Will China Impose a New World Order?

When Pax Britannica gave way to Pax Americana, the transition was peaceful. A repeat is unlikely, says the author of ‘Safe Passage.’

By Tunku Varadarajan

When Kori Schake was a senior at Stanford in 1984, she enrolled in a seminar on Soviet politics taught by Condoleezza Rice, then 29. The two young women hit it off. “I was a dreamy, impractical kid, and didn’t have a plan for what I was going to do after I graduated,” says Ms. Schake (pronounced “shocky”). “Condi saw me at loose ends and offered me a job as her research assistant.” They worked together for a year on a book about “elite selection in the military that Condi never ended up writing. But I read everything about what makes the American military tick. Everything.”

Thirty-four years later, Ms. Schake has written a book—her fourth—whose jacket carries a glowing blurb from her illustrious former professor. The book, “Safe Passage,” traces the international order’s transition from British to American hegemony. With all of the talk of China’s rise and what it will mean for the U.S., Ms. Schake says, she “got curious about the history of transitions between a rising power and an established global hegemon. The only peaceful transition in all of history, I found, is the one between Britain and the United States.” (Ms. Schake has made that transition in reverse. She moved earlier this month from Stanford to London, where she is an executive at the International Institute for Strategic Studies, a defense think tank.)

The U.S. did not fully supplant Britain until 1945. But the American challenge began in 1823 with the Monroe Doctrine, under which the U.S. declared the Western Hemisphere to be its own exclusive zone of influence. “It was the first opportunity the United States had to assert a different calculus for the rules of international order,” Ms. Schake says. “A hegemon isn’t just a country that’s powerful or wealthy, but one that aspires to set the rules and is willing to enforce them.”

Is China the next hegemon? President Xi Jinping appears to challenge the U.S. frequently and deliberately. Ms. Schake agrees that Mr. Xi is “clearly telegraphing that China wants different rules.” She points to the “One Belt, One Road” initiative—a plan to establish a China-centered global trading network that would extend to Western Europe, Northern Africa and Australia, under which Beijing would make loans to countries that need to expand their infrastructure.

She also cites Beijing’s aggressive maritime claims, most prominently in the South China Sea, to which “Chinese scholars make comparisons with the Monroe Doctrine. It’s a legitimation device, by which they say, ‘You had your sphere of influence when you were a rising power. Now we have our sphere.’ ”

                                            Illustration: Terry Shoffner 

Not that Ms. Schake thinks the U.S. should accede. “There’s no reason for us to accept that Chinese assertion,” she says, because China’s neighbors—over whom Beijing seeks to impose its will—are “friends and partners and allies of the United States. We aren’t a modern parallel of European states seeking to colonize Latin America.”

Most states in the Asia-Pacific region seem content with the existing order, and “by being so brazen and uncooperative during its rise, China has actually activated the antibodies that will help prevent its success.” The exception is the Philippines, which has cozied up to Mr. Xi, “but that has less to do with China and more to do with the leadership in Manila”—a reference to the maverick Filipino president, Rodrigo Duterte.

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In her book, however, she warns that “America is making the same strategic choice with China that Great Britain did with a rising America,” in assuming that the rising power “can be induced to comply with extant rules.” Does that mean that the Pax Americana must someday give way to a Pax Sinica? After all, that British tactic of accommodation helped pave the way for the U.S. to take over world leadership.

Ms. Schake demurs. “What the U.S. is saying to China,” she says, “is that if you behave as a liberal political and economic power in the international order, we’ll help you succeed in the existing global order.” The U.S. expects China to understand that “our allies will be protected, even if China is the challenger. If the autonomy or security of South Korea and Japan, Australia or Taiwan, is challenged, we’ll defend them.”

The U.S. has also made clear that disputes over territories and waters need to be resolved by peaceful negotiation. China, says Ms. Schake, will not be allowed to “use force to impose its will on weaker states in the region.”

Ms. Schake worries about the Trump administration’s protectionist inclinations: “I do think that President Trump is calling into question some of the fundamental rules of the liberal international order that the hard men who won World War II created in its aftermath.” Free trade, she says, “undergirds political relationships. Prosperity gives states reasons to cooperate, and to broaden participation in a liberal order.”

She fears that Mr. Trump “does not seem persuaded by those fundamental American arguments,” and she laments his withdrawing the U.S. from the Trans-Pacific Partnership. Ms. Schake invokes the late Nobel economics laureate who supervised her doctoral dissertation: “ Tom Schelling would be shaking his head if he were here, saying that Trump gave that enormous strategic advantage to China without even getting anything in return.”

