Disappearing trick

China’s vanished current-account surplus will change the world economy

The yuan will become more volatile, but also start to rival the dollar

NOT long ago China was a leading culprit in global economic imbalances. Whether blame was ascribed to its undervalued yuan or its frugal people, the problem seemed clear. China was selling a lot abroad and buying too little back. One data-point summed this up: its current account surplus reached 10% of GDP in 2007, well above the level that is generally seen as reasonable. Far less attention has been paid to its steady decline since then. In the first quarter of 2018 China ran a current-account deficit, its first since joining the World Trade Organisation in 2001. Just as its massive surpluses of yore had big consequences for the global economy, so does this swing in the opposite direction.

China still exports many more goods than it imports, to the tune of nearly $500bn annually. But its share of global exports appears to have peaked. At the same time its trade deficit in services is getting bigger, largely thanks to all its tourists venturing abroad (see chart).

At bottom, a current-account balance is the difference between a country’s investment and savings. When China had a big surplus, its savings, at 50% of GDP, far outstripped even its colossal investment. Data on savings are patchy in China. But it is known that investment has declined as a share of GDP. The implication is that the rate of savings has almost certainly declined more sharply, reflecting a big increase in consumption. Its economy is, in other words, better balanced than just a short while ago.

China’s current-account deficit in the first quarter was exaggerated, since exports tend to be subdued at the start of the year. It is likely to return to a surplus in the coming months. But Ding Shuang of Standard Chartered, an emerging-markets bank, forecasts that the surplus will be just 1% of GDP this year and 0.5% next year. The trade ruckus with America could reinforce the downward trend. To placate President Donald Trump, China will try to import more from America and pay more for foreign intellectual property (IP), Mr Ding says.

One probable outcome is that the exchange rate will become more volatile. In recent years capital outflows have pressed down on the yuan, but the current-account surplus has countered that effect. In the future China will have a thinner cushion. Depending on quarterly trade swings, the yuan will be as likely to fall as to rise.

If China’s current-account deficits become more frequent, it will have to run down its foreign assets or borrow more from abroad to pay for its consumption. Should its external liabilities—that is, money it owes the rest of the world—increase rapidly, that might signal greater financial vulnerability. But as long as the increase is moderate, it could actually help China by boosting the yuan’s global profile.

To fund its deficit, China might choose to sell more bonds to foreign investors. And in paying more for goods and services than it earns, it could supply its currency abroad. By itself this would not be enough to make the yuan go global. Investors would need more faith in China’s institutions. But technically, the conditions would be ripe for the yuan’s emergence as a more credible rival to the dollar. America might find itself pining for the days when the Chinese currency was undervalued.

Iran, Russia: What’s at Stake in the Syrian Civil War

By Xander Snyder

The era of foreign intervention in Syria is coming to an end – at least that’s what Russian President Vladimir Putin said when Bashar Assad, Syria’s president, visited Sochi last week. Granted, Putin’s statement was ambiguous – “in connection with the significant victories … of the Syrian army … foreign armed forces will be withdrawn from the territory of the Syrian Arab Republic” – but Russia’s Syria envoy clarified the next day that Putin was, in fact, calling on all militaries to vacate the country.

