Private equity plays risky game of musical chairs

Cash-rich firms increasingly buy from each other but debt could threaten some deals

Javier Espinoza in London


© Getty


Lorraine Kelly has been going to the Gala bingo hall in Stratford most weekends for the past two decades. Even though the east London business has changed hands multiple times over that period, she says the place has stayed largely the same.

“Sometimes you get free passes to come and play when new owners take over and that encourages you to play more,” says Ms Kelly, who once won £1,000 in a single evening of bingo.

While the customers might not have seen much change, the same cannot be said for the business model. Gala, which merged with rival Coral in 2005, was at the epicentre of one of Europe’s least successful and controversial leveraged buyouts as it was passed around private equity firms in a financial game of pass the parcel that lasted over a decade.

Successive owners would pay themselves high dividends, aided by easy financing, before selling to the next private equity house. In total, Gala was bought and sold five times by different firms from 2002 to 2015. Through the whole process, the levels of debt the business carried, measured as a multiple of its earnings, kept creeping up.

The business performed well in the decade up to 2008, with strong sales growth and aggressive expansion. But Gala’s former private equity owners spent much of the past decade in retreat, cutting back on shops and laying off staff, after they were nearly overwhelmed by a toxic mix of tough market conditions and high levels of borrowing.

Chart showing value and number of sales from private equity firm to another


Over time, the debt burden became unsustainable. Gala Coral nearly went bust, before the business was eventually acquired by rival Ladbrokes in 2016, which in turn was bought by GVC Holdings earlier this year.

The Gala Coral story might have proved a salutary experience about the risks of such pass-the-parcel dealmaking. However, the opposite has been the case. Last year, the industry did a record 576 so-called secondary deals, when a company or a stake in a company is sold by one private equity firm to another, according to Preqin, the data provider. That compares with 394 such transactions in the peak of the deal boom in 2007, just before the financial crisis.

Private equity advisers are increasingly worried that the sector could see a repeat of Gala Coral’s experience as interest rates start to rise, increasing debt payments and raising the chance of a recession.

Secondary deals can often be more vulnerable when conditions change, either because they have higher debt levels or because more money has already been taken out of the business by previous owners.

A recent analysis of the performance of 2,137 companies owned by 121 PE firms by Saïd Business School at Oxford university showed that secondary transactions have lower returns than other deals when done by a firm that is under pressure to deploy capital.

Some executives liken the situation to a form of private equity “musical chairs”, where firms are exposed when the market turns against them.

“Every time a company is sold between private equity funds there is a risk that you are taking off some of the potential upside as the business may have been optimised through acquisitions or operational improvements,” says Neel Sachdev, a leveraged finance partner at the law firm Kirkland & Ellis, which advised Apollo in acquiring the debt of Gala Coral in 2009. “So there may be less potential upside every time you pass it on.”

Mr Sachdev adds: “The risk is really that there is not that much juice in the lemon to squeeze.”

Gala Coral is not the only secondary buyout where private equity groups ran out of juice to squeeze. In the US, mattress maker Simmons Bedding, which was bought and sold by private equity owners seven times in 20 years, filed for Chapter 11 bankruptcy protection in 2009 and more than 25 per cent of the workforce was laid off. Still, its former owners, which included Thomas H Lee Partners, made a profit of $750m through special dividends, according to a New York Times investigation. In Europe, Phones4U, the British mobile phone retailer, collapsed in 2014 after eight years in private equity hands.

Recent examples of pass-the-parcel deals include Cinven’s acquisition this year of laundry services business JLA from peer HG Capital, and KKR’s sale of roses supplier AfriFlora to Sun European Partners last year.

“Buyout groups like secondaries because they are buying an asset from a peer and it feels like there is not much work to do,” says Per Stromberg, a professor of finance and private equity at the Swedish House of Finance, a research centre. “But often this leads to them paying too much.

”Secondary deals often increase the incentives for private equity owners to load more debt on to a business. “If you buy a company that has been improved by one or two previous private equity owners and if there is not much to do to improve it, then one way to get returns up is to add more leverage to it,” he says.

Defenders of pass-the-parcel deals argue that the demise of Gala Coral and others under multiple private equity ownership was merely bad luck as conditions in their industries quickly deteriorated.Gala and Coral: A marathon of dealmaking


 
Paul Dolman, a partner at London-based law firm Travers Smith, who estimates that he has worked on approximately 60 pass-the-parcel transactions in the past 15 years, argues that secondary deals are not necessarily to blame if things go wrong.

“The key is to work out why the house is selling. If it is because they are under pressure to return money to investors, then you can understand that is a credible reason,” he says. “If it is because they think the market is about to turn and they have sweated the asset as much as they can, then that is clearly not a good reason.”

