Light on the shadows

China’s tighter regulation of shadow banks begins to bite

Non-banks’ share of new credit has dropped by more than half

THE teller at ICBC, China’s (and the world’s) biggest bank, ushers a new, well-heeled customer into a private room. It is not for VIP treatment but a stern warning. The customer wants to invest in products offering higher returns than a basic savings account. The teller fixes a camera on her and reels off a series of questions. Are you aware that prices can go down as well as up? Do you understand that the bank does not guarantee this product? Only when the customer has been recorded saying “yes” does she get her wish.

Some complain that these videotaped agreements, now mandatory at Chinese banks selling similar investment products, feel like interrogations. But for the financial system, they are a step away from the precipice. Banks have used such transactions to channel cash into off-balance-sheet loans, serving riskier corners of the economy. Firms with little lending expertise have also muscled into the same space. 
The catch-all phrase to describe this is shadow banking. It is a global phenomenon, partly a response to stricter regulation after the financial crisis of 2007-08. But China is at the extreme end. Its shadow-banking sector is vast, fuelled by a big rise in corporate debt. Estimates of its assets run from 50trn to 90trn yuan ($7.8trn-14trn); the middle of that range is more than three-quarters of GDP. Its growth has been dizzying, from almost nil ten years ago. Its structure is byzantine. And its pathologies have been worsened by the belief that if anything goes wrong, the government will cover the losses. The International Monetary Fund has repeatedly highlighted shadow banking as one of the big dangers to the Chinese economy.

The best disinfectant

Yet in the past year shadow banking’s seemingly unstoppable progress has all but stopped.

Last year the 30trn yuan market for “wealth-management products” (WMPs), a main conduit for savings to fund banks’ off-balance-sheet loans, stalled for the first time in its decade of existence. Insurers had also been sucked in, selling short-term, high-yield products. But in 2017 sales of these fell by about half. Between 2010 and 2017 non-banks issued a third of all new credit; in the first four months of 2018 their share plunged (see chart). 

The reason is much tighter regulation, ordained from the top of the political system by the economic officials around President Xi Jinping—notably Liu He, a vice-premier. A government adviser says their appraisal of the past few years is that the economy has performed well, and that all the big dangers have been outgrowths of the financial system. He pointed to three incidents that shook Mr Liu and his colleagues: the stockmarket boom and bust of 2015; the ensuing gush of capital outflows; and the reckless investments of companies such as Anbang, a disgraced insurer.

So since 2016 the focus of economic policy has been to reduce financial risks. This is not the first time these have been targeted, but Zhang Licong, an analyst with CITIC Securities, a broker, says that this campaign has been the hardest-hitting yet. The rise in corporate debt has slowed. Banks have recognised more of their bad loans, writing off about 1.5trn yuan per year. The government has merged regulatory bodies to strengthen its oversight. And it has clamped down on shadow banking.

Officials began slowly, requiring banks to video customers acknowledging the risks of WMPs, a way of forestalling disputes if they go bad. They soon turned to peer-to-peer (P2P) lending, a small, unruly segment of shadow banking. The authorities capped loan sizes and required lenders to go into partnership with custodian banks. The number of online P2P platforms has dropped from 3,433 at the end of 2015 to below 1,900 today. Then they ordered banks to reassess their own books. Many had classified large dollops of credit as investments in order to hide bad loans.

The biggest step in the clean-up came on April 27th, when regulators published sweeping new asset-management rules. Among other things these bar firms from giving punters guarantees against losses and from pooling funds to invest in bank loans. Banks will still be able to offer investment products, but they will resemble mutual funds. They have until the end of 2020 to comply, longer than first planned. Banks need the time. They are under pressure to fortify their balance-sheets with more capital. Even before factoring in the new rules, Jason Bedford, an analyst at UBS, a Swiss bank, reckons China’s banks have an equity shortfall of about 1trn yuan.

The regulators’ clampdown was overdue. Moody’s, a rating agency, says the new asset-management rules give it more confidence in China’s banking system. The biggest banks’ share prices have rallied by about a third since the start of 2017, in part reflecting the easing of investors’ worries. There is, however, still far less enthusiasm for hard-charging smaller banks, which have a sketchier asset mix and a much weaker deposit base.

