The China Question

Geopolitical tensions are rising, calling into question longstanding deep economic ties between the United States and China.

“Well, the Chinese government is worrying all the capitalists in the world way more than it used to. And of course we don’t like that, and we wish that China and the United States got along better. If you stop to think about it, think about how massively stupid both China and the United States have been to allow the existing tensions to arise. What bad is ever going to happen to China or the United States if we two are close? If we make good friends out of the Chinese and vice versa, who in the hell is ever going to bother us?”

— Charlie Munger, February 16, 2022

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Over a decade ago, I wrote a review of Superfusion: How China and America Become One Economy and Why the World’s Prosperity Depends on It. In the book, Zachary Karabell traces the history of China’s rise during the 1990s and 2000s and concludes that China and America have “fused” into a single economy of “Chimerica”.

The integration that has taken place over the past decade has further deepened ties between the U.S. and Chinese economies. Both countries benefit from trade and face dislocations in the event of disruptions brought about by any reason. However, there are times when geopolitical considerations take precedence over economics. We appear to be approaching an inflection point that could bring severe repercussions.

Last, year I wrote the following as part of an article on over-optimization:

Global trade harnesses the benefits of comparative advantage, a concept familiar to any first-year economics student. During peaceful times, global trade has the potential to generate mutually beneficial conditions between trading partners. 

There are always controversies regarding how far to take trade and to what extent domestic industries should be protected. Usually, these debates are prompted by the economic plight of individuals working in industries that are being displaced. However, the broader question for society is whether the macroeconomic advantages of global trade outweigh the fragility that is introduced into the system during times of crisis.

Another consideration that is often ignored is the extent to which we are willing to trade with countries that do not share the values embodied in the American creed, most notably the idea that individuals should be free to pursue life, liberty, and happiness in political systems that respect the will of voters. 

Do we wish to trade with countries that, even in the best of times, do not afford their citizens any of these rights? Or are we only concerned with trading with such countries when they are engaged actively in wars of aggression?

There is no escaping the fact that China’s government is highly authoritarian and has a system blending various aspects of capitalism and communism. China’s system has worked to generate remarkable economic growth over the past few decades. This economic growth has been driven by trade with countries that have various economic systems with different degrees of individual freedom. That is certainly true for the United States, and we should accept the reality that we have been willing to trade with a country that, in many respects, is a tyranny when it comes to human rights.

Rather than explicitly recognizing the reality of our relationship with China, most consumers in the United States have been content to essentially look the other way for a long time. This has become increasingly untenable since the start of the Russia-Ukraine war in February 2022. This week’s meeting between Xi Jinping and Vladimir Putin serves to highlight the reality that China and Russia have economic and political systems fundamentally at odds with the United States.

The degree to which the United States is willing to trade with countries that do not share our values is ultimately a political matter that should be debated fully and determined at the ballot box. Charlie Munger’s view, as we can see from the quote at the beginning of this article, is that China and the United States both have significant incentives to be on friendly terms despite our differences. The quote, taken from Mr. Munger’s comments at the 2022 Daily Journal annual meeting, went on as follows:

“Of course we should make friends with China. And of course we should learn to get along with people who have a different system of government. We like our government because we’re used to it, and it has advantages of personal freedom. China could never have handled its life with a government like ours. They wouldn’t be in the position they’re in. They had to prevent five hundred million or six hundred million people from being born in China. They just measured the women’s menstrual periods when they came to work and aborted those who weren’t allowed to have children. You can’t do that in the United States. And it really needed doing in China. And so they did what they had to do using their methods. And I don’t think we should be criticizing China, which has terrible problems, because they’re not just like the United States. They do some things better than we do. They should like us, and we should like them… I think nothing is crazier than people who foment resentments on either side of that one.”

That statement was difficult to listen to a year ago and it is difficult to read today because of the example of the Chinese government interfering in a matter so fundamental to human rights. But at least Mr. Munger directly stated what many people gloss over. He is directly stating that despite serious differences in systems of government, we should nonetheless not only trade with China but that we should like one another and be on friendly terms. But for many, that’s a very tough pill to swallow.

When Russia invaded Ukraine in February 2022, the United States and other western countries imposed severe economic sanctions that were hardly cost free for the west, especially when it came to energy security in Europe. However, the overall effect of the sanctions was still asymmetric: Russia was hurt by the sanctions more than the west. In the event of China invading Taiwan, it would not be possible to impose massive sanctions on China in an asymmetric manner — in other words, the United States specifically and the west in general would be severely harmed along with China.

Rather than considering macroeconomic effects, let’s take the example of Apple. In the company’s latest fiscal year, the Greater China segment (mainland China, Hong Kong, and Taiwan) accounted for 18.8% of net sales and 20.4% of segment operating income. China is the company’s most important country other than the United States.

As much as Apple might be hurt by the loss of revenue in China, that pales in comparison to the risk facing the company when it comes to its global supply chain. Apple’s annual report indicates that “substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in Asia, including China mainland, India, Japan, South Korea, Taiwan and Vietnam.” However, it is well known that the vast majority of manufacturing takes place in China rather than being diversified throughout Asia. Management is taking steps to move some production out of China, but this process will take many years to meaningfully reduce risk.

These are not simple problems and there is no easy solution that will fit in a tweet or into a soundbite in a political stump speech. As Americans, we take a great deal of pride in our country’s long history as a beacon for human freedom. The United States is still the most desired destination for millions of economic migrants and political refugees indicating that the freedom the country represents is still more than merely symbolic. Yet there are firm limits to how far America can go when it comes to demanding that other countries adopt our attitude toward politics and human rights.

Whether the United States should take military action or provide armaments to countries that are threatened by their neighbors is a valid political question, and the same is true when it comes to trading with countries that have systems we disagree with. Unfortunately, in today’s political and social climate, intelligent debates are increasingly difficult. Anyone who advocates less interventionism far from American shores risks being branded an “isolationist” or even a traitor who secretly admires or supports dictators. Maximalist attitudes toward intervention have become the only acceptable position one can take in many social and political settings.

The deterioration of the relationship between the United States and Russia is most concerning when it comes to the risk of nuclear escalation. The same nuclear risk exists in the event of conflict with China over Taiwan. However, the United States is also exposed to massive economic turmoil in a conflict with China. This is a fact that Xi Jinping is well aware of and will consider in his calculations regarding Taiwan.

As an American, I worry about the geopolitical situation, especially the risk of nuclear war which does not seem to get as much attention as it deserves. As an investor, I have grave concerns about companies that have major exposure to China. As a shareholder of Berkshire Hathaway, the extent of Apple’s exposure is especially troubling. Tim Cook is clearly aware of the problem but it is not certain that he will have enough time to diversify Apple’s manufacturing base before a crisis occurs.

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No direct position in Apple, but a large indirect position via Berkshire Hathaway.