July 27, 2014 5:32 pm

China’s perilous tangle of military and economic fortunes

Beijing gives an air of invincibility in one debate and implosion in another

A Chinese worker cuts a steel pipe at the Industrial Museum of China, in Shenyang city, Liaoning province, China, 01 November 2013. The Industrial Museum of China covers an area of 80,000 square-meters. It was built and transformed in an old industrial area displaying the history of China's industrial development. China's purchasing managers' index (PMI) for the manufacturing sector rose to 51.4 percent in October 2013 hitting an 18-month new peak since May 2012, the National Bureau of Statistics (NBS) said on 01 November 2013©EPA

Two debates are under way over China. The first, about Beijing’s aggression in the South and East China seas, is between naval strategists and diplomats who know little about economics. The second, about the fragility of the Chinese economy, is between economists who know little about naval strategy and diplomacy.

These debates should intersect but they rarely do. In one, China appears invincible; in the other, it seems to be on the brink of implosion.

The background to the first debate is China’s seemingly inexorable military expansion, especially in sea, air, ballistic missiles and cyber warfare. As regards sea forces, this includes not only warships but also coastguard vessels, merchant shipping and strategic deployment of oil rigs. Beijing’s ability to co-ordinate all these attributes of power has resulted in a subtly shifting military balance in maritime Asia.

No longer does the US Navy rule the western Pacific as though it were an American lake, as it did for decades following the second world war. Instead, there is an increasingly multipolar arrangement, with China able to intimidate Vietnam, the Philippines and Malaysia in the South China Sea, and to challenge Japan in the East China Sea.

China’s military rise has caused Japan to slip out of its quasi-pacifism and rediscover nationalism as a default option. Thus stability in east Asia can no longer be taken for granted.

The naval debate pits those who say China must be stopped against those who believe it must be accommodated. If Beijing’s naval forces continue to expand, the hardline view suggests, US allies in the region will be forced to make quiet, separate deals with Chinaweakening ties with the US, with vast geopolitical implications. A more sanguine view is that China’s economic growth has been so astounding in the past three decades that its military rise is natural, and the US must make some room for Chinese power in the region.

Both views assume Chinese military power will keep growing. But what if under pressure from, say, domestic political and economic stressesit does not?

The background to the second debate is China’s overheated economy. For 30 years, double-digit growth has been the norm, but this could not go on for ever. The official growth rate of 7.5 per cent probably errs on the high side – and, even if not, growth on the more populous and developed Pacific coast is surely below that, since the poorer interior has tended to grow at a faster rate.

Then there are the credit and housing bubbles; house prices fell by more than 10 per cent in the first five months of 2014. The economy has, especially since 2008, been on a nonstop stimulus. To think that such a situation can continue, with China eventually surpassing the US as the world’s biggest economy, constitutes linear thinking in the extreme.

This second debate pits those who believe China’s economy will muddle through against those who think it could collapse. The muddle-through scenario assumes that China’s very capable and collegial autocrats are not in denial about any of these problems, and can act nimbly – in ways democracies cannot – to make a successful course correction

The culture of discipline, and $4tn in foreign exchange reserves, will help. Others believe China is subject to the same economic laws as everyone else, and that the leadership, as capable as it may be, is still in over its head. It is China’s very authoritarianism that undermines economic reform, they say.

What is lost in this debate is the exact degree to which China will be able to muddle through, and the effect on ethnic, social and political tensions within China. Being in the economic doldrums for a few years is different from a sudden implosion. The first favours a containment of ethnic and social tensions, coupled with more aggressive nationalism on the high seas to buttress Beijing’s legitimacy in tough times. But an imploding economy could ignite ethnic warfare against the Han majority by the Tibetans and Muslim Turkic Uighurs. Such social and economic stresses could reveal the limits of China’s ability to keep increasing military spending

Here is where debates on the South and East China seas and the economy intersect. A sluggish Chinese economy leads to more aggression at sea; an absolutely terrible economy could lead to the opposite. It is the degree of weakness that matters.

While economic collapse could curb the naval threat in the western Pacific, it could also unhinge the Asian and world economies, leading to severe pain in any number of nations, including Japan, South Korea, the US, and EU states. The world would simply be less stable.

Meanwhile, today’s maritime tensions are benign compared to what may come with a weakening Chinese economy. The naval stand-offs in the South and East China seas are the result of strong and strengthening states projecting power through expensive military platforms. And that is itself a sign of continued prosperity in East Asia.

The writer is author of ‘Asia’s Cauldron: The South China Sea and the End of a Stable Pacific’

Copyright The Financial Times Limited 2014

The Non-Eclipse of America

Norton A. Schwartz, John K. Hurley

JUL 28, 2014

WASHINGTON, DCThe recent creation of a new international development bank by Brazil, Russia, India, China, and South Africa – the so-called BRICS – is just the latest challenge to America’s global leadership. But, from an international business perspective, the United States remains in a strong position.

