The Federal Reserve treads a fine line on monetary tightening

Inflation will determine how bumpy the ride will be

by Martin Wolf

 © James Ferguson

Is a surge in inflation a significant threat to sustained recovery? The likely answer is: no. But the proposition is no longer absurd, as it was when Kevin Warsh, then a governor of the Federal Reserve and now a candidate for chairman, stated in March 2010 that “I don’t think we should be complacent about inflation risk”. That misjudgment should rule out his candidacy.

Yet times have changed. This explains the Fed’s commitment to gradual monetary tightening.

The European Central Bank is planning to withdraw stimulus. The question is whether this tightening cycle will be smooth or bumpy. Inflation would make the difference.

Even a broken clock will be right twice a day. Austrian economists and goldbugs have warned of an imminent upsurge in inflation for years. Maybe they will be right, at last. The consequences would be highly disruptive. If inflation rose really rapidly, monetary policy would have to tighten significantly. That would trigger fears of a recession. Moreover, even if long-term real interest rates did not rise, risk premia on inflation, expected future short-term interest rates and the uncertainty surrounding those expected future rates would all jump, raising yields on conventional bonds substantially.

All this would undermine elevated asset markets and might trigger worries over debt sustainability. In a still fragile world economy, the results might be ugly. One might even see a return to the stagflation of the 1970s, with far lower inflation, but also far higher indebtedness.

The focus of attention is on the Fed. The US is still the world’s most important economy and the Fed the most important central bank. The US is also far more advanced in its return to normal economic conditions than other large, high-income economies. In a lucid recent speech, Janet Yellen laid out the issues. She also demonstrated why she is, of known candidates for next chairman, the outstanding one. Donald Trump would only choose one of the others if he were as determined to destroy the Fed as he is to ruin the state department and other agencies.

The starting point is a puzzle: why is inflation so low when the rate of unemployment is already a little below the level the Fed (and most economists) consider to be “full employment” (the rate at which inflation should start to accelerate upwards). The Fed’s analysis suggests that labour market slack is no longer an important downward factor, while a series of temporary downward shocks are also now in the past. So, the Fed believes, inflation will soon move back towards its target. (See charts.)

Why might this view be wrong? One possibility is that more labour market slack still exists than the unemployment rate suggests. The ratio of employment to population for those aged 25 to 54 is still well below previous cyclical peaks. The rate of part-time employment is also somewhat elevated. A thorough study by the International Monetary Fund in its latest World Economic Outlook notes, more broadly, that “while involuntary part-time employment may have helped support labour force participation and facilitated stronger engagement with the workplace than the alternative of unemployment, it also appears to have weakened wage growth”. Yet most other measures of labour market pressure are back to pre-recession levels. So even if US wage growth is well contained, this might not last.

Another factor is inflation expectations. This cuts two ways. At the moment those expectations are well anchored, the only big worry being a decline in market expectations of inflation (or inflation risk) more than five years hence. Such expectations might feed into behaviour, generating a self-fulfilling prophecy of low inflation. This would counteract the symptoms of the labour market pressure. At some point, however, the latter could boil over into rapidly rising wages, probably at rates well above those consistent with stable inflation. We have seen that before.

At present, however, the risks do not seem that great. But, as always, this is a matter of risk management. We can have little doubt that a substantial rise in inflation above target would create significant danger. Raising the target in such a situation would certainly destroy confidence in the Fed. Yet trying to hit the target could, for reasons indicated above, be destructive, possibly tipping the US back into a recession from which it would be hard to exit. This would be particularly true if the damage to asset price effects were large and much bad debt re-emerged. Yet, under this scenario, short-term interest rates would at least have to rise substantially, giving the Fed more room to cut than it has now.

If a big jump in inflation would be destructive, so would premature, or excessive, tightening. That could further lower inflation, destabilising expectations further. It might weaken the economy so much that, given still limited room to cut interest rates, without going into negative territory, it would be difficult to restore demand, without going into negative territory. Above all, after the huge and politically destabilising shock of the Great Recession, a lengthy period of strong labour markets would be hugely desirable, even healing.

The Fed has to balance between tightening too fast and too slowly. Nobody can be sure it is now wrong. My best guess is that an explosive rise in inflation is highly unlikely. The Fed can afford to take its time, while testing the capacity of the US economy to expand supply. But risks are real on both sides. The Fed has probably been right to tighten a little. But it must be careful not to go too far. It has earned much credibility over inflation. Sometimes what one has earned should be spent. This is just such a time.

Bond markets need to wake up to global upswing

Investors are mistaken if they think yields will be able to stay low for much longer

by Michael Heise

Markets predict no interest rate rises in the foreseeable future from the ECB © Reuters

Since the financial crisis in 2008, the global economy has been characterised by slow growth, low inflation and extremely expansionary monetary policies. Markets seem to expect a continuation of this so-called “new normal”. They predict no interest rate rises in the foreseeable future from either the ECB or the Bank of Japan, and they expect the Fed funds rate to stay lower than indicated by the Fed`s governors.

