Reserve managers’ relationship with the dollar is unhealthy

They may try to diversify, but the global currency will drag them back

JAMES M. CAIN’S novel “The Postman Always Rings Twice” portrays a violent love affair between Frank Chambers, a drifter, and Cora Papadakis, a former beauty queen now married to a man she despises. Their romance is doomed from the beginning. Every attempt to find happiness fails. Any attempt at being apart is equally hopeless. “Why did you have to come back?” she hisses after one break-up. “I had to, that’s all,” he replies.

The story comes to mind when contemplating the fate of the managers of the world’s $11trn-worth of foreign-exchange reserves. This is not to say they are obsessives wracked with guilt and paranoia (though a few might be). But rather that, like Frank and Cora, it has probably occurred to them that their dominant relationship, which is with the dollar, may not be entirely good for them.

The latest figures from the IMF show that the share of dollars in global reserves fell to 62% at the end of last year. Reserve managers seem to be for a cooler, less intense affair with the dollar. But eventually, they will find that it is hard to break free. That is not so much because the alternatives to the dollar have flaws (though they do); rather, it is because the pain of a weaker dollar will become too much to bear.

The dollar is the closest thing to a world currency. Commodities that are traded globally are quoted in dollars. So are other currencies. A lot of cross-border trade is invoiced and settled in dollars, too. Dollars are the unit by which the world of finance keeps score. So there is logic to countries keeping stores of them in reserve. It is generally dollars that you need in an emergency.

But money is also a store of value. There is no guarantee that the dollar will hold its value better than other currencies. So like other portfolio managers, reserve-holders seek to diversify.

That means fewer dollars.

There are other reasons for breaking free of the greenback. Its global role gives America the means to impose financial sanctions to great effect. Its use of such powers has steadily grown.

In response, Russia has slashed the share of dollars in its currency reserves. It is not hard to imagine that some other countries have weighed the odds of at some stage being caught in a dispute with America.

Changes in the market value of currencies can mask underlying shifts in the mix of assets within reserves. For instance, if the euro falls sharply against the dollar, its share in reserves would also fall without any change in the stock of assets held. Steven Englander of Standard Chartered, a bank, applies a constant exchange rate to the IMF data to adjust for this valuation effect. What emerges is a clearer long-term trend downwards in dollar holdings and a sharp sell-off last year (see chart). What kept the dollar strong was the strength of private-sector purchases.

Reserve managers appear to be countercyclical investors, selling when others are buying. This is rather cheering. The dollar looks overvalued on many benchmarks. And if anyone can take a long-term view, it ought to be reserve managers. Even so, Mr Englander suspects that some of them are waiting for signs of dollar weakness before selling.

By then it may be too late. Once private-sector demand for dollars wanes, the combination of this downward pressure and selling by reserve managers might mean that the dollar has to fall a long way to balance supply and demand. That would be a big headache for reserve managers. In one regard they are not like other portfolio managers. They are also charged with keeping their own currency at a competitive level to support exports.

Reserve managers who start off wanting to sell dollars often end up buying them back when they see competitiveness is at risk, says Mr Englander. Their attempts to diversify by, say, selling those dollars for euros is doomed to fail. It is hard to induce private-sector investors to buy dollars for euros when they, too, are trying to diversify away from them. The outcome, says Mr Englander, is that both dollar and non-dollar reserves increase, with the dollar share not much changed.

In Cain’s novel, the star-crossed lovers are joined by a dark passion and by complicity in a murder. What tethers reserve managers to the dollar is not quite as sinister. For a while they can achieve a little distance: if they want to get out of dollars, they can do so while everyone else is trying to get into them. But if the dollar falls hard enough, they will be buyers. Ask a reserve manager, then, why he ever went back, and he may tell you: “I had to, that’s all.”

Foreign Investors are Checking Out of the Chinese Stock Market

Record outflows from China’s mainland-listed stocks confound expectations that their inclusion in indexes would underpin investor appetite

By Mike Bird

2019 was meant to be the year many Western investors began buying Chinese stocks. It is turning out to be the first year many investors began selling them.

Foreign investors are offloading shares listed in Shanghai and Shenzhen through Hong Kong’s flagship Stock Connect platform. In the 20 trading sessions up to May 14, they sold so-called A-shares, worth 52 billion yuan ($7.56 billion), net of purchases—by some distance the largest amount on record.

On one level this isn’t surprising: Mainland-listed stocks are down around 11% over the past month as trade talks between the U.S. and China have taken a turn for the worse and Beijing’s efforts to stimulate the economy have petered out. International investment in equities is usually closely related to their recent performance.

But it marks a change for China. Overseas investors had barely ever sold equity on a net basis through the Stock Connect system before. Last year, when the MSCI China A Onshore index fell roughly 31%, the drawdowns lasted no more than a few days and ran to a fraction of the size of the current one.

The shift could be related to the fact that access has been progressively widened to allow more buying and selling.

The previous pattern of inflows reinforced the idea that international investors would prove to be a prop for Chinese markets. Photo: Eddie Moore/Zuma Press

The previous pattern of inflows reinforced the idea that international investors would prove to be a prop for Chinese markets. A lot of the commentary around the inclusion of A-shares in major global indexes, which started in 2018 and ramped up significantly this year, focused on the prospect of a wave of passive money. Some predicted inflows worth hundreds of billions of U.S. dollars over a number of years.

Chinese policy makers have been content with a gradualist approach to liberalizing capital inflows, based on a long-running desire to avoid the hot-money outflows recorded by its near neighbors during the late-1990s Asian financial crisis. Officials can exert considerable pressure on domestic investors, freezing trading accounts and instructing or advising investors not to sell. The new legions of international investors will be harder to control.

