Executive pay rows show that governance matters

The contract between business and wider society has broken down

John Plender



By unhappy coincidence, the row unleashed by institutional investors over executive pay at Royal Mail last week came just after the unveiling of the UK’s newly revised corporate governance code. It was a salutary reminder that egregious boardroom pay awards remain endemic despite repeated reform efforts on both sides of the Atlantic.

An underlying message that should also be heeded is that abstruse matters of corporate governance and company law can have explosive political and economic consequences, most notably through their impact on inequality. Bad governance is an under-acknowledged factor in the populist tide that threw up US president Donald Trump, Brexit and much else besides.

Admittedly, the connection between flawed governance and inequality is not straightforward. In the UK, income inequality as measured by the widely used Gini coefficient rose considerably in the 1980s when the Thatcher government was dramatically reducing income tax rates. Inequality has since fallen, though it remains well above its 1970s levels.

Looked at in terms of the share of the top 1 per cent, the British plutocratic elite saw a rising income share from the late 1970s into the 2000s, but the trend then reversed a little after the financial crisis. Yet wealth inequality has since been greatly increased by the Bank of England’s post-crisis bond buying, which boosted the price of assets held mainly by the better off.

Moreover, as Charles Dumas, author of a compelling new book on the economics of populism argues, it is people’s perception of their relative position rather than actual financial loss that matters — not least perceptions of inequitable sharing of the pain in the 2007-8 financial crisis, where bankers continued to draw bonuses while in receipt of bailout money from the taxpayer.

Here, too, more recent boardroom pay episodes at such companies as Persimmon and WPP have reinforced the impression that business is run by a greedy, self-serving plutocracy.

In the US, inequality is more extreme. The Gini coefficient has risen pretty consistently since the late 1960s to the present day, with the top 1 per cent hogging the bulk of the income gains of the past three decades or so. The trend has been exacerbated by redistributive taxation from the poor to the rich, first under the George W Bush administration, now under President Trump. Wealth inequality has increased markedly since the late 1970s partly thanks to stock awards to top executives at a time when ordinary people’s incomes have been stagnant. This has been accompanied by a huge widening of the gap between chief executive and average employee pay, which bears no obvious relation to improved corporate performance.

It is also economically damaging. Economists at the IMF point to “the tentative consensus in the literature that inequality can undermine progress in health and education, cause investment-reducing political and economic instability, and undercut the social consensus required to adjust in the face of shocks”.

All this, says Deborah Hargreaves, founder of the High Pay Centre, leaves many feeling the system is rigged by a greedy business elite that has imposed globalisation and trade liberalisation on a populace that discerns no benefits. These feelings endanger the corporate sector’s licence to operate as public faith in business and even capitalism itself is thus eroded.

Flawed corporate governance is responsible for a different form of inequality, that between the corporate and household sectors, which damages the world economy. A lack of management accountability to shareholders in parts of Asia and especially Japan has encouraged an excess of savings over investment by business. With too much income bottled up in the corporate sector there is a shortage of household income and thus spending power in the economy. This has contributed to global imbalances and to increased debt in the US, UK and elsewhere.

A similar lack of accountability afflicts Big Tech in the US, thanks to two-tier voting structures that protect founding entrepreneurs from effective oversight. This encourages a hubristic culture, which helps explain why Google faces a €4.3bn antitrust fine in Europe for abusing its power in the mobile phone market. It is also one reason why Facebook was slow to confront privacy issues around its users’ data and Apple to address smartphone addiction.

Perhaps the most fundamental question in relation to corporate governance and the wider economy concerns the shortcomings of limited liability. As Mr Dumas argues in his book, this Victorian invention ensures that a company and its owners have only limited exposure to damaging consequences of their actions. Yet the implicit contract behind limited liability — companies pay tax in exchange for limited exposure — has broken down because globalisation has turned corporate taxes into an increasingly voluntary levy. Limited liability also contributed to excessive risk-taking in banking before the 2007-8 crisis.

Amid all this potent governance arcana, a substantial reform agenda clearly needs to be addressed.

Twilight of the Euro?

Hans-Werner Sinn



MUNICH – In May 1998, irrevocable conversion rates for the currencies that would be merged into the euro were implemented. In a sense, this makes the single currency just over 20 years old. The first decade of its life had the feeling of a party, particularly in Southern Europe; but the second decade brought the inevitable hangover. Now, as we enter the third decade, the prevailing mood seems to be one of increasing political radicalization.

