The post below comes from a new site that was introduced to me a couple weeks ago, One Road Research. I have chatted with one of the founders, Peter Pham and will be having him on the show next week.

One Road Research is a research firm with its team actually in China relaying their insights on the culture and markets through its website – www.oneroadresearch.com. The coverage they provide ranges from economic commentary to geopolitical to financial market analysis. The site is free for now so I highly recommend clicking the link below and browsing the daily articles.

Click here to visit the One Road Research website.

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Welcome to the latest edition of The Great Investment Frontier (TGIF) report. So far in this series we’ve seen how tensions in the South China Sea are bubbling closer to the surface as old peace treaties become ever more fragile. The rising power of China and the aggression of North Korea have brought the region to the brink and created an unprecedented arms race. Now, the world holds its breath…

But if a full-blown conflict is the last resort… and if China dumping the dollar does not lead to a trade war… is it all quiet on the eastern front?

Not quite.

Storm clouds are still gathering over the South China Sea. And rather than stand toe-to-toe with the U.S., China prefers to follow a model of “acupuncture” warfare.

In the past, global superpowers from Rome to the British Empire built huge armies to project their power around the globe. But the world is changing. And China has no interest in sending thousands of troops overseas as the U.S. has done. It is much more interested in growing its influence in the region (in particular over Taiwan and the South China Sea) and in constraining U.S. power.

So, despite having the largest armed forces in the world, China is not about to use a sledgehammer to crack a nut. Instead, it is developing technologies and tactics that can disrupt and disarm its enemies.

China has high-tech air platforms, precision weapons and ballistic and cruise missiles. But analog weapons, on their own, don’t cut it in the digital age. So China is also developing electronic warfare capabilities designed to knock out their enemies’ communications and computer networks (more on this next week).

And China is funding it with U.S. debt.

The U.S. is Spending More in Asia

Under Donald Trump, the United States is spending more than ever on its armed forces. The president has proposed increasing the U.S. defense budget almost US$54 billion in 2018 alone… that’s a 10 percent increase on 2017 and would bring the total to around US$600 billion.

And more of those dollars are being spent in the South China Sea.

Senator John McCain, Head of the Senate Armed Services Committee, proposed US$7.5 billion of new funding for U.S. forces (and their allies) in the region, to counter the rising threat of China and North Korea.

But freedom in the South China Sea isn’t free. It costs… a lot. And while countries like Japan and South Korea share the burden of U.S. bases and troops stationed in their countries, it still leaves the U.S. shouldering a huge cost.

Now it’s Deeper in Debt

So where is this new spending coming from? The answer is simple: debt.

The United States is over US$22 trillion in debt (as we’ve written before). China is one of the largest holders of that debt, along with Japan, in the form of bonds. Both countries own just over US$1 trillion each in U.S. government debt.

Bonds are debt issued to fund government spending. Government bonds, and U.S. Treasuries in particular, are seen as a safe investment in troubled times because the U.S. government is a low-risk borrower… it is never going to default on its debt.

Now, as we said last week, holding large amounts of debt does give China some leverage in the event of a trade war between the two countries. And it keeps the renminbi cheaper than the dollar, which makes Chinese goods and services more competitive in the global marketplace.

But there’s another, hidden reason behind China’s rampant purchasing of U.S. debt… the debt interest.

In 2016, the U.S. government spent $US264 billion on debt interest… and a considerable amount of that went to bond holders in China and Japan.

However, thanks to both countries absorbing huge amounts of U.S. debt, the U.S. government is able to borrow on the cheap. The yield of U.S. bonds has decreased since 2008, and that means the U.S. can continue to borrow more to fund spending on its armed forces.

U.S. Debt is Fuel to the Fire

If I borrow hundreds of thousands of dollars from the bank for a new house, at the end of the loan term the bank gets back more than it lent in interest. It’s the same with government debt.

And China is using the interest it receives on U.S. government debt…which, don’t forget, is being borrowed to fund the increasing costs of containing China in the first place, to ratchet up their presence in the South China Sea still further. In other words, U.S. debt interest is funding the rise of U.S. enemies.

Interests paid on U.S. government bonds has been rising since 2012, as a result of increasing federal debts, as this graph shows.

So the United States is caught in a trap.

It can’t pull out of the South China Sea: there’s too much trade at stake (as we’ve written before) and old treaties mean it is honor-bound to protect countries like Taiwan, Japan and South Korea from rising Chinese aggression.

But the longer it remains in the region, the more it strengthens China through the interest paid on its enormous (and growing) debt.