Lies, damned lies and ...

The sanctity of trade statistics

Bilateral trade flow data are misleading. But a reported tweak will not help

MIGHT Donald Trump’s promise to shake up America’s trade policy extend to its statistics?
According to a report in the Wall Street Journal, discussions are afoot on changing the way trade figures are tallied. The Bureau of Economic Analysis, the country’s main statistical body, calls this “completely inaccurate”. But in trade as elsewhere, the new administration seems prone to using statistics as a drunk uses a lamppost—for support rather than illumination.

The proposal reportedly involves stripping out some of America’s exports from the gross numbers. America sold $1.5trn of goods abroad in 2016, but of that $0.2trn were re-exports that left the country much as they had arrived. This type of trade has been growing, reflecting America’s role as a hub for North American trade. As a share of its combined exports to Mexico and Canada, re-exports rose from 12% to 20% between 2002 and 2016. Truckers and shippers benefit from this kind of trade. But critics see it as “padding”, obscuring gloomier trends in “made in America” exports.
Stripping out re-exports makes no sense when thinking about the overall trade imbalance unless a corresponding adjustment is made to imports. Taking out re-exports would shrink America’s recorded exports to countries like Mexico and Canada. Without reducing the import number, it would also puff up America’s recorded trade deficit in goods with them, by $54bn for Mexico, and $46bn for Canada (more than triple the raw balance).

So excluding re-exports from the total would provide Mr Trump with some more eye-popping figures with which to bash Mexico. A bid to tweak trade statistics need not be politically motivated, though. It could also reflect the (correct) realisation that standard measures of imports and exports do not always capture what is really being “made in America”.

Statisticians do sometimes adjust for re-exports, which can mask underlying trends. For example, they routinely strip out from Hong Kong’s figures its re-exports (a staggering $498bn-worth in 2016, compared with domestic exports of $13bn) to avoid double-counting China’s exports in world-trade totals.

Such adjustments are supposed to deal with the underlying gripe with re-exports: that they may not reflect a country’s value added. But tackling this properly involves a much deeper dig into the data. There is also foreign value added embedded in American exports, such as the Mexican parts in cars made in Michigan. The imports side is just as important. American imports from Mexico include both American value added and inputs from other countries. Accounting for all this is far more complicated than stripping out just one component.
Luckily for Mr Trump, trade geeks are on the case. Robert Johnson, a trade expert at Dartmouth College, talks of a “quiet revolution” in economists’ thinking about trade. Aware that gross trade flows do not capture where value is being created and sent, the WTO and the Organisation for Economic Co-operation and Development, a rich-country think-tank, have painstakingly constructed the very data that Mr Trump’s administration would be interested in. The latest available figures, covering 2011, suggest that foreign value added makes up 15% of the content of America’s gross exports. Overall, this is offset by a corresponding adjustment to imports. America’s overall trade balance with the rest of the world is not affected by a switch to a value-added measure.

Drilling down into bilateral trade relations, accounting for value added has big effects. But these data suggest that some might not be as large as often assumed. One commonly-cited factoid is that 40% of Mexican exports to America are embedded American content. New figures from the OECD put that figure at 14% (see chart).

That is still high enough to create a lot of American losers were America to sever trade relations. And the effect on the reported trade imbalance between America and Mexico is dramatic. Overall, however, switching to the more sophisticated value-added measure of trade flows would not provide political ammunition as powerful as ditching re-exports. On a value-added measure, the bilateral-trade imbalance between America and Mexico in 2011 was 43% smaller than the gross trade flows would suggest. The trade deficit with Canada would have become 39% smaller.

Focusing on value-added trade data is better than looking at the gross flows, but Mr Johnson questions whether the debate should focus on bilateral imbalances at all. When someone incurs a trade deficit with a bookshop and a trade surplus with his employer, neither matters in isolation—the overall balance is important. And for a country’s trade, that will be most determined by macroeconomic factors. Fiddling the figures might move the lamppost; it will still leave the future direction of trade in the dark.

The Mist Of Central Bank Balance Sheets

by: Otaviano Canuto

- Central banks of large advanced and many emerging market economies have recently gone through a period of extraordinary expansion of balance sheets and are all now possibly facing a transition.

- However, the fact that one group is comprised of global reserve issuers and the other, bystanders, receiving impacts of the former’s policies carries substantively different implications.

