The Great Game of Power: Cold Wars, Proxy Wars, and The Path Well Trodden

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National security requires far more than military power. Economic and moral factors play indispensable roles.  Any program that endangers our economy could defeat us.  Any weakening of our national will and resolution, any diminution of the vigor and initiative of our individual citizens, would strike a blow at the heart of our defenses.

Annual State of the Union Message
President Dwight D. Eisenhower
January 10, 1957

“Igitur qui desiderat pacem, praeparet bellum.”
(“Therefore he who desires peace, let him prepare war.”)

De Re Militari
Publius Flavius Vegetius Renatus
4th Century A.D.

Since the dissolution of the Soviet Union in 1991, which unofficially ended the Cold War, United States economic and foreign policy became based on the premise that global rivalries no longer existed.  That the U.S. could and should help other countries to grow.  And that the need to maintain an enormous military capability would no longer prove necessary.  Thus, the US entered into NAFTA in 1993 with Mexico and Canada.  And followed it with a conclusion to the long running global trade discussions between the Emerging Markets (EM) and Developed Economies (DM) that led to the creation of the World Trade Organization (WTO).  Through the WTO, America and other Western countries provided unfettered access to their economies for foreign goods and provided a rules structure that favored EM economies.  This led to 20 years of accelerated EM economic growth and enabled China to modernize its economy.  For those who put these policies in place, they did their job producing the intended results.

Unfortunately, thirty years later these policies look out of place in a world in which both China and Russia resumed their traditional roles as Great Power rivals to the United States.  And while numerous politicians continue to extol the virtues of these globally oriented policies, the dawning of a new view of China by the U.S. and European public over the past two years, as China militarized the South China Sea and demanded Western citizens and corporations apologize for exercising their democratic rights to free expression, brought to the fore a very different reality. This reality reflected the massive change in China’s economy since 2000 and its Communist political orientation.  And when coupled with Russia’s invasion of Ukraine and Vladimir Putin’s recent move to deploy hypersonic weapons, the past 30 years look more like an intermission between Act 1 and Act 2 of a continuing Cold War.  And with the U.S. moving to counter China and Russia for the first time in over 25 years, events look set to accelerate over the next five years.  Even Henry Kissinger, who engineered the opening of China through President Nixon’s visit in 1972, recently stated that the US and China stand in the “foothills of a Cold War”.  (New Economic Forum speech, November 2019.  Please see the following link to the speech on Bloomberg: https://www.bloomberg.com/news/articles/2019-11-21/kissinger-says-u-s-and-china-in-foothills-of-a-cold-war .)

To understand China’s actions to elevate its global economic and strategic position at the expense of other countries and the growing global reactions by other nations over the past two years, a few concrete examples of China’s strategy will illustrate clearly the issues at bay.  First, China’s BAIC Group, a Chinese State Owned Enterprise (SOE), announced it took a 5.23% position in Daimler A.G.’s voting stock.  This stands in addition to Zhejiang Geely Holding Group, another Chinese company already owning a 9.7% stake in Daimler.  Given Daimler’s poison pill, China could not increase its position in Daimler through the same company, so it used a separate SOE in order to increase its stake.  This gives China a 15% stake in Germany’s leading automotive company and one of the largest commercial vehicle manufacturers in the world.   Also, in order for Daimler to continue to grow its business in China, Daimler agreed to create a jointly owned electric battery research lab with BAIC in Beijing.  After the Chinese takeover of Kuka, the premier robotics company in Germany and one of the leading global robotics companies, the German public reacted negatively to the government allowing this sale to occur.  As a result, Germany passed laws to limit foreign companies’ ability to take over German companies involved in key areas of the German economy.  To what extent Germany will allow China to influence Daimler and exactly what technology Germany will allow the company to share, remains to be seen.

Second, over the past five years, China opened plant after plant to produce LCD TV panels, displacing foreign imports to the country, putting in place excess capacity for export, and creating massive oversupply in the global markets.  This excess supply led to the expected results.  Foreign plants saw capacity utilization come under pressure over the past year. Global Capacity Utilization dropped from 89% in early 2019 to 82% lately.  With Capacity Utilization collapsing, TV Panel prices fell to less than the cash cost to produce them. With cash losses on every panel produced, this put massive financial pressure on foreign rivals to close capacity while the Chinese companies could depend on the Chinese government to infuse cash to fill the gap through this period, however long it needed to be.  This strategy to put pressure on foreign rivals appears successful, as Korean manufacturers announced the closure of some capacity in an attempt to balance the market and stem the losses.