China’s growth has held up well over the past two years, partly thanks to a strong global economy. But the stricter rules are now starting to weigh on activity. Infrastructure investment, a pillar of growth, has slouched to its slowest since 2012. Liquidity is also tightening. Annual growth in the broad M2 gauge of money supply has slowed sharply, to 8%, the lowest in more than 30 years, and companies are finding finance harder to obtain. Since late 2016 the gap between the yields on AA-rated corporate bonds and those on top-rated government bonds has doubled to two percentage points. Borrowers have defaulted on 20bn yuan of bonds in 2018, up by nearly a third from a year ago, though still just 0.1% of the overall market.

The question is whether China will flinch as the pain mounts. In the stop-go style of the past decade, supervisors have relaxed their grip whenever the growth toll looked too high. Banks have already been lobbying them to ease up: the extended deadline for complying with the asset-management rules is one result. “Regulators are using very strong drugs to cure an ill person,” says a manager at a Chinese bank. “If the drugs are too strong, they will create another disease.”

So far the government has paid little heed to such gloomy talk. Mr Liu, the vice-premier, said recently that investors must bear the risks for their own investments. In most countries that would sound like common sense. But in China it was taken as a hawkish sign. The cameras in the banks are not just for show.

What the End of Net Neutrality Actually Means


On June 11, the Federal Communications Commission officially ended network neutrality rules that were put in place three years ago by the Obama administration. Opponents decried the move. “Now your cable company can scam you for more money, censor websites, and slow down online content,” according to the Battle for the Net campaign by nonprofit advocacy groups Fight for the Future, Free Press and Demand Progress. “People are angry. And rightly so.” Meanwhile, FCC Chairman Ajit Pai and his family reportedly continue to receive death threats due to the decision.

But the situation is more complicated than what the inflammatory rhetoric would suggest. “There is this misunderstanding that net neutrality is kind of this catch-all provision that prevents broadband companies from doing bad things. It’s not,” said Kevin Werbach, Wharton professor of legal studies and business ethics who worked at the FCC under the Clinton administration, on the Knowledge@Wharton show that airs on SiriusXM channel 111. “What it has to do with is [banning] certain kinds of discriminatory practices about the treatment of data.”

Net neutrality is a set of rules ensuring that wired and mobile broadband providers — primarily cable and phone companies — treat all data transmissions that go through their pipes or airwaves equally, irrespective of content as long as it’s lawful, and subject to reasonable network management practices. When broadband providers manage data flows, they need to have a legitimate reason such as alleviating internet traffic congestion. What they can’t do, for example, is purposely hamper a rival company. Comcast cannot lawfully block the video streams of Netflix just because it is a rival of Hulu, which it partly owns. 
The FCC’s 2015 Open Internet Order that established net neutrality rules bans the blocking and throttling of lawful content, applications, services and devices. It also prohibits “paid prioritization,” which creates favored “fast lanes” on the web. For example, Amazon cannot pay or otherwise compensate Verizon to speed up internet traffic going to its website to get an edge over other online shopping sites. Even if some prioritization benefits consumers, Obama’s FCC argued that “the threat of harm is overwhelming” if it allowed the practice.

The bigger industry concern in the 2015 order was that it also classified wired and mobile broadband providers under Title II of the Communications Act of 1934. That means it considers them “common carriers” just like traditional landline phone companies. That means they could be much more highly regulated, including controlling the prices they charge consumers. However, the net neutrality order said it would adopt “light-touch” Title II rules. The FCC said it would not regulate prices and allow other exceptions so as not to discourage broadband providers from investing in their networks.

‘Right a Wrong’ The FCC’s Pai argues that the internet has thrived since its creation without them and would be just fine going forward absent these rules. He also said that reclassifying broadband service under Title II caused investment in networks to drop by 5.6%, the first decrease outside of a recession.
Pai said that 80% of small, fixed wireless providers in rural areas have delayed or decreased their network expansion and services because budgets went towards paying for compliance. The Wireless Internet Service Providers Association commended the FCC’s repeal of net neutrality, saying it did “right a wrong” by removing “heavy-handed, one-size-fits-all regulations.” The trade group said the Obama FCC cannot have it both ways: putting “disproportionate burdens” on small broadband providers and at the same time expecting them to invest in underserved areas.

