How the West got China wrong

Decades of optimism about China’s rise have been discarded

Clear thinking and a united front are needed, but they may not be forthcoming

IN MARCH 2000 Bill Clinton divided American opinion on China into two camps. First came optimists with an eye on the future, who could see China becoming “the next great capitalist tiger, with the biggest market in the world.” Then came hawks and pessimists, stuck in the past, who saw China stubbornly remaining “the world’s last great communist dragon and a threat to stability in Asia.” A generation later, those words have the poignancy of a message from a lost world.

Like many either/ors, this one turned out to be a both/and. The China of Xi Jinping is a great mercantilist dragon under strict Communist Party control, using the power of its vast markets to cow and co-opt capitalist rivals, to bend and break the rules-based order and to push America to the periphery of the Asia-Pacific region. It is confident of its strength—since the financial crisis of 2008 it has touted state-guided capitalism as superior to free markets—and newly willing to show its teeth, deploying military might to redraw maps in the South China Sea. It punishes foreign businesses for the actions of their home governments. It is engirdling Eurasia with the contracts and rules that come along with the roads, railways and fibre-optic cables of its Belt and Road Initiative.

This has led to the starkest reversal in modern geopolitics. Political leaders and China-watchers across the West—most notably in America, but also in Europe, Australia and Japan—have come to believe that they were wrong about China’s rise. From cabinets to boardrooms to book-lined studies, voices which once argued that a growing middle class would drive China towards Western values have fallen silent. Hopes for reform were dealt a fresh blow when the Communist Party announced the scrapping of term limits for China’s presidency, allowing Xi Jinping to remain head of state indefinitely.

Greatest good, greatest number

Instead debate divides those who think that it was naive to try engaging with China on the basis of such optimism and those who believe it was rational to make the attempt. Defenders of engagement have a point. China decided to rejoin the world after decades of Maoist isolation of its own accord; thinking that it was better to manage the process than not, as successive American governments did, made sense. Few were entirely Panglossian on the subject. Even in the headiest times America paired engagement with a need for “balancing” China’s rise, strengthening American forces in the Asia-Pacific and deepening security and trading alliances.

The benefits were real. Cheaper goods have been a boon for American consumers; many American companies have done well out of China. And the simple fact that hundreds of millions of Chinese were raised from poverty counted for something with some Westerners.

But the China sceptics had a point. The West was too confident that a prosperous China would inevitably see its liberal democracies as a model. In hindsight, a lot of clever predictions about China look like wishes in disguise.

There is nothing dreamy about the National Security Strategy America published late last year.

A general statement of the administration’s worldview, it says that China “challenge[s] American power, influence, and interests”. For decades, it goes on, American policy was “rooted in the belief that support for China’s rise and for its integration into the post-war international order would liberalise China.” This is deemed a mistake: “Contrary to our hopes, China expanded its power at the expense of the sovereignty of others.”

In consequence, though the strategy stops short of urging a return to cold-war containment, it proposes tougher curbs on Chinese spying and theft of intellectual property, especially from the most innovative American firms. In January an American business delegation warned Chinese officials of Politburo rank that aggressive trade actions by America are more likely than not.

Mr Trump’s administration announced tariffs on aluminium foil on February 28th. It is soon to decide on steep tariffs against steel imports and the merits of a trade complaint punishing China for forced transfers of technology; that may allege close to $1trn in total damages.

Even those on the free-trade side of these debates worry about such showcase policies as “Made in China 2025”, a technology strategy aiming to create national champions in robotics, biomedicine, electric vehicles and more. When asked if they worry that China-curbing measures might disrupt global supply chains, nationalists on Team Trump reply that they want to reroute such chains back into America, while there is still time. In the Senate Republican free-traders like John Cornyn of Texas and Democratic champions of openness like Dianne Feinstein of California are co-sponsoring a bill to tighten the screening of Chinese and other foreign investments for national security.

Not long ago, such sabre-rattling would have triggered an uproar from corporate chieftains, worried about reprisals that would shut them out of China’s markets. But big business is no longer a reliable cheerleader for China. The Stockholm China Forum, a private gathering of senior government officials, diplomats, business bosses and academics from China and the West, recently met in Hong Kong. Never before in the forum’s 11 years have those assembled sounded so gloomy.