To be sure, the recent outflows aren’t enough to derail the performance of mainland Chinese stocks, whose market capitalization runs to over $5 trillion. And inflows could well return later in the year.

But the current reversal shows that index inclusion isn’t enough to sustain permanent inflows to China. The traffic won’t all be one way.

The Future of Economic Growth

Given the failures to foresee the 2008 financial crisis and subsequent weak recovery, it is easy to think that economists have little to offer in the way of predictions. But when it comes to national-level GDP growth, past projections have largely been borne out; even when wrong, they can be used to diagnose structural problems.

Jim O'Neill

oneill60_getty images_graphic

MANCHESTER – Last month, I wrote about the growing divide between economic theory and real-world economic conditions, and reminded readers that economics is still a social science, despite whatever loftier ambitions its practitioners may have. Nonetheless, when it comes to the specific question of what drives economic growth in the long term, one can still offer rigorous predictions by focusing on just two forces.

Specifically, if one knows how much a country’s working-age population will grow (or shrink), and how much its productivity will increase, one can predict its future growth with considerable confidence. The first variable is reasonably predictable from a country’s retirement and death rates; the second is more uncertain. Indeed, the reported slowdown in productivity across advanced economies since 2008 is widely regarded as an economic mystery.

Is it really a mystery, though? Consider the following table, which shows GDP growth since the 1980s for the larger economies, the BRICs (Brazil, Russia, India, and China), and the “Next Eleven” (N-11) most populous developing countries.

With the fourth column (2011-2020) showing what my colleagues and I had projected back in 2001 when we coined the BRIC acronym, one can observe differences between what was forecast and what has happened this decade (2011-2017*). For the world as a whole, we predicted growth of just over 4% in the current decade, owing to the rise of China and the other major BRICs. And it is precisely for that reason that growth in the 2001-2010 period was stronger than in the preceding decades, when the persistence of 3.3% annual growth led some economists to conclude that the global economy had reached its full potential.

Now consider what has actually happened. Growth in the United States, the United Kingdom, Japan, China, and (arguably) India has come close to what we predicted. But the same cannot be said for the eurozone, Brazil, and Russia, whose poor performance must reflect weak productivity, given that our predictions had already accounted for demographic trends.

It is worth noting that no major country or region has performed better than we predicted back in 2001. The table shows that there can be some asymmetry between actual and potential growth, and that such divergences are not random. On the contrary, the eurozone, Brazil, and Russia clearly have underlying problems that need to be addressed.

Of course, we also may have been too optimistic about these economies’ long-term potential in the first place. Such is the nature of a social science. Whether any of them can achieve strong productivity growth will depend on a variety of factors, not least the policies they have in place. At this point, it would be a pleasant surprise if any of them achieved the level of growth that we predicted for 2021-30.

It is also worth noting that the US and the UK registered growth close to the level we predicted despite their weak productivity gains, owing to the rapid increase in employment in both countries. But with the unemployment rate having reached near-historic lows, and with public policy turning against immigration, it will be mathematically impossible to achieve the same level of employment growth in the decade ahead. For overall growth to continue, productivity must improve.

When it comes to the next decade, much of the focus lately has been on China, whose current slowdown seems to have taken markets by surprise. It should not have. As we predicted almost 20 years ago, China will struggle to attain growth above 5% in the 2021-2030 period, for the simple reason that its workforce growth will have peaked. While pessimists will no doubt find validation in the further Chinese growth disappointments that are to come, optimists can point to the fact that 5% annual growth in China is nominally equivalent to 15-20% growth in Germany. At this stage in China’s development, faster growth would actually be quite extraordinary.

It is equally predictable that India will start to grow at a much faster rate than China, simply because its workforce still has a lot of growing left to do. The real question is whether India can implement strong productivity-enhancing reforms. If it can, it could be the one major economy to exceed expectations in the next decade. But even failing that, India will soon overtake the UK and France to become the world’s fifth-largest economy; it will overtake Germany at some point in the next decade, possibly by 2025.

Meanwhile, unless Brazil and Russia reduce their dependence on the commodity-price cycle, they will only ever experience strong growth during price spikes. With or without reform, Russia is already heading for another disappointing decade as a result of its demographics. Brazil, on the other hand, could register growth close to what we originally predicted if it could implement difficult social and health reforms. But that is a big “if.”

As for the eurozone, we appear to have been too optimistic, even though we foresaw a decline in potential growth to 1.5%. Nowadays, most forecasters put the region’s growth potential at around 1%. If Germany cannot shift to a more domestic-demand-driven growth model, that projection will probably turn out to be correct. Yet while most press coverage has focused on Germany’s falling exports and manufacturing output, the country’s services sector remains strong. For its own sake as well as for Europe’s, Germany should embrace that strength permanently.

Among the loose assortment of N-11 countries – most of them in Asia and Africa – are some fast growers like Vietnam. Others, especially Nigeria, have remarkable potential given their demographics, but will never reach it unless they undertake significant reforms. In that, they have something in common with many of the advanced economies.

Jim O'Neill, a former chairman of Goldman Sachs Asset Management and a former UK Treasury Minister, is Chairman of Chatham House.

