China’s Command Innovation

By John Mauldin

TFTF Image

Hardly a day passes without some sort of China news in the financial headlines. There’s a good reason, too. China is the global economy’s 600-pound gorilla, second in size only to the US. Yes, it was largely a copycat business economy up until the early 2000s, but Chinese entrepreneurs have really taken charge in the last 10 years. Fueled by the profits from huge consumer demand, they are expanding not only in China but globally. This story is largely ignored in the US and in much of Europe. We hear about a few projects here and there, but we don’t understand the extent.
China is on its way to becoming the largest economy in the world, which because of its population, it should be (possibly with the exception of India, if they ever get their act together). Short-term events and arguments sometimes obscure this longer-term reality. China’s transition from rural poverty to export powerhouse to consumer goliath may be the most consequential economic event in centuries. Possibly ever—I can’t think of a historical example to rival it. Historians might argue the British Empire or even the US from 1800–2000, but that took centuries. China has done it in a little over 30 years.
When I say “consequential,” I mean they can be either good or bad. We’ve seen both and will continue doing so. Along with Worth Wray, I wrote a 2015 anthology on China called A Great Leap Forward? So this is not my first deep-dive into China.
Even so, periodically I like to step back and assess where we are in this massive change, and that will be my focus for the next three letters. Today and next week, we’ll look at the bright side: The good things happening in China, much of which will help the rest of the world, too. Just like the work going on in the US and Europe and other countries is helping the rest of the world. Entrepreneurs and scientists inventing new ways for us to better our lives is good for everyone everywhere. Then the third letter will consider some darker possibilities. It is not all sweetness and light in China, as long-time readers know.
I could start by going through all the stats on how big China is, but they are so mind-boggling, we really can’t process them. In just one generation, something like 300 million+ people went from rural subsistence farming to urban industrial and technology jobs. Some of the cities in which many now work, didn’t exist when they were born. Hundreds of millions more are waiting in the wings to make that same journey or have already made a journey to “smaller” cities of just a few million people (note sarcasm).
I can find 13 cities with over a 10 million population in China. There are literally scores over 5 million. But that doesn’t tell the story. China is currently creating 19 “super city” clusters by strengthening the links between them. HSBC projects that 80% of Chinese GDP will come from those cities.
Last week, Financial Times reported Beijing plans to integrate former Western colonies Hong Kong and Macau with other nearby urban areas including Shenzhen and Guangzhou into this “Greater Bay Area.” Already, it accounts for 12% of Chinese GDP and 37% of the country’s exports. Beijing wants the GBA to lead the nation’s innovation and economic growth.

Photo: Getty Images

To that end, the government is pouring infrastructure investment into the region, including a 22-mile bridge connecting Hong Kong and Macau (not cheap!) with the mainland and a new $11 billion rail link for Hong Kong. It also plans to eliminate some of the bureaucratic barriers that presently slow down commerce.

“The GBA is home to a high concentration of dynamic private businesses, such as Tencent, Midea, and Huawei. It is also China’s most innovative urban cluster, generating more than 50% of the country’s international patent applications. And, according to HSBC, the GBA is the least burdened by inefficient state-owned enterprises and excess capacity.
“The reason is simple: The GBA is far more market-oriented than its counterparts, with Hong Kong and Macau much more open to the outside world than any other Chinese cities. Both cities not only permit the freer flow of goods, services, capital, technology, talent, and resources, but also meet global standards in terms of regulations, business practices, soft infrastructure, and even lifestyles.”
(Source: Andrew Sheng and Xiao Geng, Project Syndicate)
Part of this area is Shenzen, just north of Hong Kong.

Image: Google Maps

In 1980, Shenzhen was a fishing village of 30,000 people. Today, it produces 90% of the world’s electronics and is home to over 12.5 million people. It has 3 million registered businesses. It is compounding its growth at over 12% a year, doubling in the last six years.
The size of this region is hard to comprehend. With nearly 70 million people and $1.5 trillion GDP, it is economically bigger than Australia or Mexico. Guangdong (the mainland China part) alone exported $670 billion in goods last year. Three of the world’s ten busiest container ports are in the region. It will be Silicon Valley on steroids.
For that matter, it could be the US on steroids, at least geographically.

From Hong Kong you can fly to Singapore, Kuala Lumpur, Bangkok, Manila, Shanghai, Seoul, and Tokyo as fast as I can get from Dallas to San Francisco. This Greater Bay Area will be the center of the world’s fastest-growing region, with billions of smart business people, scientists, and consumers.
According to Wealth-X, Hong Kong just overtook New York as the world’s largest concentration of ultra-wealthy people (net worth of $30 million or more). Their study specifically attributes it to enhanced links with mainland China. Look for this to continue.

