Bizarre and Ominous

Doug Nolan

Things have gone from surreal to the bizarre. The President points blame directly at Putin for a chemical attack in Syria. Russia threatens to shoot down any missiles fired into Syria. President Trump tweets "Get ready Russia, because [missiles] will be coming, nice and new and 'smart!'" A presidential tweet the next morning provided an unequivocal update: "Could Take Place Very Soon Or Not So Soon At All." Russia claims false flag. "U.S. Says Syria Has Used Chemical Weapons at Least 50 Times During War." Missiles were flying Friday night.

The President's personal attorney, a target of a criminal investigation, had his office and residences raided by the FBI. An enraged President is said to be considering firing the special council and/or the Deputy Attorney General. "Trump Sees Inquiry Into Cohen as Greater Threat Than Mueller." The Speaker of the House announces he's through with Washington.

The former Director of the FBI will release his memoirs next week, with interviews lined up. It's not going to be pretty. Leaks began to flow this week. James Comey likens the "unethical" President to a "mob boss." The President tweeted that Comey is an "untruthful slime ball."

The Treasury department announced the U.S. budget deficit had reached $600 billion during the first-half of the fiscal year. March's deficit of $209 billion was 12% above the consensus estimate. Federal spending during the month was up 7% y-o-y, while revenues increased 2.7%. The CBO announced that Trillion dollar annual deficits will commence soon - about two-years sooner than recently expected.

"President Xi Jinping presided over the Chinese navy's largest-ever military display on Thursday…, the country's latest show of force in the disputed South China Sea." On board a navy destroyer dressed in full military garb, XI announced China would hold live-fire military drills in the Taiwan Strait next week. "…The task of building a strong navy 'has never been as urgent as present.'"

Russian stocks sank 4.5% this week. Russian bond yields surged 43 bps to 7.49%, and the ruble fell 6.2%. Russia canceled a ruble bond auction, as Russian sovereign CDS posted the biggest jump in five years. "The Russian government on Monday called the latest US sanctions against the country 'scandalous' and 'illegal' and vowed it would retaliate…" Russia is putting together a list of banned U.S. imports, including rocket engines and titanium. With the lira down another 1.3% to record lows, Turkish President Erdogan warned that those committing "economic terror" would pay a steep price.

"Vitaly Churkin, Russia's ambassador at the United Nations, said he unfortunately 'cannot exclude any possibilities' when asked about the danger of war between the US and Russia." An ominous Friday evening Bloomberg headline: "Russia, U.S. Near Brink in Syrian Standoff With Nuclear Risks."

The Hong Kong Monetary Authority intervened three straight sessions to support the Hong Kong dollar peg against the U.S. dollar. It was the first currency intervention since 2005.

Aluminum prices surged 15% this week. Palladium jumped 9.2%, and Nickel increased 3.0%. Crude (WTI) surged 8.6%, trading at a three-year high. "Americans Face Highest Pump Prices in Years." Gasoline rose 5.7% this week, and heating oil jumped 7.3%. The GSCI Commodities index jumped 5.5% this week to the high since December 2014.

FOMC minutes offered added confirmation that the Powell Fed is not rushing to coddle the markets. Increasingly, they see upside risks to both growth and inflation. Rates remain much too low. "Fed Leans to Faster Pace of Hikes…" "Excluding food and energy, the core consumer-price index rose 2.1% from March 2017, the most in a year…" "U.S. wholesale prices advanced in March by more than forecast, reflecting broad increases in the costs of services and goods…" Even Chicago Fed President Charles Evans is calling for more hikes.

April 11 - Wall Street Journal (Nick Timiraos): "Federal Reserve officials at their meeting last month expressed greater confidence inflation would rise to their 2% target over the coming year, a development that could affect how much they raise interest rates in coming years. They also debated the costs and benefits of allowing the economy to run hot and discussed how they might need to later raise rates to a level that would deliberately slow growth… The minutes highlight just how much Fed officials' outlook has changed since last fall, when surprisingly slow inflation raised questions about the need for continued rate increases."
April 10 - Bloomberg (Alexandre Tanzi): "Global debt rose to a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher from a decade earlier, according to… the Institute of International Finance. Among mature markets, household debt as a percentage of GDP hit all-time highs in Belgium, Canada, France, Luxembourg, Norway, Sweden and Switzerland. That's a worrying signal, with interest rates beginning to rise globally… Still, the ratio of global debt-to-gross domestic product fell for the fifth consecutive quarter as the world's economic growth accelerated. The ratio is now around 317.8% of GDP, or 4 percentage points below the high in the third quarter of 2016…"

Failing to make the top 1000 newsworthy items of the week, Chinese Credit data nonetheless continues to fascinate. China's March growth in Total Social Finance was reported much weaker than expect. At $212 billion (1.33 trillion yuan), growth was about 25% below estimates. Bank's New Loan growth ($180bn) slightly missed estimates. The big story is the intensifying slowdown in shadow lending, which posted a net contraction during the month. Total Social Finance has expanded about $1.49 TN over the past six months, down 17% from the comparable year ago period.

The marked slowdown in system lending is leading a deceleration in money supply expansion. March saw a notable slowdown. M2 money supply expanded 8.2% y-o-y versus estimates of 8.9%. And at this point it would appear the slowdown in money and Credit has impact general pricing pressures. March CPI was reported up 2.1% y-o-y versus estimates of 2.6%. PPI came in up 3.1% y-o-y versus estimates of 3.3%.