Needless to say, this didn’t sit well with Iran, which has been cooperating with Russia in support of the Assad government. Iran rejected Russia’s announcement, insisting that it deployed its military at the behest of the Syrian government. Iran has its own reasons for being in Syria, of course, regardless of what the government in Damascus wants. It means to establish greater command of the Middle East and acquire land access to Lebanon and sea access to the Mediterranean. Even if this territory isn’t under its direct authority, Iran wants to keep Israel and Turkey from encroaching on its borders. In the process, Iran, the de facto leader of Shiite Muslims, hopes to quell Sunni resistance, which, as the Islamic State showed, can be a potent threat.
Russia shares none of these goals with Iran. The two may tactically work toward the same goal – keeping Assad in power – but cooperation between Russia and Iran has always been a marriage of convenience, not a true alliance. Russia needs to prevent any one power from controlling too much of the Middle East. A state that eliminates competition in the Middle East would be able to look north, to the South Caucasus, a critical buffer region for Russia. Any power that can gain a foothold in the South Caucasus threatens the North Caucasus, which, in turn, threatens the Russian heartland. Russia must keep Middle Eastern powers competing against one another if it is to prevent any single actor from cementing a position of strength in the South Caucasus.
Russia and Iran’s interests also diverge on oil. The government in Moscow relies heavily on oil and natural gas revenue, so any increase in the price of oil benefits Russia. Iran has a relatively low fiscal breakeven point for producing oil – it can turn a profit when oil is roughly $55-65 per barrel – so it could afford to produce more to keep prices low. Now that the Iran nuclear deal is all but dead, uncertainty around Iranian production has driven up oil prices, giving Russia a little more breathing room. In other words, sanctions on one U.S. enemy, Iran, benefit another, Russia.
Then there’s Israel, with which Russia has friendly relations. Iran’s expansion has begun to invite attacks from Israel, which objects to having an Iranian presence so close to its northeastern border. While Russia is content to bomb rebels in Syria who have no real way to defend against air attacks, it is far more apprehensive about getting caught up in a war against a country with a powerful military and strong motivations to intervene. Israel’s fight isn’t with Russia, and Russia’s isn’t with Israel. But Russia and Iran’s joint support of Assad nevertheless risks pitting Russia against a country it has no interest in fighting.

This explains why Russian declined to retaliate after Israel attacked Russian anti-aircraft installations controlled by the Syrian military. In fact, Moscow didn’t even mention the incident. Sure, the installations in question were outdated, but the fact that Russia decided against selling Syria a more modern air-defense system, the S-300, a day after Prime Minister Benjamin Netanyahu’s visit to Moscow illustrates Russia’s desire to avoid providing Syria with the capability to damage Israel’s air force.
But for all the geostrategic reasons behind Russia’s intervention in Syria, Moscow also had a far simpler reason for propping up Assad: It needed to show the Russian people that, despite ongoing hardships, Russia had re-emerged as a global power. After 25 years of losing ground to NATO and the West, it needed to prove that it could counter the United States. It needed to test the preparedness of its military, which has undergone a number of reforms since its 2008 war with Georgia. (For Russia, the war was a success, but it exposed some weaknesses in its air force and in its missile capabilities.)
In Syria, a successful show of Russian force requires a victory and an exit strategy. Claiming that the Syrian military is strong enough to fend for itself, thanks largely to Russian assistance, fits with this narrative. It enables Russia to save face despite the fact it has been in Syria months after it declared its mission accomplished.
It’s unclear when, exactly, Moscow intends to withdraw its forces. When it does, Iran will be left with only a few options. It can continue to support Assad by spending more on the Syrian war, and begin to commit its air force, which, compared with Russia’s, is dated and dilapidated. Spending more is a difficult proposition for a country in the throes of protests over economic issues.
Otherwise, Iran could maintain its current level of support of Assad, but if Russia were to withdraw, Iran would be faced with Israel in its south and Turkey, which also has a modern air force, to its north. Without Russia’s backing, rebels, especially those who benefit from Turkish air support, would stand a better chance of retaking territory that they had lost to Assad.
Last, Iran could reduce its presence in Syria and instead focus on gaining greater control of Iraq, which is much closer to home anyway. That, however, presents its own set of challenges, and in any case risks opening up Syrian territory currently serving as buffer space to be taken by Turkey.
Though Russia hasn’t yet left Syria, its departure will put even more pressure on Iran and open the Middle East up to Turkey. Russia just needs a public relations victory. Iran’s battle is existential, and there are no clear paths to exit in sight. Nevertheless, fissures in the Iran-Russia relationship, even if just rhetorical, reflect the weakness of Russia’s position in the Middle East.

North Korea Is a Dangerous Distraction

The real struggle in Asia is with China — and Trump is throwing away U.S. advantages.