Research Capital
When Americans import Chinese goods, we get stuff we want and China gets our US dollars to spend. Ditto for China’s other customers. They receive goods, China receives cash. On this end, much of what we purchase ends up in landfills, or like our iPhones, being replaced every few years. Not so over there. They often spend our cash more wisely than we use their doodads. (Infrastructure is a good example. Many Chinese highways, railroads, and airports are far superior to ours.)
This is a great chart on the world’s top exporters in 2017. While you can easily see that China out-exports the US, I find it interesting that Germany is almost the size of the US, and that the Netherlands, with only 17 million people (barely 5% of the US population), exports $652 billion. On an export dollar per population, why isn’t the US worried about the Netherlands?

Beijing sees this same data and realizes its leadership is not guaranteed.

China needs to develop its own technology, and doing so requires research, and research requires capital. So, through a combination of government edicts and profit-seeking, it is right now in a major effort to build its own innovation economy.
The plan isn’t complicated. To summarize, “Throw money at it.” Beijing is forcing money into venture capital at an astonishing pace. My friend Peter Diamandis toted up the numbers last month.
By end of 2017, 3,418 Chinese VC funds were launched within the year, raising a combined $243 billion USD or 1.61 trillion RMB.
Of the $154 billion worth of VC invested in 2017, 40 percent came from Asian (primarily Chinese) VCs. America’s share? Only 4 percentage points higher at 44 percent.
In the first three quarters of 2017, 493 state-backed funds were founded with a capital size of 114 billion USD (756.8 billion RMB).
And as of two years earlier, Chinese VC coffers had surpassed a remarkable $336.4 billion USD.
In a great push to scoop up intellectual property and drive growth in key tech sectors, China’s VC scene is booming.

As of 2016—before the numbers Peter lists there—China VC investment had roughly caught up to US level. Now it is probably ahead.

Image: VentureBeat

Of course, merely spending money isn’t the same as spending it wisely, nor does it mean the resulting products will succeed. But the research is the first step, without which little is likely to happen. AI doesn’t invent itself (yet).
Peter Diamandis says Chinese VC firms are targeting three segments: robotics, driverless vehicles, and biotechnology. I can see why, too: demographic necessity. It’s odd to imagine labor shortages in such a huge country, but that is a growing problem for China. Decades of the one-child policy produced a severe age imbalance. Robotics and driverless vehicles will address that problem, while biotechnology may help China avoid the healthcare spending that weighs down the US economy.
Yet this is good news for the whole world. Chinese innovation in these segments won’t stay in China. They will export it and, if it’s better than what others produce, the market will let everyone benefit. So, I hope they go full speed ahead. May the better tech win. (Of course, I will still root for the home team!)

Paper Wars

It is common knowledge that China has produced more scientists and engineers for decades than the West has combined. Many of us had suspicions about the qualities of the universities and their degrees. They couldn’t be as good as ours, could they? Well, we’re beginning to see the answer to that, and it turns out they were comparable and possibly even better in some areas.
As a graphic indication, here’s the countries with the most STEM graduates:

Image: Forbes

We know China’s contribution to scientific knowledge has grown, but how much so is less clear. Exactly what counts as “Chinese” research? You have Chinese people working both within China and in other countries, including at many top US and European universities. How do we categorize their contributions? It’s hard to assess.
A recent study gives us new data. Last month, Quartz cited a study by Qingnan Xie of Nanjing University and Richard Freeman of the National Bureau of Economic Research, which looked at the number of scientific papers with Chinese authors. Unlike other such studies, they included not just authors in China, but those with Chinese names but located elsewhere.
That’s an imperfect standard, of course. You can have a Chinese name and live in Singapore. Many US citizens have Chinese surnames, and the Chinese diaspora is well known. Likewise, not all research by ethnically Chinese researchers will find its way back to Chinese businesses or government agencies, nor is every paper an equally valuable contribution to the world’s knowledge base. But the study seems as rigorous as possible, so I think the general findings are probably right, at least in their direction.
Xie and Freeman found that in 2016, roughly 24% of scientific papers had an author with a Chinese name or address. If you include Chinese-language papers, it jumps to 37%.

Image: NBER

Looking at it another way, China has 15% of global GDP but produces more than a third of the scientific papers. It seems those university degrees are beginning to pay off in actual research.
Again, we’re not considering the value of those papers. Some may be worthless. But just in terms of output volume, China is producing far more research than its share of the world economy and population says it should. As the chart shows, this figure has been trending steadily higher, too.
Now, recognize how breakthroughs happen. They are often a consequence of large numbers. The more smart people you have trying to solve a problem, the more likely one of them is to solve it. Most will fail and that’s ok. All you need is one success.
If China has more scientists working on more problems than anyone else—and it does—then we can expect China to find more solutions, other things being equal.
As I said, this is okay from a global perspective because we will all get the benefit of those breakthroughs. But we won’t get it free, and the price will be higher for us in the US if we have to import it from China.
So, this is not a race the US or Europe or the West or anyone should concede, but we are conceding it in some ways. For instance, when we admit Chinese students to study at our top universities then don’t let them stay here to build their careers. We educate them and send them back. It makes no sense. We should give them a green card and an open door.

