A compassionate man once caught a turtle. He wanted to
make it into soup, but unwilling to be accused of taking life, he
boiled a pan full of water and, placing a narrow rod over the
pan, said to the turtle, "If you can get across the pan, I will
set you free."
The turtle was in no doubt as to the intentions of the
man. But he did not want to die. So, summoning up all his will,
he accomplished the impossible.
"Well done!" said the man. "Now … please try it again."
Cheng Shi (12th - 13th century AD)
It doesn't matter whether the cat is black or white, as
long as it catches mice.
Deng Xiaoping (1904 - 1997)
In approaching a problem a Marxist should see the whole
as well as the parts. A frog in a well says, "The sky is no
bigger than the mouth of the well."
Mao Zedong (1893 - 1976)
What the caterpillar calls the end, the rest of the world
calls a butterfly.
Lao Tzu (604 - 531 BC)
Everything ends badly. Otherwise it wouldn't
Brian Flanagan (Tom Cruise), "Cocktail" (1988)
How much are you worth?
I have no idea. How much do you want?
I just want to know what you're worth. More than 10
Oh my, yes!
Why are you doing it? How much better can you eat? What
could you buy that you can't already afford?
The future, Mr. Gittes! The future. … You see, Mr. Gittes,
most people never have to face the fact that at the right
time and the right place, they're capable of ANYTHING.
Robert Towne, "Chinatown" (1974)
Deng Xiaoping was a survivor. That's why I love this picture of
the man, here 80-something years old, looking for all the world
like Emperor Palpatine of Star Wars fame, still dying his hair
jet-black and chain-smoking his Panda cigarettes. Purged not once
but twice. Wife and daughter dead in childbirth. Friends mowed down
by the Kuomintang. Eldest son tortured by Red Guards before being
thrown out a 4th-story window.
You think this veteran of the Long March, who lived in
caves and ate rats … when the war was going well, wasn't willing to
do ANYTHING to set the future course of the modern Chinese
You think that Tiananmen Square kept this guy up at night?
Deng Xiaoping and his ally/mentor, Zhou Enlai, are the
architects of modern China, of China as a Great Power. For 30 years
Zhou tempered the Maoist ideology of permanent revolution,
preserving the kernel of a stable army and stable government
bureaucracy, setting the stage for a pragmatic successor to Mao.
But it was Deng who was able to out-maneuver the Gang of Four and
seize control of the Army and the Party after Mao's death (and
Zhou's) in 1976, replacing that Maoist ideology of permanent
revolution with a market-driven ideology of modernization and
economic growth. Deng wasn't interested in political purity, but in
economic results. It's not the color of the cat, as he famously
said, but its ability to catch mice.
Deng's political genius - the core attribute that made him such
a consummate survivor - was his ability to sell his vision of
economic modernization and growth as an end in itself to other
political and military leaders. Permanent revolution is … tiring …
and doesn't really pay that well. Deng offered a vision of
stability and wealth, and by 1979 that vision proved to be
enormously successful in uniting what Clausewitz called the iron
triangle of a Great Power - Army, Government, and People, acting as
one for a common goal.
Economic growth was, to paraphrase "The Big Lebowski", the
rug that tied the whole room together.
Importantly, Deng's unifying vision of economic growth and
modernization was socialist and nationalist in nature, not liberal
and individualistic. Deng was no petty oligarch, stashing away
billions in foreign bank accounts during his tenure as Paramount
Leader, and this was a big part of what made his transformation of
the Chinese nation so successful. Deng was authentic. He was a
survivor and he was a patriot. He was a Dude, enforcing at the
highest levels of the Party and the Army an understanding that
economic growth was (primarily) in the service of the nation rather
than (primarily) in the service of personal aggrandizement. Sure,
there might be the occasional provincial governor egregiously
lining his family's pockets rather than kicking up to the central
authorities in Beijing, but this has only been a problem for the
Chinese government for … oh, the past 3,000 years or so, and it's
nothing that a few show trials and public executions can't bring
back in line. No, the important thing was that China's top
political and military leaders shared Deng's vision of
market-oriented AND socialist/nationalist ideologies existing
hand-in-hand. And for a while there, they did.
