The Winds of War (Part One)

by Kevin D. Freeman on January 29, 2018

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There is a lot of positive economic news. Economic growth has substantially strengthened in the wake of regulatory reform, corporate repatriation, and tax cuts. The stock market is at all-time highs. Interest rates are appearing to normalize, at least in small measure.

Despite this, according to this week’s BARRON’S, capital is fleeing the US (BARRON’S, January 29, 2018, “Talking Down the Dollar”):

That’s despite the U.S. having higher interest rates than most other economies and a stock market whose performance the president cites as a barometer of the success of his policies. In fact, capital is flowing away from the U.S. despite these positives, according to Northern Trust senior economist Ryan James Boyle.

Mutual fund flows were negative for U.S. equities in 2017 but positive for the rest of the world. “Essentially, the U.S. has gone from being the source of the best investment opportunities, to merely being one of many great destinations for capital. The dollar’s slide can be at least partially attributed to this change,” Boyle writes in a report.

This analysis would suggest that the United States has simply lost its advantage of growth to other parts of the world. Thus, other economies have supposedly increased in relative attractiveness even though we are doing quite well. But what if something more sinister is at work? What if we are witnessing without understanding the early phases of the next great war?

The first thing we must recognize is that the global financial system is already under severe stress. Some of this is natural. Some of it is induced. And, in our view the induction is purposed as an act of Unrestricted Warfare.

Readers of this blog already have a detailed understanding of the efforts underway to displace the dollar as the primary reserve currency of the world. Beyond that, there are massive dividing lines being formed regarding the global financial system. With the help of Russia, China has developed a complete alternative financial infrastructure. In addition, the Chinese have used their considerable influence to establish new trading alliances that purposely exclude the United States. They are also establishing a command and control structure over all companies doing business with China regardless of where they are domiciled. Finally, they have established technological leadership, in part based on brazen intellectual property appropriation over the past few decades.

China has been preparing for a war footing. There are multiple clues that when pieced together suggest that a combination attack plan using economic pressure, technology, and physical invasion to assert Chinese dominance in Asia and ultimately over the planet. It is no longer acceptable to naively overlook this reality.

The good news is that the Trump National Defense strategy is perhaps the first since President Reagan to properly acknowledge the threat and to begin the process of addressing it. The bad news is that we still have a great deal of work to undertake just to get on the same page.

Let’s begin with an acknowledgment of the financial stresses already in operation. Quoting Ambrose Evans-Pritchard from last week:

The world financial system is as dangerously stretched today as it was at the peak of the last bubble but this time the authorities are caught in a “policy trap” with few defences left, a veteran central banker has warned.

Nine years of emergency money has had a string of perverse effects and lured emerging markets into debt dependency, without addressing the structural causes of the global disorder.”

All the market indicators right now look very similar to what we saw before the Lehman crisis, but the lesson has somehow been forgotten,” said William White, the Swiss-based head of the OECD’s review board and ex-chief economist for the Bank for International Settlements.

Basically, the concern is that Western Central Banks flooded the system with easy money to offset the risks of the last financial collapse. Now, there is too much debt and misallocation of capital resulting in a policymaker’s dilemma. To stabilize, interest rates must normalize. However, rising rates could threaten to destroy a debt-laden house of cards. There is a push for inflation but a fear that it could get out of control. And, trying to tamp it down could set off another shock.

Of course, it is normal for economies to go through cycles. This one is different for two reasons. First, the response to the last crisis was extraordinary, a massive debt buildup of historic proportions. We warned about this in the report produced for the Department of Defense in 2009 (Economic Warfare Risks and Responses) and again in the 2012 book Secret Weapon: How Economic Terrorism Brought Down the U.S. Stock Market and Why It Could Happen Again. In the “what’s next section of the DoD report and Chapter Nine of the book, “The Next Attack,” we outlined what Phase 3 would look like. First, there would be a massive build-up of debt on Central Bank balance sheets as well as a massive increase in U.S. Federal Government debt. At some point this would trigger almost unstoppable inflation. It would seem unstoppable because the requisite increase in interest rates would collapse the debt pile. Then, China and others would move against the U.S. dollar, replacing it as primary global reserve currency and wresting control of the global financial system. When we wrote that years ago, many said it far-fetched (along with a few less-kind comments). Yet, we are seeing everything play out right on script today.