By Michael Fullilove, Hervé Lemahieu

People watch a television news screen showing pictures of US President Donald Trump (center) and North Korean leader Kim Jong-Un (right) at a railway station in Seoul on Nov. 29, 2017. (Jung Yeon-Je/AFP/Getty Images)
People watch a television news screen showing pictures of US President Donald Trump (center) and North Korean leader Kim Jong-Un (right) at a railway station in Seoul on Nov. 29, 2017. (Jung Yeon-Je/AFP/Getty Images)

President Donald Trump continues to express enthusiasm for a summit meeting with North Korean leader Kim Jong Un despite growing signs in the past few days that the summit will be delayed or may not happen at all due to Pyongyang’s latest recalcitrance.

The U.S. president has not abandoned hope that he will be able to pull off the deal of the century even if it now leaves him open to being stood up. If the summit meeting proceeds at all, the United States will go in from a position of strength. The inaugural Lowy Institute Asia Power Index, released this month, finds that the United States remains the preeminent power in Asia — in large part because it retains the most powerful military force and a network of allies in the región.

The index ranks 25 countries and territories in terms of their capacity to influence regional events. In the largest comparative assessment of its kind, we evaluate states’ military capabilities and defense networks, economic resources and relationships, diplomatic and cultural influence, resilience, and future trends.

Yet the U.S. position in Asia also faces significant challenges. Pyongyang’s brash nuclear-fueled confidence has distracted Trump from the real Asian story. After all, North Korea is a misfit middle power, ranked only 17th in the Asia Power Index. Its power is concentrated in one instrument — a nuclear arsenal that it cannot use without provoking retaliation that would end the regime.

Trump has shrunk the White House’s Asia policy to the dimensions of North Korea. His singular focus stands in stark contrast to his administration’s national security and defense strategy papers, which emphasize China as the true peer competitor of the United States. The president’s approach to his Chinese counterpart, Xi Jinping, as with several other authoritarian strongmen, has oscillated between the transactional and the acquiescent. Ultimately, Trump’s unorthodox worldview undercuts Washington’s ability to compete effectively against Beijing in the Asian power game.

China is closing in fast on the United States. By 2030, China’s GDP in purchasing power parity terms is forecast to be almost twice as big as that of the United States.

While U.S. military commitments are spread across the globe, China can concentrate its resources on its near abroad. As Adm. Philip Davidson, tapped to lead U.S. Pacific Command, acknowledged in his recent confirmation hearings, the People’s Liberation Army Navy is now capable of controlling the South China Sea in all scenarios short of a war with the United States. For now, China is unlikely to choose a fight with the most powerful military force in Asia. Instead, it is playing a long game, hoping the United States will eventually become weary of its Asian commitments.

The Asia Power Index demonstrates that Beijing has been successful at competing with Washington below the threshold of conflict. The Belt and Road Initiative and other projects play to Beijing’s strengths as the primary trade partner — and main source of foreign assistance and lending — in the region.

Yet the United States still remains preeminent in Asia, thanks in large part to its regional alliances. Defense networks are a cost-effective force multiplier. China has only one mutual defense treaty in the region — North Korea — and it is hardly reliable. Beijing eschews traditional alliances but has so far had limited success with its defense diplomacy despite its alleged interest in gaining enhanced access for its navy to bases and ports in the region. In addition, China has ongoing boundary disputes with many of its neighbors, several of which, such as India and Vietnam, are deeply distrustful of its intentions.

China’s soft power has hardened in recent years. But promises of the Chinese dream are still no match for America’s appeal in the region, as evidenced by the half-million Asian students choosing to attend U.S. universities each year compared with the tens of thousands enrolled in China. Independent U.S. newspapers and broadcasters — lambasted by Trump as “fake news” — constitute the most popular foreign media in all the countries covered by the Asia Power Index. China has spent billions of dollars on its state-owned media offensive abroad but has achieved only a fraction of this success.