Curiously, China also report disappointing March trade data. China posted a trade deficit of $5.8 billion, the first deficit since February 2017. Imports surged a stronger-than-expected 14.4% y-o-y, while imports were down 2.7% (after a huge February). It's worth noting that China's first quarter trade surplus with the U.S. was up 19.4% to $58.25bn.

Stocks, well, they enjoyed just a splendid week. The S&P500 rose 2.0%, outdone by the Nasdaq100's 3.0% jump. The Biotechs surged 8.6%, and the Semiconductors advanced 5.0%. The DJIA was up about 440 points at Monday's trading highs following Chinese President Xi's "conciliatory" weekend speech. Not enamored with the interpretation, Chinese officials pushed back: "Beijing says Xi speech wasn't a concession to US, it's ready to hit back at any escalation." With option expiration next Friday, it's been another month to tease - then torment - put buyers.

Earnings season started off with a bang. "JPMorgan Q1 Earnings Beat on Better Rates and Trading." "Citi beats, profits jump 13%." "Wells Fargo beats by $0.05 and beats on revenue." On Friday's earnings reports, JPMorgan's stock fell 2.7%, Citigroup dropped 1.6% and Wells Fargo sank 3.4%. Mark Zuckerberg travels to the nation's capital and is grilled for 10 hours. My nine-year-old son asked me why the Democrats were meaner to him than the Republicans. Reasonable question. Facebook rallied 4.7% this week.

Treasuries were a little worried that stocks remain oblivious to an extraordinary host of mounting risks. Ten-year Treasury yields added five bps to 2.83%. Two-year yields jumped nine bps to 2.36%, the high since August 2008.

It will be interesting to see how markets respond to tonight's missile strikes on Syria. It appears as many as 100 missiles hit at least three targets, in a more intensive operation than a year ago.

"Russia's ambassador in Washington Anatoly Antonov said in a statement on Friday immediately after the first strikes on Syria. 'The worst expectations have materialized. Our warnings fell on deaf ears. A pre-planned scenario is being acted on. We are being threatened again. We have warned that such actions will not remain without consequences. All responsibility for them rests upon Washington, London and Paris. Antonov stressed that insulting the Russian president was inadmissible.'"

The week was bizarre and ominous. Reports had President Trump livid after Monday's FBI raid on his personal attorney. I can imagine Putin is absolutely livid in Moscow. For different reasons, I worry increasingly about them both.

Trade disputes reveal the EU’s strategic weakness

A bloc of nations with small-country mindsets wallowing in a permanent state of dependence

Wolfgang Münchau

German Tornado jets at a base in Incirlik, Turkey, in 2016. The warplanes are no longer considered fit for Nato missions © Reuters

The EU is the world’s largest economy. It is home to many of the world’s most successful companies. It has its fair share of political tension and economic crises, but its democracies are robust and its societies stable. And it has an overwhelming interest in maintaining a rules-based system of global governance. Why then is its influence in the world so small?

The reason is not so much the proverbial lack of a single telephone number. The deeper problem is a permanent state of dependence: on Russia for energy supplies; on the US for defence; and on the rest of the world to absorb the EU’s current account surpluses.

The majority of EU countries that are also Nato member states promised in 2006 to increase their defence budget to 2 per cent of GDP. Only four can claim to have met or nearly met the target — the UK, Poland, Greece and Estonia. France is not far off, but Germany’s defence expenditure was only 1.24 per cent last year. German media are full of reports about the decrepit state of the Bundeswehr. German Tornado warplanes are no longer considered fit for Nato missions. The country has scope to increase defence spending if it wanted to. But the combination of a self-imposed rule to run permanent fiscal surpluses and the non-defence spending priorities of the recently constituted grand coalition prevent this.

Despite sanctions against Russia, the EU’s dependence on Russian energy is also now greater than ever. In 2017, Gazprom, the Russian gas company, registered a bumper year of gas deliveries to the EU with record sales to Germany and Austria.

The macroeconomic dependency is more subtle, but it shows up in trade policy. The eurozone had a current account surplus of 3.5 per cent of GDP in 2017 — almost €400bn — a sum that needs to be absorbed by offsetting deficits in the rest of the world. The trade surplus explains why the EU is not keen to impose counter-sanctions to the US steel and aluminium tariffs once the temporary exemption ends on May 1.

The root cause of the EU’s overdependence on other powers is, as it has always been, a collective action problem: a collection of small countries, each of which has their own small-country mindset. There is no such thing as an overall economic, let alone geopolitical, strategy.

The current account surplus, for example, is not a deliberately chosen objective but an effect of national accounting — a number at the bottom of a long spreadsheet. EU households and companies are running external savings surpluses. The collective decision by most eurozone member states to shift the government sector into a permanent surplus then implies a structural current account surplus for the entire eurozone economy.

I recall a conversation a decade ago with the late Italian economist Tommaso Padoa-Schioppa, who saw the euro as a potential instrument of geopolitical power, similar to the role the dollar has played for the US. The idea was to acquire what US economists like to refer to as “the exorbitant privilege” — a status bequeathed by the role of the dollar as a global reserve currency. The exorbitant privilege allows the US to print dollars to finance its own imports. In such a lucky position, you cannot conceivably face a balance of payments crisis.

The eurozone could at least have tried to share its spoils with the US. Such a strategy could indeed have raised its global power and influence. But instead, the EU preferred to subject itself to small-country fiscal rules, giving rise to the triple whammy of a structural current account surplus, an underfunded defence system, and an over-dependence on energy imports.

