by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of what some observers are starting to describe as a Stalinist purge by General Secretary Xi.  We note that Xi’s firing of military officers and defense industry officials may not be for corruption, but for real or imagined susceptibility to being recruited by the CIA.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more attacks on Red Sea shipping and a range of new labor laws in the U.S.

China:  The country’s top legislative body, the National People’s Congress, said on Friday that it has kicked out nine People’s Liberation Army generals, including five from the scandal-ridden PLA Rocket Force, two working on weapons procurement at the Central Military Commission, and one each from the PLA Air Force and the PLA Navy.  Also late last week, the Chinese People’s Political Consultative Conference, a prestigious government advisory body, said it has removed three top-level defense industry leaders from its membership.

• The sackings come three months after the mysterious firings of former Defense Minister Li Shangfu, who had previously been involved with procurement at the CMC, and former Foreign Minister Qin Gang, who was rumored to have had an affair that led to the birth of a child in the U.S. Prior to that, several top PLARF leaders were fired and put under investigation in July, sparking a scandal that has now reportedly caught up more than 70 officials.
• At first glance, the common thread linking most of these firings is that the officials were involved with developing and procuring equipment for the military. That suggests the officials were involved with kickbacks or other types of financial corruption, and that’s how most press reports seem to be describing the story.  That alone would point to some organizational weakness and lack of loyalty in the Chinese military.  However, we think there may be a more profound implication for U.S. security and global investors:
  • China’s widespread corruption among government and business leaders is usually described as a political challenge or economic risk, but it has also been a key source of leverage for Western spies to recruit Chinese sources.
  • Like other intelligence services, the Central Intelligence Agency knows that the way to convince a Chinese citizen to sell Beijing’s secrets is to use MICE: Money, Ideology, Compromise, or Ego.  Corrupt officials or lower-ranking workers are already susceptible to being bought with money.  If the CIA threatens to expose their corruption, they can also be susceptible to compromise.
• What many people don’t realize is that the CIA had leveraged Chinese corruption to build an extensive and effective network of human intelligence sources within China in the first decade of this century, but it was compromised and destroyed by the Chinese Ministry of State Security from 2010 to 2012, just as General Secretary Xi was coming to power. Discovery of the CIA’s network in China was reportedly a key factor in sensitizing Xi to the threat from Western spies and corruption in his own ranks.
  • CIA Director Burns has recently said his agency is successfully rebuilding its network in China. If so, it’s probably doing so by leveraging corruption again, and the corrupt Chinese officials with some of the most valuable secrets would be those associated with procuring weapons — especially the PLARF missiles that threaten U.S. forces in the Western Pacific Ocean and even the U.S. mainland.
  • In sum, the U.S.-China intelligence war is already in full swing, so the true import of Beijing’s military corruption scandal is that it suggests large numbers of Chinese military and defense industry personnel are susceptible to being turned by the CIA. We suspect that will exacerbate Xi’s security concerns, prompting further aggressive moves against the U.S. geopolitical bloc and even more of the global fracturing that is creating risks for investors.

China-Philippines:  Responding to Manila’s stated plan to build permanent civilian facilities on a disputed shoal in the South China Sea, Beijing on Friday warned that such an action would “seriously impinge on China’s sovereignty” and prompt it to “respond resolutely.”  The warning shows how the increasingly acrimonious territorial dispute between China and the Philippines could spark a conflict.  Given that the U.S. and the Philippines have a mutual defense treaty, any such conflict could potentially lead to a U.S.-China conflict.

China-Mexico:  Late last week, the Mexican government imposed an anti-dumping tariff of almost 80% on some types of steel imported from China.  The action came in response to complaints by Mexican producers that Chinese steelmakers have been disposing of their excess output abroad at artificially low prices.

• One little noticed aspect of China’s economic rise over the last two decades is that the country’s state-supported, low-cost producers have often undercut budding manufacturers in other so-called emerging markets around the world. Waves of cheap Chinese goods have often put domestic producers in Latin America, Africa, and South Asia out of business, short-circuiting their governments’ economic development strategy of boosting manufacturing and forcing them to stick with low-value added commodity production.
• Under pressure from imports, domestic steel production in Latin America is expected to cover just 83% of the region’s needs in 2023.
• More broadly, various reports suggest that China’s current economic slowdown is prompting many of its manufacturers in multiple industries to dump goods at low prices on world markets. In turn, that’s pushing down import prices and helping push down consumer price inflation in the U.S. and elsewhere.

Taiwan:  As campaigning ramps up for the presidential election on January 13, front-runner Lai Ching-te of the ruling Democratic Progressive Party has come under fire for the government’s 2019 decision to slash readings of classical Chinese literature in school curricula.  The DPP has long leaned toward independence from China, but Lai’s opponents are casting the curriculum change as an example of anti-Chinese extremism that could prompt Beijing to attack if the DPP stays in power.  It’s still unclear if the controversy could throw the election to the China-friendly KMT.

Japan:  An earthquake registering 7.6 on the Richter scale hit the western coast of Japan yesterday, causing widespread damage and prompting a tsunami warning.  At this point, it appears the quake has produced relatively limited casualties and damage, probably because it struck a sparsely populated area on the coast.

South Korea:  Lee Jae-myung, head of the opposition Democratic Party, was attacked and stabbed in the neck today by an assailant at a public event in Busan.  His injuries are considered serious but not life threatening.  Nevertheless, the incident is a reminder of the potential political volatility we could see in 2024 as countries ranging from South Korea and Taiwan to Mexico and the U.S. hold important elections.  South Korea holds legislative elections in April.

United Kingdom:  Although many of the strikes the country faced last year have died down, some labor actions continue.  Today, junior physicians are launching a six-day strike against the National Health Service for better pay and working conditions, in what may turn out to be one of the most disruptive labor actions to date.  Continued labor unrest is feeding into the sense of economic malaise gripping the U.K. as it deals with challenges like high interest rates, slow growth, continuing trade lethargy due to Brexit, and the uncertainty of upcoming elections.

Israel-Hamas Conflict:  As Iran-backed Houthi rebels in Yemen continue to aggressively attack commercial shipping in the Red Sea in sympathy with the Hamas government in Gaza, the U.S. Navy sank three Houthi vessels over the weekend that were attacking a private container ship.  With the threat of the Israeli-Hamas conflict now escalating again, global oil prices so far this morning have risen about 2%, with Brent trading at $78.58 per barrel.

U.S. Labor Market:  Even though the federal minimum wage remains at the same $7.25/hour rate that it’s been at since 2009, 22 states lifted their minimum rate starting yesterday.  The highest minimum wage in 2024 will be in the state of Washington, where it will stand at $16.28, up 3.4% from the previous rate of $15.74.  However, a new analysis by the Wall Street Journal suggests the minimum wage is becoming increasingly irrelevant, as even the lowest-paid workers in most states typically make almost 50% more than their state’s wage floor.

• In an interesting new law going into effect in Alabama, any employee hours in excess of 40 per week will be exempt from state income taxes.
• Essentially, the law will exempt overtime from state taxation. The law could therefore help incentivize overtime work, effectively increasing the labor supply.

U.S. Business and the Elections:  As mentioned above in the paragraph on South Korea, business leaders around the world are looking warily at the large number of countries holding key elections in 2024.  In the U.S., a new survey indicates that senior executives and risk managers now see escalating political polarization as their second-most important emerging risk, right after generative artificial intelligence.  The report shows many leaders are starting to prepare for the possibility that political protests could disrupt their companies’ operations.

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