Trump’s attacks on the Fed trigger global alarm

Economists warn central bank independence is under assault around the world

Sam Fleming and Chris Giles in Washington

Fed chair Jay Powell has come under pressure from President Donald Trump to lower rates © Reuters

Donald Trump’s attempts to influence the US Federal Reserve have triggered anxiety among policymakers gathered for meetings in Washington, as economists fret that the apparent absence of an inflationary threat is making it easier for politicians to push for looser monetary policy.

Officials at the spring meetings of the International Monetary Fund and World Bank defended the Fed following Mr Trump’s attempts to appoint two political allies to its board, and demands that it lower rates and restart quantitative easing.

The Fed is not alone in facing a threat to its independence: the Turkish and Indian central banks have also been pressured to loosen policy in recent months.

“I am certainly worried about central bank independence in other countries, especially in the [US], the most important jurisdiction in the world,” said Mario Draghi, president of the European Central Bank. With 19 governments, the ECB had an advantage because any advice from different governments was generally contradictory, he said. But he stressed that independence was crucial for the credibility of the decisions central banks take to regulate the economy.

“Populism on the left and the right is also encroaching on central banks,” said Tharman Shanmugaratnam, deputy prime minister of Singapore and chairman of its central bank. The political pressure, “does pose a very real risk of central banks being encouraged, urged and forced into new and much larger quasi-fiscal roles”.

Mario Draghi, president of the European Central Bank, has expressed concern about political interference, particularly in the US © Bloomberg

Economists fear that given sluggish growth rates and an absence of inflation, central banks are likely to face increasing political demands for looser policy. In a lecture last week, Kenneth Rogoff, the Harvard economist, warned that central bankers have traditionally been able to warn that if they are not independent, “the devil will break loose and there’ll be high inflation”. Yet that threat no longer felt urgent given low price growth around the world, which could diminish the perceived need for independence.

The independence of major central banks seemed assured after they tamed the scourge of inflation and helped lead efforts to fight and mitigate the financial crisis a decade ago. As government budget deficits exploded and fears of a debt crisis grew earlier this decade, central bankers became the only game in town for delivering economic stimulus and quelling market panic.

This was best epitomised by Mr Draghi’s 2012 comment that he would do “whatever it takes” to solve the eurozone crisis, a comment, which at a stroke, marked the moment its intensity began to fade.

That high watermark is now long gone and the discussion today is about the assault central bankers are facing. In a lecture on central bank independence, Mr Rogoff, a former IMF chief economist, argued that some central banks had been too “rigid” in sticking to inflation targets when more flexibility was required, and in taking credit for the good times even when this was not justified.

He set out a number of further reasons for the challenge facing central bankers — including a lack of inflation, an absence of tools to boost economies when interest rates are zero, and a lack of fiscal policy expertise in central banks, which limits their ability to advise governments on stabilisation when monetary policy is out of ammunition.

Now, the attitude, “Thank you very much independent central banks, you did a great job, we really appreciated it, we don’t need you any more” was taking hold, Mr Rogoff said. While this view was gaining strength, it was almost certainly wrong because inflation would come back at some point, he added. “Completely undermining the independence of central banks, those countries that do that, including the US, will live to regret it,” he said.

Amid the concern expressed at the IMF spring meetings, there were some more sanguine voices. Axel Weber, the former Bundesbank president, stressed that attempted political interference was nothing new. He pointed to unsuccessful attempts by former German chancellor Konrad Adenauer to pressure the central bank in the 1950s, and more recently from former French president Nicolas Sarkozy when Mr Weber was on the ECB governing council. “My answer was ‘who cares what Mr Sarkozy thinks?’”, Mr Weber recalled.

Donald Trump has drawn fire for saying he will nominate Stephen Moore, a long-time supporter of the president, for a seat on the Federal Reserve Board © Bloomberg

“The credibility and the sovereignty and the independence of the Fed is under no threat whatsoever. The Fed knows what to do,” said Mr Weber, who is now chairman of UBS, on Friday. “We just need to be aware that we need to stay our course despite calls from politics to do something else.”

The Fed, currently chaired by Jay Powell, has itself faced down political lobbying in the past. In an interview with Paul Volcker posted as part of an oral history project by the Fed, the former chairman recalled being summoned in 1984 into the White House library to a meeting with Ronald Reagan and his then-chief of staff James Baker. “The president wants to give you an order”, Mr Baker told him: ensure rates did not go up before the election. Mr Volcker said he gave the men no response. “It was not jovial, but President Reagan’s silence seemed to reflect some discomfort,” he recalled in the interview, which was conducted in 2008 but posted on the Fed’s site on Friday.

Some politicians acknowledged the strain that politics is now imposing on central bankers. Philip Hammond, the UK chancellor, said the political firestorm around Brexit was making it harder for the UK to attract central banking talent as it seeks a successor to Mark Carney at the Bank of England. “There may be some candidates who might be deterred from application because of the political debate around Brexit, which the governor of the BoE cannot avoid being part of,” he said.

Christine Lagarde, IMF managing director, stressed that central banks still had great power in the global economy. They were “bright spots” in the global landscape, she argued, praising their willingness to perform a U-turn and become more dovish as the slowdown took hold last year, which had an “almost instantaneous” impact.

Canadian soldiers taking part in the Nanook-Nunalivut exercises, partly meant to get the Atlantic alliance’s troops up to Russian levels of readiness in extreme-cold climes.CreditCreditAndrew Testa for The New York Times

RESOLUTE BAY, Canada — After finishing a training drill on surviving the bitter cold, the soldiers gathered around Ranger Debbie Iqaluk to hear about an inescapable fact of life in the high Arctic: The ice is melting despite the frigid temperatures.

And that means the Russians are coming.

