What China wants

After a bad couple of centuries, China is itching to regain its place in the world. How should America respond?

Aug 23rd 2014

AN ALARMING assumption is taking hold in some quarters of both Beijing and Washington, DC. Within a few years, China’s economy will overtake America’s in size (on a purchasing-power basis, it is already on the cusp of doing so). 

Its armed forces, though still dwarfed by those of the United States, are growing fast in strength; in any war in East Asia, they would have the home advantage. Thus, some people have concluded, rivalry between China and America has become inevitable and will be followed by confrontation—even conflict.

Diplomacy’s task in the coming decades will be to ensure that such a catastrophe never takes place. The question is how?

Primacy inter pares

Some Western hawks see a China threat wherever they look: China’s state-owned businesses stealing a march in Africa; its government covering for autocrats in UN votes; its insatiable appetite for resources plundering the environment. Fortunately, there is scant evidence to support the idea of a global Chinese effort to upend the international order

China’s desires have an historical, even emotional, dimension. But in much of the world China seeks to work within existing norms, not to overturn them.

In Africa its business dealings are transactional and more often led by entrepreneurs than by the state. Elsewhere, a once-reactive diplomacy is growing more sophisticated—and helpful. China is the biggest contributor to peacekeeping missions among the UN Security Council’s permanent five, and it takes part in anti-piracy patrols off the Horn of Africa. In some areas China is working hard to lessen its environmental footprint, for instance through vast afforestation schemes and clean-coal technologies.

The big exception is in East and North-East Asiaone of the greatest concentrations of people, dynamism and wealth on Earth. There, both its rhetoric and its actions suggest that China is unhappy with Pax Americana. For centuries China lay at the centre of things, the sun around which other Asian kingdoms turned. First Western ravages in the middle of the 19th century and then China’s defeat by Japan at the end of it put paid to Chinese centrality

Today an American-led order in the western Pacific perpetuates the humiliation, in the eyes of Chinese leaders. Soon, they believe, their country will be rich and powerful enough to seize back primacy in East Asia.

China’s sense of historical grievance explains a spate of recent belligerence. China has deployed ships and planes to contest Japan’s control of islands in the East China Sea, grabbed reefs claimed by the Philippines in the South China Sea and moved an oil rig into Vietnam’s claimed exclusive economic zone. All this has created alarm in the region

Some strategists say America can keep the peace only if it is firm in the face of Chinese expansionism. Others urge America to share power in East Asia before rivalries lead to a disaster.

America cannot walk away without grave consequences for the region and its own standing. Since the end of the second world war, American security has been the basis of Asian prosperity and an increasingly liberal order. It enabled Japan to rise from the ashes without alarming its neighbours. Indeed, China’s race to modernity could not have happened without it. Even Vietnam, America’s old foe, is clearer than ever that it wants America’s stabilising, reassuring presence.

Yet, if the liberal order is to survive, it must evolve. Denying the reality of China’s growing power would only encourage China to reject the world as it is. By contrast, if China can prosper within the system, it will reinforce it. That is why the United States needs to acknowledge one increasingly awkward aspect of its leadership: American advantage is hard-wired into the system in ways that a rising power might justifiably resent.

For a great power to find a new equilibrium with an emerging one is hard—because every adaptation looks like a retreat. Three principles should guide America.

First, it should only make promises that it is prepared to keep. On the one hand, America would be foolish to draw red lines around specks of reef in the South China Sea. On the other, if America is to count for anything, its allies need to know that they can depend on it. Although Taiwan is central to China’s sense of its own honour, America should leave Beijing in no doubt that it would come to the island’s defence.

Second, even in security, America must make room. China’s participation in America’s recent RIMPAC naval exercises off Hawaii was a start. China could be invited to join Asian exercises, including for disaster relief. And America should avoid a cold-war battle for the loyalty of regional powers.

Lastly, America will find it easier to include China in new projects than to give ground on old ones—and should make more effort to do so. It is nonsensical that America should be leading the formation of the region’s biggest free-trade area, the Trans-Pacific Partnership, without the inclusion of the region’s largest economy

And there is no reason to exclude China from co-operation in space. Even during the cold war American and Soviet astronauts worked together.

Let the dragon in

Why should China be satisfied with a bit more engagement when primacy is what it seeks? There is no guarantee that it will be. Just now the rhetoric coming out of Beijing is full of cold-war, Manichean imagery

Yet sensible Chinese understand that their country faces constraintsChina needs Western markets, its neighbours are unwilling to accept its regional writ and for many more years the United States will be strong enough militarily and diplomatically to block it. And in the longer run, the hope is that the Chinese system will of itself adapt from one-party rule to some more liberal polity that, by its nature, is more comfortable with the world as it now is.