But Pinar Yildirim, Wharton professor of marketing, is not buying Pai’s argument that “mom and pop” internet service providers are burdened by the cost to comply with net neutrality rules. ISPs serving fewer than 100,000 already had relief from some of these regulatory burdens by the time net neutrality rules passed, she noted. “It’s not clear whether these costs are really a burden on these ISPs,” Yildirim said. While it would undoubtedly benefit them if all net neutrality rules went away, Yildirim argued that if larger ISPs face fewer restrictions, they might disadvantage smaller ISPs, consumers and websites.

Comcast, AT&T and Verizon all say that they are committed to an open internet. Comcast said it does not “block, slow down or discriminate against lawful content” and supports “sustainable and legally enforceable net neutrality protections for our customers.” Verizon said it supports net neutrality, while an open letter from AT&T CEO Randall Stephenson not only pledged support for no blocking or throttling but also called on Congress to draft new rules governing the internet, and stop the whirlwind of shifting policies due to court decisions or new presidents. Werbach noted that ISPs have said publicly that net neutrality rules have not hurt their business.

So What Will Change?
If net neutrality wasn’t a factor in the development of the internet, what would its absence mean? One outcome is the arrival of fast lanes on the internet. ISPs could give customers a choice of different types of access. In marketing, “this is a form of segmentation,” said Yildirim. That means a company would provide different products and services to cater to the needs of different users. But fast lanes would benefit websites that can afford to pay at the expense of smaller e-commerce or content sites without deep pockets. “That’s, I think, the concern here.”

Werbach pointed out, however, that “it’s important to understand that even though that repeal has now gone into effect … that doesn’t mean this is the end. This is just another step on this ongoing journey.” The debate over internet regulation has been going on for decades. “The FCC has gone through multiple cycles under many different administrations attempting to put in place these rules,” said Werbach, who wrote a seminal white paper on the digital revolution while at the FCC. “We haven’t heard the last of this,” he added, citing pending litigation and congressional action to restore net neutrality.

Several states such as Washington and Oregon also are moving to put net neutrality rules in place, Yildirim added. “The concerns are exactly around three things,” she said. “Blocking or censorship of content; throttling, slowing down of data transmission; and prioritization — fast lanes that are created which could favor some of the larger websites.” Washington passed its own net neutrality law in March while Oregon did it in April. Vermont signed a similar law in February. Meanwhile, lawmakers in 29 states have introduced more than 65 net neutrality bills while 22 states and D.C. are suing the FCC over the repeal.

It is important to note that the internet landscape today is not the same as it was in 2000 when ISPs were dominant amid a sea of smaller internet startups. “We now have an industry that has some very large, very influential players that, by the way, also have massive amounts of infrastructure,” Werbach said. “Google and Amazon run huge fiber networks across the country, even though they are not providing telephone service per se or broadband access service, except for a few exceptions.”

Given this new landscape, a criticism of net neutrality is that it regulates just one set of players — broadband access providers — while benefiting companies that use their networks, like Facebook, which are giants themselves. “We need to move to a point where we’re looking at the way the market works today,” Werbach said. He believes the solution could very well be found in the political realm, in the form of a legislative compromiso.
Where critics and supporters of net neutrality agree is that broadband access and the internet are the “foundation for the entire digital economy. Everyone agrees that those markets need to be open to innovation,” Werbach said. Therefore, he added, the debate is whether “essentially just allowing market competition, such as it is, will facilitate a free and open market where there is opportunity for creativity and new startups to be formed … or whether the FCC needs to be there as a kind of cop on the beat to deal with anticompetitive procedures and practices by the broadband access providers.” He said history has shown, though, that broadband companies have taken advantage of their “gatekeeper” role in ways that harm competition and consumers.
But practically speaking, it is not in the interest of broadband providers to block or slow down traffic to certain websites, Werbach said. People use ISPs to go anywhere they want online, and any disruption in this process will backfire. “Companies make decisions that are in their business interest. There’s nothing wrong with that,” he added. “The point of net neutrality is not to say that broadband providers are somehow wrong or unethical or bad just because they’re trying to capture market share.”