Nothing to lose but your supply chains

Foreign businesspeople talked of the “promise fatigue” that has set in as Chinese markets are opened only after they have ceased to matter (the recent decision to allow in American credit cards now mobile payment systems have made them irrelevant is an example). There was talk of dawn raids by Chinese regulators who take away computers filled with priceless intellectual property and global client lists, and of Western businessmen detained on murky grounds. They were especially shaken by the Chinese government’s punishment last year of Lotte, a South Korean-Japanese firm which owns land south-east of Seoul on which American anti-missile batteries are now based. The Chinese dislike the radars, which could see deep into their territory. So they have closed Lotte supermarkets in China, ostensibly as fire hazards. Such arbitrary actions oblige even those businesses making hefty profits in China to think hard about diversifying their risks.

Though some sectors of American business, including retailers and commodity exporters, enjoyed a bumper 2017 in China, the days when boardrooms would nod through anything resembling a bold China strategy are over. Today, faced with continued Chinese subsidies, competition from state-backed rivals and limited market access, the mood is grim.

It could get grimmer. Western officials and experts note China’s growing military strength and its increased willingness to interfere in political debates across the democratic world, whether by funding friendly politicians and academic institutions, stirring up nationalism among Chinese students overseas, buying up foreign media outlets or bullying publishers. The “window” for confronting and challenging Chinese aggression, they say, is closing.

Part of what is so spectacular about the decline of Sino-optimism is how recently and how thoroughly it held the high ground. The idea that global engagement and rising prosperity would drive Chinese convergence with Western values was one of the last beliefs shared by all sides in the Washington elite. In that speech from 2000, aimed at encouraging Congress to dismantle barriers to commerce with China prior to its joining the World Trade Organisation (WTO), Mr Clinton drew a direct line between free enterprise and pressure for accountable government. When individuals have the power to realise their dreams, he enthused, “They will demand a greater say.” Just two months later George Bush, campaigning for the presidency at a giant Boeing plant, predicted that China’s WTO entry would bring both more jobs and political benefits. American goods would flow to Chinese consumers, China would enjoy “more open contact with the world of freedom.’’

The optimists’ camp could count on support from political and business elites, and from diplomats and sinologists who had been watching China’s rise since the last days of Chairman Mao. The pessimists’ camp was much smaller, and was dominated by old-school security hawks and hard-to-impress trade union leaders, sniffing a plot by bosses to lower American wages.

Now one of their number sits in the Oval Office.

Westplaining modernity

The optimists made two sorts of mistake. The first was to overestimate the subversive power of various novelties. This was often an error of projection: they could not imagine being as tireless as Chinese leaders turned out to be in defending their authority. Modern telecommunications technologies “have proved an unambiguous threat to totalitarian regimes,” Rupert Murdoch claimed in 1993. He later recanted, seeking to assuage appalled Chinese leaders, but plenty of others insisted that he had been right first time, if not about the faxes and satellite televisions of the 1990s, then about the internet of the 2000s. Why, technology entrepreneurs would scoff in Beijing bars a generation ago, China would have to hire hundreds of thousands of secret policemen to control the internet. Then China did more or less precisely that.

When Britain returned Hong Kong to China in 1997, under a 50-year agreement to preserve its free speech, free markets, rule of law and limited democracy, a New York Times columnist wondered if the city would prove a “colossal Trojan Horse”, bringing democracy to China’s mainland. Today Benny Tai, an activist law professor, sees little scope for an Odysseus of Hong Kong. Mr Tai was one of the founders of the Occupy Central protest movement which blocked streets in the business and financial heart of Hong Kong for weeks in 2014, in a bid to press the government to move towards universal suffrage—something Hong Kong’s Basic Law promises.

But he no longer believes that direct pressure from Hong Kong democrats is enough to achieve universal suffrage. He now believes Hong Kong’s best hope is the emergence of a democratic movement in China.

