1. China’s
    silk road

    Third Quarter 2017
    Camel caravan in the desert on the silk road China.
  2. China is a sleeping lion. Let her sleep, for when she wakes she will shake the world.
    Quote widely attributed to Napoleon Bonaparte
    © Universal Images Group Editorial/Getty Images.
  3. At a conference I recently attended in North America, distinguished speaker after distinguished speaker lamented the beginning of the end for globalisation. This collective valediction was presented as a fait accompli, supported by the apparently incontrovertible evidence of Brexit, Trump, the collapse of the Trans-Pacific Partnership and rising protectionism. The audience nodded sagely, not presuming to question such prevailing wisdom. And then, from the back of the room, a lonely voice interjected: “What about China?”

    What indeed. Whilst markets and western media have been fixated by short-term political machinations, China has been forging ahead with a 30-40 year development policy that will utterly revolutionise global trade. In establishing land corridors across Central Asia and the Middle East to Europe, and creating a web of sea lanes through the South China Sea and the Indian Ocean, Chinese President Xi Jinping is looking to create a ‘community of common destiny’ that spurs growth, weaving a web of interdependence across Asia and beyond.

    In short, and in direct contrast to the imbroglio dominating much of the politics in the developed world, China has a plan. That plan is called the ‘Silk Road’ and it might just be one of the most exciting opportunities for long-term growth investors in the last one hundred years.

    The Silk Road of antiquity was a network of trade routes, stretching from the Korean peninsula and Japan, through Eurasia to the Mediterranean Sea, along which traders transported horses, spices and, inevitably, silk. Reaching its height during the Mongol Empire and the travels of the Venetian explorer Marco Polo, the Road involved much more than just trade. It facilitated, for the first time, long distance political and economic relations between separate civilisations and encouraged a sharing of ideas in the religious, philosophical and architectural realms. As a metaphor for cultural exchange, the Silk Road was the primary driver behind early globalisation.

    The Road’s modern reincarnation first came to widespread notice in 2014 when President Xi, addressing the Asia-Pacific Economic Cooperation Forum, announced the establishment of a US$40 billion Silk Road Fund. “The development prospect of our region hinges on the decisions and actions we take today. We are duty-bound to create and fulfil an Asia-Pacific dream for our people” Xi told delegates attending the forum. No Chinese leader in history has had the resolve to talk about an Asia-Pacific dream under Chinese leadership. Coming two weeks after the launch ceremony for the Asian Infrastructure Investment Bank (AIIB), the Chinese sponsored multilateral development lender, this pledge signalled the magnitude and importance that the country’s leadership attaches to the Silk Road.

    So what does this 21st century Marshall Plan actually consist of? There are two primary components: land corridors known collectively as the Silk Road Economic Belt and a Maritime Silk Road.

    The land corridors, forged by the construction of new roads, bridges, railways and industrial zones, will cross some of the wildest terrain on the planet. Not only will they dismantle investment barriers and establish new trade routes but, crucially, they will deepen regional financial integration. The Maritime Silk Road is a complementary initiative which seeks to establish a network of interconnected ports clustered in three blue economic passages, sea lanes linking Asia with Africa, Oceania, Europe and beyond, in effect creating shipping outlets for the aforementioned land corridors.

     

    President Xi Jinping makes a toast during a welcome banquet for the Belt and Road Forum.
    © WU HONG/AFP/Getty Images.

  4. The New Silk Road

     

  5. Unequivocally, the scale of investment is vast. In aggregate, $900 billion in projects is either planned or underway, spanning at least 65 countries. This is seven times larger than the Marshall Plan, where cumulative aid may have totalled $130 billion at 2016 dollar value. A sum of $62 billion is being spent on the China- Pakistan Economic Corridor (CPEC) alone. This is a sprawling web of motorways, railways, factories and power plants that ultimately will allow oil and gas to be pumped from the Arabian coast to the Chinese province of Xinjiang. 

    In the last 24 months, Chinese companies have announced plans to buy or invest in overseas ports in projects valued at almost $30 billion. The maritime route from China to Europe via the Arctic Ocean is also being looked at. One project, which envisages a deep-water port near Arkhangelsk on Russia’s White Sea and a railway deep into Siberia, is being led by a Chinese State Owned Enterprise (SOE).