When you need the world more than it needs you, you are weak. The eurozone is in that position. The US is strong because it has made itself indispensable to the global economy. Of course, President Donald Trump’s trade sanctions will be bad for the US economy. But the point is that he can get away with it.

Russia is more self-sufficient than the EU. China is moving in that direction. What bothers me about the eurozone is not its failure to attain a geopolitical role, but that it never wanted it in the first place.

A Lost Decade Made in China

China’s history is one of cycles – it unifies, it fragments, then it unifies again. The duration of each phase varies, as do the causes of each breakdown, but for hundreds of years the cycle has been reliable. The last devolution followed the European intervention in the 19th century, starting a period of regionalism in which strongmen effectively controlled parts of the country. The Chinese civil war, launched in the 1920s and culminating in the Communist victory in 1949, followed by Mao Zedong’s reign, marked the beginning of the current era of centralization.

Looking at China today, it’s plain to see that the likeliest cause of the next devolution – if there is one – will be financial. China has taken on an enormous debt burden so that it could support state-owned enterprises, which help prop up employment and economic growth. To be sure, China’s economic growth in this era of unity is unprecedented. But the consequence of its approach is an array of economic and political challenges – the problems China will have to overcome if it’s going to break the cycle of unification and fragmentation – of a magnitude that is equally unprecedented. 

To try to predict how China will fare in its endeavor to avoid fragmentation, we look at a comparable and recent example, Japan: The Japanese economic crisis in the late 1980s and early 1990s set off the infamous Lost Decade (though in truth, nearly three decades later Japan is still trying to get out of its slump). Like China, Japan accumulated a lot of debt that was intertwined with its real estate industry, which had systemic implications for its financial system. Japan managed to hold together. Will China?

This Deep Dive will focus on the similarities and differences between Japan’s crisis and the one facing China. It will consider how their different political systems might affect their ability to initiate stimulus and implement reform. And it will investigate China’s earlier banking crisis from the late 1990s to the early 2000s to understand what tools China had at its disposal then, and whether it can leverage them again this time around.

China Now, Japan Then

China’s economic growth over the past four decades has been astonishing. Once a country dependent on agriculture, with near-ubiquitous poverty, it has been transformed into a modern industrial power with falling poverty rates. The sheer size of China, however, means that many people, especially those in rural areas, have not benefited as much as those in the coastal cities. In search of higher incomes, more than 260 million people have moved from the countryside to the cities for work. The result has been a major shift in the composition of China’s economy from being primarily based on agriculture to being overwhelming composed of industry and service sectors. In some ways, this process mirrors that of other industrializing countries, only China’s was largely state-driven and was on a grander scale.

Like most developing countries, China has a fundamental problem: It wants to transition to a consumption-based economy (which is more stable than relying on exports), but its domestic consumer base is not yet wealthy enough to support the level of economic productivity needed to allow for that transition. It has plugged the gap with exports – a vulnerability given that global demand will probably remain limited in coming years – and government-driven investment, resulting in a significant expansion of credit in China’s economy. Its debt grew after the 2008-09 global recession, when Beijing implemented a nearly $600 billion fiscal stimulus package to mitigate the severity of the crisis.

Depending on the source, China’s total debt (both public and private) to gross domestic product ratio is no less than 260 percent and potentially as high as 300 percent. Much of this debt is either directly or indirectly intertwined with the real estate market, which makes it a systemic threat to the financial sector should property prices drop precipitously. To get a handle on the situation before such a financial crisis materializes, President Xi Jinping has assumed vast new authority, placing him at the center of nearly all organs of state, and has begun to implement far-reaching reforms.

Japan’s circumstances were different – its economy had just been wrecked by World War II – but, like China, it rebuilt itself on exports. With the U.S. guaranteeing its security, post-war Japan could focus all its energy on constructing a modern economy. Also like China, Japan first competed on the international market by providing cheap labor for low-cost exports, gradually moving up the value chain to gain a reputation for high-quality manufactured products.

Japan’s economy started to liberalize toward the end of the 1970s and in the 1980s. For the first time, companies could raise money on the capital markets rather than depend entirely on bank loans. Suddenly, Japan’s large commercial banks weren’t making enough money on loans to corporations, and Japanese regulations prevented them from moving into complementary services like investment banking. Other aspects of liberalization drove up funding costs for large commercial banks. They began to undertake riskier lending practices, including more euro-yen borrowing and prime rate borrowing – both of which provided lower interest rate loans to small and medium-sized companies that previously would not have qualified. This put pressure on banks’ margins. Then, with larger banks targeting smaller companies than they normally would, smaller banks, which had previously catered to those small and midsized companies, also found their profits squeezed.

As competition increased, banks extended riskier loans. Maturity periods were extended, which increased exposure to liquidity risk (since the loans would not be paid back for longer periods of time) and interest rate risk (the risk that rates would increase but bank margins would be locked in low in pre-existing loans). Critically, both large and small banks began to seek new lending opportunities in the real estate market. The combined effect was an increase of debt, beginning in the 1970s in the public sector and continuing in the 1980s in the private sector, and an accompanying increase in land values and asset prices driven by the growing availability of credit to the real estate market.

Then things went from bad to worse. To combat high inflation, the U.S. raised interest rates in the early 1980s. This resulted in a large trade deficit in the U.S. that threatened to lead to protectionist measures, which would have done considerable damage to Japan’s and West Germany’s export-driven economies. So, in 1985, West Germany, France, Japan, the United States and the United Kingdom agreed to the Plaza Accords, which devalued the dollar relative to a number of other currencies, including the Japanese yen.