After years of sluggish growth, many people seem to be stuck in a “great recession” or secular stagnation mindset. There are, however, clear signs of a cyclical recovery and it is accelerating.

First, global trade is staging a comeback — notwithstanding the protectionist rhetoric of some political leaders. After two dismal years in 2015 and 2016, the trade recovery is fuelled by a recovery in the Chinese economy and the turn of commodity markets. The interlinkages of trade are reinforcing global growth.

Second, globally, a new expansionary credit cycle is supporting growth. In emerging Asia, credit growth remains strong, despite policy efforts to limit financial stability risk, especially in China. In the US, the credit cycle turned about three years ago, with first the corporate sector and then households assuming more debt. The debt-to-GDP ratio in the private non-financial sector, which had declined massively in the years following the financial crisis, has been rising again since 2014. In the eurozone, the new credit cycle is in its infancy, but here, too, loans to the private sector are rising again. The time of deleveraging and consolidation of private debt is over.

Finally, capacity utilisation in most developed markets is back to normal or even above normal.

Current estimates of output gaps indicate there is hardly any slack in the world`s big economies. That is true even in the eurozone, where capacity utilisation in manufacturing is reported to be above average. While it is true that prices and wages and prices in today’s globalised and digitised economy don’t react to capacity utilisation as strongly as they used to in former decades, it seems unrealistic to expect no reaction at all. Improving business confidence, little idle capacity and tightening labour markets will at least gradually increase wage demands and output prices.

What does the economic upswing imply for bond yields and stock markets? Usually, we would expect bond yields to be roughly in line with nominal GDP, both on the basis of economic logic and historical experience. But while nominal GDP growth has averaged 2.7 per cent in the eurozone and 3.5 per cent in Germany in the last three years, bond yields have remained much lower, in many countries close to zero.

One reason for this discrepancy is, of course, monetary policy. Our own estimates, as well as statements by ECB officials, suggest that the central bank’s asset purchase programme has pushed down the German 10-year Bund yield by about 0.8 percentage points. A normalisation of monetary policies, notably an end to QE, would drive up bond yields. By how much is an open question, as the phasing out of QE will to some extent have been priced into yields already. An exit, if done carefully and gradually, should therefore not unsettle markets. It would leave eurozone bond yields much below nominal growth rates.

Bond yields could react more forcefully, if and when market participants upgrade their expectations concerning future growth and inflation. Once investors wake up to the return of the economic cycle, their expectations about interest rates and the course of monetary policy will also change. The ECB is cautioning against overly optimistic expectations and remains expansionary in its forward guidance. But as the cyclical expansion gains force, central banks might have to take tougher action to correct an excessively expansionary path. Further delaying the exit from QE therefore harbours risks.

Rising bond yields in an economic expansion are nothing unusual and should not cause a fundamental repricing of stocks. After all, even bond yields of 2 or 3 per cent imply price earnings ratios for bonds that are way above stock market valuations. The transition from a “new normal” with a rather bleak outlook to a more cyclically driven expansion will inevitably generate volatility. Keeping it low as low as possible is a challenge for the ECB. A timely, but gradual correction of monetary policy is the best option.

Michael Heise is chief economist at Allianz

Why Financial Markets Underestimate Risk

Jeffrey Frankel

CAMBRIDGE – During most of 2017, the Chicago Board Options Exchange Volatility Index (VIX) has been at the lowest levels of the last decade. Recently, the VIX dipped below nine, even lower than in March 2007, just before the subprime mortgage crisis nearly blew up the global financial system. Investors, it seems, are once again failing to appreciate just how risky the world is.

Chicago Board Options Exchange Volatility Index (VIX
Known colloquially as the “fear index,” the VIX measures financial markets’ sensitivity to uncertainty – that is, the perceived probability of large fluctuations in the stock market’s value – as conveyed by stock index option prices. A low VIX signals a “risk-on” period, when investors “reach for yield,” exchanging US Treasury bills and other safe-haven securities for riskier assets like stocks, corporate bonds, real estate, and carry-trade currencies.
This is where we are today, despite the variety of actual risks facing the economy. While each of those risks will probably remain low in a given month, the unusually large number of them implies a reasonably strong chance that at least one will materialize over the next few years.
The first major risk is the bursting of a stock-market bubble. Major stock-market indices hit record highs in September, in the United States and elsewhere, and equity prices are high relative to benchmarks like earnings and dividends. Robert Shiller’s cyclically adjusted price-earnings ratio is now above 30 – a level previously reached only twice, at the peaks of 1929 and 2000, both of which were followed by stock-market crashes.
cyclically adjusted price-earnings ratio
We also face the risk of a bursting bond-market bubble. Former US Federal Reserve Board Chair Alan Greenspan recently suggested that the bond market is even more overvalued (or “irrationally exuberant”) than the stock market.
The market is accustomed to falling bond yields: both corporate and government bonds were on a downward trend from 1981 to 2016. But interest rates can’t go much lower than they are today; in fact, they are expected to rise, particularly in the US, though the European Central Bank and other major central banks also appear to be entering a tightening cycle. If, say, an increase in inflation generates expectations that the Fed will raise interest rates more aggressively, a stock- or bond-market crash might result.