- Furthermore, using Brazil and the U.S. as examples, we also illustrate how the relationships between central bank and public sector balance sheets have acquired higher levels of complexity, risks and opacity.
Otaviano Canuto and Matheus Cavallari
Central banks of large advanced and many emerging market economies have recently gone through a period of extraordinary expansion of balance sheets and are all now possibly facing a transition to less abnormal times. However, the fact that one group is comprised of global reserve issuers and the other, bystanders, receiving impacts of the former's policies carries substantively different implications. Furthermore, using Brazil and the U.S. as examples, we also illustrate how the relationships between central bank and public sector balance sheets have acquired higher levels of complexity, risks and opacity.
Bloating central bank balance sheets (I): unconventional monetary policies
Since the global financial crisis hit the international economy in 2008, central banks in major advanced economies have widened their range of monetary policy instruments, increasingly resorting to unconventional tools. Initially, to avoid a deepening of the financial destabilization and bankruptcy of solvent-but-illiquid private sector balance sheets (Brahmbhatt, Canuto and Ghosh, 2010) and subsequently to fight economic stagnation and deflation risks as private agents deleveraged, the U.S. Federal Reserve Bank (Fed), the European Central Bank (ECB), Bank of England (BOE) and Bank of Japan ((BoJ)) have all - in different moments and intensities - implemented programs of massive purchases of government securities and/or private assets from markets with a simultaneous creation of bank reserves on their liabilities side ("quantitative easing" - QE). Central bank policies seemed to shift towards including financial stability as a goal (Canuto and Cavallari, 2013), while uncertainty regarding counterparty risks remained elevated. To that aim, crisis-hit economies saw broad liquidity provision to domestic banking systems through QE, with the latter evolving later on to becoming a tool to boost the efficacy of interest-rate cuts.
Together with forward guidance, debt swap programs, lines of long-term loans to banks and, more recently in the Eurozone, negative interest rate policies, such use of unconventional monetary policies led to an extraordinary expansion of their balance sheets (Chart 1 - left side) (Credit Suisse, 2017). First, central banks' balance sheets expanded by supplying reserves to assure smooth settlement of financial transactions: because of the elevated uncertainty on counterparties' solvency, banks were hoarding those reserves instead of lending in interbank markets - also as a way to self-insure. This balance sheet expansion could be seen as "liability-driven" - i.e. originated from policies aiming at central banks' liabilities. The second wave of expansion came from QE per se: policymakers bought assets to reduce long-term interest rates and shift portfolio compositions. Those asset purchases were financed by creating reserves, making this second expansion of central bank balance sheets an "asset-driven" one (Rule, 2015).
The asset composition moved from government bills only to various types of bonds and equities (Chart 1 - right side) - with differences among central banks mirroring underlying structural differences in shapes of local financial markets (weights of bank intermediation versus capital markets, shares of government bonds in private portfolios) (Rule, 2015). In the case of the Eurozone, institutional weaknesses, the fragmentation of the banking system and risks of country exits imposed additional challenges to ECB policies (Canuto, 2012).
The size and responsibilities acquired by central bank balance sheet operations also reflected an over-reliance on monetary policy to support macroeconomic recovery. Either because of an option for fiscal austerity in the Eurozone as a whole or for early pursuits of fiscal consolidation (U.S., U.K.), opportunities to resort to fiscal policy as an additional engine were left behind (Canuto, 2014a).