The second broad error made by optimists was to imagine that Western governments and organisations could explain to Chinese leaders where China’s self-interest lay. The modern history of foreign interactions with China is littered with such sometimes condescending attempts. An ambassador to Beijing, 20 years ago, was fond of describing one of the West’s roles as helping China to correct its worst blunders. Our job is “to build ladders for China to climb down,” he would sigh.

More subtle attempts to influence China aimed to harness forces pushing for change within the system. Working with reformist officials, Western governments promoted the idea that China could benefit from the rule of law, even if it were not ready to adopt universal values. They organised seminars and gave scholarships to judges and lawyers to study abroad on the argument that, if prosecutors, police officers and courts were to grant citizens the rights which in theory they already enjoyed under China’s laws and constitution, that would be a big advance. But with some reformist lawyers jailed and many more silenced, and with Mr Xi opposed to any separation of powers that might put laws above the Communist Party, a foreign expert says: “The window has closed, the chance of using the rule of law to advance human rights has vanished.”

Attempts to explain to China why it should join the West in a rules-based global order reached a high point in 2005. In an influential speech Robert Zoellick, then America’s deputy Secretary of State, urged China to become a “responsible stakeholder” in the international system that was helping it become stronger and more prosperous. The world, he said, was watching China’s rise and was wondering how it would use the influence that came with it. That very gentle, veiled threat came along with an assessment of China’s fragility. Pointing to strikes, rural anti-corruption protests and rising crime, Mr Zoellick advised: “Closed politics cannot be a permanent feature of Chinese society. It is simply not sustainable—as economic growth continues, better-off Chinese will want a greater say in their future, and pressure builds for political reform.” Seeking signs of hope, he pointed to village and grassroots elections and suggested that “they might be expanded—perhaps to counties and provinces—as a next step.”

That turned out to be a mirage—but only after American presidents had praised such elections time and again in speeches to Chinese audiences.

Western leaders also spent years praising China for embracing global goods, with varying degrees of justification. Europeans spoke admiringly of the leadership it showed in climate diplomacy and renewable energy. Its rulers were hailed for hosting six-party talks aimed at curbing North Korea’s nuclear programme. The mood has soured now. China has signed up to unprecedented sanctions on North Korea, curbing its coal trade with that murderous regime.

But Chinese leaders continue to water down and resist still-harsher sanctions, as they fear the collapse of the Kim regime more than its nukes.

The strong and the weak

Some past optimism was a form of cockiness. Asked about some warships China had bought from Russia in 2000, an American in Beijing described them as “an interesting morning’s work for the Seventh Fleet.” Not now. Pentagon types question the military utility of China’s outposts in the South China Sea. But the new bases, built atop reefs bulked up with dredged rock and sand, have real diplomatic nuisance value. Ian Storey of the Institute of Southeast Asian Studies in Singapore notes that China is urging neighbouring governments to agree on a Code of Conduct for the South China Sea that would ban military exercises within the 200-nautical-mile (370km) Exclusive Economic Zone of any coastal state without that state’s permission. That would greatly complicate America’s life in the Pacific.

Far from China converging with international laws, Western officials see the country seeking to be subject only to weak and vague rules over which it maintains strong powers of interpretation. Though not challenging bodies like the WTO or UN directly, China is increasingly keen on alternative forums. Nobody is quite sure what China means when it calls for schemes funded under the Belt and Road Initiative to be subject to special dispute settlement courts in China, but it makes American and European officials anxious.

Weighing the challenge of a rising China dispassionately is made harder by a simultaneous, and not coincidental, crisis of confidence in the West. One happy story that no longer provides much cheer is the idea that open societies will always outpace lumbering autocracies. In 2013 America’s vice-president, Joe Biden, dropped in on the visa queue at the American embassy in Beijing and startled the Chinese students there with his observation that though American school pupils might not be at the top of global league tables, their defiance of orthodoxy gave them an edge. “Innovation can only occur where you can breathe free,” he told them. In a speech in 2014 Mr Biden conceded that China is graduating lots of scientists, but challenged his audience to name “one innovative product that has come out of China.”

Today the West is in a funk. It is a time for serious thinking about how to balance China more effectively, with a united front and without losing sight of the strengths of democratic, accountable government, a free press and independent courts. Instead the West feels tired, timid and tetchy. From Washington to the capitals of Europe, the air is filled with calls for “reciprocity” in dealings with China. Such calls cover everything from more aggressive screening of investments to proposals to deny Chinese academics visas if Western counterparts are denied access to China. More transparency is a necessity when Chinese money is on offer.