The result of the rapid devaluation of the dollar was a rapid appreciation of the yen relative to the dollar. The exports on which Japan’s economy depended became more expensive for its foreign customers. The resulting slump in exports led the Japanese government to introduce stimulus measures, which, in the late 1980s, began to add considerably to the country’s already large debt burden. By the end of the 1990s, Japan’s total private and public debt peaked at nearly 350 percent of GDP.

Similar to China’s current situation, new credit extended to the real estate sector generated a bubble in land values and asset prices. The Japanese government tried to deflate the bubble by implementing restrictions in real estate lending in 1990. This caused real estate and stock prices to fall rapidly, and real estate companies immediately saw decreased access to credit and a drop in the value of their collateral. Many banks had held reserves in the form of stocks, which put added pressure on the banks’ financial positions when the equity market bubble popped. Economic growth slowed, further undermining the ability of borrowers to service their debt.

All of these factors contributed to growth in nonperforming loans, the extent of which the Japanese government became aware only gradually between 1990 and 1994, when banks found themselves undercapitalized because of the decline in equity prices. Tokyo’s delayed recognition of the severity of the problem was one of the major factors that contributed to the extended malaise of Japan’s economy in the 1990s. The other was the government’s inability to convince the public to provide bailout funds for the banks until 1998, after several major banks began applying for government financial support and others had been ordered by the Ministry of Finance to suspend operations. There are many similarities in this story to what China is undergoing today – the dependence on exports, the stimulus that accelerated the growth of debt, the real estate asset bubble – but China has some advantages that Japan didn’t have. It also has some serious disadvantages.

What Sets China Apart

The comprehensive reforms being implemented by Xi are an indication that China’s elites understand the true magnitude of their problem in a way that Japan, for years, did not. The Chinese elites are willing, at least for now, to concentrate decision-making power with one man who can make the painful changes the country needs – ostensibly without getting mired in bureaucratic sludge. The Communist Party is aware of how much Chinese society must transform to reach a point of greater stability, and it does not intend to let paralysis or hesitation get in its way.

Even before Xi began implementing his most recent reforms following the October 2017 party congress, the government had made some strides in attacking its debt. As Chinese savers have sought higher yields than those from deposit accounts, they have invested ever-growing amounts in shadow banking assets, such as wealth management products, which offer a greater rate of return but are invested in riskier projects (often real estate construction). These have been a headache for the government, which for years has struggled to even understand the true size of the shadow banking market (WMPs are not actually carried on bank balance sheets, hence the term “off-balance sheet product”), let alone discourage their growth. But in 2017, Beijing introduced new regulations that reduced liquidity in the interbank lending market, including a nearly $550 billion decline in WMPs being sold and purchased between banks. That said, interbank WMPs account for only about a fifth of all WMPs, which themselves make up less than half of all shadow banking assets.

Another important distinction between China now and Japan of 30 years ago is their level of development. By the late 1980s, the eve of the Lost Decade, Japan was already a major industrialized country. China is still a developing country. Some regions have made tremendous progress, but much of the country is still quite poor, making China far more unequal than Japan was in 1990. Since many parts of China are still poor, it has not yet developed a robust domestic consumer base. As a result, consumer spending in China is a far smaller component of GDP than it was in Japan when Japan’s crisis hit.

It will be much more difficult for China to develop a consumer economy than it was for Japan – it has a much larger population, spread over a much larger area than Japan. But it is worth noting that China’s levels of investment fairly closely track those of Japan – and, as another point of reference, South Korea – at the same points of their development. Still, China’s investments as a percentage of GDP have diverged in recent years from the trend set by the other two countries.

There are two ways to look at China’s underdevelopment relative to that of 1990s Japan and how it may impact China’s ability to manage its economic woes. On the one hand, that so many people have failed to reap an equal amount of the rewards from China’s success means that, were a financial crisis to hit, people would hurt more in China than they did in Japan, making the country more susceptible to political agitation. Unlike in Japan, where leaders come and go and can be voted out, in China the Communist Party is the government. The only way to throw the bums out in China is to oppose the government itself.

On the flip side, that China arguably has significant growth potential left relative to what Japan had means that it may grow enough over the coming years –  despite projections of slower growth – to overcome some of the financial challenges that could otherwise turn into political unrest. Gauging whether a country is poised for more growth is a difficult task, especially in China, where statistics always have to be viewed with a healthy degree of skepticism. One area that could provide some insight is labor productivity.

Increases in labor productivity can come from a number of sources, such as urban migration and technology. There’s a limit to how much urbanization and worker relocation can add to labor productivity, because there’s a limit to how many workers can leave agricultural jobs in the countryside to pursue industrial work in the cities. Eventually, technology needs to become the driver of increases in labor productivity.

Japan began industrializing in the mid-to-late 19th century, whereas China remained essentially an agricultural society until the onset of Deng Xiaoping’s reforms in the 1980s. Japan’s industrial base was destroyed in World War II and was subsequently rebuilt with U.S. assistance. By the ‘80s, Japan had an advanced economy with a large portion of its society living in cities and working in productive industries. Any further increase in labor productivity at this point would largely have to come from technological innovation. China, however, still has the low-hanging fruit of relocating capital and labor to more productive enterprises and regions. In fact, China’s labor productivity still lags 1980s Japan’s significantly.