Her retelling of how she watched as an enormous iceberg fractured, just a few feet from the military base here, was riveting. It is one thing to be told constantly that the melting polar ice cap has opened up the Arctic, disappearing what used to be an impenetrable barrier between North America and Russia. It is quite another to see it firsthand.

The iceberg took five years to melt, but by 2018 it was gone, taken over by a sea that with each year is melting earlier in the season. That has brought Russia right to Canada’s doorstep, cutting into the “Fortress North America” concept that has long comforted military planners on this side of the Atlantic Ocean.

NATO is rushing to try to catch up. Last month, hundreds of troops from member countries and partners, including France, Norway, Finland and Sweden, joined Canadian soldiers, reservists and rangers for the Nanook-Nunalivut exercises that aimed in part to help alliance forces match Russian readiness in extreme-cold climes. (The United States sent observers but no troops this year.)
“Russia is increasing its military presence in the Arctic,” said Dylan White, a spokesman for the North Atlantic Treaty Organization, citing the new Russian icebreaker fleet, weapons systems and radar. The Western military alliance, he said, is “monitoring Russia’s Arctic buildup carefully.”

In fact, Russia has already claimed the North Pole, and in 2007 sent two minisubmarines to place a titanium Russian flag on the seabed, two and a half miles underwater. Twelve years later, during last month’s alliance exercises, Canadian military officers were still grumbling about the stunt.

Ships now successfully ply the Northwest Passage in July — something that was unheard-of in 1845 when Sir John Franklin, a British explorer, tried to sail it, only to become icebound near King William Island. He lost his life and those of his 129-member crew.

Twenty percent of Russia’s gross domestic product is pulled from the Arctic, whether in minerals or through its shipping lanes. It is far ahead of North America when it comes to maneuvering in the region; by comparison, less than 1 percent of the United States’ economic output is derived from the Arctic. 
Over the summer, a Maersk vessel loaded with Russian fish became the first container vessel to complete an Arctic sea route that Moscow is planning as part of an Arctic superhighway.
The Beaufort Sea, seen in March, was once frozen over for most of the year. Global warming has opened up the Arctic, bringing Russia right to North America’s doorstep.

The Beaufort Sea, seen in March, was once frozen over for most of the year. Global warming has opened up the Arctic, bringing Russia right to North America’s doorstep.CreditAndrew Testa for The New York Times

Rangers at Resolute Bay in Canada. The area was ground zero for Operation Nanook-Nunalivut, the efforts to train troops how to survive in the high Arctic.CreditAndrew Testa for The New York Times

Moscow’s military ambitions in the Arctic have also increased as Russia moves to defend the territory that it claims.

Last month, Russia’s Defense Ministry flew a group of reporters to a military base on Kotelny Island, between the Laptev Sea and the East Siberian Sea on its new Arctic shipping route, to show off antiship missile launchers and air defense systems firing shots at a practice target.

Russia has also expanded its fleet of icebreaker ships to more than 40 (the United States has only two that are operational) and reopened military bases in the Arctic that were shut down after the end of the Cold War. Two months ago, a top Russian lawmaker told a state-run news agency that Russian special forces were training for a potential conflict in the Arctic.

At a meeting on Tuesday of the International Arctic Forum, President Vladimir V. Putin of Russia outlined an ambitious program, including new ports and infrastructure, to further cement Russia’s standing in the region. “We don’t see a single matter that requires NATO’s attention” in the Arctic, Foreign Minister Sergey V. Lavrov of Russia said at the same event.

In a telephone interview, Defense Minister Harjit Sajjan of Canada made clear that the alliance had no intention of ceding the icy expanse.

“We want Russia to know what our capabilities are,” Mr. Sajjan said. “It prevents them from doing more aggressive things.”

Resolute Bay is known as the “place with no dawn” by the Inuit people, who were forcibly relocated there in 1953 as part of a Canadian government plan to lay claim to land in the far north before Moscow could.

It is the second most northerly military base in North America; Canadian Forces Station Alert, just 500 miles from the North Pole, is first. Until Russia appeared on the horizon, “force protection” detail at Resolute Bay simply meant soldiers armed with ancient rifles standing guard against polar bears.

This year, it was ground zero for Operation Nanook-Nunalivut, the efforts to train troops how to survive in the high Arctic.

There are no northern lights despite the clear night, the troops are told, because, well, it is too far north. Trees cannot survive either. The landscape is unrelentingly white — white snow meeting white sky. The sea is white, the land is white.

Resolute Bay is known as the “place with no dawn” by the Inuit people.CreditAndrew Testa for The New York Times

Last month, troops from France, Finland, Sweden and Norway joined Canadian soldiers, reservists and rangers for the exercises.CreditAndrew Testa for The New York Times

“I thought I knew what winter was about,” said Lt. Col. Aaron Williams, the commanding officer of the First Battalion of the Royal Canadian Regiment. “But then I arrived here, and realized I don’t know anything.”

The most important thing that Colonel Williams said he tried to impress upon his troops was that of the two hostile forces in Arctic warfare, the one loaded with sophisticated weaponry was probably the lesser threat. The weather, he said, can dwarf everything: “You can’t fight somewhere if you can’t survive it.”

Simple tasks have to be entered into daily calculations. Going to the bathroom at night means putting on multiple layers of winter gear, like long johns, socks and liners, as well as a balaclava, parka and hoodie, before trudging into the frigid cold. With all that, soldiers said they routinely questioned whether they really needed to go.

The weather dominates conversation as if it is a separate presence. The troops wake up talking about how cold it is and go to sleep thinking about how cold it will be when they wake up.