The good news is that the other 11 members of the trade deal “have determined to continue to try to bring the TPP into effect without the United States. So it’s an example of the liberal international order being sustained without American leadership.”

And Ms. Schake’s overall view of the administration’s foreign policy is favorable. Trade, she says, is “the only area in which Trump has, so far, been demonstrably damaging to the liberal international order.” In other areas, she thinks the administration “has actually made policy decisions consistent with the existing order,” even if Mr. Trump is an “outlier” regarding the philosophy on which it rests.

She points to Mr. Trump’s “continuing to assist Afghanistan until it has the ability to secure its own territory from threats to itself and to us.” She also cites U.S. assistance to the government of Iraq, “to secure it against malign external and internal influence,” as well as support for the security of “our stalwart Asian allies.” Besides, she says, Mr. Trump’s predecessor was hardly a champion of the Pax Americana: “I think you could make a strong case that President Obama’s foreign policy was one of retrenchment, shifting burdens onto allies and off America’s shoulders.”

As for China, Ms. Schake says she is “less convinced than many other people” that its rise will continue. But if Beijing does seriously challenge the U.S., she is “deeply skeptical that a hegemonic transition would happen peacefully.” A fundamental difference between the two countries is that even when the U.S. acts in ways that many would regard as globally unpopular, it does so while sincerely proclaiming universal values.

What values might a hegemonic China impart on the world? “Their leadership is groping to come up with something,” Ms. Schake says. “Xi has talked about the Chinese Dream, but it’s of a prosperous China where people don’t agitate for political control, where they trust the leadership to do the right thing for them.”

The unwillingness of major Western leaders to endorse One Belt, One Road illustrates for Ms. Schake “how much concern the established powers—the U.S., France, Britain—have about China attempting to change the rules.” She cites with evident pleasure Defense Secretary Jim Mattis’s remark last year: that in a globalized world “there are many belts and many roads.” Mr. Mattis and Ms. Schake are close friends and longtime colleagues, and have edited a book together.

The Chinese initiative has also served, unintentionally, to highlight the attractions of the American-led international order: “The rules we established are advantageous not only to us, but also foster prosperity and peace for other countries.” The rest of the world sees its interests advanced by sustaining the current system, and the U.S. rarely has to enforce the rules. As Ms. Schake puts it, “we get the advantage of playing team sports because of the nature of the rules we’ve established.” That isn’t true for China. It claims One Belt, One Road is mutually advantageous, “but other countries’ concerns about sovereignty and what happens if loan terms aren’t met may yet stall China’s ambitions.”

In other words, unless China can come up with a more attractive narrative about itself and its ambitions, most countries will continue to favor the American-led order. “We have been a clumsy hegemon, certainly,” Ms. Schake says, “but we have also been a largely beneficent one.”

Mr. Varadarajan is a fellow at Stanford University’s Hoover Institution.


Passive funds tracking an index lose out when its make-up changes

Maybe there is hope for active fund managers after all

IS THERE hope for fund managers after all? Conventional “active” managers, who try to pick stocks that will beat the market, have been losing ground to “passive” funds, which simply own all assets in a given sector in proportion to their market value. The main advantage of the latter group is that they charge a lot less.

William Sharpe, a Nobel prizewinning economist, argued in 1991 that the “arithmetic of active management” means that the average fund manager is doomed to underperform. To understand why, assume that there are equal numbers of active and passive managers and, between them, they own all the market. The market returns 10%. How much will the passive managers earn? The answer must be 10%, before costs. The active managers own that bit of the market the passive managers don’t. But that proportion of the market must, thanks to simple arithmetic, also return 10%, before costs. Since the costs of active investors are higher, the average active manager must underperform. These numbers hold true, regardless of the proportion of the market owned by the two groups.

But Lasse Heje Pedersen, in a new paper* in the Financial Analysts Journal, takes issue with Mr Sharpe’s argument. Mr Pedersen, who is an academic and a principal at AQR, a fund-management firm, says that Mr Sharpe’s reasoning only holds true if the composition of the market remains unchanged.

In practice, new companies float on the market; others are relegated from—or promoted to—indices such as the S&P 500; and some firms buy back their own shares. The holdings of those investors that were truly passive (ie, did nothing at all) would cease to resemble the market. Someone who bought all listed American stocks in 1986 and did nothing would by now own less than half the market.