However, in an environment where most people have few choices for wired broadband and overlapping choices for mobile internet, “it doesn’t make sense to say, ‘let the market work because that will be in everyone’s best interest,’” Werbach said. “There are important and significant discussions to have about exactly what is the boundary between legitimate business models and practices on the one hand and unreasonable discrimination on the other hand. But the way to do that is to have a set of rules and define where they are,” not the FCC’s current hands-off attitude. Besides, he added, “having some regulation is not always something that’s going to be against their interest.”

Gold Weekly: Ready For Takeoff

by: Boris Mikanikrezai 

- Gold bulls rush to the exit.

- Net long positions in Comex gold are their lowest since January 2016, the CFTC data reveals.

- ETF investors continue to liquidate their gold holdings in spite of rising risk aversion, FastMarkets’ estimates show.

- A short-term bottom in gold seems to be very likely at this juncture, thanks to a slightly friendlier macro backdrop.

- I am bullish on my gold outlook, hold a long position in BAR, and stand ready to lift the size of my position in case of an unexpected dip.

Source: Pinterest.
Welcome to my Gold Weekly.
In this report, I wish to discuss mainly my views about the gold market through the GraniteShares Gold Trust ETF (BAR).
To do so, I analyse the recent changes in speculative positions on the Comex (based on the CFTC) and ETF holdings (based on FastMarkets' estimates) in a bid to draw some interpretations about investor and speculator behavior. Then, I discuss my global macro view and the implications for monetary demand for gold. I conclude the report by sharing my trading positioning.
While the CFTC statistics are public and free, the data about gold ETF holdings are from FastMarkets, an independent metals agency which tracks ETF holdings across the precious metals complex.
Speculative positioning
Source: CFTC
According to the latest Commitment of Traders report (COTR) provided by the CFTC, money managers slashed massively their net long positions in Comex gold over the reporting period (June 12-19), during which gold prices sold off 1.6% from $1,296 per oz to $1,275.

The net long fund position - at 29.85 tonnes as of June 19 - tumbled 127.50 tonnes or 81% from the previous week (w/w). This was primarily driven by short accumulation (+99.11 tonnes w/w) and further reinforced by long liquidation (-28.39 tonnes w/w).
The net long fund position is now at its lowest since January 2016 (1.24 tonnes) and close to its historical low reached on December 29, 2015, when money managers were net short of 77.11 tonnes.
The extremely low level of gold's net long speculative positioning suggests that a normalization is around the corner. The substantial accumulation of gross shorts (light blue) raises the likelihood of a powerful short-covering sooner rather than later. Be ready for takeoff!
According to my estimates, a mean-reversion process, whereby the net long fund position (currently at ~30 tonnes) would converge toward its long-term average (~325 tonnes), would produce an increase of $103 per oz in the spot gold Price.
As such, I expect gold prices to move higher toward $1,378 per oz at some point in the second half of the year.
Investment positioning
Source: FastMarkets
ETF investors sold roughly 10 tonnes of gold last week, which was the 7th consecutive week of outflows. Gold prices weakened 0.9% from $1,279 per oz to $1,268 over the period.
Despite the intensification of the gold sell-off in recent weeks, ETF investors have preferred to liquidate their holdings rather than buy the dips. The lack of buying interest in gold among ETF investors is primarily the result of the dollar rally, itself driven by a powerful bout of short-covering, as the chart below illustrates.
Source: SG
ETF investors are net sellers of ~46 tonnes of gold so far in June, the largest monthly pace of selling since July 2017 (~69 tonnes).
In the year to date, ETF investors are net buyers of a small 8 tonnes, marking an increase of only 0.4% in gold ETF holdings, in sharp contrast with the increase of 173 tonnes or 8% in the whole of 2017.
Macro backdrop for gold
The macro backdrop for gold has turned friendlier of late, in part triggered by the escalation in trade tensions between the US and its largest trade partners.
Source: Bloomberg
This has resulted in a renewed depreciation in the dollar and lower US real rates, which should theoretically support gold prices via a rebuilding of long speculative positions.
The tough stance on trade adopted by the US administration has resulted in retaliatory measures by its trading partners. The EU has imposed import tariffs on €2.8 billion worth of US products while the Chinese government has announced import tariffs on $34 billion of US goods (25%). But the US administration is already considering tit-for-tat actions. As a result, it is safe to argue that trade tensions are likely to worsen before getting any better.
In the turn, global risk-taking appetite could decline more pronouncedly (even if central banks step in), the dollar could give back its earlier gains, and US real rates could accelerate their decline, especially when considering the extent to which short positions in the 10Y US bond are extended.
Source: SG
Against a friendlier macro backdrop for gold, I expect gold prices (proxied by SPDR Gold Trust ETF - GLD) and gold mining equities (proxied by the VanEck Vectors Gold Miners ETF - GDX) to move higher toward their monthly highs in the near term.
Source: Seeking Alpha
Trading positioning
I have a long position in the GraniteShares Gold Trust ETF - BAR. BAR is presently the lowest cost physical gold backed ETF in the marketplace, with an expense ratio of just 0.25%, the lowest across its competitors.
Source: Seeking Alpha
An increasing number of investors is likely to deploy their capital to BAR at the expense of more traditional, expensive ETFs (such as GLD), thereby resulting in a gradual improvement in liquidity conditions in BAR.
My time horizon is very long term, namely 5+ years, which is why the expense ratio is a crucial parameter to take into account when choosing the most suitable ETF to express my view.
For now, the risk of my long position in BAR is relatively small, at 3% of my portfolio. The reason is that I prefer to build a position at a steady pace rather than go all-in while all my trading criteria are not met. In the same spirit of my previous note (Gold Weekly: Patience Is Power), I would emphasize that gold may need time before rallying at a more convincing pace. From a long-term perspective, gold has bottomed out for the past two years, and like most bottoming-out processes, they are confusing at first before (1) getting clearer and (2) attracting an increasing number of investors in it.
Since I realize that I may be early, I refrain myself from taking a too large position but stand ready to build more aggressively in case of an unexpected dip in prices.
For the sake of transparency, I will update my trading activity on my Twitter account and post my trade summary at the end of each report.