You think they are taking jobs? No, they are creating jobs in China when they could be creating jobs here. Just saying…

A Place to Innovate

Matt Ridley says human progress and prosperity make the greatest leaps when “ideas have sex with each other.” They produce offspring, in other words. This creative process happens faster and more easily when the idea-holders share proximity. Many inventions come from large cities not because city folk are any smarter, but because the necessary mix of ideas was in the same place, at the same time. In the US, Silicon Valley often serves this purpose. Along with Austin, Dallas, Boston, New York, and others.
China has abundant venture capital to fund research and large numbers of researchers cranking out ideas. It needs a central place for those ideas to have frequent sex with each other. The government is aware of this and, in true command-economy style, has decreed it will happen in the Greater Bay Area I mentioned above.
Economic growth is largely a numbers game: workers times productivity. China already has both ingredients and is working assiduously to enhance them further. For now, the US is still ahead, but we shouldn’t be complacent. Nothing requires the global economy to keep us in the lead, and we are not doing what we should to keep it.
There are literally books written on this. Everywhere you turn is an amazing story. Many readers are going, “Okay, China has a lot of large cities and fast trains. So what?” Serious research shows that creativity goes up the larger the city gets, measured in either new businesses or GDP or patents. Putting humans together has been a spark for new ideas since man first began to organize cities 10,000 years ago.
But large cities are not the real story. China is shifting from an export-driven to a consumer-driven economy. That will be a rough transition in itself, but the government is leaving little to chance. Here in the US, we’re skeptical of central planning. I certainly am. But I have to admit, if it’s possible for a centrally planned economy to achieve sustainable long-term growth, China will be the one to do it.
And again, there is decades old accepted economic research to demonstrate that a centrally planned economy has some advantages in the early stages of development. The transition to a consumer-oriented society is the most difficult for a top down, centrally planned economy to manage. So far, China seems to be letting entrepreneurs put capital to work without having to tell them how to do it. They just give them the tools and, sometimes, the money as well.
Next week, we will look at some even more astounding data, then later go on to what could cause China to stumble. Remember those 1980s predictions Japan would own the world? It turns out you can only do so much on credit. Stay tuned.

New York, Houston, and Dallas

I leave for New York City on Sunday to meet with my Mauldin Economics partners, Ed D’Agostino and Olivier Garret, to talk about some new ventures and the conference and so on. We try to get face-to-face every few months to go over the details and keep up with what is happening with each other.
After a day of meetings, the next night I will have a small dinner with Art Cashin and some of the usual suspects. The next day will be videotapes and maybe some media. Then in theory, I’m in Houston next Thursday night for a meeting at Rice University and dinner with the RISE committee (The Rice Initiative for the Study of Economics). This is an extraordinarily interesting group of people and gives me a chance to get back to my old college stomping grounds. Sometime that day, I have to do the next letter. And then maybe some more meetings Friday before I fly home.
I will be doing two presentations in Dallas on October 4 (my 69th birthday) at the Dallas Money Show, which is at the Hyatt Regency Dallas. Click on the link to register for free.
This letter is long enough, so I’m just going to hit the send button and wish you a great week!
Your trying to get into the gym more analyst,

John Mauldin
Chairman, Mauldin Economics

Europe risks failure on migration

While the EU tries to agree a policy, nativist politicians are whipping up prejudice

Tony Barber

There is a refugee and migrant question in Europe. But is it a crisis? Measured by the actual numbers of refugees and irregular migrants arriving this year in the 28-nation EU, there is no crisis. Measured by the impact on European politics, however, there is a serious one and it shows no sign of fading away.

This crisis expresses itself in poisonous, polarising debates about national identity and the place of Islam in Europe. It generates support for radical rightwing parties, such as Italy’s League, which entered the government in June and has turned into the nation’s most dynamic political force. It drives centre-right parties further to the right. As in Germany, it undermines coalition governments that it made difficult to form in the first place.

The crisis also fuels mistrust between some western European governments and societies and some in central and eastern Europe. It paralyses efforts to reform the EU and to strengthen its core, the 19-nation eurozone. Lastly, it harms the EU’s reputation as a foreign policy actor and damages relations with neighbours, especially in north Africa.

Viewed from some parts of the world, the European agitation over refugees and migrants can often seem obsessive. According to the UNHCR, the UN refugee agency, there are 68.5m forcibly displaced people in the world, of whom 25.4m are refugees. The burden of caring for refugees in countries such as Iran, Jordan, Lebanon and Turkey is higher than in the EU. Jordan has 89 refugees for every 1,000 inhabitants.

By contrast, just over 60,000 migrants and refugees crossed the Mediterranean into Europe between January 1 and August 12, says the UN’s International Organisation for Migration. Almost 120,000 did so during the same period of 2017. The EU’s population is roughly 510m. If the bloc were to receive 100,000 refugees and migrants this year, that would represent about one person for every 5,000 inhabitants.