The original party was a cornucopia of cheap credit, which capital markets happily issued to the countries of Southern Europe under the protection of the euro. For a while, these countries finally had enough money to increase public-sector salaries and pensions, as well as spur private consumption and investment.

But the credit flooding into these countries created inflationary bubbles, which burst when the 2008 financial crisis in the United States spread to Europe. As capital markets refused to extend further credit, Southern Europe’s previously halfway-competitive but now overpriced economies soon ran into serious trouble.

The Southern Europeans’ response was to start printing what they could no longer borrow. Aided by the European Central Bank – which loosened its collateral policy for refinancing credits and increased its tolerance for emergency liquidity assistance and credits under the Agreement on Net Financial Assets – they drew hundreds of billions of euros out of the monetary system through so-called Target overdrafts. And from 2010 onward, they were the recipients of EU fiscal rescue packages.

But, because financial markets viewed these rescue packages as insufficient, the ECB, in 2012, issued a promise to cover unlimited member-state government bonds under its “outright monetary transactions” program, turning them into de facto euro bonds. Finally, in 2015, the ECB launched its quantitative-easing program, whereby member states’ central banks bought €2.4 billion ($2.8 billion) worth of securities, including €2 billion of government bonds. Accordingly, the eurozone’s monetary base grew dramatically, from €1.2 trillion to over €3 trillion.

But, rather than using the extra money to lubricate their domestic economies, Southern European countries used it to carry out payment orders to Germany. They forced the Bundesbank to credit the purchase of goods, services, real estate, corporate shares, and even whole companies – or at least to credit the filling of bank accounts in Germany that would be readily available for asset purchase should the risk of a euro breakup arise. The purchases of goods and services are one of the reasons for Germany’s huge export surpluses.

By mid-2018, the net amount of payment orders to Germany through the Target system had risen to €976 billion. As a perpetual overdraft drawn from the Bundesbank, this money was not unlike the International Monetary Fund’s Special Drawing Rights, except that there is much more of it – a sum greater than all of the funds IMF countries are willing to loan to one another. Spain and Italy alone drew down about €400 and €500 billion, respectively.

Despite – or because of – this windfall, Southern European countries’ manufacturing sectors are still a long way from regaining competitiveness. In Portugal, for example, the output of the manufacturing sector is still 14% below what it was in the third quarter of 2007, after the first breakdown of the European interbank market. And for Italy, Greece, and Spain, that figure is 17%, 19%, and 21%, respectively. Meanwhile, youth unemployment is above 20% in Portugal, more than 30% in Spain and Italy, and almost 45% in Greece.

Now that we are entering the euro’s third decade, it is worth noting that Portugal, Spain, and Greece are all governed by radical socialists who have abandoned the concept of fiscal responsibility, which they call “austerity policy.” Worse still, Italy’s establishment parties have all been swept away. The country’s new populist government – comprising the Five Star Movement and Lega Nord – intends to increase the country’s debt substantially to pay for its proposed tax cuts and guaranteed-income scheme; and it might threaten to abandon the euro altogether if the EU refuses to play along.

In view of these facts, even the most committed euro enthusiast cannot honestly say that the single currency has been a success. Europe has quite plainly overextended itself. Unfortunately, the great sociologist Ralf Dahrendorf was right to conclude that, “The currency union is a grave error, a quixotic, reckless, and misguided goal, that will not unite but break up Europe.”

It is hard to see a clear path forward. Some argue for still more debt socialization and risk sharing at the European level. Others warn that this would push Europe into an even deeper quagmire of financial irresponsibility. The attendant capital-market distortion would cause severe economic damage, which Europe can scarcely afford, given its difficult global competitive position vis-à-vis an emerging China and an increasingly aggressive Russia and America. One way or another, the euro’s third decade will decide its fate.


Hans-Werner Sinn, Professor of Economics and Public Finance at the University of Munich, was President of the ifo Institute and serves on the German economy ministry’s Advisory Council. He is the author, most recently, of The Euro Trap: On Bursting Bubbles, Budgets, and Beliefs.