The Fed Dulls Hopes of an Emerging Market Rebound

The dollar’s rally means emerging-market pressures are set to stick around

By Richard Barley

The rally in the dollar turned a winning emerging market trade into a loser

Emerging markets have swung from investor darling to disappointment this quarter. Any bet on a rebound will require patience.

One big stumbling block is the strengthening dollar. This week’s decisions by the Federal Reserve and the European Central Bank have dented hopes that the greenback might start weakening again. The contrast between the ECB’s caution on rates and the Fed’s confidence is stark.

A weaker greenback not only mathematically increases local-currency returns; it also boosts investment flows to poorer countries, which helps to brighten the growth outlook.

Exchange Rates against the U.S. Dollar

When the dollar rises, as it has since April, this mechanism goes into reverse. With signs that the U.S. economy is outperforming, the latest move has been sharp: The ICE dollar index has climbed 6.3% in just two months.

Moreover, there is little sign that the weak links exposed by the dollar’s rise are out of the woods. The Argentine peso and the Turkish lira are still under pressure, even with Argentina signing up for a $50 billion International Monetary Fund package and Turkey belatedly raising interest rates sharply.

Argentines protested after the IMF welcomed the government's austerity measures. Photo: Sarah Pabst/Bloomberg News 

The initial hope was that these fault lines might not spread. After all, many other nations have increased their resilience by reducing economic imbalances. But now further problems have arisen.

The Brazilian real has fallen 13% against the dollar so far in 2018. Tax concessions made by the government to end a truckers’ strike in May have raised concerns about its failure to reform Brazil’s pension system, on which the IMF says spending is unsustainable. With an election due in October, this worry will remain live.

One consolation is that emerging-market assets and currencies are cheaper. The yield on the JPMorgan index of local-currency bonds has risen half a percentage point this year to over 6.6%. The gap between the yield on dollar emerging-market bonds and Treasurys has expanded to 3.5 percentage points. In a world still hungry for yield, that might sound attractive.

However, it is probably too early to turn bullish. Markets require a catalyst to change direction. In the absence of a weaker dollar to grease the wheels, that requires fundamental improvement. The best hope might be that growth outside the U.S. stages a rebound, but that will take time to show up in the data.

Emerging-market bonds and currencies may be cheaper, but the headwinds to a rebound have built too.