Finally, it’s worth mentioning that, though asset and land prices have increased substantially in China, they are still not as large as the bubble experienced by Japan. Japan’s stock index, the Nikkei, grew by nearly 500 percent in the 1980s compared with the 90 percent growth seen in the Shanghai Composite since 2009 (though it did reach about 220 percent growth at its peak in 2015). Land and property values also increased more in Japan than they have in China. A direct comparison on that account is difficult, however, since the Chinese government technically owns all land and therefore can more easily restrict or increase the supply to property developers – though not without causing other problems.

Lessons From an Earlier Chinese Crisis

Yet another distinction between Japan and China is the nature of China’s political system itself. China’s handling of an earlier crisis is an example of the advantage inherent in its system. During the wave of liberalization in Japan’s financial system, banks had to offer higher deposit rates to appeal to capital that could more easily find opportunities abroad. The Chinese government, however, can intervene more directly in the capital markets, and it has been implementing strict capital outflow controls to prevent too much money from leaving the country. This could put pressure on sources of funding and risk an uncontrolled decline in the value of the yuan. China’s authoritarian political system provides it with a greater degree of control over the flows of money and its economy generally. Of course, aggravating an elite segment of the population trying to protect its fortunes by relocating part of them outside of China has political ramifications.

In the wake of China’s banking crisis in 1999, the government moved quickly to set up asset management companies (so-called bad banks) to purchase nonperforming loans from the big state banks, which were subsequently recapitalized. At the time, the financial system was nearly insolvent: NPL rates were estimated to be as high as 40 percent. Compare that to today’s level, where estimates of NPLs in the Chinese economy range from 8 to 16 percent. (The official rate is 1.74 percent, but even most Chinese authorities don’t believe that number.)

Five years later, the Chinese government was able to return banks to profitability by setting a ceiling on deposit rates. This ceiling, notably, was below the inflation rate at the time. Low deposit rates let banks lend to heavily indebted state-owned enterprises at low interest rates, minimizing their debt service burden while also providing a profit margin to banks.

But by requiring deposit rates to be set below inflation, the government was effectively forcing savers to incur a reduction in the value of their savings. Put another way, the government was seizing wealth from the Chinese people and distributing it to state-owned banks and companies to keep them afloat. At the time, the fledgling stock and bond market could not absorb the quantity of capital in the economy, and savers were therefore forced to hold their money in banks. The strategy worked. Chinese banks recovered profitability, which enabled them to undergo a series of initial public offerings to raise even more capital, and the economy kept humming.

This method of asset confiscation may not be available to Beijing this time around. In large part because of savers’ experience last time, a new market for non-banking products has developed that provides both a higher rate of return and, at least for a while, a place to park money that is out of sight of the central government. A large amount of Chinese savings is now placed in WMPs and other such vehicles, which minimizes the state’s ability to corral capital into traditional savings accounts and suppress deposit rates.

The Chinese government, however, has been taking real steps to increase transparency and control of the shadow banking market, and it is not unforeseeable that the government could force people to relocate their money into traditional savings accounts again. The government also hopes to at least minimize the “regulatory arbitrage” opportunities that gave rise to the growth of shadow banking in the first place. For years, China had distinct banking and insurance regulators. Banks and other financial institutions found gaps in the two agencies’ rules and exploited them to sell riskier but more profitable products to investors. Xi recently announced, however, that the regulatory agencies will merge and will be stripped of policymaking powers. The ability to set policy had given rise to interagency competition for oversight and led to a sort of race to the bottom to weaken regulations. Now, the central bank and the Financial Stability and Development Committee will set policy and the regulators will focus on enforcement.

Just because the previous way of seizing wealth may have lost some effectiveness does not mean the Chinese government couldn’t more directly take money from the rich to fund infrastructure development in rural areas and other means of redistributing the benefits of economic growth to the poor. In fact, this is a scenario that many wealthy Chinese are deeply concerned about. As a result, over the past several years, a sizable amount of Chinese capital has fled the country in search of hard assets abroad. This is also why even more capital controls were implemented over the past year.


China has a range of tools available to it, has been generally proactive about its financial problems, and, because of the consolidation of Xi’s power, will likely be able to move more rapidly on its debt problems than Japan could. Still, the magnitude of the obstacles that China must overcome should not be understated. China’s population today, about 1.4 billion people, is more than 10 times that of Japan in 1990. China is far larger than Japan, and far more unequal. Connecting so many people to the growing economy will require massive infrastructure investment that may be outside the scope of China’s funding capacities.

Just because Japan was able to convert from an investment-driven to a consumer-driven economy does not mean China will be able to. The countries’ demographics and size are different, but so is the timing: One of the most significant periods of growth in human history occurred in the latter half of the 20th century, when Japan was reindustrializing and establishing itself as a major value-added exporter. Today, prospects for global growth, and thus demand for Chinese exports, are much dimmer. If global demand slumps before China can achieve higher rates of consumption in its economy, and more people begin to suffer from a stagnant rather than a merely slow-growing economy, then the pain felt in China could sap support for further reform. Not to mention Japan is still essentially recovering from the Lost Decade. China, which lacks the wealth and standard of living that Japan had in the 1990s, may not be able to withstand a similar period of stagnation without slipping into the political instability that the regime so deeply fears.

Then there’s the data issue. China’s government is highly incentivized to manipulate growth figures. After all, slower growth could be a sign of coming hardships, generating political opposition to the Communist Party and endangering the country’s ability to complete its reforms and maintain stability. Just this week, Caixin reported that Chinese manufacturing growth had slowed because of lower export demand, while Chinese official statistics over the weekend said manufacturing growth in fact grew on increased domestic and foreign demand – essentially the opposite claim. There are also mounting examples of Chinese municipalities misreporting data to the central government, which makes it difficult for Beijing to know what exactly is going on in its provinces. This was a non-issue for Japan, which, even before its asset bubble burst in 1989, reported fairly reliable data. It was public data that led the Bank for International Settlements to require Japanese banks to shore up their capital reserves, in part forcing Japan to recognize the full extent of its banking problems.