Regional lenders: China’s most dangerous Banks

In the second part of an FT series, Gabriel Wildau and Yizhen Jia explain how reliance on short-term funding and exposure to the industrial economy have put some lenders at risk

Gabriel Wildau and Yizhen Jia in Shenyang


© Shenyang Machine Tool Group has received loans from Bank of Shengjing, one of a group of regional lenders who are exposed to loss-making enterprises. FT montage; Bloomberg


At dusk under a smoggy sky, in the heart of north-east China’s rust belt, workers in beige uniforms file out of Shenyang Machine Tool, a lossmaking state-owned enterprise that is a pillar of the regional economy.

It looks like the end of any day in the company’s 35-year history, but workers know the factory’s best days are behind it. The manufacturing and construction boom that powered China’s economy, fuelling demand for heavy machinery, is winding down, and Shenyang Machine has posted losses every year since 2013, once government subsidies — of between Rmb29m and Rmb53m ($4.3m to $7.8m) — are excluded.

“They’ve been talking about reform for 10 years, but personally I haven’t seen much change here,” says one worker who only gives his surname, Kong, who does aftersales service for Shenyang Machine and has worked there for 30 years. “People aren’t using geared lathes any more. We’re being forced out of the market.”

The workers are oblivious to the company’s $78m loan from Bank of Shengjing, the largest regional lender in Liaoning province, whose capital city is Shenyang. But the nexus between lossmaking companies and regional banks has emerged as a key risk to China’s economy, where an explosion of debt since the global financial crisis has sparked warnings from the IMF and other watchdogs.


Map: Shadow loans are concentrated in economically-distressed northeast China


For the bank, whose name in Chinese means “prosperous capital”, the problem goes beyond Shenyang Machine. Bank of Shengjing is highly exposed to the broader economy of Liaoning, where average annual growth was the weakest of any Chinese province between 2014 and 2017. ´
Adjacent to the Shenyang Machine factory complex are several other struggling state-owned industrial groups that according to Economic Daily, a state-controlled media outlet, have also received loans from Bank of Shengjing, including Northern Heavy Industries and Shenyang Blower Works.

Over the past 18 months, regulators have unleashed a “ windstorm” against Chinese banks, with rules to prevent out-of-control lending growth and risky funding practices that are especially prevalent among regional players.

The forcefulness of the campaign, which has inflicted significant pain on weak corporate borrowers by denying them access to credit, reflects policymakers’ concerns that if left unchecked, problems at regional banks could spark contagion across the financial system.



The connection between weak regional economies and local banks has also drawn the attention of investors such as Alexander Campbell, chief executive of Black Snow Capital, a New York-based hedge fund that has placed a bearish bet on Bank of Shengjing and other publicly traded regional lenders.

In February, Brandon Emmerich, founder of Granite Peak Advisory, a research company based in New York, co-authored with Mr Campbell a ranking of “China’s worst banks” based in part on the stability of a bank’s funding sources and its exposure to various regional economies. Those in Liaoning were clustered near the top.

“If and when China’s economic growth begins to sputter, problems will surface first in the set of small banks with fragile balance sheets and lending exposure to anaemic regional economies,” says Mr Emmerich.


Zhang Yukun, then chairwoman of Shengjing Bank, at the company's listing ceremony in December 2014 © Bloomberg


Several regional banks have already gone bankrupt in all but name before being bailed out and restructured by local authorities. Others have become piggy banks for local governments or politically-connected tycoons with an outsized influence over local banks.

These lenders are largely not permitted to operate outside their home territory and are therefore highly dependent on local governments, state enterprises and entrepreneurs to support their businesses. An institution that refuses to lend to a local champion, even if doing so is risky, could find itself shut off from other, more profitable, projects.

“The further out towards the tail you go, the sketchier it looks,” says Mr Campbell.

Problems at small banks matter because their role in China’s financial system is growing. The country last year surpassed the eurozone to become the world’s largest banking system by assets. Meanwhile, small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43 per cent in the past decade.

And their role is set to grow further. Some 17 regional lenders are seeking approval for initial public offerings on the Shanghai or Shenzhen exchanges.

“Once these former rural credit co-operatives were able to get real banking licences, you can’t imagine how happy they were. While the big players were more conservative, the small ones expanded as fast as they could, and now they’ve become a substantial part of the system,” says Han Hanjun, an economist at the Shanghai Academy of Social Sciences. Bank of Shengjing and Shenyang Machine both declined to comment for this article.



Mr Campbell has never been to Liaoning, but when he looks at balance sheets of the region’s banks, he has a feeling of déjà vu. In 2008, as a proprietary trader of bank shares at Lehman Brothers, he witnessed first hand how banking crises unfold. For him and other observers, the risk posed by regional lenders comes not only from their exposure to weak companies such as Shenyang Machine but also from the way these banks obtain funding to make these loans.