There are intrinsic challenges to isolate and assess the impact of QE on macroeconomic outcomes. However, most analysts agree that, besides precluding deep downward spirals of debt deflation and bankruptcy, its transmission through lower debt service, positive wealth effects and weaker currencies (Euro, Yen) contributed to an economic recovery, including by helping banking, household and corporate deleverage in countries that adopted those unconventional policies. The size acquired by central bank balance sheets was to some extent a flipside of the over-size of domestic and international private portfolios built in the run-up to the global financial crisis, the unwinding of which would have been even more disorderly otherwise. The incompleteness of such unwinding - including debt restructuring and consolidation of portfolios - helps explain the relative feebleness of recovery and the extended time horizon of unconventional monetary policies in the Eurozone (Credit Suisse, 2017).
After almost a decade since unconventional monetary policies came to unfold, a casual observer might be asking when the policy agenda will shift to exit strategies and unwinding of central bank portfolios. Indeed, the main provider of global liquidity, the Fed, is already gradually hiking interest rates, as the U.S. economy came close to full employment. In fact, two presidents of regional Federal Reserve Banks have already expressed their willingness to shrink the Fed's balance sheet.
Other major central banks may start exiting only later down the road, as further private sector deleveraging - or public debt restructuring - is still needed. However, spillovers from the first mover have already induced capital flows rebalancing. Lack of synchronization in paces of economic recovery will place additional challenges for orderly balance sheet adjustments.
There are strong reasons to believe that there will be no return to the pre-QE configuration of balance sheets (Credit Suisse, 2017). Together with the pro-recovery motivation for central bank policies, structural and regulatory factors have contributed to their balance sheet dynamics, and made central banks not just market regulators, but also "quasi-market makers." First, the increasing global financial integration in the last decades has imposed increasing challenges to make liquidity management effective as cross-border volumes of capital flows expanded significantly. Second, changes in financial regulation have induced private agents to alter their behavior and strategies.
Basel III requires banks to carry a minimum amount of high quality liquid assets, which could be met by simply holding reserves at central banks. These rules have discouraged banks from receiving short-term cash balances from institutional investors and made central banks the only remaining player able to provide liquidity services. Finally, central banks may need to accept an increasing role as funding providers, as banks are not incentivized to use short-term balances for arbitrage trades.
Thus, a new task came under the purview of central banks: monitoring relations between various benchmark curves - i.e. operating as quasi-market makers. One may expect that the "new normal" configuration of central bank balance sheets will not necessarily be as bloated as the one during recent "abnormal" times, but will not return to the pre-crisis size and profile.
Bloating central bank balance sheets (II): spillovers from abroad
As financial markets started normalizing globally in the wake of acute crisis moments, unconventional monetary policies generated a collateral effect by shifting abundant liquidity to other countries - small advanced economies and emerging market economies (EMES), mostly casual bystanders at that point (Canuto, 2013a). Until the 2013 "taper tantrum" started to affect EMEs following the Fed's first announcement of a forthcoming end of QE, liquidity excesses eventually turned into massive capital flows to those countries (Canuto, 2013b).
Capital inflows had already led to a piling up of foreign currency reserves in recipients - particularly when accompanied by high current account surpluses - prior to the global financial crisis. After a slowdown in the immediate aftermath of the crisis, those flows and the corresponding reserve accumulation returned with strength for some time, until slowing down again more recently (Chart 2) (Canuto, 2016). The intensive wave of capital flows to EMEs in between the crisis eruption and the "taper tantrum" reflected unconventional monetary policies in large advanced economies, combined with enthusiasm about what then seemed to be a steady "growth decoupling" of the former (Canuto, 2011). It is worth noticing the higher weight of short-term flows and bond purchases in the QE-influenced wave comparative to previous periods (Canuto, 2014b).
While capital inflows and reserve accumulation had already been leading to challenges faced by monetary policymakers in EMEs, these were exacerbated by the features of the QE-originated wave (Canuto and Cavallari, 2013). Even an EME not "manipulating exchange rates" - i.e. pursuing strategies of curbing domestic demand and deliberate exchange rate undervaluation (Canuto, 2017) - would not be expected to take a hands-off approach to exchange rate pressures and allow the "liquidity wave" from abroad to be fully absorbed via local currency appreciation. Therefore, accumulation of reserves with corresponding central bank balance sheet accommodation became the norm. Holding up against local currency appreciation while sterilizing monetary impacts of reserve accumulation meant expanding balance sheets of recipient EMEs - an "asset-driven" increase of the central bank balance sheet (Rule, 2015). That was a major factor behind several EMEs' central bank assets reaching proportions of GDP comparable to those of economies adopting unconventional monetary policies (Chart 3).
Chart 3
Source: International Financial Statistics, IMF
Differences in monetary policy frameworks
From the standpoint of the component of reserve balances in central bank balance sheets, unconventional policies in advanced economies shifted their banking systems from a "structural deficit" of reserve balances to a "structural surplus." EMEs in turn, by then already with a long history of surplus reserve balances - usually caused by exchange rate interventions, government financing and, sometimes, provision of assistance to unhealthy banks - had asset-driven surpluses intensified by QE (Gray and Pongsapam, 2015).
There are three basic means to sterilize monetary impacts of asset purchases - foreign assets and government or private securities - when the central banks intend to outweigh their initial effect as additions to commercial bank reserves on the liabilities side: retaining them as additional required or voluntary free reserves, fine-tuning the corresponding remuneration in the latter case; (ii) issuing central bank own securities; and (iii) using government securities held in their portfolio to make "reverse repo" operations with the private sector.
Central banks vary widely in the use of those tools. Ferreira (2016) compares the cases of Brazil (BCB), Fed, ECB, Mexico (Banxico) and Korea ((BoK)) and remarks that:
The sterilization of central bank purchases of private assets, government bonds and foreign assets was mainly done with retention of remunerated voluntary reserves (mainly Fed and ECB) and issuance of central bank own bonds (notably Korea). Fed and BCB are not legally authorized to issue own bonds (Chart 4a). Brazil is the only case where reverse repos based on government bonds were the predominant tool. Relatedly, government bonds held on the asset side by the central bank had to augment considerably in order to make feasible the ramp up of foreign asset accumulation and its sterilization. That explains the tall sizes of both foreign assets and government bonds in BCB's assets as a feature unique to Brazil in this group (Chart 4b). It also is part of the explanation of why the bloating of BCB's balance sheet took it to a size equivalent to almost 50% of Brazil's GDP, substantially taller than all other central banks in the group-see also Chart 3.
Relationships between central bank and public sector balance sheets: it's complicated!
There are multiple channels through which monetary policy and central bank balance sheets interact with government fiscal accounts and balance sheet. Bloated central bank balance sheets have magnified the weight and the complexity of that web of relations, one in which country-specific institutional features matter. Let's offer some examples.
Take for instance the unique Brazilian over-reliance on reverse repos for monetary sterilization approached in the previous item. As observed, BCB relies mainly on reverse repos to drain liquidity surpluses, being current reserve requirements considered already high. So, the monetary authority sells - with repurchase agreement - government bonds from its balance sheet, and the Treasury supplies those bonds if needed to avoid losing control of the policy rate.
That tool has an accounting implication beyond the monetary policy realm (Ferreira, 2016). It implies that Brazil's general government gross debt as measured by the International Monetary Fund (IMF) and most other analysts is higher than what would be the case if there was no single reliance on reverse repos and therefore less need to hold so huge volumes of government securities in BCB's balance sheet. The standard method to account for gross public debt is to consider all public debt in the central bank balance sheet, including even the extra buffer held to minimize the risk of losing the capacity to set the monetary policy rate. It is fair to say that this part of the gross public debt corresponding to assets held by BCB and not by markets should not be treated as a result or a component of Brazil's fiscal and public debt dynamics. Cross-country comparisons of public debt should take that into account.