Geopolitical risk is also high – indeed, it has rarely been higher than it is today, just as faith in the stabilizing influence of US global leadership has rarely been lower. The most acute risk relates to North Korea’s advancing nuclear program, but there are also substantial risks in the Middle East and elsewhere.
These risks are being exacerbated by US President Donald Trump, who has made a number of foreign-policy missteps, from mishandling the North Korea crisis to threatening to abrogate the Iran nuclear agreement. So far, the consequences of Trump’s wild rhetoric on the domestic front have been limited, because most of it has not been translated into legislation. But on the international front, it could have disastrous implications.
Beyond Trump’s capriciousness is a broader crisis in US politics. Though showdowns in the US Congress over the debt ceiling did not result in a government shutdown this month, US leaders have only kicked the can down the road to the end of the year, when the stakes could well be higher and the stalemate more intractable. The US may even face a constitutional crisis, if Special Counsel Robert Mueller were to find, for example, evidence of illegal contact between the Trump campaign and the Russian government.
The last time the VIX was as low as it is today, in 2006 and early 2007, one could also draw up a lengthy list of potential crises. Most obvious, housing prices in the United Kingdom and the US were at record highs relative to benchmarks like rent, raising the risk of a collapse. Yet markets acted as if risk was low, driving down the VIX and US Treasury bill rates, and driving up prices of stocks, junk bonds, and emerging-market securities.
When the housing market did crash, it was regarded as a surprise. The crash lay outside any standard probability distribution that could have been estimated from past data, analysts declared, and was therefore a black swan event, or a case of “Knightian uncertainty,” radical uncertainty, or unknown unknowns. After all, the analysts argued, housing prices had never fallen in nominal terms before.
But, while nominal housing prices had not fallen in the US in the previous 70 years, they had fallen in Japan in the 1990s and in the US in the 1930s. This was, therefore, not a case of Knightian uncertainty, but of classical uncertainty, in which the data set generating the probability distribution was unnecessarily limited to a few decades of domestic observations.
In this sense, it is the “black swan” term that fits best – indeed, better than those who use it realize. Nineteenth-century British philosophers cited black swans as the quintessential example of a phenomenon whose occurrence could not be inferred from observed data. But that, too, reflected a failure to consider data from enough countries or centuries. (The black swan is an Australian species that had been identified by ornithologists in the eighteenth century.)
This type of failure to take a sufficiently broad view turns out to be a key reason why investors periodically underestimate risk. The formulas for pricing options, for example, require a statistical estimate of the variance. Likewise, the formula for pricing mortgage-backed securities requires a statistical estimate of the frequency distribution of defaults. Analysts estimate these parameters by plugging in just the last few years of data for the given country.
Moreover, in the boom-bust cycle described by Hyman Minsky, a period of low volatility lulls investors into a false sense of security, leading them to become over-leveraged and ultimately producing a crash.
Perhaps investors will re-evaluate the risks affecting the economy today, and the VIX will adjust.
But, if history is any guide, this will not happen until the negative shock, whatever it is, actually hits.
Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