Traditional banks rely on deposits from households and companies to fund their lending. Banks in which deposits comprise a large share of total liabilities are viewed as safe because deposits are unusually “sticky”. In the UK, for example, the average retail account holder stays with their bank for 17 years, longer than with their spouse at 12 years.

“As an investor, you’d love to see a bank that’s completely deposit-funded. Once you see banks levering up through non-deposit sources, the cost of funds increases and you develop the potential for an interest rate shock or a liquidity shock,” says Jason Bedford, executive director for Asian financial institutions research at UBS in Hong Kong.

“Interbank funding is very short term. It can be here today and gone tomorrow,” he adds.



In China, regional banks struggle to attract deposits because regulators rarely allow them to open branches outside their home provinces.

Yet they have displayed a voracious appetite for growth. In a country where licences for tightly-regulated sectors like banking are a scarce commodity, entrepreneurial managers of regional banks viewed their upgrade from rural co-operatives as a golden ticket.

“To rise from a small local lender to achieve the size and stature we are today — it took incredibly hard work. You can’t even believe the challenges we’ve overcome,” says an executive at a regional lender in north-east China.

With modest deposit growth unable to satisfy their appetites for balance-sheet expansion, small banks turned to volatile, wholesale borrowing from other banks. The share of deposits in total liabilities at regional banks fell from 73 per cent to 64 per cent between 2013 and 2017, according to Mr Bedford’s data from 244 Chinese lenders.

For the institutions that have grown most aggressively, the share of deposit funding is even lower. At Bank of Shengjing, it was 48 per cent at the end of 2017, while at Bank of Jinzhou, another Hong Kong-listed bank in Liaoning, it was 52 per cent. Bank of Jinzhou said in an emailed statement that its “risks are controllable”. At Wells Fargo, the largest pure commercial bank in the US, deposits were 77 per cent of total liabilities last year.

“A lot of regional banks only care about short-term profits. They just grab what is right in front of them but don’t consider a long-term development strategy,” says Mr Han.



The state-owned and subsidised Shenyang Blower Works © Getty


In addition to exposure to weak regional economies and reliance on volatile funding sources, a third element adds to risks at these banks: the use of complex financial engineering and creative accounting to expand lending beyond regulatory limits.

A decade ago, much as bank liabilities were mostly customer deposits, banks’ asset portfolios were also simple and transparent, comprised mainly of corporate loans and home mortgages. But breakneck growth pushed banks up against lending limits set by the People’s Bank of China.

In order to keep loans flowing without directly violating central bank quotas or rules on capital adequacy and loan-loss provisioning, regional banks resorted to financial innovation. By partnering with non-bank financial institutions like trusts, securities companies, and fund managers, they were able to transform loans into assets recorded on their balance sheets as “ investment receivables”.

“If my assets are increasing by Rmb17bn in a year, but my loans are only allowed to grow by Rmb8bn, then I have no choice but to move the rest of those loans into another category on my reports,” says the north-east China bank executive. “So we shift them over into the investment receivables item.”

Bailed out Baoshang bank




Baoshang Bank Following the abduction of billionaire Xiao Jianhua from Hong Kong last year by mainland agents, Mr Xiao is working with authorities to sell assets from his conglomerate, Tomorrow Group. According to Caixin, the financial news outlet, Tomorrow Group is seeking a buyer for half of the group’s 70 per cent stake in Baoshang Bank, based in Baotou, Inner Mongolia. But Tomorrow Group is not just a shareholder in Baoshang, it is also apparently the bank’s biggest client.

Baoshang’s disclosures state that exposures to one borrower of shadow loans equalled 122 per cent of net assets — far higher than the banking regulator’s 15 per cent limit, which applies only to a bank’s formal loan book. Though this borrower is not named, its description matches reporting by Caixin, which quoted an unnamed source describing Baoshang as a “piggy bank” for Tomorrow Group. Baoshang declined to comment, and Tomorrow Group could not be reached.



Disguised loans took the form of financial products with exotic names such as “trust beneficiary rights” and “targeted asset management plans”. These products are loans in all but name, but they allowed banks to abide by formal loan quotas and lower risk-weighted assets, which are used to measure capital adequacy.