But few will win from tit-for-tat reprisals.

Western politicians have spent years rationalising their retreats in the face of Chinese pressure.

The West has lost hope that it can make China embrace universal values. That would be a poor reason for the West to betray those values in response.

Pessimism Amid Plenty

Michael Spence

MILAN – A few years ago, I wrote a book called The Next Convergence, about how developing economies were “catching up” to their advanced counterparts in terms of income, wealth, health, and other measures of wellbeing. I looked not just at how these countries had achieved rapid growth – including the central role played by an open global economy – but also at the opportunities and challenges this process of convergence would bring.

In writing the book, I had planned to include a lot of data in visual form. But a respected literary agent told me that using graphs was a bad idea, because only a small share of people absorb quantitative information better when it is presented visually. I came to realize that graphs are, in a sense, answers to questions. If you don’t pose a question, a graph is somewhere between uninteresting and meaningless.1

Recently, the Harvard University psychologist Steven Pinker published a book documenting long-term positive trends in multiple dimensions of wellbeing, which he calls “the fruits of the Enlightenment.” Progress is not, Pinker acknowledges, consistent; there have been significant setbacks as new challenges, such as climate change, have emerged. But, generally, wellbeing has been improving since at least the mid-eighteenth century, with the Industrial Revolution bringing a sharp acceleration in welfare gains. Since World War II, 85% of the world’s population living in developing countries have benefited as well.

Yet, while Pinker uses many graphs to demonstrate this progress, most people seem not to perceive it, or at least to discount it relative to immediate problems and worries. Why?

A host of factors contributes to the divergence between data and perception, beginning with people’s innate biases. One such bias is the “optimism gap”: people tend to be more optimistic about their own circumstances than they are about those of others, or of society in general. Another is what the Nobel laureate Daniel Kahneman and his long-time collaborator, the psychologist Amos Tversky, refer to as the “availability heuristic”: people estimate the frequency of events by the ease with which examples come to mind.

When it comes to assessing economic and social trends, both biases are shaped by the news cycle. Pinker cites data indicating that the share of negative news stories has trended upward in the post-war period. Since the advent of digital and social media, the news cycle has been shortened to minutes, encouraging a continuous flow of imprecise, sensational, false, or deeply biased content. Negative news tends to sell better, perhaps because of a built-in negativity bias. It doesn’t help that on social media, users can “self-select” the type of content to which they are exposed, potentially reinforcing their existing biases.

Uncertainty, too, can fuel a more pessimistic assessment of trends. And there is no shortage of uncertainty in the world today.1

In developed countries, globalization and automation have already produced significant shifts in labor markets and income distribution. The continuing takeover of economic activity by artificial intelligence and robotics is likely to sustain and even accelerate these trends. Such global economic and technological forces are widely viewed as beyond the control of countries’ governance structures, raising doubts about the efficacy of policy responses.

Similarly, climate change is beyond the capacity of any country to address alone, and there are serious questions about whether the global community’s response is even close to aggressive enough to stave off disaster. The apparent crumbling of the post-war global order – and the lack of a clear idea as to what will replace it – compounds concerns about the efficacy of international cooperation.

It is also true that aggregate economic data can and do obscure more localized problems. While the benefits of globalization have been enormous, they have been unevenly spread. Many regional and local economies have been rocked by job losses and the decline of entire industrial sectors – developments that have contributed to rising inequality.

The danger of ignoring the distributional aspects of growth patterns has lately come to the fore, as widening inequality has emerged as a key contributor to negative attitudes about economic and social progress. Pinker and others rightly point out that rising inequality does not imply absolute losses for subgroups, unless overall income growth is flat.

But while extreme inequality and poverty are unacceptable in most societies, some disparities of income and wealth are widely viewed as a tolerable, even inevitable, corollary of a market economy, though the specific level of inequality that is considered appropriate varies across countries. The real issue, then, becomes perceived fairness in a particular society – a hard indicator to quantify. Meritocracy, transparency, and constraints on the extremes seem to be the most salient dimensions of that question.