Ilan Goldfajn, BCB's president, has recently declared that remunerated voluntary deposits will be added to the monetary policy toolkit in the near future, offering a remuneration equivalent to reverse repos. The stock of the latter has reached levels above 16% of GDP of last year and over time shall be partially replaced with remunerated voluntary reserves, with relevant fiscal accounting implications (Romero, 2017). By following the Fed's practice of paying interest on banking reserves, the central bank's portfolio of government bonds could be reduced. Consequently, the gross public debt, as compiled, for example, by the IMF, would be lower.
Another connecting channel between fiscal and monetary policy realms is made by occasional profits and losses incurred by central banks in their operations. That is a channel that has now, obviously, become much more significant than in the past.
An example comes from Fed's "Operation Twist" in 2011 and 2012, a debt swap program in which the Fed bought long-term Treasury bonds in the market and sold short-term Treasury bonds to flat long-term interest rates. The transaction amounted to hundreds of billion dollars.
The Fed holds these long-term bonds in its assets, where an increase of 100 basis points in interest rates of the 30-year Treasury bond would impose up to a 20-percent loss on their value.
In January 2017, the Fed's balance sheet had up to 55 percent of government securities and close to 40 percent of Asset Backed Securities (ABS) (Credit Suisse, 2017).
Despite implicit potential losses in the Fed's balance sheet, Operation Twist is directly accounted as part of U.S. gross public debt. Moreover, the Fed has profited from the difference between negative short-term real interest rates and the positive yield-to-maturity on the long-term bonds. By buying ABS and drying up the surplus of reserves, the Fed also pays interest on these reserves. This "carry trade" has been profitable for the Fed. Profits amounted to up to U$ 97.7 billion in 2015, being transferred to the U.S. Treasury in 2016 (Chart 5 - left side). However, this picture can revert dramatically as short-term interest rates rise and the yield curve steepens.
The Fed's capacity to pay interest on reserves and resort to the latter as a sterilization tool-seen in the previous item-is not an old practice. It was introduced to avoid losing control of monetary policy from the QE collateral effects (Bernanke, 2015). Hypothetically, a situation could arise that might make the Fed run out of Treasury bonds to sell in the market. However, paying interest on reserves affects central bank's profit-there is a budgetary impact-and does not require government bonds as a collateral. Therefore, the gross public debt would be higher than in the case the monetary authority had kept using reverse repos to drain liquidity excesses, such as in Brazil, creating distortions in cross-country comparisons.
Another example of this complexity - and risks and opacity - acquired by fiscal-monetary links in the era of bloated central bank balance sheets associated to central bank operational income comes from Brazil (Chart 5 - right side). Given the magnitude of foreign assets held by BCB, like some other EMEs, exchange rate oscillations often lead to significant central bank non-realized gains and losses in local currency.
In Brazil, central bank's income is legally mandated to be transferred every six months to the Treasury Single Account on the liabilities side of the BCB's balance sheet. Chart 4a exhibits how high has reached the balance in that account. According to Mendes (2016) and Ferreira (2016) to a large extent this stems from the treatment of gains and losses from non-realized results from exchange rate variations - which are accounted apart from other balance sheet items. While gains have been deposited in the Treasury Single Account, losses have been compensated with government transfers of new public bonds to the BCB's balance sheet. Over time, this has raised balances on both the Treasury Single Account (liabilities) and Treasuries (assets).

By the same token, there are challenges associated with the accounting of results from foreign currency swaps, which were intensively adopted by BCB during and after the 2013 "taper tantrum" in order to smooth local currency depreciation pressures. By design, swap results are in opposite direction to the ones from actual foreign reserves: e.g., actual exchange rate depreciations imply local currency gains with the BCB stock of foreign assets, while there is a simultaneous payment of premium on (smaller) notional values of swaps. Nonetheless, while the latter are non-realized, the former is accounted in the fiscal balance.
Final remarks
Nobel Prize Sir John R. Hicks argued that monetary systems and institutions are particular to each epoch in history. In that context, he wrote in his "Monetary Theory and History" (1967):
Monetary theory is less abstract than most economic theory; it cannot avoid a relation to reality, which in other economic theory is sometimes missing. It belongs to monetary history, in a way that economic theory does not always belong to economic history" (p.156).
Such variability and evolutionary nature of monetary systems and institutions over time also has a flipside when it comes to space. Analyses and policy choices on monetary and financial systems cannot rely simply on abstract and universal principles, and is obliged to take into account historic-specific contexts.
That historical specificity of money and finance was shown here in our approach to the two recent distinctive - but - combined types of experiences of bloating balance sheets lived by central banks.
Furthermore, we saw how variegated and country-specific the array of monetary policy tools and institutions is. On the other hand, as this recent evolution does not seem likely to be unwound and reverted, all share in common the challenge of facing new risks and complexity coming with the "new normal" of central bank balance sheets.
Otaviano Canuto is an Executive Director at the World Bank and Matheus Cavallari is a Senior Adviser to the Executive Director. All opinions expressed here are their own and do not represent those of the World Bank or of those governments Mr. Canuto represents at its Board.