In 2015, when more than 1m refugees and migrants entered Europe, largely from conflict-ridden Afghanistan, Iraq and Syria, the challenge was much more substantial. However, rather than overwhelming the EU’s financial resources or administrative capacities, this wave of arrivals put the spotlight on a quite different problem — the inability of national governments to agree among themselves on how, indeed whether, to share responsibility for the newcomers. This problem persists to the present day. But it is a European political crisis, not a refugee and migrant crisis.

In some countries, public perceptions depart wildly from the facts. According to the European Commission’s latest Eurobarometer survey, released in June, EU citizens as a whole regard immigration and terrorism as the most important issues facing the bloc. Some 38 per cent of respondents put immigration top of the list. Terrorism was second at 29 per cent.

Yet attitudes across the EU differ considerably from nation to nation. The four countries ranked most averse to non-European immigration were the Czech Republic, Hungary, Latvia and Slovakia, where at least 80 per cent of respondents expressed negative feelings. Compared with elsewhere in the EU, however, none of these countries is host to large numbers of asylum-seekers or any other kind of non-Europeans.

Small, recently independent states, with little historical experience of receiving uninvited outsiders, are no doubt more apprehensive about perceived risks to culture and identity than are larger countries with a tradition of imperialism and immigration. This is understandable and justifies a refugee and migrant policy more tailored to national conditions than the rigid formulas too often devised in Brussels.

However, what is inexcusable is the way that politicians whip up anti-immigrant prejudice to court popularity, win elections and consolidate their grip on power. Western Europeans like to point the finger at Viktor Orban, Hungary’s prime minister, and Jaroslaw Kaczynski, Poland’s de facto leader. But there are plenty of similar examples in Austria, Belgium, France, Germany, Italy, the Netherlands, Sweden and the UK.

What can be done? EU authorities rightly contend that to win public trust on immigration they must exert stricter control over the bloc’s external borders and crack down on people traffickers. But every national leader should also muster the courage to present the case for well-run, legal migration routes, reformed asylum procedures and proper treatment of refugees under international law. Recent initiatives do not inspire confidence.

In June, EU leaders discussed setting up “controlled centres” for irregular arrivals on European soil and “ regional disembarkation arrangements” for people rescued at sea. Whatever one makes of these Orwellian phrases, it beggars belief that the leaders aired their ideas without agreeing which EU countries might construct such centres, and without holding prior talks with north African governments about the crucial role they are expected to play.

Even if successful, these initiatives would leave other problems to fester. The most pernicious is that anti-immigrant demagoguery has become part and parcel of European politics. This not only pollutes the public sphere and hinders the search for solutions. It also increases the risk that the EU will be underprepared for the next big refugee and migrant wave, whenever it comes.

America, China and the route to all-out trade war

For political reasons, Trump and Xi will find it hard to back away from this fight

Gideon Rachman

While US president Donald Trump, left, could accept a symbolic victory in a trade war with China, president Xi Jinping could not afford a symbolic defeat © AP

Trade wars are good, and easy to win.” Donald Trump’s breezy tweet of last March may go down in history as the economic equivalent of prediction in Britain, in August 1914, that the first world war would “all be over by Christmas”.

The US president’s initial tariffs, imposed on $50bn worth of Chinese exports in June, did not bring swift victory. Instead, they were met with Chinese retaliation. Now Mr Trump is preparing to impose tariffs on a further $200bn worth of imports from China, which will probably be met, once again, by a tit-for-tat response from Beijing. The world is on the very brink of a major trade war between the US and China, and it is unlikely to end quickly.

To date, markets have been oddly relaxed about all this. Perhaps they have assumed that a last-minute deal would be reached between the US and China? But that is far too complacent. Instead, there are political, economic and strategic reasons that are pushing the two sides towards prolonged confrontation.

If both sides proceed as threatened, they will soon have covered more than half of their bilateral trade — with Mr Trump threatening even further tariffs after that, which would essentially cover all Chinese exports to the US.

America’s biggest companies and products are already in the line of fire. Apple warned last week that the cost of its products will rise if the next round of proposed tariffs are imposed. It was met with a presidential suggestion that they relocate production to the US. American farmers, hit by Chinese tariffs on soyabeans, have been offered government subsidies and appeals to their patriotism.

For political reasons, both Mr Trump and President Xi Jinping of China will find it very hard to back away from this fight. It is possible that Mr Trump would accept a symbolic victory. But Mr Xi cannot afford a symbolic defeat. The Chinese people have been taught that their “century of humiliation” began when Britain forced the Qing dynasty to make concessions on trade in the 19th century. Mr Xi has promised a “great resurgence of the Chinese people” that will ensure that such humiliations never occur again.

There is also reason for doubt that, when it comes to China, the Trump administration would settle for minor concessions — such as Chinese promises to buy more American goods or to change rules on joint ventures. The protectionists at the heart of the administration — in particular Robert Lighthizer, the US trade representative, and Peter Navarro, policy adviser on trade and manufacturing in the White House — have long regarded China as the core of America’s trade problems.

Optimists will take heart from the fact that Mr Trump has backed off, possibly temporarily, from the dire trade threats he was aiming at Mexico and the EU. The Mexicans have promised to restructure automobile supply-chains, and the EU has pledged to buy more American soyabeans and gas, and to open discussions about a free-trade pact.