    From an investor’s perspective, a number of truisms quickly dampen the froth created by this leviathan plan. First, many projects are being driven by political diktat and national security considerations rather than commercial reality; hardly fruitful hunting ground for finding great growth companies.

    Second, much of the initial thrust will involve billions of tonnes of steel and cement, thousands of cranes and diggers, and dozens of dams, power stations and electricity grids. This will be a lifeline for indebted domestic SOEs looking to export overcapacity but, again, such projects are hardly fertile territory for growth investors.

    Third, it is hard to believe that any publicly laid out details offer investors much chance of profitable insight; the first order effects of the initial construction phase will quickly be priced into markets. However, for those prepared to look beyond this infrastructure build out, the opportunities are potentially staggering. Think about the impact the 1869 First Transcontinental Railroad had on the formerly ‘wild’ American West.

    Let’s start with some basic numbers. Chinese businesses currently have a domestic pool of 1.4 billion potential customers. That is clearly sizeable in itself but, if companies are able to move along the land corridors, snapping at the heels of the SOEs building out the infrastructure, then target markets start increasing by multiples of that number. Eurasia, as a contiguous continent stretching from the west of Europe to the east coast of China, is being stitched together by the Silk Road. Not only does it contain 75% of the world’s energy resources and 30% of its GDP, but it also has 60% of the world’s population. Little surprise then that Jack Ma, the redoubtable founder and chief executive of the e-commerce platform Alibaba, talks about having 2 billion customers by 2036, half of whom are based outside of China.

    But it goes beyond sheer scale. It is the pace at which the countries and companies may be enabled to grow that makes the Silk Road so exciting.

    Many of the land corridors pass through countries that are still, in the traditional sense of the word, developing. They have low levels of per capita GDP, high levels of illiteracy and manufacturing bases that focus on ‘low end’ value production. Typical development, mirroring that experienced by the West over the last century, would see these countries take generations to move up the manufacturing value chain, whilst separately building out a physical footprint of banks, retail outlets, education facilities and national power grids. 

    But technological advancements are rapidly changing how countries develop. Online education is starting to replace physical schools and universities. Solar power and micro grids are making national grids redundant. Bricks and mortar retail is simply not required in an age of online shopping. And a network of bank branches will never be built when mobile banking is threatening to become ubiquitous. The internet is the clear facilitator of much of this change. With businesses being actively encouraged by the Chinese government to build out a ‘Digital Silk Road’, the potential for technologically savvy companies to leverage this model of development in new markets is enormous.

    A subtler but no less important impact worth considering is the potential for cultural influence to travel up and down the Silk Road. Americana heavily influenced European, Australian, Korean and Japanese popular culture, clothing and diet in the second half of the last century, following significant military and investment programmes. Will the remainder of the first half of this century be defined by the spread of Chinese soft power? For several decades a buy and hold portfolio invested in American soft power exporters such as Walt Disney, Coca-Cola and McDonalds would have produced very satisfactory returns indeed.

    In short, the Silk Road increases greatly the addressable markets along its routes, presses the accelerator on economic growth for many hundreds of millions of people and furthers China’s soft power influence.

     

    Jack Ma speaks at the Asian Leadership Forum
    © Bloomberg/Getty Images.

  6. Let us pause for breath and reaffirm the sorts of companies that we like to invest in. We firmly believe that one of the best ways to generate sustainable long-term outperformance is by deploying our clients’ capital into businesses that embrace change and have the vision to look out a decade and more. We applaud the ability to commit capital to future growth; and encourage a disparagement of the short-term whims of the market. With this in mind, greater connectivity between countries on the Road presents enormous opportunities for stock-pickers looking to invest in growth companies that can embrace innovation and harness new markets.

    Let us explore how this might evolve, by returning to Alibaba as an example. This e-commerce giant is firmly established in China, accounting for roughly 10% of the country’s total retail sales and more than 75% of online sales. Its innovative spirit and willingness to commit huge amounts of capital to future expansion have seen it create an ecosystem that encompasses online banking, money market funds, media, entertainment and logistics. 