Central Asia’s Dangerous Homecoming


Nearly four years ago, the Islamic State was on top of the world. After seizing large segments of Iraq and Syria, the group announced the establishment of a caliphate on June 29, 2014. Islamist extremists from all over rushed to join the group. Major militaries bent on destroying the group were not far behind. By the end of 2017, the Iraqi government was declaring Iraq “totally liberated” of IS, and the Russian General Staff was touting similar results in Syria.

The same year IS was making headlines in Iraq and Syria, a branch of the group was taking root in the Afghanistan-Pakistan border region. Its fate has been very different. In April 2017, when U.S. officials estimated there were 700 IS members in Afghanistan, the U.S. military made its intentions to dismantle the group known when it dropped the “mother of all bombs” on IS targets in Nangarhar province. A few months later, a U.S. airstrike in Kunar province killed the leader of the Afghan branch. By November, however, with the war still raging, the top NATO commander in Afghanistan said American forces had killed over 1,600 IS fighters in Afghanistan. In late December, IS blew up a cultural center in Kabul, killing 50 people. Other bombings followed, the largest of which killed almost 70 on April 22, 2018. A few days ago, on June 8, the top U.S. general in Afghanistan said anti-IS operations would intensify during the ongoing temporary cease-fire against the Taliban.

The Islamic State branch in Afghanistan benefited somewhat from the demise of IS in Iraq and Syria. As the latter crumbled, current and would-be foreign fighters – many of whom come from Central Asia – sought out the next battleground, which many decided was Afghanistan. Looking ahead, in much the same way that successes against IS in Iraq and Syria pushed the fight to Afghanistan, successes in Afghanistan could push the fight north, into Central Asia. Thousands of people from Central Asia are believed to have joined IS in Iraq and Syria, so in a way, this would be a homecoming.

Terrorist groups near the borders of several Central Asian countries are already growing more active. More than 15,000 IS fighters are at the southern borders of Uzbekistan, Tajikistan and Turkmenistan, the secretary of the Security Council of Russia said in late May. There are reports of IS fighters concentrating in the northeastern Afghan provinces of Badakhshan, Takhar and Kunduz, all of which border Tajikistan. Specifics on the fighters are hard to come by, but Tajikistan’s State Committee for National Security believes they number about 7,000. This includes about 4,000 in Kunduz, an estimated 95 percent of whom are Uzbeks from the Islamic Movement of Uzbekistan (which pledged its loyalty to IS in 2015).  

To be fair, many prognosticators – ourselves included – have been waiting for years for the turmoil in Afghanistan and Pakistan to drag down Central Asian states. Yet the Institute for Economics and Peace, which puts out a yearly Global Terrorism Index, placed only Kazakhstan, Tajikistan and Kyrgyzstan in the half of countries most affected by terrorism, and even those only barely. (Kazakhstan ranked the worst at 67 – the higher the ranking, the more effect terrorism has on the country – just behind Canada.) Incidents of terrorism actually dropped between 2002 and 2016 in Tajikistan, Turkmenistan and Uzbekistan, according to the index. But think tank indexes don’t change geopolitics, and they can’t fix socio-political or economic stresses. What those indicators say is that Central Asia has a rather high chance to become a new hotbed for terrorists. This would be bad news not just for Central Asia but also for its neighbors, especially China and Russia. In this Deep Dive, we’ll look at the geopolitics and the internal stresses of the region, as well as how Russia and China are preparing to fight back.
An Islamic Arc of Instability
Central Asia is surrounded by a sort of Islamic arc of instability. In the south, it borders Afghanistan and Pakistan. To the east is the Xinjiang Uighur Autonomous Region, China’s most unstable region, where a plurality of the population – about 45 percent – is Muslim. And to the west, the restive Caucasus is separated from Central Asia by only the Caspian Sea. The southern section of the instability arc is the most contagious, so although the socio-economic vulnerabilities in each state are fairly comparable, the three that border Afghanistan – Tajikistan, Turkmenistan and Uzbekistan – are most immediately vulnerable to the spillover of IS and the Taliban.
Tajikistan has the weakest army and the longest border with Afghanistan – more than 800 miles (1,300 kilometers) – of the Central Asian countries. It is simply incapable of securing its borders and stopping extremists from slipping into its territory. Turkmenistan’s border with Afghanistan is a little more than half as long as Tajikistan’s, but a nearly 500-mile border is not much more defensible. Turkmenistan is also attractive to Islamists because of its sparse population, weak military and the absence of Russian military bases, factors that combine to make it easier to put down roots and spread.