At Bank of Shengjing, formal loans comprised only 26 per cent of total assets at the end of last year, while shadow lending was 54 per cent. At Bank of Jinzhou, shadow loans are 56 per cent of total assets.

“These banks are quite vague and blurry when it comes to investment receivables,” says a private fund manager that specialises in banks. “There’s so much massaging of the balance sheet, and they won’t tell you about their internal manoeuvrings.”


Bailed out Bank of Fuxin




Bank of Fuxin The gross domestic product of Fuxin city in Liaoning province shrank by 12.2 per cent in 2016, according to official data, although the reported decline probably reflects recognition of inflated GDP figures in previous years.

That same year, the provincial government arranged a bailout of Bank of Fuxin that involved sales of non-performing loans worth Rmb11bn — or 22 per cent of the bank’s total loan book — at face value to a group of five state-owned institutions. But there was a catch: about a third of these NPLs were apparently packaged into special purpose vehicles in which the bank itself then invested, says Jason Bedford, a UBS Asia financial institutions analyst. The arrangement means that the bank remains exposed to bad loans that the clean-up was ostensibly designed to erase.


Despite the risks, most analysts do not expect problems at small Banks to erupt into systemic crisis. The central government has the financial resources and technocratic expertise to extinguish small fires before they blaze out of control, and several small banks have been quietly bailed out with minimal systemic impact or even public awareness.

“I’m not worried about systemic risk. Right now the system is safer than it has been since 2010 because of the competence of the regulatory authorities,” says Mr Bedford. “The processes around management of contagion risks are extremely good in China.”

Still, small banks are expected to face significant turmoil as they adapt to new regulations intended to curb their risky behaviour. Banks lobbied fiercely to dilute a draft framework, published in November, that would limit their ability to transform loans into “investments”, but the final version was largely unchanged apart from extending the phase-in period to the end of 2020.


Bailed out Bank of Dalian




Bank of Dalian Based in the provincial capital of economically distressed Liaoning province, Bank of Dalian underwent two bailouts in 2015 and 2016. Six board directors and five senior executives were replaced. China Orient Asset Management, one of the country’s dedicated bad loan banks, acquired 21 per cent of its loan book in exchange for a 50.3 per cent stake in the lender.


Last year, the China Banking Regulatory Commission also capped the share of interbank borrowing in total liabilities at 33 per cent. As a result, the share of deposits in total liabilities for the overall banking system increased by four percentage points to 72 per cent, though it is still below 79 per cent at the end of 2013, according to Mr Bedford’s data analysis. At the same time banks’ asset structure is also improving, with banks’ reducing their partnerships with non-bank financial institutions that helped them invest in disguised loans.

“The theme underlying these various moves is a push for banks to return to their traditional business model of taking deposits and making loans, and to reduce their use of investment products,” says Chen Long, an economist at Gavekal-Dragonomics, a Beijing-based research company.

Barbarians grow up

As private-equity firms mature, the way they buy and sell is changing

They are reshaping Wall Street’s ecosystem



“SELL in May and go away,” say the denizens of Wall Street, and to the usual summer lethargy is added the excuse of a heatwave. But for those working in private equity, there is no let-up. The “shops”, as private-equity funds like to call themselves, are stuffed with money and raising more: $1.1trn in “dry powder” ready to spend around the world, according to Preqin, a consultancy, with another $950bn being raised by 3,050 firms.

So hot is the market that there are rumours of money being turned away. Even the firms themselves, which receive fees linked to assets under management, cannot fathom how to use all that may come their way. It is not for want of trying. The year to date has seen nearly 1,000 acquisitions (see chart 1). Health care has been particularly vibrant.



Even more noteworthy than the volume of money pouring into private equity is the way the business is maturing. Banks are reconfiguring their operations to serve such a transaction-heavy clientele. Limited partners—the public-pension schemes, sovereign-wealth funds, endowments and family offices that provide the bulk of private-equity investment—are playing more active roles. It all adds up to a stealthy, but significant, reshaping of the financial ecosystem. 
Data on returns are patchy. Odd measures are often used to gauge performance and disclosure is intermittent. But there is plenty of reason to believe that private-equity funds have done well in the past decade. Low interest rates have favoured their debt-heavy business model. Rising asset prices have made it easy to sell for large gains.