Supporters of such deals argue that buyout groups bring much-needed injections of capital to fund the growth of a business through acquisitions or expansion. They also point to successful transactions, including vehicle leaser Zenith, which has been owned by four different private equity owners and has returned strong results. In Zenith’s case, one of the owners tripled its initial investment before successfully selling to the next private equity house.

Secondary buyouts, they argue, are part of the evolution of an industry that owns more and more companies and is awash with cash to deploy on deals. Buying the businesses already owned by other private equity firms has become an attractive way to invest their funds, especially as these firms also face growing competition from corporations hungry to find new assets.

Such deals were largely non-existent at the start of the century. The Gala Coral saga offers an extreme example of how they can sometimes go sour in a short period of time.

Private equity buyers were first lured into the leisure industry in the early 2000s by the growing popularity of gambling and a relaxation in advertising restrictions.

Before the merger with Gala, Coral itself was passed around three times between financial sponsors from the late 1990s until it was sold for a fourth time to a group of private equity buyers that included Candover and Cinven in 2003. The deal was largely financed with debt and the valuation was £1.3bn or close to 9 times earnings before interest, tax, depreciation and amortisation. Among private equity deals, a price of more than 10 times ebitda is considered high.

Business was booming and the new owners went on an expansion drive. Two years later, the buyout houses returned £275m to shareholders — the equivalent of seven times the company’s debt.

Coral’s owners had banked on the British authorities further relaxing rules on advertising around gambling, and longer opening hours. Their assumptions turned out to be optimistic, while a smoking ban also damaged the prospects in an industry where many of the customers had enjoyed a cigarette during their game of bingo.


Lionel Assant of Blackstone © Bloomberg


Despite speculation about tougher regulations, the interest from private equity firms showed no signs of diminishing.

In 2005 a new private equity owner, Permira, bought a 30 per cent stake, valuing the business at 15.1 times ebitda and with debt at 9.75 times ebitda. The new owners went on a hunt for acquisitions, leading to the merger of Gala and Coral. The business was further loaded with debt. For the next two years, the company’s revenues grew in the high single digits.

But then came the financial crisis and a period of anaemic growth. By the end of 2008, the equity value of Gala Coral had been written down to zero by Candover, Cinven and Permira. Buyout groups Apollo, Cerberus and other specialist lenders spotted an opportunity and started buying up its debt at significant discounts — later becoming the company’s main creditors. Eventually, the private equity backers of the company lost ownership to the lenders and Coral and Gala demerged in 2015. Both now owned by GVC, the businesses trade separately.

The high debt levels were key to Gala Coral’s travails. Sebastien Canderle, author of The Debt Trap, a book on how leverage affects the performance of private equity deals, writes that “what brought Gala to the brink of bankruptcy was . . . [that it was] absurdly overleveraged compared to its peers”. While the other large companies in the sector suffered in the period after the financial crisis, none faced the risk of default or administration. “As Gala’s competitors demonstrated, without that much debt laden on the balance sheet the business would not have needed a financial restructuring.”

The private equity industry is now in overdrive, buoyed by record fundraisings. However, some senior figures in the industry say they are shying away from secondary transactions.

Lionel Assant, the European head of private equity at Blackstone, said only 1 per cent of global deals represent secondary transactions because of concerns that they may deliver meagre returns. One of the exceptions: earlier this year, Blackstone bought Averys, a maker of tracking and storage solutions for warehouses, from rival Equistone.

“If the economy slows a bit, the multiples contract and I think investors are going to have very average returns . . . especially on secondary deals,” he says. “The idea that because you can lever up a business at six or even seven times ebitda today at a very cheap cost of debt and that you’re going to re-lever with cheap cost of debt in five years from now is obviously ludicrous.”

What he calls “the musical chairs game”, where private equity firms do some “quick flips”, could continue for a few years if there is no recession but, he adds: “We don’t want to be in this game.”

Joana Rocha Scaff, head of European private equity at the investment management firm Neuberger Berman, warns that dealmakers are underestimating the risks of debt-heavy structures that come with secondary buyouts.

“When rates rise, pay attention because it may put significant liquidity pressures on these firms,” she says. “In some cases liquidity is not being fully understood. People are putting a great amount of focus on the capital structure. But where is the cash?”

However, few experts predict that these deals will stop any time soon. Ludovic Phalippou, a finance professor at Saïd Business School, predicts an increase in pass-the-parcel transactions. “These deals will accelerate because private equity guys have a lot of dry powder [unspent capital] and they have to keep deploying it,” he says.