To some extent, societies’ perceptions of economic trends – whether positive or negative – comes down to policy responses. When policymakers ignore losses in particular regions or sectors, the result is anger and social division – and negative views about the economy’s trajectory. When policymakers provide adequate protection to their citizens, those views may be more likely to skew positively.

This point was driven home in a recent New York Times article, which cited a European Commission survey indicating that 80% of Swedes “express positive views about robots and artificial intelligence.” On the other hand, “a survey by the Pew Research Center found that 72% of Americans were ‘worried’ about a future in which robots and computers substitute for humans.”

Swedes broadly view technology as essential to foster competitiveness, fuel productivity growth, and thus expand surpluses that will be distributed among workers, management, and owners according to shared values, or used to help adapt worker skills. And there is a comprehensive – and admittedly expensive – social-security system to support people in transition. In the US, pessimistic views of major economic trends may be fueled partly by a lack of adequate policy responses and less robust social-safety nets. Attitudes toward globalization and digital technology also tend to be more positive in high-growth developing countries like India and China, where progress is highly visible and digital technologies look more like growth engines than threats.

While there is no shortage of challenges facing economies and societies today, they should not be allowed to obscure positive long-term trends. The best remedies for “undue” and potentially debilitating pessimism are practical: effective fact-based policymaking, shaped by scientific inquiry and social solidarity.

Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, Advisory Board Co-Chair of the Asia Global Institute in Hong Kong, and Chair of the World Economic Forum Global Agenda Council on New Growth Models. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence – The Future of Economic Growth in a Multispeed World.

How Gargantuan Can Private Equity Get?

The previous fundraising boom led to some of the most troubled deals ever done by private equity

By Paul J. Davies

Total assets under management

Stephen Schwarzman has a simple mission for Blackstone , the world’s biggest listed private-equity group: double assets under management. For a group that already has $434 billion up from less than $100 billion a decade ago, that sounds ambitious, but Blackstone isn’t alone.

The biggest private-equity firms are in a fund-raising frenzy, fed by insurers’ and pension funds’ hunt for yield and a conviction that private markets will produce better returns than highly liquid and efficient public markets.

Across the entire private equity, hedge fund and alternatives industry globally assets under management are forecast to more than double to $21 trillion by 2025, according to consultants PwC. That would include $10.2 trillion in private equity—or enough money to buy half of the $22 trillion of stocks listed on the New York Stock Exchange today or every stock in mainland China.

Apollo Global Management , APO 1.03%▲ Blackstone, Carlyle and KKR increased their assets by a mind-boggling $247 billion between them just last year — and they all have plans to raise billions more.

Fundraising in 2017 and univested assets at year end

The question is whether the biggest firms, which have attracted a growing share of the money, can keep finding the returns that have made them such money magnets. The industry built its reputation on being the most active of managers, that trick will be tough to repeat on an ever-larger scale.

Part of their answer is to move away from classic private equity into other areas. First that was private credit, where they double-up on their existing skills by buying and lending to the same or similar companies. That is a smart synergy in good times, but means they can be twice exposed when companies hit trouble.

More recently they increasingly moved beyond their core skills into infrastructure, real estate and other assets sometimes targeting lower returns and tying up money for longer.

Blackstone alone took in $108 billion of new assets last year, but just 12% of that was in private-equity funds, while more than half, or $59 billion, was raised in its credit business, and of that nearly $23 billion was in insurance company assets. Blackstone is following the example of Apollo, which already manages $85 billion for insurance companies it built.

Assets under management by type in 2017

The point of all this: generating streams of management fees, which are predictable, steady and valued by public shareholders. On many of their funds, firms collect management fees of 1% to 2% of assets before doing anything. They can then get 20% of the profits as performance fees.

They are tying up investor funds for longer by running listed vehicles that never have to return capital, such as in business development companies, and striking strategic partnerships where investors’ money is tied up for 15 years, instead of the customary eight to 10 years. Scott Nuttall, co-president of KKR, told a conference in December that the firm had good sight of its revenues out to 2035. “And yes, I meant to say 2035,” he added.