There are also fundamental differences in what China is facing compared to Japan that go beyond economics. In Japan, although consensus on government action took a long time to materialize, once there was consensus the government moved quickly to rescue the failing banks. Xi’s purges are a sign that, in China, such a consensus doesn’t really exist. There are winners and losers, and though Xi has purged everyone who opposed him, his ability to maintain support from the elites if his reforms fail is a major question. In this sense, while Xi appears strong now, much of that strength comes from purges that both eliminated opposition and cleared a fair degree of corruption from the administrative bureaucracy, which the Chinese have generally sanctioned.

China’s violent history must also be taken into consideration. In the Meiji Restoration, Japan was able to undergo a sort of nonviolent, top-down revolution guided by the elites. This enabled Japan to industrialize extremely rapidly in the latter half of the 19th century. In China, it took a civil war spanning multiple decades, culminating in a bottom-up, peasant-led revolution, to even set the stage for economic development, which didn’t really begin until Mao died 30 years later. Within the past 150 years, there are no examples of Japanese domestic mass violence. In China, there are several.

China is in a race against time to complete a colossal restructuring of its economy. Complete success – that is, a smooth, nonviolent transition to a consumption-driven economy, without suffering an extended period of economic stagnation – seems unlikely given the scale of the challenges. But it would be a mistake to underestimate China’s ability to effect mammoth changes in the structure of its society in short periods of time.

'Get Ready Russia'

Donald Trump Is Stuck In The Syrian Quagmire

Following last weekend's suspected chemical weapons attack, the Syrian conflict could escalate once again. U.S. President Donald Trump's Twitter threat and Russian response show just how dangerous the situation has become. By DER SPIEGEL Staff

Smoke rises from Douma just north of Damascus.

The images that follow a chemical weapons attack can be difficult to look at: infants gasping for breath and receiving CPR from rescue workers; mothers screaming desperately; children being sprayed with water to help wash off the chemicals; people foaming at the mouth.

Such images could be seen following the suspected chemical weapons attack last Saturday on the Syrian city of Douma, a rebel-held suburb of Damascus. Although it isn't possible to verify the authenticity of every photo or prove beyond doubt that the Assad regime was behind it, the April 7 attack still alarmed an international community that has otherwise followed the war in Syria with relative apathy.

The horrific images and news of the use of chemical weapons banned under international law succeeded in doing what other terrible news coming out of Syria has failed to: United States President Donald Trump has raised the prospect of punitive military action that would exceed all previous Western interventions against the Assad regime. Great Britain and France have also indicated they would participate. But it remains unclear when the attack would take place or how big it might really be.

Mohammed Adel of Douma didn't just see pictures of the attack on his district, he says he experienced the attack firsthand. He arrived as a refugee on Monday in al-Bab, a city in the Aleppo Governorate currently occupied by the Turkish military as part of its Operation Euphrates Shield. Adel says that life had already become unbearable in embattled Douma in the weeks preceding the attack because of the unrelenting bombing by the Assad regime and its Russian allies.

"We were sticking to our basements," he says. "Anytime anyone went out to get something to eat or to fetch water, they said goodbye to everyone. You didn't know if they would make it back alive. People died just trying to cross the street." But he still didn't want to leave Douma, his hometown. Following the chemical attack on Saturday, however, he says he has now left the city behind "forever."

He says it was almost impossible to even pull the victims out of their homes after the chemical weapons fell from the sky because the bombing continued after the strike. "When we finally managed to get to one of the sites, what we saw shook even us: men, women, children, some dead, and others desperately trying to breath -- and there was nothing we could do."

Even before the suspected chemical attack, Douma had already begun looking in the past several weeks like a turning point in the Syrian conflict in the form of the defeat of the rebels who had been holding out there since 2012. After Homs and Aleppo, the defeat would mean the rebels had now also lost the suburbs of Damascus. They would be forced to withdraw to the northern Idlib Governorate and Syria's most important cities would once again be entirely under the regime's control.

Trump's Erratic Syria Policy

The escalation between the powers controlling the Syria of today no longer has much to do with the origins of the conflict. The battle between President Bashar Assad and his opponents has faded into the background. Instead, the conflict is escalating because of the actions of regional powers including Iran, Israel and Turkey, as well as Russia and the U.S. The military strike recently threatened by Trump could serve to further exacerbate the situation. In the worst-case scenario, observers fear, it could even result in a direct confrontation between the U.S. and Russia. Nobody seems to be concerned with the Syrians themselves any longer.

Donald Trump: "Russia vows to shoot down any and all missiles fired at Syria. Get ready Russia, because they will be coming, nice and new and 'smart!' You shouldn't be partners with a Gas Killing Animal who kills his people and enjoys it!"

Trump's tweet on Wednesday sounded like a declaration of war. "Get ready Russia," he typed on his smartphone shortly before 7 a.m. that morning. The U.S. missiles would be coming to Syria, he wrote, and they would be "nice and new and 'smart!'" It appeared that an airstrike against Assad was imminent, a military action that could also affect Russian military installations in Syria. Then, half a day later, the all-clear signal came from White House spokesperson Sarah Huckabee Sanders, who said final decisions hadn't yet been made. The next morning, Trump tweeted that the missiles could be fired "very soon or not so soon at all!"