And some recent clouds on the horizon have dissipated. Mooted tax reforms would have stopped private-equity firms from deducting the interest they pay on debt from their taxable income and forced their managers to pay the personal-tax rate on their investment profits (or “carried interest”), rather than the lower capital-gains rate. In the event, however, the new rules brought in last year did not touch carried interest at all and only slightly reduced the benefits of debt.

Another fear had been that regulations would become less supportive. Jay Clayton, who took over at the Securities and Exchange Commission (SEC) last year, made it clear that he wanted to see a shift towards public markets. He noted that the loss of companies to private equity had denied opportunities to small investors. A flurry of public offerings followed his appointment, including sales by private-equity firms. But the burdens of being listed remain heavy. These include onerous filing requirements and the knowledge that routine business decisions may become the subject of caustic public debate. 
The result is that the value of public companies being taken private continues to rise (see chart 2). The figures understate the trend, since they omit the growing number of large companies selling off divisions to private-equity firms. These deals attract little attention—which is partly the point. Headquarters do not move; senior executives keep their jobs. Recent examples include the decision by J.M. Smucker, a food company, to sell its baking business to Brynwood Partners and GE’s move to sell its industrial-engines division to Advent International. Similarly unremarked is the rising number of transactions in which one private-equity firm sells to another, rather than listing an asset on the public markets.




Private equity’s growing heft has knock-on effects throughout the financial sector. Goldman Sachs has 25 merger bankers assigned to private-equity firms, working on deals alongside colleagues who focus on specific industries. Its analysts monitor 5,500 private-equity holdings—50% more than the number of listings on the American public markets. The other big institutional banks, such as Morgan Stanley and JPMorgan Chase, are just as attentive to private equity.

The most significant change may be in private equity’s investor base. In the past two years the number of limited partners with more than $1bn invested has grown from 304 to 359. Together they account for $1.5trn—half of all private-equity money, according to Preqin. And this statistic does not fully capture their growing activism. As well as placing cash in private-equity funds, they increasingly “co-invest”—ie, take direct stakes in a buy-out.

The advantage for limited partners is that they avoid management fees—often 2% annually, plus 20% of profits. Private-equity funds gain from being less reliant on each other. Not long ago, large deals often required several funds to collaborate. The purchase of Nielsen Media in 2006, for example, involved seven. That alarmed antitrust regulators, complicated management and made it hard to exit from investments, since many potential buyers were already co-owners. The value of deals done by more than one private-equity firm has fallen by half since the Nielsen deal. Even when firms work together, the average number involved is smaller than it was.

For the biggest deals, private-equity firms are today making acquisitions solo and then syndicating large stakes through co-investments to limited partners. Notable among numerous recent examples are Blackstone’s purchase of Thomson Reuters’ finance and risk division in January for $20bn, and Carlyle’s of the specialty-chemicals division of Akzo Nobel, a Dutch multinational, in March for $12bn. The process often begins with a phone call by a private-equity firm to big, sophisticated investors such as GIC, Singapore’s sovereign-wealth fund, or CPP Investment Board, a giant Canadian pension fund. They can quickly put together teams to analyse transactions. Smaller limited partners are brought in later if needed, along with select outsiders, notably family offices.

This trend does not just reduce risk for private-equity managers. It also underlines a change in financial markets. Why should companies accept the costs and scrutiny that come with selling shares to the general public when there is a sophisticated, rich, private alternative? And when the time comes for one private-equity owner to sell, another private-equity fund can put together such a network to buy. Brokers and exchanges developed a century ago to help companies tap money where it lay—in individual pockets. Today that capital increasingly lies elsewhere.

The Currency Crisis of 2018?

It’s not too early to consider whether what’s happening in Turkey is simply a Turkish matter.

By Jacob L. Shapiro     

 

(click to enlarge)

All under heaven

China’s belt-and-road plans are to be welcomed—and worried about

The “project of the century” may help some economies, but at a political cost



SHUNNING all false modesty, China’s leader, Xi Jinping, calls his idea the “project of the century”. The country’s fawning media hail it as a gift of “Chinese wisdom” to the world’s development. As for the real meaning of the clumsy metaphor to describe it—the Belt and Road Initiative (BRI)—debate rages.

The term itself is confusing. The “road” refers mostly to a sea route; the “belt” is on land.

Countries eager for China’s financing welcome it as a source of investment in infrastructure between China and Europe via the Middle East and Africa. Those who fear China see it instead as a sinister project to create a new world order in which China is the pre-eminent power.