Uzbekistan, on the other hand, may be the best-prepared country in Central Asia to counter an influx of terrorists from Afghanistan. The border is less than 90 miles long and traces the Amu Darya river, a natural obstacle to clandestine crossings. Uzbekistan also has Central Asia’s largest active-duty military, according to a 2017 International Institute for Strategic Studies report, and it inherited a great deal of the Soviet Union’s military equipment when the USSR collapsed.

Farther north, Kazakhstan and Kyrgyzstan are shielded from the Afghan border, but they have another threat: Xinjiang. The Chinese state-run Global Times newspaper quoted unnamed sources in 2014 as saying some 300 Chinese Uighurs were fighting with IS in Iraq and Syria. And in the late 1990s, Chinese Uighurs in Xinjiang formed what is now known as the Turkistan Islamic Party, a terrorist group whose goal is to create a caliphate in Xinjiang and Central Asia. Moreover, Kazakhstan’s vast steppes are desirable terrain for jihadist groups, including those that could come from the south, because many areas are sparsely populated and hard to patrol. From there it is also possible to move into Russia and the Caucasus, where allies would not be difficult to find.
Turmoil Inside the Arc
The roots of extremism and terrorism in Central Asia can be clearly traced back to the 1990s, but that isn’t when the first wave of Central Asian terrorism began. The first terrorist movement there was actually the Basmachi movement, a Muslim revolt against the Bolsheviks and the Russian people under the banner of a “holy war,” starting in 1917. The movement was defeated by the Red Army in 1938, but Central Asian Islamism was not extinguished. In the Soviet Union, Muslims could not openly profess their religion and were instead forced to accept state atheism. The successes of Islamists in Afghanistan against the USSR in the 1980s, combined with the fall of the Soviet Union in 1991, breathed new life into Central Asian Islamism, and a number of groups emerged that began to cooperate with, for example, the Taliban movement.

The strict authoritarianism that took hold in the newly independent states of Central Asia in the mid-1990s was fuel to the Islamist fire. Government efforts to stop the spread of Islam and Islamist groups, which they perceived to be a threat to their power, had the reverse effect. Political opposition became violent resistance, and terrorist movements formed in Uzbekistan, Kyrgyzstan and Tajikistan, bent on creating an Islamist state inside their territory.

The Islamic Movement of Uzbekistan, established in the late 1990s, became the largest terrorist group in the region. Its mission was to topple the regime of Uzbek President Islam Karimov, who died in 2016, and establish an Islamic state uniting the five states of Central Asia. The IMU was once aligned with al-Qaida but it formally switched loyalties to IS in 2015. Other groups include Hizb ut-Tahrir, the Islamic Renaissance Party of Tajikistan, Jamaat Ansarullah (originally from Tajikistan) and the Turkistan Islamic Party (formerly the East Turkestan Islamic Movement), which mostly threatens China. A newer group, Lashkar-e-Khorasan, has formed with the goal of creating a Central Asian caliphate, though it is not tied to IS, according to Andrei Serenko, a scholar at the Russia-based Center for Studies of Modern Afghanistan. Lashkar-e-Khorasan consists mostly of people from Central Asia.

The motivation of terrorists is a hotly debated topic, but religion alone is rarely a sufficient driver. Extremism usually spreads when there are unfavorable social or economic conditions and the legal avenues for political dissent prove ineffective. Central Asia in the 1990s is a case in point. In the first years of independence, Central Asian countries had poor economic performances, and parts of the population were marginalized.
Much has changed in the two decades since. Macroeconomic indicators in Central Asia today are positive. The World Bank estimates that Uzbekistan, Turkmenistan and Tajikistan all experienced gross domestic product growth of at least 5.3 percent in 2017 and expects 5 percent or better growth for each for at least the next three years, while the GDPs of Kazakhstan and Kyrgyzstan grew by an estimated 4 and 4.6 percent last year, respectively. But their rapid modernization covers up demographic problems and widening social divisions. Poverty and unemployment – especially youth unemployment – are still an issue, even if official statistics don’t always show it. Many are trying to move abroad to find work. Most go to Russia, since Russian is still commonly spoken in post-Soviet states. Some become radicalized. Frustrated youths are the ideal target for jihadist recruiters, and Central Asia has plenty of them.
Pre-Emptive Action
For years, Central Asian extremists concentrated their efforts on Central Asia. But when the Islamic State declared its caliphate in Iraq and Syria in 2014, the most dedicated jihadists in Central Asia rushed to join the effort. Most of the fighters came from Kyrgyzstan, Tajikistan and Uzbekistan.