On Thursday, Secretary of Defense Jim Matthis entered the fray, attempting to lower expectations of an imminent strike. "On a strategic level, it's how do we keep this from escalating out of control -- if you get my drift on that," he said. His language betrayed clear concern.

The back and forth underscores just how erratic the Trump administration's Syria policies are. In January, then Secretary of State Rex Tillerson sketched out five aims for the U.S. to pursue in Syria during a speech given at Stanford University. First, Tillerson said, Islamic State and al-Qaida must suffer enduring defeat. Second, the civil war needs to be resolved through a UN-led diplomatic process. Third, the U.S. wants to diminish Iranian influence in Syria. Fourth, conditions need to be created for Syrian refugees to return to their homes. And fifth, Syria must be free of weapons of mass destruction.

Trump's own staff helped develop that strategy, making it even more astounding that the president would unceremoniously tear up the plan with two sentences at the end of March. In a speech to union workers in Ohio, Trump said: "We will be coming out of Syria very soon." He then added: "Let the other people take care of it now." Observers in Washington interpreted those statements to mean a complete withdrawal from Syria, as soon as possible, on the direct orders of the president. Trump's staff would later backpedal, but either way, it would be difficult to argue that the administration has anything resembling a Syria strategy at the moment.

Most observers assumed that the retaliatory strike would be more extensive than the one conducted in April 2017. Back then, the Assad regime had attacked rebels using the nerve agent sarin in the town of Khan Sheikhoun. Trump, shocked by the images of dead babies, ordered a retaliatory strike, one that was largely symbolic in nature. The U.S. bombarded Syria's Shayrat air base with 59 Tomahawk cruise missiles, but the airport was returned to full functionality within 24 hours.

Washington's Quandary

Trump's problem is that he must now balance competing impulses. On the one hand, he wants to punish Assad for the chemical attack. On the other, though, he wants to avoid creating the impression he intends to stay militarily engaged in Syria on the long term. Good relations with Moscow also remain important to him.

Syria is the first and, so far, only example of an instance in which Trump has criticized Vladimir Putin by name. Russia "shouldn't be partners with a Gas Killing Animal" like Assad "who kills his people and enjoys it!" Trump tweeted on Wednesday. To be on the safe side, he also tweeted that "much of the bad blood with Russia" is being caused by the Russia investigation in the U.S. and not by the president himself. But her too, his attempt to split the difference merely served to increase the confusion this week.

Despite the threat of an attack from Washington, Moscow is currently demonstrating what could be described as gleeful indifference. The TV station Rossiya 24 provided joking but also thorough advice to its viewers on the products they can store for the long term in nuclear bunkers. Officials in the Kremlin seemed to remain calm. Addressing Trump's tweets, Putin's spokesman Dmitry Peskov replied, "We don't participate in Twitter diplomacy. We advocate serious approaches."

Nevertheless, Valery Gerasimov, the chief of staff of the Russian armed forces, drew a new red line in March by saying that if there were any Russian victims in a U.S. attack on the Assad regime, Moscow "will take response measures against both the rockets and the platforms from which they're fired." But the Russian newspaper Kommersant is reporting that military officials in Moscow assume that the Americans will also warn them in advance of where and when it intends to strike, just as they did in 2017.

Assuming an accidental escalation is avoided, it is likely that any U.S. strikes against the regime would only have slight influence on the course of the conflict in the country. Syria's future hinges on other more essential decisions that have yet to be taken. Issues like what will happen with the U.S. bases and soldiers in the northeast, where Syria's oil reserves are located, sites the regime would like to regain access to. Around 2,000 U.S. soldiers are stationed in the Kurdish-controlled region. This military presence is the only leverage the U.S. has in the country.

But it's not the Americans who will decide how things further develop in Syria. That is primarily up to those countries that have significantly more soldiers or militias in the country -- Russia, Iran and Turkey.

The Key Players

In Syria, there's no way of getting around Russia, which has catapulted itself back to the status of a global power with its intervention in Syria, which began in 2015. But the country is also slowly becoming a problem for Moscow. The Russians helped prevent victory by Assad's opponents and, in addition to its relatively unimportant naval support base in Tartus, it built the massive Hmeimim air base nearby. But Moscow's strategy was also to include a second step: that of using military means to obtain a political solution that would bring an end to the war and the also share the burden of reconstruction costs with other countries. Russian and Iranian companies would stand to profit especially from reconstruction efforts. Plus, the international community would have to be willing to pay the bill for reconstruction. But that won't happen for as long as Assad is in power.

It's not only the opposition, but also Assad, who are frustrating Moscow's policies. Assad doesn't want to make any compromises if he can secure a complete victory. As such, Russia, which already announced its planned withdrawal from Syria twice, has been pulled into the war for the longer term.

Iran has far deeper influence on Assad than Russia and is at the same time a rival to the Syrian leader. Indeed, Tehran is deeply intertwined with the regime in Damascus, politically, militarily and economically. Its ultimate goal is to create the so-called Shiite Crescent, a sphere of influence that would stretch all the way into Lebanon -- and also pose a threat to Israel.

And then there's Turkey. In the beginning, Ankara wanted to establish a new order in Syria, but now President Recep Tayyip Erdogan is just trying to avoid ending up emptyhanded. Even if he isn't admitting it yet, he long ago abandoned his plan of toppling Assad and replacing him with Islamists. His main priority now is to prevent the creation of a Kurdish state in Syria and to secure the areas along the Turkish-Syrian border.