“I’m supposed to be learning how to make an eight-person igloo,” said Pvt. Doug Peach, from Abbotsford, British Columbia, as he huddled outside a tent in the curiously named Crystal City, essentially a bunch of tents surrounded by snow and igloos a few miles from the main base at Resolute.

Instead, Private Peach said he had been counting the days since he arrived (six) and the days until he was to leave (another 15). Icicles hung from his mustache.

The temperature that day was a balmy minus 22 Fahrenheit. By comparison, it was almost toasty inside the igloos, made of blocks of hard-packed snow, where temperatures soared to just above freezing.

Early one morning, Ranger Iqaluk stood between the frozen sea and a group of soldiers heading out on snowmobiles on a practice mission to secure an airfield. Wearing an enormous pair of whitish gloves made from the fur of a polar bear, she served as a sort of Delphic oracle for whether the expeditioners had a chance of returning with their limbs intact.

“He needs to pull up that collar,” she muttered, nodding at one soldier whose fleece-lined hoodie had dropped to expose the top of his wool hat.

As the line of snowmobiles took off, the soldiers performed a constant stream of “lookbacks” to make sure they had not lost the person following behind in the blinding snow.

Ranger Debbie Iqaluk inspecting the gear of soldiers heading out on snowmobiles and assessing their chances of returning with their limbs intact.CreditAndrew Testa for The New York Times

A map of the Arctic at the Inuvik airport. Russia is far ahead of North America when it comes to maneuvering in the region.CreditAndrew Testa for The New York Times

At least 80 soldiers examined during the exercises by Wendy Sullivan-Kwantes, a scientist, developed frostbite, mostly around their hands, feet and ears. She attributed the problem to heavy-duty mittens provided by the Canadian military that, while warm, did not allow for dexterity. Soldiers who needed to repair damaged snowmobiles, or even light a fire, had to take their mittens off.

“Many people are spending their own money to get better mitts,” Ms. Sullivan-Kwantes said.

Two days later and about 870 miles away, some of the military exercise’s participants were in Tuktoyaktuk, Canada, showing their mettle by ice diving into the partly frozen Arctic Ocean. The proposition was so breathtakingly heart attack-inducing that the Canadian hosts decided to dare visiting dignitaries sponsored by the Atlantic alliance to take part.

First, the semiprofessionals — Finnish, Swedish, Norwegian and Canadian naval divers — demonstrated how to don so-called dry suits, carrying air tanks on their backs and connected to safety ropes.

Watching the divers Janne Luukimen of Finland and Chris Trufal of Canada slide below the ice and into the frigid water underneath was almost calming; the two were pictures of gritty determination. There was no yelling, just methodical equipment checks followed by no-ripple entries into the sea, where they disappeared beneath the ice.

Not so the visiting V.I.P.s, who put their names in a hat. Three were picked for 10-second plunges into the sea: Chief Warrant Officer Dominique Geoffroy of Canada, Col. Jacques Roussell of France and Lt. Col. James Kerr of Australia. (Australia is not in the alliance but acts as if it is.)

As everyone else huddled in parkas, mittens and boots, yelling encouragement, the three men, clad in boxers and briefs, strutted onto the ice, where they were to jump in and count to 10 out loud. Only upon arriving at 10 would they be pulled out with a rope.

Mr. Geoffroy and Colonel Roussell acquitted themselves passably with a few shouts and a lot of gasping, and got to 10.

Colonel Kerr got there, too, but the route he took was shorter. “One! Two! Three!” he bellowed, using an expletive. “Four, eight, nine, 10!”

In Tuktoyaktuk, Canada, about 870 miles away from Resolute Bay, troops preparing to dive into the partly frozen Arctic Ocean.CreditAndrew Testa for The New York Times

US-China Trade Talks and American Strategy

The United States is shifting from military to economic warfare.

By George Friedman


As the U.S. continues to negotiate a trade deal with China, a shift in American global strategy has emerged. The United States is reducing its use of direct military action and instead using economic pressure to drive countries like China, Russia, North Korea and Iran into conceding to U.S. demands. Even in places where the U.S. is still engaged militarily, such as Afghanistan, serious talks are underway for a withdrawal. It’s a shift that has been long in the making. In my book “The Next Decade,” published in 2011, six years before Donald Trump took office, I argued that the United States would reduce its military activity dramatically because it couldn’t maintain the tempo of engagement it had established over the years. I also discussed the topic in a 2018 article titled “The Trump Doctrine,” which argued that the United States would eventually be forced to scale back its foreign engagements. The use of economic power to shape behavior isn’t new; what is new is the focus on economic rather than military warfare.
An Inexperienced Power
The U.S. is a global power, engaged and exposed in many theaters. Having used its military presence in far-flung corners of the world as a symbol of its global reach and superiority, the U.S. spread itself thin and became unable to defeat even enemies whose forces and capabilities were far inferior. The classic example is Korea in 1950, where the United States had deployed an insufficient force, a result of the military drawdown. The North Koreans chose to strike, compelling the U.S. to fight for three years to a truce that left the North Korean regime intact and the boundaries roughly the same as before the war. The U.S. could not initiate war with the force it had. The North Koreans could and did.

Since World War II, the United States has been victorious in only one major conflict: Desert Storm. For 28 of the past 74 years, the U.S. has been at war in places like Korea, Vietnam, Afghanistan and Iraq but has failed to achieve victory in most cases. Neither Rome nor Britain used main force to wage wars. They relied instead on capable local powers with an interest in defeating the same enemy to do most of the fighting. They underwrote the conflicts and supplied some minimal force and material aid, but they tried always to limit their own exposure. The United States, a much younger and more inexperienced power, has consistently used its own force as the main combatant, and failed.