Deals are becoming bigger and more expensive

Private equity groups have never had it so good: they are raising record amounts of cash at the fastest pace in a decade. Dry powder, the industry’s lingo for committed but unspent cash on deals, is now at $1.7tn and growing.

But such a large volume of funds also brings its own pressure to deploy the capital. This, in turn, has led to a string of deals with the sorts of valuations and debt levels that were seen just before the financial crisis.

This month, the UK schools group Cognita was sold in a £2bn deal that valued the business at 26 times earnings before interest, tax, depreciation and amortisation as of August 2018, according to people with direct knowledge of the transaction. Last year, Nets, a Danish payments group, was sold in a deal with more than seven times debt as a proportion of ebitda.

Deals are also getting bigger. Blackstone staged the largest leveraged buyout since the crisis with the acquisition this year of the financial terminals and data unit of Thomson Reuters in a $20bn deal. With Singapore’s sovereign wealth fund GIC, Carlyle bought Akzo Nobel’s speciality chemicals unit this year for €10.1bn, including debt — its largest ever deal in Europe.

“Private equity groups are having to become more creative,” says an adviser to large buyout groups in London. He expects to see more public companies being bought by private equity or carve-outs of large conglomerates also going private.

In such a giddy market, executives say it is important to stick to basic principles. “In a competitive market, it’s even more important to retain a disciplined focus and look for companies which will continue to grow and perform over time,” says Nikos Stathopoulos, a partner at BC Partners. “We don’t look for one-trick ponies.”


Investors Should Call Italy’s Bluff

As long as most Italians support the euro, market turmoil in Italy looks likely to pass

By Jon Sindreu




Italy’s antiestablishment government is now on a collision course with the European Union. Investors should probably call its bluff and buy Italian assets.

On Friday, Italian 10-year government bond yields rose to 3.2% and spreads over German yields widened sharply. Shares in Italian banks led losses across Europe: UniCredit, the country’s biggest bank, was down almost 8%. This was after Italian officials agreed late Thursday to triple the estimated budget deficit for next year to 2.4% of gross domestic product, defying EU demands to rein in spending.

But investors should focus less on Italy’s budget deficits and more on its voters’ support for the euro.

The eurozone is an anomaly among sovereign borrowers. While each nation still issues its own debt, all 19 of them share the European Central Bank. Between 2010 and 2012, fears that Italy, Spain or Portugal would be kicked out of the bloc led spreads on their debt to balloon. They narrowed again when ECB President Mario Draghi promised to do “whatever it takes” to save the euro. 

The lesson here: Most of what those spreads are measuring isn’t the risk of default, as in the corporate-bond market, but the fear of a country leaving the eurozone, which would likely mean investors getting paid back in Italian lira or Spanish pesetas. This summer’s ructions in Italy reinforced the point. Italian spreads only jumped on the news that parties in the new government had drafted secret plans in which they considered exiting the euro.


Public debt in Portugal and Spain remains gigantic, and investors don’t seem to mind. They shouldn’t: As long as the eurozone doesn’t break up, sovereign debts will be paid back.

Investors who bet on this back in 2012, or after the Greek crisis in 2015, have amassed large gains. The eurozone as a whole is no different to the U.S. or the U.K., where governments can always print money to pay back creditors. 


Italian Interior Minister Matteo Salvini speaks during a press conference in Tunisia on Sept. 27. Photo: fethi belaid/Agence France-Presse/Getty Images


Of course, the Italian government might secretly want to be kicked out of the eurozone, and defying European officials could be the first step toward that goal. But a 2.4% deficit—still below the EU’s 3% rule—is unlikely to be the start of an all-out political war.

Moreover, about 59% of Italians support the common currency, eurozone official surveys show—the lowest in the bloc, but still a clear majority. Even the painful budget cuts that the EU imposed on Greece weren’t enough to energize support for ditching the euro there.

Until support for the euro crumbles, here’s a rule of thumb for longer-term investors: If any eurozone bonds yield much more than Germany’s, buy them.


Batteries Make the World Go Round

By Xander Snyder

 