So passive investors have to trade to keep their portfolios in line with the index. That gives active managers the chance to outperform. Shares in new issues tend to rise when they float. If passive investors do not take part in the flotations (because the stocks are not yet in the index), they will miss out on those gains. But suppose they do take part. A popular new issue will be oversubscribed and passive investors will get fewer shares than they desire. They will have to top up their holdings after the flotation when the issue has risen in price. Conversely, passive investors will get their full allocation of shares in unpopular flotations, which will probably fall in price.

These points are valid. But how significant are they? The average annual change in the composition of securities in the S&P 500 index is around 7.6%. On that basis, the annual trading costs for a passive investor might be about a quarter of a percentage point. Even including the index manager’s fee, the total cost is still well below the charges made by most active managers.

When it comes to bond indices, however, the market changes a lot more frequently. That is because, whereas equities are permanent capital, bonds have shorter maturities (and some issuers default). For an investment-grade index, the turnover is 49% a year and for high-yield, or “junk”, securities, it is 93%. So trading costs will be markedly higher.

Another flaw in tracking corporate-bond indices, weighted by market value, is that investors end up with the biggest exposure to the most indebted companies. All this suggests that fund managers might have more scope to beat benchmarks in bond markets than they do in equity markets. Another paper by Mr Pedersen’s colleagues at AQR (“The illusion of active fixed-income diversification”) shows that fixed-income managers did indeed outperform their benchmarks, after fees, over the 20 years from 1997 to 2017.

But there is a catch. AQR finds that the reason active managers outperformed the indices is that their holdings were highly correlated with junk-bond returns. These performed very well over the period as a whole. But they exposed the managers to more risk. Their decision might not have turned out so well.

Indeed, if investors were buying bond funds in order to diversify from equities, then the managers were actually undercutting their strategy. Economic scenarios that are bad for equities (recessions, rising interest rates, falling profits) tend to be bad for junk bonds as well.

It is one thing to discover a theoretical way for active managers to outperform. It is another to identify individual managers who can reliably do so.

*“Sharpening the arithmetic of active management”, by Lasse Heje Pedersen, Financial Analysts Journal, January 2018.

Pay-or-Play Capitalism

Jim O'Neill  

Man writing on glass screen, colleagues watching

LONDON – When I led the British government’s Review on Antimicrobial Resistance (AMR) from 2014 to 2016, we suggested various ways to fund a market-entry reward for drug makers that develop new antibiotics and vaccines. To that end, one of our most controversial proposals was what we called “pay or play”: a $12 billion pot would be financed by a surcharge levied on the overall sales of pharmaceutical companies that were not developing new drugs.

I came to embrace this idea when I learned that many leading pharmaceutical companies often manage their price-to-earnings performance by buying back their own shares, thereby reducing the number of outstanding shares in the market. And while many in the industry would say that there is little difference between this and issuing a dividend payment, I beg to differ.

A dividend payment benefits all shareholders directly, whereas share buybacks directly benefit only the firm’s senior executives. Yes, in theory, if buybacks help to boost the price-to-earnings ratio, that might help shareholders generally, all else being equal. But if pharmaceutical companies are using buybacks to boost executive compensation while avoiding investments that could lead to far-reaching societal benefits, then something is wrong.

Since proposing a pay-or-play scheme for the pharmaceutical industry, I have come to think that the same principle could be applied more broadly in business. Larry Fink, the CEO of the asset-management firm BlackRock, might agree. At a time when many people have come to doubt that the modern global economy serves their interests, Fink has called on all companies to do more to make a “positive contribution to society.”

In my view, all companies, particularly those that are publicly listed, need to embrace the principle of enlightened self-interest, and recognize that a healthy society is better for their own business in the long run. But until they do, policymakers should start thinking about how pay-or-play schemes could be used to address growing popular disenchantment with a corporate sector where only insiders seem to benefit from rising profits.

Here in the United Kingdom, there are a few areas where pay-or-play schemes could prove useful. For example, many companies now organize their affairs in such a way as to avoid paying UK corporate taxes, despite having conducted their business here. So, why not replace the tax on reported profits with a pay-or-play tax on a percentage of their overall sales?

A second problem in the UK is a shortage of skilled workers. When I was serving as Commercial Secretary to the UK Treasury in 2015-2016, business leaders often griped about this shortcoming as if they expected the government to be the sole provider of worker training. But don’t corporations also have a duty to train the labor force from which they recruit?

Former Prime Minister David Cameron started to address this issue by imposing a “skills levy” on firms hiring foreign workers, with the proceeds earmarked to fund worker-training programs. This version of a pay-or-play program now needs to be expanded so that it can have a lasting impact.

Germany, where some 20% of the federal education budget is funded by German companies and set aside for vocational training, has established a good model to follow. It should not be too much to ask British companies to do something similar, especially given that it is in their own interests.