But the US’s complaints about China are much more far-reaching than its concerns about the EU or Mexico. They relate not just to specific protected industries, but to the entire structure of the Chinese economy.

In particular, the US objects to the way China plans to use industrial policy to create national champions in the industries of the future, such as self-driving vehicles or artificial intelligence. But the kinds of changes that the US wants to see in Beijing’s “Made in China 2025” programme would require profound changes in the relationship between the Chinese state and industry that have political, as well as economic, implications.

Seen from Beijing, it looks as though the US is trying to prevent China moving into the industries of the future so as to ensure continued American dominance of the most profitable sectors of the global economy, and the most strategically-significant technologies. No Chinese government is likely to accept limiting the country’s ambitions in that way.

The contest over future technologies also underlines the fact that there is a strategic aspect to this trade rivalry — something that is completely lacking in the Trump administration’s confrontations with Mexico, Canada or even the EU.

China is the only plausible rival to the US as the dominant power of the 21st century. So while Mr Trump’s trade tariffs reflect his own personal quirks — in particular, his longstanding protectionism — they are also part of a broader mood-shift within the US.

Large parts of the US establishment, well beyond the Trump administration, have soured on the idea that economic engagement is the best way to deal with a rising China. Instead, the appetite for confrontation is growing. Prominent Democrats are now as vocal in their calls for tariffs and trade sanctions on China as Mr Trump.The dangers of US-Chinese confrontation over trade are amplified by the fact that both sides seem to believe that they will ultimately prevail. The Americans think that because China enjoys a massive trade surplus with the US, it is bound to suffer most and blink first. The Chinese are conscious of the political turmoil in Washington and the sensitivity of American voters to price rises.

Both sides are preparing for a trial of strength. It is unlikely to be over by Christmas.

The Cost of Keeping Greece in the Eurozone

Was it really worth it?

By Jacob L. Shapiro

A Grexit is finally here. Only it’s not the one that kept many of us up at night for years. Greece isn’t leaving the eurozone; it’s leaving the last of the three major emergency loan programs that allowed it to remain in the eurozone in the first place.
We have Citigroup to thank for the entrance of Grexit into common parlance. In February 2012, analysts there gave it even odds that Greece would leave the eurozone. (We can therefore hold Citigroup accountable for “Brexit,” “Italexit” and all the other ear-grating portmanteaus that have followed.) A little over three years later, the world watched Greek voters reject a joint bailout package from the European Commission, the International Monetary Fund and the European Central Bank – only to have their prime minister, Alexis Tsipras, agree to an even harsher package eight days later. In February 2017, Grexit once again seemed nigh, as the Greek government balked at IMF demands for more pension cuts and tax increases. The melodrama continued off and on until July, when the IMF at last relented.



In each case, Grexit was averted, and the integrity of the eurozone was preserved. But it came at a cost. In 2008, Greece had a gross domestic product of $354 billion. By 2017, its GDP had shrunk by 44 percent. According to the IMF, only four countries' national economies have shrunk more in the past decade: Yemen, Libya, Venezuela and Equatorial Guinea. That's not exactly the company one wants to keep when it comes to economic success. As of the first quarter of 2018, Greece’s debt-to-GDP ratio was 180 percent. Of that debt, 146 percent was in the form of loans. (For comparison, the EU average for that figure is 11.6 percent.) According to Greece’s Public Debt Management Agency, Greece will be paying off roughly $300 billion of debt until 2060.



The European Commission believes this is cause for celebration. Its official press release salutes the strength and determination of the Greek people while insisting that “Europe will continue to stand by Greece’s side.” Greek leaders have a more sober view of the milestone. Tsipras plans to address the Greek people on Tuesday – but there will be no public celebrations in Athens, nor announcement of new relief measures for Greek pensioners whose monthly payments will decline as much as 18 percent starting on Jan. 1, or to the roughly 900,000 Greeks currently without jobs. The European Commission says Greece will now be “treated like any other Europe area country.” But Greeks will remember all too well the years in which they weren’t.

And so a tough question must be asked: Was it all really worth it? Maybe this is the wrong question, since neither side had much of a choice. It’s easy to demonize Germany, the power behind the power in Brussels, for forcing austerity on Greece, but it’s hard to think any government in a similar situation would have behaved differently. No German government could have taken a more altruistic stand toward Athens’ debts and survived; German taxpayers did not want to foot Greece’s bill even if some of it was incurred by greasing Germany’s export machine. Likewise, it’s easy to demonize Tsipras for going against the will of his people, but Tsipras was torn between betraying his own principles, doing what was best for his people, and obeying the demands of Greece’s creditors. (As an aside, it’s ironic that Greek voters felt far more strongly about rejecting a bailout in 2015 than British citizens did in their own referendum on EU membership.)