For decades, Trump has shown himself to be allergic to free trade agreements and hostile to alliances. Yet these are the pillars of U.S. power in Asia. His policies in these two fields now threaten America’s standing in the región. 
Washington’s withdrawal from the Trans-Pacific Partnership was self-destructive. The threatened use of tariffs as a means of furthering U.S. economic foreign policy will only exacerbate what is already a weakness of U.S. power in Asia — its economic relationships. By virtue of its lower trade-to-GDP ratio, China is more insulated from escalating trade tensions than most other Asian economies. The biggest victims of U.S. economic nationalism and escalating trade tensions will be other Asian economies that are more reliant on global trade and the World Trade Organization’s rules-based system that Washington has long championed. With global production chains spanning across Asia, then, a trade war with China would amount to a trade war with Asia.

Finally, Trump’s long-held alliance skepticism is raising fears that he could yet undermine the credibility of U.S. security commitments in Asia, particularly extended nuclear deterrence. North Korea’s recent moves make it even clearer that the prospect of full denuclearization is off the table. One concern is that any deal with North Korea might therefore focus on Pyongyang giving up its intercontinental ballistic missile capability, which threatens the U.S. homeland, but would fail to resolve the security concerns of regional allies.

The long-term presence of U.S. troops on the Korean Peninsula has also been brought into question. Last month, Defense Secretary James Mattis caused international alarm when he said changes to U.S. force posture in South Korea would be discussed with Kim. The administration has denied reports that Trump had requested that the Defense Department prepare options for drawing down troop numbers. However, the president’s personal instincts clearly favor retrenchment. “At some point into the future, I would like to save the money,” he said recently.

A relocation of U.S. forces could conceivably be used to rebalance and consolidate U.S. defense commitments in the region in a way that offers greater security for U.S. allies and friends. But given Trump’s inclinations, it seems far more likely that it would only enable broader U.S. disengagement from the region by trading away security interests in return for a narrow peace dividend.

For seven decades, a formidable U.S. military presence in Asia has underpinned regional stability. The United States has kept a lid on interstate friction, encouraged economic liberalism, and maintained an open regional order that has allowed the rise of successive Asian countries. Now, just when a challenger is rising fast up the index of Asian power, America’s president seems unconvinced of the value of leading in Asia at all.

The Sea of Leverage in Chinese Markets

Large chunks of China’s stock markets have been pledged as collateral for loans

By Jacky Wong

Leveraged positions in China A share markets, as a percentage of market capitalization

Source: Bank of America Merrill Lynch

Passive investors are about to get more involved in Chinese stocks thanks to MSCI’s decision to include several of them in its key indexes. They will find themselves exposed to a market swimming in leverage.

About $1 trillion worth of stocks listed in Shanghai or Shenzhen—China’s two main markets—are being pledged as collateral for loans, according to data from the China Securities Depository and Clearing Corp., or ChinaClear. That’s equivalent to about 12% of the market.

Plenty of Chinese stocks are also used as collateral in margin financing, whereby investors borrow to plow more money into stocks. In all, some 23% of all market positions were leveraged in some way by the end of last year in China, according to Bank of America Merrill Lynch. 
    An investor monitors stock prices at a brokerage house in Beijing in 2016. Photo: Mark Schiefelbein/Associated Press 

The pledging of shares as loan collateral is particularly prevalent among smaller private companies. Unlike in the U.S., where institutional shareholders are a big market presence, private Chinese firms are often controlled by a major shareholders, who often own more than half of company. These big stakes are the most convenient tool for such big shareholders to raise their own funds. 
It isn’t always clear where the money they raise ends up. Former technology star Jia Yueting pledged his majority shareholding in Shenzhen-listed Leshi Internet Information & Technology to get funds to fuel his ambitions for the company from electric cars to film studios. The company still suffered a cash crunch last year, after which it was suspended from trading for nine months.

The risk for other investors when big shareholders take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors likely made the crash worse.

MSCI has limited its coming index inclusion of domestic Chinese shares to only big cap stocks, but that doesn’t mean it is free of problems. Some new entrants such as Kangmei Pharmaceutical , China Grand Automotive Services or Giant Network Group have about half or even more of their shares pledged as collateral for loans, based on data from ChinaClear.

Investors thinking of following MSCI’s lead and plunging into Chinese stocks should be aware of such hidden risks.