Today, however, the Chinese State faces two existential threats,
each stemming from or accelerated by the Great Recession and
Western policy responses to that crisis of market confidence.
QE and other "emergency" Western monetary policies of the
past five years threaten the grand political unification of Deng
Xiaoping from without.
Second, massive wealth inequality and concentration
driven largely by those same monetary policies threaten it from
The external threat to Chinese political stability comes from
the explicit purpose of recent monetary policy:
to paper over anemic real economic growth with
financial asset inflation
. It's a brilliant political solution to the political problem of
low growth in the West, because our political stability does not
depend on robust real economic growth. So long as we avoid outright
negative growth (and even that's okay so long as it can be
explained away by "the weather" or some such rationale) and prop up
the financial asset values that in turn support a levered system,
we can very slowly grow or inflate our way out of debt. Or not. The
can hang out there … forever, essentially
… so long as there's no exogenous shock. A low-growth zombie
financial system where credit is treated as a government utility is
a perfectly stable outcome in the West because our elections and
political powers don't hinge on strong economic growth. They hinge
on social issues and notions of identity. They hinge on the
preservation of wealth, the preservation of benefits, and the
preservation of rights. All good and important things in the
Western political context. But for China? Not so much.
Chinese political stability under the unified coalition formed
by Deng Xiaoping depends on robust and real domestic economic
growth. Not the veneer of economic growth as can be constructed
within capital markets. Not the liquidity-driven asset price
inflation of Western monetary policy.
Chinese political stability depends on the actual
production of actual things by actual people working in actual
factories, and the prospects for that real economic growth are made
significantly worse the longer the West persists in favoring
financial asset inflation and the ossification of a low-growth
Why? Because the domestic Chinese market is not advanced or rich
enough to support the politically necessary rates of Chinese
economic growth. I'm sure it will be one day, but that day is not
today. That day will not be with us for decades to come. And until
that happy day for China arrives, real economic growth will depend
on developed world export markets in the US and Europe.
Those export markets are
more uncertain and structurally weak
from a Chinese perspective than at any point since Deng Xiaoping
forged his coalition, and that's a risk that the Chinese regime
will do ANYTHING to redress.
The internal threat to Chinese political stability is even more
destabilizing and pernicious than the external threat. I don't care
what you think about the specifics of
Thomas Piketty's book
, if you don't recognize that the growing concentration of global
wealth within a tiny set of families is a big problem and getting
bigger worldwide, you're just not paying attention. No country in
the world is more vulnerable to the political problems caused by
wealth inequality and concentration than China. Why? Because
socialism may well be, as Deng said, fully consistent with free
market practices on a nationalist, mercantilist level, and it's
mostly consistent (or at least can co-exist) with a free market
ideology focused on individual advancement and individual wealth
creation in the 99%. But wealth creation and wealth accumulation in
an era of massive and coordinated central bank liquidity is a
totally different animal than wealth creation and accumulation when
Deng consolidated power and struck his grand bargain in the late
1970's. The unfathomable riches available today to the very top of
the economic pyramid - the 1% of the 1% of the 1% - are so enormous
that they threaten to obliterate the links that Deng created
between Army, Party, and People.
Have there always been rich people and rich families in China?
Of course. But the scope and meaning of "rich" is so different
today in 2014 than it was in 1984, or 1994, or even 2004 as to be a
laughable comparison. It's not just that concentrated private
wealth in the modern manner has created an entire class of
hyper-privileged Chinese families with the ability to bypass State
control. It's not just that these hyper-privileged families wield
political power independently of any State apparatus. Most
importantly - and most damagingly for Deng's political coalition -
these hyper-privileged families largely arose from personal
aggrandizement of positions within the core Chinese political
institutions of Party and Army.
of Party and Army has changed in China, from one of unquestioned
political legitimacy as THE guardians of Chinese socialism to one
of highly questionable legitimacy as a vehicle for personal
For the majority of Party and Army office holders - those who did
not make vast fortunes from their office, those who seek a
patriotic return to the unquestioned political legitimacy of these
institutions - this is an entirely intolerable development and they
will do ANYTHING to change it back.