    Growth beyond China’s borders will be given a huge boost by the Silk Road. Jack Ma has cited countries along the Road as being among the most important regions for his company, and he plans further expansion in Russia, Central Asia and Southeast Asia. This year, Alibaba has partnered with the Malaysian government to establish the first Digital Free Trade Zone, an initiative that aims to double the nation’s e-commerce growth and increase the GDP contribution made by this source to around $48 billion by 2020. In June 2017, it invested another $1 billion in the online mall, Lazada Group, which has a significant presence in Indonesia and Thailand – countries with huge Silk Road railway projects under construction. The company has recently launched a search for warehouse locations along the China-UK rail link – stock and delivery hubs along the line will allow for faster distribution to and throughout Europe.

    In short, the Silk Road facilitates Alibaba’s move into new markets, allowing it to use its distribution and technological expertise to rapidly build out its ecosystem.

  7. Tourism, too, may be set to benefit from the advance of the land corridors. Yunnan province shares a 4,000 kilometre border with Myanmar, Laos and Vietnam, and is China’s second poorest region. And yet this landlocked, mountainous province now has an airport that handles more passengers than Newark Liberty International and boasts a $4 billion, 1,800 kilometre highway that runs from the provincial capital Kunming to Bangkok. Tourist numbers in the Mekong Basin are increasing rapidly, aided enormously by these two infrastructure projects. Heading east, Guangzhou airport has become the gateway to the land corridors of Thailand, Malaysia and Singapore and is now the world’s 15th busiest airport by passenger numbers.

    When you consider that 122 million Chinese citizens were ‘outbound’ tourists in 2016, and that only 10% of the population have passports, then the opportunities for growth are vast. Into this space steps Ctrip, China’s dominant online travel platform. This business, benefiting from scale and first mover advantage in mobile bookings, is extremely well-placed as the number of tourists using the land corridors (in both directions) continues to rise.

    Number of Chinese Outbound Tourists 

    Source: The World Bank, Baillie Gifford & Co

    But, as with any road, traffic flows in both directions – what President Xi calls a ‘win-win’ situation. Once the infrastructure phase is complete, opportunities for local and western companies, particularly those already embedded in Silk Road countries, will become meaningful. The difficulty of addressing these high potential markets along the route and, indeed, accessing the massive Chinese domestic economy, should become a lot easier. Trade in both physical goods and intangible services should accelerate. Our initial, non-exhaustive thoughts foresee trade and tourist routes changing materially and perhaps accelerating the growth of Rolls Royce jet engines, AP Moller Maersk container ships and Royal Caribbean Cruises. 

    Economic growth along the route will help boost urbanisation (Schindler lifts), local financial services (Indian Banks) and Telecoms (MTN). The beneficiaries fall into three groups: Chinese exporters, non-domestic businesses supplying China, and beneficiaries of local market economic growth along the route. It is an exciting task to identify strong growth companies in each of these three areas. Freight trains will trundle from China to Europe laden with goods. They won’t return empty.

  8. Important Information and Risk Factors

    The views expressed in this article are those of Tim Gooding and Spencer Adair and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

    This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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  9. Tim Gooding

    Client Service Director
    Tim graduated MA (Hons) in Economics and International Relations from the University of St Andrews in 2001. He then spent seven years as a British Army officer, serving initially as a commander in the infantry before transferring to military intelligence. He undertook three six month tours of Iraq and spent 18 months peacekeeping in Northern Ireland. After leaving the Army he spent two years as an Inter-Dealer Broker, dealing in equity derivatives on the primary European indices. He joined Baillie Gifford in 2010 and is a Client Service Director in the Clients Department.
  10. Spencer Adair

    Partner
    Spencer graduated BSc in Medicine from the University of St Andrews in 1997, followed by two years of clinical training in Edinburgh. He joined Baillie Gifford in 2000 and spent time working in the Fixed Income, Japanese, European and UK teams, before becoming an Investment Manager for the Global Alpha portfolio. He became a Partner in 2013.