China, Where Reform Is Carried by an Iron Fist


Chinese President Xi Jinping is riding high into the pivotal 19th National Congress of the Chinese Communist Party, set to take place Oct. 18. He has sidelined political rivals, stacked the CPC leadership with men loyal only to him, and appears to have already become the most powerful Chinese leader in decades. His reform agenda has been bolder than many anticipated, his efforts aided in no small part by the vitality of the Chinese economy, which continues to grow as the financial system, shocked by a stock market crash in 2015, stabilizes. People are less likely to reject change, after all, if they are convinced that the change benefits them.
Still, Xi has not instituted the sorts of sweeping structural reforms needed to fix China’s economy. One of his biggest reasons for neglecting to do so was that he wanted to maintain economic stability ahead of the party congress. But he won’t be able to avoid more ambitious reforms forever – which raises the question: If Xi’s consolidation of power is formalized at the party congress, will he be freer to undertake even more substantive reforms in the years to come?
The following report explains why China is evolving from a country governed by consensus to a country ruled by a de facto dictatorship – a transition in keeping with China’s historical swings between authoritarian and decentralized rule. The report will also examine how the centralization of power, despite its many drawbacks, could help Xi execute his reforms. More than anything, this report will make the case that China’s path forward won’t get much easier from here.
Crowning the Victors
Congresses tend to be scripted affairs, short on drama but long on pageantry, meant to invigorate the party’s rank and file and convince their subjects of their continued relevance. Officially, the 2,300 delegates at this year’s gathering will select the 200-member Central Committee and approve amendments to the party’s constitution. The Central Committee will then select the Politburo, the Central Military Commission, the Politburo Standing Committee and, most notably, the general secretary of the CPC, who since 1993 has also held the presidency. It’s also a chance for the party to tout its successes and lay out policy priorities for the coming presidential term, which lasts five years.
But very little is decided during the congress itself. Preceding each congress is a season dominated by rumor and speculation about the ruthless power struggles and ideological battles waged away from prying eyes. The congress merely serves as a public coronation of the victors. The run-up to this congress has stayed true to form, marked as it was by sordid rumors of senior officials and by high-profile purges of powerful figures. How it has unfolded, though, points to a profound transformation underway in Chinese politics, a transformation that mirrors changes underway in the presidency itself.
Now entering his second term, Xi began to lay the groundwork for the upcoming reshuffle in 2012, almost as soon as the 18th Party Congress ended, when he launched a sweeping crackdown on corruption. His weapon of choice was the Central Commission for Discipline Inspection, an anti-graft body overseen by Xi’s right-hand man, Wang Qishan. In the past five years, the CCDI has taken disciplinary action against more than 1 million officials, in the government and in state-owned enterprises, at virtually every level of power. (The probe has even netted nearly 8,000 anti-graft inspectors).
Far from an exercise in altruism, the campaign served several purposes. One is fundamental: It helps to solve the problem corruption posed to the ruling party’s legitimacy. China’s economic rise ushered in a similar rise in graft, crony capitalism and conspicuous economic disparities, all of which invalidate the reasons for single-party rule. Another purpose is to reassert party primacy – over every state institution, every provincial government, every branch of the People’s Liberation Army, every state-owned enterprise and every private one – and in doing so to prevent any rival node of power from emerging. By eliminating those who oppose the government, the campaign is also meant to ease the implementation and enforcement of contentious reforms. The final purpose, of course, is to boost Xi’s own power.
High-profile cases (the targets for which are colloquially referred to as “tigers”) show just how effective Xi’s weapon could be. The dramatic fall of then-Standing Committee member Zhou Yongkang, whose political ascension followed a lucrative path through the energy sector and the state security apparatus, brought down a rival political network, reined in state security, and showed all those around him that no one – not even a member of the vaunted Standing Committee, no member of which had ever been tried before – was bulletproof. The arrests of two vice chairmen of the Central Military Commission, Gen. Guo Boxiong and Gen. Xu Caihou, removed acolytes of former President Jiang Zemin. Guo and Xu had resisted the authority of Jiang’s successor, President Hu Jintao, and their removal paved the way for Xi’s sweeping restructuring of the PLA. (Two high-level associates of Guo and Xu were purged as recently as August.) The infamous case of former Chongqing party chief Bo Xilai, a rising political star whose wife was implicated in the murder of a British businessman, was a particularly lurid example of systemic rot.
Xi has been amassing power in other ways too. He has created and chaired several “leadership small groups” – extraordinary committees that Xi tasked with policymaking authority typically reserved for other institutions – to outflank other senior leaders and their loyalists within the bureaucracy. He diluted the power of four PLA headquarters by replacing them with 15 departments. He installed loyalists from his days in Zhejiang and Fujian in posts throughout the political hierarchy. Today, 13 of 31 provincial secretaries are loyal to Xi, according to BMI Research. In 2012, that number was four.
Recognizing the Inevitable
Xi will almost certainly benefit personally from the power he has accrued. But his political maneuvering over the past five years is about more than just self-actualization – it’s a recognition, in the highest echelons of Chinese power, that the next era will require a more centralized model of leadership.

Chinese officials began to recognize as much in 2008. China is a massive state governed by a massive bureaucracy tasked with keeping the country’s massive fault lines from rupturing. The global economic crisis exposed China’s dire need for sweeping economic reform and laid bare Beijing’s inability to enforce its writ. Many officials had enriched themselves in the boom years, and with their wealth came the ability to build powerful patronage networks. Some of them, like Gen. Guo Boxiong, Zhou Yongkang and Bo Xilai, controlled powerful institutions or regional governments. Reform initiatives were routinely blocked by vested interests such as theirs or tied up by factional rivalries extending to the very top.

2008 also underscored that China’s run of guaranteed breakneck growth had come to an end. Its growth had relied on low wages and high global demand. Wages have since risen, and demand has since been unstable. Modern China is based on the promise of prosperity, and so when that prosperity declines, the legitimacy of the Communist Party declines as well. Xi and his elite supporters want to avoid this at all costs.

And he is well positioned for success. In 2012, when Xi became president, the powerful Central Committee was stacked with officials loyal to former Presidents Hu Jintao and Jiang Zemin. Xi loyalists are slated to replace most retiring members of the Standing Committee, largely at the expense of factions that had traditionally dominated the Politburo. Xi is also reportedly considering reducing the number of spots on the Standing Committee from seven to five while expanding the size of other bodies, such as the Central Military Commission. Doing so would centralize power and reduce the risk of political gridlock among Xi’s inner circle while diffusing the power of individuals holding seats in Beijing’s lower-ranking bodies.

Xi has sought to suppress an entire generation of potential successors with ties to Hu and Jiang. Contenders for the Standing Committee from rival factions, those seen as candidates to replace Xi in 2022, have been ousted. Out, for example, is former Politburo member and Chongqing party chief Sun Zhengcai, who was purged on graft charges in July. Sun, a Jiang protege, was expected to take a seat on the Standing Committee. Taking his place in Chongqing and on the Politburo is Chen Miner, a rising star with ties to Xi. Remember his name; if he secures a spot on the Standing Committee next week, he may very well be China’s next president.