Even among those Party and Army leaders who have managed to acquire
great fortunes, there is a widespread recognition that -
while the West may be able to accept, even celebrate,
unlimited private wealth - China cannot. Not if it wants to remain
a politically unified Great Power.
The common thread between the external and internal threats to
Deng's stable political architecture is Western monetary policy and
its support of a particular
of global market liberalism. What does China intend to do about it?
I believe that Chinese leadership increasingly sees itself as the
turtle in the old fable of the turtle and "the compassionate man,"
where the system is the pan of boiling water that the compassionate
man (the West) sets up to turn the turtle into turtle soup. Through
incredible focus and an application of all its resources the turtle
walks on a narrow rod to cross the pan of boiling water, but having
crossed once is now required to cross again.
that requires changing from the turtle's perspective, and I believe
that's exactly what China will seek to do.
Changing the system does not mean withdrawing from the system or
blowing the system up. Remember, China MUST continue to sell stuff
into developed world export markets as a bridge to a more stable
economic growth path based on domestic markets. Changing the system
means changing the rules, the "correlation of forces" to use a
good-old-fashioned Leninist phrase, so that China can still sell
lots of stuff to the world in order to support its domestic
factories and generate capital to build its domestic
infrastructure, but in a way that can be controlled by the State
and not usurped by these hyper-privileged families that have popped
up over the past few years. China doesn't want to be the turtle; it
wants to be "the compassionate man" who sets out the pan of boiling
water for other turtles to cross. China wants to control its own
future, and to accomplish this, strong actions must be taken
domestically and internationally.
Domestically, I expect two things.
the backlash against the privileged families, particularly
those politically active second and third generation inheritors of
both a mantle of authority and a vast fortune from Mao-era Party
and Army leaders, will widen and grow
. This is the right context for understanding the Bo Xilai
"scandal" and trial. Murder a British "banker" who helped you
quietly funnel more than $100 million into personal overseas
accounts? No problem, and thank you for not stealing more. Use your
control over a vast domestic fortune (
of dollars seized from "organized crime" in Chongqing) to fund a
personal political machine with national aspirations, in effect
becoming a Chinese conflation of Michael Bloomberg and Rudy
Giuliani? Sorry, Bub, time for you to go.
Second, and relatedly, the backlash against these Princes will
be driven by a domestic media Narrative that China is engaged in an
economic "struggle" with powerful outside forces, and that these
hyper-privileged families are in effect siding with the enemy. Of
course, the Princes can read the newspapers, too. Not only is the
message loud and clear that you should keep your domestic wealth
hidden and totally segregated from political purposes, but also
that you're only as rich as the wealth you can remove from China
entirely. Hold that thought.
Internationally, I expect three things.
First, to construct the domestic Narrative of an economic
struggle you need a foreign enemy, but it's too risky (for now) to
cast entire nations in this light. The next best thing? Japanese
and American companies that sell expensive, industrially advanced
stuff into China, and by "stuff" I mean both manufactured items and
services. Recently companies like IBM and Cisco have reported a
distinct slowdown in their Chinese business. My view? You ain't
seen nothing yet. As powerful as the "Buy American" marketing
slogan has been in this country, the "Buy Chinese" slogan in China
will be 100x more powerful.
Second, if there's one historical lesson that all Great Powers
know - particularly up-and-coming Great Powers like Germany in the
1890's, Japan in the 1930's, or Russia in the 1950's - it's that
the only way to win the Great Game is to control enough
natural resources so that the incumbent Powers can't squeeze you
. Resource independence isn't a sufficient condition to change the
rules of the system, but it's certainly a necessary one. The
resources that matter today are energy and technology, period, and
this is the context in which we need to understand China's actions
in the South China Sea, in cyber-security, in Africa, and in its
diplomatic relations with Russia. Achieving energy independence and
technological parity - or at least reducing its vulnerability to
being fatally suffocated if that's what it comes to - is not a
matter of choice to a China that sees itself under assault from the
West within and without, but a matter of necessity.