Summary

Some innovations disrupt industries. Others disrupt the world. Gunpowder, the internal combustion engine, the microchip, the internet – these are all innovations that changed what it meant for a state to be secure and, therefore, what interests the state must pursue. Many have guessed, but it’s impossible to know what the next revolutionary, world-disrupting technology will be. But we can nevertheless look at how advancements in existing technologies are creating new industries and doing things like modifying states’ military capabilities. As technology progresses, and as costs come down, new applications emerge that can generate demand for inputs that were previously mostly ignored.
One technology that is progressing with global implications is energy storage, specifically electrochemical batteries, which store energy chemically and transform it into electricity via chemical reactions. The increasing energy density of new batteries, greater lifecycles and ability to recharge mean that batteries can be used to power new devices and for longer periods. Lithium-ion batteries, for example, have become the industry standard for consumer electronics of all types and are being adopted by the electric vehicle industry. Better batteries also enable the wider adoption of new types of energy generation, such as wind and solar, by providing a way for round-the-clock use of electricity that is generated only at certain times of the day.
The states with the best batteries will have a comparative advantage in commerce and on the battlefield. Securing supply chains critical to the production of batteries, therefore, will become an increasingly strategic concern for countries in the years to come – much like oil supplies today. And that means ensuring that all inputs of production are available in sufficient quantities to produce enough batteries to meet a state’s strategic needs.
This Deep Dive will investigate the current state of one of the most promising battery types right now, lithium-ion batteries, and how the need for cobalt in those batteries’ production in the coming years is increasing foreign powers’ strategic focus on the country with the most cobalt reserves and greatest production, the Democratic Republic of Congo. China has a sizable advantage right now in the cultivation of links to the DRC’s mines, while the U.S. is gradually turning its attention to the search for alternatives. More broadly, we will lay out a framework for thinking about technological advancement in geopolitical terms: By focusing on critical components and where they are located, we can get a sense for where future zones of competition can emerge and which technologies governments will focus their investment on.
 
Not Just Your Smartphone Battery
Lithium-ion batteries are being used in more and more ways because they solve a lot of energy storage problems. They can store and discharge more energy per mass than other older batteries like lead-acid or nickel metal hydride, and they have a slower self-discharge rate (i.e., how much of its charge the battery loses on its own without usage). These properties have made lithium-ion batteries ubiquitous in smartphones and other small consumer electronic devices that require frequent charging and are intended to have a relatively long life expectancy.
Lithium-ion batteries are also becoming the standard battery in electric vehicles. Though lithium-ion-powered EVs still cannot quite match the range of gas-powered vehicles, they are getting close – a Tesla Model S with an upgraded battery can travel 335 miles (540 kilometers) on a single charge, among the longest travel ranges for any electric vehicle – even if EVs with the longest mileage are far more expensive than their gas-fueled equivalents. As the EV market pushes demand for lithium-ion batteries higher, their energy density has been increasing while the cost of production has been falling. The University of California, Berkeley estimates that the price for an EV-designed lithium-ion battery in 2016 was about $150 per kilowatt-hour – compared to over $400 a decade ago. And as the cost of lithium-ion batteries falls, they become more competitive with similar batteries and thus become viable alternatives. Advancements that lead to smaller lithium-ion batteries will also increase their potential use cases.

Broader adoption, however, has implications well beyond the world of consumer electronics and electric vehicles and into national defense. In his 2009 book “The Next 100 Years,” GPF founder George Friedman pointed out that as infantry becomes increasingly mechanized and reliant on portable electronic devices, there will develop a growing strategic need to deliver electricity to the battlefield and forward bases. This trend is already developing: In 2004, a typical NATO soldier deployed in Iraq consumed approximately 500 watt-hours during a 72-hour mission. Today, that same dismounted soldier would consume twice as much electricity. Here, too, the effect of innovation in lithium-ion battery technology is being felt. In this case, lithium-ion batteries have three major advantages over existing battery tech used by soldiers in the field. First, they are rechargeable. (In 2015, NATO said dismounted soldiers needed to carry seven different batteries, which weren’t rechargeable and therefore needed to be replaced.) Second, they last longer than traditional lead-acid batteries. And third, they are lighter than other battery types that can deliver the same quantity of energy.
Another immediate application for lithium-ion batteries is enabling longer periods of what’s called “silent watch.” Often soldiers will be stationed for long periods in a vehicle with its engine turned off to keep watch over an area. Silent watch requires vehicles to power sensors and communication suites without the engine running. Lead-acid batteries, which have been standard, provide for only about four hours of silent watch, at which point the outpost must turn its engine on to power the generator, revealing its position. Lithium-ion batteries could extend this time to 12 hours, providing for all-night silent watches.
Reducing the strain on mechanized infantry and enabling longer silent watches may not seem like huge leaps in capabilities, but in war, supply and logistics are everything, and these advantages would reduce the logistical burden and improve forward operating capabilities. Efficient lithium-ion batteries can decrease the need for constant resupply of other types of batteries and of fuel needed for generators, since independent units could use solar and wind systems in conjunction with rechargeable batteries to provide for their electricity needs. Given that fuel often costs more than 10 times its purchase price to deliver safely to forward operating bases, this has meaningful financial benefits. It would also make it easier to station ground forces farther forward for longer periods.
There are other military use cases for more efficient batteries that go beyond minimizing supply constraints – for example, signal targeting, which is when a deployed unit uses a portable electronic system to detect and jam all frequency signaling in a given area by an adversary. The ability to disrupt an enemy’s command and control is a substantial tactical advantage. Signal targeting requires batteries, and if it’s a long mission – say, 10 or more hours – a highly efficient and, preferably, lightweight battery is needed.
Pulsed power supplies are another such use for efficient batteries. These use electricity to power applications like high-powered microwaves, electromagnetic launchers, lasers, railguns and similar devices that require a quick burst of electricity. A study by the University of Texas showed that lithium-ion batteries can make these pulsed power supplies substantially more compact, mobile and efficient. Right now, most pulse powered applications continue to rely on power supplied from the grid, which clearly limits their usefulness on a battlefield.
 