Finally, there's Israel, which has so far been one of the biggest losers in the conflict. For some time, it merely looked on at what was happening in its neighboring country because it appeared to be beneficial that Israel's archenemies -- Assad, Iran and Hezbollah -- had all become embroiled in a war against the rebels. Now that this phase of the war appears to be coming to an end, the disillusionment in Israel is great. Its enemies are now triumphing and are brimming with self-confidence, new weapons technologies and combat experience. "No matter what the price, we will not allow Iran to have a permanent foothold in Syria," Israeli Defense Minister Avigdor Liberman said on Tuesday. "We have no other choice." Israelis view the Iranians as an existential threat to their country. Israel has conducted around 100 airstrikes on positions in Syria since 2013 and the country is being pulled ever deeper into the Syrian war.

It was also apparently Israel that became the first to launch a military intervention in Syria shortly after Saturday's chemical attack. Early on Monday morning, explosions rocked the Syrian air force base T-4, located between Homs and Palmyra. Seven Iranians were reportedly killed in the attack, including, according to reports from Iran, a drone expert.

Nobody has claimed responsibility for the attack, but the Russian Defense Ministry said that the rockets responsible for the blasts had been fired by two Israeli fighter jets in Lebanese airspace.

Israel has long relied on Russia to keep Iran from crossing Israel's red line and becoming a direct threat. But the Russians are apparently unable to do so, and Iran's Revolutionary Guard is becoming increasingly brazen in Syria. In February, they set a trap for Tel Aviv, which led to the shooting down of an Israeli jet.

Following the Monday morning attack, Iran issued a threat to the Israelis, and in Tel Aviv, the warning was taken seriously. Israeli officials fear that if the U.S. were to launch airstrikes on Syria, the Iranians could attack Israel from Syrian territory.

Barack Obama once predicted that Russia's intervention in Syria would end in a "quagmire," -- a messy situation out of which it could no longer free itself. In 2013, partly out of fear of getting stuck in just such a quagmire, Obama declined to enforce the "red line" he himself had drawn. In 2012, he had indicated that the use of chemical weapons in Syria by the Assad regime would not be tolerated. Whether his refusal to enforce that "red line" was a wise bit of restraint or whether it simply made everything worse is something that remains a matter of intense debate today.

Syrian President Bashar Assad: Why would he want to make any compromises when he is already so close to victory?

Now, it is yet another presumed chemical weapons deployment that threatens to intensify the Syrian quagmire for all involved. And there doesn't appear to be an obvious way out for any side.

A Challenging Mission

On Saturday, international experts from the Organization for the Prohibition of Chemical Weapons (OPCW) are set to travel to Syria. French President Emmanuel Macron has already claimed to possess proof that the regime deployed chemical weapons in Douma. And Western intelligence agencies even apparently tried to smuggle bodies and other evidence out of the town just north of Damascus. American news network MSNBC has likewise reported that the U.S. found evidence of chlorine gas and a nerve agent in urine samples taken from victims.

But the OPCW mission will be a challenging one nonetheless. More than a week has already passed since the suspected attack and the apparent site of the attack wasn't sealed off. It has been visited by members of the military. Making matters more difficult is the fact that the chemical-weapons investigators have been weakened. Following Russia's veto last year, the mandate for the international Joint Investigative Mechanism (JIM) was not renewed. Only the JIM was allowed to assign blame, whereas OPCW investigators are not allowed to say anything about who might have been responsible. They are only allowed to clarify which chemicals were used and how they were deployed -- which can be enough on its own to solidify suspicions.

It is almost impossible to deny that something horrible must have happened in Douma. Dozens of witnesses like Mohammed Adel have related what they saw. They have spoken of the clattering of the helicopter before it dropped its payload. Of the people who yelled "Chemical weapons! Chemical weapons!" Of the smell of chlorine in the air. The research website Bellingcat analyzed images showing a typical yellow cannister at the site of the kind seen at the sites of previous chemical attacks perpetrated by the regime. The UN Syria Commission has documented 33 deployments of chemical weapons in the country since 2013.

According to the World Health Organization, around 500 patients were treated in Douma who showed symptoms consistent with a chemical gas attack. Forty-three people died, WHO says.

What May Have Motivated Damascus?

But why would the Syrian regime deploy chemical weapons when it is already on the verge of victory? One motive could have been the desire to speed up the withdrawal of the hated rebels from the city. Douma was the last enclave remaining under rebel control. Or was it revenge? The Army of Islam, the Islamist group which controlled Douma, was relatively strong and regularly fired shells at nearby Damascus.

The Islamists long held a trump card in their hand: They were thought to be holding several thousand regime loyalists prisoner. That, however, was an exaggeration with which the Syrian regime sought to mislead its followers, a glimmer of hope that many troops long believed to be dead might still be alive after all. When it became clear that a large number of the presumed prisoners were in fact dead, it came as a painful blow and the thirst for revenge was correspondingly high. The rebels, meanwhile, had lost their trump card.

Mohammed Adel, the witness from Douma who has since fled to northern Syria, still doesn't want to believe that all is lost for his side. "I still hope that the West will help depose Assad, whether with military pressure or through political negotiations," he says. "And why do the Russians still need Assad? They control everything anyway. If the West and Russia could reach an agreement to depose Assad, that would be the best solution. Then the refugees, the displaced both within Syria and outside the country, could return to their homes and their land."

By Christian Esch, Maximilian Popp, Christoph Reuter, Mathieu von Rohr, Raniah Salloum and Christoph Scheuermann