Or maybe not. Xi’s political maneuvering has understandably fueled speculation that he is angling for an unprecedented third term, or that he is laying the groundwork to rule after 2022 as party chairman, a position eliminated by Deng Xiaoping after Mao. If the congress ends without an anointed successor, this speculation will kick into overdrive. (Hu was anointed Jiang’s successor a full decade before he took power; Xi was anointed five years out.) There’s also been widespread but unconfirmed reports that Xi’s political philosophy will be enshrined in the party constitution (an honor typically bestowed on leaders only after they retire), possibly mentioning the president by name (an honor previously bestowed on only Mao and Deng). Earlier this year, Xi was named party “core,” elevating him above the other members of the Standing Committee.

Of course, this may all be baseless speculation. Rumors to that effect do nothing, however, to dispel the fact that China is moving away from its traditional consensus-oriented model. The model served its purpose – it helped to keep the peace among elite factions, particularly during the three-decade economic boom that began in the late 1970s – but its drawbacks cannot be ignored. Jiang and Hu, for example, were monuments to compromises made with small power bases. They were choices meant to appease multiple factions, choices that proved easy to undermine. Hu especially struggled to rein in wayward institutions headed by Jiang loyalists and other rivals.

Xi may fare better than his predecessors. In the past five years, he has demonstrated a rare gift for political dexterity. But that doesn’t mean he will consolidate power in perpetuity, or that he intends to. (One prominent rival faction consisting of former members of the Communist Youth League appears poised to gain power during the congress.) After all, it was the need to streamline decision-making, not his thirst for power, that created room for Xi’s political maneuvering in the first place. Still, he’s playing a high-stakes game, and the reforms won’t be accepted without a fight.
Threats to the Economy
If Xi accomplishes what he intends to at the congress, he could become the most powerful leader in China since Deng, if not since Mao himself. But is a strongman model any better suited than a consensus model to solve China’s problems?

Broadly speaking, China has been combating four interrelated issues that threaten the economy from within: overcapacity, debt, financial sector instability and currency risk.

In a country such as China, large and populous as it is, economic disparities between the wealthy coast and the impoverished interior can make or break the central government. Companies with declining profitability are therefore sometimes encouraged to keep capacity artificially high. As a result, the country is awash in large, highly indebted companies unable to respond to changes in supply or demand or to competition from lower-wage countries. The economy needs these companies to stay afloat, so financial institutions have little choice but to extend cheap lines of credit to them. This has created massive amounts of debt for state-owned enterprises, private firms, households, and provincial and local governments alike, as well as an overreliance on housing and fixed-asset investment as a source of growth. According to China’s central bank, total social financing (measuring credit and liquidity in the Chinese economy) had climbed to some 260 percent of GDP by midyear. This figure doesn’t account for China’s ballooning problem of shadow lending.
The bottom line is that since China’s economic problems impinge on one another, downturns in any one sector tend to drag down the economy as a whole. The solutions, therefore, often need to be comprehensive. But since reforming any one area would require unpalatable economic tradeoffs and untenable political risk, most reform efforts have been half-measures and overcorrections. Hence Xi’s urgency in centralizing power.
Settling Debts
One of his biggest priorities has been to restructure local debt. Successes and failures in this regard are instructive. An ambitious reform package introduced in late 2014, for example, was intended to improve the fiscal standing of local governments by capping local borrowing and swapping debt obligations for bonds. It failed because of local-level reticence, risk aversion from banks, and a lack of central government financial support. A subsequent version of the program, however, achieved its immediate stabilization goals by effectively bailing out afflicted governments and forcing banks to play along. There is little evidence, though, that the reforms have compelled them to live within their means.

Similar dynamics have been on display in what is perhaps Xi’s highest-profile initiative: supply-side structural reform. Launched in 2015 to address debt, unsold housing and industrial overcapacity all at once, the program has relied on a mix of central government carrots and sticks to compel participation, punish noncompliance and manage the potential for public backlash in an attempt to close down superfluous companies. But the burden of implementation has remained with local and provincial governments, generating a lot of resistance from those who stand to suffer from capacity cuts – and leading to widely uneven results. Notably, the program’s biggest successes have been in wealthier economies that have more room for experimentation. In poorer regions, the focus has tended to devolve to mere stabilization. Both initiatives demonstrated that high-level intervention and central funding help, and yet, for fear of economic and political repercussions, reforms have often been implemented in ways that treat the symptoms of economic duress but not its underlying causes.
Forget the Titans
To address corporate debt, another fundamental problem in China, Xi’s administration has singled out titans of industry for things like speculative investments and has restricted the types of allowable acquisitions abroad. (Tycoons have routinely been denounced by name in state media; the head of one such titanic firm, Anbang Insurance, was arrested.) State media have also labeled such firms as instruments of systemic financial risk and blamed them for fueling capital outflows. (China’s foreign exchange reserves dropped below $3 trillion for the first time in six years in January.) Political motivations are also at play, as connections between these firms and senior leaders are regular topics of leaks. Private firms appear to be cowed into compliance, at least for the time being, and financial reserves have steadily recovered.