Third, China’s push, via Made in China 2025, to create a global semiconductor industry to displace foreign chips continues apace.  Memory chips will become the next area to come under pressure.  With technology stolen from Micron Technology, as documented publicly, Yangtze Memory Technologies Co. expects to manufacture 5% of global output for NAND flash memory chips by the end of 2020 and ChangXin Memory Technologies expects to produce 3% of global DRAM memory chips by the same date.  The Chinese national and local governments effectively paid for the $24 billion Yangtze plant and the $8 billion ChangXin plant.  For the U.S., South Korea, and Japan, which developed the technology and currently dominate this market, such a state subsidy coupled with massive state industrial espionage to create global rivals and displace their companies cannot sit well.  The likely reaction by these countries, to cut off these Chinese chips and any products containing those chips from Western markets and to push for an embargo from countries allied with them in Asia, Europe, Africa, and South America over the next year, should come as no surprise as these chips come to market.  For those who think the economic strife and turmoil, exhibited over the past two years, entered a truce due to the “Phase 1” deal between the U.S. and China over trade, they likely will find themselves sorely disappointed.

And Fourth, China attempted to dictate to Vietnam where it could drill for oil offshore, claiming Vietnamese waters in the South China Sea for itself.  In this instance, there exists no question about the block where the drilling occurred from June until October, utilizing a Russian vessel with the needed drilling capabilities from Rosneft.  International law long recognized this portion of the sea as Vietnamese territorial waters.  Chinese coast guard ships entered these Vietnamese waters in an attempt to stop the drilling.  Vietnam responded with its own ships to protect the Russian drilling rig.  The Chinese vessels fired water cannons at the Vietnamese vessels in an attempt to provoke a reaction.  The U.S. sent a warning to China not to escalate.  Ultimately, the Chinese did not fire live weapons at the Vietnamese ships.  This is similar to Chinese actions against The Philippines which led the United States to remind China it possessed a mutual defense treaty with the country.  However, with China claiming the whole South China Sea for its own despite internationally recognized boundaries for each country’s exclusive economic zone, the probability that such a confrontation could escalate into a shooting match will rise over time.

In reaction to these moves, the U.S. began to revive and implement policies last seen during the 1980s, during the height of the Cold War.  These policies cover a wide variety of areas, from economics to military preparedness to foreign policy.  While no “Grand Strategy” yet exists to unify these actions, taken as a whole, they represent a visible symbol of the likely Grand Strategy the U.S. will formally adopt over the next few years.  First, the U.S. directly targeted trade with China, which undermined U.S. manufacturing capabilities over the past 20 years.  With the reality of China’s State Owned Enterprises receiving massive government support and subsidies, allowing the status quo to continue would lead to further reductions in U.S. industrial base.  From a global strategic and domestic security perspective, this stands as an unacceptable result.  Second, the U.S. moved to protect its technology.  This occurred in two ways.  The legislation behind CFIUS (The Committee on Foreign Investment In the U.S.) was updated to address the current economy.  This enabled the government to legally stop China’s SOEs from buying U.S. technology to bring to China.  And this enabled the government to stop China from investing in start-ups with potential leading edge technology products.  Third, the U.S. moved to invest significant sums into critical technologies in order to keep up with China.  This can be seen in the following initiatives:

National Electric Vehicle Supply Chain Initiative
National Quantum Computing Insitute
DOD R&D Funding for Hypersonic Vehicles
National Initiative on Advanced Manufacturing, AI, and Robotics

Fourth, the U.S. set in motion initiatives to reshore critical manufacturing.  Over the past 20 years, significant advanced manufacturing moved offshore as large companies sought to save money and the U.S. government allowed this.  With a new Cold War in place, security of supply will now trump other considerations.  Integral to this effort stands the production of computer chips.  The Pentagon and TSMC continue to negotiate the construction of a fab for advanced semiconductor manufacturing to be built within the U.S. borders.  TSMC manufactures 90% of advanced semiconductor chips designed by U.S. and European companies. This includes key chips for the U.S. military that go into some of the most advanced weapons in the U.S. as well as jet fighters, radar systems, combat ships, and other key areas.  DARPA, the Defense Advanced Research Projects Agency, allocated $1.5 billion in 2017 for chip R&D through the Electronics Resurgence Initiative.  Fifth, the U.S. Congress performed numerous studies on China to provide the basis for future legislation and budget allocations.  These include The US-China Annual Economic and Security Review, China Belt and Road Initiative Analysis, and Threats to U.S. Research Enterprise: China’s Talent Recruitment Plans. The President, through his ability to direct the Executive branch and through Executive Orders, put in place the following: the American Technology Council, the Strengthening Cybersecurity Initiative, the Revival of the National Space Council, Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency Initiative, a National Security Strategy, the Critical Minerals Initiative, the Strategy for American Leadership in Advanced Manufacturing, an Automated Vehicles and Preparing for the Future of Transportation Strategy, an Accelerating America’s Lead in Artificial Intelligence Initiative, the National Space Weather Strategy, the National Resilience to EMP Strategy, and the National Strategic Computing Initiative, among other actions.  Seventh, the US significantly increased its defense spending.  With China’s real defense budget now 75% or more of the U.S. budget, the U.S. needed to increase spending to maintain its global military capabilities.  Eighth, the U.S. moved to paralyze the WTO (World Trade Organization) and reestablish the GATT (General Agreement on Tariffs and Trade).  By refusing to approve any new appellate judges, the U.S. effectively prevented the WTO from ruling on any matters leaving all disputes to country to country negotiations as under the GATT. (For a more detailed discussion of this topic, please see The Fight For Global Growth: Technology Leadership, Currency Wars, and The Death of the WTO published on August 31, 2019.)  Ninth, the U.S. moved to use economic sanctions against countries allied with China around the world.  This action seeks to undermine the governments and economies that have put themselves under China’s sphere of influence, thereby undermining China’s global strategic position.  And Tenth, as a logical extension to economic sanctions, the U.S. seeks to deny China critical items to meet its economic goals.  For example, this might mean withholding computer chips from China.  This strategy seeks to undermine the Chinese economy much as China sought to undermine the U.S. economy over the past 20 years.  For historical reference, the U.S. successfully used this strategy against Japan.  And those economic sanctions ultimately gave Japan no choice but to launch war against the U.S.