Democratic Republic of Cobalt
Though lithium-ion batteries are by no means the only new, efficient, rechargeable battery, they are one of the most promising, offering high energy density, minimal recharging memory effect (i.e., reduced longevity over time) and lower unintended discharge rates (lost charge while not in use). Among the category of lithium-ion batteries, one of the preferred types requires cobalt to be used in the cathode. (The cathode is the positively charged side of the battery; the anode is the negatively charged side. As lithium-ions flow from one side, or electrode, to the other, they emit electrons to an external circuit that powers devices.)
The problem with cobalt, however, is where it comes from. The Democratic Republic of Congo – a country not known for its political stability or ease of doing business – holds 50 percent of all cobalt reserves and provides nearly 60 percent of the global supply. From 1996 to 2003, the DRC experienced two extremely bloody civil wars, but the violence never really stopped. The second war – sometimes referred to as the Great African War because many other African countries were pulled into the fighting – is believed to have caused nearly 5.5 million deaths, making it the world’s deadliest conflict since World War II.
There are alternatives to producing lithium-ion battery cathodes with cobalt, but each has its drawbacks. For example, Daniel Abraham, a senior scientist at Argonne National Laboratory, described how cobalt can be substituted with nickel, which is cheaper. But using nickel increases the risk of a large release of oxygen – a significant fire hazard. Adding aluminum can increase the stability of a nickel cathode, but not without decreasing the cell’s capacity. To balance between these, some batteries use a combination of nickel, cobalt and aluminum, but regardless of the combination, cobalt is still the best solution for making high-capacity, efficient and stable lithium-ion batteries.
Similarly, there’s no good single substitute for the DRC when it comes to cobalt production. Though other countries have cobalt reserves, they are much smaller and more widely scattered. The remaining roughly 40 percent of production is split across several countries, with Russia, Australia, Canada and Cuba ranking as the second- through fifth-largest producers in 2017. But each of these countries produced only between about 4,000 and 5,500 metric tons of cobalt each, compared to the DRC’s nearly 65,000 metric tons.
 

As cobalt use has grown in consumer electronics, companies like Samsung and Apple have begun seeking out agreements directly with large cobalt miners, which have more oversight than smaller operations, as opposed to purchasing it on the market. This is motivated in part by companies’ desires to distance themselves from the high incidence of child labor used in mining cobalt in the DRC, especially among smaller mining companies.
But the bigger risk for these companies is that the growth in electric vehicle production could take so much cobalt off the market that it becomes difficult to source a key component of their own products. For example, though a smartphone requires only about 8 grams of cobalt, an EV battery requires 10 kilograms – more than 1,000 times as much. Research initiatives have sought to reduce the amount of cobalt needed in lithium-ion batteries, such as the nickel-cobalt-aluminum cathode, but demand for cobalt in the next 10 years is still forecast to increase significantly.
 

All of this means that, until comparable technologies can be invented to decrease the need for cobalt, the DRC will take on a more strategic role for companies and countries that depend on cobalt-based lithium-ion batteries – which is to say, every major country in the world. This is especially true as the increased production of lithium-ion batteries drives their cost down, thus increasing the number of use cases for them.
 