Drawing China into a strengthened regional framework would not be to cede primacy to it. Nor would it be to abandon a liberal order that has served Asia—and Americaso well. It may, in the end, not work. But given the huge dangers of rivalry, it is essential now to try.

Italy’s Downward Spiral

Hans-Werner Sinn

AUG 21, 2014
Downward spiral

MUNICHItaly is now in a triple-dip recession. But it didn’t get there by itself. Yes, the economy’s long slide reflects Italian leaders’ failure to confront the country’s loss of competitiveness; but it is a failure that is widely shared in Europe.

When the financial crisis erupted in the fourth quarter of 2007, Italy’s GDP plummeted by 7%, then picked up by 3%, dropped again by 5%, rebounded by a measly 0.1%, and lately, during the first half of this year, shrank again, this time by 0.3%. Altogether, Italian GDP has contracted by 9% during the past seven years.

Industrial production, moreover, has plunged by a staggering 24%. Only thanks to stubbornly persistent inflation has Italy’s nominal GDP managed to remain constant. Overall unemployment has climbed to 12%, while the rate for youth not attending school has soared to 44%.

Italy has tried to counteract the economic contraction by increasing its public debt. With the European Central Bank and intergovernmental rescue operations keeping interest rates low, Italy’s public debt has been able to rise by one-third from the end of 2007 to the spring of 2014.

Italy’s new prime minister, Matteo Renzi, wants to stimulate growth. But what he really intends to do is accumulate even more debt. True, debt spurs demand; but this type of demand is artificial and short-lived

Sustainable growth can be achieved only if Italy’s economy regains its competitiveness, and within the eurozone there is only one way to accomplish this: by reducing the prices of its goods relative to those of its eurozone competitors. What Italy managed in the past by devaluing the lira must now be emulated through so-called real depreciation.

The era of low interest rates that followed the decision in 1995 to introduce the euro inflated a massive credit bubble in southern eurozone countries, which was sustained until the end of 2013. During this time, Italy became 25% more expensive (on the basis of its GDP deflator) than its eurozone trading partners.

Seventeen percentage points of this rise can be accounted for by higher inflation, and eight percentage points through a revaluation of the lira conducted prior to the introduction of the euro. Relative to Germany, Italy became a whopping 42% more expensive. That price differential – and nothing else – is Italy’s problem. There is no other solution for the country than to correct this imbalance by means of real depreciation.

But accomplishing that is easier said than done. Raising prices is almost never a real problem. Lowering them or making them rise more slowly than prices in competing countries is painful and unnerving.

Even if a country’s trade unions enable such a policy through wage moderation, debtors would run into difficulties, because they borrowed on the assumption that high inflation would continue. Many companies and households would go bankrupt. Given that disinflation or deflation leads through a valley of tears before competitiveness improves, there is reason to doubt whether election-minded politicians, with their short-term orientation, are capable of staying the course.

Former Prime Minister Silvio Berlusconi wanted to solve the problem by withdrawing Italy from the eurozone and devaluing the new currency. He conducted exploratory conversations with other eurozone governments in the autumn of 2011, and had sought an agreement with Greek Prime Minister George Papandreou, who proposed a referendum that effectively would have meant choosing between strict austerity and exiting the eurozone.

But both leaders had to resign, only three days apart, in November 2011. Higher political considerations, as well as the interests of the banking system, militated against an exit.

The economist Mario Monti, who followed Berlusconi as Prime Minister, attempted a real depreciation, introducing greater flexibility into the labor market in order to force the unions into wage concessions. But Monti’s efforts came to naught; among other problems, the ECB, with its generous financial help, removed the pressure from both unions and companies.

Enrico Letta, who followed Monti as the head of Italy’s government, lacked a clear concept for reform, and in turn was followed by the charismatic Renzi. But, though Renzi expends much verbal energy on the economy, so far he has given no indication that he understands the nature of Italy’s problem.

Renzi is not alone in this. On the contrary, virtually the entire European political elite, from Brussels to Paris to Berlin, still believes that Europe is suffering from a mere financial and confidence crisis. The underlying loss of competitiveness is not discussed, because that is a problem that discussion alone cannot resolve.