Third, since Western monetary policy is the root of all evil
from a Chinese perspective (okay, that's a bit of poetic license,
but not as much as you might think), the primary weaponry for
China's rule-changing efforts will also be monetary policy,
particularly currency exchange rate policy. Here's a chart that
illustrates what I mean, and why I think that China is already
embarking on the paths outlined above.
First, take a look at the price level ratio of the Chinese
renminbi and the US dollar (dark blue line above) to see what I
mean when I say
that the rules of the global trade system pose a structural
challenge for China, and that the Chinese government is starting to
challenge those rules.
From 2005 through 2007 China strengthened the renminbi versus the
dollar by more than 20%, assuaging US political pressure that the
Chinese currency was too weak and created "an uneven playing field"
in international trade. This was an easy concession by the Chinese
regime, as domestic growth remained plenty strong and their
domestic stock market rocketed higher. Not coincidentally, vast
fortunes were built by the most politically connected and powerful
Chinese families over this 3-year period. But then 2008 happened,
plunging all markets and all economies into chaos. China decided
that discretion was the better part of valor during the Great
Recession, so the renminbi was kept steady against the dollar until
the end of 2009. At this point it looked like domestic GDP growth
and global markets were in the clear, and so China returned to the
exchange rate policy that had worked so well for them in the
2005-2007 period. Oops.
In a QE dominated world … in the Golden Age of the Central
Banker … renminbi strengthening has been an unmitigated
How so? Take a look at the HSCEI/SPX ratio (red line above).
Measured from the beginning of 2004, the broad mainland Chinese
equity market rose to a price level 2.5x greater than the broad US
equity market by March 2009 and the initiation of QE1. Since then,
the US market has done nothing but go up and the Chinese market
nothing but go down, so that the Chinese market's price level is
now only 50% higher than the US market in 2004 terms, down more
than 80% from its peak relative price level.
Similarly, Chinese GDP growth (green line above), after a brief
recovery along with the rest of the world in 2009 in response to
the Fed's adrenaline shot straight into the flat-lining heart of US
capital markets, has done nothing but drift down in an alarming and
totally unprecedented way. I know, I know … Chinese GDP data is
terribly untrustworthy and is largely constructed out of whole
cloth. But that fact just makes this chart even scarier! If the
manufactured data is this steadily disappointing, imagine what the
real GDP growth rates look like.
So what is China's response? Since the beginning of this year,
China has forced the renminbi down in value, making the currency
weaker and making exports cheaper, in effect administering their
own shot of adrenaline to the heart of their economy. I think
this is just the start of a multi-year weakening of the
renminbi, a sea change in Chinese monetary policy that will
inevitably create broad political tensions with the US and make
Japan's devaluation/inflation course infinitely more difficult to
For more than 40 years China has been willing to accept the lead of
the US in determining the rules of the road when it comes to
international trade. Now China is looking to call the shots. Modern
trade wars are not fought with tariffs and quotas, but with
exchange rates, and what China is doing with their currency is the
modern-day trade regime equivalent of firing on Fort Sumter.
Okay, Ben … interesting enough, but I'm not a forex trader. What
does all this mean for portfolio construction, asset allocation,
and risk management?
It means everything. It means that China intends to challenge
the current system of global trade by forcing change in the
monetary policy rules and relationships we have known for the past
40+ years. It means that ANYTHING is possible and NOTHING is off
the table as the Chinese State combats an existential internal and
To use Mao's phrase, the Chinese regime is not a frog in a well,
seeing the limits of the sky in what the mouth of the well defines.
If we want to be effective investors or allocators in the difficult
years to come, we need to look beyond the mouth of the well, too.
