On Ukraine, China Has Chosen a Perilous Path

Written by: Regina Chi, CFA® | AGF

Russia’s invasion of Ukraine has had palpable ripple effects around the world. It has contributed to rising prices for energy, food and other goods, which has in turn spurred central banks to aggressively increase interest rates this year. In turn, the global economy is slowing; recession seems increasingly likely. And equity markets have been decimated.

Inflation, monetary tightening and challenging financial markets at home and abroad, however, are not the only new realities with which investors have to grapple. A broader and potentially more lasting change is the re-orientation of geopolitics toward a more conflictual landscape, one for which Russia’s aggression may be both a flashpoint and an accelerant. This shift involves not just the West and Russia – a relatively minor contributor to global GDP despite its importance in energy markets. Another, bigger player is involved in this evolving drama as well: China. For Emerging Markets (EM) investors, the implications of China’s entanglement with the Russo-Ukraine fallout could be considerable.

The most obvious facet of China’s entanglement has been its tacit approach to Russia’s “special military operation” (a Kremlin-approved euphemism for the invasion, accepted by Chinese officials) and its pledge for a “no limits” partnership with Russia. It is a delicate balancing act, one that amounts neither to full support nor to opposition. China has called for peace negotiations, but has not imposed sanctions on Russia.

The war, meanwhile, has not exactly gone according to Putin’s plan. It has dragged on far longer than almost anyone expected, and in September the tide seemed to be turning in favour of Ukrainian forces. From the sidelines, China has clearly been surprised and disappointed by how the war has unfolded. In a mid-September meeting between the Russian and Chinese leaders in Uzbekistan – Xi’s first official visit outside of China since the pandemic – Putin acknowledged that Chinese officials had expressed “questions and concerns” about the war’s progress. (Notably, coverage of the meeting by China’s state-controlled media was rather muted.) Increasingly, it has begun to look as if China, in leaning toward Russia, may have not only backed a bad actor, but picked the wrong horse.

Abandoning the partnership, however, is likely not in the cards for China in the near term, and it is not simply a matter of saving face. This is not a relationship between equals, and China is the clear beneficiary. Domestically, there is no evidence that Xi’s grip on power has been weakened by the partnership with Russia. And maintaining ties with Russia has some tangible upside. With much of the rest of the world imposing sanctions, China (along with India, which is also officially “non-aligned” in the conflict) has VIP access to Russia and its resources. The most important of those, of course, is oil. Like India, China is buying directly from Russia and likely at a substantial discount, since few other markets will take it. That is one reason inflation in China has been quite moderate compared to the rest of the world.

Leaning towards Russia on Ukraine without explicitly backing it achieves something else: it allows China to buttress its anti-Western political stance while – without paying a meaningful economic price – testing and assessing the West’s resolve in the face of provocation. In Beijing’s calculus, Putin’s invasion may be seen as a valuable confrontation-by-proxy with the West.

China, after all, cannot afford a “hot” economic war with the United States or Europe. It has other pressing problems to address internally, including the lingering impact of its dynamic zero-COVID lockdowns and a real estate crisis. More broadly, while it has ambitions of regional (and maybe global) primacy both economically and politically, China has a long way to go before it gets there. It is still in the process – a long-term one – of rebalancing its economy toward domestic consumption. And although it wants to continue moving up the economic value chain, its manufacturing sector is hardly self-sufficient; it still relies on imports not only of materials, but also of value-added components like semiconductor chips.

To some observers, Russia’s invasion of Ukraine has raised the spectre of China following suit – with an attempt to take Taiwan by force. Certainly, it has not backed away from claiming sovereignty over Taiwan, a stance reinforced by the military exercises it staged following a visit to the island by U.S. Speaker of the House Nancy Pelosi in August. Open conflict, however, seems unlikely in the near term given the competing pressures China faces. But it is playing a potentially dangerous game with the West on both Taiwan and Russia – poking the bear while hoping not to provoke the bear into action.

What does all this mean for investors? Clearly, China’s tenuous stance on the Russo-Ukraine war has increased the risk of even further tensions with the West, which could manifest in the form of more punitive trade actions, and perhaps even economic sanctions, if the lean towards Russia turns into full support. Taiwan, meanwhile, remains a potential flashpoint. On the other hand, the opportunities China offers – a middle class larger than the population of the United States, primacy in global supply chains, a growth rate that is still exceptional, and the potential for a dramatic post-pandemic reopening – are too significant for Western investors to ignore.

One approach for investors to consider is to sequester the risks and opportunities China presents through an EM ex-China strategy, which achieves broad exposure to emerging markets without making a discrete allocation to China. Effectively, the strategy has the potential to limit China-related risk to the overall EM portfolio, but at the same time allows for China-specific allocation adjustments as events unfold.

Perhaps more importantly in the short term, an EM ex-China strategy might provide an effective means to play defence in Emerging Markets. The geopolitical landscape is in flux, and on Ukraine, China has chosen a perilous path through it. The costs of a misstep could be severe.

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