Hans-Werner Sinn, Professor of Economics and Public Finance at the University of Munich, is President of the Ifo Institute for Economic Research and serves on the German economy ministry’s Advisory Council. He is the author of Can Germany be Saved?

The foreign-exchange market

Fixed rates

The money-spinners await their fate

Aug 23rd 2014


A CITY worker looking for a quiet place to nap nowadays could do worse than head for his bank’s foreign-exchange (FX) trading floor. Once noisy with activity as gesticulating dealers moved around billions of dollars, euros and yen, it is more likely now to be an oasis of calm. Bankers are plain bored. “The FX market has been exceptionally quiet,” moaned currency analysts at Citigroup recently. “In fact, it’s been so quiet that there was almost no point in writing this report.”

The summertime torpor disguises existential angst. Regulators across the world are probing the role of banks in currency trading, apparently convinced it is the latest financial market to have been fiddled. Around 30 bank staff, including many trading-floor bosses, have been suspended or fired. Hefty fines seem inevitable

Worse, reforms may tear the heart out of the FX market as it is presently constituted. Banks, which make money by offering to buy or sell currencies from or to their clients, could go from being central actors to bit players. The future of a business which used to reap annual revenues of $20 billion is at stake.

Not that such bounty is attainable these days anyway, given the placid state of the market. Currency-trading volumes have slumped. That is largely because the world’s big central banks have replaced yo-yo-ing interest rateswhich in turn determine the levels of their currency—with a uniform near-zero level since the financial crisis (see chart 1). The upshot is that floating exchange rates have seldom been so stable: volatility has plunged to its lowest level in two decades (see chart 2).

As a result, once-keen users of banks’ FX services have learned to do without them. Multinationals that might once have tried to hedge their foreign-currency exposures now opt to live with the risk, assuming that exchange-rate movements will remain within a limited range. Financial firms, which make up over 90% of trading volumes, have also pared back

Hedge funds that wager on currencies have shrunk or left the market in recent years. And banks, whose traders sometimes also bet on market moves, are no longer keen to do so. Appetite for risk is non-existent: “This is not a time to try something clever in FX,” says a trading boss in London.

Volatility will eventually come backBritish holidaygoers may have noticed the value of the pound rising and falling this week—as the world’s biggest economies recover and interest rates move around more. But the tidy profits once made by banks may not. Much of the market for major currency pairs, such as dollar-euro or pound-yen, is now conducted electronically. Anyone wanting to exchange less than $100m is unlikely even to speak to a human being these days. The spreads on trades (the difference between the price at which banks buy and sell currencies) have become vanishingly thin. Even the profits to be made on making markets in more obscure emerging-market currencies, where spreads were once wider, have evaporated. High-frequency traders are moving in, too, hobbling banks.

But the big worry is what regulators are likely to say and do. Although they have yet to detail their case against banks, their investigations are focusing on whether FX traders bilked clients by fiddling widely-used daily benchmarks. There is nothing sophisticated about the alleged fraud: clients looking to buy or sell FX from bank trading desks agreed to price currency deals at the price prevailing at 4pm London time, regardless of when the order was placed. Bankers soon found they could bend that price in their favour, and they did. Worse, they appear to have colluded in order to execute the scam. The transcripts of online chat rooms they used, dubbed the Cartel” and “the Bandits’ Club”, are likely to amuse neither bank compliance officers nor regulators.

Much of the errant behaviour happened after banks promised to clean up, having been caught tampering with LIBOR, an interest rate used to peg contracts worth trillions of dollars. Their most plausible defence is that some watchdogs knew about the way the market actually worked, including the collusion. The Bank of England, which oversees the world’s biggest FX centre in London, has suspended an employee.

The fines for the currency fiddle could reach $26 billion globally, according to KBW, a bank. Cheated clients might sue for compensation, too. Many complain the market is no longer fit for purpose. The more powerful among them, including giant institutional investors and asset managers, might egg on regulators who want to change the way currencies are traded. The Financial Stability Board, a committee of global supervisors, has floated the idea of a “global utility” that would match supply and demand of currencies.

Whatever that means—and few know for sure—it sounds like a way of sidelining bankers. More details are expected in time for a meeting of G20 leaders in November.

Banks think a “fine-tuning” of the FX market and a stern reminder to traders not to be crooked would suffice. Some are paring back their currency activities, worried about profits being squashed between fixed costs and shrinking revenuesdown to $13 billion this year, thinks Morgan Stanley, a bank. Those that remain may find it a harder environment to thrive in.