A Busy Day in Geopolitics

By Kamran Bokhari

Massive geopolitical upheavals often fly under the radar.

There will be many days that are, geopolitically speaking, rather quiet. Yesterday was not one of them. Three separate but highly significant developments occurred involving the four major powers of the globe: the United States, Russia, China and Germany. Given that the three events illustrate a major step forward in our forecasts, we will use this Reality Check to examine all three rather than just one.

U.S.-Russian Cooperation

The first development involved a meeting between top military officers of the United States, Russia and Turkey. U.S. Joint Chiefs of Staff Chairman Gen. Joseph Dunford, Russian Armed Forces General Staff Chief and First Deputy Defense Minister Gen. Valery Gerasimov and Turkish General Staff Chief Gen. Hulusi Akar held a tripartite meeting in the Turkish city of Antalya. Media reports suggest the three generals sat down to discuss the impending assault on the Islamic State’s core turf in Syria, especially its capital of Raqqa. If we are to believe open-source accounts, the conversations involved the nuts and bolts of the military campaign against the jihadist regime and how different actors’ forces (both state and non-state) in the anti-IS camp can avoid stepping on each other’s toes.

Deutsche Bank Announces 2016 Financial Results
CFO Marcus Schenck, left, and CEO John Cryan of Deutsche Bank present the company’s financial results for 2016 during an annual press conference on Feb. 2, 2017 in Frankfurt, Germany. Thomas Lohnes/Getty Images

Anyone who understands the job description of the armed forces’ highest-ranking commanders from any country will easily recognize the spurious nature of such reports. Apex-level military leaders do not dwell on such minutiae, which is left to generals much lower on the totem pole. A meeting of the most senior generals is not about discussing tactical details. This meeting in Turkey – like all similar meetings – involves strategic-level discussions.

Another critical thing to bear in mind is that heads of different countries’ military establishments meet after their respective political bosses already have made a decision on joint action. In this case, that action involves the fight against the Islamic State. While the media portrayed it as a last-minute arrangement, several weeks – if not months – have been spent laying the groundwork for this meeting. Few details have surfaced on what the three generals actually talked about. It may be the case that official reports about battles in the Syrian towns of Manbij and Raqqa were designed to obfuscate a major agreement between the United States and Russia. It is also interesting that no leaks have come out yet from Washington on what was discussed, especially in light of the bitter fight over the Donald Trump administration’s alleged Russian connections. We would expect any signs of U.S.-Russian cooperation to be a major stick that the administration’s opponents would not hesitate to use.

There is no way of telling if any agreement has been reached. But the top American general did not meet his Russian counterpart in the presence of Turkey’s top military officer as a formality, much less to discuss mundane matters. This decision to cooperate may be limited to Syria. But given that Russia is involved in the Middle East to gain leverage in its dealings with the United States over its near abroad – especially Ukraine – it would not be surprising if a broader international U.S.-Russian understanding was in the making. Such a deal would be a major change in Washington’s relations with the Kremlin – something the Trump administration has been trying to achieve.

Chinese Power Projection in Southeast Asia

While the Americans, Russians and Turks were trying to find ways to cooperate in the Middle East, Chinese-backed rebels in Myanmar resumed a new round of attacks. The government in Naypyitaw claimed yesterday that the rebel group Myanmar National Democratic Alliance Army (MNDAA) had carried out multiple attacks in the Kokang region of Shan state. The MNDAA, one of at least five rebel groups operating near the Chinese border, has rejected the Myanmar government’s proposed peace offer. This latest round of fighting was the first major clash since early December. The renewal of rebel activity coincides with the second round of peace negotiations scheduled for later this month.

This is important because our model says that China can’t make big military moves and must create political instability in a given region (e.g. the Philippines) to advance its interests. Myanmar is a different kind of meddling but the same general idea, though not as strategically important at first blush.

Kokang is a borderland region whose residents, though citizens of Myanmar, are ethnic-Chinese who speak Mandarin, use the yuan in business transactions and have familial ties across the border in China’s Yunnan province. Two strategic interests explain Beijing’s alleged support for the Northern Alliance, an umbrella group of anti-government armed rebels that includes the MNDAA. First, free transit through Myanmar would open maritime trade routes to parts of China that otherwise require traveling great distances over land to access the Indian Ocean. Second, Beijing wants to make sure the West does not gain a foothold in a country that borders China.

The cross-border Chinese connection and a shared loathing for the Myanmar regime have Beijing and the rebels in a relationship of sorts. Another Myanmar insurgent outfit that China supports is the United Wa State Army (USWA). According to multiple media reports and think tanks, the Chinese military supplies light arms, equipment and vehicles to USWA via third-party countries such as Laos. USWA, in turn, is both an end user of this matériel support and a conduit to other rebel factions. To get a sense of the China-USWA ties, it is important to mention that in late February the group said China should serve as an arbiter in a new peace process replacing the deal offered by Naypyitaw.