The China Factor
As it turns out, though, China currently controls 80 percent of the global cobalt sulfates and oxides market – the refined products needed to produce lithium-ion cathodes. China is also the largest producer of lithium-ion batteries, and Chinese battery makers have cut large deals with cobalt mining companies. Earlier this year, for instance, Chinese battery producer GEM signed a deal with Glencore to purchase one-third of its mined cobalt from 2018 through 2020. Glencore, for its part, is responsible for mining about a third of the world’s annual supply of cobalt.
The DRC is a major recipient of Chinese investment in Africa. In early 2017, China Molybdenum purchased a majority stake in the DRC’s Tenke Fungurume Mine, one of the largest deposits of cobalt and copper in the world, from a U.S.-based company for $3.8 billion. In June, China’s Citic Metal spent $560 million on a 20 percent stake in Ivanhoe Mines, which operates the Kamoa-Kakula copper mine. (Currently, about 98 percent of cobalt is mined as a byproduct of nickel and copper.) China has also invested heavily in the Sicomines copper project, a joint venture between Sinohydro, China Railway Construction Corp. and the Congolese state. The Sicomines project is perhaps the best known of the resources-for-infrastructure deals that China has made on the African continent. In exchange for a guaranteed quantity of copper and cobalt, Beijing has agreed to build transport infrastructure that would allow for easier production and export of those resources, as well as other projects such as hospitals.
There are two reasons China is spending so much money on developing mines in central Africa. The first is economic: China is hoping to become a leader in electric vehicles and, by extension, lithium-ion batteries. This accomplishes several things for China. For one, more clean vehicles work toward Beijing’s goal of reducing pollution, which it has already begun to combat with regulations restricting the number and type of cars on its roads, especially in big cities. Persistent and increasingly toxic pollution has become a political issue in China, and Beijing is aware that reducing pollution at this point would eliminate one more motivation for social unrest. China is also hoping to move up the value chain, and electric vehicles are one product it is focusing heavily on in hopes of becoming a global leader. Developing a comparative advantage – or, if it can corner the cobalt market, an exclusive advantage – would provide China with higher-paying manufacturing jobs, which would help grow its domestic consumer base. In the long run, a robust domestic EV industry could also decrease China’s dependence on imported oil.

The second reason for China’s focus on central African mines is strategic. Because modern military technology requires an increasing supply of dependable, portable electricity, the development of exclusive or near-exclusive control of one commodity required to build that power supply would be no small advantage. This is especially true given that the U.S. imports almost all of its cobalt – approximately 70 percent of all cobalt consumed in the U.S. in 2017 was imported. Economically, this makes sense, since a lot of products with lithium-ion batteries that are sold to U.S. consumers are assembled not in the U.S. but in China. Nevertheless, the demand for cobalt is growing, and the U.S. currently has little direct access to where most of it is being mined or refined. This is why the U.S. Department of the Interior in February designated cobalt, along with 34 other minerals, as critical to the economy and national security of the United States.
In terms of securing more cobalt, however, the charge in the U.S. has mainly been led by companies like Apple and Samsung. Whether the U.S. government becomes more directly involved in the competition – a race against China, where the DRC’s cobalt reserves are the prize –  will depend on a few factors: whether stable, cobalt-free batteries are invented and at what cost they can be produced, and how high the price of cobalt goes.


The price will to some extent determine whether there will be more investment in mines outside the DRC. Australia, as an example, has 17 percent of global cobalt reserves but currently produces only less than 8 percent of what the DRC does. Because most cobalt is mined as a byproduct of nickel and copper, the supply of cobalt has hitherto been determined less by its own price than by the price of these two primary metals. Should the price of cobalt go high enough, more mines may open and focus exclusively on cobalt production, which could lead countries like Australia or Russia to produce at greater levels. Still, with as much cobalt reserves as the rest of the world combined, the DRC will remain an invaluable part of the supply.
Being in a position where it is reliant on a large and dependable supply of cobalt, then, may not be a realistic proposition for the United States. Given the national security aspect of energy storage and China’s head start in controlling the cobalt market, the U.S. government in the coming years will need to invest more money in battery technologies that are not reliant on cobalt. Lithium iron phosphate, which does not utilize cobalt in cathodes, is one such example. In 2015, the U.S. Navy awarded an $80 million contract to K2 Energy Solutions to design a battery that would be “capable of powering a large modular capacitor bank for [an] electromagnetic railgun.” The U.S. Naval Research Laboratory is also researching ways to successfully and repeatedly recharge zinc batteries, which are widely used but only as single-use batteries.
Advances in technology fundamentally alter how states project power and, therefore, dictate where they must focus to secure their interests. This, in turn, can magnify the geopolitical relevance of places in the world that may not have had as much global influence as before. The Middle East and oil is just one example of this: Saudi Arabia became a focus for countries all over the world after it discovered oil in an age when all countries’ military capacities heavily depended on it.
As the world researches and discovers alternative sources of energy, storing that energy will become critical. Researching and developing alternatives to fossil fuels, delivering electricity to the battlefield and storing electricity produced by distributed generation sources such as wind or solar will become new arenas of technological, economic and military competition between states.


The Trade Wars of Codependency

Stephen S. Roach  

US and China flags

NEW HAVEN – Codependency never ends well in personal relationships. Judging by the ever-escalating trade war between the United States and China, the same is true of economic relationships.