A third challenge in the UK is pension shortfalls resulting from firms going bust. For example, when the major government contractor Carillion recently filed for bankruptcy, it revealed that it has a £590 million ($826 million) pension deficit, despite having paid out generous dividends in recent years. Surely, companies must be held more accountable. Those failing to keep their pension balances in the black should have to pay into a bailout fund before they can pursue share buybacks or similar programs.

A final concern in the UK is, of course, Brexit. It is clear that the European Union will not allow the UK to participate in the European single market unless it provides for the free movement of goods, capital, services, and people. Still, the EU might be more willing to grant access to the single market in exchange for a sizeable entry fee. And who better to provide the funds for that than large British companies that will benefit the most from retaining access to the continent?

To be sure, many corporate leaders would hate such an idea. But at a time when the public is increasingly skeptical of corporations, CEOs are hardly in a position to complain about the effects Brexit will have on their bottom line. They need to open their minds, take out their wallets, and have faith in the promise of enlightened self-interest.

Jim O'Neill, a former chairman of Goldman Sachs Asset Management and former Commercial Secretary to the UK Treasury, is Honorary Professor of Economics at Manchester University and former Chairman of the Review on Antimicrobial Resistance.

Israel, Iran and the War for Syria

By Jacob L. Shapiro

For years, Israel and Iran have attacked each other with words and through their proxies. In Iran, calls for Israel’s destruction are routine, and support for militant groups in Syria, Lebanon and the Gaza Strip intentionally challenges Israel’s security. For Israel, meanwhile, “the year is 1938 and Iran is Germany.” Those are the words of Prime Minister Benjamin Netanyahu, the second-longest serving leader in the country’s history. He has held his position for so long in part because of his ability to convince Israelis that he is best suited to lead Israel in this existential battle with Iran.

It is not surprising, then, that this past weekend’s events seem like a watershed moment. On Feb. 10, an Iranian drone crossed into Israeli territory and was shot down. Israel responded to the Iranian incursion by dispatching fighter jets to attack targets in Syria, including the Tiyas air base, near Palmyra, where the Iranian drone reportedly took off from. Syrian anti-air systems retaliated, striking an Israeli F-16, which crashed after making it back to Israeli territory. This prompted Israel to hit eight Syrian targets and four Iranian positions, according to the Israel Defense Forces. The war of words and proxies seems to be turning into a war between nations.

Lost in this sequence of events is the broader context. Israel is not the only country to have military aircraft shot down by enemy fire in Syria recently. Last week, Russia intensified airstrikes in Idlib province after al-Qaida-linked militants brought down a Russian fighter jet. On the same day the Israeli F-16 went down, Syrian Kurdish fighters reportedly brought down a Turkish military helicopter that was part of Turkey’s invasion of northern Syria. Israel, Russia and Turkey all lost military aircraft during operations in Syria in the past week, and all three are currently working at cross purposes. The Israel-Iran showdown is about far more than just Israel and Iran. It is one aspect of a much larger war for regional power that is being waged more openly with each passing day.

Hazy Alliances

Last week’s crucial developments were not confined to downed military aircraft. On Feb. 6, pro-Assad forces attacked Turkish military forces attempting to set up an outpost close to the city of Aleppo. Some sources reported that an Iranian-backed militia was also involved in the attack. Just two months ago, Turkey and Iran were coordinating a cease-fire in Syria. Now, they are at each other’s throats.

Then on Feb. 7, pro-Assad forces attacked the U.S.-backed Syrian Democratic Forces in eastern Syria, resulting in U.S. airstrikes. Just two months ago, pro-Assad forces and the SDF were coordinating an offensive against the Islamic State. Now, they too are at each other’s throats. The war in Syria has become more than simply a civil war; it is now a regional war featuring Israel, Iran, Russia, Turkey and the United States.

If this seems confusing, that’s because it is. Allegiances are in a constant state of flux, dependent more on what various sides can do for each other in the short term than on long-standing arrangements or promises of trust. Consider that the U.S.-backed SDF, made up primarily of Syrian Kurdish fighters, is cooperating with the Assad regime so it can send reinforcements into Afrin to combat Turkish troops. In effect, the SDF is cooperating with Assad in one part of Syria and coming under attack from Assad in another part of Syria. Consider too that Turkey, officially part of a tripartite agreement with Russia and Iran to bring an end to the Syrian war, has invaded Syria to protect its interests from Russia and Iran, and yet it is equally hostile to Russia and Iran’s main enemy, the United States, because the U.S. is providing support for Syrian Kurds. The only thing that is certain in this conflict is that no alliance is certain.