Perhaps the best indication of America’s enduring stature is the dollar’s dominance in international financial transactions. Last year’s Foreign Direct Investment Confidence Index, based on a survey of more than 300 executives from 28 countries, showed that, for the first time since the Iraq War began in 2003, foreign investors view the US as the world’s most attractive destination for future investment.

The ability to project power internationally begins at home. And, despite its historically slow economic recovery, there is plenty of reason for optimism in the US.

According to the US Federal Reserve Board, the index of industrial production, which had declined by 17% during the recession, returned to its pre-crisis peak in the fourth quarter of last year. The US has also made some progress in “on-shoringmanufacturing activities, and the energy sector is booming, owing to a sharp increase in natural-gas production.

Moreover, new discoveries in life sciences, particularly biotechnology, are nearing commercial breakout. Reforms in primary education, especially at the state and local levels, have bolstered test scores. And American institutions of higher education, though often prohibitively expensive, consistently rank among the best in the world.

Despite the effects of the Congress-imposed sequester on discretionary federal expenditure, the so-called defense industrial base (DIB) has been making adjustments for more than two years. Key firms have put their fiscal houses in order, and now boast healthy debt-to-capital ratios, satisfactory margins, steady profit, and substantial cash in hand. They are also selling off non-profitable lines, purchasing small companies with promising markets, and seeking new markets overseas.

Typically, smaller DIB firms are more flexible, and can move more easily from defense to commercial work. As manufacturing gradually increases, that is precisely what they are doing.

According to the International Monetary Fund, the recent recession is the first in the US since the early 1980s to be followed by a significant recovery in the GDP share of value-added manufacturing. The report cites factors like a weaker dollar relative to emerging-market currencies, a narrowing gap between labor costs in the US and emerging economies, and a significant reduction in domestic energy prices.

Of course, there are many more forces shaping America’s global standing. But, from a business perspective, the country’s prospects are promising as long as its leaders work to sustain them. This demands a focus on the three factors of production: people, matériel, and money.

Manufacturing growth notwithstanding, the US has experienced a jobless recovery. In order to support the population’s well-being and productivity, industry and government must ensure that there is enough economic opportunity to go around. To this end, US leaders should focus on improving primary and secondary education, and use incentives and well-designed tax policies to cultivate innovation and entrepreneurship.

Matériel involves two components: physical and intellectual. Given that a large share of US production inputs are imported at various stages of the value-addition process, rather than in their raw state, the US must continue to protect the global commons to ensure communication and cooperation among trading countries. At the same time, the US must, in some cases, protect its access to critical materials, stockpiling and safeguarding unique and long-lead fabrication capabilities.

More important, the US must reinforce intellectual-property protection. This should entail the establishment of effective legal protocols to enforce patents and the creation of a strategy for protecting intellectual property in cyberspace.

Finally, the US must lead the way toward a stronger, more resilient global economy by providing sound oversight and regulation aimed at sustaining well-functioning capital markets. After all, the world’s financial woes cannot reasonably be cured without first resolving those of its largest economy.

At the same time, with US government debt hovering at or above 100% of annual GDP, the American public must compel lawmakers to pursue fiscal consolidation. Current expenditure on health and pension benefits, for example, is unsustainable. Once fiscal balance is restored, the US can chart a path to growth, make critical investments in infrastructure, and take steps to reduce its adverse impact on the environment.

The US remains the world’s biggest market, largest economy, and leading source of creativity and technological development. It is an essential component in the network of countries, companies, and individuals that are driving economic growth and development. And, tellingly, it remains the immigrant’s destination of choice.

American politics and foreign policy may be in need of upgrading. But, from a business perspective, the US is hardly in retreat.

Norton A. Schwartz is President and CEO of Business Executives for National Security and former Chief of Staff of the United States Air Force.

John K. Hurley, Founder and Managing Partner of Cavalry Asset Management, is a member of the Board of Directors of Business Executives for National Security.

Markets Insight

July 28, 2014 6:16 am

‘Three arrows’ to put eurozone back on target

Policy initiatives need to focus on core as well as periphery

It is two years since Mario Draghi, the president of the European Central Bank, made his seminal pledge to save the euro. The intervention, followed by pronounced if belated accommodative monetary policy, has put the question of the euro’s survival out of play for now, but the lacklustre economic performance of the eurozone betrays the challenges that remain.

While the US and UK recoveries reachescape velocity”, the eurozone is dogged by the spectre of deflation eerily reminiscent of 1990s Japan. Whatever the ultimate fate of “Abenomics” in Japan, policy makers in Europe would do well to develop their own three arrows to put the eurozone back on target for sustainable recovery.

As with Abenomics, Europe’s first arrow needs to be the continuation of accommodative monetary policy. The ECB has already gone too far for some by effectively transferring wealth from savers to debtors.

This action is necessary, however, to stave off Japanese-style deflation and could even intensify in the absence of cohesive political leadership among euro area nations. Political inertia could oblige the ECB to focus on minimum inflation targets just as it has emphasised upper thresholds in the past.