There is a core geopolitical reason behind the U.S. failure in these wars. The United States has fought most of its conflicts in Europe and Asia, where force deployment is a substantial logistical effort. The challenges of intercontinental logistics limit the number of troops that can be sent. More important, the moment the United States sets foot in Eurasia, it is vastly outnumbered. The U.S. has tried to overcome this challenge through technology, but as we saw in Korea, technological superiority is enough to contain the enemy but not enough to defeat it. In Vietnam and the Middle East, the United States fought dispersed forces, native to the area and therefore with better intelligence on American forces than the Americans had on them.

The U.S. failures were also due in part to the fact that no one could define what a sufficient force was, and even if they could, it would likely be much larger than what the U.S. was willing to commit to the effort. The U.S., therefore, fought long wars based on the mistaken belief that the force it was willing to supply was enough to defeat the enemy. And while the United States is outstanding in conventional war, it’s not good at occupying a country that is unwilling to be occupied.
Charting a New Path
Inevitably, the time came when the United States recognized that continuing to do what it had been doing for years and expecting a different result was insane. And so, it has developed a new path, one which Trump has followed in his dealings with several countries thus far. The first step in this new strategy is to intimidate the adversary. When that doesn’t work, threaten to carry out military action without actually doing so. The final step is to resort to economic warfare by initiating or extending sanctions or a blockade. (In some cases, Trump has used some military force to enforce sanctions but, rather than going ashore, has used the Navy as the primary vehicle of military operations.)

It’s within this context that we should view the U.S.-China trade talks. Chinese trade practices seen by Washington as establishing an unfair advantage for Chinese producers is a reasonable topic for discussion and negotiation. But such negotiations are also a powerful alternative strategy for dealing with China’s potential emergence as a global power. For Beijing, the buildup in the South China Sea is an attempt to break out of the ring of islands surrounding the sea and, therefore, undermine a geographic advantage the U.S. would have if it chose to blockade China. The U.S. wants to retain this advantage. But even more important, it also wants to retain the Western Pacific – a region from which it fought to expel Japan during World War II – as a buffer against Asia. If China broke out of the South China Sea, it could become a Pacific threat. The U.S. could prevent this from happening by committing a major military force to the region. It could also initiate an attack on the Chinese navy. But it also has a third option that requires no military commitment at all: impede the reason for China’s policy in the South China Sea in the first place – securing safe passage for Chinese exports.



China is heavily dependent on exports, which account for roughly one-fifth of its gross domestic product – possibly more given doubts over the accuracy of Chinese GDP figures. About 18 percent of Chinese exports are destined for the United States. In contrast, U.S. exports to China account for only about 0.5 percent of U.S. GDP. This is classic asymmetric warfare. China is far more dependent on its exports to the United States than the United States is on exports to China. Certainly, some Americans will be hurt by a trade war, but the U.S. as a whole is much less vulnerable than China is. The U.S. has therefore found a way to threaten vital Chinese interests without threatening war (though it also has some forces located near the South China Sea).

The U.S. has applied a similar approach to Iran, whose expansion throughout the Middle East is a concern for the U.S. and its allies. It’s questionable whether military action against Iran would succeed, so the U.S. has resorted to economic warfare here, too. It pulled out of the nuclear deal and imposed sanctions on Iranian energy exports that have hurt the Iranian economy. As for North Korea, the United States, in concert with the United Nations, introduced strict sanctions to try to limit Pyongyang’s nuclear program. It even seized a North Korean cargo ship last week that allegedly was used to violate sanctions. Similarly, the U.S. has accepted that it can do little militarily in eastern Ukraine or Crimea, but it has organized painful sanctions against Russia and made clear that additional sanctions are possible.

The U.S. is the world’s largest military power, but it is also the world’s largest economy and importer. For the most part, U.S. military engagements over the past 74 years have not ended well, but the use of economic warfare, which takes advantage of the fact that China and other countries are heavily dependent on the U.S. market, gives Washington an alternative to the military option.

It is not clear whether Trump will continue to use this approach, but thus far he has done so. As I have argued elsewhere, political leaders’ actions are shaped by geopolitical reality. The geopolitical reality of our time is that economic action has emerged as a major foreign policy tool of the United States.

Succession questions

Mario Draghi’s successor at the ECB has plenty to do

The ECB has come into its own, but 2019 will still be a momentous year

THE HEADQUARTERS of the European Central Bank (ECB) tower over the river Main. The institution has been equally imposing in the life of Europe’s monetary union. As its only policymaker, it rescued the euro from financial and sovereign-debt crises, and powered a recovery in 2015-17.

But it cannot rest on its laurels. This year promises to be one of high drama. Three of its six-strong executive board will depart, notably its president, Mario Draghi, and its chief economist, Peter Praet (see graphic). By the end of the year eight of the 19 national central-bank governors on its rate-setting body will have stepped down. The end of Mr Draghi’s eight-year tenure coincides with European elections and the top jobs in Brussels coming up for grabs. That makes the choice to replace him unusually political. Should their quest for the commission or council presidencies fail, the French or Germans could seek to put a compatriot—or in the Germans’ case another hawkish northerner—into the ECB job as a consolation prize.

All this could alter the course of monetary policy. Poor choices could mean blunders in dealing with a slowing economy or too-low inflation. The bank’s hard-won credibility as the guardian of the euro could come under threat.