But if it’s the right question, it is tempting to answer in the affirmative. The Greek economy began to grow again in 2017 by 1.4 percent. Greek pensioners will receive less money than they once did, but they will at least receive something. Greek unemployment, while still high at 20 percent, has been slowly dropping from its peak of nearly 30 percent in 2013. For the hundreds of millions who either believe in or appreciate the benefits of the European project, Greece’s rescue is a rare moment of vindication. The eurozone was brought to the brink, but it went no further. Perhaps it’s even the high-water mark of euroskepticism, one that could set a precedent for other highly leveraged European economies to follow.

Maybe this optimism will be proved right in the long run, though it is hard to see how. Greece was not just rescued by Brussels. It was forced into submission by Brussels. The eurozone could not afford to lose Greece, but neither could it afford to treat Greece like a full member of a real European union. If it had, then taxpayers in Germany, Italy and Spain would have been on the hook for Greece’s debts too. Thus is the inherent contradiction of the eurozone, and, more broadly, of the European Union. Brussels demands unity, but when tough decisions are made, it’s not the citizens of the eurozone who lose their pensions. In this case, it was the citizens of Greece. Greece’s crisis was not considered a European crisis – it was treated as a Greek problem that had to be quarantined.

The European Union’s stated purpose is “to share a peaceful future based on common values.” It is an exceedingly noble and fragile purpose – noble because peace is a virtuous end, and fragile because modern European history has been defined not by peace, but by centuries of internecine, genocidal and destructive conflicts. It is a purpose that some might argue is worth fighting and even sacrificing for. But when I second-guess my own pessimism about the long-term viability of the EU as a political project, I ask myself the question, “What would Europeans sacrifice to preserve the EU?” Today, it seems to me, the answer is that Europe sacrificed Greece. That is not a cause for celebration. It is the heroic delusion laid uncomfortably bare.

Pilot error

China is conducting fewer local policy experiments under Xi Jinping

Officials are increasingly scared to try new things

COME December, it will be 40 years since the Communist Party endorsed Deng Xiaoping’s proposal for reform. What followed was an economic transformation on a scale and at a pace that had never before been witnessed in human history. One of the secrets of Deng’s success was his encouragement of experimentation (see China section). He did not dismantle Mao’s disastrous “people’s communes” in one go. He did so over several years, allowing different places to try different methods. He turned a blind eye when local authorities allowed peasants to farm their own plots and sell their crops. When output soared, he made this official policy. In 1980, to the horror of Maoists, he set up “special economic zones” along the coast to carry out free-market trials. These too proved a success, and were eventually replicated nationwide.

Deng’s pragmatism helped rescue China from the dogmatic ditch into which Mao had forced it. His successors, though spooked by the collapse of the Soviet Union, kept experimenting even in the political realm in the 1990s and early 2000s. People in some places were even given a bit more leeway to choose local leaders in grassroots elections.

The freedom to tinker has never been unlimited, and various autocratic habits have undermined some experiments. One is secrecy. State media are often ordered to keep quiet about pilot projects in case they go wrong. Results can often be published only in classified journals; leakers face years in jail. If China’s experiments with a less draconian family-planning policy had been debated more openly after their launch in the 1980s, more heed might have been paid to their findings: that it was pointless (as well as cruel) to punish parents for having more than one child. Most wanted small families anyway.

Fear of trying

Nonetheless, as in any country, let alone one as vast and varied as China, a suck-it-and-see approach yields better results than deciding everything centrally. Alas, under President Xi Jinping, experimentation of any kind has become harder. In 2010—two years before Mr Xi took over—around 500 policy-related pilot projects were being carried out at the provincial level, reckons Sebastian Heilmann of the University of Trier in Germany. By 2016 the number had dropped to about 70.

One reason is fear. Since he came to power, Mr Xi has been waging a fierce campaign against corruption—sometimes justified, but brutal. Bureaucrats have become less willing to suggest experiments because anyone adversely affected by them might retaliate by accusing the reformers of graft. The other reason is to do with Mr Xi himself. The man who would be president-for-life has shown little interest in letting his subordinates do their own thing. When China-watchers call him “chairman of everything”, they are only half-joking.

Rather than stifling experimentation, Mr Xi should unleash it. Several areas are crying out for fresh thinking. Many state-owned firms are woefully inefficient. Why not privatise some and see what happens? Chinese farmers lack clear title to their land. Perhaps some places could try giving them property rights? Rural migrants are treated as second-class citizens in big cities, deprived of public services. If their grievances are not dealt with, they could destabilise China. Why not ask some of these cities to try scrapping the pernicious household-registration system that is the root cause of the migrants’ woes?

The worry is not just that fresh experiments with local democracy are all but unthinkable under Mr Xi. It is that countless good ideas of all kinds will never be tried, will never prove their worth and will never spread. Wise leaders recognise that they do not have all the answers. Does Mr Xi?

'Everybody Knew This Was Coming'

by: The Heisenberg

- Emerging markets have continued to melt down amid the crisis in Turkey and amid ongoing questions about the unwind of the carry trade in the face of Fed tightening.