Meanwhile, Xi has been a champion of state-owned enterprises, not because they are particularly efficient – they accounted for a quarter of China’s total assets but only a seventh of GDP last year – but because, if harnessed properly, they can be compelled to participate in commercially dubious One Belt, One Road projects and employ a lot of people. As part of his supply-side structural reform initiative, Xi has urged more profitable SOEs to absorb underperforming ones – and their outstanding debt. This tightens the central government’s control over operations with political objectives, but it conflicts with the second focus of reform: boosting efficiencies by allowing private enterprises to invest more substantially in SOEs. With SOEs receiving compulsory support from banks and facing few budgetary constraints – not to mention a mandate to carry bloat – investors are likely to be motivated by what are effectively state-guaranteed returns, not real profits.

As a result, under Xi, the central government has become increasingly interventionist, leaning on his ability to frighten firms that are not aligned with his political priorities abroad to rein in excesses. In keeping with tried and true historical tactics, he’s cultivated a narrative that wealthy businessmen are to blame for China’s economic woes. But, particularly with SOEs, he’s stopped short of structural reforms aimed at boosting efficiency. He has instead treated state firms as social security vehicles that execute his political priorities.
Ghosts and Consequences
China’s overcapacity issues are also apparent in the real estate sector, in which developers have been encouraged to build at breakneck speeds, consequences be damned. China’s infamous “ghost cities” – empty, would-be urban centers such as Inner Mongolia’s Kangbashi – vividly illustrate this problem. In other regions, however, cheap credit has fueled housing bubbles. (This issue heightens the debt woes facing local governments, which rely on land usage fees for revenue.) Attempts to manage real estate markets have likewise yielded mixed results, featuring swings between heating and cooling measures, increasingly complicated restrictions on homebuying and the occasional protest from dismayed homeowners.
Beijing has several tools to use in this regard. Since the central government technically owns all the land in China, it can manage the supply of land in the market. It’s also been tightening its control over various interest rates, restricting capital outflows to incentivize internal investment, and experimenting with an array of measures to manage credit growth. As with supply-side structural reform, however, Xi’s administration has been forced to delegate powers to local and provincial officials since problems differ so much from one city to the other. This, along with the whack-a-mole policies and lack of progress on reducing the economy’s exposure to real estate, underscores the limits of a top-down system in addressing one of the most pressing issues of the day.
Beijing to the Rescue
The risk all this poses to the financial sector was laid bare during the stock market crisis of 2015, which, having caught authorities off guard, led to belated and extemporaneous responses. The crash accelerated capital outflows, forcing the central bank to drain its foreign exchange reserves to stabilize the yuan. Alarmed by the crisis, along with continued runaway credit growth, Beijing has launched a raft of reform initiatives. Earlier this year, in fact, Xi elevated the importance of financial stability and strengthened the role of the judiciary in combating financial crimes. Here, too, results have been mixed, though they exemplify the limits of China’s emerging model.
For example, authorities have tried to insulate China’s banking system from risk in industries highly exposed to real estate volatility, such as construction and building materials. But banks have skirted this restriction by off-balance sheet investments such as “wealth management products” – opaque, lightly regulated securities that leave banks no less exposed to volatility. An estimated $9 trillion is believed to have been poured into such vehicles. The China Banking Association’s 2017 annual report showed that off-balance sheet assets in the Chinese financial system are 109 percent of on-balance sheet assets (approximately $38 trillion). WMPs have been particularly problematic, since investors often assume that they are guaranteed by the central government and thus risk-free. Notably, Beijing has gone out of its way to make clear that WMPs do not have state guarantees. This, along with new regulations, appears to have slowed their growth over the first half of this year, from 43 percent to around 8 percent, according to official figures. Given the systemic risk some WMPs pose to the Chinese economy, however, Beijing would have little choice but to come to their rescue, so the government’s denial of implicit guarantees rings hollow.

The prospects of modernizing the country’s outdated financial regulatory system likewise remain cloudy. This summer, a strengthened oversight body monitoring China’s banking, securities and insurance regulators was established to eliminate the sort of regulatory arbitrage that has helped fuel the rise of WMPs and other shady investment vehicles. As has become common with Xi’s reforms, the move was accompanied by stern punishments for misbehaving firms, and senior regulators were felled by anti-graft probes. But Beijing has refrained from overhauling the entire regulatory framework, at least for now, in ways that would make it better equipped to handle modern financial instruments. Decisions on the final shape of the new system were evidently delayed until after the congress.

Ultimately, Beijing has learned that where there’s will to invest, there’s a way. Though it has the ability to respond to problems forcefully, the central government lacks the financial oversight to anticipate and deflate bubbles before they become too large. In any case, it may not even have the political capital needed to gain such oversight.
An Orderly Decline
Difficult though it may have been for Xi to implement in his first term the kind of reforms China needs, there is reason to believe it may be easier in his second. With newfound power, rules and regulations could be easier to enforce. The more stable and secure Xi’s administration is at the top – and the more the lower ranks fear its power – the more it can sideline, without fear of recourse, those who resist reform. The more stakeholders stand to lose from contentious reforms, the more important Xi’s impunity becomes. With loyalists in key positions, Xi will be able to shepherd potentially controversial policies through a much more coherent bureaucracy, or at least one that is not actively hostile to his cause.