The ECB was set up in 1998, a central bank without a fiscal counterpart. To soothe German fears that it would go too easy on inflation, it was based in Frankfurt and modelled on the Bundesbank. Its intellectual direction came from its chief economist, Otmar Issing, a former Bundesbank rate-setter. Like other central banks, it targeted inflation. But to appease the Germans, it also concerned itself with the rate of money-supply growth.

Two decades on, the Bundesbank’s influence has waned. The ECB focuses less on the money supply, after its link with inflation proved wildly unstable. Philip Lane, a doveish Irishman, takes over as chief economist in June. Neither the economic nor monetary-policy areas is overseen by a German staff member.

To see why the choice of successor for Mr Draghi is so important, consider what he has done—and left undone. Observers are gushing: one compares him to Cincinnatus, a loyal citizen who saved the Roman republic from invasion. His open-minded pursuit of price stability led to the use of unconventional tools such as quantitative easing (QE) to stave off deflation, despite northern members’ horror of monetising government debt. Like other central banks, the ECB has gained bank-supervision and macroprudential powers since the crisis.

Fittingly for a governor who sees communication as central to his role, his biggest policy intervention was uttered but not implemented. In 2012 he said he would do “whatever it takes” to save the euro, promising to buy unlimited amounts of government bonds if sovereigns hit trouble. The ECB’s communications compare well with those of other big central banks, says Marcel Fratzscher, a former staffer now at DIW, a think-tank. Recent policy shifts have caused remarkably little market volatility, unlike some by the Federal Reserve.

The next boss, though, will need to overhaul the bank’s monetary-policy strategy. Mr Draghi seems almost certain to depart having never raised interest rates; price pressures and inflation expectations, currently subdued, are likely still to be well below target. An economic slowdown kiboshed rate rises this year: on April 10th the bank promised to keep them on hold in 2019. They are already at rock-bottom levels, and the bank has bought €2.6trn ($3trn) of government bonds. Should the slowdown worsen, the new boss will have to find the firepower to reassure markets.

The ECB’s independence is a matter of international law. EU members must all agree to any changes to its mandate. But another risk defies any attempt to legislate: that of politicised appointments to its governing council. National central-bank governors are often picked for reasons of domestic politics. The march of populism across the continent complicates matters. Austria’s incoming central-bank boss has no monetary-policy experience and is reportedly linked to the FPö, a hard-right party. Italy’s populists want to “reboot” their central bank’s management.

Such appointments could exacerbate divisions among the governing council, which tend to be along national lines. It must set policy for the euro zone as a whole. But some members still play to domestic audiences. Take the decisions to announce outright monetary transactions (OMTs) that backed up Mr Draghi’s “whatever it takes” commitment, and to begin QE. Both were attacked by some northern central-bank governors and faced legal challenge in Germany. Jens Weidmann, the head of the Bundesbank and a possible successor to Mr Draghi, testified against OMTs.

One interpretation of a ruling on QE by the European Court of Justice in 2018 is that the ECB has room to raise self-imposed limits on the share of government bonds it can buy in each member country. But heightened national divisions would make it harder to build support in the governing council. It might not help that, according to the Eurobarometer poll, public trust in the bank is far below pre-crisis levels both in countries like Spain and Greece, where the ECB is regarded by some as partly to blame for austerity, and in Germany, no fan of low interest rates and bond-buying.

As the ECB gains powers, clashes with politicians become more likely. It now oversees large lenders, in which governments also take a keen interest. Last year, under pressure from the European Parliament, its supervisory arm toned down a plan to ask banks to make more provisions for non-performing loans. It also withdrew a request for new powers to centralise the regulation of clearing houses. Governments had sought to narrow their scope; the bank says that threatened its ability to conduct independent monetary policy.

The ECB keeps banking supervision and monetary policy quite separate. But the president will set the tone of its response to political pressure, argues Sir Paul Tucker, a former deputy governor of the Bank of England who has written a book on the power of central banks in democracies. And Mr Draghi’s successor will need great skill to nudge governments to speed up fiscal and banking reforms, he says, to avoid monetary policy being the only game in town.

That person will have to direct the bank’s efforts to return inflation to target, and perhaps deal with a recession, while balancing competing political interests. If its only functioning economic institution stumbles, so too will the euro zone.

Bruised Retailers Face More Pain

Retail stocks, already down on tariff worries, could be hit further this week as retailers begin reporting earnings

By Michael Wursthorn

Macy’s reports quarterly earnings this week. Like other retailers, it must decide how to respond to increased tariffs on goods from China. Photo: paul j. richards/Agence France-Presse/Getty Images

Shares of retailers, buffeted by rising trade tensions in recent sessions, face a key test this week when Macy’s Inc., M -0.87%▲ Walmart Inc. WMT +0.00%▲ and others begin reporting quarterly earnings.

The S&P 500 Retailing index fell another 3.2% Monday, extending last week’s 3% slide after President Trump pushed ahead with tariff increases on billions of dollars of Chinese imports. That outpaced the broader S&P 500’s 2.4% decline Monday, as shares of Macy’s, J.C. Penney Co. JCP -2.38%▲ , Best Buy Co. BBY +0.21%▲ and Ralph Lauren Corp. all fell more than 3%.

The slides could worsen later this week once retailers begin reporting earnings, analysts said.

Investors will want details on how merchants plan to absorb 25% tariffs on more than $40 billion of goods that are imported from China and directly purchased by U.S. consumers. Macy’s and Walmart are among the first to release results, with reports due Wednesday and Thursday, respectively.