All roads lead to Beijing

One cause of confusion is that the BRI is not a single plan at all. A visitor to its website would click in vain to find a detailed explanation of its aims. There is no blueprint of the kind that China’s leaders love: so many billions of dollars to be spent, so many kilometres of track to be laid or so much new port capacity to be built by such-and-such a date.

Chinese maps show the belt and road as lines that trace the routes of ancient “silk roads” that traversed Eurasia and the seas between China and Africa. That was the original conceit, but these days China talks about BRI as if it were a global project. The rhetoric has expanded to include a “Pacific Silk Road”, a “Silk Road on Ice” that crosses the Arctic Ocean and a “Digital Silk Road” through cyberspace.

To the extent that this is all about building infrastructure, the idea is welcome. Trillions of dollars’ worth of roads, railways, ports and power stations are needed in countries across Asia, Africa and Europe. China’s money and expertise could be a big help in spreading wealth and prosperity.

China says anyone can join in. Countries such as Azerbaijan and Georgia, which stand to benefit immensely from better connections to the world, are wildly enthusiastic. One of China’s motives is to strengthen security on its western flank by helping Central Asian countries prosper—thereby, it hopes, preventing them from becoming hotbeds of Islamist terrorism. Everyone would benefit from that, too.

But there are worries. The BRI is bound up with the growing cult around Mr Xi. State media call it “the path of Xi Jinping”. It has become shorthand for China’s overseas aid, state-led investment abroad and for Mr Xi’s much-ballyhooed “great-power diplomacy with Chinese characteristics”. China urges other countries to praise the BRI, so that their words can be relayed back home as propaganda. Few Chinese dare offer open criticism; that makes mistakes more likely.

The citizens of countries hosting BRI projects may come to regret their governments’ enthusiasm. Like all Chinese cash, the BRI billions come without pesky questions about human rights or corruption. Indeed, the terms are often shrouded in secrecy, raising fears that local politicians may benefit more than their people. Projects tend to require the use of lots of Chinese labour. BRI countries risk piling up dangerous amounts of debt, which some fear is designed to give China a strategic hold over them. Pakistan, one of the most important BRI countries, has just held an election in which candidates vied to take credit for Chinese investment; yet the debts are so large that, before long, Pakistan is likely to need an IMF bail-out.

Then there are possible security risks. In his metaphorical flights, Mr Xi sometimes speaks of his belt and road as a single thoroughfare, a “road of peace”. But what if the Chinese navy were to take advantage of ports such as Hambantota? This was repossessed by a Chinese state-owned firm after the Sri Lankan government struggled to repay the debts it had amassed to build it. Military planners worry that China could develop a string of such berths that its ships could use to extend their reach far beyond China’s shores.

Analysts in Asia and the West believe that China wants to displace America as the Asian hegemon. The BRI could end up furthering that plan, even if it is not its focus. China’s crude maps show the belt and road running through disputed territory, including the bitterly contested waters of the South China Sea where China has been busy building fortresses on reefs.

Some Asian countries, including India and Vietnam, are wary and most Western countries share their unease. Last year America’s defence secretary, James Mattis, said that: “No one nation should put itself into a position of dictating [BRI]”. In January France’s president, Emmanuel Macron, warned that the BRI “cannot be the roads of a new hegemony that will make the countries they traverse into vassal states.” He added: “The ancient silk roads were never purely Chinese…These roads are to be shared and they cannot be one-way.”

Keep those American signposts

What should the world do about the BRI? For a start, it needs to keep some perspective. Even if China does hope to use it as a political tool to beat back Western influence, Beijing is bound to face difficulties, as projects go awry, debts go bad and people grow hostile to China’s presence. History suggests that simply doling out money will not, on its own, usher in a Pax Sinica.

The world can also use its influence to make the BRI more beneficial. Even China’s billions cannot finance everything on offer. Money coming from the West, from the European Union and from institutions such as the World Bank and the IMF should be lent according to international standards—including on such things as transparency, environmental safeguards, public procurement and debt sustainability. So long as they are good projects, let China include them in the BRI if it wants to.

Last is security. The way to assuage fears about the BRI’s threat to the balance of power is not by trying to frustrate China’s efforts, let alone by starting a trade war or by pulling America’s armed forces out of Asia, as President Donald Trump sometimes seems to contemplate. On the contrary, the balance of risks and benefits of the BRI is related to America’s commitment to Asia. If the United States is engaged, the world can mitigate the dangers of BRI and reap its rewards. If not, the risks will outweigh the benefits. The BRI is yet one more argument for America to stay in Asia.