Reform and power, in other words, are mutually beneficial. Reform can mitigate the risks of economic disruption, which would, in turn, make officials such as Xi politically vulnerable. Well-enforced reforms disrupt rival patronage networks and open positions for loyalists, who are more likely to carry out the reforms.

High-profile reforms, moreover, reinforce the narrative that party leaders alone can keep the country together. And the more popular Xi is among the masses, the more weight the central government can bring to bear in pursuit of reform, particularly when Xi endorses or advocates an issue. For example, Xi has been visibly involved in environmental reform, dramatically cracking down on provincial polluters through environmental inspection teams consisting of high-ranking officials and, critically, enforcers from the now-feared CCDI. (In China, environmental reform is particularly politically important because of public health; officials can’t convince the masses that they are not seeing China’s famously thick smoke when, in fact, they are.)

Finally, a tightly centralized government is, in theory, better equipped to manage the risk of mass unrest associated with disruptions to the status quo. Control of the media, cyberspace and other purveyors of information – this enables Beijing to manage the inevitable fallout generated by ambitious socio-economic change.

The limitations to centralized control, though, are obvious: Authoritarian governments and command economies have a shaky track record, to say the least. And Xi himself wasn’t always successful in his first term. In an authoritarian regime, success is contingent on the talents of the leader and his inner circle. It risks creating a culture that prioritizes loyalty over technocratic talent and expertise. Similarly, it can engender the practice of picking winners based on political favor rather than performance.

Centralization also risks fostering echo chambers that leave leaders blind to realities on the ground and thus looming crises while skewing the performance incentives of lower-level officials. The tragedy of Mao’s Great Leap Forward, when lower-level cadres routinely overreported steel output, is a cautionary tale well-understood in Beijing. More recently, these problems were illustrated by the revelation that several depressed provinces were in effect cooking their books, regularly overstating their growth rates to keep Beijing at bay. The first phase of the 2014 debt swap initiative, meanwhile, failed in part because depressed local entities were incentivized to overstate their debt burdens.

The regime’s slow and uneven response to the 2015 stock market upheaval exposed how rigid, top-down systems, in which power is delegated reluctantly, can become paralyzed in a crisis. There are, simply put, fewer people available to conduct the affairs of state – something that is particularly problematic in a model that infrequently allows market principles to cleanse the system. Centralization, particularly when built around a cult of personality, can also hinder the development of state institutions needed for sustainable reform. Xi’s reliance on leadership small groups, rather than large, established entities, for policymaking and implementation is a risk in this regard.

Most important, the things that prevented Xi from doing anything more than taking aim at easy targets and picking off low-hanging fruit are not going away. The potential for high-level power struggles will not simply vanish once the congress ends. The CPC’s economic and political imperatives will continue to conflict. For reforms to be successful, they need to be rooted in economic reality, yet political imperatives mean the CPC will never be able to tolerate the levels of unemployment such reforms would create.

China’s fundamental problem will remain the same. It’s trapped between contradictory forces, and trade-offs cannot be wished away, no matter how powerful Xi becomes. Measures to deflate the real estate bubble risk worsening overcapacity in construction and ancillary industries, which itself risks inflating corporate and household debt. Measures to keep underwater firms afloat with easy credit encourages continued profligacy. Every leak in the dam you plug risks springing another three. When buoyed by robust growth, these trade-offs are more palatable. (In fact, the most innovative and successful reform efforts to date have occurred in coastal provinces with the strongest economies.) But China has entered a prolonged period of declining growth and remains highly vulnerable to external shocks. In a country of 1.4 billion people, neither a painful U.S.-style correction nor a Japan-style “lost decade” is tolerable for a single-party government that has taken full credit for the boom years. It’s only realistic choice is to try to nip and tuck its way to an orderly decline.

Understanding that this is so, a quorum of Chinese elite has accepted Xi’s unprecedented consolidation of power, which may yet give Beijing some of the tools it needs to muddle forward. The government’s large foreign exchange reserves, an invaluable buffer to shocks against the system, give China some breathing room. But in this environment, Xi’s reform agenda over the next five years will boil down to a single overriding objective: staving off a reckoning.

The European Banking Landscape Has New Powerhouses: French Lenders

Société Générale and BNP Paribas have emerged as two of continent’s strongest banks after the debt crisis and years of economic stagnation

By Noemie Bisserbe

Société Générale had a return on equity of 9.5% in the first half of the year, as French banks have gained a surprising edge over their European rivals. Photo: gonzalo fuentes/Reuters

PARIS—France’s biggest banks have rediscovered their mojo by becoming boring.

When Pascal Augé, an investment banker at Société Générale SA, SCGLY -2.05%▲ was transferred to the French lender’s cash-management unit—which helps companies manage their cash flow—he was surprised: “For years, cash management wasn’t considered as a very sexy business,” said Mr. Augé, who now heads Société Générale’s global transaction and payment-services unit. “But we rediscovered the virtues of that business with the crisis.”