- It's important to note that large asset allocators knew this was coming, but they had no choice but to contribute to the conditions that made it inevitable.

- There's nothing written in stone that says this has to spill over into U.S. stocks, but I think it's time for Jerome Powell to take a page out of Yellen's book.
Let's face it: virtually everybody knew this was coming. But in the frantic QE-inspired hunt for yield, nobody cared.

That's from the latest note penned by SocGen's Albert Edwards and he is of course talking about the ongoing trials and tribulations of emerging market assets (hereafter "EM" assets).
Albert's latest piece is longer than usual, and it has a kind of "where do I even start?" feel to it, which makes it similar in tone to a lot of the recent research on this subject. The overarching problem when it comes to writing for the institutional crowd and for professional investors more generally about the turmoil in EM is that with the possible exception of those who aren't old enough to understand the context, it's just an exercise in preaching to the choir. It's not that everyone was comfortable being herded into EM assets and various other carry trades, it's that increasingly, there was no choice.
Remember, when it comes to markets, "choice" and "selection" are two different things.

Deutsche Bank's Aleksandar Kocic talked about this at length back in January. By mid-2017, everything had converged one choice: harvest carry or go out of business, as AUM hits the exits thanks to underperformance. Here's how Citi's Hans Lorenzen put it in a note dated February 8, 2017:
When spreads are low, volatility is low and dispersion is low, a few basis points of carry can matter a lot to a fund’s percentile performance against peers. And against the short-term metrics by which performance tends to be measured many will struggle to forego the incremental carry – until a negative trigger becomes immediately obvious.
And so, asset allocators didn't really have choice", per se. As Kocic put in January, "free choice" was replaced by "free selection" form a set of options. Those options were simply different ways of expressing the same trade. The only thing that separated one from the other was the amount of carry on offer. Citi's Matt King summed this up neatly last November, writing that "trades and strategies which explicitly or implicitly rely on the low-volatility environment continuing, are becoming more and more ubiquitous."
That dynamic is in no small part responsible for overcrowding in EM assets. If you think back to a post I published here on May 19, I suggested that Jerome Powell was either not entirely cognizant of the situation or, far more likely, simply playing it down in order to try and verbally reassure markets in the face of a persistently hawkish Fed. Here's what Powell said at an IMF/SNB event in early May:
Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.
Obviously that isn't true. A charitable interpretation would be to say it's "mostly false". Here are some simple visuals:
(BIS, St. Louis Fed, SocGen)
Fed tightening is leading to a reversal of the dynamics described above. For instance, there are now actual "choices" again, with the quintessential example being USD cash. Here's what the above-mentioned Matt King wrote in a note dated Thursday:
The big trade during the years of QE and zero rates has been out of cash and into just about anything. Returns in 2018 are proving nothing like as good as in 2017.  
Rising volatility and meagre YTD returns are suddenly being complemented by renewed awareness of how single-name blow-ups can at a stroke wipe out months of carry. That sucking sound is the irresistible lure of 2.5% on $ cash – risk-free – pulling money from your asset class.
It's important to remember the role that U.S. fiscal policy plays in that equation. I've written exhaustively on this. Late-cycle fiscal stimulus and the prospect of tariffs driving up consumer prices are contributing to the Fed's propensity to lean hawkish. At the same time, the deluge of Treasury supply necessitated by the tax cuts and spending bill is colliding with Fed balance sheet rundown to force private investors to absorb more U.S. debt. That sucks liquidity out of the rest of the USD bond market. Just about the last thing you want, given the setup illustrated in the right pane shown above, is a dearth of liquidity in the USD bond market.
This setup would already be conducive to an unwind in the various carry trades that have proliferated in the post-crisis era and naturally, the weakest hands would be flushed out first.
Turkey is one of the weakest hands from a fundamental standpoint (i.e., large current account deficit and large reliance on foreign currency debt), which is why it isn't surprising that it's one of the first dominos to fall. Below, find a handy scorecard and the accompanying instructions for reading it from Nomura.
To arrive at an overall summary measure for each country, we first convert the values for vulnerability indicators into standardized Z-scores. We then take a weighted average of the six Z-scores for each country (we assign higher weightings to the current account and FX reserves) to arrive at our overall summary statistic (final column in Figure 1). The higher the Z-score, the larger the BOP risk. 
But again, asset allocators already knew this - all too well in fact, given that they were the ones who were forced into misallocating investor capital as developed market (hereafter "DM") central banks forced everyone down the quality ladder and out the risk curve.
That's what makes writing about this challenging if the audience is professional investors. If you're an analyst or a macro strategist, you have to talk about it because it's the only thing that matters in markets right now, but because asset allocators are fully apprised of what's going on by virtue of the fact that they were compelled to participate in creating the conditions for the unwind, reiterating the points is akin to rubbing it in. Here's Albert Edwards again from the same note cited here at the outset:
And this is always the problem while liquidity is washing through the financial markets because of loose money polices (usually centered around the Fed). Almost nobody is interested in heeding the pessimists and positioning of the inevitable financial market blow-up when eventually excessively loose monetary policy is belatedly tightened. Investors, drunk on the elixir of free money, think the good times will roll on forever. And even if they are cautious, a few quarters of underperformance usually invites either capitulation or being fired.