When the industry has $1.6 trillion of uninvested money to deploy, $1 trillion of which is in private equity, it is going to be ever harder to find good deals. Valuations on buyout deals, for instance, have risen steadily since the crisis and are now higher at 10.5 times underlying earnings than they were in 2007.

Buyout deal prices
as a multiple of earnings
before interest, tax,
amortization and depreciation

The previous fundraising boom led to some of the most troubled deals ever done by private equity: think of Chrysler, or TXU, or Caesars Entertainment . Since the crisis, returns for the industry have been in the low-to-mid teens rather than the 20%-plus levels it built its reputation on.

The more money that floods in, the greater the likelihood of disappointment.


The long-term returns from collectibles

Investing in the finer things of life

BONDS, shares and Treasury bills are all very well, but in the end they are just pieces of paper. They are not assets you can hang on the wall or display to admiring neighbours. Many rich people like to invest their wealth in more tangible form; property, of course, but also collectibles such as art, fine wine and classic cars.

Is that wise? Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS) have run the numbers for their annual analysis of the financial markets in the Credit Suisse global investment-returns yearbook. Some of these assets have done rather better than others (see chart). Fine wine delivered the best returns; surprising to cynics who might assume that, in the long run, the value of wine vanishes as it turns into vinegar. Really old wine often has historical resonance. A bottle of Chateau Lafite Rothschild from 1787 was sold for $156,450 in 1985 because it was thought to belong to Thomas Jefferson.

Estimating the returns from these assets, after costs, is tricky. Indices covering art or musical instruments are much less comprehensive than those covering shares. There may be an upward bias inherent in collectible returns, as successful works are more likely to survive.

Transaction costs, if valuables are sold at auction, may be 30-40%. But these are the kind of assets that tend to be held for many decades (and passed between generations) so the annual cost burden may compare reasonably with equities, which are traded much more frequently.

Then there are the costs of insurance. If people want to keep a Stradivarius at home, theft is a big risk; robbery with violins is a serious crime, after all.

But tax is a potential advantage for collectibles. Financial assets come with income streams that have historically been taxed at marginal rates of 40% or more. Art and stamps generate no income stream and incur tax only when they are sold. The academics calculate that, after tax, collectibles have generated higher returns than equities for British investors since 1900.

On top of that, investors may get an “emotional return” out of owning these assets, which may be as much a hobby as an investment. Anyone who has met an owner of a classic car will know they can display spaniel-like devotion to their vehicles.

What about the largest asset that many people hold—their home? The total value of global property was around $228trn at the end of 2016, against $170trn for equities and bonds. The academics are highly sceptical of a recent paper* that claimed housing has enjoyed equity-like real returns with less risk. They think this is an example of Twyman’s law: “If a statistic looks interesting or unusual, it is probably wrong.”

In terms of rental income, they say the study made “heroic” estimates of the effect of agency fees and voids (periods when the property is empty). When it comes to the level of house prices over the decades, the LBS academics say that a number of downward adjustments need to be made. The most significant is that the quality of the housing stock has improved. Over the past century homeowners have spent a great deal of money on extensions, central heating, indoor plumbing and so on. When all the adjustments have been made, the real return on housing has probably been less than on equities but more than on government bonds.

Perhaps the most surprising finding in the yearbook is that gold and silver have both done worse than cash and bonds over the past 118 years, despite high inflation during much of that period. In fact, gold performed best in real terms (although only as well as Treasury bills) when there was sharp deflation. Gold did substantially outperform T-bills during high-inflation periods, but this hedge comes at a long-term cost.

In the long run, equities have been the best-performing asset class, with a global real return of 5.2% since 1900. But that does not mean investors should assume those high returns will continue.

The prospective return on shares is equal to the real return on riskless assets (such as T-bills) plus a risk premium. That premium is now around 3.5% a year, the LBS trio think. As the real return on T-bills is currently negative, that suggests a real return on equities of around 3%.

The LBS academics made a similar forecast about low returns in 2000. The real return on shares since then has been 2.9%. If the professors are right again, more investors will be tempted by Bordeaux and Bugattis.

* The Rate of Return on Everything 1870-2015 by Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick and Alan Taylor