What's beyond the mouth of the well? What are the specific policy
choices China could make to restore political legitimacy to Party
and Army while also driving real economic growth? Beyond forcing
the renminbi down, staking out energy-rich geographies, "acquiring"
technological know-how by any means necessary, and aligning with
Russia on all of these issues … I have no idea. But I am certain
that there is more to come, in both scale and scope. I am certain
that whatever these policy choices may be, they will be outside
every macroeconomic model, every sell-side report. I am certain
that some historical correlations we treat today as ironclad market
laws will be turned on their heads, wreaking havoc on portfolios
that insist on treating the past as some immutable Truth with a
In this environment I think the most useful response from a
portfolio construction perspective is to adopt what I call
about what the future holds. Or expressed with fewer $10 words,
what's required is to accept that no one has a working crystal ball
right now. If ever there was a time when it makes sense to
structure a portfolio in an adaptive fashion, where you start with
a balanced allocation to a wide range of asset classes and then let
the market tell you what's working and what's not, today is the
day. I've said it before and I'll say it again:
the Golden Age of the Central Banker is a time
for investment survivors, not investment heroes.
China's challenge to the Western status quo reinforces that claim
I'll close with an observation of a less defensive sort, because
the forthcoming Chinese challenge to the current monetary policy
rules will present opportunities as well as dangers, and because a
good risk manager is always looking for asymmetric risk/reward
ratios in either direction. Here's a 40-year price chart of 1 US
dollar expressed in Hong Kong dollars. The vertical axis (number of
$HK = 1 $US) is inverted because a higher number of Hong Kong
dollars reflects a weakening of that currency.
For the past 30+ years, the HK dollar - the world's eighth most
traded currency - has been pegged to the US dollar with rock-solid
certainty. In the world of international trade, the HK dollar hard
peg is the equivalent of the law of gravity, with all the certainty
for future economic transactions that implies. As you can see
clearly from the chart, there has been essentially zero volatility
in the exchange rate since October 1983 and the creation of the
currency board system.
To use a geological analogy, the Hong Kong dollar is the most
stable tectonic plate in all of global economics, and the fault
line between the Hong Kong dollar tectonic plate and the US dollar
tectonic plate hasn't had a tremor in 30 years. But here's the
The stability of the Hong Kong / US dollar fault line is
entirely due to politics.
It's stable because the Hong Kong government says that it's stable.
There is zero reflection of fundamental economic pressures in this
exchange rate, because it is entirely a political creation. And if
the politics change at a deep enough level, such that it is no
longer in Beijing's interest to maintain the hard peg, you will
have a massive earthquake.
Very smart guys have predicted either an end to the hard peg or
an end to the Hong Kong dollar altogether, and they've been
entirely wrong. In 1995 Milton Friedman predicted that the currency
could not survive the 1997 handover of Hong Kong to Beijing, a
prediction that Jim Rogers has adopted as a policy prescription
since 2007. In 2011 Bill Ackman famously went long the Hong Kong
dollar, arguing that the fault line between the Hong Kong dollar
and the US dollar could not withstand the inflation Hong Kong would
be importing from the US (you can access a copy of Ackman's
150-page slide presentation
). In investments as in comedy, timing is everything. So why do I
think it's different this time? Why do I think the clock is now
ticking on an earthquake in the fault line between the Hong Kong
dollar and the US dollar?
It's different this time because China is under greater
pressure, both externally and internally, to change the
international rules of the road than at any time since Deng forged
his domestic political coalition. It's different this time because
there are specific catalysts - the weakening of the renminbi, the
creation of a domestic media Narrative that trumpets an economic
"struggle" with the West, the claiming of vast swaths of strategic
offshore territories, the acceleration of cyber-espionage, the
strengthening of ties with Russia to create a new economic axis -
that are forcing the Great Powers of the 21st century onto a
collision course. It's different this time because the
hyper-privileged families of modern China need to get their wealth
out of China ASAP, and parking it in Hong Kong (or in Hong Kong
dollars) is no longer safe enough. I can't tell you the timing, the
odds, or the form of this or that earthquake-provoking event. My
crystal ball is just as broken as anyone else's. But I think where
is useful is in providing the right lens for evaluating these
events as they occur, and that this monitoring function can help
investors and allocators alike interpret environmental risks as
part of an adaptive framework.
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Salient Partners, L.P. and affiliates ("Salient"), and is provided
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