Of course, everything looks good on the surface. The global economy is performing about the best it has this decade, thanks in big part to the Trump tax cuts and regulatory reform. Even the head of the International Monetary Fund admits this to be true. And, we are more than pleased to see growth  return. But it is more than obvious that there are signs of global financial stress. One of these is the rise of Bitcoin. Another is the still-remaining large amount of money loaned at negative interest rates (where the lender pays the borrower). Only now are European government rates almost set to turn positive. after years in negative territory

The point is that despite growth, the global financial structure is still vulnerable and in some ways increasingly so. It is in precisely this context that a move against the West might succeed. And, as we have been sharing, China and Russia have been planning just that.

Rather than go into all the details, just review the following headlines and articles that support this concern:

Russia and China Are Dead Serious About Ditching the Dollar

(Russia Insider, January 24, 2018) The Russian government has recently announced it will issue nearly $1 billion equivalent in state bonds, but denominated not in US dollars as is mostly the case. Rather it will be the first sale of Russian bonds in China’s yuan. While $1 billion may not sound like much when compared with the Peoples’ Bank of China total holdings of US Government debt of more than $1 trillion or to the US Federal debt today of over $20 trillion, it’s significance lies beyond the nominal amount. It’s a test run by both governments of the potential for state financing of infrastructure and other projects independent of dollar risk from such events as US Treasury financial sanctions….

The steps to begin issuing Russian state debt in yuan are paralleled by another major development towards broader international yuan acceptance vis-a-vis the US dollar. On December 13, Chinese regulators completed final testing in preparation for launch of not a dollar-backed, but rather, a yuan-backed oil futures contract to be traded on the Shanghai Futures Exchange. The implications are potentially large. China is the world’s largest oil importing country. Control of financial oil futures markets until now has been the tightly guarded province of Wall Street banks and the New York, London and other futures exchanges they control. Emergence of Shanghai as a major yuan-based oil futures center could significantly weaken dollar domination of oil trade….

Command and control: China’s Communist Party extends reach into foreign companies

(Washington Post, January 28, 2018) American and European companies involved in joint ventures with state-owned Chinese firms have been asked in recent months to give internal Communist Party cells an explicit role in decision-making, executives and business groups say.

It is, they say, a worrying demand that threatens to put politics before profits, and the interests of the party above all other considerations. It suggests that foreign companies are no longer exempt from President Xi Jinping’s overarching vision of complete control.

“The creeping intrusion by the party apparatus into the boardrooms of foreign-invested enterprises has not yet manifested itself on a large scale, but things are certainly going down that path,” said James Zimmerman, a managing partner of the law firm Sheppard, Mullin, Richter and Hampton and former chairman of the American Chamber of Commerce in China….

China just reminded the United States that Beijing is its banker

(CNBC, January 11, 2018)  Markets took a hit following a Bloomberg News report that cited unnamed sources as saying that officials in Beijing have recommended China, the largest holder of U.S. Treasurys, to slow or even halt its purchases of that debt…

China’s foreign exchange regulator publicly refuted the Bloomberg report on Thursday, saying it cited “false information.” But the jolt to markets may have been designed as a warning to Washington, which is clashing with China over trade and other issues.

China sidelining US in Asia with growing economic clout- Nikkei Asian Review

(Nikkei.com, January 6, 2018) TOKYO — Asian economies that once relied on the U.S. are reaching a turning point as China comes to the fore, a trend that may weaken Washington’s ability to promote democracy and free markets.

The U.S., as the world’s largest consumer market, was the dominant export destination for Asian countries for decades after World War II. But this has changed in recent years. The Association of Southeast Asian Nations exported more to China than to America in the decade following the global financial crisis. The bloc’s China-bound shipments totaled $143 billion in 2016 — 9% more than its exports to the U.S.

Chinese economic influence is also growing in Japan, where exports to China for the 11 months through November totaled 13.38 trillion yen ($118 billion), topping the full-year record set in 2014.

Should this momentum continue, it could alter the balance of power between Washington and Beijing in the region.

Pakistan is ditching the dollar for trade with China

(CNBC, January 3, 2018)  A day after the U.S. leader slammed Islamabad for harboring terrorists in a New Year’s Day tweet, Pakistan’s central bank announced that it will be replacing the dollar with the yuan for bilateral trade and investment with Beijing.