The tariffs, which took effect Friday, hit clothing, luggage, handbags and furniture, among other consumer products. And retailers have few options: They can absorb the added costs themselves, spread them across their vendors or pass them on to customers.

None of those options is particularly attractive, analysts said, and retailers’ pain could signal broader implications for the U.S. economy. Initial estimates project the additional tariffs will shave 0.3% from U.S. growth this year.

“When this tariff conversation started last year, retailers were in a stronger position,” said Simeon Siegel, a senior retail analyst at Instinet. At the time, economic conditions were better and retailers were cutting back on inventories. “But now, things have normalized, inventories are up again and retailers can’t really raise prices,” Mr. Siegel said.

Profit margins are already under pressure, as companies such as Walmart and Target Corp. TGT -0.39%▲ have been spending heavily on upgrading their digital capabilities and remodeling their stores. Absorbing higher tariff-related costs would further stifle margin expansion, analysts said.

In the previous earnings-reporting season, both companies reported slimmer profit margins, but results were upbeat overall, helping to send their shares higher. Walmart’s stock remains up 7.2% this year, while shares of Target have added 8.5%.

Consumer-discretionary stocks, excluding internet retailers, are expected to log a 5.2% contraction in first-quarter profit margins from a year earlier, according to data compiled by Credit Suisse. Margins among consumer-staples companies, which include Walmart, are expected to shrink 5.8%.

That could lead retailers to raise prices in an effort to protect their margins, analysts said, but companies run the risk of stifling revenue if customers pull back on spending. Consumers’ pockets appear relatively healthy thanks to a tight labor market and rising wages. But retail spending has been mixed in recent months following a weak holiday sales season, a sluggish February and a rebound in March, according to Commerce Department data.

With a 25% tariff on apparel items, retailers would have to raise prices by 2.3% to maintain their gross margins, according to analysts at Bank of America. If they can’t raise prices, analysts say the tariffs could compress retail earnings by 39% this year.

Some companies have been trying to insulate themselves from the U.S. and China trade spat, which could soften the blow of tariffs, analysts said. Several companies have been shifting production from China to other Southeast Asian countries in recent years. Others had been rushing goods over from China, ahead of the tariffs, Credit Suisse’s retail analysts wrote in a note recently.

Even if the fallout isn’t as bad as expected, the market has reacted harshly to the idea of tariffs. Last year’s volatility was spurred, in part, by President Trump’s protectionist policies. And the S&P 500’s 2.2% slide last week—its biggest weekly loss of the year—came after President Trump’s initial threat to raise the levies on Chinese imports.

The S&P 500 took another leg down Monday after China retaliated Monday by raising tariffs on about $60 billion of U.S. goods, falling 2.4% for its biggest daily decline since Jan. 3. As long as tariffs remain in place, investors’ doubts alone could be enough to drag retail-stock prices even lower.

“The fear of global trade…deteriorating amid macro fears during previous U.S./China escalations” had the biggest impact on stocks over the past six months, Credit Suisse analysts said, even though costs didn’t drastically increase.

Investors wrongfooted by downturn at emerging Asian economies

Some analysts expect the headwinds facing the region to last for some time

Jonathan Wheatley in London

Analysts expect the Indonesian central bank to join the rate-cutting club by the end of the year © Bloomberg

The engines of the world economy are sputtering. Last week the central banks of Malaysia and the Philippines cut their interest rates, to the surprise of many observers. Indonesia, which begins a two-day policy meeting on Wednesday, is expected to stay on hold. But, increasingly, analysts expect the central bank to join the rate-cutting club by the end of this year.

This is not what many investors expected from emerging Asia, often seen as one of the few parts of the world able to deliver solid and sustainable economic growth.

Capital Economics, a consultancy, blamed a “sharp slowdown” in Malaysian growth and “underwhelming” growth in the Philippines, along with benign inflation, for last week’s rate cuts. It said its proprietary growth tracker also pointed to a sharp slowdown in Indonesian output in the last quarter of 2018, and saw gross domestic product growth slowing further this year.

Adam Wolfe at Absolute Strategy Research, a consultancy, expects the headwinds facing the region’s economies to last for some time. “You still have significant drag from [negative] global export growth and we haven’t seen the bottom yet,” he said.

Widely followed data on world trade volumes from CPB of the Netherlands show that global exports, on a rolling three-month basis, began contracting in December and were down more than 2 per cent in February, the most recent month of data.

ASR’s proprietary leading indicator for Asia ex-Japan, meanwhile, has just turned negative for the first time in more than three years. Industrial production in the region, too, has taken a downward turn in recent months, to its lowest level in more than a decade.

Mr Wolfe says the semiconductor cycle is especially problematic, as the industry awaits the roll-out of 5G mobile internet technology. “Until semiconductor prices firm up and feed into the electronics supply chain, it is hard to see a pick-up in regional growth,” he said.

China’s economy has a dominant influence. Steel production there, Mr Wolfe notes, has been propping up economies in the rest of emerging Asia but has slowed significantly this year.

“If that were to turn over, it would point to further downside risk,” he said. Such concerns are fed by weak housing demand in China, and limits on the ability of Chinese local governments to raise finance for infrastructure investment, he added.

Others say fears of a regional downturn have been exaggerated. Sergi Lanau of the Institute of International Finance expects Chinese growth to stabilise around its current level and for other countries to keep up a healthy clip.

“Unless you think the world is really going to deglobalise and Asia won’t be central to the supply chain any more, I don’t see why that picture would change in the next four or five years,” he said.