Pensions risk could make schmucks of savers

Post-crisis, banks have become safer but the dangers have been pushed elsewhere

John Authers


Former Lehman Brothers chief Richard Fuld encounters protesters in 2008 following the collapse of the bank © Reuters


When Richard Fuld, the chief executive of Lehman Brothers, received the news in 2008 that no one would ride to the rescue of his failing bank, he is reported to have said: “So I’m the schmuck?”

Almost a decade later, Lehman is still the only US investment bank that was allowed to fail. Its peers have been restored to health with risks removed. Mr Fuld appears to be the ultimate “schmuck” of the financial crisis. But that judgment may be premature.

Risk has been gently and painlessly excised from the US banking system over the past 10 years. On any sensible measure, US banks are far safer now. Europe’s banks, which entered the crisis in a far more parlous state, have at least improved. The nightmare scenario, which seemed very close in 2008, of all-out banking collapse seems now to have been averted. The prospect of ATMs failing to pay out cash, or of companies failing to pay wages, has receded.

While risk no longer sits in the banking system, it has not vanished. It grows ever clearer that risk has been moved, primarily to the pension system. This means that the long-term dangers in the financial system have become more insidious: easier to ignore but ultimately even more dangerous.

Pension funds have been the principal losers from quantitative easing, the main tool used to bail out the banks. QE bond purchases pushed down bond yields. This created pain for pension funds, which buy bonds to offer their members a guaranteed income. The lower the yield on bonds, the more expensive it becomes for them to fund any given guarantee. This problem has created a true crisis among US public sector pensions. Many are looking for ways out of the guarantees made to their members, only to find that courts — rightly — defend the members.

In the US, pension deficits — the gap between assets and the notional cost of funding the guarantees — widened sharply after the financial crisis. According to Mercer, the consulting actuaries, companies in the S&P 1500 index currently face a pension deficit of $229bn, or 11 per cent of their assets. This number has improved this year thanks to a rise in bond yields. At the worst, this deficit exceeded $600bn, or more than 30 per cent of assets.

QE has passed the buck to pension funds in other ways, too. With bonds barely offering an income, many funds have resorted to taking greater risks. That has meant buying into funds and strategies that go under the umbrella term of “alternative assets”, many of which rely on leverage for their returns.

Private equity has been a principal beneficiary of QE, as it has turned pension funds and other large asset managers into willing providers of capital. According to the tally kept by the London-based research group Preqin, the assets controlled by private equity groups have just passed $3tn for the first time, after growth of more than 20 per cent in the past year.Once the preserve of wealthy individuals, private equity is now principally an asset class for large institutions, with pension funds holding more than half of private equity assets.

Meanwhile, hedge funds have also flourished in the post-crisis years, despite mediocre returns. HFR, the Chicago-based research group, found that total assets held globally by hedge funds have risen to $3.23tn, up from $1.4tn at the end of 2008. Once vehicles for the rich to take risks, they now exist to serve large institutions. The policies that gave US banks the breathing space to make themselves safer also allowed alternative asset managers to sell to a new customer base of large institutions.

There are good reasons for pensions to take the strain. Unlike a banking crisis, a pensions crisis has no one moment of critical danger. Its ill effects settle in over time, and there is opportunity to fix them. To put this more negatively, politicians who want to delay a reckoning can do so if the risk is stashed where it can be ignored, or even left to the next generation to sort out.

The sheer complexity of pensions also helps to make them a much more attractive place to bear risks. Few understand them, so they tend not to be the subject of mainstream debate. But the events of 2008 demonstrated that risks that seem complicated and obscure can soon become very relevant indeed, and the subject of extremely heated political debate. Even if the risk of a sudden banking crash has diminished, the risk that much of the population will be subject to poverty in retirement is growing.

It is difficult to focus on esoterica like this at a time of political anger across the world. But as it stands, pension savers — virtually all of us — may find to our horror that we are the schmucks.

From a Space Station in Argentina, China Expands Its Reach in Latin America

Our correspondent went to the deserts of Patagonia to examine how China secured its new base, a symbol of its growing clout in the región.

By Ernesto Londoño

The antenna is the centerpiece of a $50 million station built by the Chinese military.Credit Mauricio Lima for The New York Times