Albert has the luxury of being more blunt than most analysts, but that last point about being "fired", is just a more direct way of saying what Citi's Hans Lorenzen said in the 2017 note mentioned above and what Deutsche Bank's Aleksandar Kocic wrote in January when he said the "choice" between harvesting carry and going out of business isn't really much of a "choice."
But while everyone was well apprised of the inevitability of an unwind, what no one was quite prepared for was a scenario where that unwind would coincide with a series of geopolitical headwinds that have served to meaningfully exacerbate the situation and heighten the risk that the well telegraphed reversal of the carry trade will mushroom into something that turns systemic.
Those three geopolitical headwinds are as follows:
  1. the trade war
  2. the diplomatic row between the U.S. and Turkey and the concurrent power grab by Turkish President Recep Tayyip Erdogan
  3. the threat of sanctions on Russian sovereign debt
Without jumping too far down the rabbit hole on those three points, let me just add a bit of color on each.
The trade war threatens to undermine global growth and could weigh on the Chinese economy at a time when activity data is already decelerating. That's clearly negative for emerging markets as an asset class.
The diplomatic row between the U.S. and Turkey makes it potentially more challenging for Ankara to secure an IMF bailout (given Washington's sway over the institution) and also puts anyone who might otherwise be inclined to throw Turkey a lifeline in the awkward position of effectively undermining the U.S. at a time when the current administration is already at odds with most of the world on trade. Erdogan's move to install his son-in-law as economic czar and the concurrent decision to amend the central bank's articles of association to give himself more sway, mean the chances of an appropriately strong monetary policy response to the lira crisis are diminished.
The threat of U.S. sanctions on Russian sovereign debt (as proposed by U.S. Senators Lindsey Graham and Bob Menendez earlier this month) raises the specter of dramatically reduced non-resident participation in the OFZ market and a repeat of the rout in Russian assets that unfolded in April.
Those are all tail risks, and one of them has already come calling in the form of the collapse of the Turkish lira. A rout in the Russian ruble or a steep downturn in global growth would be highly destabilizing for EM given how concerned everyone already is about the space.
Allow me a brief tangent here in the interest of making a point about one of those tail risks.
Earlier this month, Citi ran a detailed simulation to try and predict where USD/RUB would trade in the event the Graham/Menendez bill gets traction on Capitol Hill. The bank's worst-case scenario was "about 70". The cross was at ~62.50 when Citi's analysis was published. As the Turkish lira plunged and the State Department imposed sanctions on Russia in connection with the the Skripal case, the ruble slid beyond 68.
People are always asking me for predictions and I'll oblige those folks here. If the U.S. sanctions Russian sovereign debt and the unfolding EM crisis doesn't abate before then (either due to a Fed pause, an IMF program for Turkey or a definitive break in the trade stalemate between the U.S. and China), the ruble will careen well beyond the "worst-case" scenario of ~70 and Russian assets more generally will come under more intense pressure than they did in April when the imposition of sanctions on Kremlin-aligned oligarchs led to a "Black Monday" for Russian equities.
Ok, panning back out to EM at the asset class level, you should note that the disconnect between U.S. stocks (SPY) is pretty dramatic. Here's the S&P versus EM stocks and EM FX:
And the following visual is implied volatility on the JPMorgan EM FX index relative to implied volatility on the G7 FX index:
What you see in that visual is basically just carry trades blowing up.
There is of course nothing written in stone that says U.S. equities can't continue to ignore what's going on in EM, but I would gently suggest that it's unlikely. One of the last remaining pillars of support for U.S. stocks is buybacks, and while Goldman recently raised their estimate for repurchase authorizations in 2018 to a record $1 trillion, SocGen's Andrew Lapthorne questioned not only the assumption that those announcements will actually manifest themselves in executions, but also the relative wisdom of the whole endeavor in a late-cycle environment.

Here's Andrew, from a note dated August 13:
We have written before on how announcing a buyback, but not actually carrying through with the buyback, has empirically been the best course of action for a company. So, seeing a high level of buyback announcements makes sense. What does not make sense is to assume that in the long-term this will be good for US equities. Yes, the overall pay-out ratio is high when you add buybacks to dividend payments, but a large chunk of this increase is being funded by cash from the balance sheet and the selling of liquid investment. Net Debt is therefore on the rise.
None of the above should necessarily be construed as an overtly bearish call in the near term.

Rather, I would echo JPMorgan's Marko Kolanovic in suggesting that now is the time for Jerome Powell's Fed to take a pause. This is playing out a lot like it did in 2015 and I think it would be wise for Powell to try and learn something from Janet Yellen's caution in September three years ago when turmoil in EM prompted the FOMC to delay "liftoff".
After all, if there's anyone who knows a thing or two about how to keep a rally going, it's Janet Yellen.