In early 2017, Russian President Vladimir Putin said there were some 9,000 people from Commonwealth of Independent States countries (the five Central Asian states plus Armenia, Belarus, Moldova, Russia and Ukraine) fighting in Syria. Uzbekistan led the way with 1,500 citizens fighting alongside IS. Tajik official data said about 1,150 of its citizens in recent years had gone to Syria or Iraq to join IS. Tajikistan’s Ministry of Internal Affairs says 519 Tajiks are fighting with IS, while 150 more have died and 36 were allowed to return home and avoid criminal prosecution. Kyrgyz authorities estimated that about 600 of their citizens joined extremist groups in Syria and Iraq; Kazakhstan puts its own estimate at 500; and Turkmenistan says 400. Reliable data does not exist – these estimates count only men, for instance – but the totals are in line with the upper end of most other estimates.

The flow of fighters started to reverse when IS began losing ground and running out of funds. The extremists who left for Iraq and Syria years ago return home battle-hardened, experienced and devout. Border authorities attempt to catch them, but some inevitably slip through the cracks. The fear inside the governments of Central Asia is that the returning militants will create sleeper terrorist cells in their countries, recruiting more fighters and ultimately unifying Islamist movements in the region.

Central Asian governments are also concerned that refugees from Afghanistan could become radicalized, or that Taliban or IS fighters could hide among them. However, the number of refugees in Central Asia is still small: At the start of 2017, 729 refugees were registered in Tajikistan, 653 in Kazakhstan, 339 in Kyrgyzstan, and 27 each in Turkmenistan and Uzbekistan.

Central Asian governments have been taking pre-emptive action. Since fall 2015, Tajikistan has closed more than 1,500 mosques in an effort to combat religious extremism. Earlier this year, Russia and Tajikistan carried out joint anti-terrorism drills near the Afghan border. In May 2018, Collective Security Treaty Organization countries launched anti-terrorism drills in Kazakhstan. Uzbekistan, which strives for independence and neutrality, ratified the Shanghai Cooperation Organization Convention on Countering Extremism last June and rejoined SCO counterterrorism drills after a long absence. And the president of Kyrgyzstan said he is not opposed to opening a second Russian military base in the country.

Central Asia’s most powerful neighbors, Russia and China, are keeping a watchful eye on the situation and have been quick to offer help. Both share long borders with Central Asian states and realize that they could be next if terrorism started to spread in the region. In addition, China is cognizant of the threat to its One Belt, One Road projects through Central Asia.

Russia and China, in the framework of the CSTO and the SCO, are working out joint plans with partner states to combat the terrorist threat. After a seven-year hiatus, the SCO-Afghanistan Contact Group, designed to help Afghanistan fight terrorism, drugs and crime, met in October 2017 in Moscow. The group met again this year in Beijing. In late April, Russian Defense Minister Sergei Shoigu said Moscow was increasing the combat readiness of Russian military bases in Tajikistan and Kyrgyzstan to prevent the spread of militants from northern Afghanistan to Russia’s allies in the CSTO.

Iran and the U.S. have also shown an interest in the stability of Central Asia, and Russia and China are wary of their intentions. Whether it’s conspiracy theory or legitimate fear, Russia seems particularly concerned that the U.S. could be encouraging unrest in Central Asia. Instability there could disrupt China’s One Belt, One Road initiative and distract Russia from interfering in areas more important to U.S. foreign policy. On the other hand, the U.S. will never forget what happened in 2001 when Islamism in Afghanistan grew powerful enough to reach even the United States. And as Central Asian governments have already shown in recent years, nothing gets Russian military bases in the region upgraded or joint drills carried out like hyping the threat of terrorism.