China is trying to become a regional hegemon in Asia. Under its currently weakening political and economic circumstances, the best option at its disposal is subversion in neighboring countries.

Keeping its neighbors preoccupied with domestic conflict prevents the United States from forming stable anti-China coalitions. The recent activity by the MNDAA, USWA and other rebel groups indicates that China is employing the subversion tactic in Myanmar to protect Beijing’s interests and to build regional influence. Between conventional wisdom focused on Chinese naval power projection in the South China Sea and North Korea’s bellicose activities, China’s moves to back rebel groups in India’s backyard are largely going unnoticed.

German Banking Sector in Trouble

At its March 5 board meeting, Deutsche Bank (DB) decided to raise 8 billion euros ($8.5 billion) of fresh capital by issuing 687.5 million new shares on March 21, pricing them at a 39 percent discount from the shares’ March 3 closing price of 19.14 euros. The stock then fell another 6 percent on Monday following the news. Separately, Germany’s largest financial institution decided to integrate its Postbank unit into its retail banking operations after failing to secure a reasonable price.

Additionally, DB will lay off staff to attempt to recover a sustainable trajectory. Not only is this bad news for shareholders, but also it is an indication that DB is struggling with restructuring, and by extension, with efforts to contain a liquidity crisis. DB also is selling a minority stake in its asset management business as well as other assets in its investment banking business, which combined are anticipated to yield an additional 2 billion euros.

This is a bad sign for Germany and the European economy. Deutsche Bank is not only Germany’s biggest bank and one of the world’s 30 systemically important banks, it also plays an important political role in Germany and the EU. While technically it is a private bank, Deutsche Bank is tied to the government informally, and formally to most major German corporations. Those that rely on exports or shipping already are experiencing financial strains.

DB’s fate will be shared by all of Germany. In the 1990s, Germany’s top lender began operating more like a typical investment bank, looking to take advantage of financial globalization. Deutsche Bank prioritized short-term gains and invested in risky assets, like any other bank. The 2008 crisis has meant not just financial losses for the bank, but also that it was delegitimized and faced investigations, legal troubles and potential fines to be paid in coming years, seriously weakening its position.

The latest news only confirms the bank is in a difficult position and at risk of potential crisis with no signs of improving soon. This shows that people don’t have confidence in DB if the bank must cut its share price that much to convince people to buy. If DB cannot steer itself out of this crisis, it will have huge implications for Germany’s banking sector and Europe’s largest economy. Germany already is struggling to limit the extent to which the European Union is devolving. A German financial crisis will have an enormous effect on the economic health of the Continent.

Forward Movement

Yesterday was exceptional. Geopolitical Futures spends a great deal of energy daily sifting through the deluge of noise in an effort to identify events with massive geopolitical implications.

Usually it is no more than a single event. Yesterday we discovered three events involving great powers. All of them showed significant forward movement in our forecasts on U.S.-Russian relations, Chinese regional power and a German banking crisis. While details of these events continue to unfold (eventually we will know what the chiefs of staff discussed), it is imperative that we lay out these developments with what we know so far. Today’s forecasts are tomorrow’s news. Such days are rare, but we do run into them from time to time.

The Philippines Criticizes China

The honeymoon phase of the Philippines' opening to China is over.

By Jacob L. Shapiro

China’s commerce minister canceled a planned trip to the Philippines on Feb. 23 after only informing Philippine officials about the cancellation the previous afternoon. Unnamed sources at the Philippine trade and finance ministries told Reuters that China canceled the visit because of the Philippine foreign minister’s critical comments about China at an ASEAN meeting on Feb. 21. China’s foreign minister told reporters in Beijing that the meeting simply had been postponed, not canceled, and that preparations to execute previously negotiated economic deals between the two countries were continuing. China’s foreign minister, however, also made a point of describing his Philippine counterpart’s remarks as “baffling and regrettable.”

Since President Rodrigo Duterte came to power, the Philippines has maintained an unprecedentedly open stance toward cooperation – and even alliance – with China. This openness was punctuated by Duterte’s visit to China in October 2016, where he agreed to many deals concerning economic development (Chinese investment in the Philippines) and proclaimed a Philippine “separation” from the United States. The honeymoon phase turned out to be very short. The investment checks have not been written or cashed, but merely promised. The Philippines sent a note of diplomatic protest to China in January over Chinese moves in the South China Sea. The Philippine defense minister said in January that China’s activities in the South China Sea were “very troubling.” In other words, the Philippines has been cultivating a position of strategic ambiguity when it comes to its relationship with China.

China’s Vice-Premier Zhang Gaoli, right, walks past Philippine President Rodrigo Duterte in a file photo from the Philippines-China Trade and Investment Forum at the Great Hall of the People in Beijing, on Oct. 20, 2016. WU HONG/AFP/Getty Images

For China, however, ambiguity was a step up from antagonism. It also represented an extremely important opportunity China could not pass up. The entire clamor about China building facilities in the South China Sea misses the fact that these installations are for defensive – not offensive – purposes. The various islands and reefs China is reclaiming cannot even hold strategically significant amounts of weapons and materiel and are easy targets for foreign missile strikes. Not to mention that high tide is as potent as an enemy’s air force.

