese and other foreign companies listed on U.S. exchanges or invested in by U.S. pension funds to comply with U.S. auditing standards. If they didn’t, firms could be delisted from U.S. bourses or banned from outbound investment. The thinly veiled goal: Limiting the flow of American capital into Chinese companies.

Advocates of both bills argue they would help address what they see as an increasingly poisonous economic imbalance between the U.S. and China and what Trump and others see as the economic damage wrought by what they label an unnaturally strong dollar.

We are seeing China and the US increasingly squaring off in a contest for world dominance.

It’s already creating geopolitical, technology and trade conflicts.

But the financial markets today also play an intricate part.

Hedge fund manager Ray Dalio wrote an interesting article on LinkedIn on how this could happen. You can read it in full here.

Here is the extract that concerns us:

Regarding the capital and currency wars, the ability of the US president to unilaterally cut off capital flows to China and also freeze payments on the debts owed to China and also use sanctions to inhibit non-American financial transactions with China must be considered as possibilities. That’s why the proposed step of limiting American portfolio investments in China makes me both think about the implications of this step and wonder if it is an inching toward bigger moves. For perspective about what can be done and how it would be done, one can look at the US freezing of Japanese assets and embargoing of oil to Japan in the late 1930s to early ‘40s; they show how the use of special emergency powers gives the president the ability to do these things.

Emergency powers today are most accessible to the president under the International Emergency Economic Powers Act of 1977 (IEEPA). It empowers the president to unilaterally impose capital and FX controls, freeze assets and/or payments on assets (coupons), and force asset divestures to “deal with any unusual and extraordinary threat” from outside the US to “the national security…economy of the United States.” Just the realization that these moves can be used has important implications for capital flows. […] In any case, from not having to worry about such things in the past, now all market participants need to worry about them.

We’ve written here before about similarities between today and the 1940s.

In the 1940s, the US cut off Japan’s access to oil and seized Japanese assets. The conflict escalated out of control and led to Pearl Harbour.

Much like the 1940s, we are also seeing wealth inequalities and a very clear and increasing divide between left and right in politics.

China is already clearly looking at ways to avoid getting their oil supply cut off, but access to financial markets is crucial.

Dalio is worried that we are on a ‘classic dangerous journey’.

Admittedly, I am too. Everything works around cycles and cycles tend to repeat themselves.

We can’t be sure where this path is leading us. But what is clear is that everything is changing. We have reached peak globalisation, and now it is retreating.

The added struggle for Australia is that they are very clearly stuck in the middle of two clashing powers.

Navigating these choppy waters will be key.


Selva Freigedo Signature

Selva Freigedo,
Editor, The Rum Rebellion

PS: Our own editor Greg Canavan recently sat down with gold expert Jim Rickards for an exclusive interview. Greg and Jim talked about how the US-China confrontation could affect Australia. But also why gold could reach US$10,000, where the Aussie dollar is heading and more. You can watch the video here.

Selva Freigedo is a research analyst for The Rum Rebellion.

Born in Argentina, her passion for economic analysis started at a young age. Her father was an economist for the Argentinean governments and the family used to discuss politics and economics at the dinner table.

Argentina is a country with an unusual economic history. Growing up there gave Selva first-hand experience on different economic phenomena such as hyperinflation, devaluation and debt default.

Selva has also lived in Brazil, Spain and the USA.

Back in 2000 she was living in the US as the dot com bubble popped…
And in 2008 she was in Spain as the property market exploded and then collapsed…

She has seen first-hand what happens when bubbles burst.

Selva joined Fat Tail Investment Research’s team in 2016, as an analyst. She now writes from her vantage point in Australia, where she settled in 2015.

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