The same day, Chinese Foreign Ministry spokesman Geng Shuang defended Islamabad’s counter-terrorism track record…

The Chinese Regime is Spreading a New World Order under its ‘China Model’

(The Epoch Times, December 22, 2017)  The Chinese regime has been promoting its “China model,” which opposes the ideas of human rights and democracy promoted by the United States. While the concept is making the rounds in the international community, many China watchers have warned that the system presents a new form of hegemony under a totalitarian system based on absolute control.

China expert Steven Mosher details this system in his new book, “Bully of Asia: Why China’s Dream is the New Threat to World Order,” and explains the nature of the system the Chinese Communist Party (CCP) is attempting to press onto the world. The China model is based on the concept of what the CCP refers to as “socialism with Chinese characteristics.” While many are familiar with the communist goals in socialism, the CCP’s definition of “Chinese characteristics” is often less understood. This system can be traced back to dictator Mao Zedong, who led the CCP after it seized control of China in 1949. As part of Mao’s strategy to apply the Leninist and Marxist models of communism to China, he studied classical Chinese texts and histories of Chinese emperors, creating his new Maoist system….

The CCP is spreading its system using a variety of tactics that are outside of conventional military force. This includes militarized use of businesses, education, law, media, and other institutions to spread its control without needing to engage in conventional warfare.

Mosher noted that former CCP leader Deng Xiaoping declared a war on the United States in 1991, “saying there was a new Cold War between the United States and China, and China will win. It was a war on all fronts.”

China is trying to influence other countries from the inside, and the West isn’t happy about it

(CNBC, December 18, 2017) Officials in the U.S., Australia, New Zealand and Germany — major recipients of Chinese foreign direct investment — have been questioning the extent of Beijing’s interference on their home turfs amid recent developments that suggest rising Chinese clout….

Experts widely believe that Beijing is using education, spying, political donations and people-to-people diplomacy to gain a greater say in local decision-making in these countries. And at a time when Beijing is dominating the global trade conversation, the issue threatens to strain bilateral relations between China and Western economies….

Xi’s team also has spent billions “to shape norms and attitudes in other countries, relying on the cultivation of relationships with individuals, educational and cultural institutions, and centers of policy influence,” Shanthi Kalathil, director at the International Forum for Democratic Studies, the National Endowment for Democracy, said at the CECC hearing. This complex network of liaisons falls under the domain of the United Front Work Department, a Communist Party agency driving the nation’s push for global soft power.

Confucius Institutes, Beijing-sponsored educational organizations aimed at promoting Chinese language and culture on global university campuses are a major example of how Beijing is looking to alter global narratives.

China’s using cheap debt to ‘bend other countries to its will,’ academic says

(CNBC, December 22, 2017)

China’s continents-spanning Belt and Road network threatens to “shackle” partner countries and deprive them of valuable natural assets, according to one critic. Beijing is financing and executing massive infrastructure projects across the 68 nations participating in the ambitious scheme, which snakes along Europe, the Middle East and Asia. These recipient countries, many of them emerging economies in dire need of investment, obtain funding in various forms such as sovereign loans from Chinese President Xi Jinping’s administration and credit from Chinese state-owned banks. But concerns of developing countries taking on unrealistic financial obligations have sparked allegations of what’s being called ‘dept-trap diplomacy.’ Earlier this year, Indian Prime Minister Narendra Modi’s administration released a statement warning of unsustainable debt burdens being created by Belt and Road….As a result, the world’s second-largest economy holds political leverage over governments and can “force borrowers to swap debt for equity, thereby expanding China’s global footprint by trapping a growing number of countries in debt servitude.”

Three critical points. First, this is now out in the open. We have been writing on this for a decade now but finally the truth is being recognized. Second, most of Wall Street is mostly unaware of what’s happening or the implications. Wall Street continues to view China more as opportunity than threat.

Third, these are the “winds of war.” Herman Wouk wrote a tremendous novel with that title published in 1971, that is considered by many to be a masterpiece of historical fiction. It documented with human drama the prelude to World War II. It was presented in a miniseries in 1983 starring Robert Mitchum.

What we are experiencing today is quite possibly the prelude to World War III. We should not ignore it. The good news is that for the first time in decades, the President’s National Security Strategy suggests a clear understanding of the challenge and outlines a plan to address it. We will review this strategy, and what we ought to be doing with it in the next installment.

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