Hazy as these strategic arrangements are, they all boil down to one thing: Iran’s attempt to take over Syria. Turkey talked about its invasion of northern Syria for over a year, and its troops entered Afrin with great media fanfare. But while Turkey was talking, Iran was actually doing. Since the Syrian civil war started in 2011, Iran has been dispatching soldiers, militias, money and weapons to support the Assad regime. The result has been the transformation of Syria from an authoritarian military dictatorship friendly to Iran to an Iranian proxy in desperate need of Iranian support just to stay alive. For Iran, that is a massive strategic opportunity: It can make its continued support of Bashar Assad contingent on Assad’s allowing Iran to do whatever it wants in Syria. And what Iran wants in Syria is a forward base into the Levant.

That is what has Israel so nervous. Despite all the rhetoric, Israel and Iran haven’t fought a war against each other because there is no way for Israel and Iran to fight a war. They are too far apart. That would no longer be the case if Iran can make Syria a staging ground for Iranian attacks against Israel. It is one thing for an Iranian proxy like Hezbollah, with its limited number of fighters, to fire rockets at Israel from Lebanon. It is quite another thing for Iran to start building missiles, massing ground forces and stationing aircraft in Syria, just across the Israeli border. To make matters worse for Israel, it has no comparable position on the Iranian border. Even if it did, Israel cannot expend soldiers the way Iran can in a protracted conflict. For Israel, Iran’s nuclear program is concerning, but Syria as a base of Iranian operations is a mortal threat.

Israel’s Advantages

Israel has a few things going for it, though. The Assad regime is not dependent on just Iran but Russia too, and Moscow has no interest in Syria becoming an Iranian protectorate. Russia wants to preserve Syria as an independent actor and a Russian ally, not as a part of Iran’s plan to project power throughout the region. The Tiyas air base, which was the target of the Israeli strike over the weekend, has also been a base for Russian aircraft in Syria. Russia and Israel have close relations – Netanyahu was in Russia just last month to express Israeli concerns to Moscow – and Russia is not looking to pick a fight with Israel. Israel may not be able to fight a conventional war against Iran, but the Israeli air force is without peer in the Middle East – and that includes Russia’s aerial presence. Furthermore, the U.S. has Israel’s back on this one. It doesn’t want Iran in Syria any more than Israel does. The Russian-Iranian marriage of convenience will fracture the more ambitious Iran gets.

Iran’s moves in Syria also directly threaten Turkey, which also has no desire to see Iranian bases on its border. The more Iran engages in Syria, the closer it pushes Israel and Turkey together. Ties between the two have been strained since the Mavi Marmara flotilla incident in 2010, but the real reason Israeli-Turkish relations are tense is that Turkey’s position in the Middle East has changed. It went from being a dependable U.S. and NATO ally to a powerful nation-state concerned primarily with securing its own interests, which Israel must view with inherent suspicion. That said, both will see eye to eye on limiting Iran in Syria. If Israel comes to believe Russia is not doing enough to rein Iran in, it will also not hesitate to deepen coordination with Turkey, which would be disastrous from Moscow’s perspective. It would also align with our 2018 forecast.

Last but not least is that the majority of the region’s powers are hostile to Iran. Notably absent from the recent developments in Syria is Iran’s most vociferous enemy, Saudi Arabia. The Saudis, who as recently as November were threatening war against Iran, have fallen eerily silent. But make no mistake: Saudi Arabia remains extremely antagonistic to Iran and will support Israeli moves against it (and Saudi Arabia, unlike Israel, is within range of Iran). In addition, Egypt and Jordan remain aligned with Israel. Egypt invited Hamas leaders to Cairo for a meeting this past weekend, perhaps to let them know that their recent willingness to mend relations with Iran is a nonstarter.

Iran is attempting to take control of Syria. Israel does not want that to happen. Israel has been bombing targets in Syria for years to prevent it from happening. It will continue to do so. But Israel’s future depends not on its bombs but on its ability to position itself within a regional coalition that opposes Iran’s ambitions for power. The outline of that coalition is beginning to take shape: The interests of Israel, Turkey and the Arab states are converging. In a sense, Iran is now in the position the Islamic State was mere months ago. The Islamic State’s emergence created strange bedfellows, all of whom cooperated to ensure its demise. Now Iran is seeking to fill the power vacuum left behind by the Islamic State’s defeat. The responses, of which Israel’s attacks over the weekend are just one example, show why in the long term Iran’s gains are likely to be ephemeral. In the short term, however, Iran will press its advantage. The war in Syria has only just begun.