While Henry Kissinger speaks of the “foothills of a Cold War”, the reality of the actions outlined above by both China and The United States speaks only of the early stages of a full blown Cold War.  The closest historical analogy stems from the late 1940s when Russia and the U.S split Europe.  There followed a global alignment of countries either with the Western democracies or with Russia and China.  This effectively split the world into two for the next 50 years.  Winston Churchill in his 1946 Sinews of Peace speech famously stated, “It is my duty, however, for I am sure you would wish me to state the facts as I see them to you, to place before you certain facts about the present position in Europe.  From Stettin in the Baltic to Trieste in the Adriatic, an iron curtain has descended across the Continent.”  With the U.S. and China moving down The Path Well Trodden, the world will likely split into two once more over the next decade.  And instead of an Iron Curtain, a Red Curtain will fall.  As it does, the likelihood of a Proxy War somewhere in the world, with the U.S. and China backing different sides for their own strategic gain, becomes highly likely, with the most probable location Asia or the Middle East.  For China, the issue will come down to how to manage a U.S. that now recognizes its strategy to become the dominant country in the world and who will act to oppose this outcome.  For the U.S., not only will it need to address China’s strategy across all spheres of action, but it will need to address the moral leadership of those opposed to the authoritarian system offered by China and enabled with today’s technology.  As President Dwight D. Eisenhower famously stated in his State of the Union Address in January 1957:

 

Our pledged word, our enlightened self-interest, our character as a nation commit us to a high role in world affairs: a role of vigorous leadership, ready strength, sympathetic understanding.  The State of the Union, at the opening of the 85th Congress continues to vindicate the wisdom of the principles on which this Republic is founded.  Proclaimed in the Constitution of the Nation and in many of our historic documents, and rounded in devout religious convictions, these principles enunciate:

A vigilant regard for human liberty
A wise concern for human welfare
A ceaseless effort for human progres

Fidelity to these principles, in our relations with other people, has won us new friendships and has increase our opportunity for service within the family of nations.  The appeal of these principles is universal, lighting fires in the souls of men everywhere.  We shall continue to uphold them, against those who deny them, and in counselling our friends.

With The Great Game of Power once more afoot, the world will become a more dangerous place.  And simple differences easily can morph into major crises once national interests become involved.  Unfortunately, with a new Cold War raging and The Path Well Trodden for the combatants, Proxy Wars stand ahead on The Path.  Which fork the travelers take will become critical in determining whether these crises can be contained or will spill over, as before, into a larger conflagration.  And should they spill over, the world will once more engage in the conflicts that tore it apart numerous times before, but on a greater scale.  (Data from public sources coupled with Green Drake Advisors analysis.)

 

 

Confidential – Do not copy or distribute.  The information herein is being provided in confidence and may not be reproduced or further disseminated without Green Drake Advisors, LLC’s express written permission.  This document is for informational purposes only and does not constitute an offer to sell or solicitation of an offer to buy securities or investment services. The information presented above is presented in summary form and is therefore subject to numerous qualifications and further explanation.  More complete information regarding the investment products and services described herein may be found in the firm’s Form ADV or by contacting Green Drake Advisors, LLC directly.  The information contained in this document is the most recent available to Green Drake Advisors, LLC.  However, all of the information herein is subject to change without notice.  ©2019 by Green Drake Advisors, LLC.  All Rights Reserved.  This document is the property of Green Drake Advisors, LLC and may not be disclosed, distributed, or reproduced without the express written permission of Green Drake Advisors, LLC.

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