While I published a book in 2014 on the codependent economic relationship between the US and China, I would be the first to concede that it is a stretch to generalize insights from human psychology to assess the behavior of national economies. But the similarities are striking, and the prognosis all the more compelling, as the world’s two largest economies sink into a dangerous quagmire.

In its most basic terms, codependency occurs at one of the extremes of relationship dynamics – when two partners draw more from each other than from their own inner strength. This is not a stable condition. Codependency deepens as partner feedback tends to grow in importance and self-confidence steadily diminishes as a result. The relationship becomes highly reactive and fraught, with mounting tensions. Invariably, one partner hits a limit and seeks a new source of sustenance. This leaves the other feeling scorned, steeped in denial and blame, and ultimately with a vindictive urge to lash out in response.

The case for US-China economic codependency has been compelling for many years. On the brink of collapse in the late 1970s, following the cumulative convulsions of Mao’s Great Leap Forward and Cultural Revolution, China was quick to turn to the US for external support for Deng Xiaoping’s strategy of “reform and opening up.” Meanwhile, the US, in the grips of stagflation in the late 1970s, was eager to seek new growth solutions; low-cost Chinese imports were the antidote for income-constrained American consumers.

The US also began to borrow freely from China’s vast reservoir of surplus saving – a convenient solution for the world’s largest deficit saver. Born out of innocence, this two-way dependency blossomed into a seemingly blissful marriage of convenience.

Alas, it was not a loving relationship. Deep-seated biases and resentments – China’s so-called century of humiliation following the Opium Wars of the nineteenth century and America’s inability to get out of its own skin when assessing the ideological threat posed by a socialist state like China – sustained a long-simmering distrust that set the stage for the current conflict. As the human pathology of codependency would predict, a parting of the ways eventually occurred.

China was the first to embrace change – committing to an economic rebalancing by shifting its growth model from external to internal demand, from exports and investment to private consumption. China’s progress has been mixed, but the endgame is no longer in doubt, underscored by a shift from surplus saving to saving absorption. After peaking at 52.3% in 2008, its gross domestic saving rate has fallen approximately seven percentage points and should continue to decline in the years ahead as China strengthens its long-porous social safety net, encouraging Chinese families to reduce fear-driven precautionary saving.

At the same time, an explosion of e-commerce in an increasingly digitized (that is, cashless) economy is providing a powerful platform for China’s emerging middle-class consumers. And a transformation from imported to indigenous innovation is central to China’s long-term strategy, both to avoid the “middle-income trap” and to achieve great-power status by 2050, as per President Xi Jinping’s “new era” centenary aspirations.

Consistent with the human pathology of codependency, China’s shifts have become a source of growing discomfort for the US, which can hardly be thrilled with China’s saving pivot. With America’s saving shortfall now worsening in the aftermath of last year’s poorly timed tax cuts, the US will only become more reliant on surplus savers like China to fill the void. Yet China’s move to saving absorption narrows that option.

Moreover, while China’s nascent consumer-led growth dynamic is impressive by most standards, limited market access has constrained US companies from capturing what they judge to be a fair market share of the potential bonanza. And, of course, there is enormous controversy over the innovation shift, which may well lie at the heart of the current tariff war.

Whatever the source, the conflict phase of codependency is now at hand. China is changing, or at least attempting to do so, while America is not. The US remains stuck in the time-worn mindset of a deficit saver with massive multilateral trade deficits and the need to draw freely on global surplus saving to support economic growth. From the perspective of codependency, the US now feels scorned by its once compliant partner and, predictably, is lashing out in response.

Which brings us to the burning question: Will the US-China trade conflict end with a peaceful resolution or an acrimonious divorce? The lessons from human behavior may hold the answer.

Rather than react out of blame, scorn, and distrust, both countries need to focus on rebuilding their own economic strength from within. That will require compromises on both sides – not just on the trade front, but also on the core economic strategies that both nations embrace.

The innovation dilemma is the most contentious issue by far. The conflict phase of codependency frames it as a zero-sum battle: US allegations of Chinese intellectual property theft are portrayed by the Trump administration as nothing less than an existential threat to America’s economic future. Yet, seen as a classic symptom of codependency, those fears are overblown.

Innovation is indeed the lifeblood of any country’s sustained prosperity. But it need not be depicted as a zero-sum battle. China needs to shift from imported to indigenous innovation to avoid the middle-income trap – a key stumbling block for most developing economies. The US needs to refocus on innovation to overcome yet another worrisome productivity slowdown that could lead to a corrosive stagnation.

That may well be the bottom line on the trade conflicts of codependency. The US and China both need innovation-led economies for their own purposes – in codependency terms, for their own personal growth. Transforming a zero-sum conflict of codependency into a positive-sum relationship of mutually beneficial interdependence is the only way to end this economic war before it turns into something far worse.


Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.


Saving liberal democracy from the extremes

Elites must recognise that mismanaged economies have helped to destabilise politics

Martin Wolf


Protesters in Warsaw in July, angry at what they see as an attack on the judiciary © AFP


Nothing to excess”. This motto, also known as “the golden mean”, was displayed in the ancient shrine of Delphi. Such restraint is particularly crucial for the preservation of liberal democracy, which is a fragile synthesis of personal freedom and civic action. Today, the balance between these two elements has to be regained.

Larry Diamond of Stanford University has argued that liberal democracy has four necessary and sufficient elements: free and fair elections; active participation of people, as citizens; protection of the civil and human rights of all citizens; and a rule of law that binds all citizens equally. The salient feature of the system is the restraints it imposes on the government and so on the majority: any victory is temporary.

It is easy to see why this system is so fragile. Today, that truth is, alas, not theoretical. In its 2018 report, Freedom House, a well-regarded federally funded, non-profit US organisation, stated that: “Democracy is in crisis. The values it embodies — particularly the right to choose leaders in free and fair elections, freedom of the press, and the rule of law — are under assault and in retreat globally.” This “democratic recession”, as Prof Diamond has called it, is not restricted to emerging or former communist countries, such as Hungary or Poland. The commitment to norms of liberal democracy, including the right to vote and equal rights for all citizens, is in retreat even in the established democracies, including the US. Why has this happened?

In a recent book, The People vs. Democracy, and an earlier article, Yascha Mounk of Harvard University argues that both “undemocratic liberalism” and “illiberal democracy” threaten liberal democracy. Under the former, democracy is too weak: social bonds and economic security are sacrificed on the altar of individual freedom. Under the latter, liberalism is too weak: power is captured by demagogues ruling in the name of an angry majority or at least a sizeable minority, who are told they are the “real people”. Undemocratic liberalism ends in elite rule. Illiberal democracy ends in autocratic rule.

Mr Mounk’s argument, moreover, is that undemocratic liberalism, notably economic liberalism, largely explains the rise of illiberal democracy: “vast swaths of policy have been cordoned off from democratic contestation”. He points to the role of independent central banks and to the way in which trade is governed by international agreements created by secretive negotiations carried out inside remote institutions. In the US, he also notes, unelected courts have decided many controversial social issues. In such areas as taxation, elected representatives retain formal autonomy. But the global mobility of capital restricts the freedom of politicians, reducing the effective differences between established parties of the centre-left and centre-right.

How far does such undemocratic liberalism explain illiberal democracy? The answer is: it does, up to a point.

It is surely true that the liberal economy has not delivered what was hoped, the financial crisis being a particularly severe shock. One aspect of such liberalism — migration — has, as the British writer David Goodhart argues in his book, The Road to Somewhere, persuaded many “people from somewhere” — those anchored to a place — that they are losing their countries to unwelcome outsiders. Moreover, institutions that represented the bulk of ordinary people — trade unions and left-of-centre parties — have ceased to exist or ceased to do their job. Finally, politics has been taken over by “people from anywhere” — the mobile and the highly educated.

Thomas Piketty suggests that a “Brahmin left” and a “merchant right” now dominate western politics. These groups may differ sharply from each other, but both are attached to liberalism — social, in the case of the Brahmins and economic, in the case of the merchants. The public has noticed.

A big point is that if undemocratic liberalism has gone too far for the comfort of a large portion of the voting public, that liberalism is not just economic: this is not just about neo-liberalism. Moreover, little of it has to do with overmighty international institutions, with the arguable exception of the EU. Indeed, the prosperity high-income countries desire is heavily bound up with international commerce. That, in turn, necessarily involves more than one jurisdiction. A future that does not include international co-operation on cross-border regulation or taxation will not work. This, too, has to be recognised.

A view that the economic dimension of undemocratic liberalism has driven the people towards illiberal democracy is exaggerated. What is true is that poorly managed economic liberalism helped destabilise politics. That helps explain the nationalist backlash in high-income countries.
Yet the kind of illiberal democracy we see in Hungary or Poland, which is rooted in their specific histories, is not an inevitable outcome in established democracies. It will be hard for Donald Trump to become a US version of Hungary’s Viktor Orban.

Yet we cannot just ignore the pressures. It is impossible for democracies to ignore widespread public anger and anxiety. Elites must promote a little less liberalism, show a little more respect for the ties binding citizens to one another and pay more tax. The alternative of letting a large part of the population feel disinherited is too dangerous. Is such a rebalancing conceivable?

That is the big question.