A potential alliance with the Philippines, however, is another thing entirely. First, it would eliminate a key U.S. ally in the region. Second, if the Philippines were willing to host Chinese forces, it would give China its first real strategic foothold in the region. This is why China would be willing to pony up almost 20 percent of its annual foreign direct investment to all countries in the world in just one set of agreements with the Philippines in return for a better relationship. Flipping the Philippines from enemy to ally would be far more consequential than any Chinese island-building activity or rudimentary aircraft carriers put to sea with fanfare disproportionate to their capabilities.

The potential importance of this relationship means China is willing to go to great lengths to secure the relationship, including offering the Philippines significant amounts of economic development or accepting Philippine ambiguity on its strategic relations. But the Feb. 21 incident at the ASEAN foreign ministers’ meeting was a bridge too far. China is upset about this incident because of the context in which the Philippine foreign minister’s criticism was proffered. The Philippine foreign minister spoke to reporters after the ASEAN meeting concluded. In his public remarks, the minister made a point of singling out China’s moves as “unsettling” and encouraging militarization of the region, and said that he spoke for all the foreign ministers in attendance.

This was much different than the official ASEAN statement released after the meeting, which contained no revelations. What was new was the Philippines publicly criticizing China and insisting that there had been unanimity at ASEAN over dissatisfaction with Chinese aggression. In upbraiding the Philippines for these remarks, China’s foreign minister made a point of mentioning that China and the Philippines had agreed to work out such issues bilaterally. China’s insistence on bilateral relations with South China Sea claimants is a euphemism for “divide and conquer.” None of the claimants in the South China Sea can stand up to the Chinese military or economic influence. But if all the countries banded together against China, it would significantly curtail China’s advantage.

The key question lurking behind all of this: Why did the Philippines decide to do this now? On the surface, it is even stranger considering that Duterte had a meeting with an International Department of the Communist Party of China delegation on Feb. 20 that, by all accounts, was pleasant and in line with improving Chinese-Philippine ties. The Philippines knew what it was doing by criticizing China in the manner that it did, and understanding the reason behind the Philippine move is key to understanding the future of both U.S.-Philippine and Chinese-Philippine relations.

The answer to this question has three distinct levels. At the public level, it is not a coincidence that U.S. officials leaked a story to Reuters the day after the Philippine foreign minister made his statement. The leak said that China has almost finished several structures meant to store long-range surface-to-air missiles on Subi, Mischief and Fiery Cross reefs in the Spratly Islands chain. It is a fair inference that the U.S. shared this intelligence with the Philippines before it was leaked and that there was more to share than what has appeared so far in the media. That the Philippine foreign minister doubled down on his statements on Feb. 23 and made specific mention of Scarborough Shoal, which has been a major bone of contention between China and the Philippines since a standoff there in April 2012, is further evidence of this.

Dive a level deeper and the answer likely has more to do with political pressure applied behind the scenes by both the United States and Japan on the Philippines. The U.S. provides the Philippines with its defense. The U.S. is also a major trading partner and source of foreign investment in the Philippines. The U.S. does not want the Philippines messing around with China. The U.S. has likely made this clear, and can tacitly offer things Duterte wants like more U.S. investment, less condemnation of his domestic policies and more active defense of Philippine interests in the South China Sea. Japan is also a major investor in the Philippines. Japanese Prime Minister Shinzo Abe visited Manila in January – the first visit by any head of state to the Philippines under the Duterte administration. The U.S. and Japan can tolerate flirtation with China. But they also can remind the Philippines of how much is at stake if the Philippines were to follow through on some of Duterte’s most extreme public statements.

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At the geopolitical level, there is the simple fact that China and the Philippines claim parts of each other’s territory as their own and neither side can give up those claims. For the Philippines, giving up territorial claims for the benefits of an alliance with China makes little sense. Money can be secured elsewhere. More powerful allies concerned with defending the Philippines rather than taking Philippine territory are readily available.
China giving up some of its claims for the sake of an alliance makes more sense, but nationalism is a crucial part of the legitimacy of the regime, and every Chinese grade school student learns that everything within the “nine-dash line” is China’s. China giving up on those claims would make both the regime and President Xi Jinping appear very weak, which for many reasons is not something China’s ruling class can afford right now.

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The Philippines has its problems with the U.S., not least of which is the serious baggage of U.S. imperial rule. But the U.S. is more powerful than China, located 8,000 miles away and interested in maintaining the status quo, which by extension means maintaining Philippine territorial integrity. That makes the U.S. the superior partner for the Philippines no matter how mercurial the president in Manila seems. Like all countries, the Philippines would prefer more independence in its foreign policy decisions. Cultivating the relationship with China is a good play to increase Philippine leverage with its current allies. But there are limits to how far this can go, and the sudden cancellation of a Chinese commerce minister’s visit to the Philippines reveals one of the boundaries.

Japan and the US: Mutual Alliance, Unbalanced Fear

The integral alliance is driven by distinct motives and experienced uniquely by each country.