Now, a few years later, the decidedly unfashionable business generates nearly as much revenue for the bank as securities trading.

Société Générale and crosstown rival BNP Paribas SA BNPQY -2.39%▲ have emerged from the financial crisis, the eurozone debt crisis and long years of European economic stagnation as two of the continent’s strongest banks—and two of the few able to withstand the invasion from U.S. investment banks in Europe.

Société Générale had a return on equity of 9.5% in the first half of the year and BNP Paribas 10.6%, making them among the most profitable banks in Europe.

French Banks Societe Generale and BNP are gaining market share*
Net Revenues from fixed income, currencies and commodities

*Total Revenues for the top seven euopean Banks
Source: Goldman Sachs Global Investment Research

Part of their success has come from using dull but important service businesses, such as handling cash and securities, to attract clients they can upsell to investment banking and trading. The French lenders also have benefited from having long had a focus on corporate banking. France’s big corporate sector has remained comparatively strong through years of economic stagnation on the continent.

While European powerhouses such as Deutsche Bank AG , Credit Suisse Group AG and Royal Bank of Scotland Group PLC remain steeped in restructuring, Société Générale is expanding its lead in equities trading and BNP Paribas is growing its fixed-income business.

Société Générale saw its market share in equities in Europe rise to 16.4% in 2017 from 14.2% in 2013, while BNP Paribas’s market share in fixed income rose to 14.6% from 13.4% in the same period, according to a recent study by Goldman Sachs Group Inc. based on the revenue of the top seven European investment banks.

Meanwhile, Credit Suisse’s equities market share fell to 15.4% from 22.3% in Europe, and Barclays PLC’s fixed-income market share dropped to 12.9% from 16.7%.

“Unusual suspects continue to outshine” investment banks, Goldman Sachs analysts noted.

Net Revenues from equity trading*

* Market share of total revenues for the top seven European investment Banks
Source: Goldman Sachs Gobal Investment Research

France’s largest lenders were relatively sheltered from the 2007-2008 financial crisis, despite Société Générale’s embarrassing €4.9 billion ($5.85 billion) loss from rogue trader Jérôme Kerviel in 2008. Investment bank Natixis also ran into trouble in 2009 due to wrong bets on complex derivatives, eventually forcing the government to orchestrate a merger between its two parent companies.

Most French banks specialized in trading stocks, rather than the fixed-income products that were most hurt during the financial crisis. And more of their business came from traditional banking activities with corporate clients, not investment banking.

The sovereign-debt crisis of 2010-2012 hit them harder. French lenders were hurt especially by their dependence on short-term U.S. money markets, which became harder for some foreign banks to access during the crisis. Franco-Belgian lender Dexia SA ultimately had to be bailed out.

Crédit Agricole SA booked losses totaling more than €5 billion over five years before selling off its Greek banking arm Emporiki to domestic rival Alpha Bank for just one euro in 2013. BNP Paribas wrote down €900 million of goodwill related to its Italian unit BNL in the face of tougher regulation.

The sovereign-debt crisis forced France’s surviving banks to find new funding in capital markets and through corporate and institutional deposits, and to restructure their corporate and investment-banking business.

“French banks responded quickly to the crisis,” says Kinner Lakhani, head of pan-European bank research at Deutsche Bank. Because of the quality of their corporate loan book, French lenders were able to source new funding and rethink their business models, he adds.

BNP Paribas had a return on equity of 10.6% in the first half of the year. Photo: Christophe Morin/Bloomberg News        

The liquidity crunch in the summer of 2011 acted as a trigger.

“We realized that we needed to completely change the way we did business,” says Yann Gérardin, the head of BNP Paribas corporate and institutional banking.

French banks developed their cash management and securities services to attract new customers for other investment-banking businesses like fixed-income and foreign exchange.

Royal Bank of Scotland’s departure in 2015 from the international cash-management business helped. The U.K. lender referred its clients to BNP Paribas as part of their agreement, and Société Générale hired some of RBS’s top staff in Europe.

French banks also benefited from Deutsche Bank’s financial trouble; many of the German lender’s clients sought to work with a second bank to manage their cash, French bankers say.

French banks’ focus on corporate clients, which have been far more active than institutional ones—such as mutual funds, pension funds and hedge funds—in recent quarters, has also given them an edge over many of their European rivals.

“French banks are well positioned to continue to gain market share across most corporate and investment banks products,” says George Kuznetsov, of the research firm Coalition.

Still, French investment banks are starting from a relatively low base.

Investment banking accounts for roughly one-third of French banks’ revenue, compared with more than half of revenue at Deutsche Bank or Credit Suisse. And French bankers are eager to preserve that balance.

“We believe in the strength of our diversified business model,” said BNP’s Mr. Gérardin.

French banks also remain largely focused on European markets.

“We don’t want to be a merger and acquisition bank in the U.S. and Asia, that’s not our core business,” said Didier Valet, Société Générale deputy chief executive officer.