Reform agenda

The eurozone’s second arrow needs to be a more concerted round of pension, labour market and tax reforms.

While the crisis precipitated a round of pension reforms in Greece, Spain and Italy, the sheer scale of the issues facing many European countries has not been adequately addressed. Pension expenditure in the majority of eurozone countries already stands at more than 10 per cent of gross domestic product compared with about 4, 5 and 8 per cent in Australia, the US and the UK.

These pressures will increase as people live longer and the ratio of retirees to workers rises sharply. In western Europe, the old age dependency ratio (OAD) is set to rise from 28 per cent in 2010 to near 50 per cent by 2050. Yet France, for instance, retains various early retirement options that mean the effective retirement age is only 60.

Meanwhile Germany, where the OAD is projected to almost double to 60 per cent by 2050, is sending the wrong signal by lowering the statutory age of retirement for long-term insured from 65 to 63. Increasing the effective retirement age is a critical policy challenge.

More labour reforms are also essential to boost dismally low growth and counter stubbornly high unemployment, which remains above 11 per cent. In particular, policy makers need to address the impact of excessive protection for workers on entrepreneurs and the unemployed. While large companies in countries like France, Italy and Spain continue to do well, start-ups and companies more dependent on local employees are understandably cautious about taking on new staff.

Taxation measures are also required to reduce inequality and create higher consumer demand. Most of the discussion has focused on higher taxes for the rich, but more could be achieved with greater emphasis on lowering taxation, especially in countries such as Germany, which has the greatest fiscal room for manoeuvre.

It is little wonder that Germany’s private household consumption is so anaemic, when one considers that its low-to-middle income workers are among the hardest hit in terms of total taxation. According to the OECD, the tax wedge for German workers earning two-thirds of the median national wage is 45 per cent, second only to Belgium. This beggars belief; removing what are in effect regressive taxes would ease the burden on lower to middle incomes and boost consumer demand.

Infrastructure investment

The eurozone’s third arrow should be a programme of investment, particularly in infrastructure. This has been talked about in a number of countries, most recently in France, but the scale and realisation of such investment still falls short. As with taxation, Germany has the scope and the justification to do the most.

Reunification led to massive capital investment in the east of the country at the expense of investment in the west. Annual government capital investment in Germany has declined steadily from about 4 per cent of GDP in the 1970s to an average of just 1.6 per cent since 2000, even less than in the US and UK

Indeed, a study by the German Institute of Economic Research pointed to a chronic lack of investment in infrastructure, education and factories, which risks undermining the country’s long-term competitiveness and growth.

So, while the urgency of the crisis has abated, the eurozone has much more to do to propel itself out of the doldrums. Contrary to the received wisdom that the policy focus should be on troubled periphery countries, the eurozone would benefit more from three arrows that are targeted as well on the core.

Andreas Utermann is co-head and global chief investment officer at Allianz Global Investors

Copyright The Financial Times Limited 2014

Don't Be Fooled by the Fed's Placid Facade

By Mohamed A. El-Erian

Tuesday, 29 Jul 2014 08:21 AM

One of the unwritten rules of modern central banking is that, unless compelled by events on the ground, officials should refrain from making big policy changes during the summer. With many traders on holiday, any sudden moves risk destabilizing markets.

Look for the Federal Reserve to abide by this rule when it meets Tuesday and Wednesday — and the European Central Bank to do the same in early August. Janet Yellen and her colleagues on the policy-making Federal Open Market Committee will maintain their well-telegraphed, gradualist approach, reducing monthly bond purchases by another $10 billion, signaling no urgency in raising interest rates, and reminding us of the importance of looking beyond the unemployment rate to understand what's happening in the job market.

Still, behind this comforting steady as she goesfacade, Fed officials will be dealing with five complex and inter-related issues, the resolution of which will be months in the making:

To what extent is the central bank's policy approach increasing the risk of financial instability down the road? This question is preoccupying a growing number of regional Fed presidents.

How much damage has the recession inflicted on the economy’s growth potential and its productivity, thus limiting the effectiveness of Fed policies?

How quickly will this year’s faster-than-expected drop in the unemployment rate translate into wage gains, and will they undermine the Fed’s 2 percent inflation target?

How should policy makers respond to a seemingly endless series of geopolitical shocks, the cumulative impact of which is getting harder to dismiss?

By carrying the bulk of the economic-stimulus burden, does the Fed risk undermining the political and operational autonomy that is so critical to its effectiveness?

Publicly, the Fed will be in no rush to opine definitively on any of these issues, for understandable reasons. The analytical foundation is still being developed, the market and economic reactions are too uncertain, and the timing is not appropriate.

Yet investors should not be lulled into complacency by the Fed’s outward calm. We are getting closer to the point where the Fed will have to make some difficult decisions, and will face greater challenges in maintaining the buoyant, placid markets to which we have become accustomed.

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