By Xander Snyder and Cheyenne Ligon

In his recent trip to the Pacific, U.S. Defense Secretary James Mattis reaffirmed the United States’ commitment to guard Japan against foreign threats: “I made clear that our long-standing policy on the Senkaku Islands stands – the U.S. will continue to recognize Japanese administration of the islands, and as such, Article 5 of the U.S.-Japan security treaty applies.” Both the United States and Japan have interests in the South China Sea. This is a shared interest – and an increasingly important one – that ties the two countries together. However, overlapping interests are not the same as identical interests, and while the United States and Japan both want to protect sea lanes in the Pacific, the motivations driving each country’s national strategy differ. Japan’s greater dependency on imports that must be transported across sea lanes and its proximity to China, which could develop the capability to block them, makes events in the South China Sea a greater threat for Japan than for the United States.

While China’s progressively aggressive posturing in the South China Sea is primarily designed for domestic consumption – by stirring up national pride to legitimize the regime – Japan nevertheless perceives these moves as serious threats. Japan must import nearly all the oil and raw materials it requires to function both economically and militarily. Japan is an island nation and must have all of its imports transported via maritime trade routes. Thus, it is imperative for Japan’s survival to maintain open, unfettered access to critical shipping lanes in the South China Sea. The United States is currently the dominant naval power in the Pacific and grants Japan, its ally, freedom of movement in South China Sea. The current arrangement works for Japan, but it means that Japan is dependent on its relationship with the U.S. to import required materials.

CHINA-NAVY-MILITARYAn aerial photo taken on Jan. 2, 2017 shows a Chinese navy formation, including the aircraft carrier Liaoning, center, during military drills in the South China Sea. STR/AFP/Getty Images

Oil is one of Japan’s greatest vulnerabilities. According to a study by British Petroleum, Japan consumes an average of 4.15 million barrels of oil per day. It has an estimated 500-600 million barrels in strategic reserves. This is further bolstered by an agreement with South Korea to share oil reserves in an emergency. South Korea’s oil reserves of approximately 81 million barrels would give Japan extra time in a potential blockade or war. On its own, Japan only has enough oil in reserve to last for about four months. In a best-case – but highly unlikely – scenario, if South Korea were to give Japan all of its oil, it would only provide Japan an additional three weeks’ worth of reserves. However, in such an emergency it is unlikely that South Korea would be willing or able to grant Japan access to all of its oil reserves. This makes Japan hyper-vigilant toward any Chinese threat to block sea lanes. Cutting off oil from Japan is an existential threat, the same one that drew Japan into the Pacific war with the United States.

On the other hand, the United States’ primary concern in the Pacific is preventing the rise of a single state that could upset regional order and establish regional hegemony to challenge U.S. naval supremacy. Currently, China has the largest economy and is pouring money into increasing its military capabilities, which makes it the greatest threat to the existing regional equilibrium. While this distribution of power is constantly in flux, China today remains the power that the United States must balance. The U.S. has guaranteed the defense of Pacific countries including Japan, the Philippines and Taiwan since World War II and is using this interwoven web of alliances to balance China’s challenge. The United States is preoccupied with its allies’ defense not because of any moral benevolence but because those countries play a critical role in its grand strategy for balance of power.

A credible U.S. guarantee means the United States must actually intervene if China were to cross a red line, thus changing its strategy from one of deterrence to forceful ejection.

There are two clear red lines China could not cross without provoking a U.S. military response. One would be any sort of offensive against Taiwan. The Senkaku Islands is the other. President Barack Obama’s administration made clear that any assault on those islands would be considered an offensive against Japanese sovereign territory, and Mattis reaffirmed that current U.S. policy considers the Senkakus to be covered under the U.S.-Japan mutual defense agreement.

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Understanding Japanese fears requires understanding China’s own motivations in the South China Sea. China also needs access to maritime trade routes. Unlike Japan, however, China is more concerned with its ability to export goods than its ability to import them. China is afraid of being boxed in by the United States and its regional allies, including Japan and the strategically important Philippines, which could use their positions in the Pacific to block China’s access to sea lanes. This mentality encourages its offensive posturing. By building artificial islands in the Pacific, China is trying to secure additional territory to increase its area denial capabilities, making any potential attack more difficult. China’s regional interests place it in direct conflict with those of Japan. China is not currently ready for a real fight with either Japan or the United States, but its threats are felt more acutely by its nearby neighbor than by the U.S.

Mattis’ recent remarks do indicate U.S. concern about Chinese aggression and territorial claims in the South China Sea, but the U.S.’ preoccupation is more for Japan and other regional allies than for the protection of its own economic or military interests. Mattis’ remarks show what the U.S. would view as a red line for Chinese activity in the Pacific.

Japan would prefer that the U.S. enforce this line on all Chinese activity in this region.

From the U.S. perspective, however, China’s pursuit of the islands and activity in the region thus far are not serious enough threats for the U.S. to respond with anything but posturing. China does not have an interest in provoking a war, but Japan must base its national defense strategy on what is possible even if unlikely. And since this dynamic has defined the geopolitics of the Asia-Pacific region for over a century, it is important to be precise about both U.S.-Japanese shared interests as well as the gaps between them.